Taxing multinational group excess profit in the US, UK, and Belgium

By Dr. J. Harold McClure, New York

As discussed recently in MNE Tax, the Advocate General of the Court of Justice of the Europe Union issued a December 3 opinion in European Commission v. Kingdom of Belgium and Magnetrol International that would overturn the February 14, 2019, decision by the General Court of the European Union.

The European Commission concluded that this Belgian tax scheme, which allowed the “excess profits” of Belgian affiliates of multinationals to go untaxed, was unlawful State aid in a decision issued January 11, 2016. The General Court decision concluded that the Commission had failed to prove its contention. This issue affects at least 55 multinationals.

Belgium is not the only country that seeks to draw multinational group investment and jobs to their shores by adopting a tax regime that gives “excess” income preferential tax treatment. The US and UK have adopted similar approaches, though the tax benefits provided are not as significant as Belgium’s.

Excess profits in the UK, US, and Belgium

In contrast to the current state of affairs, the UK and the US both imposed taxes on what they deemed to be excess profits in efforts to pay for the cost of World War I.

The UK enacted the 1915 Finance Act, which included an excess profits duty. This duty applied to both UK companies and to foreign companies owned by UK residents. The duty was charged upon profits, in excess of a pre-war standard of profits. The duty rate was initially 50 percent but later was increased to 80 percent.

The US set tax rates on excess profits initially at 20 percent but later raised them to 60 percent. The US also adopted excess profits tax regimes during World War II and during the Korean War. Excess profits were defined as profits above an 8 percent return to invested capital.

More recently, these countries have instead taxed excess profits at preferential rates.

The 2017 US Tax Cut and Jobs Acts lowered the US statutory tax rate to 21 percent and allowed residual profits to be taxed at rates equal to 13.125 percent or less. Foreign-derived intangible income (FDII) is the income that a US parent earns on export-related activity that is above a routine return, defined as 10 percent of invested capital.

Global intangible low taxed (GILTI) income represents income earned by the foreign affiliates of US-based multinationals above a routine return. This routine return is also 10 percent of invested capital.

The patent box regime implemented by the UK in 2013 has a similar purpose. Income derived from intangible property owned by UK entities can qualify for a 10 percent tax rate instead of the 19 percent statutory rate.

The Belgian tax authorities took this a step further, allowing all income above a routine return to escape taxation.

A transfer pricing illustration of the Belgian excess profits ruling

The cases investigated by the European Commission generally involve Belgian central entrepreneurs in the sense that the Belgian entity performs routine functions but also owns the valuable intangible assets of the multinational. Consider an example of a Belgian manufacturing affiliate that produces electronic components sold to European customers by distribution affiliates in France, Germany, the UK, and other European nations.

The Belgian manufacturing operation’s routine profits are estimated using the transactional net margin method (TNMM). The distribution affiliate’s routine profits are estimated by a separate application of TNMM. Excess profits are defined as consolidated profits minus these routine returns for manufacturing and distribution.

Table 1 presents the income statement for a Belgian manufacturer of electronic components and its European distribution affiliates.

European sales = €100 million per year. Production costs are assumed to be 75 percent of sales, while selling costs are assumed to be 8 percent of sales. As such, consolidated profits are 17 percent of sales or €17 million per year.

Table 1: Income statements for European electronic components manufacturer and distributors

Millions	Belgian	Distributors
Sales	€0.0	€100.0
Intercompany price	€90.0	€90.0
Cost of production	€75.0	€0.0
Gross profits	€15.0	€10.0
Selling expenses	€0.0	€8.0
Operating profits	€15.0	€2.0
Routine return	€7.5	€2.0
Residual profits	€7.5	€0.0

Table 1 assumes that the intercompany pricing policy affords the distribution affiliates a 10 percent gross margin, which implies that these affiliates retain operating profits equal to 2 percent of sales. Let’s also assume that a TNMM analysis has concluded that this 2 percent operating margin is consistent with the routine return for these limited function distribution affiliates.

Under this transfer pricing policy, the Belgian manufacturing affiliate retains €7.5 million in profits per year, which represents a 20 percent markup over production costs. Let’s further assume that its operating assets are €75 million, so operating assets to production cost ratio is 100 percent.

