United States: Who's Got The B.E.A.T.? A Playbook For Determining Applicable Taxpayers And Payments

Last Updated: March 11 2019
Article by Stanley C. Ruchelman and Rusudan Shervashidze

INTRODUCTION

Code §59A was enacted to impose tax on U.S. corporations with substantial gross receipts when base erosion payments to related entities significantly reduced regular corporate income tax imposed at a 21% rate. The tax is known as the base erosion and anti-abuse tax (the "B.E.A.T."). In late December, the I.R.S. proposed regulations that will provide guidance for affected taxpayers.

This article is the first in a series that will explain how the proposed regulations identify the taxpayers affected by the B.E.A.T. and the ways those taxpayer will be affected.

APPLICABLE TAXPAYERS

According to Prop. Treas. Reg. §1.59A-2, the B.E.A.T. applies only to a corporation, other than a R.I.C., R.E.I.T., or S-corporation, that satisfies the gross receipts test and the base erosion percentage test. For this purpose, related corporations within a "controlled group," per Code §52(a), generally are treated as a single taxpayer. The controlled group includes domestic and foreign corporations. For the latter, only gross receipts that generate effectively connected income ("E.C.I.") subject to tax under Code §882(a) are taken into account.

The Aggregate Group Concept

The regulations use the term "Aggregate Group" to refer to members within the controlled group that are taken into account as part of a single taxpayer

The proposed regulations limit the Aggregate Group to corporations that benefit from deductions – and for that reason may have base erosion tax benefits. They exclude foreign corporations that are not subject to net U.S. income tax. Thus, foreign corporations that generate U.S.-source income taxable under Code §881 on a gross basis, only, are excluded. If a foreign corporation has both E.C.I. taxed under Code §882 and fixed and determinable annual and periodic income taxed under Code §881, only the former is included. If a foreign corporation determines its net taxable income under an applicable income tax treaty, so that part of its E.C.I. is not attributable to a permanent establishment in the U.S. and therefore not taxed, the foreign corporation is a member of the Aggregate Group only with regard to gross receipts attributable to the permanent establishment, which are taxed as business profits.

The proposed regulations generally provide that payments between members of the Aggregate Group are not included in the gross receipts of the Aggregate Group or in the numerator or the denominator used to calculate the base erosion percentage. This approach is consistent with the single entity concept of Code §59a(e)(3). Payments between the Aggregate Group and any outside foreign corporation are taken into account in applying both the gross receipts test and the base erosion percentage test. On the other hand, payments to a foreign corporation from within the Aggregate Group that are subject to net income tax in the U.S. are not taken into account in applying the gross receipts test and the base erosion percentage test. It follows that one payment by a domestic corporation to a foreign corporation may not be taken into account in determining whether an Aggregate Group is an applicable taxpayer, while another payment between the same parties is taken into account.

The I.R.S. has requested comments on the proposed Aggregate Group concept.

Gross Receipts Test

A taxpayer satisfies the gross receipts test if the taxpayer or the Aggregate Group has $500 million or more of average annual gross receipts during the three prior taxable years. In the case of a foreign corporation, gross receipts are taken into account only if subject to net income tax under both U.S. domestic law and an applicable income tax treaty.

The taxpayer's Aggregate Group is determined as of the end of its taxable year for which B.E.A.T. liability is being computed, and the calculation includes the gross receipts of those Aggregate Group members during the prior three-year period. The proposed regulations include specific rules for corporations that have been in existence for fewer than three years or have short years. The rules are generally consistent with Code §§448(c)(3)(B) through (D). The proposed regulations also clarify how gross receipts are determined when members of the Aggregate Group have differing taxable years.

In addition, if a member of an Aggregate Group owns an interest in a partnership, the proposed regulations provide that the group must include the member's distributive share of items of gross income from the partnership.

Base Erosion Percentage Test

The base erosion percentage for a taxable year is computed by dividing (i) the aggregate amount of base erosion tax benefits (the "numerator") by (ii) the sum of the aggregate amount of deductions plus certain other base erosion tax benefits (the "denominator"). The B.E.A.T. applies only when the numerator exceeds 3% of the denominator – or 2% if the applicable taxpayer or a member of its Aggregate Group is a domestic bank or registered securities dealer.

