An Analysis of Tech Sector Taxation

The technology sector’s tax landscape is distinct from traditional industries due to its reliance on intangible assets, global scalability with minimal physical presence, and innovative employee compensation. These factors challenge tax principles designed for an economy based on tangible goods and physical locations. Tech business models generate value that is difficult to pinpoint geographically. For example, a software company can serve millions of global users from a few server farms, complicating the application of conventional tax rules based on physical presence.

Key Domestic Tax Considerations for Tech Companies

Research and Development (R&D) Tax Credit

A significant tax incentive for the tech sector is the Research and Development (R&D) Tax Credit, a federal benefit that provides a dollar-for-dollar reduction in income tax liability for qualifying research expenditures. To be eligible, research must be technological in nature, aim to develop a new or improved business component, involve experimentation, and seek to eliminate uncertainty. Qualifying expenses include wages for R&D employees, costs of supplies, and a portion of payments to third-party contractors for research.

A notable feature for startups is the ability for certain small businesses to apply the credit against payroll taxes. Under a provision from the Inflation Reduction Act of 2022, qualifying small businesses with less than $5 million in annual gross receipts can offset up to $500,000 of their payroll tax liability. This allows early-stage companies that may not be profitable to receive an immediate cash benefit from their research investments.

Amortization of Research and Experimental Expenditures

A major change in U.S. tax law affects how Research and Experimental (R&E) expenditures are treated. Before 2022, businesses could immediately deduct 100% of domestic R&E costs in the year they were incurred. Beginning with the 2022 tax year, a provision from the Tax Cuts and Jobs Act of 2017 (TCJA) requires these costs to be capitalized and amortized over five years for domestic research and fifteen years for research performed abroad.

This shift from immediate expensing increases a company’s taxable income and tax liability in the short term. For example, a company with $1 million in R&E costs that previously reduced its taxable income by the full amount now has its deduction spread out over several years. There is pending legislation that may temporarily suspend this requirement for domestic research.

Stock-Based Compensation

Stock-based compensation is a primary tool for tech companies to attract and retain talent. The two most common forms are Restricted Stock Units (RSUs) and Incentive Stock Options (ISOs), each with distinct tax rules. RSUs are a promise to grant shares at a future date, typically upon meeting service-related conditions.

For the employee, the value of RSUs is treated as ordinary income when they vest, subject to income and payroll taxes. The company is entitled to a tax deduction equal to the income recognized by the employee. In contrast, ISOs give an employee the right to purchase stock at a predetermined price. An employee recognizes no income for regular tax purposes when an ISO is granted or exercised.

If the employee holds the stock for at least two years from the grant date and one year from the exercise date, any gain from a sale is taxed at lower long-term capital gains rates. Because of this favorable treatment, the company does not receive a tax deduction for ISOs unless the employee sells the stock before meeting the required holding periods.

Taxation of Intellectual Property

Defining IP for Tax Purposes

In the technology sector, intellectual property (IP) is often a company’s most valuable asset. For tax purposes, IP is a broad category that includes legally protected assets like patents, trademarks, and copyrights, as well as trade secrets, proprietary algorithms, and user data. The Internal Revenue Service (IRS) considers IP a capital asset.

Costs to create or purchase IP must often be capitalized and then amortized, or deducted, over a set period. For many acquired intangibles, this amortization period is 15 years. The classification of each type of IP dictates its tax treatment.

IP Valuation and Location

A central tax planning strategy for tech companies involves the valuation and legal location of their IP. Common valuation methods include the income method, based on future earnings; the market method, which compares the IP to similar assets; and the cost method, which calculates the cost to create a similar asset.

Many multinational tech companies hold their IP in separate legal entities located in jurisdictions with low corporate tax rates. This structure allows operating subsidiaries to pay royalties or licensing fees to the IP-holding entity for the right to use the assets. These payments can be structured to reduce taxable income in higher-tax countries where sales occur.

Onshoring vs. Offshoring IP

The decision to house IP domestically (onshoring) or in a foreign jurisdiction (offshoring) is influenced by tax factors. Historically, many U.S. tech companies offshored their IP to take advantage of lower foreign tax rates, allowing profits from that IP to accumulate in low-tax jurisdictions. Transferring IP before it becomes commercially viable can result in a lower valuation and a smaller tax impact on the transfer.

However, the 2017 Tax Cuts and Jobs Act, which lowered the U.S. corporate tax rate to 21%, has altered this calculation. These changes, combined with new anti-abuse rules, have made holding IP in the United States more attractive for some companies, prompting a re-evaluation of offshoring strategies.

