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Treasury & Taxation

Europe Not Loving Parts of US Tax Reform

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January 26, 2018

EU objects to at least two parts of the new law saying it violates global agreements

IRS and dollarDonald Trump’s new tax rules run counter to resolutions from the G-20 and the OECD and make the US a tax haven, according to the EU and others. European regulators have objected to at least two different aspects of US tax reform.

One involves a reduced tax rate of around 10% on companies’ global income from patents and licenses. This, according to reports, conflicts with agreed-to tax rules. The other issue involves “foreign derived intangibles income” (FDII), which is defined as all income generated from property sold, leased or licensed by a US corporation to any person that is not a US person. 

The first issue surrounding the licensing means that if an MNC has large US operations, then the US subsidiaries for the most part are subject to a 10% minimum tax on the amount of any “base erosion tax benefits” they derive from transactions with non-US affiliates. This is part of the tax bill’s base erosion and anti-abuse tax (BEAT) provision, which applies to non-US corporations that derive US business income or gains, including US real property income or gains that are taxed to them as US business income.

Before the tax reform, MNCs would often set up their formal headquarters in a low-tax country, like Bermuda, and assign their intellectual property to that headquarters. It would then write contracts requiring all the company’s foreign subsidiaries to pay an inflated licensing fee for the use of intellectual property. By reducing the tax to 10%, the US becomes that low-tax country for MNCs to establish themselves in.

European regulators, particularly the German Finance Ministry, say this is a “patent box” scheme. Patent boxes are set up to attract innovation to countries by reducing the tax rate on income from intellectual property assets. Critics of the new US tax rules say the US structured the tax in order to repatriate income from abroad and tax it in the US at a much lower rate. This they say violates OECD standards and could force the US into the EU's tax haven “blacklist” penalty box.

As for the FDII, the new US tax rules provide a “rate benefit” or deduction for a US MNC’s income derived from serving non-US markets. From now to 2018, US MNCs will be taxed at a 13.1% rate on its FDII; then from 2018 through 2025 the rate increases to 16.4%. In the previous tax regime, royalties paid to a unit in the US would have been taxed like other US. income, which was the top corporate tax rate of 35%. The FDII deduction is considered the “carrot and stick” approach for incentivizing US-based companies to increase their US operations relative to non-US operations. This carrot also includes global intangible low-taxed income (GILTI), which stipulates that a US parent is entitled to a credit against US income tax, for 80% of the total amount of non-US income taxes that it and its subsidiaries pay on their GILTI. This means from 2018 to 2025, a US parent will pay no US income tax on its GILTI, provided the effective rate of non-US tax imposed on such income is at least 13.1%.

European critics of the provisions say that that incentivizing US MNCs to locate more of their assets and operations used in serving overseas markets back to the US go against international tax agreements. They also speculate that this would subsidize exports and could face challenges as an illegal export subsidy under World Trade Organization (WTO) rules.

But this impact of this could be limited, according to a paper written by Philip Wagman, Richard Catalano and Alan Kravitz of Clifford Chance. “It is unclear how strong this incentive will prove to be: sales to overseas customers made by a non-US subsidiary of a US parent generally are subject to US tax under GILTI at a 10.5% rate (13.1% after 2025),” they write. In other words, that is “2.6 percentage points lower than the rate imposed on the US parent’s FDII. Also, it has yet to be determined whether the FDII rules comply with international trade agreements.”

Whether the tax reform still “contains elements that risk seriously hampering trade and investment flows between” Europe and the US and lead to “unfair trade practices or discrimination that would appear to be incompatible with WTO rules and other international commitments taken by the US,” as four EU commissioners have previously suggested in a letter to US Treasury secretary Steven Mnuchin, remains to be seen. The US has yet to respond to the European criticism, although it is reported that the US says the reforms pass the WTO smell test.

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