NYSBA Tax Section Seeks More Clarity in Proposed BEAT Regs

February 19, 2019

The Honorable David J. Kautter
Assistant Secretary (Tax Policy)
Department of the Treasury
1500 Pennsylvania Avenue, NW
Washington, DC 20220

The Honorable William M. Paul
Acting Chief Counsel and Deputy
Chief Counsel (Technical)
Internal Revenue Service
1111 Constitution Avenue, NW
Washington, DC 20224

The Honorable Charles P. Rettig
Commissioner
Internal Revenue Service
1111 Constitution Avenue, NW
Washington, DC 20224

Re: Report No. 1409 — Report on Proposed Section 59A Regulations

Dear Messrs. Kautter, Rettig, and Paul:

I am pleased to submit Report No. 1409, commenting on the proposed regulations issued by the Internal Revenue Service and the Department of the Treasury under Section 59A of the Internal Revenue Code.

We commend the Internal Revenue Service and the Department of the Treasury for these thoughtful proposed regulations. Our Report is attached, and we include for your convenience as an Appendix a prior Report that we submitted on Section 59A. While our prior report made suggestions for Treasury to consider for regulations, this Report focuses on the proposed regulations and comments requested by Treasury.

We appreciate your consideration of our Report. If you have any questions or comments, please feel free to contact us and we will be glad to assist in any way.

Respectfully submitted,

Deborah L. Paul
Chair
Tax Section
New York State Bar Association

Enclosure

Cc:
Lafayette “Chip” G. Harter III
Deputy Assistant Secretary (International Tax Affairs)
Department of the Treasury

Douglas L. Poms
International Tax Counsel
Department of the Treasury

Brian Jenn
Deputy International Tax Counsel
Department of the Treasury

Brett York
Associate International Tax Counsel
Department of the Treasury

Lindsay Kitzinger
Attorney-Advisor
Department of the Treasury

Kevin C. Nichols
Attorney-Advisor
Department of the Treasury

Gary Scanlon
Attorney-Advisor
Department of the Treasury

Daniel Winnick
Attorney-Advisor
Department of the Treasury

Jason Yen
Attorney-Advisor
Department of the Treasury

Brenda Zent
Special Advisor to the International Tax Counsel
Department of the Treasury

Margaret O'Connor
Acting Associate Chief Counsel (International)
Internal Revenue Service

Daniel M. McCall
Deputy Associate Chief Counsel (International)
Internal Revenue Service

John J. Merrick
Senior Level Counsel, Office of Associate Chief Counsel (International)
Internal Revenue Service

Raymond J. Stahl
Special Counsel, Office of Associate Chief Counsel (International)
Internal Revenue Service

Peter Merkel
Branch Chief, Office of Associate Chief Counsel (International)
Internal Revenue Service

Jeffrey G. Mitchell
Branch Chief, Office of Associate Chief Counsel (International)
Internal Revenue Service

Kristine A. Crabtree
Senior Technical Reviewer, Office of Associate Chief Counsel (International)
Internal Revenue Service

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New York State Bar Association Tax Section

REPORT ON PROPOSED SECTION 59A REGULATIONS
February 19, 2019

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TABLE OF CONTENTS

Proposed Section 59A Regulations

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Proposed Section 59A Regulations¹

I. Introduction

This Report comments on proposed regulations (the “Proposed Regulations”)² issued by the Department of the Treasury and Internal Revenue Service (together, “ Treasury”) under new Section 59A³ on December 13, 2018. While our prior report (the “Prior Report”),⁴ submitted on July 16, 2018, made suggestions for Treasury to consider for regulations under Section 59A, this Report focuses on the Proposed Regulations and comments requested by Treasury.

Part II of this Report contains a summary of our recommendations. Part III contains a detailed discussion of our recommendations. This Report does not provide an overview of the statutory and proposed regulatory framework for Section 59A, but rather addresses specific issues with respect to which we have comments and recommendations. Our comments do not address all aspects of Section 59A and the Proposed Regulations.

