New Sec. 59A, enacted by the law known as the Tax Cuts and Jobs Act, P.L. 115-97, imposes a base-erosion and anti-avoidance tax (BEAT) on certain corporations making payments to related foreign persons. Because these payments are also governed by the arm's-length principle of Sec. 482, the BEAT adds fresh complexity to the calculation of transfer-pricing tax and accounting results.
However, not all corporations governed by Sec. 482 and making substantial payments to non-U.S. affiliates will be subject to the BEAT. This discussion explores the threshold issue of which corporate taxpayers need to consider potential BEAT liability.
To be subject to the BEAT in any tax year, corporate taxpayers must meet a three-part test:
- The taxpayer must be a corporation that is not a regulated investment company, a real estate investment trust, or an S corporation;
- The taxpayer must have average annual gross receipts of at least $500 million over the three-year period ending with the preceding tax year; and
- The taxpayer's "base erosion percentage" determined under Sec. 59A must be at least 3% (2% for certain banks and securities dealers).
The first criterion exempts certain passthrough entities and is relatively easy to apply. The latter two conditions, however, require greater analysis. Each is discussed below.
$500M gross-receipts test
Two factors complicate the three-year-average-gross-receipts test: (1) The gross receipts of certain taxpayer groups must be aggregated and treated as gross receipts of one taxpayer, and (2) not all gross receipts of foreign entities count toward the $500 million BEAT trigger.
Sec. 59A cross-references Secs. 52 and 1563(a) to identify entities whose gross receipts must be aggregated for purposes of the gross-receipts test. The essence of these cross-references is that any chain of corporations affiliated by 50% or more ownership, by vote or value, will be treated as a single taxpayer for purposes of determining the $500 million BEAT threshold. Under Sec. 1563(a), controlled groups may include parent-subsidiary chains, sibling corporations with a common parent, or any combination of the two.
Significantly, Sec. 59A(e)(3) also removes an exception to the controlled group rules of Sec. 1563 under which foreign corporations are not considered part of the controlled group. As a result, foreign-parented groups of U.S.-resident corporations, the foreign parent itself, and other foreign persons within the group may have to aggregate gross receipts in the three-year-average-gross-receipts determination. For example, to determine whether they are subject to the BEAT, two U.S.-resident corporations under common foreign ownership of 50% or more must aggregate their gross receipts, even if they do not file a consolidated return.
Not all gross receipts of the foreign parent or other foreign group members are included in the $500 million gross-receipts test. Sec. 59A(e) includes only the gross receipts of a foreign group member to the extent they are effectively connected with the conduct of a trade or business in the United States. Therefore, while two or more U.S.-resident corporations sharing a common foreign parent must aggregate all gross receipts, the gross receipts of the foreign parent often will not count in the aggregated gross receipts total.
3% base-erosion test
The apparent purpose of the BEAT is to identify and impose a special tax on entities that make payments to affiliates for intangibles and most services that substantially reduce U.S. taxable income. A corporation that passes the $500 million average-gross-receipts threshold for the most recent three tax years will still not be subject to the BEAT as long as its "base erosion percentage," a proportion of those payments compared with total deductions, is less than 3%.
Two concepts underlie the 3% test:
1. A "base erosion payment" is any amount paid or accrued to a foreign related party for which a deduction is allowable, including amounts subject to depreciation or amortization, as well as certain reinsurance payments. "Related parties" are broadly defined to include any 25% owner of the taxpayer by vote or value, related persons under Sec. 267(b) or 707(b)(1), or any person related under Sec. 482. Base-erosion payments also include amounts paid or accrued to a surrogate foreign corporation and members of the expanded affiliated group of the surrogate foreign corporation, as defined in the anti-inversion rule of Sec. 7874.
2. A "base erosion tax benefit" is generally any allowable deduction with respect to a base-erosion payment, excluding amounts subject to withholding on fixed or determinable annual or periodical income under Sec. 871 or 881.
The "base erosion percentage" is the taxpayer's aggregate base-erosion tax benefit divided by all allowable deductions. A simpler formulation of the concept would be to consider the base-erosion test passed when deductible payments to related parties are greater than 3% of all deductible payments, including payments to related parties but excluding cost of goods sold. As an obvious and common example, many U.S.-resident corporate subsidiaries of foreign parents that make large royalty or service payments to the foreign parent or other foreign group members and that pass the $500 million average-gross-receipts threshold could be subject to the BEAT.
Overview of BEAT calculation
Having determined that a taxpayer is potentially subject to the BEAT, one must again consider base-erosion payments, base-erosion tax benefits, and the base-erosion percentage to determine whether any BEAT is due. The BEAT equals 10% (5% for 2018; 12.5% after 2025) of the taxpayer's "modified taxable income," which is essentially regular taxable income calculated without the inclusion of any base-erosion tax benefit or base-erosion percentage of any net-operating-loss (NOL) deduction, over the taxpayer's regular tax liability, net of most tax credits:
Modified taxable income = Taxable income + Base-erosion tax benefits + Base-erosion percentage of NOL deduction
Base-erosion minimum tax = (10% × Modified taxable income) - Regular tax liability net of certain credits
FASB ASC Topic 740 consideration
The accounting issue is whether companies with certain worldwide entities with significant U.S. operations and intercompany transactions that expect to incur BEAT every year would have to account for the incremental tax in measuring deferred income taxes. At its meeting on Jan. 10, 2018, FASB decided that an entity subject to BEAT should recognize deferred tax assets/liabilities at their regular tax rate rather than the reduced BEAT rate. Additionally, even though an entity may expect to be subject to the BEAT for the foreseeable future, it is not required to forecast the BEAT for the purpose of a deferred tax asset realization assessment.
EditorNotes
Kevin Anderson is a partner, National Tax Office, with BDO USA LLP in Washington.
For additional information about these items, contact Mr. Anderson at 202-644-5413 or kdanderson@bdo.com.
Unless otherwise noted, contributors are members of or associated with BDO USA LLP.
