Whither FDII — OECD Discusses FDII in Harmful Tax Practices Update

On August 5, 2021, the OECD released updated Peer Review Results for preferential tax regimes reviewed by the OECD Forum on Harmful Tax Practices (“FHTP”) in connection with BEPS Action 5. Of particular interest to Multinational Enterprises (“MNEs”), the Peer Review Results report that the Foreign-Derived Intangible Income (“FDII”) regime is already “in the process of being eliminated” and that “the United States has committed to abolish this regime.”

The possibility that FDII might be repealed should come as no surprise given the Biden Administration’s Green Book proposal to eliminate FDII. And in any event, the repeal cannot actually take effect until and unless FDII is repealed by legislation. Nevertheless, for MNEs that would be adversely affected by the possible repeal, the references in the Peer Review Results send a strong signal that FDII repeal may be a key priority in future tax reform negotiations.

BEPS Action 5

OECD BEPS Action 5 focuses on “Countering Harmful Tax Practices More Effectively, Taking into Account Transparency and Substance.”  It is one of four BEPS Actions that constitutes a “minimum standard” for which all BEPS Inclusive Framework members (currently, 139 countries) are expected to comply. Of note, BEPS Action 5 requires BEPS Inclusive Framework members to spontaneously exchange rulings related to IP and other preferential tax regimes and to ensure that IP and other preferential regimes require a certain nexus between the IP-related income eligible for the regime and the performance of the R&D functions that generated the IP. Action 5 also requires certain no-tax and nominal tax jurisdictions to maintain a certain “substantial activities” requirement.

As a minimum standard, BEPS Inclusive Framework members’ compliance with Action 5 are subject to peer review by the FHTP. A 2018 Progress Report on Preferential Regimes released by the OECD in January 2019 indicated that FDII was under review by the FHTP, but no determination regarding FDII had been made at that time. Then on August 5, 2021, the OECD released updated Peer Review Results indicating that FDII is already “in the process of being eliminated” and that “the United States has committed to abolish this regime.”[1]

FDII

Enacted by the Tax Cuts & Jobs Act of 2017 (the “TCJA”), the FDII regime allows US corporate taxpayers to deduct 37.5% of their FDII-eligible income in taxable years 2018 through 2025, which results in a 13.125% effective rate (assuming a 21% corporate rate). For taxable years after 2025, the FDII deduction is 21.875% which, assuming a 21% corporate tax rate were to remain in effect, would bring the effective rate to 16.406%. For this purpose, FDII generally applies to income in excess of a 10% return on tangible assets earned by a domestic corporation from the performance of services or sales, leases or licenses of property to non-US persons for foreign use. FDII is calculated mechanically in this manner, and as such, is a deemed, not an actual, intangibles return that does not require that any intangibles be developed or even owned in the United States. It is for this reason that FDII was presumably subject to Action 5 review by the FHTP.

In the overall scheme of the TCJA, FDII was a “carrot” intended to incentivize US MNEs and US subsidiaries of foreign MNEs to bring intangible property held offshore back to the United States, or to otherwise structure operations to attribute foreign intangibles-related returns to the United States. FDII is the flipside of the Global Intangible Low-Taxed Income (“GILTI”) tax, that was (and still is) intended to dis-incentivize US MNEs from holding intangibles and attributing intangibles-related returns offshore.

Why this is Significant 

With the advent of the DEMPE standard in BEPS Action 8 and the need for MNEs to restructure out of “Double Irish” and “CV/BV” structures, a number of US MNEs repatriated IP back to the United States in reliance on the benefits of the FDII incentive. Upon repeal of FDII, these MNEs could face a significant effective tax rate increase (which may be disproportionately higher than that faced by other MNEs adversely affected by potential regular corporate and GILTI rate increases) unless they restructure again, likely at a significant tax cost.

The FDII regime was the latest in a long line of incentives in the US Internal Revenue Code designed to encourage US exports. These incentives included the domestic international sales corporation (DISC), the foreign sales corporation (FSC) and the extraterritorial income exclusion (EIE), each of which was disallowed as an illegal export subsidy by the WTO and its predecessor GATT. When FDII was enacted, a number of countries raised concerns that FDII was also an illegal export subsidy. While the Trump Administration believed that FDII passed muster under the WTO rules, some US MNEs were hesitant to put all their eggs in the FDII basket. The OECD FHTP’s review of FDII as a potentially harmful tax practice likely further contributed to this hesitancy.

This said, although the OECD Peer Review Results indicate that FDII repeal is already in process, it is not a done deal since the United States cannot actually repeal FDII without legislation passed by both houses of Congress. The Peer Review Results may provide further indication of the Administration’s already-known support for FDII repeal, but whether and when FDII is actually repealed — and whether it is replaced with any comparable IP incentives — is still to be determined. MNEs that avail of FDII, particularly those that restructured or made significant investments in the United States in reliance on FDII being in effect, should therefore closely monitor future legislative developments and maintain as flexible of approach as feasible to responding to these developments.

[1] FDII is one of 18 regimes for which updated results were presented in the updated Peer Review Results. It also provides a consolidated summary of results of the FHTP’s review of 309 preferential regimes to-date, of which 106 had been abolished as of April 2021.

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