Both the Biden administration and Congressional Democrats are pursuing significant changes to the way the U.S. taxes the foreign earnings of U.S.-based companies, with the Ways and Means Committee recently advancing major tax increases on foreign earnings to the full House of Representatives for further consideration.[1] While NTU is strongly opposed to the Ways and Means text, one under-the-radar change would mark a positive step forward for U.S.-based companies operating in multiple countries that previously faced net losses here at home.
We are opposed to provisions in Sec. 138121 of the Ways and Means bill that would significantly raise the effective tax rates on companies’ profits from foreign intangible income (Global Intangible Low-Tax Income, or GILTI) and on export income derived from U.S.-based intangible assets (which is taxed at a preferential rate after applying the Foreign-Derived Intangible Income, or FDII, deduction).[2] Sec. 138121 would raise the GILTI rate from between 10.5 percent and 13.125 percent to between 16.6 percent and 17.5 percent. It would raise the FDII rate from 13.125 percent to 20.7 percent. However, on a positive note, the section would also allow GILTI or FDII deductions for companies with domestic net operating loss (NOL) carry-forwards, an important change that has escaped the notice of some tax policy experts amidst hundreds of pages of new and significant tax legislation.
Here’s how the Committee explains that change in their section-by-section (emphasis ours):
“This provision reduces the section 250 deduction with respect to both FDII (to 21.875%) and GILTI (to 37.5%). In combination with the proposed 26.5% corporate rate, this yields a 16.5625% GILTI rate and a 20.7% FDII rate. If the section 250 deduction with respect to GILTI or FDII exceeds taxable income, the excess is allowed as a deduction, which will increase the net operating loss for the taxable year.”
What does this mean in practice? It means that a company with a prior domestic loss but foreign earnings abroad could access the preferential GILTI rate (16.6 percent if the Ways and Means proposal passes), rather than being taxed at 26.5 percent under the new proposal and losing the ability to carry their loss forward to a future tax year.
Why is this change important? That requires a quick overview of why NOLs are a vital feature of the corporate tax code, and how the GILTI regime as originally enacted in 2017 failed to provide equal treatment to companies with domestic profits and companies with domestic losses.
Under current corporate tax law, companies with net operating losses in a given year can be carried forward to a future tax year and offset tax liabilities from net profits in that future year. This principle is important because, as the nonpartisan Congressional Research Service (CRS) has put it:
“Economic theory suggests that, under certain conditions, symmetrical tax treatment of gains and losses can reduce the distorting effects of taxation on investment decisions and, in turn, increase economic efficiency.”
The Tax Cuts and Jobs Act (TCJA) made several changes to the tax treatment of NOLs, prohibiting corporate taxpayers from carrying NOLs back to a prior profitable year, but allowing indefinite carry-forwards of NOLs.[3] TCJA also limited NOL offsets from a prior year to no more than 80 percent of taxable income in any given year (which makes the indefinite carry-forward all the more important for U.S. companies). The CARES Act expanded NOLs for a temporary period in an effort to provide some liquidity to companies struggling with COVID-related losses.[4]
Unfortunately, the current international tax system -- in place since the passage of TCJA in 2017 -- inadvertently treats U.S. multinational companies (MNC) with domestic losses in a different and more discriminatory way than MNCs with domestic profits.
If a U.S.-based MNC has profits in both the U.S. and abroad, they will be typically taxed on their domestic profits at a rate of 21 percent and on their profits earned abroad at a rate of 10.5 percent (which includes effective foreign tax rates). On the other hand, a U.S.-based MNC with domestic losses that outstrip their foreign earnings could be taxed at a rate of 21 percent on their profits earned abroad, rather than 10.5 percent, while also being denied a NOL that can carry forward and offset domestic tax liability in a future year. It’s a double whammy for certain companies that may take losses due in part to significant investments made in the U.S.
BKD, a U.S. accounting firm, explains further (emphasis ours):
“Where a domestic corporation has an NOL carryforward, the GILTI deduction under Internal Revenue Code (IRC) Section 250 is limited to 50 percent of taxable income after the NOL. If the NOL completely wipes out taxable income, GILTI will eat into the NOL dollar for dollar—no 50 percent reduction.”
And Tax Foundation’s Daniel Bunn demonstrates the interaction with an example:
“If the U.S. company runs a loss of $100 on its U.S. operations, it would usually be able to claim that loss against future tax liability and save $21 in future taxes (assuming a 21 percent corporate tax rate).
However, if that same company has enough profits abroad that it has $300 in earnings subject to GILTI, the situation changes. Instead of being able to claim the full 50 percent Section 250 deduction (which, in this case would be $150), the company is required to use its U.S. losses first before using the Section 250 deduction. The company’s GILTI tax base is reduced to $150 by first applying the $100 domestic loss and then $50 remaining from the Section 250 deduction.
Rather than having the $100 loss to offset future tax liability and the $150 Section 250 deduction against GILTI, the company loses its loss offset and part of the value of its Section 250 deduction. The $21 value of the loss offset has been used up against GILTI, and future tax liability for that company will rise by that same amount.”
