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Economic Analysis: Two Approaches to Less BEATing on the GILTI

Posted on May 28, 2018

Few would try to cast the Tax Cuts and Jobs Act’s treatment of multinational corporations as a simplification, but determining how the tax on global intangible low-taxed income and the base erosion and antiabuse tax interact can leave even the most astute tax practitioners scratching their heads. Designed to be a minimum tax, the BEAT in particular is an object of scorn and bewilderment. It’s a minimum tax that is supposed to be a backstop to the practical shortcomings of the arm's-length method. But it is a meat-ax and at the same time leaves the backdoor open for transfer pricing manipulation. Draconian. A disaster. Bad news. Protectionist. A misfire. Overboard. These are words folks are using to describe the BEAT in public.

The TCJA's international provisions are full of unpleasant surprises. For example, expense allocations that reduce foreign tax credits can increase the effective tax rate on GILTI above the 13.125 percent minimum suggested in the legislative history of the TCJA (P.L. 115-97). A similar but less well-known boost to the effective tax rate on GILTI can occur when the source of a controlled foreign corporation’s GILTI is a base erosion payment from its U.S. parent that is subject to the BEAT.

Here’s a simple example. Suppose a U.S. parent company sells pharmaceuticals in the United States that were developed by and imported from its Swiss CFC. The U.S. parent pays the Swiss subsidiary a $50 royalty and $10 for the physical products. Assume the subsidiary’s costs are zero, so it pays $6 of Swiss tax imposed at a 10 percent rate.

The U.S. parent has $80 of sales, and with $60 of costs it pays $4.20 (that is, 21 percent of $20) of U.S. tax on its U.S. activities. If the CFC’s income is GILTI, it will pay U.S. tax before credits of 21 percent of one-half of $60, or $6.30. Its deemed paid FTC is $4.80 (80 percent of $6). So the U.S. parent’s net regular U.S. tax liability on its foreign-source income is $1.50.

Now enter the BEAT — the new add-on minimum tax separate from the regular income tax. The BEAT liability is the excess, if any, of 10 percent of modified taxable income less regular tax liability plus certain tax credits, most notably including 100 percent of FTCs. Modified taxable income is regular taxable income (in this case, $20 on U.S.-source income and $30 on foreign-source income) plus base erosion payments of $50. Only the royalties are base erosion payments. Cost of goods sold doesn’t count. The regular tax liability is $10.50 (equal to 21 percent of $50). As noted, FTCs are $4.80. So the BEAT liability (officially known as the base erosion minimum tax amount, or BEMTA) is 10 percent of $100 less $10.50 plus $4.80, or $4.30. Note the large effect that tax credits can have on BEMTA.

The $6 paid to Switzerland plus $1.50 of U.S. regular tax on GILTI results in a combined effective rate of $7.50/$60, or 12.5 percent, which left to itself would keep the implied promise of no effective tax rates above 13.125 percent. But the $4.30 of BEMTA adds approximately 7.2 percentage points to the overall effective rate, which now totals 19.7 percent. Column 1 of the table lays out those calculations in more detail.

Let’s make some big-picture observations to help get an idea of how prevalent this phenomenon may be. First, as the statute states, the BEAT applies only to applicable taxpayers. Section 59A(e)(1) tells us that that an applicable taxpayer is a corporation (other than a subchapter S corporation, a mutual fund, or real estate investment trust) with average annual gross receipts over the prior three years of at least $500 million, and a base erosion percentage — that is, generally, base erosion payments over total deductions — greater than 3 percent in the current year (or 2 percent if you are a bank).

Even after regulations help clarify the definition of base erosion payments, many taxpayers will be nervous because they may not know until the end of the year whether they’re above or below the threshold. If an applicable corporation has total deductions of $400 million and for some reason finds its base erosion payments have moved from 2.99 percent to 3.01 percent ($80,000), it will have an extra $12 million in section 59A liability. Better to throw the money into the sea than pay it to a related party. Including such a cliff effect in the statute is inexcusably bad policy.

Second, as noted, the BEAT applies only when 10 percent of taxable income excluding base erosion payments exceeds a threshold amount. We can (and do in the appendix) provide a precise formula for when the BEAT applies, but it’s complex and hard to interpret. Let’s just say for now that the BEAT is more likely to apply when foreign tax rates are high, when foreign-source income is large relative to U.S.-source income, and — of course — when the base erosion payments account for a large reduction in domestic taxable income.

Third, as stressed by Thomas Zollo et al., because payments for goods are excluded from the definition of base erosion payments, the BEAT is more likely to ensnare service companies with complex supply chains and contractual arrangements. That’s especially true because gross outbound related-party payments with no netting for inbound related-party receipts are added to regular taxable income. (Prior analysis: Tax Notes Int’l, Apr. 30, 2018, p. 627.)

Fourth, as pointed out by Ted R. Stotzer and Sunnie CY Kwong, it’s not just GILTI that can be subjected to a second layer of U.S. tax by the BEAT. The BEAT can apply to subpart F income already subject to regular U.S. corporate income tax at the full 21 percent rate. (Prior analysis: Tax Notes, Apr. 30, 2018, p. 671.) A calculation of the effect of the BEAT on subpart F income (much simpler than the calculation for GILTI) is shown in column 2 of the table.

