On September 1, 2020, the US Department of the Treasury (Treasury) and Internal Revenue Service (IRS) released final regulations on the base erosion and anti-abuse tax (the BEAT) under section 59A. These regulations finalize proposed section 59A regulations issued in December 2019 (the Proposed Regulations), with certain modifications. This discussion addresses several key topics of the final regulation package (the Final Regulations), which includes the BEAT deduction waiver election, adjustments to the basis step-up anti-abuse rule in Treas. Reg. § 1.59A-9(b)(4), and the determination of a taxpayer’s aggregate group.
BEAT Deduction Waiver Election
The centerpiece of the Proposed Regulations was the inclusion of a deduction waiver election (the „Waiver Election“) to help taxpayers manage the base erosion percentage. The BEAT statutory language creates a cliff effect, in that a small amount of deductions can tip a taxpayer over the 3% base erosion percentage threshold, causing the BEAT to apply even to base erosion payments that were under the threshold. The Waiver Election addresses this problem by allowing a taxpayer to forgo a deduction on an item-by-item basis to keep the base erosion percentage below the 3% threshold. While some sort of deduction waiver ability would have existed anyway under general case law, the provision of an IRS-approved framework for deduction waiver, with specific terms and procedures, was a very welcome development. While waiving deductions is generally a costly solution to a BEAT problem, the ability to do so helps taxpayers sleep at night knowing that a future discovery of previously unknown deductible payments will not trigger disproportionate BEAT consequences. The Proposed Regulations would allow a taxpayer to waive deductions on an original or an amended return, or even on audit. Under the Proposed Regulations, deduction waiver operates as a one-way ratchet—a taxpayer can increase the amount of deductions waived, but once waived cannot reduce the amount of the waiver. The Final Regulations generally adopt the Waiver Election provisions of the Proposed Regulations, but provide clarification on certain points and address comments in several notable areas. Commenters had requested greater flexibility in applying the election, but these requests were rejected.
Comments requested that taxpayers be allowed to reduce the amount of a previous deduction waiver. For example, if a taxpayer overestimated the amount of deductions that they needed to waive to reduce the base erosion percentage to below 3%, a maximally flexible approach would be to allow the taxpayer to reduce the extent of their previous waiver and thereby obtain the regular tax benefit of the deductions that the taxpayer ultimately had no need to waive. The Final Regulations did not adopt this approach, based on concerns about adding to the complexity of audits. Thus, the Waiver Election remains a one-way ratchet. As a result, taxpayers should carefully, and conservatively, estimate the amount of the deductions they wish to waive, because they will not be able to take deductions back once they decide to waive them. Relevant to this issue, the Final Regulations clarify that a deduction may be waived in part, as opposed to in full. The Proposed Regulations had implied that a partial waiver was possible in discussing certain rules, but did not explicitly state that it was allowed. The Final Regulations‘ clarification is favorable, because allowing partial waivers can help taxpayers refine the amount of deductions needed to be waived to avoid the cliff, while ensuring that the remaining deductions are not wasted. At the same time, taxpayers need to be mindful of the Waiver Election’s procedures, as the option to elect or increase the deduction waiver on audit is available only under general IRS procedures for submitting affirmative adjustments and thus may be available only very early in the audit (although the safety valve of electing or increasing a deduction waiver via amended return is available even well into an audit, as long as the statute of limitations is kept open).
The Final Regulations also address comments that requested that taxpayers that made elections to capitalize and amortize research and experimentation expenditures (R&E) for purposes of BEAT, as well as electing to not claim bonus depreciation, be entitled to automatic relief on revoking such elections. Additionally, comments requested that taxpayers be allowed to retroactively make the elections to capitalize and amortize R&E or not claim bonus depreciation to provide relief from permanent BEAT consequences. The Final Regulations reject both proposals, citing concern that it would permit taxpayers to use hindsight to reduce or eliminate BEAT liability or regular income tax.
The Final Regulations make several modifications to the Waiver Election in the context of partnerships. For example, the regulations permit a corporate partner to make the Waiver Election with respect to partnership items and clarify that a partnership may not make an election. This change is helpful, as partners may have differing circumstances with respect to BEAT and an election benefiting one might have negative consequences for others. The Final Regulations also provide certain rules to conform the partner-level waiver with section 163(j). Further, the regulations provide that waived deductions are treated as nondeductible expenditures, thereby reducing the adjusted basis of a partner’s interest in a partnership. In this regard, the regulations made a similar revision for consolidated groups, by clarifying that waived deductions attributable to a consolidated group member are treated as noncapital, nondeductible expenses that decrease the tax basis in the member’s stock for purposes of the stock basis rules in Treasury Regulation section 1.1502-32.
Basis Step-Up Anti-Abuse Rule
The Final Regulations also provide some needed relief to taxpayers by narrowing the anti-abuse rule in Treas. Reg. § 1.59A-9(b)(4) with respect to basis step-up transactions that precede inbound nonrecognition transactions involving depreciable and amortizable property (the „Basis Step-Up Anti-Abuse Rule“).