II. Summary of Principal Recommendations

The following is a summary of the principal recommendations in this Report, organized by Section of the Proposed Regulations. All terms capitalized in this part have the meanings ascribed to them in Parts I and III of this Report.

Proposed Regulations Section 1.59A-1

• We request clarification regarding the application of Proposed Regulations Section 1.59A-1(b)(13) to certain loans and highly leveraged businesses.

Proposed Regulations Section 1.59A-2

• We recommend that Section 988 losses be included in the denominator of the Base Erosion Percentage to the extent that such losses arise out of transactions with unrelated parties.

• We request clarification regarding the application of the mark-to-market rule of Proposed Regulations Section 1.59A-2(e)(3)(vi) to physical securities, repurchase agreements and securities loans.

Proposed Regulations Section 1.59A-3

• We recommend that exchanges described in Section 351, liquidations described in Sections 332 and reorganizations described in Section 368 generally should not give rise to Base Erosion Payments, and that final regulations augment the applicable anti-abuse rules to prevent taxpayers or their related parties from engaging in related-party transactions that step up the basis of assets prior to engaging in such transactions.

• We recommend that the exception from the definition of Base Erosion Payment for payments made with respect to TLAC securities also apply to interest payments made with respect to certain other types of debt instrument that certain banks are required to issue pursuant to similar regulatory rules.

• We recommend that property and casualty losses incurred by insurance companies pursuant to reinsurance arrangements not be treated as Base Erosion Payments but suggest that Treasury should consider whether such losses arising from transactions with unrelated parties ought to be taken into account in the denominator of the Base Erosion Percentage.

• We suggest that Treasury consider treating netting arrangements as giving rise to a single payment for purposes of Section 59A where the underlying economic arrangement is that parties to a transaction exchange net value in the form of a single payment (as opposed to engaging in multiple value-for-value exchanges and netting contemporaneous cash payments).

• We request clarification that global dealing allocations under Proposed Treasury Regulations Section 1.482-8 and, in comparable cases, allocations that result from the use of the profit split methods under Section 482 and Treasury Regulations Section 1.482-6 are treated as allocations of income, rather than payments among related entities, for purposes of Section 59A.

• We recommend that the exclusion under Section 59A(c)(2)(B) from the definition of Base Erosion Payment for amounts that are subject to full withholding be interpreted to apply to any Excess Interest subject to full withholding under Section 884.

• We recommend that, subject to the considerations discussed below, where a payment is made to a CFC, and the payment results in a current inclusion to a U.S. taxpayer of either Subpart F income or GILTI, such payment not be treated as a Base Erosion Payment.

• We recommend that final regulations not treat a transfer of property to a foreign related party resulting in a recognized loss as a Base Erosion Payment, and if final regulations do treat such transfers as Base Erosion Payments, we request that Treasury include illustrative examples and clarify that a loss recognized on the transfer of property to a foreign related party only gives rise to a Base Erosion Payment if the loss is utilized by the taxpayer.

• We recommend that the rule in Proposed Regulations Section 1.59A-3(b)(2)(iii) applying the Mark-to-Market Rule to determining the amount of Base Erosion Payments be withdrawn.

Proposed Regulations Section 1.59A-5

• We recommend that final regulations provide that the BEAT Tax Rate for a fiscal year taxpayer for its taxable year that begins in calendar year 2018 is 5% for the entire taxable year.

Proposed Regulations Section 1.59A-6

• We recommend that (i) repurchase premium and rebate interest amounts paid with respect to securities lending transactions and sale-repurchase transactions be excluded from the definition of Qualified Derivative Payment and (ii) securities loans be treated as “derivatives” for purposes of Section 59A that accordingly may give rise to Qualified Derivative Payments.

Proposed Regulations Section 1.59A-7

• We request that Treasury clarify that an acquisition by a partnership in exchange for issuing its own interest may give rise to a Base Erosion Payment based on a deemed exchange by the other partners of their proportionate share of partnership assets rather than based on the fact that the partnership exchanged its own interest.

