Firm Seeks Equitable Treatment of Service Companies in BEAT Regs

February 19, 2019

CC:PA:LPD:PR (REG-104259-18)
Room 5203
Internal Revenue Service
1111 Constitution Avenue, NW
Washington, D.C. 20224

Re: REG-1042259-18

Dear Sir or Madam:

Miller & Chevalier Chartered respectfully submits this letter in response to the Notice of Proposed Rulemaking under section 59A of the Internal Revenue Code (the “Code”), as amended by the Tax Cuts and Jobs Act, P.L. 115-97 (the “2017 Act”), published in the Federal Register on December 21, 2018 (the “Proposed Regulations”) and made available to the public on December 13, 2018.¹ Our comments are with respect to the definition of “base erosion payment” under section 59A(d), for purposes of calculating a taxpayers potential liability for the base erosion minimum tax amount. In particular, we respectfully request the following:

• The final regulations should provide that the services exception of section 59A(d)(5) applies to the cost element of amounts paid or accrued for all “covered services” as defined in Treasury regulations section 1.482-9(b)(3), without regard to the business judgment rule of Treasury regulations section 1.482-9(b)(5) (as provided by the Proposed Regulations) or the excluded activity rule of Treasury regulations section 1.482-9(b)(4); and

• The final regulations should provide that, for purposes of section 59A(d)(2), “amounts paid or accrued” to purchase depreciable or amortizable property do not include the deemed and transitory issuance or exchange of stock in inbound liquidations, reorganizations, or other nonrecognition transactions.

The requested guidance is necessary to ensure that section 59A applies equitably to services companies and to provide appropriate treatment for inbound nonrecognition transactions consistent with the language and objectives of section 59A.

I. BACKGROUND — SECTION 59A AND BASE EROSION PAYMENTS

Section 59A imposes a “base erosion minimum tax,” commonly referred to as the “base erosion and anti-abuse tax” (“BEAT”), on certain large corporate taxpayers. Its objective is to “address[ ] base erosion that results from U.S. and foreign companies serving the U.S. market through foreign affiliates located in low- or zero-tax jurisdictions, rather than through U.S. affiliates.”² Thus, for example, the payment of a deductible management fee by a U.S. taxpayer to a foreign related person for support in managing the U.S. taxpayer's U.S. business would be considered a “base erosion payment” that is subject to the BEAT.

The applicability and magnitude of the BEAT depend in part on the amount of a taxpayer's “base erosion payments.” In effect, for taxpayers with a base erosion percentage in excess of 3%, section 59A operates by adding the base erosion tax benefits from base erosion payments back into the U.S. tax base, thereby preventing the use of such payments as a mechanism for U.S. tax base erosion. A taxpayer's base erosion percentage equals the aggregate of its base erosion tax benefits from base erosion payments, divided by the aggregate of all deductions.³

The term “base erosion payment” generally refers to: (1) any amount paid or accrued by the taxpayer to a foreign related person, for which a deduction is available;⁴ and (2) any amount paid or accrued by the taxpayer to a related foreign person in connection with the acquisition by the taxpayer from such person of depreciable or amortizable property.⁵ This term also includes certain reinsurance payments to foreign related persons, and payments that reduce gross income of the payor and are made to certain expatriated entities that are foreign related persons.⁶

II. SERVICES EXCEPTION

A. Statutory Framework and Legislative History

The term base erosion payment does not include any amount paid or accrued by a taxpayer for 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)” if such amount “constitutes the total services cost with no markup component.”⁷ In addition, except in the case of payments to certain expatriated entities, the term base erosion payment does not include payments that are accounted for as reductions in gross receipts rather than deductions. The legislative history explains that base erosion payments generally therefore do not include payments included in inventory costs and recovered as cost of goods sold.⁸

