The New Base Erosion Minimum Tax
The recently enacted 2017 tax reform act imposes a new “base erosion and anti-abuse tax” (BEAT) on large corporations. The BEAT operates as a limited-scope alternative minimum tax, applied by adding back to taxable income certain deductible payments made to related foreign persons. Although positioned as an anti-abuse rule, the BEAT presents challenges for a wide range of common business structures employed by both non-US-based and US-based multinationals.
General. The recently enacted 2017 tax reform act added section 59A to the Code, which imposes a new “base erosion” minimum tax on large corporations. The additional tax is generally calculated after adding back to taxable income certain deductible payments made to related foreign persons. This new tax is described as a base erosion and anti-abuse tax, or “BEAT.”
The BEAT generally applies to domestic corporations and to foreign corporations with income effectively connected with a US trade or business. The BEAT, however, does not apply to corporations whose annual gross receipts for the 3-taxable-year period ending with the preceding taxable year are less than $500 million. The BEAT also does not apply to individuals, S corporations, regulated investment companies or real estate investment trusts. Finally, a de minimis exception is provided for companies whose foreign related party payments are very low, relative to overall deductions.
The BEAT generally is calculated as 10 percent of modified taxable income less the regular tax liability (generally reduced by certain tax credits). The tax rate is 5 percent for 2018 as a sort of phase-in of the new regime, and eventually increases to 12.5 percent beginning in 2025 as one of several quantitative adjustments made by the legislation toward the end of the budget window in order to meet revenue targets. These rates are increased by one percent for certain banks and securities dealers. The BEAT calculations generally are made on a group basis (thus, for example, the related-party payments, deductions, and income of affiliated domestic corporations are aggregated for BEAT purposes).
Modified Taxable Income. A corporation’s modified taxable income is determined by adding back to taxable income current year deductions involving payments to related foreign persons. For this purpose, 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) or satisfies various other relationship or control tests. Direct, indirect and constructive ownership is taken into account for purposes of the ownership tests.
The BEAT’s add-backs for deductible amounts paid or accrued to a related foreign person generally include payments for services, interest, rents and royalties. If a deduction for interest is limited by section 163(j), the reduction in the amount of deductible interest is allocated first entirely to interest on loans from unrelated persons. An exception is provided for services that are eligible for the application of the services cost method under the section 482 regulations (without regard to the requirement under those regulations that the services not contribute significantly to the fundamental risks of business success or failure), to the extent that the amount in question constitutes total services costs, with no mark-up component. Based on the statute and legislative history (including a floor colloquy between Senator Orrin Hatch and Senator Rob Portman), in many cases it may be possible to bifurcate service fees into cost and mark-up components, with the BEAT applying only to the mark-up component. Another exception is provided for certain qualified derivative payments.
Deductions for depreciation and amortization of property acquired from related foreign persons also are added back to taxable income in calculating modified taxable income. This applies to property purchased in taxable years beginning after December 31, 2017.
Deductible payments 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. For example, a $1,000 royalty paid by a domestic corporation to a related CFC would generally be Subpart F income that is included in the domestic corporation’s income, thus resulting in no net benefit for the royalty deduction in computing the domestic corporation’s regular tax liability. Nevertheless, modified taxable income is computed by including the Subpart F inclusion and adding back the $1,000 deduction for the royalty expense. Under certain circumstances, it may be desirable to conduct the foreign operations as a branch of a US corporation to avoid adding such payments in calculating modified taxable income (although other ramifications of a branch structure would need to be considered, including the continued imposition of current-basis US tax on branch operations and the establishment of a separate foreign tax credit basket for branch operations under the new legislation).
In addition, the legislation does not expressly permit netting of payments if a US company pays a foreign related person a deductible amount and then charges another foreign related person for a portion of such amount. For example, if a domestic corporation functioned as a services hub and paid foreign related persons $1 million for services and then charged other foreign related persons $800,000 for their shares of the services, apparently the entire $1 million paid to foreign related persons would be added back in calculating modified taxable income, which would already include the $800,000 of service payments received from other foreign related persons. Under these circumstances, it may be better for a foreign entity to function as the services hub, resulting in a reduced add-back of $200,000. Similarly, there is also no explicit basis in the legislation for netting payments between a US company and the same foreign related person. If the BEAT indeed must be applied on a gross basis in these situations, it would seem that the legislation significantly overshoots its target of curtailing the erosion of the US tax base through related-party payments. Presumably no one would contend that the US tax base is eroded to the extent that a US company and a CFC make offsetting interest payments to each other (e.g., under a cash pooling arrangement). Guidance may be appropriate to develop some reasonable netting approach to provide relief in situations not involving US base erosion.
