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Tax Cuts and Jobs Act

Prop regs on base erosion anti-abuse tax (BEAT): taxpayers subject to BEAT and computation

Thomson Reuters Tax & Accounting  

Thomson Reuters Tax & Accounting  

Preamble to Prop Reg REG-104259-18Prop Reg §1.59A-1, Prop Reg §1.59A-2, Prop Reg §1.59A-3, Prop Reg §1.59A-4, Prop Reg §1.59A-5, Prop Reg §1.59A-6, Prop Reg §1.59A-7, Prop Reg §1.59A-8, Prop Reg §1.59A-9, Prop Reg §1.59A-10, Prop Reg § 1.1502-59A, Prop Reg §1.1502-100, Prop Reg §1.6038A-1, Prop Reg §1.6038A-2

IRS has issued proposed regs that would provide guidance on the base erosion anti-abuse tax, or BEAT, enacted by the Tax Cuts and Jobs Act (TCJA; P.L. 115-97, 12/22/2017). This article examines the proposed regs on determining which taxpayers are subject to the BEAT, the amount of base erosion payments, and base erosion tax benefits arising from base erosion payments.

For application of the proposed regs to partnerships, see here.

For modified taxable income and base erosion minimum tax amount, see here.

For anti-abuse rules, NOL and credit carryover limitations, and reporting rules, see here.

Background.   Code Sec. 59A, as added by the TCJA, imposes a tax equal to the “base erosion minimum amount” on certain “applicable taxpayers.” In general, applicable taxpayers are corporations, excluding regulated investment companies, real estate investment trusts, and S corporations, that satisfy a “gross receipts test” and a “base erosion percentage test.” (Code Sec. 59A(e)(1))

The gross receipts test limits the application of the BEAT to taxpayers with at least $500 million in average annual gross receipts for the previous three years (Code Sec. 59A(e)(1)(B)), and the base erosion percentage test limits it to taxpayers with “base erosion payments” that account for 3% of their deductions (2% if the affiliate group includes a bank). (Code Sec. 59A(e)(1)(C)) Under Code Sec. 59A(e)(3), taxpayers that treated as a single employer under Code Sec. 52(a) are aggregated for purposes of determining whether these tests are met.

The tax is the excess of 10% (5% for 2018) of the modified taxable income of the taxpayer over its regular tax liability (reduced by certain allowable credits). The taxpayer’s modified taxable income is its taxable income without the benefit of specified deductible payments.

New guidance.  IRS has issued proposed regs under Code Sec. 59A that explain which taxpayers are subject to the BEAT (“applicable taxpayers”) and how a taxpayer’s BEAT liability is calculated.

“Applicable taxpayers.” As described above, the BEAT only applies to “applicable taxpayers.” The proposed regs provide guidance on the determination of whether a taxpayer is an “applicable taxpayer” under Code Sec. 59A.

Determination of “aggregate group.” Corporations that are treated as a single employer under Code Sec. 52(a),  which treats members of the “same controlled group of corporations” (as defined in Code Sec. 1563(a) with certain modifications) as one person, are aggregated for BEAT purposes under Code Sec. 59A(e)(3).

A “controlled group” under Code Sec. 1563(a) can include both foreign and domestic persons. However, the proposed regs would generally treat foreign corporations as outside of the controlled group for purposes of applying the aggregation rules, except to the extent that the foreign corporation has effectively connected income (ECI) and is subject to tax under Code Sec. 882(a). In the case of a foreign corporation that determines its net taxable income under an applicable income tax treaty of the U.S., the foreign corporation is a member of the aggregate group with regard to gross receipts taken into account in determining its net taxable income.

The proposed regs generally would provide that payments between members of the aggregate group are neither included in the gross receipts of the aggregate group, nor taken into account for purposes of the numerator or the denominator in the base erosion percentage calculation (below).

Gross receipts test.  In the case of an aggregate group, the proposed regs would measure gross receipts of a taxpayer by reference to the taxpayer’s aggregate group determined as of the end of the taxpayer’s tax year for which BEAT liability is being computed, and takes into account gross receipts of those aggregate group members during the 3-year period preceding that tax year. Special rules would apply in certain situations, including for corporations that have been in existence for fewer than three years or have short years, aggregated groups with members that have different tax years, and corporations that are subject to tax under subhapter L (including a foreign corporation subject to tax under Code Sec. 842(a)). For an aggregate group with a member that owns an interest in a partnership, the proposed regs would provide that the group includes its share of the gross receipts of the partnership in its gross receipts computation.

