The Tax Cuts and Jobs Act of 2017 (the TCJA) introduced the Base Erosion and Anti-Abuse Tax (BEAT), an additional tax designed to ensure that corporations with significant base erosion payments made to related foreign parties pay a certain amount of U.S. federal income tax. On Dec. 13, 2018, the U.S. Treasury Department and the Internal Revenue Service released proposed regulations on the BEAT (the Proposed Regulations). The BEAT applies to corporate taxpayers that have average annual gross receipts for the three-taxable-year period ending with the preceding tax year of at least $500 million and have a base erosion percentage of three percent or more the tax year (two percent when a bank or registered securities dealer is part of the taxpayer’s affiliated group).
Taxpayers may rely on the Proposed Regulations for tax years beginning after Dec. 31, 2017 until the regulations are finalized, provided the taxpayer consistently applies the rules contained therein. The Proposed Regulations are very complex and address a variety of technical issues raised by the statutory language that implements the BEAT.
For example, the Proposed Regulations require that taxpayers who are related (i.e., applying a 50 percent common ownership standard) aggregate their income and other relevant financial information for purposes of applying the gross receipts and base erosion percentage tests. This aggregation includes related foreign corporations, however, the Proposed Regulations require taxpayers to include only the income that is effectively connected with a U.S. trade or business of the related foreign corporation. In addition, the Proposed Regulations generally provide that intercompany payments between members of such an “aggregate group” are not included in the gross receipts test or base erosion percentage calculation for the aggregate group.
Under the Proposed Regulations, the taxpayer must apply the gross receipts test by reference to the gross receipts of the taxpayer’s entire aggregate group determined as of the end of the taxpayer’s taxable year.
The guidance provides rules for when members of the aggregate group have different tax years. In general, the Proposed Regulations require each taxpayer to calculate the aggregate amount of gross receipts and base erosion percentage based on its own taxable year, including the gross receipts and base erosion payments of each aggregate group member based upon the taxpayer’s taxable year. This rule could result in members of a related group with different taxable years each having different base erosion percentages, and could result in a significant computational burden. Taxpayers may use a reasonable method to determine the gross receipts and base erosion percentage information to account for the taxable years of aggregate group members that have different tax years.
The Proposed Regulations also provide special computational rules where corporations have been in existence for less than three years.
Like the statute, the Proposed Regulations except intercompany payments that qualify under the “services cost method” under the transfer pricing rules from the definition of base erosion payments. The rules also clarify a key question regarding whether the services cost exception applies where taxpayers apply a markup to cost as a way to price intercompany services. The Proposed Regulations take a taxpayer-friendly position that the services cost method exception applies even if taxpayers add a markup. However, the portion of any payment that exceeds the total cost of the services is not eligible for the exception. In order to avail themselves of this exception, taxpayers must satisfy all of the requirements contained in the transfer pricing regulations governing the services cost method. In addition, the Proposed Regulations require taxpayers to maintain books and records adequate to permit verification of the amount paid for services, the total services cost incurred by the renderer of the services, and the allocation and apportionment of costs to those services in accordance with special transfer pricing expense allocation rules.
The Proposed Regulations also provide helpful transition rules. For example, base erosion payments that accrued in tax years beginning before Jan. 1, 2018 are excluded as base erosion payments for purposes of calculating the BEAT. The Proposed Regulations provide several helpful examples that illustrate this principle and these rules will help taxpayers transition into BEAT compliance more smoothly. Further, the Proposed Regulations provide that any disallowed disqualified interest under the old section 163(j) rules that is carried forward from a tax year beginning before Jan. 1, 2018 is not considered a base erosion tax benefit. Where interest is paid to multiple recipients and some amount is disallowed under the new section 163(j) rules, the Proposed Regulations also provide complex ordering rules to determine whether such interest should be treated as paid to related or unrelated parties, and whether such parties are foreign or domestic, for purposes of determining whether such interest is a base erosion payment. These rules could add enormous complexity to the BEAT calculation over time because taxpayers must keep track of whether disallowed interest is paid to related or unrelated parties and keep track of the foreign or domestic status of such parties on a year-by-year basis, since disallowed interest carries forward and is treated as incurred in the following year.
In a win for taxpayers, the Proposed Regulations provide that the base erosion percentage of net operating losses is zero for net operating losses incurred in tax years beginning before Jan. 1, 2018, effectively exempting such vintage losses from the BEAT. The Proposed Regulations also set forth various other computational rules, including eliminating foreign currency losses from the BEAT calculation, and treating the special deduction provided for the one-time transition tax enacted by the TCJA as other than a base erosion payment (a taxpayer-favorable result).
The Proposed Regulations also provide clarification on the calculation of the regular tax liability used in calculating the BEAT minimum tax amount. For example, the rules provide that the research and development credit will reduce the regular tax liability used in calculating the base erosion minimum tax amount for tax years beginning after Dec. 31, 2025. This lowers the threshold at which BEAT becomes relevant, which would likely increase the amounts due under the BEAT for many taxpayers.
The Proposed Regulations also provide special guidance for insurance companies, anti-abuse rules, special rules with respect to consolidated groups, and impose new reporting requirements to help the IRS monitor compliance.
The Proposed Regulations offer both friendly and unfriendly rules for taxpayers. Taxpayers with global operations should therefore carefully review the regulations to understand the impact of the BEAT on their U.S. income tax liability.