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On September 1, 2020, the Treasury Department and the Internal Revenue Service (IRS) issued final regulations in T.D. 9910 (the “Regulations”) permitting taxpayers to waive deductions to reduce or eliminate liability for the base erosion and anti-abuse tax (generally referred to as the “BEAT”). The BEAT was introduced as part of the Tax Cuts and Jobs Act of 2017 to prevent U.S. corporations from unduly reducing their U.S. taxable income through payments to related foreign parties. As described in more detail below, although the Regulations are only effective prospectively, taxpayers can elect to apply them to earlier years for which they had BEAT liability. In addition, the Regulations provide additional rules regarding the determination of a taxpayer’s aggregate group for purposes of the BEAT, the application of the BEAT to partnerships, and the application of the anti-abuse rule to certain basis step-up transactions.
The BEAT operates as a minimum tax that is calculated separately from a corporation’s regular federal income tax liability. If the BEAT minimum tax exceeds the taxpayer’s regular tax liability, the taxpayer must pay the greater amount. In very general terms, the BEAT minimum tax applies at a reduced rate (currently 10% for most corporations) but is calculated by disallowing a taxpayer’s “base erosion tax benefits” (generally, deductions or certain reductions in gross income resulting from payments to foreign related parties).
The BEAT applies only to “applicable taxpayers,” which are certain corporations that satisfy a gross receipts test and a base erosion percentage test. For this purpose, the “base erosion percentage” for a tax year is calculated by dividing (1) the aggregate amount of base erosion tax benefits by (2) the sum of the aggregate amount of deductions allowable to the taxpayer in computing its taxable income (subject to certain exclusions). A taxpayer satisfies the base erosion percentage test if its base erosion percentage is 3% or more (or 2% or more, if the taxpayer or a member of the taxpayer’s aggregate group is a member of an affiliated group that includes a domestic bank or registered securities dealer). The base erosion percentage test may create a cliff effect for large corporate taxpayers that have base erosion tax benefits. If the base erosion percentage test is less than the applicable threshold, then the taxpayer will not pay any tax with respect to the BEAT regardless of the amount of its BEAT liability. If the base erosion percentage is even slightly over the threshold, the taxpayer must calculate its BEAT liability and pay tax with respect to the BEAT if its BEAT liability exceeds its regular tax liability. Consequently, in some cases a taxpayer might pay less overall federal tax if it did not take allowable deductions if forgoing such deductions results in the taxpayer’s base erosion percentage falling short of the threshold and thereby allowing the taxpayer to escape the incremental tax liability imposed under the BEAT.
The government previously issued final and proposed regulations (the “2019 Final Regulations” and the “2019 Proposed Regulations,” respectively) relating to the BEAT on December 2, 2019.
Consistent with the 2019 Proposed Regulations, the Regulations provide that a taxpayer may forgo a deduction and that such forgone deduction will not be treated as a base erosion tax benefit if the taxpayer elects to waive the deduction for all U.S. federal income tax purposes and follows specified procedures (the “Waiver Election”). The Waiver Election is particularly helpful for taxpayers that have a base erosion percentage slightly above the relevant threshold because it allows taxpayers to reduce their Base Erosion Percentage and thus potentially avoid treatment as an applicable taxpayer. Given that the BEAT currently adds back foreign tax credits (FTCs) in its calculation of minimum tax liability, the detriment of forgoing waived deductions for other purposes of the Internal Revenue Code (the “Code”) will often be outweighed by the benefit of not losing the FTCs.
The Regulations retain the Waiver Election with certain changes made in response to comments received.
Waiver Election Procedure
A taxpayer makes the Waiver Election with its annual federal income tax return. The election is made on an annual basis, and a taxpayer does not need approval from the IRS to change its election from year to year. A taxpayer can also increase the amount of deductions it waived by filing an amended tax return or during the course of an examination. After making a Waiver Election, a taxpayer cannot later reduce the amount of waived deductions.
To make the Waiver Election, a taxpayer must report certain information to the IRS. The 2019 Proposed Regulations required the inclusion of a detailed description of the item or property to which the deduction relates. The Regulations remove the word “detailed” in response to a comment that asserted that requiring a detailed description would cause the reporting requirement to be too onerous.
