Thursday, December 13, 2018
The Internal Revenue Service issued 193 pages of proposed regulations today on the IRC section 59A base erosion and anti-abuse tax ("BEAT"). New Internal Revenue Code (IRC) section 59A imposes a tax equal to the base erosion minimum tax amount for certain taxpayers beginning in tax year 2018.
The Base Erosion and Anti-Avoidance Tax targets companies that potentially reduce their U.S. federal income tax liability through cross-border payments to their foreign affiliates. Under BEAT, an applicable taxpayer is required to pay a tax equal to the base erosion minimum tax amount for the taxable year on base erosion payments that are deductible payments made by certain corporations to their non-U.S. affiliates.
The base erosion percentage is determined for any taxable year by dividing the deductions taken by the applicable taxpayer with respect to its “base erosion payments” by the overall amount of deductions taken by the corporation (including deductions taken with respect to “base erosion payments,” but excluding net operating loss carrybacks and carryforwards, deductions for dividends attributable to foreign earnings, deductions in connection with GILTI and FDII, deductions for payments for certain services and deductions for “qualified derivative payments”. If the base erosion percentage is at least three percent (or two percent in the case of a bank or security dealer), then the taxpayer may be subject to BEAT.
The base erosion minimum tax amount is equal to the excess of (a) the product of the applicable base erosion tax rate and an applicable taxpayer’s modified taxable income, over (b) the applicable taxpayer’s regular tax liability reduced by certain credits. Credits cannot be applied against the base erosion minimum tax amount.6 BEAT is a five percent rate in 2018, a 10 percent rate from 2019 until 2025, and a 12.5 percent rate for all years thereafter. Banks or a registered securities dealer endure one percent higher BEAT rate than regular applicable taxpayers.
Impact of Income Tax Treaties On U.S. Permanent Establishments
Certain U.S. income tax treaties provide alternative approaches for the allocation or attribution of business profits of an enterprise of one contracting state to its permanent establishment in the other contracting state on the basis of assets used, risks assumed, and functions performed by the permanent establishment. The use of a treaty-based expense allocation or attribution method does not, in and of itself, create legal obligations between the U.S. permanent establishment and the rest of the enterprise. These proposed regulations recognize that as a result of a treaty-based expense allocation or attribution method, amounts equivalent to deductible payments may be allowed in computing the business profits of an enterprise with respect to transactions between the permanent establishment and the home office or other branches of the foreign corporation (“internal dealings”). The deductions from internal dealings would not be allowed under the Code and regulations, which generally allow deductions only for allocable and apportioned costs incurred by the enterprise as a whole. The proposed regulations require that these deductions from internal dealings allowed in computing the business profits of the permanent establishment be treated in a manner consistent with their treatment under the treaty-based position and be included as base erosion payments.
The proposed regulations include rules to recognize the distinction between the allocations of expenses. In the first instance, the allocation and apportionment of expenses of the enterprise to the branch or permanent establishment is not itself a base erosion payment because the allocation represents a division of the expenses of the enterprise, rather than a payment between the branch or permanent establishment and the rest of the enterprise. In the second instance, internal dealings are not mere divisions of enterprise expenses, but rather are priced on the basis of assets used, risks assumed, and functions performed by the permanent establishment in a manner consistent with the arm’s length principle. The approach in the proposed regulations creates parity between deductions for actual regarded payments between two separate corporations (which are subject to IRC Section 482), and internal dealings (which are generally priced in a manner consistent with the applicable treaty and, if applicable, the OECD Transfer Pricing Guidelines). The rules in the proposed regulations applicable to foreign corporations using this approach apply only to deductions attributable to internal dealings, and not to payments to entities outside of the enterprise, which are subject to the general base erosion payment rules as provided in proposed §1.59A-3(b)(4)(v)(A).
Exception from BEAT Payment with Respect to Services Cost Method
The SCM exception described in IRC Section 59A(d)(5) provides that IRC Section 59A(d)(1) (which sets forth the general definition of a base erosion payment) does not apply to any amount paid or accrued by a taxpayer for services if (A) the services are eligible for the services cost method under IRC Section 482 (determined without regard to the requirement that the services not contribute significantly to fundamental risks of business success or failure) and (B) the amount constitutes the total services cost with no markup component.
