The final Base Erosion and Anti-Abuse Tax regulations recently approved in T.D. 9885 generally follow the December 21, 2018, proposed regulations with a few important changes. The IRS also issued new proposed regulations at the same time that it released the final BEAT regulations. In this article, we analyze what the changes mean for nonrecognition transactions, loss sales and the election to waive the deduction, among other issues.
Nonrecognition Transaction Exception
One very important taxpayer-favorable change is the exception for nonrecognition transactions (sections 332, 351 and 368) from the definition of base erosion payment. In the proposed BEAT regulations, inbound nonrecognition transactions were treated as base erosion “payments” in nearly all cases and were broader than the statute permits. Nonrecognition transactions are often used in post-acquisition restructurings and other internal restructurings to align legal structures and IP ownership. Making nonrecognition transactions BEAT-able created an inappropriate potential cost for foreign acquisitions. The final regulations ameliorate this error and appropriately limit the broad reach of the proposed rule.
The nonrecognition exception, however, does not apply to any other property (boot) that is transferred in the exchange. For example, if a foreign corporation transfers depreciable property to its wholly-owned domestic subsidiary in a section 351 transaction for common stock and cash, the cash may be treated as a base erosion payment, while the common stock may not.
In order to address concerns that the nonrecognition exception would be used inappropriately, the final regulations contain a new nonrecognition anti-abuse provision in Treasury Regulation section 1.59A-9(b)(4) that can apply if the transaction, plan or arrangement has a principal purpose of increasing the adjusted basis of the property. A per se related party principal purpose presumption applies if a related party basis step-up transaction occurs within a six-month period before the specified nonrecognition transaction.
The final regulations also clarify that a pure distribution for no consideration, such as a section 301 distribution, is not treated as an exchange. However, a redemption of stock for property (such as a redemption described in section 302(a) or (d) or section 306(a)(2)) or a transaction in which there is an exchange for stock (such as a section 304 or section 331 transaction) does constitute an exchange to which the BEAT provisions potentially apply.
One controversial aspect of the proposed regulations was the inclusion of losses recognized on the sale or exchange of property by a taxpayer to a foreign related party in the definition of base erosion payment, particularly because this transaction involves no payment from the taxpayer to a foreign related party. The final regulations correctly reverse course from the proposed regulations and exclude from the definition of a base erosion payment a loss realized from the consideration provided to the foreign related party. That is, the term “base erosion payment” does not include the amount of built-in-loss because that built-in-loss is unrelated to the payment made to the foreign related party.
Changes not Made in the Final Regulations
A number of comments recommend expanding the Cost of Goods Sold exception, however, no changes to the COGS exception were made in the final regulations.
The final regulations do not provide any relief for passthrough payments to a foreign related party in connection with global services performed outside the United States or for third-party costs borne by a foreign related party. The preamble states that there is no indication that Congress intended to create a broad services exception. The final regulations also do not adopt the recommendation to specifically exclude payments that are priced based on the profit split method. The preamble states that the BEAT provisions are applied after the general application of U.S. federal income tax law, leaving open the application of such principles as conduit, substance over form, common law agency and the reimbursement doctrine.
Numerous comments recommended the netting of income and expenses. The preamble states that the Treasury Department and the IRS have determined that it is appropriate to retain the approach in the 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. The BEAT Netting Rule was adopted to ensure that only a single deduction is claimed with respect to each marked transaction. 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. The final regulations also do not provide for a netting rule for related-party hedging transactions.
Comments recommended that the related party definition exclude related publicly traded companies or otherwise provide an exception for payments between publicly traded companies. The preamble states that the Treasury Department and the IRS determined that it is not appropriate to modify the statutory definition of a related party to exclude publicly traded companies.
The final regulations contain the same Service Cost Method exception contained in the proposed regulations. Comments requested an expansion of the SCM exception for research and experimentation services. The preamble, consistent with the statute, states that the SCM exception is available for all services that are typically low margin even if, in the context of a particular business, the service is a core competency of a business that may not satisfy the criteria in Treasury Regulation section 1.482-9(b)(5).
The final regulations do not include a subpart F, GILTI, or PFIC exception to base erosion payment status.
