The 2017 Tax Cuts and Jobs Act (TCJA) made sweeping changes to the Internal Revenue Code (Code). When coupled with the implementation of the various Action Items included in the OECD’s Base Erosion and Profit Shifting (BEPS) initiative, life sciences multinationals responded by making major changes to their supply chains and structures for holding and exploiting intellectual property (IP).
The Biden administration has proposed significant changes to the Code that would increase the corporate income tax rate, alter the mechanics for taxing foreign income and eliminate incentives included in the TCJA designed to encourage US multinationals to hold and relocate IP back to the United States. Moreover, the Biden proposals are intended to influence the OECD’s Pillar One and Two process by forcing consideration of a global minimum tax standard. As a result, life sciences companies, many of whom have only recently come to grips with the changes wrought by TCJA, will need to revisit their planning.
TCJA, BEPS and the Life Sciences Industry
TCJA and the OECD’s BEPS initiative forced life sciences multinationals to make significant changes to their supply chains and international tax structures. BEPS Action 8 essentially required life sciences companies to relocate IP to a location where the multinational had sufficient substance. Action 8 created the “DEMPE” standard for determining whether sufficient substance existed. Action 8 has been interpreted to mean that a company is only entitled to a premium return for the use of IP if that company had sufficient functionality relating to the Development, Enhancement, Maintenance, Protection and Exploitation of IP. As a result of Action 8, many multinationals moved IP to locations where DEMPE functions existed or could be placed.
At the same time, US life sciences multinationals were grappling with the changes brought about by TCJA—in particular, new rules for taxing foreign income. While ostensibly moving toward a participation exemption system, under the new global intangible low-taxed income (GILTI) regime, income of a controlled foreign corporation (CFC) became subject to current US taxation even if such income was not otherwise subject to tax under existing anti-deferral measures (i.e., subpart F).
Corporate taxpayers were allowed a 50% deduction on their GILTI income, making the effective rate of tax on GILTI income 10.5%. Taxpayers were also entitled to an 80% foreign tax credit (without carryover) for foreign taxes attributable to the GILTI income. In theory, as long as the effective rate of foreign tax on GILTI income was at least 13.125%, there should be no residual US tax after taking into account the foreign tax credit. In practice, however, this often does not hold true as a result of the expense allocation rules and the inability to carryforward foreign tax credits in the GILTI basket. In some cases, but not always, the elective “high tax exclusion” permits taxpayers to avoid the US residual tax on high-taxed GILTI that may otherwise result from the application of the expense apportionment rules.
Another feature of TCJA was the enactment of the foreign-derived intangible income (FDII) regime which provided a tax incentive for the exploitation of IP owned in the United States. The FDII incentive is a 37.5% deduction on foreign derived intangible income, in general income earned from sales of property or services for foreign use above a fixed return on tangible property. The 37.5% deduction equates to an effective rate of tax of 13.125%, comparable to a combined US and foreign tax rate on moderately taxed GILTI income.
As a result, life science companies looking to relocate IP in light of Action 8 could consider a number of countries that had relatively low tax rates but still high enough to offset a GILTI inclusion. Ireland, Switzerland (particularly after Swiss tax reform), Singapore, the Netherlands and the United Kingdom were common destinations for post-BEPS, post-TCJA restructuring. At the same time, the FDII incentive also led multinationals to consider relocating IP back to the United States (or owning newly developed IP in the United States), especially in cases where the multinational would not be able to establish sufficient DEMPE substance elsewhere. Life sciences companies (among others) were lured by the FDII incentive to relocate IP back to the United States. All of this decision-making occurred in the context of the newly lowered corporate tax rate to 21%.
Overlaying GILTI, FDII and the reduced corporate income tax rate was the enactment of BEAT, the base erosion anti-abuse tax. BEAT acts as a corporate minimum tax by recalculating taxable income but excluding deductions for payments made to foreign related parties. BEAT hits life sciences companies particularly hard in that it may deny deductions for certain royalties paid to related parties as well as payments to related parties for certain services performed outside the United States. For example, life sciences companies routinely engage foreign contract research organizations (CROs) to conduct clinical trials outside the United States. Often, a foreign subsidiary in the group is engaged to consolidate CRO relationships. Prior to the enactment of BEAT, the US parent company would reimburse the foreign subsidiary for third-party CRO costs plus a mark-up. BEAT can deny the US parent a deduction for the reimbursement payment to the foreign subsidiary.
As a result of these BEAT concerns, many life sciences companies restructured their supply chains and changed their contractual relationships with CROs and other vendors. This often resulted in considerable upheaval as new vendor contracts needed to be agreed to and accounting systems updated.
