This article is intended to provide a high-level overview of the new rules regarding the taxation of foreign payments and earnings and discuss how accounting methods may affect a company’s BEAT liability, FDII deductions, and GILTI inclusion.
Base erosion anti-abuse tax
Enacted as part of the Tax Cuts and Jobs Act of 2017 (TCJA) under Internal Revenue Code (IRC) Section 59A, the base erosion and anti-abuse tax (BEAT) operates to impose a minimum tax when a U.S. taxpayer makes deductible payments to related foreign entities for items such as interest, royalties, and certain services.
The tax is imposed on large (gross receipts of at least $500 million) domestic or foreign corporations operating in the United States that make deductible payments to related foreign entities in excess of 3 percent of total deductions. Gross receipts must be aggregated among all operations paying U.S. tax in order to determine if the rules apply. So, when two or more companies are considered a common employer under IRC Section 52, their gross receipts must be combined to determine if the $500 million threshold is met.
Payments to related foreign parties are added back to taxable income to arrive at adjusted taxable income. Adjusted taxable income is multiplied by the BEAT rate (5 percent for 2018, 10 percent for tax years 2019 through 2025, and 12.5 percent for 2026 and later years), and the taxpayer pays incremental tax to the extent that the BEAT tax exceeds regular tax.
Payments for inventory or items included in cost of goods sold (COGS) do not qualify as BEAT payments For example, assume a company with taxable income of $100 million pays a related foreign entity $50 million in royalties for know-how to produce certain items and $75 million in interest. In determining the BEAT for 2019, the company would compare its regular tax liability of $21 million to its BEAT liability of $17.5 million (10 percent x [$100 million + $75 million of interest]) resulting in no incremental BEAT liability. If the $50 million in royalties were not properly includable in COGS, the BEAT liability would be $25.5 million, resulting in an incremental tax of $4.5 million.
In determining if a cost is properly allocable to COGS or subject to capitalization to inventory, taxpayers can look to the uniform capitalization (UNICAP) rules under IRC Section 263A. Under these rules, taxpayers are required to capitalize costs that are incurred by reason of the production or resale of inventory. The UNICAP rules generally require that a taxpayer consider all direct, indirect, and mixed service costs to determine the appropriate amount of these costs to be capitalized to ending inventory. Generally, mixed-service costs benefit both the inventory production and resale activities and non-inventory activities such as sales and overall company management and can be overlooked in the inventory valuation process. The UNICAP rules generally require that royalties related to the production of inventory be properly accounted for in COGS and subject to capitalization to ending inventory.
This rule is illustrated by the Robinson Knife case1 in which a taxpayer paid a fee for the use of a trade name in the production and sale of inventory. The taxpayer generally incurred the royalty only on the sale of the goods, and the government asserted that a portion of the royalty must be capitalized to ending inventory. Ultimately, the taxpayer won the case and was not required to capitalize the costs to ending inventory but instead could account for the costs as associated with the goods produced and sold within the tax year. This decision resulted in revisions to the UNICAP regulations2 allowing taxpayers to treat sales-based royalties as items properly accounted for in COGS and attributed to the goods sold for the year.
In addition to royalties, payments to a foreign-related entity for services related to the production or resale of inventory should be evaluated to determine if they are attributable to COGS. As illustrated above, below-the-line deductions increase the BEAT base. With the increased importance in identifying costs appropriately attributed to COGS, companies should evaluate how revisiting the UNICAP rules might benefit them if they are subject to BEAT.
If it is determined that costs are not being properly accounted for under the UNICAP rules, an accounting method change might be required in order to change to a proper method of accounting. This requirement is accomplished by filing a Form 3115, “Application for Change in Accounting Method.”
Foreign-derived intangible income
Also part of the TCJA, the foreign-derived intangible income (FDII) deduction under IRC Section 250(a) allows U.S. C corporations that sell goods and services to foreign customers a deduction that reduces the effective tax rate to 13.75 percent on that income. For a U.S. corporation, the first step is calculating its deduction-eligible income (DEI), which is its gross income determined without regard to certain items of income including any foreign branch income, less deductions allocable to the gross income3.
The second step is for the corporation to determine the foreign-derived portion of DEI (FDDEI)4. FDDEI includes the DEI derived from a sale of property to a foreign person for foreign use or services provided to a foreign person or with respect to foreign property. Under these rules, the term "sale" is defined very broadly and includes any lease, license, exchange, or other disposition5. Foreign use is any use, consumption, or disposition that is not within the United States6.
The third step is for the corporation to calculate its deemed intangible income (DII). This is the excess of the corporation's DEI over 10 percent of its qualified business asset investment (QBAI)7. QBAI is the average of the corporation's adjusted basis in its depreciable tangible property used in the production of DEI8. In computing QBAI, adjusted basis is determined on an average quarterly basis using straight-line depreciation over lives determined under the alternative depreciation system (ADS).
