BEAT Update: Newly Proposed and Final Regulations Make Some Concessions, but the BEAT Goes On
V&E Tax Update, January 9, 2020
In the past month, the IRS has issued a spate of proposed and final regulations on various international tax law topics, including the foreign tax credit, sourcing of personal property sales, and the base erosion and anti-abuse tax (BEAT).1 The full text of these regulations can be found on our International Tax Developments page. Below, we highlight the changes made or proposed in new BEAT regulations, issued on December 2, 2019.
The final BEAT regulations, which address taxpayer comments on proposed regulations issued in December 2018, incorporate some taxpayer-favorable changes in areas where the proposed regulations overreached, but retain some rules that commentators found problematic. In addition to the final regulations, the IRS has proposed new regulations allowing taxpayers to avoid the BEAT by waiving allowable deductions in order to keep deductible payments to foreign affiliates below the de minimis threshold. Under the new guidance, taxpayers will need to plan carefully to avoid the BEAT.
BEAT functions as a minimum tax imposed on large corporate taxpayers: those with more than $500 million of gross receipts (over a three-year average) and who make more than de minimis deductible payments to related foreign parties (generally, more than 3% of total deductions). A U.S. corporation calculates its regular tax, at a 21% rate, and then recalculates its tax at the BEAT 10% rate2 after adding back certain deductions and reductions in gross income (i.e., “base erosion tax benefits”) arising from “base erosion payments” to related parties. If the BEAT computation exceeds the regular tax, the corporation owes BEAT equal to the excess amount. Amounts added back for BEAT purposes generally include (i) deductible amounts with respect to payments to related foreign persons; (ii) deductions arising with respect to depreciable or amortizable property acquired from a related foreign person; and (iii) reinsurance amounts paid to a related foreign person. Related persons are those with ownership overlap of 25% or more.
Taxpayer-Favorable Changes in the Final and Proposed BEAT Regulations
1. Acquisition of Property in Nonrecognition Transactions
One significant taxpayer-favorable change is an exception for corporate nonrecognition transactions from the definition of base erosion payment. Under the 2018 proposed regulations, deductions arising from depreciable or amortizable property received from a foreign related person in a corporate nonrecognition transaction (sections 351, 332, and 368) would have been treated as base erosion tax benefits.
Among the many objections to this rule raised by commentators is that these nonrecognition transactions in which property is acquired in exchange for stock do not involve actual “payments” from a U.S. taxpayer to a foreign related party, and that the proposed rule would have disincentivized the repatriation of intangible and other income-producing property, contrary to the intent of the Tax Cuts and Jobs Act. Treasury agreed with these comments; accordingly, the final regulations exclude amounts transferred to or exchanged with a foreign related party in a nonrecognition transaction. However, any cash or other “boot” to a foreign related party may be treated as a base erosion payment.
For example, if a foreign parent contributes depreciable property to its wholly owned domestic subsidiary in a section 351 contribution, and the foreign parent receives stock and cash in exchange, the cash, but not the stock, may be treated as a base erosion payment. In addition, if a domestic parent contributes property to a foreign subsidiary in exchange for stock and other property, the property contributed to the foreign subsidiary in exchange for other property may be treated as a base erosion payment.
2. Built-in Loss Rules
Another source of controversy in the 2018 proposed regulations is that losses recognized on the sale or exchange of property to a foreign related person would have been included in the definition of base erosion payment. Commentators pointed out that, in the case of recognition of built-in loss with respect to property sold by a domestic corporation to a foreign related party, there is no deduction arising from a payment. First, the transfer of the built-in loss property is itself not a payment; instead, it is a transfer of property in exchange for a payment. Second, even if it were treated as a payment, the deduction for the recognition of the built-in loss is not a deduction with respect to such payment. Treasury agreed, reversing course in the final regulations, which exclude built-in loss recognition from the definition of base erosion payment.
3. Election to Waive Allowable Deductions
The 2019 proposed regulations provide an election allowing a taxpayer to permanently forgo a deduction for all U.S. tax purposes. Forgone deductions will not be treated as base erosion tax benefits. This rule offers flexibility to taxpayers whose base erosion percentage is close to 3%, and who are willing to give up the benefits associated with a deduction in order to avoid a larger BEAT hit. Where the base erosion percentage is significantly above 3%, the medicine of forgone deductions may be more painful than the BEAT tax.