III. Detailed Discussion of Recommendations

A. Proposed Regulations Section 1.59A-1

1. Aggregate group definition

Proposed Regulations Section 1.59A-1 provides a definition of an “aggregate group” of corporations (an “Aggregate Group”). This definition is relevant for applying the gross receipts test of Section 59A(e)(1)(B) (the “Gross Receipts Test”) and the base erosion percentage test of Section 59A(e)(1)(C) (the “Base Erosion Percentage Test”) to corporations that are members of such a group. In general, payments between members of an Aggregate Group are not included in the gross receipts of the Aggregate Group, and payments between members of the Aggregate Group are not taken into account for purposes of the numerator or the denominator of the Base Erosion Percentage Test.⁵

Under the Proposed Regulations, an Aggregate Group is defined as a controlled group of corporations as defined in Section 1563(a), subject to certain modifications, including that 50% (rather than 80%) common ownership (by vote or value) is required.⁶ An Aggregate Group includes foreign corporations to the extent that such corporations have income that is effectively connected with the conduct of a trade or business in the United States (“ECI”) or are otherwise subject to U.S. net income taxes under an applicable tax treaty.⁷

In the Prior Report, we suggested that regulations should confirm that transactions between members of a group that is a controlled group for purposes of Section 59A are excluded from the calculation of the Base Erosion Percentage. We applaud the fact that the Proposed Regulations adopt such an approach.⁸

2. Bank or registered securities dealer de minimis exception

Section 59A(e)(1)(C) generally provides that the Base Erosion Percentage Test is satisfied if an applicable taxpayer within the meaning of Section 59A(e)(1) (an “Applicable Taxpayer”) has a base erosion percentage as determined under Section 59A(e)(4) (a “Base Erosion Percentage”) of 3% or higher, but in the case of a taxpayer that is a member of an affiliated group that includes a bank or registered securities dealer, the Base Erosion Percentage Test is satisfied if a taxpayer or Aggregate Group has a Base Erosion Percentage of 2% or higher.⁹ The Proposed Regulations establish a de minimis exception to the latter rule by providing that an Aggregate Group that includes a bank or registered securities dealer that is a member of an affiliated group is not treated as including a bank or registered securities dealer for purposes of the Base Erosion Percentage Test if, in a taxable year, the total gross receipts of the Aggregate Group attributable to the bank or registered securities dealer represent less than 2% of the total gross receipts of the Aggregate Group.¹⁰ When there is no Aggregate Group, the same rule applies, mutatis mutandis, to a consolidated group.¹¹ We believe that this rule is a sensible interpretation of the statute.

3. Gross receipts definition

The Proposed Regulations define “gross receipts” by reference to the definition contained in Temporary Treasury Regulations Section 1.448-1T(f)(2)(iv).¹² That definition is used, pursuant to Section 448(c)(1), to determine whether taxpayers are eligible to employ the cash receipts and disbursements method of accounting.

Although Section 59A(e)(2)(B) makes reference to Section 448, Section 59A does not directly define gross receipts by reference to the definition in Section 448. Instead, Section 59A(e)(2)(B) references several provisions of Section 448, such as the provision that addresses the treatment of returns and allowances.¹³

In the Prior Report, we noted that additional guidance would need to be provided in order to determine a corporation's gross receipts, particularly for banks and other financial services corporations.¹⁴ We also noted that for certain highly leveraged businesses, such as banks and other financial intermediaries, the gross receipts amount may not provide a true measure of the size of a taxpayer's U.S. business. For instance, under the applicable definition referenced in the Proposed Regulations, while the repayment of a loan made by a bank is not considered gross receipts, a bank selling a loan is not permitted to reduce gross receipts by the bank's basis in the loan. This rule may lead to unexpected and potentially inappropriate results. It is unclear from the discussion in the Preamble whether such results were intended.