Treasury regulations under section 482 impose three substantive requirements for eligibility for use of the services cost method.⁹ First, the service must qualify as a “covered service” as defined in Treasury regulations section 1.482-9(b)(3). Second, the service cannot be an “excluded activity” as defined in Treasury regulations section 1.482-9(b)(4), such as manufacturing, production, extraction, or construction; reselling, distribution, or acting as a sales or purchasing agent; research and development; or engineering or scientific. Third, under Treasury regulations section 1.482-9(b)(5), 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 in one or more trades or businesses of the controlled group. In addition, Treasury regulations section 1.482-9(b)(6) imposes an administrative requirement: the taxpayer must maintain books and records that include a statement evidencing the taxpayers method to apply the services cost method, and would allow verification of total services costs.

The legislative history to section 59A indicates that Congress intended for the services exception to apply broadly. In particular, the intended effect of the services exception was “to exclude all amounts paid or accrued for services costs with no markup.”¹⁰

B. Proposed Regulations

With respect to the services exception, the Proposed Regulation generally provide that the cost component¹¹ of amounts paid for certain services “eligible for the services cost method exception” is not considered a base erosion payment. The Proposed Regulation define “services eligible for the services cost method exception” to mean services that satisfy the requirements of Treasury regulations section 1.482-9(b), except that: (1) the requirements of Treasury regulations section 1.482-9(b)(5), the business judgement rule, do not apply, and (2) the taxpayer must maintain adequate books in accordance with the Proposed Regulations, and not in accordance with Treasury regulation section 1.482-9(b)(6).¹² The preamble to the Proposed Regulations explains that the Proposed Regulations interpret the parenthetical text of section 59A(d)(5), which provides that the question of whether services are eligible for the services cost method must be “determined without regard to the requirement that the services not contribute significantly to fundamental risks of business success or failure”, to be a reference to the business judgment rule of Treasury regulations section 1.482-9(b)(5).¹³ The preamble to the Proposed Regulations specifically requested comments with respect to the services exception.

C. Scope of Services Exception Should Apply to All Covered Services

The scope of the services exception of section 59A, and in particular the parenthetical language that modifies the requirements for eligibility for use of the services cost method in Treasury regulations section 1.482-9(b), is unclear. The narrow interpretation of that parenthetical language by the Proposed Regulations will lead to problematic and unequitable results for services companies as compared to similarly-situated U.S. manufacturers and distributors of goods. As discussed above, base erosion payments do not include the cost or markup components of payments to related foreign persons that are accounted for as the cost of goods sold, such that U.S. manufacturers and distributors face no BEAT liability for incurring direct costs in the manufacture or sale of goods to customers. By contrast, no explicit statutory exception exists for cost of services sold.

An overly limited application of the services exception would expose U.S. service companies to potential BEAT liability when incurring direct costs in the provision of services to customers in a manner that seems inconsistent with the objectives of section 59A and sound tax policy. More so than U.S. manufacturers or distributors of goods, U.S. service companies face commercial constraints in terms of the location of operations, including local sales and marketing, as activities often must be conducted in specific locations which may be outside the United States. The services exception should be administered in a way that mitigates this inequity to the extent possible.

Accordingly, the final regulations should provide for a broader scope for the services exception, consistent with the text of section 59A. The final regulations should provide that the services exception applies to all “covered services” as defined in Treasury regulations section 1.482-9(b)(3), without regard to the business judgment rule of Treasury regulations section 1.482-9(b)(5) (as provided in the Proposed Regulations) or the excluded activity rule of Treasury regulations section 1.482-9(b)(4). Covered services are services that are eligible for the services cost method in the first instance. Covered services generally consist of common, low-margin support services identified by Revenue Procedure,¹⁴ as well as other low-margin services for which the “median comparable markup” does not exceed a 7-percent threshold.¹⁵ Under this approach, the services exception would apply to the cost element of payments for all back-office or low-margin services, thereby excluding such amounts from base erosion payments.

