Tax legislation generally includes promises to simplify the process of computing taxes. But in the process of transforming legislation into law, those good intentions often are overshadowed by new complexities.
The Tax Cuts and Jobs Act of 2017 is no exception, especially for U.S. multinational corporations. Although most corporations herald their much lower 21% tax rate under the TCJA, it comes with a price.
The law’s Base Erosion Anti-Abuse Tax (BEAT) is designed to discourage companies from steering revenue to lower-tax countries overseas by reducing the incentive to shift profits to foreign-related parties.
Previously, corporations shipped $300 billion of profits annually to lower-tax countries. The Congressional Budget Office estimates that BEAT and other measures will instead add $65 million annually to the federal government’s coffers.
BEAT’s intricacies, of which there are many, haven’t been sorted out entirely, because the IRS has yet to issue final guidelines. But corporations with more than $500 million in U.S.-sourced revenue who make deductible payments to foreign-related entities are vulnerable. It amounts to an alternative minimum tax (AMT).
The BEAT calculation itself is fairly straightforward. It’s computed from Modified Taxable Income (MTI), which equals the corporation’s regular taxable income, with certain foreign-related payments added back.
The BEAT is the excess of 10% of MTI over the company’s regular liability, minus certain tax credits. (There will be an initial 5% phase-in rate for the 2018 tax year, then the 10% will apply through 2025, after which it will rise to 12.5%.) Like-kind payments may be aggregated in the calculation.
As befits tax legislation, details related to the BEAT calculation are more complex.
To begin, corporations must have U.S.-generated revenue of $500 million for the prior three years, subject to some deductions. Unlike the repealed AMT regime, there is no future credit for any BEAT that the taxpayer incurs. Thus, it is a lost cost.
BEAT affects both U.S. and non-U.S. corporations (controlled and consolidated groups), except for regulated investment company (RIC), REIT, and S corporations. The “foreign” entity criterion is satisfied by determining ownership of at least 25% of the taxpayer’s stock and/or other tests to determine relationship or control.
Banks will not receive the benefits of the historic rehabilitation tax credit and the new markets tax credits, and their rate is 1% higher; rates for registered securities dealers and affiliates can be 2% to 3%. BEAT may be considered an additional tax in determining a bank’s effective tax rate, which could reduce regulatory capital. And there is no netting of BEAT payments.
But calculating payments is more involved. Accruals of interest, rents, royalties, trademarks, and certain fees for services are included (though it’s unclear whether deemed/allocated interest expense for foreign banks under Treasury regulations Section 1.882-5 will be considered a BEAT payment).
Payments made in the ordinary conduct of business are excluded, such as cost of goods sold (COGS) and labor, plus qualifying derivative instruments, and other eligible service payments. (This should be addressed specifically in the proposed regulations due out for comment later this year; check IRS website for schedule dates.)
Although BEAT applies to foreign corporations with effectively connected income (ECI), it does not appear to exempt payments to foreign-related entities that treat such payments as ECI. Also, low taxable income due to net operating losses or large credits against regular tax may trigger BEAT.
Planning Around the BEAT
Paying heed to the composition of payments and seeking to classify them in the “included” category is vital. For example, a corporation can restructure its foreign payments in two ways.
For one, U.S. domestic entities can make payments to other, non-related foreign entities, rather than to foreign entities (where the payment would be included in the BEAT calculation).
Secondly, a foreign-related corporation receiving the BEAT payment can make a check-the-box election. This governs how a foreign business organization is classified for U.S. tax purposes, and thus allows a U.S. corporation to disregard payments to the foreign-related entity that has undertaken the election.
Also, corporations can analyze all payments to determine whether any may be recategorized as COGS. Because COGS is exempted from the calculation, recategorizing may reduce (or entirely eliminate) the corporation’s BEAT exposure by reducing its base-eroding payments.
Corporations also can apply the Service Cost Method (SCM), a transfer pricing mechanism under Section 482 of the Internal Revenue Code. Certain services that do not contribute to the risk of a business’s success or failure are exempt from the BEAT calculation, provided they have no markup. These include manufacturing, distribution, research, development, and engineering.
Additionally, corporations can review transfer pricing reports associated with any foreign-related party payments to determine whether they can leverage either the SCM or a more appropriate transfer price that may yield a lower base-erosion percentage to the taxpayer (subject to any anti-abuse regulations).
Because the BEAT calculation includes interest payments made to foreign-related parties, corporations could refinance inter-company debt through more traditional, third-party sources. Examples are bank loans, leases, and convertible debt.
The overarching step corporations should take is to model the impact of adjusting various base-eroding payments inputs. Those can encompass tax attributes, allocation of interest payments, income or loss credits, and financing options.
Some states are targeting ways to benefit from BEAT’s implications. They may consider changing from a pass-through entity to a corporate entity but should consider the state impact first. BEAT is a separate federal tax and does not affect the calculation of federal taxable income, so states are not likely to conform to the BEAT unless specific legislation is enacted.
States’ treatment of these issues can encourage foreign-owned and domestic investments. Their response to BEAT can showcase their mastery of its provisions and consequences to foster a business-friendly environment and more easily attract new business investment.
In conclusion, US Treasury has not yet issued regulations on BEAT (regulations are expected in November or December of this year). But corporations should exercise caution in performing an initial, basic BEAT calculation to facilitate informed future planning.
Steps include undertaking a proof of concept — using material factors to analyze a limited data set to better understand the approach to take and the challenges it engenders.
Corporations should coordinate the various internal groups to devise and implement a solution, which may entail a change-management process that embraces finance, accounting, derivatives business units, IT, and assorted data groups.
The Tax Cuts and Jobs Act gave corporations a bonanza in the form of a much lower tax rate to make it easier to compete in the global marketplace. The BEAT provision, which may reduce the tax benefits of payments made to foreign-related entities, requires proper guidance to manage its implications.
Tifphani White-King is a principal and international tax services leader for accounting, tax, and consulting firm Mazars USA. Tom Barber is a Mazars partner who leads the tax support team for GAAP, IFRS, and statutory financial statement audits. Ilene Mak leads Mazars’ China Desk. Tim Evans is a tax manager at Mazars.