As lawmakers have considered changes to the tax code over the years, a few common principles have underpinned those efforts. First, they have wanted to create incentives to locate jobs in the United States. Next, they have wanted to encourage companies to perform their research and development (R&D) – which usually means high-paying jobs – domestically. Lastly, they have wanted to provide incentives for businesses to locate their intellectual property (IP) in the U.S.
The Tax Cuts and Jobs Act (TCJA) shared these goals. However, as its implementation has moved forward, it has become clear that some of those objectives are being unintentionally undermined. Specifically, a provision governing how taxpayers allocate their expenses for purposes of calculating their foreign tax credits will have a significant impact on where companies locate vital R&D activities, which could encourage businesses to look to invest and innovate outside of the United States. That’s why ITI recently sent a letter to the U.S. Department of the Treasury asking that it provide relief to ensure that R&D will continue to be performed in the United States to the greatest extent possible.
Research and development is the lifeblood of the tech sector. Innovation fuels the economy and is the force that has allowed our companies to create new global products and industries. The tech sector as a whole spends over $200 billion every year on R&D, meaning that how it is treated for tax purposes is especially important to tech companies. In determining how these expenses should be allocated, Treasury has an opportunity to meaningfully impact where businesses will choose to locate these activities.
Expense allocation is important because it assigns indirect costs, such as a company’s rent, utilities, or R&D costs, to particular streams of income for tax purposes. After TCJA, there are six relevant streams or “baskets” of income – U.S.-generated income; Foreign-Derived Intangible Income (FDII); foreign “active” general income, which includes amounts that may be fully exempt from U.S. taxes, but any foreign taxes attributable to those amounts are not eligible for foreign tax credits; foreign passive income (including Subpart F); foreign branch income; and Global Intangible Low-Taxed Income (GILTI), which represents higher-than-normal returns on foreign tangible assets, which are presumed to come from intellectual property.
The amount of income in each “basket” once expenses have been allocated and deducted dictates the maximum amount of foreign tax credits that can be taken against U.S. taxes on income in that basket. Less income in a basket means that fewer foreign tax credits can be taken – which makes it less likely that a business will be able to receive credit for all of the foreign taxes it has paid on that stream of income. The effect is severe with GILTI income, because those foreign tax credits are already subject to a 20 percent cut and also cannot be carried over to a subsequent year. If they can’t be used in a given year because a taxpayer’s limitation is too low, they are lost permanently. This increases the effective tax rate on those income streams.
Because requiring U.S.-based R&D expenses to be allocated to GILTI income would reduce the amount of income in that basket, it also has the effect of reducing the amount of foreign tax credits that can be taken against taxes on that income. Unfortunately, this would serve to offset or even eliminate the benefits of domestic incentives like the R&D Tax Credit and create an incentive for companies to locate their R&D functions and the associated jobs elsewhere. For many companies who perform R&D around the world, how these expenses are allocated for tax purposes is critical in determining where their R&D activities will be located. Accordingly, ITI believes that the goal of promoting U.S.-based R&D would be best served by not requiring R&D expense to be allocated to GILTI income, which we outlined in our recent letter to Treasury.
Incentives aside, ITI also believes that this is the right answer from a tax policy perspective. Under the current regulations, companies are required to allocate expenses solely to classes of income that can “reasonably be expected to benefit, directly or indirectly, from the taxpayer’s research expense.” The regulations further provide that expenses should be allocated in a manner that reflects the factual relationship between the deduction and grouping of income. For companies who own their IP in the United States, the U.S. parent company benefits from the R&D expenditures – not the foreign subsidiaries who may be licensing the U.S.-based IP from the parent. Generally speaking, these foreign subsidiaries are not directly or indirectly benefiting from the improvements or breakthroughs that the R&D results in because their functions are limited to areas like manufacturing and sales. Therefore, their income is based on performing those functions, not the value of the U.S.-based IP.
Additionally, the structure of GILTI was originally designed to prevent taxpayers from incurring residual U.S. taxes if they were paying an effective tax rate above 13.125 percent. However, because foreign tax credits under GILTI are so limited, many taxpayers will face higher rates and the risk of double taxation. Allocating R&D expense to GILTI income increases that risk, another reason why it would benefit the system overall to not require these expenses to be apportioned to GILTI.
ITI shares the goals of TCJA and we look forward to working with Treasury as it moves ahead with finalizing implementation of this important law to ensure that new regulations, as well as existing regulations affected by the new system, continue to incentivize businesses to innovate in the United States.