The Treasury Department and the IRS published proposed regulations yesterday on the Base Erosion and Anti-Abuse Tax (BEAT) that was enacted by the Tax Cuts and Jobs Act of 2017. The BEAT had the potential to cause adverse U.S. tax consequences to companies that had material value chain inputs from foreign affiliates. These inputs may have come from borrowed capital, purchases of depreciable property, purchased services, IP licenses, etc. It did not matter whether the ultimate parent of the multinational group was in the United States or outside the United States.
The proposed regulations are instead taxpayer favorable on a number of important points and clarify a number of uncertainties in how the BEAT applies. Favorable rules adopted by the IRS include:
- Exemption for payments relating to the cost component of certain low-margin (often administrative) services that a U.S. affiliate purchases from foreign ones.
- Exclusion of pre-effective date net operating losses (NOLs) from the BEAT.
- Exemption from base erosion payment treatment for property a U.S. affiliate purchased from a foreign affiliate prior to the effective date, but where depreciation deductions arise during post-effective date years; and exemption for payments to foreign affiliates where the foreign affiliate is subject to tax in the United States on a net basis.
Below is a high-level summary of the key aspects of the BEAT rules:
1. Base erosion percentage and gross receipts test
- Aggregate Group: For purposes of the gross receipts test and base erosion percentage test, only consider the domestic corporate group and foreign corporations with effectively connected income (Aggregate Group).
- Intra-Group Payments: Payments between Aggregate Group members are not taken into account in determining whether the group meets the gross receipts test and the base erosion percentage test.
- Inter-Group Payments: Payments between Aggregate Group members and any foreign corporation not within the group are taken into account unless the payments are subject to U.S. net income tax.
- Numerator – Denominator Consistency: Where a payment is excluded from the numerator of the base erosion percentage fraction on the basis of the service cost method (SCM) exception, qualified derivative exception or total loss absorbing capital (TLAC) exception, then it is also excluded from the denominator.
- De Minimis for Small Banks and Broker-Dealers: Provides a de minimis rule for the lower base erosion percentage applicable to groups with banks or securities dealers where the gross receipts attributable to such an entity are less than 2 percent of the group’s aggregate revenue for the year.
2. Base erosion payments
- Profit Component Only: Only the profit component of a payment eligible for the SCM is treated as a base erosion payment ‒ not the cost component. Moreover, there are record-keeping requirements that require a taxpayer to maintain books and records adequate to permit the verification of the amount paid for services, the total services cost incurred, and the allocation and apportionment of costs to services. The general requirements of the SCM must be met as well; simply charging cost for a service that is not eligible for the SCM does not exempt a payment for a service from being a base erosion payment.
- Effectively Connected Income Exception: Payments that are effectively connected income to the recipient are not treated as base erosion payments.
- Aggregate Approach for Partnerships: Apply an aggregate approach to partnerships in determining whether payments to or from a partnership are base erosion payments.
- Apply BEAT on a Gross Payment Basis; No Netting: Where taxpayers have netting arrangements because one party owes payments under one contract and the other party owes payments under another, the netting does not apply for purposes of the BEAT. Gross amounts must be considered under each leg.
- Nonrecognition Transactions and Depreciable Property: A base erosion payment may arise with respect to an acquisition of depreciable property even where the property is acquired in a nonrecognition transaction, such as a contribution to capital, liquidation or reorganization.
- Coordination With Section 163(j) Rules: For deferred interest deductions under Section 163(j), carry forward the related party aspect of the deduction on a pro rata basis. However, in determining what portion of interest expense is related-party or nonrelated-party interest expense, the proposed regulations provide that the amount of allowed business expense is treated first as the business interest expense paid to related parties, proportionately between foreign and domestic related parties.
- Transition Tax Deduction: The Section 965(c) deduction related to the inclusions by U.S. shareholders of income from deferred foreign corporations under Section 965(a) is included in the denominator.
- Adjustments to Gross Income Not a Base Erosion Payment ‒ Generally: With the exception of certain reinsurance payments and payments by surrogate foreign corporations, reductions to gross income are included in neither the numerator nor the denominator of the base erosion fraction. This can arise for items that are treated as adjustments to gross income under Treas. Reg. Sec. 1.61-3.
- Interest Expense of U.S. Branches: Part of a foreign corporation’s interest expense that is allocable to its U.S. branch operations can constitute a base erosion payment.
