Tax reform provides planning opportunities for German-owned companies
By using the new Foreign Derived Intangible Income (FDII) regime as well as the decreased federal corporate income tax rate German owned U.S. corporations may be able to significantly reduce the group’s overall tax burden where eligible functions such as research and development or certain services are relocated to the U.S.
Corporate taxation under the Tax Cuts and Jobs Act
Historically, the U.S. has been known for its high effective corporate tax rate relative to other developed countries, as well as its “worldwide” system of taxation on foreign-sourced income. The Tax Cuts and Jobs Act makes significant reductions to the rate as well as major changes to taxation of foreign income.
The centerpiece of the act and its touted benefits to corporations is that the U.S. federal corporate tax rate is decreased from 35 percent to 21 percent. Historically, the high corporate tax rate in the United States has provided an incentive for multinational businesses to minimize profits attributable to their U.S. affiliates, which is often accomplished through transfer pricing mechanisms such as royalty payments.
The greatly reduced U.S. corporate rate dramatically changes the arbitrage equation, as it is now likely more tax-favorable on a worldwide basis in many cases to earn a dollar of income in the United States than in a foreign country where rates may exceed the new lower rate.
In addition to the reduction of the general federal corporate tax rate, the tax reform provides further incentives for multinational businesses to generate revenue in the U.S. For German companies, being subject to an average corporate income taxation of 30.18 percent (OECD statutory corporate income tax rates 2017), the new rules provide a strong planning opportunity to reduce the group’s overall tax burden by restructuring the U.S. subsidiary’s functions and activities.
Foreign Derived Intangible Income taxed at 13.125 percent
The reform establishes a new tax regime for so-called FDII which acts as a taxpayer-favorable counterpart to anti-deferral rules for Global Intangible Low-Taxed Income (GILTI). Under new section 250(a)(1) of the Internal Revenue Code, the FDII rules are an incentive for U.S. companies to sell goods and provide services to foreign customers. Qualified income from the sale of goods and services abroad is effectively taxed at a rate of 13.125 percent rather than 21 percent.
The reduced rate is applicable to the company to the extent the domestic entity has certain types of foreign service or sales destination income and the profits of the domestic entity exceed a level above an average return on its tangible qualified business asset investments (10 percent).
The FDII rules apply to taxable years beginning after Dec. 31, 2017 and is reduced to an effective tax rate of 16.4 percent in taxable years beginning after Dec. 31, 2025. Further guidance is expected from the IRS to explain the operations of this new regime.
German tax implications
From a German tax perspective – either as the source country of FDII or as the U.S. company’s German parent’s country of residence – the tax implications depend on the qualification of FDII under German laws.
As far as FDII is based on the foreign use of IP, the IP needs to be the result of research and development activities based in the U.S. Otherwise FDII payments may not be deducted as business expenses on the German source company level or the payments could be subject to German CFC-rules on the German parent company level.
As far as FDII is based on services, which are part of the U.S. company’s ordinary business, the company can basically benefit from the FDII rules without negative tax implications in Germany. Naturally, transactions between related parties need to be in accordance with the so called arm’s length principle and general transfer pricing guidelines.
This article originally appeared in GACC Legal and Tax Newsletter’s 2018, volume 1 edition. Reprinted with permission.