This approach is consistent with the purpose of the BEAT, which is to address erosion of the U.S. corporate tax base that results from U.S. and foreign companies serving the U.S. market through foreign affiliates located in low- or zero-tax jurisdictions. Such base erosion is prevented by ensuring that the markup component of any amount paid for services (e.g., the net income or profit) is retained in the U.S. corporate tax base and subject to U.S. corporate tax. It is instructive that the only service fee referred to in the legislative history of the BEAT, “management fees,”¹⁶ typically connotes an unsupported charge by a foreign parent corporation to a local operating subsidiary that does not related to the provision of actual services that benefit the subsidiary.¹⁷ In such a case, even if the management fee reflected an amount paid for a covered service, there would be no costs associated with these putative management services, and therefore the entire amount paid would be considered a base erosion payment.

This approach also best coordinates the language of section 59A(d)(5) with the section 482 regulatory scheme to which it refers, by treating covered services that fall into one or both of the business judgment and excluded activities rules in the same manner. Neither rule would operate to disqualify the characterization of a service as a covered service and in turn, cause the cost element of amounts paid for the service to be treated as a base erosion payment. Accordingly, covered services described in the business judgement rule would be treated in the same manner regardless of whether they are also described in the excluded activities rule.

Such a result is appropriate because the business judgment and excluded activities rules serve the same purpose within the section 482 regulatory scheme to which section 59A refers. The purpose of the services cost method is to “minimize the compliance burdens applicable to [intragroup back office services], especially to the extent that the arm's length markups are low and the activities do not significantly contribute to business success or failure.”¹⁸ Activities that significantly contribute to business success or failure are not eligible for the services cost method because such services should be subject to a more robust transfer pricing analysis. These rules were designed “to focus transfer pricing compliance resources of both taxpayers and the IRS principally on significant valuation issues.”¹⁹ The regulations implement this policy by providing a definition of services eligible for the services cost method in the first instance, covered services, and then by providing rules intended to remove from this category services that contribute significantly to business success or failure. Covered services in general do not present significant valuation issues because they constitute routine back-office functions or because they can be benchmarked against low-margin services. Treas. Reg. §§ 1.482-9(b)(4) and (5) exclude from the definition of covered services “excluded activities” and services that, in the business judgment of the taxpayer, otherwise contribute “significantly to key competitive advantages, core capabilities, or fundamental risks of success or failure” of the taxpayer's business. Based on the history of the transfer pricing regulations, the excluded activities list is intended to identify activities that per se contribute to key competitive advantages, core capabilities, or fundamental risks of success or failure, thereby requiring a more robust transfer pricing analysis.

The excluded activities list is derived from a similar list of services from the 1968 transfer pricing regulations. Under the 1968 regulations, services could be priced at cost under the election of the taxpayer unless such services were “integral part of the business activity” of the taxpayer.²⁰ Services were considered an integral part of the business activity of the taxpayer if they met one of several overlapping objective and subjective tests.²¹ In particular, services provided to affiliates were considered an integral part of the business if the costs of such services exceeded 25 percent of the total cost of the taxpayer, unless the services constituted one of several activities, in which case the 25 percent safe harbor did not apply.²² That list of activities was preserved and expanded in the 2003 proposed regulations, which proposed an excluded activities list substantially identical to the list in current Treas. Reg. § 1.482-9(b)(4). The preamble to the 2003 proposed regulations explained that the list from the 1968 regulations was retained because “such services generally constitute core profitmaking functions of an enterprise. The Treasury Department and the IRS therefore believe that such services should continue to be subject to a full transfer pricing analysis.”²³