Eligibility for the Waiver Election
In response to a request for clarification, the Regulations specify that, to make the Waiver Election, a taxpayer must first determine that it would otherwise be an “applicable taxpayer.” In other words, a taxpayer can only elect to waive one or more deductions if the taxpayer would otherwise satisfy the gross receipts and base erosion percentage tests for applicable taxpayer treatment.
Comments noted that amounts treated as reductions to gross premiums and similar income in the reinsurance context were not explicitly eligible for the Waiver Election under the 2019 Proposed Regulations even though such amounts were treated as base erosion tax benefits. The Regulations provide that reductions to gross premiums may also be waived for BEAT purposes under a Waiver Election.
Effect of the Waiver Election
A deduction that is waived under a Waiver Election is considered waived for all purposes of the Code. However, if a deduction is not waived, the Waiver Election provisions do not affect any other rules that apply when a taxpayer fails to take a deduction. The Regulations clarify that waived deductions are excluded from the denominator of the base erosion percentage, not just the numerator.
The 2019 Proposed Regulations referred to waivers of deductions “in whole or in part.” In response to a request for clarification, the Regulations provide that taxpayers may make Waiver Elections for portions of a deduction and not only deductions in their entirety.
Comments had requested that taxpayers be allowed to revoke elections made under sections 59(e)(4) and 168(k) that reduced the amount of deductions previously allowed to such taxpayers in light of the fact that taxpayers may not have made those elections had they been aware that a BEAT waiver provision would be implemented. The Regulations declined to adopt this request, and thus taxpayers who previously delayed certain deductions to reduce their BEAT exposure cannot reverse those choices.
Effective Dates and Retroactive Election Options
Although the Regulations are only effective 60 days after they are published in the Federal Register, they provide two options for taxpayers seeking to apply the Waiver Election retroactively. First, taxpayers can elect to apply the Regulations to taxable years beginning after December 31, 2017 in their entirety. Second, taxpayers can elect to apply only the Waiver Election and certain related provisions to taxable years beginning after December 31, 2017. This provides taxpayers with the flexibility to apply the Waiver Election retroactively without necessarily changing their tax return position for earlier taxable years with respect to issues that the rest of the final BEAT Regulations address in a less favorable manner than anticipated.
Application to Partnerships
The Regulations address how partnerships and the partners therein may utilize the Waiver Election. The Regulations clarify that the Waiver Election is made at the partner level and that partnerships cannot make a Waiver Election. To prevent a corporate partner benefiting from waived deductions upon disposition of its partnership interest (through reduced gain or increased loss in connection with the disposition), the Regulations provide that waived deductions are treated as nondeductible capital expenditures under section 705(a)(2)(B). The Regulations also provide for rules conforming the partner-level Waiver Election with the partnership-level section 163(j) determinations. Additionally, the Regulations allow for a partner to make a Waiver Election with respect to increased deductions that get pushed out to a partner under the Bipartisan Budget Act audit procedures.
Application to Consolidated Groups
The Regulations adopt a clarifying comment that waived deductions that are attributable to a consolidated group member are treated as noncapital nondeductible expenses that decrease the basis of the member’s stock.
As noted above, the BEAT applies only to “applicable taxpayers,” which are certain corporations that satisfy a gross receipts test and a base erosion percentage test. For purposes of applying such tests, corporations are aggregated into an “aggregate group” if they are treated as a single employer under section 52(a), with certain modifications. In general, corporations are aggregated for this purpose if they are related by 50% common ownership.
The 2019 Final Regulations apply the gross receipts and base erosion percentage tests by reference to the gross receipts, base erosion tax benefits and deductions for the taxpayer’s taxable year and, for each member of the taxpayer’s aggregate group, the taxable year of the member that ends with or within the taxpayer’s taxable year (the “With-or-Within Rule”). The 2019 Proposed Regulations proposed additional rules within the context of the With-or-Within Rule, including the treatment of short taxable years, members leaving and joining an aggregate group, members that deconsolidate from a consolidated group and join a different aggregate group, and predecessors of a taxpayer.