Base erosion percentage test.  The proposed regs would provide that the lower 2% threshold for the base erosion percentage test, which generally applies for taxpayers or affiliated groups that include a domestic bank or registered securities dealer, would not apply in the case of an aggregated or consolidated group that has only de minimis bank or registered securities dealer activities.

Under the proposed regs, the base erosion percentage for a tax year is computed by dividing (1) the aggregate amount of base erosion tax benefits (the numerator) by (2) the sum of the aggregate amount of deductions plus certain other base erosion tax benefits (the denominator). Base erosion tax benefits are generally the deductions or reductions in gross income that result from base erosion payments (see below). The proposed regs include detailed rules for certain types of deductions that are excluded when calculating the base erosion percentage (see below).

Where tax is imposed by Code Sec. 871 (tax on nonresident alien individuals) or Code Sec. 881 (tax on income of foreign corporations not connected with U.S. business) and that tax has been deducted and withheld under Code Sec. 1441 or Code Sec. 1442 on a base erosion payment, the base erosion payment is not treated as a base erosion tax benefit for purposes of calculating a taxpayer’s modified taxable income, and is not included for purposes of the base erosion percentage computation. 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 the reduction in withholding under rules similar to those in pre-TCJA Section 163(j)(5)(B).

Application of tests to aggregate groups members of which have different tax years.  The proposed regs provide rules that would apply in determining whether the gross receipts test and base erosion percentage test are satisfied with respect to a specific taxpayer when other members of its aggregate group have different tax years. (Prop Reg §1.59A-2(e)(3)(vii)) In general, each taxpayer would determine its gross receipts and base erosion percentage by reference to its own tax year, taking into account the results of other members of its aggregate group during that year. As a result of this rule, two related taxpayers with different tax years will compute their applicable gross receipts and base erosion percentage by reference to different periods, even though in each case the calculations are done on an aggregate group basis that takes into account other members of the controlled group. Taxpayers may use a reasonable method to determine the gross receipts and base erosion percentage information for the time period of the member of the aggregate group with a different tax year.

Calculation of base erosion percentage for mark-to-market taxpayers.  For taxpayers (or taxpayers that are members of an aggregate group) to determine the base erosion percentage, the proposed regs provide rules that would apply in determining the amount of base erosion tax benefits in the case of transactions that are marked to market, and determining the total amount of the deductions that are included in the denominator of the base erosion percentage computation.

Specifically, to ensure that only a single deduction is claimed with respect to each transaction, the proposed regs would combine all income, deduction, gain, or loss on each transaction for the year for purposes of determining the amount of the deduction that is used for purposes of the base erosion percentage test. This rule does not modify the net amount allowed as a deduction pursuant to the Code and regs. This rule is intended to prevent distortions in deductions from being included in the denominator of the base erosion percentage, including as a result of the use of an accounting method that values a position more frequently than annually.

Base erosion payments. The proposed regs would define a base erosion payment as a payment or accrual by the taxpayer to a foreign related party that is described in one of four categories (categorization generally determined under U.S. federal income tax law):

  1. a payment with respect to which a deduction is allowable;
  2. a payment made in connection with the acquisition of depreciable or amortizable property;
  3. premiums or other consideration paid or accrued for reinsurance that is taken into account under Code Sec. 803(a)(1)(B) or Code Sec. 832(b)(4)(A);
  4. a payment resulting in a reduction of the gross receipts of the taxpayer that is with respect to certain surrogate foreign corporations or related foreign persons.

Specific types of “base erosion payments.” The proposed regs describe operating rules that would apply for purposes of determining whether there is a payment or accrual that can give rise to a base erosion payment, as well as for coordinating the definition of a “base erosion payment” with rules that allocate deductions for purposes of determining a foreign corporation’s ECI.