And here is a version of Bunn’s example visualized in a table comparing two scenarios: 1) a U.S. company’s tax treatment if they have GILTI and no domestic NOL carry-forward, 2) a U.S. company’s tax treatment if they have GILTI and a domestic NOL carry-forward:
|
| U.S. Company With No Domestic NOL, GILTI (Current Law) | U.S. Company With Domestic NOL, GILTI (Current Law) |
Year 1 | Domestic Net Income | $100 | -$100 |
Taxes on Domestic Income | $21 ($100 * 21%) | $0 | |
GILTI | $300 | $300 | |
GILTI Deduction | $150 ($300 * 50%) | $150 ($300 * 50%) | |
GILTI Deduction After Applying Domestic NOL | N/A (No NOL) | $50 ($150 GILTI Deduction - $100 NOL) | |
GILTI Taxes | $31.50 ($150 * 21%) | $31.50 ($150 * 21%) | |
Total Domestic and GILTI Net Income | $400 | $200 | |
Total Tax on Domestic and GILTI Income | $52.50 ($21 + $31.50) | $31.50 | |
Effective Tax Rate | 13.125% | 15.75% | |
Year 2 | Domestic Net Income | $100 | $100 |
Taxes on Domestic Income | $21 ($100 * 21%) | $21 (100 * 21%) | |
GILTI | $300 | $300 | |
GILTI Deduction | $150 ($300 * 50%) | $150 ($300 * 50%) | |
GILTI Deduction After Applying Domestic NOL | N/A (No NOL) | N/A (No NOL) | |
GILTI Taxes | $31.50 ($150 * 21%) | $31.50 ($150 * 21%) | |
Total Domestic and GILTI Net Income | $400 | $400 | |
Total Tax on Domestic and GILTI Income | $52.50 ($21 + $31.50) | $52.50 ($21 + $31.50) | |
Effective Tax Rate | 13.125% | 13.125% | |
Years 1 + 2 Combined | Total Domestic and GILTI Net Income | $800 | $600 |
Total Tax on Domestic and GILTI Income | $105 | $84 | |
Effective Tax Rate (across Years 1 + 2) | 13.125% | 14% |
As the table above demonstrates, two companies with GILTI would pay different effective tax rates on their combined domestic and GILTI income across a two-year period solely based on whether or not the company had net loss carry-forwards in the U.S.[5] That was not the intention of GILTI.
The Ways and Means legislation would fix this, treating domestic companies with net GILTI the same way whether they have domestic NOL carry-forwards. This change helps to avoid punishing companies that choose to invest in the U.S. (and, as a result, have net operating losses here at home). The Senate Finance Committee should adopt this particular provision of the Ways and Means bill as they consider international tax changes.
[1] See page 6 of the linked JCT estimate. The changes to the Global Intangible Low-Tax Income (GILTI) and Base Erosion and Anti-Abuse Tax (BEAT) regimes, along with proposed changes to the Foreign-Derived Intangible Income (FDII) deduction, would raise revenues by a net $257 billion over 10 years, according to the Joint Committee on Taxation (JCT).
[2] The U.S. taxes GILTI in an effort to capture the foreign profits U.S.-based multinational companies earn on highly valuable, highly mobile intangible assets, such as patents, trademarks, and other intellectual property. Rather than assess (or require companies to assess) a direct, annual measure of foreign profits earned from intangibles, the U.S. calculates GILTI by measuring net income from the controlled foreign corporations (CFCs) of a U.S.-based multinational company and exempting a 10-percent return from the value of tangible assets (the Qualified Business Asset Investment, or QBAI, carve-out). The U.S. taxes FDII at preferential rates in an attempt to incentivize the onshoring (and retention) of intangible assets in the U.S., by taxing export income derived from U.S.-based intangibles at a lower rate than regular income. For more, read the following from NTU: “What’s the Deal With International Tax Reform?”
[3] Before that, there were two-year carry-back and 20-year carry-forward limits. See this CRS report for more details.
[4] The CARES Act allowed business losses in 2018, 2019, or 2020 (the three years succeeding passage of TCJA) to be carried back up to five years, including to years when the corporate tax rate was 35 percent rather than 21 percent after TCJA. CARES also lifted the limits on NOL offsets, allowing NOLs carried back or forward to offset up to 100 percent of taxable income for a given year (rather than 80 percent). JCT estimated these changes would reduce revenues by $160.5 billion over 10 years. For more, see this CRS report.
[5] The company with domestic NOLs would be subject to a higher effective tax rate even though 100 percent of their net income is attributable to GILTI rather than domestic income, and GILTI is taxed at the preferential 10.5-percent rate (rather than the 21-percent rate on domestic profits). The company with no NOLs, on the other hand, can attribute 25 percent of their next income to domestic sources taxed at the 21 percent rate, meaning their effective tax rate should be higher than the company with NOLs in this scenario.