The IRS released its first round of proposed regulations (REG-104259-18
) on Dec. 13 resolving many questions surrounding the base erosion anti-abuse tax (BEAT) regime enacted by the Tax Cuts and Jobs Act (TCJA), and deciding favorably on several issues, including marked-up services and net operating loss limitations.
BEAT addresses base erosion concerns by effectively imposing a tax based on deductible payments to related foreign parties. It primarily targets foreign-owned multinationals entering into base-eroding transactions, but the rules have broad applicability impacting many large U.S. multinationals. TCJA also imposed a number of reporting requirements on those companies subject to the BEAT.
The statue implementing BEAT, Section 59A, left many aspects of the regime in the hands of the regulators. Other ambiguous aspects were also hotly debated. Proposed BEAT regulations were released under Sections 59A, 383, 1502, 6038A, 6038C and 6655. They provide much-needed guidance in a number of areas, and resolved several issues in favor of taxpayers. Notable aspects of the proposed regulations include:
- An exception from the definition of base erosion payment (BEP) for amounts that are subject to tax as income effectively connected with the conduct of a U.S. trade or business
- Favorable transition rules addressing BEPs and net operating losses (NOLs) originating before the effective date
- Clarification that the services cost method exception is available if there is a markup, but that the portion of any payment that exceeds the total cost of services is not eligible for the exception and is a BEP
Despite broad relief, the proposed regulations did not provide a so called “netting” exception, nor did they provide safe harbors in gray areas such as what payments constitute deductible payments as opposed to reductions of gross income (i.e., cost of goods sold). The proposed regulations also provided an unanticipated rule that “clarifies” a payment or accrual may be a BEP regardless of whether it is in exchange for non-cash consideration (e.g., property contributed in exchange for stock in a Section 351 transfer).
Many of the rules are proposed to be retroactively effective for tax years beginning after Dec. 22, 2017, and may be relied upon prior to finalization so long as they are applied consistently. Taxpayers should begin assessing how the proposed rules would affect them, and start planning for opportunities to structure activities in ways to avail themselves of the new exceptions.
The aforementioned issues and other select highlights from the proposed regulations are summarized below.
BEAT imposes a minimum tax on certain domestic corporations with substantial gross receipts. The BEAT applies to domestic corporations other than S corporations, real estate investment trusts (REIT) and regulated investment companies (RIC) that are part of a group with $500 million or more in annual gross receipts over a three-year period and have a ratio of base erosion deductions compared to total deductions of 3% or higher (2% or higher for certain banks and securities dealers) for the taxable year.
The BEAT tax is phased in at a rate of 5% for tax years beginning in 2018, 10% for tax years beginning in 2019 through 2025, and 12.5% for tax years beginning after Dec. 31, 2025. These rates are increased by 1% for certain banks and securities dealers. The BEAT amount is the excess of 5% (or the applicable rate as described above) of the taxpayer’s “modified taxable income” over the regular tax liability reduced for certain credits (including the foreign tax credit). The credits reducing the regular tax liability exclude the R&D credit and up to 80% of other select general business credits. For taxable years beginning after Dec. 31, 2025, the regular tax liability is reduced by the aggregate amount of all credits (i.e., no adjustments are made for R&D and the other select general business credits). As a result, prior to Dec. 31, 2025, taxpayers may retain the benefit of the research credit and 80% of certain other general business credits when determining the BEAT tax, however, all other credits would not be allowed to reduce the ultimate BEAT tax liability.
Modified taxable income is regular taxable income computed without regard to the base erosion tax benefit of BEPs made to foreign-related parties or to the base erosion percentage of any NOL deduction under Section 172. For purposes of the BEAT, cost of goods sold is not be considered a BEP (except in the case of inverted corporations) and the term “foreign-related party” is defined broadly to include any 25% foreign shareholder or any person related to the domestic corporation or to a 25% foreign shareholder. Constructive ownership rules under Section 318, with some modifications, apply when determining relatedness.