B. Proposed Regulations Section 1.59A-2

Proposed Regulations Section 1.59A-2 contains rules for determining whether a taxpayer is an Applicable Taxpayer, including rules regarding the Gross Receipts Test and the Base Erosion Percentage Test.

1. Section 988 losses

The Proposed Regulations provide that foreign exchange losses under Section 988 are not treated as base erosion payments within the meaning of Section 59A(d)(1) (“Base Erosion Payments”)¹⁵ and also are not treated as deductions that are added to the denominator that is used in the Base Erosion Percentage Test pursuant to Section 59A(c)(4)(A)(ii)(I).¹⁶ We agree with Treasury that Section 988 losses do not present the same base erosion concerns as other deductions, and accordingly we agree with Treasury's decision not to include Section 988 losses in the numerator of the Base Erosion Percentage and not to treat such losses as Base Erosion Payments.

However, we disagree with the exclusion of Section 988 losses from the denominator of the Base Erosion Percentage where such losses arise from transactions with unrelated parties. The gross amount of such losses appears to continue to be properly deductible.¹⁷ In the case of several other categories of payments that are not treated as base eroding, only payments that are made to related parties and thus excluded from the numerator are similarly excluded from the denominator. For example, as discussed below, service cost method amounts that are excluded from the numerator of the Base Erosion Percentage by application of Proposed Regulations Section 1.59A-3(b)(3)(i) are also excluded from the denominator,¹⁸ but other service cost method amounts may be included in the denominator. Similarly, deductions for qualified derivatives payments¹⁹ and deductions for amounts paid or accrued to foreign related parties with respect to TLAC securities²⁰ are excluded from the denominator of the Base Erosion Percentage only if also excluded from the numerator.

We agree with the treatment of these other deductible amounts and see no reason to differentiate Section 988 losses arising with respect to transactions with unrelated parties. To the extent that Treasury is concerned that including Section 988 losses in the denominator of the Base Erosion Percentage could cause taxpayers to enter into potentially offsetting transactions with unrelated parties that inflate the denominator without reflecting the taxpayer's actual economic exposure, we note that the anti-abuse rule of Proposed Regulations Section 1.59A-9(b)(2) would generally disregard any transaction, plan or arrangement that has “a principal purpose of increasing the deductions taken into account for purposes of” the Base Erosion Percentage computation.²¹

Further, we note that the exclusion of all foreign exchange losses from both the numerator and the denominator of the Base Erosion Percentage could have a significant impact on certain taxpayers, in particular, on dealers in foreign currency derivatives. Without such losses, these taxpayers may have a limited amount of deductions in the denominator that may not be representative of their overall business, leading to unexpected and unintended results.

2. Mark-to-market transactions

The Proposed Regulations generally provide that in the case of any position with respect to which the taxpayer (or Aggregate Group that includes the taxpayer) applies a mark-to-market method of accounting for federal income tax purposes, all income, deductions, gains or losses on each transaction for the year are combined to determine the amount of the deduction that is used for purposes of calculating the Base Erosion Percentage (the “Mark-to-Market Rule”).²² We believe this rule reaches a sensible outcome with respect to derivatives by avoiding double-counting both a current mark-to-market loss as well as a future payment to which the current loss relates. For example, if an interest rate swap is marked to market for a loss of $50, because the taxpayer will have to make five future payments that are above-market by $10, then taking both the $50 loss into account and the series of $10 payments in the future into account in the denominator of the Base Erosion Percentage would result in double-counting, because, assuming market conditions do not otherwise change, each payment causes the swap's value to increase toward par, and that increase is captured by a mark-to-market gain. However, by causing the taxpayer in future years to offset, for purposes of Section 59A, the deduction associated with each above-market payment and corresponding mark-up of the swap as a result of the reduced volume of above-market payments owed in the future, the taxpayer takes into account the full economic loss associated with the swap in the first year but does not take any additional losses with respect to the swap into account in the future.²³

