However, this general exception from base-erosion payments for COGS does not apply to payments that constitute reductions in gross receipts (e.g., COGS) of a taxpayer when the payments are paid or accrued with respect to (1) a surrogate foreign corporation that is a related party of the taxpayer (as defined under Sec. 7874(b)), but only if such person first became a surrogate foreign corporation after Nov. 9, 2017; or (2) a foreign person that is a member of the same expanded affiliated group as the surrogate foreign corporation (collectively, an SFC) (Sec. 59A(d)(4)).
The BEAT, a new provision under Sec. 59A enacted in the law known as the Tax Cuts and Jobs Act, P.L. 115-97, is effective for base-erosion payments paid or accrued by an applicable taxpayer in tax years beginning after Dec. 31, 2017. An applicable taxpayer is a taxpayer that is a corporation (other than a regulated investment company, a real estate investment trust, or an S corporation) with average annual gross receipts for the three preceding tax years of at least $500 million and a base-erosion percentage of at least 3% (2% in the case of certain banks and registered securities dealers) (Sec. 59A(e)). The BEAT, which generally is viewed as a minimum tax on an applicable taxpayer, is equal to the excess (if any) of (1) 10% of modified taxable income (5% for tax years beginning in 2018 and 12.5% for tax years beginning after 2025) of the taxpayer over (2) the regular tax liability of the taxpayer as defined in Sec. 26(b), reduced (but not below zero) by all credits except the Sec. 41 research credit and a portion of applicable Sec. 38 credits (regular tax is reduced by all credits for tax years beginning after 2025).
Modified taxable income is equal to the taxpayer's taxable income determined without regard to the tax benefits arising from base-erosion payments or the base-erosion percentage of any net-operating-loss (NOL) deduction allowed for the tax year (Sec. 59A(c)). The base-erosion percentage is determined by dividing the aggregate amount of base-erosion tax benefits by the aggregate amount of the deductions allowable under Chapter 1 (including base-erosion tax benefits for which a deduction is allowed), plus the base-erosion tax benefits attributable to certain reinsurance payments and payments made to SFCs, and minus any deduction allowed (1) under Sec. 172, 245A, or 250; (2) for amounts paid or accrued with respect to services that meet the services-cost-method exception; and (3) for qualified derivative payments that are not base-erosion payments.
Cost of goods sold
The amount of COGS is equal to the sum of (1) inventory held by the taxpayer at the beginning of the year, (2) purchases, (3) the cost of labor, (4) additional Sec. 263A costs, and (5) other costs allocable to the inventory, less the inventory on hand at the end of the year. COGS is considered a reduction in gross receipts rather than a deduction. Because COGS is not considered a deduction, amounts included in COGS are not base-erosion payments (except in the case of those made to a related SFC) and, therefore, are not subject to the BEAT. Accordingly, taxpayers should consider whether they are appropriately including items in COGS to reduce their potential BEAT exposure.
Sec. 263A specifies that direct and allocable indirect costs of property produced or acquired for resale by the taxpayer must be capitalized to the cost of inventory. This calculation commonly is referred to as the UNICAP (uniform capitalization) calculation. As the underlying inventory is sold, the costs that have been capitalized to inventory are taken into account through COGS. If amounts are determined to be capitalizable costs under Sec. 263A, then they are included in COGS and are not base-erosion payments subject to the BEAT (except in the case of those made to a related SFC).
Companies should review their UNICAP calculations to confirm whether costs are being appropriately capitalized to inventory. Two particular costs that may provide an opportunity for capitalization under Sec. 263A and exclusion from the BEAT calculation are sales-based royalties and management fees paid or accrued by a taxpayer to a foreign related party.
Sales-based royalties are the licensing fees, payments, and royalty costs related to the use of intellectual property that become due upon the sale of property produced or acquired for resale. Sales-based royalties are capitalizable indirect costs under Sec. 263A, as clarified by final regulations published in 2014 (T.D. 9652). Under the final regulations, if a taxpayer has sales-based royalties that must be capitalized under Sec. 263A, the taxpayer can choose to allocate sales-based royalties entirely to property that has been sold. By capitalizing sales-based royalties under Sec. 263A and allocating them entirely to COGS, taxpayers generally may be able to exclude this item from base-erosion payments subject to the BEAT.
Taxpayers may incur management fees for management services received from foreign related parties. To determine whether the management fees must be capitalized under Sec. 263A, taxpayers should look to the underlying services being performed. If those services relate directly or indirectly to capitalizable activities (e.g., purchasing, production, storage, or handling), then some or all of the fee may be capitalizable. For example, if a foreign related party provides assistance with the sourcing of raw materials, then the entire management fee may be capitalizable under Sec. 263A. If a foreign related party provides assistance with human resources, accounting, or information systems, then a portion of the management fee may be capitalizable under Sec. 263A. That portion generally would be excluded from base-erosion payments because the amount will be included in COGS when the inventory is sold. It is important to note that a management fee attributable solely to deductible activities, such as sales and marketing, cannot be capitalized under Sec. 263A.
If a taxpayer currently is not capitalizing sales-based royalties and management fees in its UNICAP calculation, it may request a change in method of accounting to begin capitalizing these costs by filing Form 3115, Application for Change in Accounting Method. Generally, a change to begin capitalizing these costs under Sec. 263A would qualify as an automatic method change under Rev. Proc. 2017-30. In addition to filing an accounting method change, taxpayers should include these costs in COGS on Form 1125-A, Cost of Goods Sold.
As discussed, appropriately capitalizable costs under Sec. 263A generally are not considered base-erosion payments for purposes of the BEAT. To reduce their tax liability attributable to the BEAT and comply with the Sec. 263A rules, applicable taxpayers should review their UNICAP calculation to determine if any payments paid or accrued to foreign related parties should be capitalized to inventory (assuming the payments are not made to a qualifying SFC).
Annette B. Smith is a partner with PricewaterhouseCoopers LLP, Washington National Tax Services, in Washington.
For additional information about these items, contact Ms. Smith at 202-414-1048 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with PricewaterhouseCoopers LLP.