  • Non-cash consideration. The proposed regs would clarify that a payment or accrual by a taxpayer may be a base erosion payment regardless of whether the payment is in cash or in any form of non-cash consideration (Prop Reg § 1.59A-3(b)(2)(i)), and regardless of whether the transfer was part of a nonrecognition transaction. (Preamble) The proposed regs also clarify that, for transactions in which a taxpayer that owns stock in a foreign related party receives depreciable property from the foreign related party as an in-kind distribution subject to Code Sec. 301, there is no base erosion payment because there is no consideration provided by the taxpayer to the foreign related party in exchange for the property and thus no payment or accrual.
  • Interest expense—ECI. The proposed regs would generally provide that a foreign corporation that has interest expense allocable under Code Sec. 882(c) to ECI will have a base erosion payment to the extent the interest expense results from a payment or accrual to a foreign related party.  The amount of interest that would be treated as a base erosion payment depends on the method used under Reg. §1.882-5.
  • Other deductions—ECI. The amount of a foreign corporation’s other deductions properly allocated and apportioned to ECI under Reg. §1.882-4 would also be base erosion payments to the extent that those deductions are paid or accrued to a foreign related party. The proposed regs would generally identify base erosion payments by tracing each item of deduction, and determining whether the deduction arises from a payment to a foreign related party.
  • Income tax treaties. In the Preamble, IRS noted that certain U.S. income tax treaties provide alternative approaches for the allocation or attribution of business profits of an enterprise of one contracting state to its permanent establishment in the other contracting state on the basis of assets used, risks assumed, and functions performed by the permanent establishment, which can result in amounts equivalent to deductible payments being allowed in computing the business profits of an enterprise with respect to transactions between the permanent establishment and the home office or other branches of the foreign corporation (“internal dealings”). The proposed regs would require that these deductions from internal dealings allowed in computing the business profits of the permanent establishment be treated in a manner consistent with their treatment under the treaty-based position and be included as base erosion payments.
  • Payments to domestic pass-throughs with foreign owners or to another aggregate group member. Under Prop Reg §1.59A-3(b)(2)(v), if an applicable taxpayer pays or accrues an amount that would be a base erosion payment except for the fact that the payment is made to a specified domestic passthrough, then the applicable taxpayer would be treated as making a base erosion payment to each specified foreign related party for purposes of Code Sec. 59A and its regs. Prop Reg §1.59A-3(b)(2)(vi), which would apply when a taxpayer transfers certain property to a member of an aggregate group that includes the taxpayer, would ensure that any deduction for depreciation (or amortization in lieu of deprecation) by the transferee taxpayer remains a base erosion tax benefit to the same extent as the amount that would have been a base erosion tax benefit in the hands of the transferor.

Exceptions to “base erosion payments.” The proposed regs would also explain and clarify a number of exceptions from base erosion payments in Code Sec. 59A:

  • SCM exception.  Code Sec. 59A(d)(5), the “service cost method” exception (SCM exception), excludes from the definition of a base erosion payment certain amounts paid or accrued by a taxpayer for services if certain requirements are met. The proposed regs, resolving an ambiguity on the applicability of the SCM exception when an amount paid or accrued for services exceeds the total services cost but the payment otherwise meets the other requirements, would provide that the SCM exception is available if there is a markup (and if other requirements are satisfied), but that the portion of any payment that exceeds the total cost of services is not eligible for the SCM exception and is a base erosion payment.To be eligible for the SCM exception, the proposed regs would require that all of the requirements of Reg. § 1.482-9(b) be satisfied, except as modified by the proposed regs. Finally, the proposed regs would require a taxpayer to maintain books and records adequate to permit verification of, among other things, the amount paid for services, the total services cost incurred by the renderer, and the allocation and apportionment of costs to services in accordance with Reg. §1.482-9(k).
  • QDP exception.  Code Sec. 59A(h) provides that a qualified derivative payment (QDP) is not a base erosion payment, with certain exceptions. Prop Reg §1.59A-6 would define a QDP as any payment made by a taxpayer to a foreign related party pursuant to a derivative for which the taxpayer recognizes gain or loss on the derivative on a mark-to-market basis, the gain or loss is ordinary, and any gain, loss, income or deduction on a payment made pursuant to the derivative is also treated as ordinary. The QDP exception would apply only if the taxpayer satisfies reporting requirements in Prop Reg §1.6038A-2(b)(7)(ix). The proposed regs would further clarify that sale-repurchase transactions aren’t treated as derivatives for Code Sec. 59A purposes.
  • Payments to persons subject to U.S. tax. While a payment or accrual generally must be to a foreign person in order to be treated as a base erosion payment, IRS determined that it is appropriate to consider the U.S. tax treatment of the foreign recipient, and provided in the proposed regs an exception for amounts that are subject to tax as ECI.
  • Exchange loss from Section 988 transaction.  Prop Reg §1.59A-3(b)(3)(iv) would provide that exchange losses from section 988 transactions described in Reg. §1.988-1(a)(1) are not base erosion payments. Exchange gain from a section 988 transaction, however, would be included as a gross receipt for purposes of the gross receipts test under Prop Reg §1.59A-2(d).
  • Interest on certain instruments issued by GSIBs.  Certain global systemically important banking organizations (GSIBs) issue TLAC securities as part of a global framework for bank capital that has sought to minimize the risk of insolvency. IRS has determined that, because of the special status of TLAC as part of a global system to address bank solvency, and the limits to which they are subject, interest paid or accrued on TLAC securities required by the Federal Reserve would generally be excepted from base erosion payments.