However, the Mark-to-Market Rule by its terms could also be read to apply to physical securities (stocks and bonds), as well as repurchase agreements (also known as “repos”) and securities loans with respect to which a taxpayer applies a mark-to-market method of accounting. It is not clear whether Proposed Regulations Section 1.59A-2(e)(3)(vi) should apply to such transactions, because unlike in the case of many derivatives, such transactions generally do not entail a loss of value to the holder of the relevant instrument that is subsequently crystallized in the form of a payment made by the holder and that effectively gives rise to an offsetting mark-up of the security. The Mark-to-Market Rule accordingly is not necessary to avoid the double-counting of deductions in such transactions. For example, assume that a share of stock in a company is worth $100 in Year 0, when a dealer buys the share; in Year 1, the share price drops to $90 and the company pays a $1 dividend with respect to the share; and in Year 2, the dealer sells the share for $90. In the absence of the Mark-to-Market Rule, the amount of the dealer's deduction in Year 1 would be $10; with the application of the Mark-to-Market Rule, however, the amount of the deduction is $9. Because for non-BEAT purposes the dealer would have either a $10 loss on a non-mark-to-market basis (in Year 2), or would have a $10 loss on a mark-to-market basis (in Year 1) without treating the amount of the $1 dividend as an offset to the loss, it seems that the deduction for BEAT purposes should be $10. Rather than preventing double-counting, the effect of the Mark-to-Market Rule in such a situation is to net amounts that would not be netted under Section 475 and that are not duplicative of other inclusions or deductions by the taxpayer.

Similarly, to take another example, assume that a dealer sells a share of stock short in Year 0, when the share is worth $100; in Year 1, the value of the share drops to $90, and the dealer pays a $1 substitute dividend. Absent the Mark-to-Market Rule, the dealer would have a $1 deduction. Applying the Mark-to-Market Rule, the dealer has a net gain of $9 and no deduction. Once again, on a non-mark-to-market basis, or applying mark-to-market principles for non-BEAT purposes, the dealer would have a gain of $10 and a $1 deduction.

We note that the Mark-to-Market Rule would be adverse to a taxpayer where a payment to the taxpayer effectively reduces the amount of a third-party deduction that would be included only in the denominator of the Base Erosion Percentage, but the Mark-to-Market Rule would be beneficial to a taxpayer where a deduction that would otherwise have been added to both the numerator and the denominator of the Base Erosion Percentage in the absence of the Mark-to-Market Rule is netted to a smaller amount, or becomes income rather than a deduction.

We request clarification from Treasury regarding whether Proposed Regulations Section 1.59A-2(e)(3)(vi) applies to the various types of transactions described above.

C. Proposed Regulations Section 1.59A-3

Proposed Regulations Section 1.59A-3(b)(1) defines Base Erosion Payment and base erosion tax benefit (within the meaning of Section 59A(c)(2)) (a “Base Erosion Tax Benefit”).

1. Payments or accruals of non-cash consideration in nonrecognition transactions

Consistent with Section 59A(d)(2), Proposed Regulations Section 1.59A-3(b)(1)(ii) provides that the term Base Erosion Payment includes “[a]ny amount paid or accrued by the taxpayer to a foreign related party of the taxpayer in connection with the acquisition of property by the taxpayer from the foreign related party if the character of the property is subject to the allowance for depreciation (or amortization in lieu of depreciation).” Proposed Regulations Section 1.59A-3(b)(2) provides that for purposes of the definition of Base Erosion Payment, “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.”