The numerator of the base erosion percentage excludes deductions for the following:

  • Amounts paid or accrued to foreign related parties for services qualifying for the services cost method ("S.C.M.") exception in Prop. Treas. Reg. §1.59A-3(b)(3)(i)
  • Payments covered by the qualified derivatives payments ("Q.D.P.") exception in Prop. Treas. Reg. §1.59A-3(b)(3)(ii)
  • Amounts excluded pursuant to the total loss-absorbing capacity ("T.L.A.C.") exception in Prop. Treas. Reg. §1.59A-3(b)(3)(v)1

In certain circumstances, an applicable taxpayer may make a payment to a foreign related party that is not a member of the Aggregate Group. This would occur if the recipient of the payment is a 25% owner2 of the applicable taxpayer but does not own more than 50%y. If that payment qualifies for the S.C.M., the Q.D.P., or the T.L.A.C. exception and is properly characterized as E.C.I.,3 the payment will be included in the denominator of the fraction when computing the base erosion percentage. On the other hand, if the excluded payments are not properly treated as E.C.I., they are removed from the denominator of the fraction in addition to the numerator

Code §988 addresses currency gains and losses derived in connection with certain debt obligations, accrued but unpaid expenses, and certain forward or futures transactions. Such losses are removed from the numerator and the denominator in determining the base erosion percentage.

The numerator of the base erosion percentage only takes into account base erosion tax benefits for which a deduction is allowed under the Code in the taxable year. Similarly, the denominator of the base erosion percentage takes into account only deductions allowed under the Code. Disallowed deductions are excluded. Therefore, since a deduction allowed under Code §965(c) to a U.S. Shareholder of a deferred foreign income corporation is not specifically excluded, that deduction is included in the denominator.

A base erosion tax benefit is not included in the numerator when the payment is subject to tax under Code §871 or Code §881 and 30% withholding tax has been collected and paid over to the I.R.S. If the payment is subject to a reduced rate of withholding tax under an income tax treaty, the actual payment is treated as two separate payments. One such deemed payment is treated as subject to 30% withholding. The other such payment is treated as fully exempt. To determine the taxable portion, the withholding tax rate under the applicable treaty is divided by the 20% rate provided by domestic law. As a result, if the withholding tax rate in the treaty is 10%, one-third of the total payment is deemed to be fully taxed (10% ÷ 30% = 33.33%). The remaining two-thirds of the payment is treated as fully exempt. This computation uses rules similar to those in Code §163(j)(5)(B), as in effect before the T.C.J.A.

The base erosion percentage also takes into account (i) certain premiums or other considerations paid to a foreign related party for reinsurance and (ii) amounts paid or accrued by the taxpayer to certain surrogate foreign corporations that result in a reduction in gross receipts for the taxpayer.

Taxpayers in an Aggregate Group with Different Taxable Years

A corporation is determined to be an applicable taxpayer based on the gross receipts and base erosion payments of each member of the Aggregate Group. However, each member must compute the Aggregate Group amount of gross receipts and base erosion payments based on its own taxable year and based on those corporations that are members of the Aggregate Group at the end of such taxable year.

In general, the proposed regulations provide that each taxpayer determines its gross receipts and base erosion percentage by reference to its own taxable year, taking into account the results of other members of its Aggregate Group during that taxable year.4 As a result, two related taxpayers with different taxable years will compute their applicable gross receipts and base erosion percentage by reference to different periods.

The fact pattern where this rule applies is broad. It can involve two or more separate chains of U.S. corporations in separate business segments where each chain separately files a consolidated tax return or brother-sister corporations having the same foreign corporation as a shareholder.

Footnote

1. The Federal Reserve requires that certain global systemically important banking organizations ("G.S.I.B.'s") issue T.L.A.C. securities as part of a global framework intended to minimize the risk of insolvency. A full discussion of the T.L.A.C. rules is beyond the scope of this article.

2. Prop. Treas. Reg. §1.59A-1(b)(17).

3. Prop. Treas. Reg. §1.59A-3(b)(3)(iii).

4 Prop. Treas. Reg. §1.59A-2(e)(3)(vii)

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