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Highlights of the Base Erosion and Anti-Abuse Tax (BEAT) Final and Proposed Regulations Issued by Treasury and the IRS in December 2019

By: John V. Aksak Sonali Fournier Lauren Ansley Alexis Bergman David Flores |

On December 2, 2019, the US Treasury and IRS released final regulations (T.D. 9885) (the Final Regulations) and new proposed regulations (REG-112607-19) (the 2019 Proposed Regulations) for the Base Erosion Anti-Abuse Tax (BEAT) under section 59A of the Internal Revenue Code.  The BEAT was enacted as part of the 2017 US tax reform legislation, referred to as the Tax Cuts and Jobs Act (TCJA) (Pub. L. No. 115-97 enacted December 22, 2017).  Proposed regulations were released on December 21, 2018 (the 2018 Proposed Regulations).

In Part 1 of our analysis of the new BEAT guidance, this article will highlight the key issues addressed by the Final Regulations generally for corporate taxpayers with details on provisions retained from the 2018 Proposed Regulations and modifications made resulting in new guidance.  In Part 2 of our BEAT analysis, we will highlight issues related to partnerships.  We will cover the new guidance included in the 2019 Proposed Regulations in both parts of our analysis.

Summary

  • In response to comments received, the Final Regulations generally exclude amounts transferred to, or exchanged with, a foreign party in certain non-recognition transactions described in sections 332 (liquidations), 351 (transfers to a controlled corporation), 355 (distributions of stock of a controlled corporation), and 368 (reorganizations) from the definition of base erosion payment.
  • The Final Regulations include language that is intended to ensure that the non-recognition exception is not used inappropriately – a new non-recognition anti-abuse provision in Treasury Regulation section 1.59A-9(b)(4), which can apply if the transaction, plan or arrangement has a principal purpose of increasing the adjusted basis of the property.
  • The Final Regulations clarify that a distribution for no consideration, such as a section 301 distribution, is not treated as an exchange.
  • The Final Regulations provide that the determination of the gross receipts and the base erosion percentage of a taxpayer’s aggregate group is made on the basis of the taxpayer’s own taxable year and the taxable year of each member of its aggregate group that ends with or within the applicable taxpayer’s taxable year.
  • The Final Regulations state that a loss incurred on a transfer of property to a related person will not be treated as a base erosion payment on the theory that the loss arises from the investment in the transferred asset and is not attributable to the transaction with the foreign related person.
  • The Final Regulations retain the anti-abuse and recharacterization rules from the 2018 Proposed Regulations and include a new anti-abuse rule related to non-recognition transactions.
  • The Final Regulations do not include an expansion of the ECI exception to cover certain payments to controlled foreign corporations (CFCs) or passive foreign investment companies (PFICs) to the extent they are included in the income of a US person under the US anti-deferral regimes (subpart F, GILTI, and PFIC).
  • The Final Regulations provide no relief for passthrough payments to a foreign related party in connection with global services performed outside the US or for third-party costs borne by a foreign related party.
  • Treasury received many comments on the issue of the netting of income and expenses, but the Preamble to the Final Regulations states that the decision was made to retain the approach in the 2018 Proposed Regulations that the amount of a base erosion payment is determined on a gross basis, except as provided in the BEAT Netting Rule and to the extent otherwise permitted by the code or regulations.
  • Despite taxpayer comments, the Final Regulations retain the add-back method to determine modified taxable income (MTI) without regard to both the base erosion tax benefits and the base erosion percentage of net operating loss (NOL) deductions.
  • The Preamble to the 2019 Proposed Regulations provides that the determination of whether a payment gives rise to a base erosion tax benefit is determined first under general US federal income tax principles (such as assignment of income, agency, reimbursement and conduit doctrines). There is no separate determination under section 59A.
  • The 2019 Proposed Regulations include an important taxpayer-favorable change that could help taxpayers avoid having to pay the BEAT if they are close to the 3% threshold by allowing them to elect to waive certain deductions.