A TNMM analysis would likely establish that a 10 percent return on operating assets would represent the routine return for manufacturing. In this case, routine returns would represent a 10 percent markup over labor costs or €7.5 million. Under these assumptions, residual or excess profits equal €7.5 million or 7.5 percent of sales.

A Belgian excess profits rulings would allow these residual profits to escape income taxation.

In contrast to the Belgian approach, a transfer pricing approach would inquire what the intangible assets are and which legal entity owns these intangible assets.

For example, if the intangible assets were marketing intangibles owned by the distribution affiliates, they would not belong to the Belgian affiliate but should be part of the distribution affiliates’ tax base in the other European jurisdictions.

However, if these intangible assets represented manufacturing intangibles created by the Belgian manufacturing affiliate, the rulings allowed a significant income to escape the 29 percent Belgian corporate profits tax rate.

The use of the FDII regime by US exporters

Table 2 presents 2018 information for Boeing and Northrup Grumman. Northrup Grumman designs and manufactures aircraft, spacecraft, radars, and cybersecurity systems primarily for the US government. Its sales in 2018 were $30 billion, with 15 percent of those sales to foreign customers.

Boeing designs and manufactures airplanes, rockets, missiles, satellites, and telecommunications equipment. Its sales in 2018 were just over $100 billion, with 56 percent of those sales to foreign customers. Boeing’s operating margin was 12 percent, which was also the operating margin for Northrup Grumman.

The 10-K filings for these two companies noted that the FDII benefit for Boeing was $549 million but was only $16 million for Northrup Grumman.

The FDII benefit depends on the share of overall profits that can be attributable to residual profits. The benefit represents the difference between the 21 percent statutory tax rate and the 13.125 percent rate for FDII income, which is 7.875 percent times residual profits.

Table 2: Estimates of FDII benefit for Boeing and Northrup Grumman

Millions	Northrup	Boeing
Foreign sales	$4500	$56000
Residual profits/sales	4.5%	12.0%
Residual profits	$202.50	$6720.00
FDII benefit	$15.95	$529.20

Boeing derives more FDII benefits because its sales are much larger and the percentage of sales coming from exports is larger than Northrup Grumman’s. Table 2 demonstrates that Boeing’s reported FDII income is consistent with a 12 percent residual profit to sales ratio, while Northrup Grumman is apparently assuming residual profits represent only 4.5 percent of sales.

Table 3 presents a transfer pricing model for Northrup Grumman, similar to Table 1, the transfer pricing illustration used to illustrate the Belgian excess profits ruling.

Table 3 assumes that the manufacturer incurs costs equal to 80 percent of sales, while the foreign distribution affiliates incur selling expenses equal to 8 percent of sales. Consolidated operating profits represent 12 percent of sales.

Table 3: Illustration of Northrup Grumman exports and FDII benefit

Millions	Distributor	Manufacturer
Sales	$4500.0	$0.0
Intercompany price	$4050.0	$4050.0
Cost of production	$0.0	$3600.0
Gross profits	$450.0	$450.0
Selling expenses	$360.0	$0.0
Operating profits	$90.0	$450.0
Routine return	$90.0	$247.5
Residual profits	$0.0	$202.5

Table 3 also assumes that the foreign distribution affiliates receive a 10 percent gross margin, so their operating profits represent 2 percent of sales. The manufacturer’s operating profits represent 10 percent of sales.

The division of manufacturer profit between its routine return versus its residual profits depends on the ratio of manufacturer tangible asset to sales. If this ratio is 55 percent, then routine return would be 5.5 percent of sales using the statutory 10 percent return to capital. Residual profits would therefore be only 4.5 percent of sales, which appears to be a conservative application of the FDII benefit.

Boeing’s FDII benefit assumes a much higher residual profit to sales ratio. Its worldwide operating margin is only 12 percent, but we should caution that it is possible that Boeing earns higher operating margins on foreign sales than on domestic sales. In the absence of segmented financial data, it is difficult to provide a model for its transfer pricing on foreign sales.