Not surprisingly, therefore, the last three years have been particularly challenging for the tax departments of multinational life sciences companies. The Biden proposals and the potential knock-on effect on global tax rates have the potential of forcing life sciences companies to rethink much of their planning.
The Biden Proposals
On March 31, 2021, the White House released a “Fact Sheet” describing President Biden’s American Jobs Plan, a broad jobs and infrastructure plan. The Fact Sheet includes a high-level summary of the Made in America Tax Plan which would pay for the American Jobs Plan through corporate tax reform and by changing or eliminating altogether many of the international tax provisions enacted under TCJA that primarily impact multinationals.1 On April 7, 2021, the US Treasury (Treasury) released a report providing greater detail on the Made in America Tax Plan (Treasury Proposal together with the Fact Sheet, the Biden Tax Plan).2 Finally, on April 8, 2021, Treasury released its presentation to the Steering Group of the OECD/G20 Inclusive Framework on BEPS summarizing aspects of the Biden Tax Plan and proposing changes to OECD’s Pillar One and Pillar Two initiatives (the “US Proposal”). When reading these three documents together, the contours of the Biden Tax Pan—the goal of which is said to be to make American companies and workers more competitive by eliminating incentives to offshore investment, substantially reducing profit shifting and countering competition on corporate tax rates—begin to take shape.
Concurrently, on April 5, 2021, Senate Finance Committee Chairman Ron Wyden (D-Ore.) and Senators Sherrod Brown (D-Ohio) and Mark Warner (D-Va.) released a framework for “Overhauling International Taxation” (the SFC Framework) which is said to ensure that multinational corporations pay their fair share of US corporate income tax.3
We describe the proposed changes to US tax law, the United States’ shift in policy vis-à-vis OECD’s Pillar One and Pillar Two Blueprints, and the potential impact these proposed changes may have on companies in the life sciences industry and the structuring undertaken in response to TCJA.
Increased Corporate Rate
The Biden Tax Plan proposes increasing the federal corporate income tax rate to 28% from TCJA’s 21% in order to fund US investments in infrastructure, clean energy and research and development. Notably, the SFC Framework does not propose a change to the corporate rate, but does recognize that any changes to the GILTI rate will depend on the corporate rate. Recently, President Biden made it clear that he is open to compromise on the rate, and it is possible a 25% rate, an approximate of the global average corporate income tax rate, or other corporate income tax rate could be agreed upon.
Changes to the GILTI Regime
The Biden Tax Plan reiterates a campaign proposal to (1) increase the rate on GILTI to 21% (75% of the proposed 28% corporate rate) from 13.125% (10.5% through 2025),4 (2) apply GILTI to a US shareholder’s earnings and foreign taxes on a country-by-country basis rather than in an aggregate basket, and (3) eliminate the exemption from GILTI for deemed returns equal to 10% of a CFC’s foreign depreciable tangible assets (“qualified business asset investment” or “QBAI”).
The SFC Framework supports increasing the GILTI rate, but whether it equals the US corporate tax rate or remains a lower proportion of the corporate rate, e.g., 75% (which would result in GILTI of 18.75% assuming a 25% corporate rate), is an open question. The final determination likely depends on changes to the US corporate rate, base stripping protections and other incentives or disincentives for US and foreign investment.
The SFC Framework states that requiring GILTI to be calculated on a country-by-country basis would prevent taxpayers from offsetting, through foreign tax credits, high-tax income generated from operations in major economies (such as Germany and Japan) with income from intangibles in low-tax jurisdictions. Two options to effect a country-by-country determination are presented in the SFC Framework—(1) expand the existing system for foreign tax credits to have separate GILTI “country baskets” for each country in which a company operates or (2) divide global income into low-tax and high-tax categories and apply GILTI only to the income in the low-tax income category. Income from high-tax jurisdictions would be excluded from GILTI through the use of a mandatory high-tax exclusion (i.e., if a corporation paid taxes in a foreign at an effective rate above the GILTI rate, the corresponding income would be excluded from GILTI).