Background

The BEAT, which applies in addition to a taxpayer’s regular tax liability, is intended to prevent the reduction of tax liability by certain large corporate taxpayers, both US-owned and foreign-owned corporations doing business in the US, through certain payments made to foreign related parties and certain tax credits.  It applies to corporate taxpayers with average annual gross receipts of at least $500 million over a 3-year period.

The BEAT operates as a minimum tax on deductions paid or accrued to foreign related parties arising from “base erosion payments” in any tax year that are greater than 3 percent of their total deductions.  The BEAT increases taxable income with most payments made by US taxpayers and US branches of non-US taxpayers to their non-US affiliates (non-US persons connected through 25% or greater common ownership) to arrive at modified taxable income (MTI).  The BEAT is then applied to the MTI and, if this tax exceeds the taxpayer’s regular tax, the excess (base erosion minimum tax amount or BEMTA) is owed as an additional tax.

A base erosion payment generally is a payment to a non-US related party that results in a deduction, either currently or in the future.  Base erosion tax benefits generally include deductible payments for services, interest, rents and royalties.  Depreciation and amortization deductions with respect to property acquired from related foreign persons may also be considered base erosion tax benefits and be disregarded in determining modified taxable income.

The BEAT is effective for base erosion payments paid or accrued in tax years beginning after 2017, and the tax rate is generally 5% in 2018, 10% starting in 2019, and 12.5% starting in 2026.  Note that the proposed “blended rate” for fiscal taxpayers for 2018 that was proposed in the 2018 Proposed Regulations was not adopted by the Final Regulations, so the 5% rate will apply to the first fiscal year of a taxpayer subject to the BEAT, even if part of the year is in 2019.

The Final Regulations provide guidance regarding which taxpayers are subject to section 59A, the determination of what is a base erosion payment, the method for calculating the base erosion minimum tax amount (BEMTA), and the required BEAT resulting from that calculation.  They are generally aligned with the 2018 Proposed Regulations with some changes that appear to be taxpayer-favorable, but they do not address all of the issues that were raised by taxpayer comments.

The Final Regulations apply to 2019 tax years.  For 2018 tax years, taxpayers may elect to apply the Final Regulations or 2018 Proposed Regulations provided that the taxpayer uses the rules chosen in their entirety.  Taxpayers may also use the 2019 Proposed Regulations as long as they use all of the rules in that guidance.

The 2019 Proposed Regulations include operating rules for multiple taxpayers in a group, rules for partnerships, and a new procedure for waiver of deductions in order to reduce BEAT liability.

Final Regulations

Non-Recognition Transactions

One of the key taxpayer-favorable changes in the Final Regulations relates to an exception for nonrecognition transactions (sections 332, 351, and 368) from the definition of base erosion payment.  In the 2018 Proposed Regulations, inbound non-recognition transactions were treated as base erosion payments for the majority of cases, which appeared to be beyond the scope of what the statue permitted.

The BEAT tax base references tax benefits from “base erosion payments,” which includes “any amount paid or accrued by the taxpayer to a related foreign person for the acquisition of depreciable or amortizable property.”  Under the 2018 Proposed Regulations, the provision of non-cash consideration, such as stock, was treated as an amount potentially “paid or accrued” and thus, the transfer of stock in certain nonrecognition transactions could have given rise to a base erosion payment.  In response to comments received, the Final Regulations generally exclude amounts transferred to, or exchanged with, a foreign party in a transaction described in sections 332 (liquidations), 351 (transfers to a controlled corporation), 355 (distributions of stock of a controlled corporation), and 368 (reorganizations) from the definition of base erosion payment.

The exception, however, does not apply to amounts treated as “other property” (boot) that might be transferred in the exchange.  For example, if stock and cash are transferred in a section 351 transaction, the cash may be treated as a base erosion payment, even if the common stock is not.

The preamble explains the policy underlying this rule as consistent with the general intent to eliminate disincentives for taxpayers who hold assets offshore from repatriating those assets.