As background, base erosion payments generally include amounts paid or accrued by a corporate US taxpayer to a related foreign party in exchange for depreciable or amortizable property. The final 2019 BEAT regulations adopted a limited exception that generally excludes from the definition of a base erosion payment transfers or exchanges of stock made in connection with an inbound corporate nonrecognition transaction. Thus, any transfers or exchanges of stock by a corporate US taxpayer to a related foreign party in exchange for depreciable or amortizable property in connection with a section 351 exchange, a section 332 liquidation, a section 355 spin-off, or a section 368 reorganization generally do not give rise to base erosion payments (the „Nonrecognition Transaction Exception“). As a result, any future depreciation or amortization deductions claimed by the corporate US taxpayer on property received as part of the inbound nonrecognition transaction do not give rise to base erosion tax benefits for purposes of calculating potential BEAT liability.
The 2019 BEAT regulations also introduced the Basis Step-Up Anti-Abuse Rule. As initially finalized in 2019, this rule provided that if a transaction, plan, or arrangement had a principal purpose of increasing the basis of depreciable or amortizable property that a corporate US taxpayer later received as part of an inbound nonrecognition transaction, the Nonrecognition Transaction Exception was completely turned off. The anti-abuse rule also included an irrebuttable presumption that transaction, plan, or arrangement had such a tainted principal purpose if it: (i) was between related parties; (ii) occurred within the six-month period before an inbound nonrecognition transaction; and (iii) increased the depreciable or amortizable basis of property the corporate US taxpayer would acquire as part of the inbound nonrecognition transaction.
The scope of the initial version of the Basis Step-Up Anti-Abuse Rule was criticized as being overly broad and too vague. Treasury and the IRS recognized some of these concerns and, as indicated above, made taxpayer-favorable changes to the anti-abuse rule as part of the recent 2020 BEAT regulation package.
First, as initially finalized, the Basis Step-Up Anti-Abuse Rule created a new cliff effect that disqualified otherwise pre-existing basis in depreciable or amortizable property. For instance, under the initial version of the rule, if one week before an inbound section 332 liquidation, the liquidating foreign corporation purchased depreciable property from a related foreign party for $100x (which created only $5x of gain for the selling foreign related party and thus only $5x of basis step-up), all of the stock treated as exchanged by the corporate US taxpayer for the depreciable property worth $100x as part of the subsequent inbound section 332 liquidation would have been disqualified from falling within the Nonrecognition Transaction Exception, thus resulting in a base erosion payment based on the Basis Step-Up Anti-Abuse Rule.
In the new Final Regulations, Treasury and the IRS removed the cliff effect from the Basis Step-Up Anti-Abuse Rule. Under the modified version of the rule, only the stock treated as exchanged by the corporate US taxpayer that is attributable to the incremental increase in basis in the depreciable or amortizable property that occurred as part of the preceding taxable transaction will be disqualified from falling within the Nonrecognition Transaction Exception. Thus, based on the example above, under the updated version of the Basis Step-Up Anti-Abuse Rule, $95x of the $100x of stock exchanged by the corporate US taxpayer in the section 332 liquidation would fall within the Nonrecognition Transaction Exception (and thus not give rise to a base erosion payment) with the remaining $5x falling within the anti-abuse rule and giving rise to a base erosion payment. As illustrated by the example, this change to the anti-abuse rule should provide greater flexibility when planning into inbound nonrecognition transactions, because pre-existing depreciable or amortizable basis will not be counted for purposes of calculating any future BEAT liabilities.
Second, as initially finalized, there was confusion as to the potential reach of the Basis Step-Up Anti-Abuse Rule. For instance, some corporate US taxpayers were unclear whether an unrelated section 338(g) election that occurred years prior to an inbound nonrecognition transaction, which created basis that was still being depreciated or amortized by the corporate US taxpayer who received the property as part of the inbound nonrecognition transaction, was subject to the anti-abuse rule. To allay these concerns, Treasury and the IRS clarified that the transaction, plan, or arrangement with a principal purpose of increasing the adjusted basis of depreciable or amortizable property must have a factual connection with the acquisition of such property by the corporate US taxpayer as part of the subsequent inbound nonrecognition transaction. This change should provide corporate US taxpayers with greater confidence as to which basis step-up transactions are or will be subject to the Basis Step-Up Anti-Abuse Rule.
In summary, as before the changes to the Basis Step-Up Anti-Abuse rule, corporate US taxpayers generally should remain comfortable that basis step-up transactions involving an unrelated party that precede an inbound nonrecognition transaction should not be subject to the anti-abuse rule. However, even if related parties are involved, with the removal of the cliff effect from the Basis Step-Up Anti-Abuse rule, corporate US taxpayers should have greater flexibility when planning into nonrecognition transactions without having to take into account pre-existing depreciable or amortizable basis for purposes of computing future BEAT liabilities.