Short Taxable Years
The 2019 Proposed Regulations required that a taxpayer with a taxable year of fewer than 12 months (i.e., a short taxable year) to annualize its gross receipts, base erosion tax benefits, and deductions (i.e., such amounts x 365 / number of days in the short period).
In addition, the 2019 Proposed Regulations required taxpayers to use a reasonable approach to determine the gross receipts and base erosion percentage of its aggregate group members for the short taxable year. For this purpose, a reasonable approach would neither overcount nor undercount the gross receipts, base erosion tax benefits, and deductions of the members of the taxpayer’s aggregate group, even if the taxable year of a member does not end with or within the taxpayer’s short taxable year.
The Regulations retain these rules and clarify that a reasonable approach does not include an approach that does not take into account the gross receipts, base erosion tax benefits, or deductions of the member. In addition, the Regulations provide examples of a reasonable approach by reference to:
Members Leaving and Joining an Aggregate Group
Close of Taxable Year Rule
The 2019 Proposed Regulations provided that when members join or leave a taxpayer’s aggregate group, for purposes of determining the gross receipts and base erosion percentage of the aggregate group, only items of members that occur during the period that they were members of the taxpayer’s aggregate group are taken into account. For purposes of determining which items occurred while a corporation was a member of a particular aggregate group, the 2019 Proposed Regulations treated a member joining or leaving an aggregate group as having a deemed taxable year-end immediately before the member joins or leaves the aggregate group (the “time-of-transaction rule”). A taxpayer could determine items for the short taxable year by either deeming a close of the member’s books or a pro rata allocation of items (other than “extraordinary items”).
To better align with other provisions of the Code and regulations, such as section 381 and Treas. Reg. § 1.1502-76(b), the Regulations replaced the time-of-transaction rule with a rule that treats the deemed taxable year-end as occurring at the end of the day of the transaction. Extraordinary items incurred during the portion of the day following the closing of the transaction causing the member to join or leave the aggregate group are treated as occurring in on the day after the transaction. Extraordinary items include any payment that is not made in the ordinary course of business and that would be treated as a base erosion payment.
The Regulations declined to adopt a suggestion to provide a simplified “no-cut-off” alternative to the deemed year-end approach.
Aggregate Group Members with Different Taxable Years
A comment expressed concern with certain situations that arise under the 2019 Proposed Regulation’s With-or-Within Rule when a taxpayer and a member of its aggregate group have different taxable years. For example, a taxpayer could be required to count more than 12 months of the gross receipts of a member of its aggregate group.
The Regulations rectifying this issue by providing that if a member of an aggregate group has more than one taxable year end with or within the taxpayer’s taxable year and together those taxable years are more than 12 months, the member’s gross receipts, base erosion tax benefits and deductions are annualized for purposes of determining the aggregate group’s gross receipts and base erosion percentage.
Similarly, if an aggregate group member’s taxable year ending with or within the taxpayer’s taxable year is fewer than 12 months (unless the short taxable year is attributable to a new member of a consolidated group adopting the common parent’s taxable year), the member’s gross receipts, base erosion tax benefits, and deductions are annualized to 12 months.
Finally, the Regulations adopt an anti-abuse rule that disregards transactions that have a principal purpose of changing the period taken into account under the gross receipts test or the base erosion percentage test to avoid applicable taxpayer status.
A comment requested a clarification that items that are paid or accrued in a period before a corporation joins the taxpayer’s aggregate group but that are deducted after the corporation joins the aggregate group are not base erosion tax benefits. Because under the statutory framework the determination of whether a deduction is a base erosion tax benefit is at the time the amount is paid or accrued, the Regulations do not include this rule.
Predecessors and Successors
The 2019 Proposed Regulations provided that if the taxpayer or any member of its aggregate group is also a predecessor of the taxpayer or any member of its aggregate group, the gross receipts, base erosion tax benefits, and deductions of each member were taken into account only once. The Regulations clarify that the gross receipts of foreign predecessor corporations are taken into account only to the extent the gross receipts are taken into account in determining income that is effectively connected with the conduct of a U.S. trade or business of the foreign predecessor corporation.
