Extracted from Law360
Perhaps discontented with the repeal of the corporate alternative minimum tax, Congress introduced in the Tax Cuts and Jobs Act a minimum tax with an international flair. New Internal Revenue Code Section 59A’s base-erosion anti-abuse tax, or BEAT, aims to prevent large corporate taxpayers from using deductible payments to offshore affiliates (especially those in low- or no-tax jurisdictions) to reduce their U.S. taxable income below 10 percent. Born of the worldwide frustration that animated the Organization for Economic Cooperation and Development initiative against base-erosion and profit-shifting (BEPS) and other countries’ unilateral measures such as the United Kingdom’s diverted profits tax, the TCJA’s new BEAT is more than a little off.
Overview of BEAT
The BEAT’s building blocks are base-erosion payments, which include (1) any deductible amount paid or accrued by a taxpayer to a related foreign person; (2) any amount paid to acquire depreciable property from a related foreign person; (3) certain reinsurance premiums paid to a foreign related person; and (4) cost of goods sold paid to the foreign acquirer of an inverted corporation under the anti-inversion rules (or to members of that corporation’s expanded group). The BEAT provisions naturally employ an expansive definition of “related party.” Only three types of payments are not treated as base-erosion payments: costs of goods sold except as described above, payments for services without a markup, and qualified derivative payments (essentially, certain payments on marked-to-market derivatives).
Only corporate taxpayers with gross receipts over $500 million and a base-erosion percentage of 3 percent are subject to the BEAT. For this purpose, base-erosion percentage roughly translates to the ratio of the taxpayer’s deductions for base-erosion payments to its total deductions (with some exceptions). To determine whether it has a BEAT liability, a taxpayer first computes a modified taxable income, which is its taxable income increased by deductions for base-erosion payments and a portion of its net operating loss (NOL). The taxpayer next calculates its “regular tax liability” reduced by all tax credits except — through 2025 — the research credit and 80 percent of each of the low-income housing credit, renewable energy production credit and energy investment credit.
The BEAT applies if the taxpayer’s regular tax liability, as adjusted for tax credits, is less than 10 percent of its modified taxable income. After 2025, the rate increases from 10 to 12.5 percent. (The BEAT rate for banks, securities dealers and their affiliates is always one percentage point higher than for other taxpayers.)
The Up and Down (of) BEAT
New taxes rarely thrill taxpayers, but the BEAT could be worse. Congress actually made a few taxpayer-friendly improvements between the Senate Finance Committee’s initial BEAT proposal in mid-November and the new law’s passage in late December. In response to criticism that the BEAT, as proposed, would scuttle tax benefits and consequently funding for low-income housing and renewable energy projects, the TCJA added the low-income housing and energy-related credits to the research credits taxpayers can enjoy without negatively affecting their BEAT exposure (at least through 2025). The new law also introduced a one-year phase-in for 2018 when the BEAT rate is only 5 percent rather than 10 percent.
Still, the BEAT could be better. The TCJA’s rule that interest deductions disallowed under the new Section 163(j) are treated as paid first to unrelated parties translates to a greater portion of deductible interest being treated as paid to related parties and, consequently, as base-erosion payments. The lower base-erosion percentage threshold (3 percent, down from the Senate’s initially proposed 4 percent) and higher BEAT rate of 12.5 percent after 2025 were unwelcome modifications in the final law. But setting aside these (presumably) deficit math gimmicks, the TCJA does a pretty poor job of confining the BEAT’s reach to its purported target: base erosion.
The new law’s definitional carve-outs do not cure its overbreadth. As drafted, the BEAT provisions may treat as “base-erosion payments” amounts that do not actually escape U.S. tax. For example, a foreign affiliate (or its U.S. branch) that receives the deductible payment may be taxable on the amount as effectively connected income, or ECI. Similarly, deductible interest or royalties paid to a controlled foreign corporation, or CFC, may be taxable under Subpart F to the CFC’s U.S. shareholders.
The statute provides BEAT relief only if and to the extent 30 percent U.S. withholding tax on a base-erosion payment is deducted and withheld under Code Section 1441 or 1442. Certainly, the gross-basis withholding tax is not the only U.S. tax regime that can ensnare outbound payments. The TCJA even fails to relieve outbound reinsurance payments that attract the Section 4371 excise tax, which is effectively a stand-in for the regular withholding tax.
The TCJA’s ham-fisted treatment of tax credits in computing a taxpayer’s regular tax liability for BEAT purposes also has nonsensical implications. A taxpayer reduces its regular tax liability for all credits other than, through 2025, those noted above. Read literally, even credits representing prepaid U.S. taxes, such as credits for ECI withholding on foreign partners or tax overpayments, could trigger and increase a taxpayer’s BEAT liability.
The BEAT’s math also means that a taxpayer with BEAT liability effectively loses a portion of their tax credits (other than certain research, low-income housing and energy-related credits, at least through 2025). Similarly, a taxpayer with BEAT liability may lose a portion of its NOL, even though its NOL carryovers may have no link to base erosion. The possible haircut on foreign tax credits reflects a stark difference between unilateral measures like the BEAT, which looks to preserve the U.S. tax base, and the multilateral approach of the OECD’s BEPS project, which concentrated on whether a payment was taxed anywhere (and not doubly taxed).
The BEAT also raises other murky interpretative and policy questions. Should the BEAT apply to genuine commercial arrangements? Should taxpayers lose credits and deductions that have nothing to do with base erosion? Should base-erosion payments include payments for marked-up services entirely or only to the extent of the markup? Is the profit allocation resulting under the BEAT consistent with the arm’s-length standard of international transfer pricing principles or an undoing of that standard? Should payments to foreign affiliates otherwise eligible for U.S. tax treaty benefits be disfavored by the BEAT? How does the BEAT apply to a corporate partner of a foreign partnership that makes a base-erosion payment?
The BEAT puts more pressure on hair-splitting exercises carried over from the pre-TCJA era, such as whether a transaction generates sales, services or royalty income under the “software regulations” of Section 1.861-18. There is concern that the BEAT creates incentives that would undermine its goal to preserve the U.S. tax base. For example, a taxpayer may eliminate royalty payments on foreign-owned IP used in domestic manufacturing and instead move its manufacturing offshore to the IP-holding affiliate — replacing a base-erosion payment royalty with an excluded payment for cost of goods.
Adding to taxpayers’ BEAT-induced headaches are the potential reactions from other countries. Even before the passage of the TCJA, five European countries’ finance ministers lodged complaints with U.S. Treasury Secretary Steven Mnuchin about the BEAT and other international proposals, arguing that the provisions unfairly advantaged U.S. companies and ran afoul of trade agreements and U.S. income tax treaties — worries the final law does not assuage. Some jurisdictions have indicated that their foreign tax credit rules may not allow a credit for the BEAT (treating it as a non-income tax). Others have threatened to drum up their own BEAT-like rules.
The TCJA expressly directs the IRS and Treasury’s attention to BEAT anti-avoidance measures, though the law broadly authorizes any “guidance as may be necessary or appropriate to carry out the [BEAT] provisions.” While officials have informally promised BEAT-related guidance, there is no telling when the IRS and Treasury will get to this item on their long TCJA to-do list. Even more uncertain is whether the forthcoming administrative measures will be able to correct (or overcome) all of the BEAT’s legislative shortcomings.