The preamble to the Proposed Regulations (the “Preamble”) states that an accrual by a taxpayer to a foreign related party may be a Base Erosion Payment under the definition contained in the Proposed Regulations even if the accrual is in the form of non-cash consideration and even if the transaction qualifies under a nonrecognition provision of the Code. Thus, for example, the Preamble states that a Base Erosion Payment could result where a domestic corporation acquires depreciable assets from a foreign related party in an exchange described in Section 351, a liquidation described in Section 332, or a reorganization described in Section 368.²⁴ The Preamble notes that “[t]he statutory definition of this type of Base Erosion Payment that results from the acquisition of depreciable or amortizable assets in exchange for a payment or accrual to a foreign related party is based on the amount of imported basis in the asset. That amount of basis is imported regardless of whether the transaction is a recognition transaction or a transaction subject to rules in subchapter C or elsewhere in the Code.”²⁵

We believe that Treasury's sole focus on the “import” of basis into the U.S. is misguided and that, both from a policy perspective and from a technical standpoint, the types of nonrecognition transactions enumerated in the Preamble generally should not give rise to Base Erosion Payments. These transactions can be divided into two different types: those in respect of which the transferor of the depreciable asset disappears and those in respect of which the transferor stays in existence. We first address transactions in respect of which the transferor disappears.

A nonrecognition transaction in respect of which the transferor of the depreciable asset disappears, such as a tax-free liquidation of a foreign subsidiary into its U.S. parent described in Section 332 (an “Inbound 332 Transaction”), or a reorganization of a foreign corporation into a U.S. corporation described in Section 368(a)(1)(F) (an “Inbound F Reorganization”), should not give rise to Base Erosion Payments. As a policy matter, subjecting such transactions to BEAT is questionable, because these transactions are adding presumably income-generating assets to the U.S. tax base, such that depreciation deductions with respect to such assets, when taken together with the income intended to be generated, will not necessarily cause the assets to erode the U.S. tax base.²⁶ Further, where the transferor foreign party disappears, there is no real transfer of value from the U.S. party to a foreign related party. In an Inbound 332 Transaction, the foreign subsidiary distributes all of its assets in complete cancellation or redemption of its stock and immediately ceases to exist. Similarly, in an Inbound F Reorganization, the foreign corporation is treated as forming a new U.S. corporation, contributing all of the foreign corporation's assets to the U.S. corporation in exchange for stock, and then immediately distributing such stock to the shareholders of the foreign corporation.²⁷ In both cases, all that has happened is that the foreign corporation's assets and future income have become those of a U.S. corporation, such that there has, in the aggregate, likely been a base enhancement rather than base erosion, and no foreign related party has obtained anything of value.

As a technical matter, Section 59A(d)(2) requires that an amount treated as a Base Erosion Payment be “paid or accrued” by the taxpayer. In the context of Section 59A, a payment or accrual would seem to entail that there be a recipient of the payment or accrued amount, and such recipient must be related to the taxpayer. As discussed above, however, in both an Inbound 332 Transaction and an Inbound F Reorganization, no recipient remains once the “payment” has been made. Moreover, the only potential “payment” is the non-U.S. corporation's own stock, which ceases to exist for U.S. tax purposes in the hands of the payee. Thus, a technical analysis of the language of Section 59A(d)(2) supports not treating such transactions as giving rise to Base Erosion Payments. In addition, in the deemed transactions occurring in an Inbound F Reorganization described above, the foreign corporation and U.S. corporation are only “related” within the meaning of Section 59A(g) for the instant in which both corporations are deemed to exist, further calling into question the existence of a payment to a foreign related payee.