Effectively Connected Income
The 2019 Final Regulations provide an exception (the “ECI Exception”) where a base erosion payment results from amounts paid or accrued to a foreign related party that are subject to tax as effectively connected with the conduct of a U.S. trade or business (“ECI”). The Regulations expand the ECI Exception to partnership transactions where the taxpayer is treated as making a base erosion payment by virtue of a payment made to a partnership being treated under the BEAT rules as made to a partner that is a foreign related party, and where the foreign related party is subject to U.S. federal income tax on allocations of income from the partnership as ECI.
For example, if a taxpayer purchases an interest in a partnership from a foreign related party, the 2019 Final Regulations treat the transaction as a transfer of a portion of the partnership assets by the foreign related party to the taxpayer. To the extent the partnership assets are used or held for use in connection with a U.S. trade or business, the ECI Exception applies to exempt the purchase from giving rise to base erosion payments.
The ECI Exception also may apply to situations such as when (1) a U.S. taxpayer contributes cash and a foreign related party of the U.S. taxpayer contributes depreciable property to the partnership, (2) a partnership with a partner that is a foreign related party of the taxpayer partner engages in a transaction with the taxpayer or (3) a partnership engages in a transaction with a foreign related party of a partner in the partnership, in each case where the amount paid or accrued (or deemed paid or accrued) to the foreign related party is taxable as ECI. The ECI Exception does not apply, however, where a U.S. taxpayer purchases depreciable or amortizable property from a foreign related party where the property is not held in a U.S. trade or business but the U.S. taxpayer contributes the property to a partnership that subsequently uses the property in a U.S. trade or business.
To implement these changes, the Regulations include modified certification procedures similar to those in the 2019 Final Regulations.
The Regulations retain the rule under the 2019 Proposed Regulations that if a partnership adopts the curative method of making section 704(c) allocations, the allocation of income to the contributing partner in lieu of a deduction allocation to the non-contributing partner is treated as a deduction for purposes of the BEAT. Curative allocations that arise as a result of a revaluation (i.e., reverse section 704(c) allocations) are treated in a similar manner.
Anti-Abuse Rules for Derivatives Involving Partnerships
The 2019 Proposed Regulations included an anti-abuse rule that if a taxpayer acquires a derivative on a partnership interest or partnership assets with a principal purpose of eliminating or reducing a base erosion payment, the taxpayer is treated as having a direct interest in the partnership interest or partnership asset (instead of a derivative interest) for purposes of applying the BEAT. The Regulations clarify that the anti-abuse rule does not apply when a payment with respect to a derivative on a partnership asset qualifies for the exception for qualified derivative payments.
The 2019 Final Regulations generally excluded from base erosion payments any amount transferred to, or exchanged with, a foreign related party in a transaction described in section 332, 351 or 368 (i.e., a corporate nonrecognition transaction). The 2019 Final Regulations also included an anti-avoidance rule that would deny the benefit of the rule for nonrecognition transactions where a transaction (or series of transactions), plan or arrangement has a principal purpose of increasing the adjusted basis of property that a taxpayer acquires in a corporate nonrecognition transaction. A step-up in basis within six months of an acquisition of property in a corporate nonrecognition transaction is deemed to fall under the anti-avoidance rule.
The Regulations modify these rules in two respects. First, where it applies, the anti-abuse rule turns off the exclusion of a corporate nonrecognition transaction only to the extent of the basis step-up amount. Second, the Regulations clarify that the transaction, plan or arrangement with a principal purpose of increasing the adjusted basis of property must also have a connection to the acquisition of the property by the taxpayer in a corporate nonrecognition transaction. This effectively limits the application of the anti-abuse rule to increases in basis that are attained in anticipation of transferring property to a U.S. taxpayer to reduce BEAT liability without causing it to apply to other inbound transfers of assets that occur in the ordinary course of business.
Taxpayers should evaluate not only how the Waiver Election and other aspects of the Regulations apply going forward but whether the Waiver Election can mitigate BEAT issues from previous years. In particular, taxpayers should carefully consider whether they want to apply the Regulations retroactively in their entirety, only with respect to the Waiver Election, or not at all.
For further information, please contact any of the authors of this article or your regular contact at Shearman & Sterling.