Final and new proposed regulations on the base erosion anti-abuse tax (the BEAT) under section 59A have been issued by the United States Treasury and IRS, providing clarifications and some relief tied to inbound liquidations and reorganizations and transfers of loss property. However, many changes requested by the business community were not adopted, such as exceptions for payments that give rise to subpart F income or global intangible low-taxed income (GILTI).
The United States Treasury Department and the Internal Revenue Service have issued final and new proposed regulations on the base erosion anti-abuse tax (the BEAT) under section 59A. The new BEAT regulations provide some helpful relief, such as for inbound liquidations and reorganizations and transfers of loss property, as well as several welcome clarifications. At the same time, Treasury and the IRS declined to adopt many of the more ambitious changes that the business community had requested, such as exceptions for payments that give rise to subpart F income or global intangible low-taxed income (GILTI).
As background, the BEAT imposes a minimum tax on US corporations (and certain foreign corporations, which are not the focus of this On the Subject) that consistently have annual gross receipts of $500 million or more and claim more than a de minimis amount of “base erosion tax benefits” for a taxable year. In general, as base erosion tax benefits increase, a corporate taxpayer’s BEAT liability increases. The regulations include guidance for determining the base erosion payments that will give rise to annual base erosion tax benefits. Consistent with the proposed regulations, Treas. Reg. § 1.59A-3(b) applies the same four categories of base erosion payments found in section 59A(d) for amounts paid or accrued to a related foreign party. The two categories that should affect the most corporate US taxpayers are the general category for currently deductible items and the special category for the acquisition of depreciable or amortizable property.
Relief Provided for Certain Situations
A controversial aspect of the earlier proposed regulations was that the proposed regulations treated stock consideration in non-cash transactions as BEAT “payments,” thereby creating the potential for BEAT liability in situations involving certain liquidations, tax-free reorganizations and other non-cash transactions. [See Proposed BEAT Regulations: Tax-Free Transactions May Give Rise to a Liability Insight]. While the final regulations adopt the rule in the proposed regulations that an amount paid or accrued to a related foreign party includes any form of consideration (including both cash and non-cash consideration such as property, stock, or the assumption of a liability), the final regulations generally exclude transfers and exchanges of stock made in connection with a corporate non-recognition transactions from the definition of a base erosion payment. Thus, as a general matter, corporate US taxpayers may acquire depreciable or amortizable property in an inbound related party exchange described in section 351, a liquidation described in section 332, or a reorganization described in section 368 without triggering base erosion tax benefits when claiming future depreciation or amortization deductions on acquired property.
Corporate US taxpayers should be aware of two potential exceptions to this rule when undertaking inbound corporate non-recognition transactions. First, the use of “other property” or money (such as types of consideration described in sections 351(b), 356(a)(1)(B), and 361(b), including liabilities described in section 357(b)) in an inbound corporate non-recognition transaction are not subject to the exception and will be treated as base erosion payments. Second, the broad anti-abuse rule in Treas. Reg. § 1.59A-9 is potentially applicable and may override the exclusion for inbound corporate non-recognition transactions in some situations in which the corporate taxpayer undertakes a basis step-up transaction shortly before the inbound non-recognition transaction.
Moreover, the final regulations adopted the rule from the proposed regulations that depreciation or amortization deductions claimed on property acquired in connection with a “pure” inbound section 301 distribution will not give rise to base erosion tax benefits. However, the beneficial treatment was not extended to dividend-equivalent redemptions under section 302(d) (including by operation of section 304) or redemptions of section 306 stock even though such distributions are otherwise generally taxed at the shareholder-level as a section 301 distribution.
The final regulations also provide relief for losses triggered on transfers of built-in loss property to foreign affiliates. To the extent a corporate taxpayer transfers built-in loss property to a related foreign party in a taxable exchange, the loss realized from the transfer of built-in loss property will not be treated as a base erosion tax benefit. There will be, however, a base erosion payment to the extent of the fair market value of the transferred property.
In addition, the final regulations retained the non-statutory exclusion of section 988 losses from the definition of base erosion payments. Section 988 losses are defined as exchange losses within (the meaning of Treas. Reg. § 1.988-2) from “section 988 transactions.” Such losses are also excluded from the numerator of the base erosion percentage. The proposed regulations had also provided that all exchange losses from section 988 transactions (including losses with respect to section 988 transactions with unrelated persons) were to be excluded from the denominator of the base erosion percentage. In response to comments, the final regulations now provide that section 988 losses are excluded from the denominator of the base erosion percentage only to the extent such losses result from transactions with foreign affiliates that are also excluded from the numerator.