General operating rules in the proposed regulations
The BEAT only applies to an applicable taxpayer, which is a corporation (other than a RIC, a REIT, or an S corporation) that satisfies the gross receipts and base erosion percentage tests. The proposed regulations provide that for purposes of applying the gross receipts test and the base erosion percentage tests that members of an aggregate group are treated as a single taxpayer. These rules aggregate members of a controlled group of corporations as defined under Section 1563(a) which would include both domestic and foreign members of the controlled group.
The proposed regulations clarify that, for purposes of applying the aggregation rule, foreign members are only included to the extent that they have income effectively connected with the conduct of a U.S. trade or business. This limitation ensures that payments made by a domestic corporation, or a foreign corporation with respect to its effectively connected income, to a foreign-related corporation are not inappropriately excluded from the base erosion percentage test. Accordingly, the proposed regulations provide that a taxpayer must apply the gross receipts test and the base erosion percentage test using the aggregate group consisting of members of the same controlled group of corporations that are domestic corporations and also foreign corporations, but only with regard to gross receipts taken into account in determining income which is effectively connected with the conduct of a U.S. trade or business. They also provide that a foreign member of a controlled group that determines its net taxable income under a tax treaty with the United States is treated as a member of the aggregate group with regard to gross receipts used in determining its taxable income.
Base erosion payments and base erosion tax benefit
Generally, a BEP is defined as a payment or accrual by a taxpayer to a foreign-related party. The proposed regulations made several clarifications with respect to this definition. The proposed regulations provide that a loss recognized on the transfer of property from a taxpayer to a foreign-related party is considered a BEP. With respect to the determination of a BEP made by a U.S. branch of a foreign corporation, the proposed regulations clarify that an expense properly allocable to effectively connected income of the branch is a BEP to the extent that it is paid or accrued to a foreign-related party. They also provide similar rules addressing situations when deductible expenses are determined under an income tax treaty.
In one of the more surprising provisions, the proposed regulations provide that a payment or accrual by a taxpayer to a foreign-related party may be a BEP regardless of whether consideration is in the form of cash or non-cash items. These may include non-cash payment to a foreign-related party that also qualifies under a non-recognition provision under Sections 351, 332, or 368. For example, a domestic corporation’s acquisition of depreciable assets from a foreign-related party in an exchange for stock (i.e., a Section 351 transfer) would be considered a BEP, which may give rise a base erosion tax benefit (i.e., depreciation or amortization).
Grant Thornton Insight: This is a broad interpretation of the statute. Taxpayers that have imported property, such as depreciable assets or amortizable intangibles, to the U.S. in 2018 should take note of this rule. The retroactive applicability date could have adverse implications to transactions already undertaken in 2018. Additionally, taxpayers should carefully assess how the proposed rule will impact future transactions and restructurings.
Several exceptions from the definition of a BEP also exist. Section 59A(d)(5) provides that a BEP does not include an amount paid or accrued by a taxpayer for services eligible for the services cost method (SCM) under Section 482, and the amount constitutes the total services cost without any markup component. However, it was unclear under the statute whether this exception would apply only if no mark-up was charged, or if it applied to the portion related to the reimbursement for services but not to the mark-up competent. Prior to the release of the proposed regulations, the tax community extensively debated whether the entire payment would be considered a BEP, or, alternatively, whether only the “mark-up” component would be considered a BEP. Taxpayers received welcomed relief in the proposed regulations, which clarified that only the portion exceeding the total services cost will be considered a BEP.
Another notable exception provided in the proposed regulations relates to payments to a foreign person that are subject to U.S. taxation. The IRS determined that it would not be appropriate to treat payments to a foreign -related party that will be taken into account as effectively connected income as BEPs. Additionally, to the extent a foreign recipient computes its taxable income under an applicable tax treaty, the exception applies to payments taken into account in determining net taxable income under the treaty provision. The proposed regulations provide a number of other exceptions, including for qualified derivative payments, exchange losses from a Section 988 transaction, and interest paid or accrued on TLAC securities (TLAC securities are part of a global framework for bank capital that has sought to minimize the risk of insolvency).