- Other Expenses of U.S. Branches: Other expenses of a foreign corporation that are allocable to effectively connected income can constitute base erosion payments to the extent those amounts are paid to foreign related persons. A tracing method applies.
- Pre-Effective Date Years: Because the BEAT only applies to base erosion payments paid or accrued in taxable years beginning after Dec. 31, 2017, depreciation deductions attributable to acquisitions of depreciable property prior to that date are not treated as base erosion payments. The same rationale applies to deferred amounts (including interest) that are paid or accrued in pre-effective date years, but carried forward and deductible in post-effective date years. In addition, disallowed business interest expense that is carried forward is treated first as business interest expense paid to unrelated parties.
- FX Gain/Loss and Denominator: Currency losses under Section 988 are excluded from the numerator and denominator of the base erosion percentage.
- Disallowed Deductions: Deductions that are not allowed during the year are not treated as base erosion payments.
3. Financial institutions and base erosion payments
- TLAC: Payments on TLAC of banks may be largely exempt.
- Treaty Method and Internal Dealings Inside a Single Legal Entity: Deductions allowed from internal dealings in computing taxable profits under a treaty method are (surprisingly) treated as base erosion payments where those amounts represent payments to other affiliates.
- Global Dealing: Where global dealing in financial instruments exists, issues arise as to whether amounts due to affiliates are (a) adjustments to gross income of the participants or (b) deductible payments (often by the booking entity). There is no specific rule on this, but different aspects of the proposed regulations would suggestion that the IRS would apply the latter (b) paradigm.
- Qualified Derivatives: There is an exception for base erosion payments for qualified derivative payments (QDPs) to related parties. If a taxpayer fails to comply with the special reporting requirements applicable to QDPs, then the portion of the payments for which the reporting requirements are not met will fail to qualify for the exception from base erosion payment status.
- Direct Ownership vs. a Derivative: The qualified derivatives exception does not apply to direct ownership of a financial position that is not a derivative. Thus, the qualified derivative exception does not apply to an insurance contract, a securities lending transaction, a repo, an ADR or substantially similar transactions.
- Mark to Market: For mark-to-market items, combine all items of income, deduction, gain or loss on each transaction (or position) for the year to determine the amount of the deduction that is used for purposes of the base erosion percentage. The frequency of marks does not matter, as only one amount of gain or loss is determined on termination of the position or at the end of the taxable year – whichever is earlier.
- Section 953(d) Companies: Payments to insurance companies that have elected domestic status for U.S. tax purposes are not base erosion payments.
- Reinsurance Payments: The Treasury has requested comments with respect to payments made by a domestic reinsurance company to a foreign related insurance company, and asked whether an exception should be adopted for life insurance companies that receive a deduction for such payments that otherwise are subject to BEAT.
4. Anti-abuse rules
- Principal Purpose: Certain transitions that have a principal purpose of avoiding BEAT will be disregarded or deemed to result in a base erosion payment:
- Use of an intermediary as a conduit to avoid BEAT.
- Transactions entered into to increase deductions that are taken into account in measuring the base erosion percentage.
- Transactions among related parties to avoid the application of the special rules applicable to banks and broker-dealers (such as disaffiliation).
5. Modified taxable income
- MTI Cannot Be Negative: Modified taxable income computation: Starting point for the NOL add-back is zero, and not negative. This issue arose due to the manner in which the NOL rules compute a current-year deduction.
- Base Erosion Percentage:
- Base erosion percentage for an NOL is the year in which the NOL arose.
- Base erosion percentage for pre-2018 NOLs is zero. Thus, there is no NOL add-back for pre-2018 NOLs.
- Single-Entity Treatment for U.S. Consolidated Members: Members of a U.S. tax consolidated group are treated as a single entity for purposes of being liable for the BEAT. This single-entity treatment also applies for purposes of making computations relevant to the BEAT.
- Differing Taxable Years: Where members of the Aggregate Group have differing taxable years, the members of the group determine their gross receipts and base erosion percentage by reference to their own taxable year and the items of the other group members that fall within that year.
- Effective Date:
- Proposed to apply to taxable years beginning after Dec. 31, 2017.
- Until finalization of the regulations, taxpayers may elect to apply the proposed regulations to taxable years beginning after Dec. 31, 2017.