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Economic Analysis: Can Marked-Up Services Skip the BEAT?

Posted on Feb. 5, 2018

There is considerable controversy and uncertainty among practitioners about the new base erosion and antiabuse tax (BEAT) included in the Tax Cuts and Jobs Act (P.L. 115-97). At least two of the main issues involve services and the cost of goods sold. Practitioners could be surprised to learn that a clarification about services in the Senate version of the act might not apply to the final version.

The questions surrounding these two problems were the focus of a lively discussion at the District of Columbia Bar Taxation Community conference on January 25 in Washington. (Prior coverage: Tax Notes Int’l, Jan. 29, 2018, p. 418.) Both involve discerning which taxpayer payments to foreign related parties are excluded from the definition of base erosion payments potentially subject to the BEAT. We believe we can clear up which payments for services are not base erosion right here, right now. But the malleable concept of cost of goods sold — a term probably impossible to nail down in practice, especially now that billions of dollars are on the line — may never have an adequately principled or administrable solution. Discussion of that issue will have to wait for a later article.

Base erosion payments are at the heart of the computation of the BEAT. Loosely speaking, the idea behind the tax is that if a large multinational is operating in the United States and makes a large amount of related-party payments in transactions that are potentially susceptible to aggressive profit shifting — namely royalties, interest, rent, and high-margin service payments to a foreign related party — then those payments may be subject to a new minimum tax. The BEAT is estimated to raise $149.6 billion over the 2018-2027 period, with nearly two-thirds of that amount collected in the last five years (because of an increasing BEAT rate). A more detailed (but far from complete) description of the BEAT can be found in the appendix at the end of this article.

Excluded Services

Probably because certain service transactions were not considered a major source of base erosion, the Senate decided to exclude them from suspect base erosion payments. Conveniently for drafters, regulations finalized in 2009 provided a definition of those services. The regulations provide that in some circumstances taxpayers can account for controlled services transactions at cost without a markup (reg. section 1.482-9(b)). (This safe harbor was advantageous to multinationals that wanted to minimize high-taxed profits in the United States and whose U.S. operations included the provision of a significant amount of services for foreign related parties. Multinationals that were overseeing substantial payments from the United States to foreign related parties, especially to affiliates in low-tax jurisdictions, would ignore the safe harbor and make the extra effort required in justifying a markup on services.)

Under the services cost method (SCM) in the 2009 regulations, if four requirements are met, no markup is required. Those requirements are: (1) the service is a “covered service” on a white list of over 100 services (Rev. Proc. 2007-13, 2007-1 C.B. 295), or it is a “low margin covered service” for which there is a controlled services transaction that has a median comparable markup on total service costs that does not exceed 7 percent; (2) the service is not an excluded activity from a blacklist of activities (for example, manufacturing, production, and extraction); (3) the service passes the business judgment test (whereby the taxpayer must reasonably conclude, in its business judgment, that the service does not contribute significantly to key competitive advantages, core capabilities, or fundamental risks of success or failure of a trade or business of either the provider or recipient of the services); and (4) adequate books and records are maintained. The Senate amendment to the House bill uses requirements (1), (2), and (4), with the modification (pertaining to requirement (1)) that there is no markup component to services, if those services are to be excluded from the definition of base erosion payments.

Now here comes the controversy. And here we will cite five sources: (1) the statutory language of the Senate amendment debated on December 1 and finally approved in the wee hours of December 2; (2) the description of the Senate amendment in the conference report; (3) the Senate floor colloquy between Sen. Rob Portman, R-Ohio, and Senate Finance Committee Chair Orrin G. Hatch, R-Utah (163 Cong. Rec. S7697 (Dec. 1, 2017); (4) the statutory language of P.L. 115-97; and (5) the description of the conference agreement in the conference report.

Based on the assumption that drafters wanted to keep matters simple for taxpayers when the stakes were low, they tried to exclude from the mix services that were akin to mere reimbursements to the provider and include substantive income-generating activities to the provider. To do this, they added the following subparagraph (emphasis added) to section 14401 of the Senate amendment for inclusion at the end of paragraph (d) of new code section 59A, “Tax on Base Erosion Payments of Taxpayers With Substantial Gross Receipts”:

(4) Exception for Certain Amounts with Respect to Service. — Paragraph (1) [pertaining generally to definition of the term “base erosion payments” paid or accrued to a foreign related party] shall not apply to any amount paid or accrued by a taxpayer for services if —

(A) such services are services which meet the requirements for eligibility for use of the services cost method under section 482 (determined without regard to the requirement that the services not contribute significantly to fundamental risks of business success or failure), and

(B) such amount constitutes the total services costs with no markup.

And the joint explanatory statement’s description of the Senate amendment echoes the italicized statutory language of the amendment’s section 59A(d)(4)(B): “and such amount constitutes the total services cost with no markup.”

