On Thursday of last week, the IRS released proposed regulations on the base erosion and anti-abuse tax (BEAT). This guidance provides answers to several outstanding questions regarding this new minimum tax, but notably does not address one of the most highly anticipated areas, the question regarding the cost of goods sold (COGS) analogue for services companies.
A critique of certain statutory language in the new BEAT regime is that it unfairly discriminates against companies that sell services and in favor of companies that sell products by allowing the latter a major exception from BEAT for the cost of goods sold, while denying an analogous exception to the services sector for the cost of services sold. While that seemed to be the result produced by the language of the statute, many believed that the IRS had sufficient authority to carve out a similar exception for service providers in the regulations; and, therefore, services companies have been anxiously awaiting these regulations in hopes of that relief. In short, these regulations dash those hopes.
On the positive side, the proposed regulations do provide welcome clarification surrounding certain other areas of taxpayer concern. The following is a brief overview of some of the highlights, the first two of which provide benefits to services companies.
- Services Cost Method Exception: The proposed regulations clarify that the Services Cost Method (SCM) exception is not “all or nothing.” The cost portion of a qualifying payment is not a base erosion payment while the markup component is. Thus, charging a markup does not disqualify the entire payment from the SCM exception. To qualify, payments must meet the standard requirements under section 482 for the SCM method other than the business judgment rule, the exclusion of which generally broadens the availability of the SCM exception.
- Existing Rules Apply Regarding Beneficial Ownership, Agency, Etc.: Companies providing services globally to their customers often use a business model where one group company contracts with the third-party customer and subcontracts out all or a portion of the work to other group companies. Where the contracting entity is a U.S. company, it may bill and collect from the customer for services provided by the other group companies. In that case, payments by the U.S. company to the other group companies could be treated as “deductions,” causing them to be taxable under the BEAT. The preamble to the proposed regulations contains some language that appears to acknowledge a planning opportunity for situations where the intra-group relationship is structured such that the U.S. group company is acting as a billing and collection agent for the other group companies, in which case the payments to the other group companies would not give rise to deductions; rather, they would never be included in gross receipts in the first instance, and so would not be subject to BEAT.
- NOL Add-Back: The Modified Taxable Income (MTI) computation starts with regular taxable income (or loss) and adds back the gross amount of base erosion tax benefits for the taxable year as well as the base erosion percentage of any NOL deduction for the taxable year. The proposed regulations clarify that the add-back of the base erosion percentage of any NOL deduction for the taxable year is based on the year in which the loss arose (i.e., for any pre-2018 NOL, the base erosion percentage will be 0 percent and accordingly, there will be no add-back).
- Interplay with 163(j): Any disallowed disqualified interest under section 163(j) that a taxpayer carries forward from a pre-2018 taxable year is not a base erosion payment (similar rules apply for any suspended losses or deferred deductions including interest deferred under section 267). This overrules Notice 2018-28, which stated that business interest carried forward from a pre-2018 taxable year will be subject to the BEAT in the same manner as interest paid or accrued in a taxable year beginning after December 31, 2017. The proposed regulations also implement ordering rules for when section 163(j) limits interest deductibility. The rule requires taxpayers to treat all disallowed business interest first as interest paid or accrued to non-related parties, and then as interest paid or accrued to related parties.
- Nuances to the Aggregate Group Approach: For BEAT purposes, an aggregate group is a controlled group as defined in section 1563, replacing the 50 percent ownership requirement with an 80 percent ownership requirement. Base erosion payments, base erosion percentage, and whether an entity is an applicable taxpayer are all determined using an aggregate group approach. Under the proposed guidance, a foreign entity may be part of an aggregate group for one payment but not for another depending on whether the specific payment is subject to U.S. tax. Further, the effective date of BEAT for each taxpayer guides when to include payments made by other members of its aggregate group, potentially resulting in additional, off-cycle calculations when members of the same aggregate group have different year ends.
- Non-Recognition Transactions: Pursuant to the proposed regulations, certain nonrecognition transactions may be BEAT payments, as consideration to qualify as a BEAT payment may be in both cash or non-cash forms (tangible assets, stock, etc.) For example, stock issued in exchange for an inbound section 351 contribution (e.g., of depreciable property) may be a BEAT payment. Similarly, other non-recognition transactions such as section 332 liquidations and section 368 reorganizations may also yield BEAT exposure.
- Parallel Tax Regime Left Out: The regulations for the Alternative Minimum Tax (AMT), and Adjusted Current Earnings, which the BEAT replaces, adopted a parallel tax regime methodology. A parallel tax regime operates independently from other tax laws, which meant that taxpayers may have had two to three sets of carryforwards for each attribute, as well as different levels of basis for certain assets. By not adopting this approach for BEAT, the IRS has greatly reduced the complexity as compared to that required under AMT.
Alvarez & Marsal Says:
Many large U.S. multinationals will need to review their payment flows and refine their BEAT calculations in light of this guidance, as they prepare for year-end reporting and compliance. Beyond this, these new rules shape the lens through which taxpayers will view future transactions. To support both compliance and planning needs, we will provide more detailed insights gleaned from these proposed regulations over the coming weeks.