The corporation takes its final step when it calculates its FDII and the FDII deduction. The corporation calculates its FDII by multiplying its DII by the ratio of its FDDEI to its DEI (DII × (FDDEI ÷ DEI)). The FDII deduction is 37.5 percent of the corporation's FDII.
An important part of the overall deduction is the determination of gross income in total and gross income derived from foreign sales. Gross income represents total sales less COGS. As noted with BEAT, the UNICAP regulations should be considered when determining what costs are properly included in COGS and how those costs can attributed to foreign and domestic activities. These rules should provide some guidance into what costs should be properly included in COGS in determining gross income. The proposed regulations state that in determining gross income with respect to DEI and FDDEI, any reasonable method can be used.
With the FDII deduction, the fact that a taxpayer is including additional costs in COGS generally would result in a lower gross income amount and could lower the FDII deduction. In comparison to the example above, a taxpayer might want to exclude royalties from costs of goods sold to increase total gross income that is allocated between FDDEI and non-FDDEI. This might or might not be beneficial depending on how other costs are allocated to the FDDEI. Ultimately, the royalties would need to be allocated or apportioned between domestic and foreign activities in determining the FDII deduction. The rules follow a reasonable allocation methodology and look to the principals under IRC Section 861, similar to the old Section 199 rules. Essentially, the main goal is to have a good understanding of the methods used in determining sales and COGS to make the most of the FDII deduction.
Global intangible low-taxed income
Tax reform also introduced a new income inclusion provision related to the earnings of controlled foreign corporations (CFCs) that might otherwise escape U.S. taxation under the foreign dividends received deduction of Section 245A. The TCJA instituted the global intangible low-taxed income (GILTI) provisions9, which significantly expands the U.S. taxation of foreign earnings. The GILTI regime theoretically results in U.S. taxation of a CFC’s earnings when those CFCs generate low-taxed intangible income.
Intangible income under GILTI is defined, in short, as CFC earnings in excess of a 10-percent return on the CFC’s QBAI, similar to a domestic corporation’s QBAI for purposes of FDII. The “low-taxed” component of GILTI is presumably achieved by allowing a deduction equal to 50 percent of the inclusion under GILTI10 and allowing a foreign tax credit for 80 percent of the foreign taxes paid with respect to the income included under GILTI, subject to the traditional foreign source income limitations under Section 904. CFC earnings for purposes of GILTI are determined by reference to the rules for computing taxable income pursuant to Treasury Regulation Section 1.952-2, which generally requires that income and deduction of a CFC be determined as if it were a domestic corporation as opposed to earnings and profits upon which most CFC inclusions are based.
From an accounting methods perspective, CFCs are generally required to use many of the same U.S. tax principles to determine taxable income as were used to determine earnings and profits. For many CFCs, this requirement had only been an issue when there was a significant event in which earnings and profits became a factor, and, arguably, pooling concepts often softened the blow even then.
One of the most significant items that many CFCs face when applying U.S. tax principles is the proper application of the depreciation rules. If assets are located in a foreign jurisdiction, they must be depreciated using the ADS rules. Generally, these rules require assets to be depreciated over longer recovery periods using a straight-line methodology. Historically, many CFCs used book depreciation as a proxy for ADS. With the broader reach of GILTI and the attendant focus on QBAI, those CFCs may need to file an accounting method change in order to adopt ADS.
Accounting for inventory is another area in which CFCs might not be compliant with U.S. tax rules. As noted above, the UNICAP rules generally require that more costs be capitalized to inventory as compared to book accounting. Many taxpayers have overlooked UNICAP when computing CFCs’ earnings and profits. When the foreign activity is similar to the U.S. activities, the CFC may be able to adopt the U.S. ratio method, which allows the foreign entity to use the absorption ratio established by the U.S. parent to capitalize costs to ending inventory under UNICAP.
The goal is to understand what methods should be used in computing tested income and determine if a method change is needed in order to use a proper method of accounting. Method changes can be made either through an automatic or advance consent process. The general rules regarding filing a method change are outlined in Revenue Procedure 2015-13, and Revenue Procedure 2018-31 provides a list of the majority of the automatic method changes available to taxpayers. The advance consent process requires that the method change be filed with the national office of the IRS prior to the close of the tax year that the method change is to be effective and generally requires payment of a user fee. The fee can vary based on the number of applicants and method changes being filed but currently starts at $10,80011 for each method change. A method change filed under the automatic method change procedures is filed with the federal tax return by the due date of that tax return, including extensions, and does not require the payment of a filing fee. Because most CFCs are not required to file a U.S. tax return, the controlling domestic shareholder must file Form 3115 on behalf of a CFC. The various rules regarding filing a Form 3115 for a CFC are outlined in Revenue Procedure 2015-13 section 6.
It has become more important for taxpayers with international activity to review and understand U.S. tax rules related to the adoption and use of proper accounting methods as they wade through the rules for BEAT, FIDII, and GILTI. Companies should evaluate the methods being used to determine if they are proper, and they should make accounting method changes where they are not.