Finally, it’s important to distinguish U.S.-parent CFC income (and therefore possibly a base erosion payment) from unrelated-party CFC income. Column 3 presents an example in which a U.S. parent corporation is subject to the BEAT and makes $400 of base erosion payments that are GILTI for its CFC. Now suppose the parent wants to reduce its tax by reducing its base erosion payments by $100. That’s achieved in column 4 by reducing base erosion payments that also shift income back into the United States. As can be seen in the shaded cells, that $100 reduction in base erosion payments decreases the parent’s tax by $5 (from $70 to $65). The marginal tax rate is 5 percent. We call that the Type A approach to reducing the BEAT. It would happen if the parent reduced its transfer prices or if it simply stopped making $100 of related-party payments.

In column 5 there’s a similar $100 reduction in base erosion payments, but it occurs with no net shift of income back into the United States. As can be seen in the shaded cells, that $100 reduction in base erosion payments decreases the parent’s tax by $10 (from $70 to $60). The marginal tax rate is 10 percent. We call that the Type B approach to reducing the BEAT. It would occur under either of two methods commonly discussed for reducing BEAT liability. Under the first method, royalty payments separately stated from cost of goods sold (and therefore considered a base erosion payment) would be recharacterized as cost of goods sold by embedding that amount in the price of tangible goods. To accomplish that, care must be taken not to violate yet-to-be-written antiabuse rules authorized by the statute. Under the second method, a U.S. parent corporation rewrites contracts, so payments for services performed by a foreign subsidiary are paid directly to that subsidiary instead of to the parent who then compensates the subsidiary.

Appendix

The formula for the minimum foreign tax rate when the BEAT will apply is:

tf ,min = 0.1375 (USINC/CFC) - 0.19375

where USINC is U.S.-source income before deductions and base erosion payments, and CFC is the before-foreign tax income of the CFC. Using the figures in column 6, the minimum effective tax rate is computed to be 1.25 percent, and for this example the rate generates a zero BEMTA. This calculation assumes base erosion payments are GILTI. The calculation also depends on other simplifying assumptions made in the model and cannot be used generally.

Proposed regulations that Treasury hopes to provide by the end of 2018 will eliminate a lot of uncertainty concerning the treatment of consolidated groups under the BEAT and the definition of base erosion payments. But the underlying statute's high compliance costs and break with long-standing tax principles cannot be papered over. That's what happens when you need to draft a larger revenue raiser in a rush. The BEAT gave Congress an estimated $149.6 billion to pay for lower rates.

Examples of Interaction Between the BEAT (Section 59A) and the Tax on GILTI (Sections 951A and 250)

 

(1) Text

(2) Sub F

(3) GILTI

(4) Type A

(5) Type B

(6) Rate

U.S.-source gross income

$80

$600

$600

$600

$600

$800

U.S. deductions (not base erosion payments)

$10

$100

$100

$100

$200

$200

U.S. net income (before BEPS) (USINC)

$70

$500

$500

$500

$400

$600

Base erosion payments

$50

$400

$400

$300

$300

$400

Net U.S.-source income

$20

$100

$100

$200

$100

$200

U.S. tax on U.S . income

$4.20

$21

$21

$42

$21

$42

Assume all CFCs have positive income

CFC income (before foreign tax)

$60

$400

$400

$300

$400

$400

Foreign tax rate

10%

10%

10%

10%

10%

1.25%

Foreign taxes

$6

$40

$40

$30

$40

$5

U.S. taxable income before gross-up or QBAI

$54

$360

$360

$270

$360

$395

Subtract NDTIR = 10 percent of QBAI (GILTI only)

$0

$0

$0

$0

$0

$0

Sub F or GILTI (= NTI - NDTIR)

$54

$360

$360

$270

$360

$395

Inclusion percentage

100%

100%

100%

100%

100%

100%

Section 78 gross-up

$6

$40

$40

$30

$40

$5

Grossed-up income before 50 percent deduction

$60

$400

$400

$300

$400

$400

Section 250 deduction (only for GILTI)

$30

$0

$200

$150

$200

$200

Taxable foreign-source income

$30

$400

$200

$150

$200

$200

Deemed paid credit (80 percent for GILTI)

$4.80

$40

$32

$24

$32

$4

Expenses allocated to basket

$0

$0

$0

$0

$0

$0

FTC limit

$6.30

$84

$42

$32

$42

$42

FTC

$4.80

$40

$32

$24

$32

$4

Net regular tax on foreign income

$1.50

$44

$10

$7.50

$10

$38

Regular taxable income = (U.S. + foreign)

$50

$500

$300

$350

$300

$400

Modified taxable income = regular + BEPs

$100

$900

$700

$650

$600

$800

Regular tax liability (before tax credits)

$10.50

$105

$63

$73.50

$63.00

$84

Adjusted regular tax liability (subtract tax credits)

$5.70

$65

$31

$49.50

$31.00

$80

BEMTA = 10 percent of MTI - ARTL

$4.30

$25.00

$39

$15.50

$29

$0

Total U.S. tax liability with BEAT

$10

$90

$70

$65

$60

$80

Total tax with BEAT

$16

$130

$110

$95

$100

$85

Total tax without BEAT

$12

$105

$71

$80

$71

$85

ETR on foreign income (just GILTI)

2.5%

11%

2.5%

2.5%

2.5%

9.5%

ETR on foreign income (just BEAT)

7.2%

6.3%

9.8%

5.2%

7.3%

0%

ETR on foreign income (GILTI + BEAT)

9.7%

17.3%

12.3%

7.7%

9.8%

9.5%

ETR on foreign income (U.S. and foreign tax)

19.7%

27.3%

22.3%

17.7%

19.8%

10.8%

Source: Author’s calculations.

 

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