Although a taxpayer cannot claim a waived deduction for any other tax purposes, the waiver is disregarded for certain limited purposes, including determining costs under section 482, the allocation and apportionment of expenses, and determining the taxpayer’s earnings and profits. The election can be made on an original filed federal income tax return, amended return, or during the course of an audit. Taxpayers may rely on the proposed regulations before they become final, provided they meet certain procedural requirements. The election is made on an annual basis, and the taxpayer does not need IRS consent to make or change its election from year to year.
Areas Where Changes Were Not Made in the Final BEAT Regulations
1. No Exception for Subpart F, GILTI, and PFIC inclusions
Commentators argued that payments to related foreign persons giving rise to subpart F, GILTI and PFIC inclusions are included in the U.S. tax base and should therefore be excluded from the definition of base erosion payments. Moreover, because the BEAT functions by adding back to a domestic corporation’s taxable income deductible payments to foreign affiliates (albeit at the BEAT 10% rate), if those payments also result in subpart F or GILTI inclusions to that domestic corporation, the same income is effectively taxed twice. Treasury rejected these comments for various reasons, including Congressional intent and administrability.
As a result, taxpayers will need to structure carefully to avoid the potential of double taxation due to the interaction of BEAT with foreign income inclusion rules.
The Final Regulations do not permit the taxpayer to net payments to and from foreign affiliates in determining the amount of any base erosion payment. This no-netting rule applies even if the contractual relationship between the taxpayer and the foreign affiliate permits netting.
For example, say a controlled foreign corporation (CFC1) provides services to another controlled foreign corporation (CFC2) under an intercompany licensing agreement, and charges U.S. parent $100 for these services. U.S. parent, in turn, charges CFC2 for these services, and remits the full amount to CFC1. U.S. parent has a base erosion payment of $100 rather than zero. This no-netting rule will increase a U.S. taxpayer’s base erosion percentage, increasing the chances that BEAT will apply. Similarly, if a domestic corporation makes deductible payments to a foreign related person and receives related payments from the same person, such that it has both items of income and deduction from the same arrangement, the income items do not reduce the amount of base erosion payments of the domestic corporation. To avoid base erosion payments arising from back-to-back payments flowing through a U.S. parent or between a U.S. person and a foreign affiliate, taxpayers and their affiliates may need to realign supply chains or restructure the location of intellectual property or payment mechanics under intercompany agreements.
Notwithstanding the general no-netting rule, netting is permitted for mark-to-market transactions, where the income, deduction, gain or loss on each marked transaction will be netted to determine the amount of any base erosion payment, and otherwise to the extent permitted or required under other provisions of the Code or federal income tax principles.
3. No Look-Through Rule
Commentators also requested clarification on whether the anti-abuse rules apply where the foreign related person to whom payment is made is solely an agent and remits the payment to an unrelated foreign person under a subcontracting arrangement. The government declined to provide clarification on this point, stating that these transactions are governed by general U.S. federal income tax law, including agency principles. However, to avoid uncertainty around this issue, U.S. taxpayers should consider restructuring their arrangements to contract directly with the unrelated foreign person rather than using a related intermediary.
In finalizing the 2018 proposed regulations and issuing new proposed regulations, the government has provided some relief from the more onerous provisions of the prior proposed regulations that expanded the reach of the BEAT regime, as well as a selective waiver of deductions. However, the BEAT goes on, presenting structural concerns for large corporate taxpayers who may need to reconsider and restructure intercompany arrangements to limit or even avoid its application.
Find more international tax articles, as well as other tax guidance and resources, on V&E’s International Tax Developments page.
Visit our website to learn more about V&E's International Tax practice. For more information, please contact Vinson & Elkins lawyer Natan Leyva.
1 The BEAT rules are found in I.R.C. section 59A.
2 The BEAT rate is 5 percent in 2018, 10 percent in 2019 through 2025, and 12.5 percent in 2026 and beyond.