No rule is provided in the statutory language to look through a related foreign person. For example, assume a domestic corporation pays a related foreign person $2,000 for services, and the related foreign person subcontracts a portion of the services to an unrelated foreign person and pays $1,500 for the support services. The entire $2,000 must be added back to regular taxable income in computing modified taxable income. Under these circumstances, it presumably would make sense for the domestic corporation simply to contract directly with both the related foreign person and the third party and thereby reduce the amount added back to modified taxable income to $500. This example is but one of many traps for the unwary under the BEAT.
If a base erosion payment is subject to full US 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 US withholding tax rate under a treaty, then the exclusion from modified taxable income is computed proportionately in comparison to the statutory US withholding tax rate.
No amount generally is added back for payments to foreign related persons that reduce a taxpayer’s gross receipts. This includes payments for costs of goods sold and may apply to certain procurement commissions or other payments that are included in costs of goods sold. Corporations that expatriate after November 9, 2017, however, must add back amounts that result in a reduction of gross receipts. The treatment of services transactions is less clear. The same rationale that supports an exclusion for the cost of goods sold of a seller of physical goods also should support an exclusion for the cost of services provided to a service provider in a situation in which some part of 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). Guidance may be necessary to ensure even application of the BEAT across sectors with a particular view to ensuring that the services sector is not unduly disadvantaged.
In addition, no amounts are added back to regular taxable income for dividends received from a foreign corporation for which a 100 percent dividends-received deduction is provided. The 50 percent deduction for amounts included in income as global intangible low-taxed income (GILTI) is not added back either.
De Minimis Exception. If the total amount of deductions added back to compute modified taxable income is less than 3 percent of total deductions (2 percent for certain banks and securities dealers) used in calculating taxable income, then the BEAT does not apply. For this purpose, excluded from the denominator are certain amounts related to section 172 net operating loss deductions, section 245A foreign-source dividends received deductions, section 250 foreign-derived intangible income and GILTI deductions, and other amounts that do not constitute base erosion payments under section 59A(d). As a practical matter, this exception already will be met by many US-based multinationals, while non-US-based multinationals typically will find it difficult to meet the exception, absent further restructuring.
Calculating the BEAT. After determining modified taxable income, a 10 percent rate is applied (5 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 US taxes. An exception is provided for research and development (R&D) credits and 80 percent of certain other section 38 credits. Again, this calculation is generally determined on a group basis taking into account all corporations that would be considered a single employer under section 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. For example, assume a corporation has regular taxable income of $1 billion and would pay $210 million of tax before taking into account foreign tax credits. Assume foreign tax credits reduce its regular tax liability to $180 million and R&D credits reduce such liability by $10 million to $170 million. Further assume the taxpayer has modified taxable income of $2 billion, which, applying the 10 percent tax rate, would result in $200 million of tax. The BEAT would be $20 million ($200 million less $180 million), which has the effect of denying a credit for that amount of foreign taxes (but not for the R&D 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.
Net Operating Losses. Additional rules are provided for taxpayers with net operating losses. Generally, a taxpayer will be required to add back base erosion payments in the year paid or accrued. However, special rules apply if a net operating loss includes otherwise deductible payments made to foreign related persons because the add-back is technically required when the deduction for the base erosion payment is allowed. In the case of a net operating loss carryforward, a taxpayer must add back the base erosion percentage of a net operating loss carryforward for the future taxable year in which the deduction is allowed. The base erosion percentage of a net operating loss is computed using similar rules to those used to compute the taxpayer’s base erosion percentage for the de minimis exception.
Larger corporate taxpayers will need to analyze the amounts of deductible payments made to related foreign persons (which can include minority owned joint ventures) and the amortization and depreciation deductions with respect to property acquired from related foreign persons. Some corporations may determine that the 3 percent de minimis exception applies, and they do not need to apply the BEAT. Other corporations subject to the BEAT should analyze their payment streams and determine if they can be restructured to reduce the amounts added back to regular taxable income in calculating modified taxable income (as discussed above). Taxpayers must be cautioned, however, 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.