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 21%. 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 is the second of a two-part series that explains how the proposed regulations identify taxpayers affected by the B.E.A.T. and how the rules are apply to those taxpayers. It focuses on the details affecting certain expenses and certain industries. For a practical outline of effected entities and payments, see "Who's Got the B.E.A.T.? A Playbook for Determining Applicable Taxpayers and Payments."
BASE EROSION TAX BENEFITS
Generally, a base erosion tax benefit is the amount of any deduction relating to a base erosion payment that is allowed under the Code for the taxable year.1 If full 30% withholding tax is collected by the U.S. entity on payments to related parties outside the U.S., the base erosion payment has a base erosion tax benefit of zero for purposes of calculating a taxpayer's modified taxable income. If an income tax treaty reduces the amount of withholding imposed on the base erosion payment, the base erosion payment is treated as a base erosion tax benefit to the extent of that reduction. Rules similar to those in Code §163(j)(5)(B) as in effect prior to the T.C.J.A. are applied in making the computation.
Coordination with Code §163(j) Limitation
Code §163(j) applies to limit the amount of a taxpayer's business interest expense that is deductible in the taxable year. The proposed B.E.A.T. regulations coordinate with Code §163(j) to determine how much of a taxpayer's interest expense deduction is limited under the B.E.A.T. and how much is limited under Code §163(j).2 Under these rules, the interest expense disallowed under Code §163(j) is allocated first to interest expense on loans from unrelated parties. Any disallowed interest expense remaining is allocated to loans from related parties. Interest paid or accrued to related parties that is not disallowed under Code §163(j) is taken into account when applying Code §59A. If some related-party lenders are U.S. persons and others are foreign, the interest expense payments are divided between U.S. and non-U.S. persons on a proportional basis. In a similar way, any disallowed business interest expense carryforward is treated first as business interest paid to unrelated parties. The remainder is treated as business interest expense paid to related parties. Again, where lenders are a mix of U.S. and non-U.S. persons, apportionment is required.
MODIFIED TAXABLE INCOME
Method of Computation
For any taxable year, Code §59A imposes a tax on each applicable taxpayer equal to the base erosion minimum tax amount for that year. The base erosion minimum tax amount is determined based on an applicable taxpayer's modified taxable income for the taxable year. The computation of modified taxable income and the computation of the base erosion minimum tax amount are made on a taxpayer-by-taxpayer basis.
The computation of modified taxable income is made on an add-back basis. The computation starts with taxable income (or taxable loss) of the taxpayer, as computed for regular tax purposes, and adds (i) the gross amount of base erosion tax benefits for the taxable year and (ii) the base erosion percentage of any net operating loss ("N.O.L.") deduction under Code §172 for the taxable year.
If a taxpayer has an excess of deductions allowed by Chapter 1 over gross income, computed without regard to the N.O.L. deduction, the taxpayer has negative taxable income for the taxable year. Generally, the proposed regulations provide that a negative amount is the starting point for computing modified taxable income when there is no N.O.L. deduction from net operating loss carryovers and carrybacks.
If an N.O.L. deduction is carried to the taxable year and that N.O.L. deduction exceeds the amount of positive taxable income, the excess amount of the N.O.L. deduction does not reduce taxable income below zero for determining the starting point for computing modified taxable income.
Base Erosion Percentage of N.O.L. Deductions
Code §59A(c)(1)(B) provides that modified taxable income includes the base erosion percentage of any N.O.L. deduction allowed under Code §172 for the taxable year. The proposed regulations apply the base erosion percentage of the year in which the loss arose, or a vintage year, because the base erosion percentage of the vintage year reflects the portion of base eroding payments reflected in the net operating loss carryover.3 In addition, because the vintage-year base erosion percentage is a fixed percentage, taxpayers will have greater certainty as to the amount of the future add-back to modified taxable income (as compared to using the utilization- year base erosion percentage).
Based on this approach, the proposed regulations also provide that in the case of net operating losses that arose in taxable years beginning before January 1, 2018, and that are deducted as carryovers in taxable years beginning after December 31, 2017, the base erosion percentage is zero because Code §59A applies only to base erosion payments that are paid or accrued in taxable years beginning after December 31, 2017.
1 Prop. Treas. Reg. §1.59A-3(c).
2 Prop. Treas. Reg. §1.59A-3(c)(4).
3 Prop. Treas. Reg. §1.59A-4(b)(2)(ii).
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