Base erosion payments before effective date & pre-2018 disallowed business interest.  Code Sec. 59A applies only to base erosion payments paid or accrued in tax years beginning after Dec. 31, 2017, and the statutory definition of a base erosion tax benefit is based upon the definition of a base erosion payment. Accordingly, the proposed regs would confirm the exclusion of a deduction described in Code Sec. 59A(c)(2)(A)(i) (deduction allowed under Chapter 1 for the tax year with respect to any base erosion payment) or Code Sec. 59A(c)(2)(A)(ii) (deduction allowed under Chapter 1 for the tax year for depreciation or amortization with respect to any property acquired with such payment) that is allowed in a tax year beginning after Dec. 31, 2017, if it relates to a base erosion payment that occurred in a tax year beginning before Jan. 1, 2018.

In the case of business interest expense that is not allowed as a deduction under Code Sec. 163(j)(1), the proposed regs—in a departure from IRS’s position set out in Notice 2018-28—would provide that any disallowed disqualified interest under Code Sec. 163(j) that resulted from a payment or accrual to a foreign related party and that is carried forward from a taxable year beginning before January 1, 2018, is not a base erosion payment. The proposed regs would also clarify that any disallowed business interest carryforward under Code Sec. 163(j) that resulted from a payment or accrual to a foreign related party is treated as a base erosion payment in the year that the interest was paid or accrued even though the interest may be deemed to be paid or accrued again in the year in which it is actually deducted.

Base erosion tax benefits. The amount of base erosion tax benefits is an input in (i) the computation of the base erosion percentage test (above) and (ii) the determination of modified taxable income. 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 tax year.

Withholding tax on payments. If tax is imposed by Code Sec. 871 or Code Sec. 881 and the tax is deducted and withheld under Code Sec. 1441 or Code Sec. 1442 without reduction by an applicable income tax treaty on a base erosion payment, the base erosion payment would be treated as having a base erosion tax benefit of zero for purposes of calculating a taxpayer’s modified taxable income. And, 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 the reduction in withholding under rules similar to those in pre-TCJA Section 163(j)(5)(B).

Interest classification rules.  Prop Reg §1.59A3(c)(4) would provide that where Code Sec. 163(j) applies to limit the amount of a taxpayer’s business interest expense that is deductible in the tax year, a taxpayer is required to treat all disallowed business interest first as interest paid or accrued to persons who are not related parties, and then as interest paid or accrued to related parties for purposes of Code Sec. 59A. Conversely, the amount of a disallowed business interest expense carryforward would be treated first as business interest expense paid to unrelated parties, and then as business interest expense paid to related parties, proportionately between foreign and domestic related party business interest expense. The proposed regs would also follow a year-by-year convention in the allocation of business interest expense and carryovers among the related and unrelated party classifications.

References: For the base erosion and anti-abuse tax, see FTC 2d/FIN ¶ D-1250 et seq, United States Tax Reporter ¶ 59A4.

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