International Tax Framework and Profit Shifting

Transfer Pricing

Transfer pricing governs the prices charged for transactions between related entities within a multinational enterprise, such as licensing intellectual property. For a tech company, a U.S. operating subsidiary might pay a royalty fee to a foreign subsidiary in a low-tax jurisdiction that owns the company’s patents. The amount of this payment affects how much profit is reported and taxed in each country.

The governing standard for these transactions is the internationally accepted “arm’s-length principle.” This principle requires the price for an internal transaction to be the same as it would be between two unrelated entities in a competitive market. Tax authorities can challenge prices that do not meet this standard, as improper pricing can be used to shift profits from high-tax to low-tax countries, a practice known as base erosion and profit shifting (BEPS).

Key U.S. International Tax Provisions

GILTI (Global Intangible Low-Taxed Income)

To address profit shifting, the Tax Cuts and Jobs Act of 2017 introduced the Global Intangible Low-Taxed Income (GILTI) rule. This provision discourages U.S. multinationals from holding intangible assets like patents in foreign countries with very low tax rates by imposing a U.S. tax on certain income earned by their controlled foreign corporations (CFCs), regardless of whether the income is brought back to the U.S.

The GILTI regime acts as a global minimum tax, targeting CFC income that exceeds a 10% return on its tangible assets, with the excess presumed to be from intangibles. U.S. corporate shareholders are taxed on this income at an effective rate of 10.5%, which is scheduled to increase to 13.125% for tax years beginning after December 31, 2025. This subjects a significant portion of foreign earnings to immediate U.S. taxation.

FDII (Foreign-Derived Intangible Income)

As a counterpart to GILTI, the Foreign-Derived Intangible Income (FDII) deduction serves as an incentive to hold intellectual property in the United States and generate export revenue from it. This provision offers a preferential tax rate on income that U.S. corporations earn from selling goods or providing services to foreign customers. The income eligible for this benefit is the portion deemed to be derived from intangible assets held in the U.S. and used to serve foreign markets.

The FDII deduction lowers the effective tax rate on qualifying income to 13.125%, though this rate is scheduled to increase to 16.406% for tax years beginning after December 31, 2025. While GILTI acts as a “stick” to discourage offshoring profits, FDII is the “carrot” to encourage domestic IP ownership. Proposed legislation seeks to make the lower rates for both GILTI and FDII permanent, but the outcome is uncertain.

The Global Response and Digital Taxation

Digital Services Taxes (DSTs)

In response to the challenges of taxing the digital economy, several countries have implemented Digital Services Taxes (DSTs). A DST is a tax on the gross revenues that large multinational companies generate from specific digital services, such as online advertising, the sale of user data, and online marketplace transactions. Countries enacted these taxes because they believe tech giants generate substantial value from their user bases without paying a fair share of tax in those jurisdictions due to a lack of physical presence.

DSTs are targeted at very large companies, often applying only to those with global revenues exceeding a high threshold, like €750 million, plus a local revenue threshold. The tax rates are typically a low single-digit percentage, such as 3%, on gross revenue sourced to that country. Nations like France, Italy, Spain, and the United Kingdom have implemented DSTs as an interim measure until a comprehensive global solution is in place.

The OECD/G20 Inclusive Framework (Two-Pillar Solution)

The spread of unilateral measures like DSTs prompted a coordinated global effort, led by the Organisation for Economic Co-operation and Development (OECD), to reform international tax rules. This resulted in an agreement by nearly 140 countries on a Two-Pillar Solution, though its implementation is progressing unevenly. As of early 2025, Pillar Two has been enacted in over 50 jurisdictions, but Pillar One’s implementation is less certain. Pillar One is contingent on ratification of a Multilateral Convention, and the United States has expressed reservations about the agreement, creating uncertainty for the framework.

Pillar One

Pillar One changes the allocation of taxing rights by moving beyond the traditional reliance on physical presence. It aims to reallocate a portion of the profits of the world’s largest multinational enterprises (MNEs) to the market jurisdictions where their customers are located. This rule applies to MNEs with global revenues over €20 billion and profitability above 10%. Under Pillar One, 25% of the profit exceeding the 10% margin will be reallocated to market countries for taxation.

Pillar Two

Pillar Two establishes a global minimum corporate tax rate to curtail the “race to the bottom” on tax rates. The agreement sets a minimum effective tax rate of 15% for MNEs with annual revenues of at least €750 million. If a company’s profits in a jurisdiction are taxed below this 15% threshold, its home country can apply a “top-up tax” to bring the total tax paid on that income up to the minimum rate. This ensures large multinationals pay a baseline level of tax on their profits wherever they operate.