In early May, the EU submitted a letter to the U.S. Treasury Department and the IRS, suggesting that the foreign-derived intangible income (FDII) regime may violate international trade law. Introduced as part of the 2017 Tax Cuts and Jobs Act, the FDII regime is intended to incentivize U.S. businesses to operate domestically, and to maintain ownership of valuable intellectual property in the U.S., by reducing the tax rate on income derived in foreign markets. The EU's statements in the letter suggest that it may formally challenge the deduction through World Trade Organization (WTO) proceedings.
The FDII regime allows for a reduced effective tax rate of 13.125% on certain foreign-derived income (increased to 16.41% after 2026). EU countries first voiced concerns with the FDII regime before the law's passage in December 2017, but they awaited regulations interpreting the regime before taking further action. In the interim, the Office of the International Tax Counsel at the U.S. Treasury has informally defended the FDII regime and argued that it is intended to work in tandem with the global intangible low tax (GILTI) regime to neutralize tax as a driver of where to place intellectual property.
The May 6 EU letter disagrees with the Office of the International Tax Counsel and concludes that the FDII regime most likely is a financial export subsidiary that is prohibited by U.S. treaty obligations and the WTO Agreement on Subsidies and Countervailing Measures. This conclusion seems to rest mainly on the fact that the deduction is directly determined by income generated through exports rather than by all sales. As previously noted, the EU can formally challenge the FDII regime in the WTO, and the language in the May 6 letter suggests that the EU may be considering the commencement of such a challenge.
Impact of a WTO Challenge
Even if the FDII regime is challenged in the WTO, and the WTO ultimately rules against the U.S., the process may take years to reach a resolution. Experience with prior U.S. export tax incentives may be instructive. The Domestic International Sales Corporation (DISC) regime was first enacted in 1971; it was challenged through the GATT (predecessor to the WTO), but a ruling was not lodged against the U.S. until 1976. It was not until the EU started to introduce retaliatory tariffs years later that Congress finally repealed the DISC regime's successor legislation in 2004 as part of the American Jobs Creation Act.
How Venable Can Help
For U.S.-based businesses with current or anticipated foreign-source income, Venable's international tax team can help explore structuring alternatives that take advantage of the highly nuanced FDII regime, with an eye to structuring in and out of the regime in the event of a WTO challenge.