The proposed regulations also provide guidance on the treatment of deductible interest under both current and former Section 163(j). Section 59A(c)(3) provides a stacking rule when new Section 163(j) applies to a taxpayer. Under this rule, the reduction in the amount of deductible interest is treated as allocable first to interest paid or accrued to persons who are unrelated parties with respect to the taxpayer and then to related parties. But, the statute does not provide rules for determining the amounts treated as paid to a foreign-related person as opposed to a domestic-related person. The proposed regulations provide that when a corporation has business interest expense paid or accrued to both unrelated parties and related parties, the amount of allowed business interest expense is treated first as the business interest expense paid to related parties, split proportionately between foreign- and domestic-related parties, and then as business interest expense paid to unrelated parties.
The proposed regulations also addressed the treatment of payments paid or accrued prior Jan. 1, 2018, that become deductible in a tax year in which Section 59A is in effect. They confirm that such deductions will not be treated as BEPs. Additionally, reversing a rule provided in Notice 2018-28, the same treatment also applies to interest carryforwards under former Section 163(j) effective prior to the TCJA. Specifically, they provide that any disallowed disqualified interest under former Section 163(j) that resulted from a payment or accrual to a foreign related party and that is carried forward from a taxable year beginning before Jan. 1, 2018, is not a BEP.
Modified taxable income
The proposed regulations clarify a number of computational matters related to modified taxable income, including that it follows a taxpayer-by-taxpayer approach and is done on an add-back basis. As a result of the latter, taxable income is not recomputed, which would impact utilization of carryforwards and taxable income limitations.
The proposed regulations also contain a number of rules coordinating the usage of current year losses and NOL carryforwards, as well as determining the base erosion percentage of NOLs. Perhaps the most notable of such rules addresses the base erosion percentage used when determining the add-back of the base erosion percentage of any NOL deduction under Section 172. The regulations clarify that the so called “vintage year” base erosion percentage applies. The vintage year is the year in which the loss arose. The base erosion percentage in the vintage year reflects the portion of base eroding payments that are in the net operating loss carryover for the respective year. The vintage year approach (as opposed to using the year’s base erosion percentage in which the loss is utilized) provides greater certainty as to the amount of the future add-back to modified taxable income, because the vintage year ratio is fixed. The proposed regulations also clarify that in the case of net operating losses that arose in taxable years beginning before Jan. 1, 2018, and that are deducted as carryovers in taxable years beginning after Dec. 31, 2017, the base erosion percentage is zero because Section 59A applies only to BEPs that are paid or accrued in taxable years beginning after Dec, 31, 2017.
Base erosion minimum tax
A taxpayer’s base erosion minimum tax is the excess of the applicable BEAT tax rate for the taxable year multiplied by the taxpayer’s modified taxable income for the taxable year over the taxpayer’s adjusted regular tax liability for that year. In determining the taxpayer’s adjusted regular tax liability for the taxable year, credits (including the foreign tax credit, but not including certain general business credits) are generally subtracted from the regular tax liability amount. The proposed regulations provide that credits for overpayment of taxes and for taxes withheld at source (i.e., credits under Sections 37 and 33, respectively) are not subtracted from the taxpayer’s regular tax liability.
The proposed regulations generally apply an aggregate approach when determining gross receipts for evaluating whether a corporation is an applicable taxpayer, and also when addressing the treatment of payments made by a partnership or received by a partnership. Therefore, when making determinations at the corporate partner level (such as whether it is an applicable taxpayer, or has made a BEP), amounts paid or accrued by a partnership are treated as paid by each partner to the extent an item of expense is allocated to the partner under Section 704. A separate, but similar rule also applies when determining whether an amount paid to partnership is treated as paid by a partner that is a foreign-related party. Under this rule, income of a partnership is treated as received by each partner to the extent the item of income or gain is allocated to each partner under Section 704. Consistent with the general aggregate approach, other BEAT determinations and exceptions for BEPs also apply at the partner level.