The business judgment rule and the excluded activity rule therefore serve the same purpose in this regulatory scheme — they each provide exceptions to the services cost method for covered services that may require a more robust analysis from a transfer pricing perspective, either on a per se basis or based on a subjective test.²⁴ The excluded activities rule provides a per se list of activities that require a more robust analysis because they are likely to be an integral part of the taxpayer's business, and the business judgment rule provides a catch all rule for other covered services. Because each of the regulatory rules plays the same role within the regulatory scheme — identifying covered services that should be subject to a robust transfer pricing analysis — each should be treated in the same manner under section 59A. The cost element of fees for activities that are described in the business judgment rule should not be treated differently based on whether the activities are also described in the excluded activity rule because the two rules are generally intended to describe services with the same basic characteristic: services that contribute significantly to the success or failure of the taxpayer's business. By including the parenthetical language in section 59A(d)(5)(A) referencing the fundamental risks of a business, Congress intended to remove consideration of this characteristic from the question of whether a payment for services constitutes a base erosion payment. Therefore, the final regulations should provide that all covered services, without regard to the business judgment or excluded activity rules of Treas. Reg. § 1.482-9(b)(4) and (5), are eligible for the services exception.

Interpreting the scope of the services exception to include all the cost component of all covered services would best coordinate the language of section 59A(d)(5) with the section 482 regulatory scheme to which it refers. Moreover, it is consistent with the purposes of the BEAT and sound tax policy because it treats fees paid for services that have similar economic characteristics in a similar manner. Finally, this approach is consistent with sound tax policy, by treating certain payments by service companies more equitably as compared to economically similar payments by manufacturers and distributors, while at the same time preventing U.S. tax base erosion resulting from the deduction of baseless “management fees” or similar items. In effect, the requested guidance would place the services exception on a more similar footing to the exception for payments that are accounted for in inventory costs. We note that payments for some of the activities identified in the excluded activities rule, notably manufacturing and production, would typically be accounted for in the costs of inventory if incurred by a manufacturer or distributor.²⁵

II. PURCHASE OF DEPRECIABLE PROPERTY

A. Statutory Framework

Under section 59A(d)(2), entitled “Purchase of Depreciable Property”, the term base erosion payment includes “any amount paid or accrued by the taxpayer” to a related foreign person “in connection with the acquisition by the taxpayer from such person” of depreciable or amortizable property. In such a case, the depreciation or amortization deductions allowed to the U.S. taxpayer are treated as base erosion tax benefits.

B. Proposed Regulations

The Proposed Regulations provide that, for purposes of section 59A(d)(2), “an amount paid or accrued includes an amount paid or accrued using any form of consideration, including cash, property, stock, or the assumption of a liability.²⁶ The preamble to the Proposed Regulations explains that this rule could apply to treat stock exchanged by a U.S. taxpayer in the acquisition of depreciable assets in a transaction that qualifies for certain nonrecognition provisions, including an inbound contribution, an inbound liquidation, or an inbound reorganization.²⁷ The preamble notes that no specific exception is provided for transactions eligible for nonrecognition treatment. In contrast, the preamble acknowledges that the receipt of property by the shareholder in a non-liquidating distribution under section 301 is not a base erosion payment because there is no amount paid or accrued to the distributing corporation. The preamble specifically requests comments on the treatment of payments or accruals that consist of non-cash consideration.

C. Amounts “Paid or Accrued” Generally Should Not Include Stock Deemed Issued or Exchanged in Inbound Nonrecognition Transactions

Based on the language of the preamble, the Proposed Regulations would appear to subject stock deemed issued or exchanged in common nonrecognition transactions as an amount “paid or accrued” for purposes of section 59A(d)(2). This result does not appear consistent with the text of the statute or with Congressional intent. Moreover, it would discourage taxpayers from increasing their investment in income-producing assets in the United States, thereby frustrating the policy objectives of the 2017 Act in general and section 59A. Finally, the proposed retroactive effect of this provision is unfair to taxpayers that engaged in internal restructurings following the enactment of the 2017 Act with no notice of the rule. Had they known that such a broad interpretation of “paid or accrued” was being contemplated, these taxpayers would have considered alternative transactions, such as inbound dividend distributions of property. Accordingly, final regulations should provide that base erosion payments do not include stock deemed issued or exchanged in inbound liquidation, reorganization, or similar nonrecognition transactions. At an absolute minimum, relief should be provided for taxpayers that undertook inbound nonrecognition transactions prior to the issuance of the Proposed Regulations.

