On Dec. 13, 2018, the Internal Revenue Service and Department of Treasury issued proposed regulations addressing the base erosion and anti-abuse tax (BEAT). In general, the regulations provide guidance for identifying an applicable taxpayer for purposes of the BEAT and computing the taxpayer’s BEAT liability. In addition, these regulations contain special rules applicable to consolidated groups, partnerships and certain businesses, such as banks, registered securities dealers and insurance companies.
Enacted in the 2017 Tax Act, the BEAT serves as a minimum tax on certain taxpayers that reduce their overall tax liability by making deductible payments to related foreign parties. The BEAT statute provides computations for taxpayers to determine whether they are subject to the BEAT, and a formula to calculate the resulting BEAT liability based on the “base erosion payments” made by the applicable taxpayer. Given the broad implications of the BEAT, taxpayers across various sectors, such as the insurance and energy industries, had concerns interpreting terms such as “base erosion payment.”
The proposed regulations provide much-needed guidance regarding various aspects of the BEAT. Below are several key takeaways.
Entities Subject to the BEAT. The BEAT generally applies to C corporations that have annual gross receipts of at least $500 million for the preceding three taxable years and a certain base erosion percentage of 3 percent or higher. Notably, the proposed regulations provide that gross receipts are aggregated among a controlled group. Once a taxpayer meets the threshold factors, BEAT liability is based on the excess of modified taxable income multiplied by an applicable rate over such entity’s regular income tax liability. Modified taxable income is computed by adding to regular taxable income certain base erosion tax benefits, which are keyed to base erosion payments, as well as the base erosion percentage of net operating losses allowed for a given taxable year.
Base Erosion Payments. The proposed regulations clarify that a base erosion payment is made regardless of whether the payment is in cash or in kind. In doing so, the IRS and Treasury highlighted that certain transactions may result in nonrecognition under the Internal Revenue Code; however, this does not necessarily preclude whether a base erosion payment has been made. Some of the transactions noted by IRS and Treasury include tax-free exchanges and reorganizations pursuant to Code Sections 351, 332 and 368.
Services Cost Method Exception. There is an exception for base erosion payments for services that are generally eligible for the services cost method under Code Section 482. Many taxpayers questioned whether the payment applied to only the markup on related party services or to the entire amount, as the statute was unclear in this respect. The IRS and Treasury signaled a taxpayer-friendly result and clarified that only the markup portion is considered a base erosion payment, provided certain other requirements are met.
Net Operating Loss. Prior to the proposed regulations, it was unclear whether the base erosion percentage would take into consideration net operating losses incurred before 2018 to compute the modified taxable income. Alternatively, the base erosion percentage would take into consideration the NOL only for the year in which a given taxpayer takes the net operating loss deduction. The proposed regulations clarify that the base erosion percentage is computed in the year the net operating loss arose and, as a backstop, the base erosion percentage for net operating losses that arose in years prior to the effective date of the BEAT would be zero.
Reinsurance Payments. Certain reinsurance payments constitute base erosion payments for purposes of calculating modified taxable income. Treasury acknowledged that certain arrangements between insurers and foreign-based reinsurers result in payment of a net settlement amount (comprised of various contractual obligations between the parties — akin to certain derivative payments, such as notional principal contracts). The proposed regulations clarify that the gross reinsurance payment is taken into account for purposes of the BEAT, and not the net settlement amount of which the gross reinsurance payment is a part.
Qualified Derivative Payments. An exception to base erosion payments exists for “qualified derivative payments.” Though the statute provided three requirements to qualify for the exception, the proposed regulations narrow the definition of qualified derivative payments in Code Section 59A. Specifically, securities lending transactions, sale-repurchase transactions and substantially similar transactions are removed from the scope of derivatives that could qualify under the exception regardless of the requirements provided in the statute
Though the regulations are in proposed form (to be finalized at a later time), taxpayers may rely on them for tax years beginning in 2018 (when the BEAT became effective). The IRS and Treasury requested public comments on various aspects of the proposed regulations but have not scheduled a public hearing as of this writing. A copy of the complete proposed regulations is available on the IRS website.