General Adherence to Proposed Regulations’ Approach of Accommodating Self-Help Approaches
Similar to the initial proposed regulations, the final regulations generally do not establish specific bright-line rules for determining whether a payment is treated as a deductible payment, which as noted above is one of the four enumerated categories of “base erosion payments.” As described below, comments to the proposed regulations requested explicit carve-outs regarding transactions involving a middleman or a passthrough payment or divisions of revenues in connection with profit split arrangements. The final regulations generally provide that the determination of whether a taxpayer’s payment or accrual to a foreign related party falls within one of these categories is made under general principles of US federal income taxation (for example, the reimbursement doctrine, and agency, conduit, and assignment of income principles).
Therefore, taxpayers are permitted to rely on general US federal income tax principles, including common law doctrines, in structuring intercompany and third-party contracting and payment arrangements in a tax efficient manner, and should consider modifying their business processes to comport with their desired treatment.
Requests Denied by the Treasury and IRS
As described below, the Treasury and IRS declined to extend specific relief to many common business arrangements and payment structures involving (1) passthrough payments, (2) netting arrangements, (3) outbound payments to a controlled foreign corporation (CFC) that result in subpart F or GILTI, (4) profit split methods, or (5) payments for generally high-margin services.
No Exception for Passthrough Payments & Netting Arrangements between Related Parties
The Treasury and IRS declined to issue specific guidance concerning transactions involving passthrough payments and divisions of revenues in connection with global service arrangements. The “passthrough payment” scenario may involve situations where a taxpayer serves as a middleman for a payment to a foreign related party, which in turn remits a corresponding payment for third party costs. Commenters cited business exigencies as one of the key reasons for driving the form of such arrangements, and suggested solutions to exempt these payments from constituting “base erosion payments.” Treasury and IRS rejected these suggestions, citing a number of reasons. For example, an exception for payments that arise because of non-tax business considerations would create the need for even more rulemaking to regulate the inherent subjectivity of using an exception for business versus non-business reasons. Further, Treasury and IRS concluded that the suggested solutions would cause BEAT to be imposed on a “net” rather than “gross” basis, thereby undermining Congress’ intent.
The final regulations also do not include a general netting rule that would allow corporate US taxpayers to reduce the gross amount of base erosion payments made to foreign related parties by the amount of payments received from such foreign related parties. As a result, base erosion payments will generally still be determined on a gross basis.
Corporate US taxpayers that make payments to foreign related parties may wish to re-evaluate their internal arrangements and business operations to determine whether their payments should be characterized as deductions incurred to a related party under common law doctrines. For example, a payment that flows through a US taxpayer’s hands solely in the taxpayer’s capacity as an administrative clearinghouse may be better characterized as never being included in or deductible from the taxpayer’s income under general principles, on the basis that the taxpayer serves as a mere agent and never has a claim of right to the funds.
No Exception for Payments that Produce Subpart F or GILTI
The final regulations do not adopt an exception from base erosion payments for payments made by a domestic corporation to a CFC that result in subpart F or GILTI inclusions. This creates the possibility of double taxation when these regimes and BEAT apply simultaneously. In declining to provide an exception for such inclusions, Treasury and IRS cited policy reasons underlying BEAT and difficulty in administering a GILTI exception due to tracing of payments and differences in tax rates.
Taxpayers faced with the predicament of being subject to double taxation should consider eliminating payments from domestic corporations to CFCs to the extent manageable from a business perspective, or affirmatively plan into exceptions under the Subpart F or GILTI rules, such as the high-tax exceptions, so that the payment does not result in a taxable inclusion.
No Exception for Profit Split Method
Comments recommended that payments by the domestic corporation to foreign related parties should not be base erosion payments if the parties have adopted a profit split as their best method of pricing the related-party transactions for purposes of section 482. Some of these comments asserted that parties to such payments could be viewed as splitting the customer revenue for purposes of section 59A. Under this view, the payments received by the foreign related party would be treated as received directly from the third-party customer, with the result that there would be no corresponding deductible payment from the domestic corporation to the foreign related party. The Treasury and IRS declined to adopt an exception for the profit split method or similar transfer pricing method that is used for purposes of section 482. The preamble notes that the use of a particular method, whether the profit split method or another method, does not change the contractual relationship between the parties. Accordingly, the final regulations do not adopt this recommendation because the proper characterization depends on the underlying facts and the relationships between the parties. Again, taxpayers in some cases may be able to achieve the intended tax treatment by modifying their agreements.