Under the Proposed Regulations, stock deemed issued or exchanged in common inbound nonrecognition transactions such as inbound liquidations or reorganizations would appear to give rise to amounts paid or accrued for purposes of section 59A(d)(2). For example, in the context of a U.S.-based group, the Proposed Regulations would apply to a complete liquidation of a foreign subsidiary into its U.S. parent, or to an inbound F reorganization of a foreign subsidiary into a new U.S. company held by a common U.S. parent. In the case of a complete liquidation, while the U.S. parent does not actually transfer any cash or property to the liquidating corporation, the U.S. parent is deemed to exchange its stock of the foreign liquidating corporation for the assets of that corporation to effectuate the liquidation. That stock is deemed to be immediately cancelled, and the foreign subsidiary goes out of existence.²⁸ In the case of an inbound F reorganization, the stock of the new U.S. company is deemed issued for the assets of the foreign subsidiary. The common U.S. parent then is deemed to exchange its stock in the foreign subsidiary for the stock of the new U.S. company, and the foreign subsidiary goes out of existence.²⁹ In each case, while no cash or non-cash consideration is actually transfer by a U.S. taxpayer to a related foreign person, stock is deemed to be issued or exchanged for assets, and the foreign related person counterparty immediately goes out of existence.

We note initially that the end result of an inbound liquidation or inbound F reorganization is the same as the result of an inbound dividend distribution taxed under section 301 — in each, income-producing assets are transferred into the United States, without any income, assets or other value being transferred offshore. The proposed rule sensibly recognizes that inbound section 301 distributions do not give rise to base erosion payments because there is no amount paid or accrued by the recipient of the distribution to a foreign related person, the sine qua non of section 59A(d). This is the case even though an inbound section 301 distribution may give rise to a step-up in basis to fair market value, thereby giving rise to higher depreciation deductions, while an inbound liquidating distribution would not. Given the economic similarity between non-liquidating and liquidating inbound distributions, and between distributions and F inbound reorganizations, the same treatment should be provided to all such transactions.

Moreover, the proposed rule is not consistent with the most natural reading of section 59A. Section 59A(d)(2) applies to amounts “paid or accrued” by a U.S. person to a foreign related person to acquire depreciable property. The term “paid or accrued” is used throughout the Internal Revenue Code, typically related to items such as interest or taxes that may be paid or accrued by a taxpayer.³⁰ Section 7701(a)(25) provides that the terms “paid or accrued” “shall be construed according to the method of accounting upon the basis of which the taxable income is computed.” Section 7701(a)(25), together with the multiple statutory references to interest, taxes, or similar items “paid or accrued,” suggest that the terms refer to outlays that could be accounted for or recovered in different periods depending on the method of accounting of the taxpayer. While these terms are broad enough to encompass cash payments as well as in-kind consideration in the context of barter transactions, the most natural reading of these terms would not encompass transactions in a taxpayer's own stock, in particular transitory issuances or exchanges of stock that are deemed to occur in inbound liquidations or reorganizations. Unlike cash consideration or non-cash consideration transferred in a barter transaction, stock deemed issued or exchanged in inbound liquidations or reorganizations is not an item the timing of which must be accounted for under a method of accounting – it is not an outlay or a cost that can be deducted or capitalized and expensed. For U.S. tax purposes or financial accounting purposes, taxpayers engaging in such transactions do not record a payment or accrual of stock they are deemed to issue or exchange. Moreover, while stock may be deemed to be issued or exchanged to a foreign related person in the execution of an inbound liquidation or reorganization, the existence of the foreign related person terminates as a result of the transaction. In effect, even if stock is considered “paid or accrued” to a foreign related person in such transactions, it immediately ceases to exist or is transferred back to a U.S. person as a result of the transaction, calling into question whether the payment should be given effect for purposes of section 59A.³¹

