The following piece is included in the most recent issue of the NJSBA's Tax Law Section newsletter, which explores issues facing international taxpayers, corporation business tax cases, and donor advised fund rules. You can find the newsletter here (login required). The newsletter is a benefit of membership in the Tax Law Section. To learn more about joining a section, email [email protected], and keep reading to learn more about the new BEAT minimum tax, written by James D. Sipple, the senior director of taxation for Tata Consultancy Services Ltd.
The Tax Cuts and Jobs Act of 2017 added a new base erosion and anti-abuse tax or BEAT minimum tax (new IRC §59A). The act is the largest overhaul of the United States tax code in over 30 years. It targets U.S. tax-base erosion by imposing an additional tax liability on certain corporations that make ‘base-erosion payments’ to related foreign persons.
This provision did not receive the fanfare and hype of the reduced tax rates and the favorable cash repatriation provisions for U.S.-based corporations. It may however, produce a significant tax impact on foreign corporations with income effectively connected with a U.S. trade or business, as well as some domestic corporations with significant foreign operations. There is an exception for corporations with average annual gross receipts of less than $500 million over the three preceding taxable years. The BEAT does not apply to S corporations, regulated investment companies, real estate investment trusts or individuals. If the total amount of deductions added back to compute modified taxable income is less than three percent of total deductions (two percent for certain banks and securities dealers) used in calculating taxable income, the BEAT does not apply.
The BEAT essentially is a minimum tax calculated on a base equal to the taxpayer’s taxable income determined without regard to: 1) the tax benefits arising from base erosion payments, and 2) the base erosion percentage (BEP) of any net operating loss (NOL) allowed for the tax year. BEP means for any taxable year, the percentage determined by dividing the aggregate amount of base erosion tax benefits by the sum of the aggregate amount of all deductions (including base erosion deductions), and depreciation/amortization plus insurance payments taken into account under IRC §803(a)(1)(B) or IRC §832(b)(4)(A).
These and other adjustments are made to arrive at the corporation’s modified taxable income. Modified taxable income is essentially regular taxable income calculated without the allowance of deductions for amounts paid or accrued to related foreign persons or depreciation or amortization deductions with respect to property acquired from related foreign persons.
The BEAT rate is five percent for tax years beginning in calendar year 2018, 10 percent for tax years beginning in 2019 through 2025, and 12.5 percent for tax years beginning after Dec. 31, 2025. Those BEAT rates increase by one percent for certain banks and securities dealers. The BEAT calculations generally are made on a group basis. As a result, the related-party payments, deductions, and income of affiliated domestic corporations are aggregated. Because the BEAT tax is a minimum tax, companies with high taxable income compared to their deductible payments to foreign affiliates may not be subject to the tax. Ignoring tax credits, the 10 percent BEAT tax will begin to apply when payments to foreign affiliates exceed taxable income by more than 10 percent.
The calculation of a corporation’s modified taxable income is determined by adding back to taxable income current year deductions of payments to related foreign persons. Under the BEAT, a foreign person is related if it is treated as owning at least 25 percent of the stock of the taxpayer (by vote or value). Direct, indirect and constructive ownership are considered for purposes of the ownership tests under the BEAT.
Dividends paid to a related foreign party are not subject to the BEAT, since they are not deductible for U.S. tax purposes. Deductible expenses paid or accrued to a related foreign person generally include payments for services, interest, rents and royalties. An exception is provided for services that are eligible for the application of the services cost method under the IRC §482 regulations (the service regs.). For this exception to apply there should be no mark-up component on the service provided. In addition, costs of goods sold (COGS) are generally excluded from the definition of base erosion payments, and so, for example, a U.S. business that imports product for manufacturing and/or resale is likely to be less effected by a company that pays for services. Effectively, there is an exception for COGS but there is no corresponding exception for cost of sales (i.e., services purchased from a related foreign affiliate).
Deductible expenses paid to a controlled foreign corporation (CFC) are added back in calculating a taxpayer’s modified taxable income, even if they are included in the taxpayer’s income as Subpart F income. There is no offsetting provision for netting. If the payments to the CFC are significant, it may be advantageous to check the box on the CFC so it becomes a disregarded entity for U.S. tax purposes. The CFC would effectively become a branch of the U.S. corporation and, thus, avoid adding such payments in calculating modified taxable income.