Elimination of FDII
FDII has been criticized as an ineffective incentive because it only applies above a 10% return on tangible assets. As a result, according to the Biden Tax Plan, it encourages US multinationals to move assets or make new investments abroad so as to increase the amount available to be deducted as FDII. The Biden Tax Plan would eliminate the FDII regime in order to no longer incentivize offshoring of assets and instead reform how the Code promotes and encourages new research and development in the United States. The Fact Sheet proposes to use the revenue from the repeal of the FDII deduction to provide other incentives for R&D.5
The SFC Framework proposes replacing the “deemed intangible income” concept with a metric referred to as “deemed innovation income” (DII) which would be an amount of income equal to the share of expense for innovation spurring activities that occur in the United States, such as research and development and worker training. The incentive would be designed to encourage continual innovation as current year spending would determine the benefit rather than prior year spending. FDII would be renamed foreign derived innovation income.6
After the enactment of TCJA and in response to BEPS Action 8, life sciences companies made critical decisions with respect to how they hold and exploit IP. Many relocated IP to DEMPE compliant locations and became subject to tax under GILTI. The proposed changes to the GILTI regime change that calculus. Now that IP is located in a DEMPE compliant country, even if a life sciences company wanted to relocate IP again in response to the Biden proposals, there would likely be some form of exit tax or other tax consequences on the movement of the IP out of the foreign country.
As discussed above, some life sciences companies were lured to relocate IP back to the United States because of the FDII incentive. FDII was intended to reward this “good taxpayer behavior.” A repeal of FDII could be viewed by some as a “bait and switch” because a taxpayer that repatriated IP in response to FDII cannot simply move it back offshore to a DEMPE compliant location without triggering US tax consequences under sections 367(d) and 482.
A different approach to the perceived flaws in FDII would be to eliminate the 10% QBAI floor and allow FDII to apply on all foreign-derived income without regard to the location of tangible assets. Elimination of QBAI would complement the repeal of the 10% QBAI base in the proposed revisions to GILTI and move away from the presumption in TCJA that the GILTI regime should focus only on excess profits and not capture routine returns. Retaining FDII would keep open the option for a life sciences company to keep IP in the United States and relocate IP back to the United States in response to the proposed changes to GILTI.
Repeal and Replacement of BEAT
The Biden Tax Plan proposes to repeal BEAT and replace it with “SHIELD” (Stopping Harmful Inversions and Ending Low-tax Developments). SHIELD would deny multinational corporations US tax deductions for related party payments subject to a low effective rate of tax, which would likely be defined relative to the rate that is ultimately agreed upon in Pillar Two or, if no multilateral agreement has been reached, then with reference to the new GILTI rate discussed above.7 SHEILD’s two significant differences from BEAT are that it would (1) apply to the first dollar of related party payments, as opposed to the 3% threshold that applies to life sciences companies now under BEAT, and (2) apply to all forms of related party payments, including reductions in gross income (i.e., cost of goods sold), such that it would include more than the deductible payments currently captured under BEAT. Is also possible that SHIELD, a rather blunt denial of deductions, could be structured to apply in a manner analogous to the complex undertaxed payments and subject to tax rules being considered as part of the OECD’s Pillar Two proposal.
As noted above, many life sciences multinationals made significant changes to their supply chains and vendor relationship to eliminate payments that would be subject to BEAT. In many cases, those payments would have been made to related parties in countries with sufficient rates of tax so as to escape the application of SHIELD. If SHIELD is enacted, life sciences companies will need to consider whether to unwind the changes made in response to BEAT or leave their systems in place notwithstanding the fact that payments may not result in additional tax under the SHIELD regime.
Proposed Changes to Pillar One and Pillar Two
In the US Proposal, the US government expressed support for the OECD’s Pillar One and Pillar Two initiatives, but proposed significant changes. Very generally, Pillar One proposed a “new taxing right” designed to ensure that multinationals pay tax on residual profits earned from activities in jurisdictions where they lack sufficient presence under existing tax rules. Pillar One was designed to apply to consumer facing and automated digital service businesses. The US Proposal would broaden Pillar One’s scope to cover all businesses without exception and would simplify Pillar One by limiting its application to “no more than 100” multinationals. The intent of the proposal is that the largest companies (the most profitable, the ones that benefit the most from global markets, that are the most intangibles-driven, and that are best equipped to handle the compliance burden) would be subject to the tax regardless of industry classification or business model.
The US Proposal would employ a two-step test to narrow the field to those top companies. First, a proposed revenue threshold would need to be met—possibly as low as $20 billion has been mentioned in the press. Such a threshold would capture many more than the top 100 multinationals as $20 billion in revenues is the equivalent of company #500 on the Fortune Global 500 list. The second threshold would consider profit margin. Over 25 life sciences companies would be included based on a $20 billion revenue threshold and most of those 25, in particular those in the pharmaceutical sector, would likely be included in this newly envisaged scope of Pillar One based on profitability.