Taxpayers Which Are Members of an Aggregate Group
The Final Regulations address several issues relevant to determining a taxpayer’s „aggregate group“ and which items of its group members are taken into account. The concept of aggregate group begins with the definition of a „controlled group“ under section 1563(a), with some modifications (including the use of a „more than 50 percent“ threshold rather than „at least 80 percent“). Clarification of precisely which corporations are members of a taxpayer’s aggregate group is essential because the gross receipts tests and base erosion percentage test are applied on the basis of the taxpayer’s aggregate group. Therefore, whether the taxpayer is ultimately subject to the BEAT hinges on which entities are included within that aggregate group.
In particular, the Final Regulations address issues regarding members with short taxable years, members joining or leaving the taxpayer’s aggregate group, and how to deal with predecessor corporations.
a) Short Tax Year
Under the new Final Regulations, a taxpayer measures the gross receipts and base erosion percentage of its aggregate group by reference to the taxpayer’s gross receipts, base erosion tax benefits, and deductions for the taxable year, and the gross receipts, base erosion tax benefits, and deductions for the taxable year of each member of its aggregate group which ends with or within the taxpayer’s taxable year (the „with-or-within method“).
In the event that the taxpayer has a short year, one or more of the members of its aggregate group may have a taxable year that does not end with or within the taxpayer’s. This could lead to an undercounting of items of a taxpayer’s aggregate group. The Final Regulations adopt the provisions in the Proposed Regulations requiring taxpayers to use a „reasonable approach“ to determine the gross receipts and base erosion percentage of its aggregate group members. A reasonable approach must not over- or under-count the items of the taxpayer’s aggregate group. In particular, the Final Regulations state that simply excluding items of a member whose taxable year does not end with or within the taxpayer’s taxable year is not a reasonable approach. Beyond that, the Final Regulations include several examples of methods that may or may not be reasonable.
b) Members Joining or Leaving an Aggregate Group
i. Close of taxable year rule for determining gross receipts and base erosion percentage
When a corporation joins or leaves a taxpayer’s aggregate group during a taxable year, the taxpayer must take into account the corporation’s items only for the period during the taxpayer’s taxable year for which the corporation was a member.
The new Final Regulations largely adopt unchanged the method described in the Proposed Regulations for part-year members. First, when a corporation joins or leaves the aggregate group, its taxable year is deemed to end. The Final Regulations state that the corporation’s taxable year ends at the end of the day on which the corporation joins or leaves the aggregate group. This is a change from the Proposed Regulations that had the deemed taxable year-end occur immediately. This change was adopted to better align the regulations with other provisions of the Internal Revenue Code and regulations (e.g., section 381 and Treas. Reg. § 1.1502-76).
Generally, the taxpayer must either use a close of the books method or a pro rata allocation of the corporation’s items to take into account the period during which the corporation was a member. If a close of the books method is used, there is a special rule that treats any „extraordinary items“ after the corporation joins or leaves the group but on the same day as occurring the next day. The Final Regulations also extend the definition of extraordinary items beyond those described in Treas. Reg. §1.1502-76(b)(2)(ii)(C) to any other payment that is not made in the ordinary course of business and that would be treated as a base erosion payment.
ii. Aggregate group members with different taxable years leading to over- and under-counting of gross receipts
Often a corporation leaving or joining an aggregate group also creates a short tax year as a result of the deemed taxable year-end. Commentators highlighted the fact that in such a situation the combination of the with-or-within method and a close of the books created an over-counting issue when the member and the taxpayer have different tax years. For example, consider a taxpayer with a calendar taxable year and a member of the taxpayer’s group with a June 30 taxable year-end. If that member leaves the aggregate group on November 30, as a result of the with-or-within rule, the taxpayer must include the full 12-month taxable year of the member that ends on June 30 plus the short 5-month taxable year of the member that is deemed to end on November 30. Thus, the taxpayer would have to include 17 months of the member’s items.
To address this, the Final Regulations adopt an annualization concept. If a member of the taxpayer’s aggregate group has more than one taxable year that ends with or within the taxpayer’s taxable year, then the taxpayer annualizes that member’s items by multiplying by a factor of 365 divided by the number of days in that member’s taxable years included. The Final Regulations also adopt a reciprocal concept when a member changes its taxable year and as a result the member’s taxable year(s) that end with or within the taxpayer’s are composed of fewer than 12 months.
c) Predecessors and Successors
Regarding predecessor corporations, the new Final Regulations largely adopt the Proposed Regulations that stated that a reference to a taxpayer included a reference to a predecessor of that taxpayer, to include distributor or transferor corporation in a section 381(a) transaction. The new Final Regulations also adopted the language from the Proposed Regulations that provided that if a predecessor of the taxpayer were a member of the taxpayer’s aggregate group, then the items of each member are taken into account only once.
The Final Regulations extend this preference against over-counting by requiring a taxpayer to take into account gross receipts of a foreign predecessor only to the extent that the gross receipts are taken into account in determining income effectively connected with a US trade or business.