Two Guys Talking

On December 1 Portman and Hatch orchestrated a colloquy from which we will quote in relevant part:

Mr. PORTMAN: Mr. Chairman, I would like to clarify a point in connection with the application of the base erosion anti-abuse tax in the Tax Cuts and Jobs Act to services companies. The act provides an exception from the base erosion anti-abuse tax for services. The act limits the exception to the “total services cost with no markup.’’ As a practical matter, companies account for amounts paid or accrued for services in a variety of ways. I would like to clarify that, if in a transaction a company used one account for services cost with no markup and another accounted for any additional amounts paid or accrued, that the first account would be subject to the exception under the bill.

Mr. HATCH: The Senator is correct. The intent of the provision is to exclude all amounts paid or accrued for services costs with no markup. Thus amounts paid or accrued in that account would be excluded from the base erosion anti-abuse tax. Other accounts related to the same transaction may or may not be excepted from this tax.

So let’s parse this. Portman is saying that a taxpayer may account for services in a manner that bifurcates payments for those services into a reimbursement component (Account 1) and an income component (Account 2). Account 1 includes taxpayer entries for amounts paid to the service provider that only constitute costs incurred by the service provider, and there is no amount in Account 1 for any markup earned by the provider. Account 2 provides a separate entry for the same transaction, but this entry only includes the part of the payment for services that constitutes markup over costs paid to the provider.

Then, after constructing this unusual accounting framework, Portman asserts and Hatch clarifies that amounts in Account 1 will be excluded from the definition of base erosion payments and that amounts in Account 2 may (or may not) be included. (It should be kept in mind that even if the substance of the colloquy became law, there are serious questions about whether a taxpayer could unilaterally adopt this type of accounting after enactment and could use this method for the express purpose of avoiding the BEAT. Subsection 59A(i) provides broad antiabuse regulatory authority to Treasury, including the ability for regulations to provide adjustments “necessary to prevent avoidance of the purpose of this section” that might be accomplished through “transactions or arrangements designed, in whole or in part,” to recharacterize or substitute payments in a manner that would reduce BEAT liability.)

So, for example, if a U.S. corporation (USSUB) that is a subsidiary of a foreign-headquartered multinational (FHQ) pays $109 million to FHQ for services that cost FHQ $100 million to provide and generated $9 million of profit for FHQ, and if USSUB has two accounting entries, first in Account 1 for services that only include costs to the provider, and second in Account 2 that only includes the profit margin of the provider, then all $100 million entered into Account 1 is excluded from the definition of base erosion payments and only the remaining $9 million entered into Account 2 may be a base erosion payment.

This colloquy, if accepted as the correct interpretation of the final law, could in many cases provide significant relief for the large corporations operating in the United States.

But ultimately, all the effort by Portman and Hatch and their staffs seems to have been for nothing because the colloquy of December 1 was an attempt at clarification of only the Senate amendment passed on December 2, not final law. After Senate passage, a conference committee met on December 13. On December 15 the conference committee released its conference agreement and a joint explanatory statement with the statutory language. It is in these documents that the conferees (and ultimately the full Congress and the president) provide the final word on what services are excluded from the definition of base erosion payment.

The final statutory language in section 14401 of the conference agreement adds one word (in italics below) to the relevant portion (of new section 59(d)(4)(B)) in the Senate amendment language: “such amount constitutes the total services cost with no applicable markup component.”

It is not clear (at least to this economist) what the addition of the word “component” here means, but at a minimum it seems to indicate that some attention was being paid to this provision between December 2 and December 15 and that some change or clarification was intended by the conferees. The joint explanatory statement released with the final statutory language, fortunately, is more expansive and makes clear that the conferees meant something quite different from what Portman and Hatch were discussing on the Senate floor two weeks earlier: “A base erosion payment does not include any amount paid or accrued by a taxpayer for services if such services [meet certain requirements in the regulations] and only if the payments are made for services that have no markup component” (emphasis added). The rewording of the explanation obviates the colloquy’s clarification.

No Base Erosion Using Services

The managers’ statement leaves no room, as the Portman-Hatch colloquy implies, for the idea that payments may be excluded if the payments (in Account 1) have no markup component. The managers’ statement blows that out of the water by stating that payments for services to which any markup component applies do not qualify. So no matter what the accounting, if payments are made for services and any portion of any payment for those services compensates the provider for more than costs, then no payments for those services qualify for the exclusion. They are base erosion payments potentially subject to the BEAT. In our prior example, all $109 million of service payments are base erosion payments.

Note that this final language is consistent with the glaringly obvious purpose of section 59A: curtailment of abusive base erosion. That being the case, it would seem that only transactions between related parties that are not susceptible to aggressive profit shifting should be considered for exclusion from the BEAT. The strained interpretation of the Senate amendment under the Portman-Hatch colloquy would provide a loophole that frustrates this goal.


The following is an attempt to describe many of the major elements of new section 59A. It uses mathematical symbols as an alternative to words in the statute and the joint explanatory statement to provide clarity where words at times may be confusing. It does not by any means capture all of the details and nuances of the new section.

