Cost of Services are Out, Services Cost Method is In
For companies in the services industry, the Base Erosion and Anti-Abuse Tax (“BEAT”) may feel like a dominating force that’s impossible to overcome. Even though the BEAT applies broadly to large U.S. corporations, companies that provide services to their customers, when compared to companies in the manufacturing or retail space, find themselves at a distinct disadvantage under the BEAT. In this edition of Tax Advisor Weekly, we explain the BEAT, why companies in the services industry are at a distinct disadvantage under the BEAT, and a method that may be used overcome that disadvantage.
What is the BEAT?
The BEAT is a new minimum tax targeted at U.S. multinationals that make base eroding payments (i.e. certain deductible payments to related foreign parties). In determining the minimum tax, base eroding payments are added back to the company’s taxable income. This new modified taxable income amount is then hit with a 5 percent rate (or 10 percent for taxable years beginning after December 31, 2018) to determine the modified tax liability. If the resulting “modified tax liability” is higher than the taxpayer’s actual tax liability, the difference is the BEAT and must be paid in addition to the “regular” U.S. Federal income tax.
Who is subject to the BEAT?
Importantly, not every U.S. corporation is subject to these rules. A U.S. corporation must pass two thresholds before the BEAT is applicable. If the taxpayer does not meet the criteria of either test, the BEAT does not apply. First, the U.S. corporation must have average annual gross receipts in excess of $500 million over the past 3 years. Second, the U.S. corporation’s deductible payments made to related parties (i.e. base eroding payments) must exceed 3 percent of the U.S. corporation’s aggregate allowable deductions in the current taxable year.
Impacts to the Services Industry: Costs of Goods vs. Cost of Services
Up to this point, you may be wondering how services companies are being treated differently than those in the manufacturing or retail space. It all hinges on a rule that allows “reductions to gross receipts” to be excluded from the definition of “base eroding payments.” The rule provides that any amounts that reduce gross receipts are excluded as base eroding payments for purposes of the BEAT. Note our emphasis on the word “reduction.” As we’ll discuss below, costs of goods (“COGs”) are considered reductions to gross revenue and as such are not subject to the BEAT. However, given the current law, it is highly unlikely that costs of services may be treated in a similar manner (i.e. as a reduction of revenue). Therefore, services firms will likely be required to include their costs of services (paid to related parties outside the U.S.) as payments subject to the BEAT. While manufacturers and retailers, on the other hand, get the benefit of excluding COGs, and thereby avoid the harsh impact of the BEAT on such imports.
So, what does “reductions to gross receipts” mean? Reduction to gross receipts is a term of art referring to the concept that some costs constitute a reduction in gross receipts when arriving at gross income. Conversely, a “deduction” is not a reduction to gross receipts. It is a deduction to gross income that is used to arrive at a company’s net income for tax purposes.
Why does this matter? Effectively, any portion of base erosion payments that can rightfully be considered COGs may be excluded, meaning that the taxpayer is not penalized (i.e., BEAT does not apply) on that portion. For services companies, however, the costs inherent in providing the services are costs of services, not COGs. These costs have historically been deductible, and, for accounting purposes, some taxpayers have even applied the deduction “above the line” – meaning that they treated the deduction as a “reduction to gross receipts” for financial statement purposes. This historical accounting treatment has created an assumption within many services companies that their payments to related parties for services would qualify as a “reduction” of revenue. However, significant doubt has been placed on whether costs of services are rightfully treated as a reduction to gross receipts for U.S. Federal income tax purposes, even if treated as a reduction of gross receipts for financial statement purposes. Unfortunately, it is our view that the stronger position is that costs of services are not considered a “reduction” to gross revenue for Federal income tax purposes and, therefore, are considered a “base eroding payment” for purposes of the BEAT. Based on the statutory language and the underlying policy objectives, at this point, we expect the Treasury and IRS to take the same position.
The difference between “reduction” and “deduction” may seem subtle, but the impact is significant. The divergent treatment of COGs and costs of services uniquely subjects the services industry to higher BEAT liabilities than their manufacturing or retail counterparts - that is, unless another exception applies.
The Good News — Another Option: Services Cost Method
But all hope is not lost. While costs of services might not be excluded from the definition of a base eroding payment for purposes of the BEAT, other options exist. For example, there may be an option to kick out the costs through the exception for payments qualifying for the services cost method (“SCM”). Under this exception, the cost portion of services that qualify for the SCM, as modified for BEAT purposes, will not be considered a base eroding payment under BEAT. Importantly, as we’ll discuss below, the BEAT rules modify the SCM in a manner that opens the gates for various types of services to now qualify.
What is the Services Cost Method?
Historically, the SCM has been a transfer pricing mechanism that allows certain low-margin related party services to be provided from the U.S. to a non-U.S. related party without charging a markup, or incremental fee, to the non-U.S. related party. Generally, markups are required for related party transactions so as to replicate how unrelated parties might charge for services – known as the arm’s length principle. Essentially, the SCM says that low-margin services that do not contribute to the fundamental risk of business success or failure will qualify, and thus the provider need not charge a markup. The SCM was intended, from a policy perspective, to provide administrative grace and tax leniency for companies wishing to base support role functions from within the U.S. Note, therefore, that certain specified services, such as manufacturing, production, reselling/distribution, research, development, engineering, etc., are expressly excluded from the SCM.
The BEAT has taken the SCM and, in a sense, flipped it on its head. First, the principles of the SCM are now being applied to outbound transactions, rather than inbound transactions – meaning that now the SCM is being applied to payments made by the U.S. to non-U.S. related parties. Second, and most notably, for BEAT purposes, services that contribute significantly to the fundamental risks of business success or failure may now qualify under the SCM so long as all other requirements are satisfied, i.e. the services are low-margin and not expressly excluded (such as R&D and distribution). This opens the door for excluding from the BEAT a plethora of services that are key to business functions, but yet still considered as low-margin under these rules.
Although the services cost method may serve to exclude the cost component of outbound payments to foreign related parties from the BEAT, it is extremely unlikely that any markup charged on these payments may be excluded from the BEAT. Additionally, it is a bit unclear how these services will be treated under the BEAT in instances where a markup is charged, however small it may be. This is an important consideration for any company looking to utilize the SCM to reduce their BEAT obligations.
Alvarez and Marsal TAXAND Says:
Many service companies are being caught unfairly by the BEAT. Some, for example, are surprised that their legacy transfer pricing and payment structures, which met various standards of acceptance in the past, are targeted to cause harmful results. Now is the time to get a real handle on how BEAT applies (or could apply) and scenarios where the liability may be mitigated. There are many opportunities to reorganize the flows of payments to mitigate the BEAT’s impact. Most services companies are already evaluating additional options as well, such as analyzing the services cost method as an appropriate means to alleviate the stinging bite of the BEAT.