The new guidance does include language that is intended to ensure that the non-recognition exception is not used inappropriately – a new non-recognition anti-abuse provision in Treasury Regulation section 1.59A-9(b)(4), which can apply if the transaction, plan or arrangement has a principal purpose of increasing the adjusted basis of the property.  There is a per se related party principal purpose presumption if a related party basis step-up transaction occurs within a six-month period before the specified nonrecognition transaction.

Finally, the Final Regulations clarify that a distribution for no consideration, such as a section 301 distribution, is not treated as an exchange.  A redemption of stock for property (under section 302 or 306) or a transaction in which there is an exchange for stock (under section 304 or 331) does constitute an exchange to which the BEAT rules can apply.

Comment:  This is a positive revision, but taxpayers will need to make sure they analyze the anti-abuse rule to determine whether a specific nonrecognition transaction qualifies for the exception.  Nonrecognition transactions may be used in a variety of restructurings including post-acquisition, often designed to address legal structures and the ownership of intellectual property.  Making these transactions subject to the BEAT would add to the cost for foreign acquisitions.  This type of transaction could include a situation where a US company purchases depreciable or amortizable assets from a foreign affiliate solely in exchange for stock, which is an example that was given during a press call with a senior Treasury official when the Final Regulations were released.  The change appears to appropriately limit the scope of the guidance to what the statute intended.

With-or-Within Method

One of the changes that was made in response to taxpayer comments will ease the burden on taxpayers who are part of an aggregate group including multiple taxpayers, each of whom is required to determine its base erosion percentage separately.  The Final Regulations provide that the determination of the gross receipts and the base erosion percentage of a taxpayer’s aggregate group is made on the basis of the taxpayer’s own taxable year and the taxable year of each member of its aggregate group that ends with or within the applicable taxpayer’s taxable year.  The 2019 Proposed Regulations include rules that clarify how to take into account the changing composition of the aggregate group covering the cases of a taxpayer with a “short year,” when a member enters or leaves mid-year, and when a disposition or acquisition occurs.

Built-in losses

In response to comments, the Final Regulations change the rule in the 2018 Proposed Regulations related to the treatment of transfers of built-in loss property to a related foreign person.  The final rule states that a loss incurred on a transfer of property to a related person will not be treated as a base erosion payment on the theory that the loss arises from the investment in the transferred asset and is not attributable to the transaction with the foreign related person.  However, if the taxpayer uses the property to make a payment to a foreign related party and the payment otherwise meets the definition of a base erosion payment, the portion of the payment that is deductible will continue to be a base erosion payment.  The Final Regulations clarify that the amount of the base erosion payment in that case is limited to the fair market value of the property transferred.

Anti-Abuse and Recharacterization Rules

The Final Regulations retain the anti-abuse and recharacterization rules from the 2018 Proposed Regulations relating to (1) transactions involving intermediaries acting as a conduit if there is a principal purpose of avoiding a base erosion payment, (2) transactions with a principal purpose of increasing the deductions in the denominator of the base erosion percentage, and (3) transactions among related parties entered into with a principal purpose of avoiding the application of the special rules for banks and registered securities dealers.  A new anti-abuse rule is also included with respect to non-recognition transactions as explained above.

Changes Not Made in the Final Regulations

No exception for GILTI, Subpart F or PFIC inclusions

The Final Regulations confirmed the provisions of the 2018 Proposed Regulations that provide that payments to a foreign related party would not be treated as base erosion payments to the extent that such payments are treated as effectively connected income (ECI) to the recipient.  Taxpayers asked that the ECI exception be expanded to cover certain payments to controlled foreign corporations (CFCs) or passive foreign investment companies (PFICs) to the extent they are included in the income of a US person under the US anti-deferral regimes (subpart F, GILTI, and PFIC). The Final Regulations do not include the expansion of the ECI exception.

The Preamble notes certain policy and practical reasons for why this decision was made.  In declining to provide these exceptions, Treasury noted that the statutory language for 59A did not include the exception, in contrast to the exception provided for in section 267A, which they explained indicated Congressional intent not to allow the exceptions.  Treasury also explained that it would be difficult to measure GILTI and subpart F inclusions.  GILTI is an aggregate calculation that combines CFCs, and Treasury said that it would have been hard to actually determine the amount of the inclusion that is by reason of the base erosion payment.

