On Dec. 13, the U.S. Department of the Treasury and the IRS issued proposed regulations for the new base erosion and anti-abuse tax (BEAT) under IRC Section 59A. The Tax Cuts and Jobs Act (TCJA) established BEAT as an alternative minimum tax on corporate taxpayers making base erosion payments – in other words, deductible payments made to related foreign parties in excess of 3 percent of total deductions. Base erosion benefits related to the base erosion payments are added back to income to arrive at modified taxable income. The taxpayer is subject to an incremental tax to the extent 10 percent of modified taxable income (5 percent for the first year beginning after Dec. 31, 2017) exceeds regular tax.
The proposed regulations provide operating rules for determining when the tax applies and how to calculate it. Most taxpayers are happiest with two taxpayer-favorable provisions:
- Only the markups on related-party services are considered base erosion payments provided certain criteria are met.
- Deductions of amounts carried forward under Section 163(j) pre-TCJA are not base erosion payments, contrary to guidance previously released in Notice 2018-28 earlier this year.
Taxpayers and tax advisers alike had feared that the provision within the TCJA that excludes payments for services at cost from the definition of base erosion payments would be interpreted to be an all-or-nothing provision. In welcome relief, the proposed regulations clarify that only the markup feature will be treated as a base erosion payment. The services still must meet the services cost method criteria contained in Treasury Regulation 1.482-9(b) other than the criterion that the services not contribute significantly to the fundamental risks of business success or failure. The proposed regulations require taxpayers to keep adequate records demonstrating the cost element of any payments for services.
Other key elements of the proposed regulations include:
- Gross receipts test: For purposes of determining whether gross receipts of the aggregate U.S. group exceed $500 million over the base period, the U.S. group comprises affiliated U.S. corporations and U.S. trades and businesses and permanent establishments of related foreign corporations at the end of the base erosion payer’s tax year. That group’s receipts are projected back for the prior three years regardless of when they joined the group, and gross receipts are based on the base erosion payer’s tax year when different members of the group have different tax years. For purposes of the gross receipts test, a partner must include its proportionate share of gross receipts from a partnership.
- Base erosion percentage test: The proposed regulations contain an intricate set of rules for determining which payments are included or excluded from the numerator and the denominator in deciding whether base erosion payments exceed 3 percent of all deductible payments. Notably, deductions under Section 988 related to foreign currency transactions are excluded from the numerator and the denominator (even if recognized in relation to transactions with third parties) and are excluded from the denominator of any payments to related foreign parties that are excluded from the numerator because they have been subject to 30 percent withholding.
- Base erosion payments: The proposed regulations clarify that a base erosion payment includes deductible payments to foreign related parties as well as deductions related to depreciable or amortizable property purchased from foreign related parties, payments to premiums paid or accrued for reinsurance under Sections 803(a)(1)(B) or 832(b)(4)(A), and payments that result in a reduction of gross receipts of the taxpayer. In addition, the proposed regulations provide guidance on which allocable expenses attributed to a U.S. trade or business or permanent establishment are base erosion payments, distinguishing between allocations based on a division of expenses (not erosion payments) and those grounded in transfer pricing principles (erosion payments). Additionally, any payments to a partnership are treated as payments to its partners, similar to the treatment for the gross receipts test, although relief is provided for partners with minimal ownership interests.
- Modified taxable income: Although testing is done on an aggregate basis, the proposed regulations clarify that once a given taxpayer qualifies, modified taxable income and BEAT are calculated on a taxpayer-by-taxpayer basis. The proposed regulations further clarify that modified taxable income is computed by starting from taxable income and then is adjusted as each entity’s modified taxable income is determined. This method alleviates any concern about whether any deductions or adjustments would need to be redetermined to take into account an increase in income. Additionally, losses generated in the current year establish a negative starting point in the computation of adjusted taxable income. Net operating loss carryforwards or carrybacks, however, cannot reduce the starting point for modified taxable income to less than zero.