The Base Erosion and Anti-Abuse Tax (BEAT) Final and Proposed Regulations Issued by Treasury and the IRS in December 2019 – Application to Partnerships
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, we highlighted 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 this article, which is Part 2 of our BEAT analysis, we are highlighting issues related to partnerships. We will cover the new guidance included in the 2019 Proposed Regulations in both parts of our analysis.
- The Final Regulations treat partnerships as an aggregate for purposes of determining whether a payment made or received by a partnership qualifies as a base erosion payment.
- The Final Regulations include details on the mechanics of using the aggregate approach and provide examples of how the rules work.
- The Final Regulations include explanations of the application of Section 59A to certain specific partnership transactions.
- Increases to the basis of partnership property also can result in BEAT payments and corresponding base erosion tax benefits.
- The Preamble to the Final Regulations states that there is no exception for non-recognition transactions involving partnerships.
- Partnership interests are included in the non-exclusive list of examples of “consideration” that may constitute a base erosion payment.
- The Final Regulations retain the “small partner exception” from the 2018 Proposed Regulations for payments made by a partnership.
- The 2019 Proposed Regulations include new rules intended to clarify the application of the BEAT to partners and partnerships including a rule for special allocations and two anti-abuse rules including one that addresses derivatives on partnership interests that are entered into with a principal purpose of avoiding BEAT and a second that targets allocations by a partnership to prevent or reduce a base erosion payment.
- The 2019 Proposed Regulations include rules on partner and partnership reporting requirements with respect to BEAT and a request for comments on the application of effectively connected income (ECI) to partners and partnerships.
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.
Final Regulations – Treatment of Partnerships
The Final Regulations treat partnerships as an aggregate for purposes of determining whether a payment made or received by a partnership qualifies as a base erosion payment. Thus, section 59A applies at the partner level and partners are treated as engaging in transactions with each other rather than with the partnership. This is the approach suggested in the 2018 Proposed Regulations.
The Final Regulations include details on the mechanics of using the aggregate approach and provide examples of how the rules work. These new rules make it necessary for taxpayers to be very careful in structuring partnerships with related US and foreign partners.
The Final Regulations include explanations of the application of Section 59A to certain specific partnership transactions. If property transferred to a partnership is depreciable or amortizable, each partner is treated as receiving its proportionate share of the property for the purposes of determining if the partner has a base erosion payment. If the property is transferred by the partnership, each partner is treated as transferring its proportionate share of the property. If a partner transfers a partnership interest, it is treated as transferring its proportionate share of the partnership’s assets. When a partnership transfers a partnership interest, each partner whose proportionate share of assets is reduced is treated as transferring the amount of the reduction.
Increases to the basis of partnership property also can result in BEAT payments and corresponding base erosion tax benefits. If a distribution of property from a partnership to a partner results in an increase in the tax basis of property that either the partnership continues to hold or the partnership distributes to a partner, the base erosion payment is determined by treating the increase in tax basis for the benefit of a taxpayer that is attributable to a foreign related party as if it were property newly purchased by the taxpayer from the foreign related party and placed in service when the distribution occurs.
The Preamble states that there is no exception for non-recognition transactions involving partnerships. As explained in Part 1 of our analysis of the new BEAT regulations, the Final Regulations generally exclude amounts transferred to, or exchanged with, a foreign party in certain non-recognition transactions. This exception is limited to corporate transactions and does not apply in the partnership context, because the aggregate theory of partnerships applies in determining BEAT liability. The partners are treated as engaging in transactions directly with each other and not with the partnership as a separate entity.
Taxpayers submitted comments to Treasury and the IRS arguing that partnership interests issued to partners in connection with Section 721(a) nonrecognition contributions and partnership distributions of assets in connection with Section 731 nonrecognition distributions should be excluded as consideration which could be considered a BEAT payment. This argument was rejected by the government on the premise that such exclusions would be inconsistent with an aggregate treatment of partnerships. Instead, a contribution to a partnership (or distribution from a partnership) is treated as if the partners exchanged assets with each other.
For example, if a US corporation and a foreign related party each contribute depreciable property to a new partnership in exchange for partnership interests in a Section 721(a) exchange, the transaction is treated as a partner-to-partner exchange that may result in a base erosion payment for the US corporation.
Partnership interests are included in the non-exclusive list of examples of “consideration” that may constitute a base erosion payment. Thus, Section 721 transactions will be treated differently than 351 transactions, which are generally excluded from being treated as base erosion payments. In addition, each contribution to a partnership is evaluated separately rather than being netted against contributions made by other partners (or other transactions involving the same partner), so pro rata contributions to partnerships or distributions from partnerships may constitute base erosion payments.
The Final Regulations retain the “small partner exception” from the 2018 Proposed Regulations for payments made by a partnership. A partner is not required to take into account its distributive share of any base erosion tax benefit that results from the partnership’s payment if the partner’s interest (1) represents less than 10% of the capital and profits of the partnership; (2) represents less than 10% of each item of income, gain, loss, deduction and credit; and (3) has a fair market value of less than $25 million. This is used only for purposes of determining (1) a partner’s amount of base erosion tax benefits with respect to a partnership and (2) status of a partner as a registered securities dealer.
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.
Application to Partnerships
The 2019 Proposed Regulations include new rules intended to clarify the application of the BEAT to partners and partnerships including a rule for special allocations and two anti-abuse rules.
With respect to curative allocations that can provide a partner with the benefits of a deduction in the partnership setting, the 2019 Proposed Regulations rules provide that a partner is treated as having a base erosion tax benefit to the extent the partnership places a taxpayer in an “economically equivalent position by allocating less income to that partner in lieu of a deduction to that partner.” To the extent a partnership allocates less income to a partner in lieu of allocating a deduction to the partner through curative allocations, the new proposed regulations provide that the partner is treated as having a base erosion tax benefit to the extent of that reduced income allocation.
Also included are new anti-abuse rules that address derivatives on partnership interests that are entered into with a principal purpose of avoiding BEAT and target allocations by a partnership to prevent or reduce a base erosion payment. For derivatives on partnership interests, the rule provides that a taxpayer is treated as having a direct interest in the partnership interest of asset if the taxpayer acquires a derivative on a partnership interest or asset with a principal purpose of eliminating or reducing a base erosion payment. With respect to allocations, there is an anti-abuse rule to prevent a partnership from allocating items of income with a principal purpose of eliminating or reducing the base erosion payments of the taxpayer transacting with the partnership (not acting in a partner capacity) when the allocation does not change the economic arrangement of the partners.
Finally, there are rules on partner and partnership reporting requirements with respect to BEAT, and there is a request for comments on the application of effectively connected income (ECI) to partners and partnerships.
The provisions relating to partnership transactions apply to taxable years ending on or after December 2, 2019. As with the Final Regulations, taxpayers may apply the 2019 Proposed Regulations for taxable years beginning after December 31, 2017, and before the final regulations are applicable. Taxpayers may rely on the 2019 Proposed Regulations in their entirety before their finalization.