The Biden administration says limiting the scope based on these criteria would have the effect of reaching multinationals that are the most intangible driven and have the highest profit-shifting potential. The US Proposal notes that following such an approach would highly reduce the need for business line segmentation, suggesting that limited exceptions to Pillar One may not be entirely off the table for large multinationals. As a result, both US and non-US multinationals would be subject to the Pillar One tax which would have the impact of addressing previous commentary that Pillar One inherently discriminated against US tech companies.
With respect to Pillar Two’s global minimum tax regime, the US Proposal expressed a “wish to end the race to the bottom” on corporate taxation and strong support for the shareholder level “top-off” or minimum tax (and backup UTPR and subject to tax rule) that generally would apply in respect of the income of a subsidiary not subject to a minimum level of taxation. However, under the US Proposal the minimum tax would be 21% (instead of the often-discussed but unspecified lower rate, such as 12.5%). Further, the US Proposal makes reference to the Biden Tax Plan without much detail but suggests those amendments to GILTI (i.e., repeal of exemption from US income tax to the extent of 10% of a subsidiary’s QBAI) should likewise be made to the Pillar Two Blueprint proposal to exclude from the “top-off” tax a percentage of payroll expense and depreciation of tangible assets of a subsidiary. This is a key point of friction between the Biden administration’s proposed changes to GILTI which would repeal QBAI versus the discussions within the OECD, welcomed by many, that would actually expand that analogous concept to include an allowance not only for tangible assets but for labor as well.
As noted, a tax rate of 12.5% has often been discussed as a suggested global minimum tax. This is due in large part to the fact that Ireland’s corporate income tax rate is 12.5%. In fact, when the contours of TCJA were first being developed, the effective rate of tax needed to enable a full foreign tax credit offset to GILTI was a foreign tax rate of 12.5% (in the first versions of the TCJA bill, the effective US tax rate on GILTI would have been 10%). Many observers believed that GILTI was designed to ensure that US multinationals with substantial operations in Ireland would be able to fully offset GILTI with Irish taxes.
A global minimum rate of 21% could force Ireland to raise its corporate rate considerably, making it much less competitive. In response to the US Proposal, the Irish finance minister recently reiterated the country’s support for its 12.5% tax rate.8 It can be expected that Ireland will strongly resist a global minimum tax rate above 12.5%. Many life sciences companies have substantial operations in Ireland and will be monitoring the debate on this issue closely.
It is quite likely that the corporate income tax rate will increase as well as the effective tax rate on foreign income. How these increases come together will depend on what will surely be a multitude of compromises made during the legislative process. Because life sciences companies are inherently global and much of their profitability derives from IP, each of the proposed changes in the Biden Tax Plan together with the re-scoping of Pillar One and the push for a global minimum tax rate has the potential to hit the industry hard.
1 https://www.whitehouse.gov/briefing-room/statements-releases/2021/03/31/fact-sheet-the-american-jobs-plan/ (last accessed, Apr. 6, 2021).
2 https://home.treasury.gov/system/files/136/MadeInAmericaTaxPlan_Report.pdf (Last accessed, Apr. 14, 2021).
3 https://www.finance.senate.gov/chairmans-news/wyden-brown-warner-unveil-international-taxation-overhaul- (last accessed, Apr. 6, 2021).
4 Effective tax rate derived from the Section 250 deduction equal to 50% (reduced to 37.5% in 2026) of the US corporation’s GILTI income (including the Section 78 gross-up for foreign taxes attributable to the GILTI inclusion).
5 Other incentives for R&D also factor into the calculation of the Biden Tax Plan’s new minimum tax of 15% on book income. The minimum tax would be in addition to a corporation’s regular federal tax liability, but could be reduced by R&D credits.
6 The SFC Framework notes that if FDII remains in the Code, the GLITI and FDII rates should be equalized. Currently through 2025, GILTI is taxed at an effective rate of 10.5% and FDII is taxed at an effective rate of 13.125%.
7 The SFC Framework discusses reforming BEAT by adding a second rate bracket in addition to the current 10% rate such that “regular taxable income would still be subject to a 10% rate, while base erosion payments would be subject to a higher rate.” Additional revenue could be used to restore the value of domestic tax credits and modify how the BEAT limits foreign tax credits.
8 Speech by Minister for Finance, Paschal Donohoe TD, to Virtual Seminar on International Taxation with the Department of Finance (Apr. 21, 2021). http://paschaldonohoe.ie/speech-by-minister-for-finance-paschal-donohoe-td-to-virtual-seminar-on-international-taxation-with-the-department-of-finance/ (last accessed Apr. 26, 2021).