No Services Exception

The preamble to the Final Regulations states that there is no indication that Congress intended to provide a broad services exception.  Therefore, the guidance provides no relief for passthrough payments to a foreign related party in connection with global services performed outside the US or for third-party costs borne by a foreign related party.

Netting of Income and Expenses

Treasury received many comments on the issue of the netting of income and expenses, but the Preamble stated that the decision was made to retain the approach in the 2018 Proposed Regulations that the amount of a base erosion payment is determined on a gross basis, except as provided in the BEAT Netting Rule and to the extent otherwise permitted by the code or regulations.  Under the BEAT Netting Rule, the amount of the deduction that is used for purposes of the base erosion percentage test is a combination of all items of income, deduction, gain or loss on each marked transaction for the year.

Add-Back Method for Computing MTI (Modified Taxable Income)

Despite taxpayer comments, the Final Regulations retain the add-back method to determine modified taxable income (MTI) without regard to both the base erosion tax benefits and the base erosion percentage of net operating loss (NOL) deductions.  Under the add-back method, these items are added back into taxable income: (1) any base erosion tax benefit with respect to any base erosion payment and (2) the base erosion percentage of any NOL allowed under section 172.  Because NOLs cannot reduce regular taxable income below zero, the BEAT can apply even if there are available NOLs from taxable years beginning before January 1, 2018.

Comment:  The Preamble notes that the add-back approach is consistent with the statute and simpler to administer than a recomputation method.

2019 Proposed Regulations

The Final Regulations became effective December 6, 2019.  The 2019 Proposed Regulations generally apply to tax years beginning on or after the date that these regulations are finalized; however, certain provisions of these proposed regulations apply to tax years ending on or after December 2, 2019.  Taxpayers can rely on the 2019 Proposed Regulations in their entirety for tax years beginning after December 31, 2017, until they are finalized.

Preamble

The Preamble of the 2019 Proposed Regulations provides that the determination of whether a payment gives rise to a base erosion tax benefit is determined first under general US federal income tax principles (such as assignment of income, agency, reimbursement and conduit doctrines).  There is no separate determination under section 59A.  The Final Regulations incorporate this language, but there is no additional guidance regarding the application of general US federal tax principles to specific factual situations.

Comment:  Taxpayers will have to continue to make a determination under general US tax principles about whether a payment gives rise to a base tax benefit.  Payments that are not deductible under current law, e.g. under the reimbursement doctrine, would not be considered a payment for BEAT purposes.  But as noted above, Treasury and the IRS declined to exclude payments that result in GILTI or subpart F inclusions from the definition of a base erosion payment based on the position that they did not have statutory authority to do so.

Election to Waive Allowable Deductions

The 2019 Proposed Regulations include an important taxpayer-favorable change that could help taxpayers avoid having to pay the BEAT if they are close to the 3% threshold by allowing them to elect to waive certain deductions.  Taxpayers are given the option to disallow part or all of any related-party deductions in order to remain under the base erosion percentage thresholds.  The taxpayer must waive the deduction for all US federal income tax purposes and follow specific procedures.  This election can be made on an original return, an amended return, or during an audit, but once the election is made, it cannot be revoked.  The election is made on an annual basis, which means the taxpayer can waive the deduction one year, and take it the next year, but the regulations do have a provision that ensures that a deduction that is waived is not taken into account as a benefit in any future year. The taxpayer does not need the consent of the IRS to make the election, but it must be reported.  The election is not a method of accounting for purposes of section 446.

Comment:  This election is intended to blunt the “cliff effect” of the base erosion percentage thresholds in the statute.  Taxpayers will have to weigh the benefits of avoiding the BEAT against the tax cost of the loss of the deduction.  The Preamble permits taxpayers to rely on this new election for any tax year to which the BEAT applies.  Taxpayers should consider establishing a procedure by which they can track any waived amounts for purposes of later adjustments to those waived deductions.