The Tax Cuts and Jobs Act (“TCJA”) significantly altered how the US taxes international operations. In Part 1 of our International series, we discussed the Section 965 Deemed Repatriation Tax.
Base Erosion and Anti-Abuse Tax
We now turn our attention to the Section 59A Base Erosion and Anti-Abuse Tax. This tax imposes a minimum tax on certain entities that have base erosion payments, discussed below, exceeding a certain amount. This tax can significantly affect an entity’s tax liability and must be carefully considered when determining the proper legal structure, corporate or pass through, for entities involved in international operations.
BEAT imposes a minimum tax on the excess of 10% of a taxpayer’s modified taxable income (“MTI”),( 5% for tax years beginning 2018 and 12.5% for tax years post December 31, 2025) over the taxpayer’s regular tax liability if the following threshold conditions are satisfied:
- The applicable taxpayer is a U.S. corporation (or foreign corporation with a U.S. branch or effectively connected income) other than a RIC, REIT or S-corporation that has:
- A minimum of $500 million of gross receipts on average annually over a three (3) year period; and
- Base erosion payments to foreign related parties that result in a base erosion percentage of 3% or higher (2% for certain financial services companies).
In general, the BEAT requires an applicable taxpayer to pay a tax of at least 10% of its MTI. The concept is similar to the recently repealed corporate alternative minimum tax, which required a corporation to pay a minimum tax on its alternative minimum taxable income.
BEAT is generally not applicable if a taxpayer generates higher taxable income in comparison to their foreign related party deductible payments.
MTI is your regular taxable income without allowance of deductions for base erosion payments to foreign related parties, or depreciation and amortization with respect to property acquired from related parties.
Base erosion payments include deductible payments (and accruals) to foreign related parties like interest, rents, royalties, and certain service fees. It is important to note that cost of goods sold is excluded from this definition.
Base erosion payments also do not include certain payments made in the ordinary course of business, qualified derivative payments, and eligible service payments.
The base erosion percentage is determined by dividing the aggregate base erosion tax benefits by the total deductions for a tax year. Base erosion tax benefits include the base erosion payments described above, as well as depreciation and amortization with respect to property acquired from related parties, defined as a 25% owner of a taxpayer by vote or value, any person related within the meaning of IRC Section 267(b) or 707(b)(1), and any person related to the taxpayer within the meaning of IRC Section 482.
In light of the significant impact of BEAT, applicable taxpayers should inventory payments that are treated as tax deductible to determine whether they are properly identified as base erosion payments rather than one of the exempted base eroding payment types discussed above (e.g., cost of goods sold).
Consider also, potentially, a change in status or structure of the foreign affiliate in receipt of a base eroding payment. For example, the transaction may be restructured such that the U.S. corporation does not make a payment to a foreign related party.
Moreover, a check-the-box election may be made on the foreign related party so that any payments from the U.S. corporation to the foreign related party are disregarded for U.S. tax purposes. These restructuring options would involve financial modeling of the tax costs or savings involved and, of course, should be reviewed in light of any pending anti-abuse regulations.
Also, be wary of any pre-U.S. tax reform disallowed interest expenses under Section 163(j) that will get deducted in future years. As of today, such interest is an add-back in the year taken for purposes of the BEAT calculation. This certainly seems to be a bit unfair in light of the fact that BEAT legislation was not enacted in the year such disallowance arose.
Additionally, now is a good time to review transfer pricing reports associated with any foreign related party payments in the event there is an opportunity to leverage the service cost method (another exempt payment not taken into consideration for application of BEAT as mentioned above), or a more appropriate transfer price that may yield a lower base erosion percentage to the taxpayer (albeit subject to any anti-abuse regulations).
Taxpayers should also be cognizant of the ever-evolving multi-state tax implications. Most states use the Internal Revenue Code as the starting point in computing state taxable income.
However, based upon the fact that the BEAT is a separate Federal tax and does not impact the calculation of federal taxable income, states would not likely conform to the BEAT unless specific legislation is enacted. In any event, any potential conversion from pass through to corporate entity should consider the state tax impact of such changes