Base Erosion Percentage Test
The final regulations clarify that a transaction is disregarded when determining the gross receipts and base erosion percentage of an aggregate group if both parties to the transaction were members of the aggregate group at the time of the transaction, without regard to whether the parties were members of the aggregate group on the last day of the taxpayer’s taxable year.
When determining the base erosion percentage of an aggregate group, the base erosion tax benefits and deductions attributable to the taxable year of a member of the aggregate group that begins before January 1, 2018, are excluded.
Comments recommended that section 988 losses should not be excluded from the denominator of the base erosion percentage because excluding all section 988 losses is not consistent with the statute. The final regulations adopt this recommendation.
The final regulations adopt the “with-or-within” method to determine the gross receipts and the base erosion percentage of an aggregate group. Under this method, 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 newly issued proposed regulations contain rules clarifying how to take into account the changing composition of the aggregate group when applying the gross receipts test and the base erosion percentage test. Specifically, the newly issued proposed regulations provide that a taxpayer with a short year must use a “reasonable approach” that neither undercounts nor over-counts the gross receipts, base erosion tax benefits and deductions of the taxpayer’s aggregate group. In addition, when a member enters or leaves an aggregate group mid-year, the taxpayer determines its gross receipts and base erosion percentage by taking into account only the items occurring while a member was in the aggregate group. Rules are provided to allocate gross receipts, base erosion tax benefits and deductions between the groups in the case of an acquisition or disposition transaction.
Election to Waive Allowable Deductions
The newly issued proposed regulations provide that a taxpayer may forgo a deduction and that those forgone deductions will not be treated as a base erosion tax benefit if the taxpayer waives the deduction for all U.S. federal income tax purposes and follows specified procedures. This election would seem to follow from the statute’s definition of “base erosion tax benefits” as consisting of deductions “allowed” to the taxpayer. If a taxpayer elects to waive the deduction for BEAT purposes, it cannot claim the deduction for other tax purposes. However, the waiver is ignored for certain limited purposes (e.g., allocation and apportionment of expenses and determination of the taxpayer’s earnings and profits). The waiver applies only to the deduction and not to the underlying cost or expense. Thus, a waiver of any portion of a deduction associated with a particular cost or expense does not cause the corresponding portion of that cost or expense not to be a cost or expense.
The taxpayer can make the election on its original filed federal income tax return, an amended return, or during the course of an audit. Importantly, until the newly issued proposed regulations are final, a taxpayer can rely on the proposed regulations provided it meets certain procedural requirements. The election is made on an annual basis, and the taxpayer does not need the IRS’ consent to make (or not make) the election from year to year.
This election provides an important clarification requested by taxpayers and will offer needed relief for U.S. companies whose base erosion percentage is close to 3%. Giving up a small deduction to stay under the 3% limit could save a great deal of BEAT tax, particularly for a U.S. taxpayer that relies on the foreign tax credit to avoid double taxation of GILTI income, for example.
Treatment of Interest Expense
In general, any interest on which tax is imposed under section 871 or 881 and tax has been deducted and withheld under section 1441 or 1442 is not treated as producing a base erosion tax benefit. However, if an income tax treaty reduces the amount of tax imposed on the excess interest, the amount of base erosion tax benefit under this rule is reduced in proportion to the reduction in tax.
The regulations also provide detailed rules applicable to branches that allocate interest expense for computing effectively connected income.
A worldwide ratio can be applied to determine the amount of a U.S. branch’s interest expense paid to foreign related parties by reference to a worldwide ratio of interest expense (the “hypothetical section 1.882-5 interest expense”), rather than a worldwide ratio of liabilities. The preamble states that the final regulations do not adopt a fixed ratio or safe harbor for the worldwide interest ratio as suggested in comments because the actual worldwide interest ratio of an enterprise may vary significantly from one industry to another and from one taxpayer to another.
Interest expense determined in accordance with a U.S. tax treaty that is in excess of the amount that would have been allocated to the permanent establishment is treated as interest expense paid by the permanent establishment to the home office or another branch of the foreign corporation.
The final regulations reduce any base erosion tax benefit attributable to interest in excess of the hypothetical section 1.882-5 interest expense to the extent of the amount of the excess interest on which tax is imposed on the foreign corporation under section 884(f) and Treasury Regulation section 1.884-4, if the tax is properly reported on the foreign corporation’s income tax return and paid in accordance with the regulations.