The proposed regulations contain a de minims exception that excludes certain partners with small ownership interests from this aggregate approach for purposes of determining base erosion tax benefits from the partnership. This de minimis exception applies to corporate partners that own less than 10% of the capital and profits interest and are allocated less than 10% of each item of income, gain, loss, deduction, and credit coming from the partnership. In addition, the partner’s interest in the partnership must also have a fair market value of less than $25 million.
The proposed regulations provide that BEAT is computed on a combined, single-entity basis for affiliated groups that elect to file a consolidated tax return. Accordingly, the BEAT tax is computed in a consistent manner as the regular tax for consolidated groups. Under this single entity approach, intercompany items between members of the affiliated group are not taken into account. The proposed regulations also contain coordinating rules regarding interest expense disallowed under Section 163(j) and interaction with the consolidated group rules.
De minimis exception for banks and securities dealers
In order for a corporation to be subject to the BEAT, it generally must have a ratio of base erosion deductions compared to total deductions of 3% or higher for the taxable year, in addition to meeting the other requirements. Generally, a lower threshold of 2% applies if the corporation, or a member of the corporation’s aggregate group, is a member of an affiliated group that includes a domestic bank or registered securities dealer. In addition to the lower threshold, certain banks and registered securities dealers are also subject to a higher BEAT tax rate than other taxpayers.
The proposed regulations provide that the lower 2% threshold does not apply in the case of an aggregate group or consolidated group that has de minimis bank or registered securities dealer activities. This de minimis exception in the proposed regulations provide that a consolidated group or a member of the aggregate group of which the corporation is a member, is not subject to the lower base erosion percentage threshold if its gross receipts attributable to the bank or the registered securities dealer are less than 2% of the aggregate group’s total gross revenue.
The proposed regulations provide that certain transactions that have a principal purpose of avoiding Section 59A will be disregarded or deemed to result in a BEP. This anti-abuse rule targets three types of transactions. The first type involves intermediaries acting as a conduit to avoid a BEP. This could include, for example, a sale by a foreign parent to an unrelated party followed by the purchase of the property by the applicable taxpayer. The next type are those entered into to increase the deductions taken into account in the denominator of the base erosion percentage. An example of this type of transaction would include a taxpayer entering into both a short and a long positions with respect to an asset with a financial institution. The final type are those among related parties entered into to avoid the application of rules applicable to banks and registered securities dealers (i.e., causing a bank or registered securities dealer to disaffiliate from an affiliated group).
Grant Thornton Insight: One of the examples in the regulations provides that a refinancing transaction entered into by the applicable taxpayer that does not involve a corresponding transaction between the bank and a foreign-related party is not subject to the anti-abuse rule. However, the regulations provide another example where the foreign parent makes a deposit following the refinancing transaction with a principal purpose of avoiding BEAT. The deposit provides the foreign parent with interest income substantially similar to the interest expense charged to the applicable taxpayer by the financial institution. The example concludes that this transaction is subject to the anti-abuse rule and that the interest expense is a BEP. Taxpayers considering notional cash pooling arrangements or considering refinancing debt with a bank that also services a foreign related party in an effort to avoid or reduce BEPs should carefully evaluate the potential impact of this anti-abuse rule.
The guidance expands on the statute and clarifies several ambiguities. It also contains numerous computational rules. As noted, the rules have broad applicability impacting many large U.S.-owned multinationals. In particular, the interaction between the global intangible low-taxed income (GILTI) regime and the BEAT regime may produce surprising results. The allowance of the foreign tax credit to reduce regular tax when computing BEAT makes many U.S. multinationals with significant GILTI inclusions susceptible to the minimum tax under BEAT (if they meet the other required thresholds). The proposed regulations also provide a number of opportunities, particularly around the services cost method. Taxpayers should assess how the proposed rules would affect them, and begin planning for opportunities to structure activities in ways to avail themselves of the new exceptions.
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