In addition, there is no evidence that Congress intended section 59A to apply to transactions in which no income or value is transferred in substance to a foreign related person. A significant policy objective of the 2017 Act was to encourage investment in income-producing property in the United States. Bringing income-producing assets into the U.S. tax base with no corresponding transfer of value is base enhancing, not base eroding. Notably, while the language of section 59A(d)(2) refers to amounts “paid or accrued” in connection with “the acquisition” of property, the heading of section 59A(d)(2), “Purchase of depreciable property,” indicates that Congress intended to limit the rule to “purchases” of property — that is, transactions in which there are actual amounts paid or accrued for the acquisition of property.³² This is consistent with the legislative history.³³ The focus on purchases, in which cash or non-cash consideration is paid to a foreign related person counterparty, rather than more generally on acquisitions of property, is consistent with the overall policy objectives of section 59A to police erosion of the U.S. tax base from deductible payments to foreign related persons or payments to foreign related person that give rise to deductible basis.³⁴ It is noteworthy that the distinction between a purchase on the one hand and an acquisition on the other has been made in other contexts based on the policies of the relevant statute. For example, a “purchase” is defined in section 355(d)(5)(A) as any acquisition, but only if the acquirer receives a purchase-price basis (rather than basis determined by reference to the basis of the property in the hands of the transferor) and the property is not acquired in an exchange to which section 351, 354, 355, or 356 applies.

Finally, it is noteworthy that many taxpayers engaged in internal restructurings such as inbound liquidations and reorganizations as a result of the 2017 Act. For example, to the extent U.S. taxpayers historically made deductible payments to foreign related persons for services that are performed outside of the United States due to commercial needs or constraints, an obvious way to mitigate any exposure under section 59A with minimal disruption to the commercial operations of the business was to convert the foreign persons into foreign branches of the U.S. taxpayer through a change in entity classification. As a result of these transactions, all income of the U.S. taxpayer and its foreign branches would be subject to U.S. tax, and there would be no amounts paid or accrued to foreign related purposes; in other words, there would be no U.S. base erosion. For U.S. tax purposes, such changes in entity classification would be characterized as inbound liquidations or reorganizations of the type described above. These transactions were discussed publicly and were commonly accepted as reasonable and legitimate reactions to the incentives created by section 59A and the 2017 Tax Act more generally.³⁵ Prior to the issuance of the Proposed Regulations on December 13, 2018, taxpayers had no notice that such inbound nonrecognition transactions could be deemed to give rise to base erosion payments, and this result would have been difficult to divine from the statutory text or any other available information. Had they known that such an was being contemplated, these taxpayers would have considered alternative transactions that would not give rise to base erosion payments under the Proposed Regulations, such as inbound dividend distributions of property.

Accordingly, final regulations should provide that base erosion payments do not include stock deemed issued or exchanged in inbound liquidation or reorganization transactions. This result need not be articulated as a specific exception to section 59A(d)(2) because it is possible to interpret the specific terms of statute, in particular the reference to amounts “paid or accrued,” to exclude such stock. Indeed, that is the most natural reading of the statute together with the legislative history. If this recommendation is not adopted, then at an absolute minimum relief should be provided for nonrecognition transactions that took place prior to the issuance of the Proposed Regulation on December 13, 2018. It would be unfair to subject taxpayers on a retroactive basis to an interpretation of section 59A(d)(2) that is difficult to discern from the statutory text given the circumstances.

* * * * *

Thank you in advance for your consideration of these comments. We commend Treasury and the IRS for their efforts in providing timely guidance on section 59A and other new provisions enacted by the 2017 Act.

Respectfully submitted,

Rocco V. Femia
202.626.5823
rfemia@milchev.com

Marc J. Gerson
202.626.1475
mgerson@milchev.com

Miller & Chevalier
Washington D.C.