To get the general feel for how the BEAT operates, let’s first make a whole bunch of simplifying assumptions, so we can say:

BEAT = Max {0, [0.1 * (modified taxable income) - 0.21 * (regular taxable income)]

This equation says there is a new tax (not part of the corporate tax) formally called the “base erosion minimum tax amount” (but what we are calling here the BEAT) equal to 10 percent of modified taxable income minus 21 percent of regular taxable income less income tax (assuming this difference is positive).

Next we provide a little more detail:

BEAT = Max {0, [0.1 * (GI - OTHERDEDUCT) - 0.21 * (GI - OTHERDEDUCT - BEPAY)]

Modified taxable income is just GI minus OTHERDEDUCT. Regular taxable income (RTI) is gross income (GI) minus all deductions under regular tax, which includes base erosion payments (BEPAY) plus all other deductions (OTHERDEDUCT).

This tells us that a considerable amount of base erosion payments can still be made to a foreign related party before the BEAT kicks into operation. In this stripped-down version of the BEAT, base erosion payments can reduce taxable income by 52.4 percent before the BEAT is positive. But there are aspects of the new tax that are unfavorable to taxpayers. For example, even if base erosion payments are made to a high-tax jurisdiction (and therefore provide little or no overall tax benefit), the BEAT can apply. Also, if the U.S. operation received royalties, rents, interest, and payments for high-margin services from a foreign related party that equaled base erosion payments to a foreign related party, the BEAT would still apply although no profit shifting out of the United States through such payments may have occurred.

Now let’s add just a little more detail in italics:

BEAT = Max {0, [0.1 * (GI - OTHERDEDUCT) - 0.21 * (GI - OTHERDEDUCT - BEPAY)] + CREDITS}

If the BEAT applies, taxpayers can lose the benefit of tax credits dollar-for-dollar. This possibility sent affected constituencies into a fury of last-minute lobbying. The politically sacrosanct research credit was always safe, and throughout the maneuvering on the Senate bill it was excluded from this amount. It was only with a lot of effort that 80 percent of low-income housing, solar, and wind credits were also excluded in the final bill.

Those are the basics. We will now add the painful but unavoidable details that make tax law so much fun in order to describe the BEAT with more (but not perfect) accuracy:

For any “applicable taxpayer” — that is, for any U.S.- or foreign-headquartered corporation (except real estate investment trusts, regulated investment companies, and subchapter S corporations) — if BE% > 0.03 (0.02 for certain financial institutions) and if [(GR-1 + GR-2 + GR-3)/3] > $500 million, then the base erosion minimum tax amount is:


  • BEAT = Max{0, [Max(0, tb * RTI) - BETB - BE% * NOL] - 0.21 * (RTI) - [ALLCRED - RECRED - 0.8 * (LIHTC - RENCRED)]}

Now, modified taxable income is the expression in the first set of brackets. Here are the definitions of the abbreviations (with a bit of explanation):

  • tb = 0.05 in 2018, 0.10 in 2019-2025, and 0.125 after 2025 (add 0.01 for banks and registered securities dealers)

  • BE% (“base erosion percentage”) = [BETB]/[all deductions (including those in BETB) + reductions in income that are BETB]

  • [(GR-1 + GR-2 + GR-3)/3] = the average annual gross receipts for the three-tax-year period ending with the preceding tax year

  • RTI = regular taxable income

  • ALLCRED = all income tax credits allowed against regular tax liability

  • RECRED = allowable business credits allocable to the research credit (= $0 in this context after 2025)

  • RENCRED = allowable business credits allocable to renewable energy production credits (wind, section 45(a)) and investment credits allocable to energy credits (solar, section 48) (= $0 after 2025)

  • LIHTC = allowable business credits allocable to the low-income housing credit (= $0 after 2025)

  • NOL = net operating loss deduction for the tax year

  • BETB = “base erosion tax benefit” = base erosion payments (BEPAY) + deductions and reduction in income associated with certain base erosion payments (related to acquisition of depreciable property and reinsurance) + costs of goods sold (only for businesses that invert after November 9, 2017) - any of the previous amounts on which (section 871 or section 881) U.S. withholding tax applies

  • BEPAY = deductible amounts paid to foreign related party (COGS are not mentioned in the statutory language and are excluded because they are not deductions but are reductions in gross income) + amounts paid for depreciable property + certain amounts paid for reinsurance - amounts paid for certain services that meet the requirements, as modified by the statute, of the services cost method - amounts paid for derivatives

It is the amount described in the above italics that is the focus of this article. Note that the $500 million threshold limits this new tax to the largest multinationals doing business in the United States. For foreign-headquartered multinationals, the threshold only applies to U.S. operations. The statute as it applies to reinsurance and derivative payments to foreign related parties; to firms that invert after November 9, 2017; to aggregation; to reporting requirements; to penalties; to exceptions for payments subject to U.S. withholding tax; to regulatory authority; and to the definition of a related party is only superficially described here or not described at all.

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