No Expansion of SCM Exception
Furthermore, the Treasury and IRS declined to expand the scope of the services cost method exception (the SCM Exception). The SCM Exception is generally based on satisfying the requirements in Treas. Reg. § 1.482-9 except that the recordkeeping requirements are modified and the business judgment rule is turned off (i.e., services may qualify for the SCM Exception even if the service contributes significantly to the success or failure of the corporate taxpayer’s business). Taxpayers had asked Treasury and the IRS to expand the SCM Exception to cover the cost-component of payments for services that are not eligible for the SCM on the basis that the services are on the per se excluded list under Treas. Reg. § 1.482-9 (for example, research and development). Taxpayers had suggested that the business judgment rule and the per se excluded list operate together in pursuit of the same policy, such that the policy rationale for turning off the business judgment rule should imply a turning off of the per se excluded rule. Treasury declined to adopt these recommendations, stating that the excluded services list and the business judgment rule serve similar, but ultimately different, policy objectives. As a result, corporate taxpayers who are adversely affected by the application of the BEAT to per se excluded services should continue to pursue other planning strategies, such as moving high-margin offshore services into a foreign branch or outsourcing such services altogether.
Treatment of Qualified Derivative Payments
As background, section 59A(h)(2) exempts qualified derivative payments (QDPs) from the definition of base erosion payments, provided that no payment is a QDP for a taxable year unless the taxpayer includes the information relating to such payments that is required to be reported under section 6038B with respect to such taxable year.
The final regulations clarify that, for purposes of the QDP exception, the section 6038B information reporting requirement applies regardless of whether or not a taxpayer is a “reporting corporation” (as defined) and that all taxpayers must report the information required by Treas. Reg. § 1.6038A-2(b)(7)(ix) for a particular payment to be eligible for QDP status. In addition, the final regulations eliminate the rule in the proposed regulations that would have required a taxpayer to report the aggregate amount of QDPs as determined by type of derivative contract, the identity of each counterparty, and the aggregate amount of QDPs made to each counterparty. Under the final regulations, a taxpayer satisfies the reporting requirement by including a QDP in the aggregate amount of all QDPs on Form 8991 or a successor form. The final regulations also extend the transition period for meeting the complete QDP reporting requirements to taxable years beginning before June 7, 2021.
Proposed Regulations Provide an Explicit Deduction-Waiver Procedure to Manage the Base Erosion Percentage
The new proposed regulations provide a taxpayer favorable deduction-waiver procedure to manage the base erosion percentage. To be considered an “applicable taxpayer” and potentially subject to BEAT, a taxpayer must satisfy the “base erosion percentage” test. A taxpayer satisfies this test when it has base erosion payments that account for at least 3% of its total deductions (2% for certain financial institutions). The base erosion percentage test is calculated by dividing the taxpayer’s aggregate amount of base erosion tax benefits (the “numerator”) by the sum of the taxpayer’s aggregate amount of deductions plus certain other base erosion tax benefits (the “denominator”). For purposes of the numerator, a “base erosion tax benefit” includes any deduction that is allowed under Chapter 1, Subtitle A of the Code for the taxable year with respect to the base erosion payment (Allowed Deduction).
The proposed regulations provide that a taxpayer may forgo a deduction on an item-by-item basis and that those forgone deductions will not be treated as base erosion tax benefits if the taxpayer elects to waive the deduction for all US federal income tax purposes, subject to certain exceptions provided by the proposed regulations. The effect of making the election is that the numerator should decrease, thereby resulting in a lower base erosion percentage. A taxpayer is permitted to make the election on an annual basis, and must follow certain procedural requirements. Further, a taxpayer is permitted to make the election retroactively by filing an amended return or during the course of an examination for the relevant tax year. As a baseline, the proposed regulations provide that any deduction that a taxpayer is permitted to claim is generally considered an Allowed Deduction, unless the taxpayer elects to waive certain deductions. The proposed regulations provide that if a taxpayer takes advantage of the deduction waiver with respect to a particular deduction for a prior year, the taxpayer is not permitted to recover the waived deduction in a subsequent year by making an accounting method change.
Although waiving deductions generally will not be anyone’s first choice as a tax planning strategy, taxpayers that find themselves at risk of satisfying the base erosion percentage test and that could otherwise suffer the “cliff effect” of falling into the BEAT should consider the availability of the deduction waiver as a fallback option. The ability to assert waiver on examination should be particularly helpful in ensuring that relatively small increases in deductions don’t ultimately lead to very large BEAT liabilities. As the election is made on an annual basis, taxpayers with BEAT exposure should review their deductions currently, prospectively, and should also review their prior 2018 US federal income tax data to determine if they can benefit from applying the deduction waiver retroactively. Taxpayers may rely on the proposed regulations to make the election until final regulations are issued.