Calculating the Base for the BEAT
Consistent with the proposed regulations, the final regulations apply the “add-back method” for calculating modified taxable income. Under the add-back method, the following 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 Net Operating Loss (NOL) deduction allowed under section 172. However, NOLs cannot reduce regular taxable income below zero. As a result, BEAT can apply even if there are available NOLs (and sometimes because the taxpayer has available NOLs) from taxable years beginning before January 1, 2018. The final regulations continue the harsh treatment of taxpayers with NOL carryovers unabated. However, regular taxable income can be a negative number as a result of current-year losses.
The taxpayer’s base erosion minimum tax amount and resulting liability are determined on a single-entity basis. In a change from the proposed regulations, the final regulations exclude alternative minimum tax credits from the calculation of regular tax liability for the purposes of section 59A.
The final regulations generally treat partnerships as aggregates rather than entities, with section 59A applied at the partner level and partners treated as engaging in transactions with each other rather than with the partnership. For example, a partnership’s issuance of a partnership interest to a foreign partner may be a base erosion payment if the foreign partner contributed depreciable property to a partnership with a related domestic corporate partner. Partnership interests are included in the non-exclusive list of examples of “consideration” that may constitute a base erosion payment. Thus, section 721 transactions are treated differently from section 351 transactions, which generally are excluded from being treated as base erosion payments. Furthermore, 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 even pro rata contributions to partnerships or distributions from partnerships may constitute base erosion payments. This adds a level of complexity (and potential income inclusion via operation of BEAT) to partnership transactions that previously had no U.S. federal income tax consequence. It is also questionable whether issuance of a partnership interest can realistically be called a “payment.”
The final regulations provide more clarity regarding the application of section 59A to specific partnership transactions. If property transferred to a partnership is depreciable or amortizable or results in a reduction of the gross receipts of a partner, 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.
Thus, a transfer to a partnership by a foreign related party before January 1, 2018, could not result in a base erosion payment. However, the acquisition of an interest in a partnership asset (including via the transfer of a partnership interest) on or after January 1, 2018, from a partnership that holds depreciable property and has a foreign related party as a partner whose interest in the asset is reduced, generally will be treated as a base erosion payment, whether or not the partnership has made a section 754 election. Gain or loss arising from the consideration used to make the payment does not affect the amount of deduction resulting from a payment; a payment from a partnership may result in a deduction even if the partnership incurs a gain on the transfer under general tax principles as a result of using built-in gain property as consideration.
These rules provide yet another reason for taxpayers to be careful in structuring partnerships with related U.S. and foreign partners.
If a series of payments or accruals with respect to a transaction that occurs over time, each payment or accrual is analyzed separately to determine if there is a base erosion payment. If a single payment results in base erosion tax benefits being allocated by a partnership to its partners over multiple years, the portion of the payment that is a base erosion payment is determined at the time of the payment, but the amount of the base erosion tax benefits will be determined based on the allocations by the partnership that occur each year.
If a distribution of property from a partnership to a partner causes an increase in the tax basis of property that continues to be held by the partnership or is distributed to a partner, the increase in tax basis for the benefit of a taxpayer that is attributable to a foreign related party is treated as if it were property that the taxpayer purchased from the foreign related party and placed in service when the distribution occurs.
Small partners are exempted from taking into account their distributive share of any base erosion tax benefits from a partnership for the taxable year if: the partner’s actual or constructive interest in the partnership represents less than 10 percent of the capital and profits of the partnership at all times during the taxable year, the partner is allocated less than 10 percent of each partnership item of income, gain, loss, deduction, and credit for the taxable year, and the partner’s actual or constructive partnership interest has a fair market value of less than $25 million on the last day of the partner’s taxable year.
Effective Date and Penalties
The final regulations generally apply to taxable years ending on or after December 17, 2018, but taxpayers may apply them in their entirety for prior taxable years. No penalties will apply to failures to comply with new reporting requirements on Forms 5472 and 8991 if such failures are corrected within three months of December 6, 2019.
Thus, taxpayers who filed tax returns for taxable years ending after December 17, 2018, (calendar year 2018, for example) and did not comply with the reporting requirements in the then‑proposed BEAT regulations now have until March 5, 2020, to refile those returns and comply with the new reporting requirements in order to avoid possible penalties.