The Treasury Department and the IRS interpret “services cost method” to refer to the services cost method described in §1.482-9(b), interpret the requirement regarding “fundamental risks of business success or failure” to refer to the test in §1.482-9(b)(5) commonly called the business judgment rule, and interpret “total services cost” to refer to the definition of “total services costs” in §1.482-9(j). IRC Section 59A(d)(5) is ambiguous as to whether the SCM exception applies when an amount paid or accrued for services exceeds the total services cost, but the payment otherwise meets the other requirements for the SCM exception set forth in IRC Section 59A(d)(5). Under one interpretation of IRC Section 59A(d)(5), the SCM exception does not apply to any portion of a payment that includes any mark-up component. Under another interpretation of IRC Section 59A(d)(5), the SCM exception is available if there is a markup, but only to the extent of the total services costs. Under the former interpretation, any amount of markup would disqualify a payment, in some cases resulting in dramatically different tax effects based on a small difference in charged costs. In addition, if any markup were required, for example because of a foreign tax law or non-tax reason, a payment would not qualify for the SCM exception. Under the latter approach, the services cost would continue to qualify for the SCM exception provided the other requirements of the SCM exception are met. The latter approach to the SCM exception is more expansive because it does not limit qualification to payments made exactly at cost.
The proposed regulations provide that the SCM exception is available if there is a markup (and if other requirements are satisfied), but that the portion of any payment that exceeds the total cost of services is not eligible for the SCM exception and is a base erosion payment. The Treasury Department has determined that this interpretation is more consistent with the text of IRC Section 59A(d)(5). Rather than require an all-or-nothing approach to service payments, section 59A(d)(5) provides an exception for “any amount” that meets the specified test. This language suggests that a service payment may be disaggregated into its component amounts, just as the general definition of base erosion payment applies to the deductible amount of a foreign related party payment even if the entire payment is not deductible.
The most logical interpretation is that a payment for a service that satisfies subparagraph (A) is excepted up to the qualifying amount under subparagraph (B), but amounts that do not qualify (i.e., the markup component) are not excepted. This interpretation is reinforced by the fact that IRC Section 59A(d)(5)(A) makes the SCM exception available to taxpayers that cannot apply the services cost method described in §1.482-9(b) (which permits pricing a services transaction at cost for IRC Section 482 purposes) because the taxpayer cannot satisfy the business judgment rule in §1.482-9(b)(5). Because a taxpayer in that situation cannot ordinarily charge cost, without a mark-up, for transfer pricing purposes, failing to adopt this approach would render the parenthetical reference in IRC Section 59A(d)(5)(A) a nullity. The interpretation the proposed regulations adopt gives effect to the reference to the business judgment rule in IRC Section 59A(d)(5). The Treasury Department and the IRS welcome comments on whether the regulations should instead adopt the interpretation of IRC Section 59A(d)(5) whereby the SCM exception is unavailable to a payment that includes any mark-up component.
To be eligible for the SCM exception, the proposed regulations require that all of the requirements of §1.482-9(b) must be satisfied, except as modified by the proposed regulations. Therefore, a taxpayer’s determination that a service qualifies for the SCM exception is subject to review under the requirements of §1.482-9(b)(3) and (b)(4), and its determination of the amount of total services cost and allocation and apportionment of costs to a particular service is subject to review under the rules of §1.482-9(j) and §1.482-9(k), respectively.
Although the proposed regulations do not require a taxpayer to maintain separate accounts to bifurcate the cost and markup components of its services charges to qualify for the SCM exception, the proposed regulations do require that taxpayers maintain books and records adequate to permit verification of, among other things, the amount paid for services, the total services cost incurred by the renderer, and the allocation and apportionment of costs to services in accordance with §1.482-9(k). Because payments for certain services that are not eligible for the SCM due to the business judgment rule or for which taxpayers select another transfer pricing method may still be eligible for the SCM exception to the extent of total services cost, the record-keeping requirements in the proposed regulations differ from the requirements in §1.482-9(b)(6). Unlike §1.482-9(b)(6), the proposed regulations do not require that taxpayers “include a statement evidencing [their] intention to apply the services cost method to evaluate the arm's length charge for such services,” but the proposed regulations do require that taxpayers include a calculation of the amount of profit mark-up (if any) paid for the services. For purposes of qualifying for the SCM exception under IRC Section 59A(d)(5), taxpayers are required to comply with the books and records requirements under these proposed regulations but not §1.482-9(b)(6).
The proposed regulations also clarify that the parenthetical reference in IRC Section 59A(d)(5) to the business judgment rule prerequisite for applicability of the services cost method -- “(determined without regard to the requirement that the services not contribute significantly to fundamental risks of business success or failure)” -- disregards the entire requirement set forth in §1.482-9(b)(5) solely for purposes of IRC Section 59A(d)(5).
 IRC § 59A(d)(1).
 Treas. Reg. §1.59A-3(b)(3)(i)(B)(2).