As with payments to CFCs, the legislation does not expressly permit netting of payments if a U.S. company pays a foreign-related person a deductible amount and then charges another foreign-related person for a portion of that amount. Similarly, there is also no specific provision in the legislation for netting payments between a U.S. company and the same foreign-related person. It appears that the BEAT is applied on a gross basis regardless of any offsetting payments. If that is ultimately the case, the legislation can be construed as overreaching its objective of curtailing the erosion of the U.S. tax base through related-party payments. It is reasonable to assume that the U.S. tax base would not be eroded to the extent that a U.S. company and a CFC make offsetting interest payments to each other (e.g., under a cash pooling arrangement). In this situation it would be appropriate to issue guidance to develop some reasonable netting approach to provide relief in situations not involving U.S. base erosion.
If a base erosion payment is subject to full U.S. withholding tax when made, then it is not added back in computing modified taxable income. Similarly, if a base erosion payment is subject to a reduced U.S. withholding tax rate under a treaty, then the exclusion from modified taxable income is computed proportionately in comparison to the statutory U.S. withholding tax rate.
As noted above, there is no similar exception for cost of sales with respect to services as there is for COGS. It would be expected that the same rationale that supports an exception for COGS of a seller of physical goods would also support an exception for the cost of services provided to a service provider in a situation in which the services are subcontracted to a foreign affiliate (especially in situations in which the subcontracted fees are treated as reducing gross receipts under generally accepted accounting principles). It appears that guidance should be issued so the BEAT is evenly applied across all sectors, with a particular view to ensuring the services sector is not unduly disadvantaged.
Dividends from a foreign corporation for which a 100 percent dividends-received deduction is provided are not added back to regular taxable income in computing the BEAT. The 50 percent deduction for amounts included in income as global intangible low-taxed income (GILTI) is not added back as well.
Once modified taxable income is computed, a 10 percent rate is applied (five percent for 2018 and 12.5 percent for years beginning in 2025). This amount is compared with the regular tax liability of the taxpayer. For this purpose, regular tax liability is generally reduced by credits, including foreign tax credits that reduce U.S. taxes. An exception is provided for research and development (R&D) credits and 80 percent of certain other section 38 credits. Regular tax liability is increased by the BEP of any NOL allowed under IRC §172 for the taxable year.
Again, this calculation is generally determined on a group basis, taking into account all corporations that would be considered a single employer under IRC §52(a). However, further guidance is needed to determine how to properly account for base erosion payments made by separate members of the same consolidated group.
If the above amount exceeds the regular tax liability (net of certain tax credits), then the excess amount is an additional tax imposed on the corporation. Unlike the former corporate alternative minimum tax provisions, there is no provision for a carryover of the BEAT as a reduction of regular tax liability in future years.
A domestic corporation with significant foreign tax credits might become subject to the BEAT, effectively losing the benefit of all or a portion of the credits. Since most income tax treaties require the United States to provide a foreign tax credit to eliminate double taxation of foreign source income, such a result may raise concerns with treaty partners.
Companies with BEAT tax exposure should review their tax situation to determine planning opportunities available to limit their exposure. It may be possible to restructure intercompany transactions so related party payments are made from foreign affiliates to the U.S., rather than from the U.S. to the foreign affiliate (subject to potential anti-abuse regulations). Some payments relating to sales of products in the U.S. might properly be accounted for under the inventory method as COGS, rather than as deductible payments. Payments included in COGS reduce BEAT-modified taxable income in the same manner as they reduce regular taxable income. A change of accounting method may be necessary, requiring IRS approval. Some payments to foreign affiliates for administrative services might properly be accounted for at cost, or with only a modest markup, and the cost portion of the payment may qualify for deduction from BEAT-modified taxable income. It may be desirable to restructure operations to cause more income to be subject to U.S. tax, as such additional income may have a low marginal tax rate when the effect of the BEAT tax is taken into account.
It should be noted that Congress has granted Treasury broad regulatory authority to issue regulations and other guidance to prevent the avoidance of the BEAT, including through the use of unrelated foreign persons.
With respect to information reporting, the law adds additional reporting related to BEAT under IRC §6038A, the current regime for Form 5472 reporting. While the specific requirements are not yet identified, reporting will include information that is necessary to determine the base erosion minimum tax amount, base erosion payments, and base erosion tax benefits for the tax year. Penalties related to this reporting have been increased from $10,000 to $25,000 per form.
The BEAT tax may be challenged internationally for favoring domestic companies over foreign companies in potential violation of the World Trade Organization (WTO) Agreement on Subsidies and Countervailing Measures or other international agreements. Regardless of the outcome of such a challenge, the BEAT is part of the U.S. tax law and must be dealt with until Congress changes the law.
The BEAT raises many issues that will require taxpayers to make reasoned interpretations of the law pending Treasury and IRS guidance. Guidance on the BEAT is expected later this year.