The appropriate treatment of nonrecognition transactions where the transferor of the depreciable asset continues to exist and to be related to the U.S. taxpayer after the payment has been made is somewhat less clear. However, in these situations, the purposes of Section 59A are not necessarily served by treating the U.S. taxpayer as making a base-eroding payment. For example, where assets are transferred to a U.S. corporation, such as in a contribution of assets by a foreign person to a U.S. corporation in a transaction described in Section 351 (an “Inbound 351 Contribution”) or in a reorganization described in Section 368(a)(1)(A) (an “Inbound Asset Reorganization”), no assets have left U.S. corporate solution that could have contributed to the U.S. tax base at a later time, because the consideration paid by the U.S. corporation is its own stock. Although depreciation of the transferred assets by the U.S. corporation may subsequently give rise to deductions, the use of the transferred assets by the U.S. corporation could give rise to gross income, the sale or exchange of the transferred assets by the U.S. corporation could give rise to the recognition of taxable gain, and a dividend of such gross income or sale or exchange proceeds would not be deductible to the U.S. corporation. More broadly, we believe that to subject Inbound 351 Contributions to BEAT would disincentivize equity investments in U.S. corporations, running contrary to the central objectives of the Tax Cuts and Jobs Act²⁸ (the “TCJA”) of making U.S. corporations more globally competitive and broadening the U.S. tax base.²⁹ On the other hand, we acknowledge that it is difficult to draw a distinction between an Inbound 351 Contribution and a situation where a foreign parent company contributes cash to its U.S. subsidiary, which cash is then used to acquire depreciable property from a related foreign party. One possible way to distinguish the two situations is that, in the case of an Inbound 351 Contribution, the depreciable basis of the contributed assets has no relation to the value of the shares issued, because the basis of the contributed assets is determined by reference to their basis in the hands of the contributor.

We have also considered whether an exclusion of nonrecognition transactions, in particular the exclusion of Inbound 351 Contributions, from BEAT might allow taxpayers to readily avoid Section 59A(d)(2). For example, it is possible that if an Inbound 351 Contribution were not treated as giving rise to a Base Erosion Payment, then, instead of a foreign parent contributing cash to a U.S. corporation which the U.S. corporation then uses to buy a depreciable asset from a foreign related person in a transaction that would be subject to Section 59A, a U.S. corporation could use its own stock to acquire an asset from a foreign person (rather than using cash, which would give rise to a Base Erosion Payment), and the foreign parent of the U.S. corporation could then use cash to purchase the newly issued stock from the foreign person, with the effect that the U.S. corporation acquired an asset using proceeds traceable to the foreign parent, even though no Base Erosion Payment was made. However, we believe that existing law and augmented anti-abuse rules under Section 1.59A-9 of the Proposed Regulations may be sufficient to address such potential abuse. For example, the statutory requirements to qualify for a contribution described in Section 351 impose a constraint on foreign corporations' flexibility to prevent Base Erosion Payments from being made when assets are transferred to a U.S. corporation in exchange for stock. Unless the applicable asset itself has sufficiently large value to give the transferor control of the U.S. corporation immediately after the transfer, the asset likely needs to be transferred first to a foreign corporation that already has control of the U.S. corporation, and such transfer may be limited by foreign law and non-tax law considerations. In another example, prior to bringing depreciable assets into the U.S. in an Inbound 351 Contribution or an Inbound Asset Reorganization, a taxpayer may attempt to step up the basis of such assets by engaging in intercompany transactions with foreign affiliates. Setting aside potential foreign and non-tax law constraints, the anti-abuse rule that disregards abusive conduit transactions under Proposed Regulations Section 1.59A-9(b)(1) may prevent such a basis step-up.³⁰ Lastly, we note that the importing of loss assets is restricted by Section 362(e), and we do not believe that Section 59A is an appropriate venue for adding additional protections if any were needed. Thus, we believe that, on balance, Inbound 351 Contributions and Inbound Asset Reorganizations should not be treated as Base Erosion Payments. We recommend that the anti-abuse rules of Proposed Regulations Section 1.59A-9 be augmented to prevent taxpayers or their related parties from engaging in related-party transactions that step up the basis of assets prior to engaging in an Inbound 351 Contribution or an Inbound Asset Reorganization.

A technical reading can support our approach. The U.S. corporation's own stock in the context of Inbound 351 Contributions or Inbound Asset Reorganizations is not, in our view, the sort of asset of the U.S. corporation that should be treated as “paid or accrued” to a foreign related person “in connection with the acquisition . . . of property” under Section 59A(d)(2). The Code uses the phrase “paid or accrued” in numerous places by referring to a transfer of property that is deductible or taxable.³¹ In addition, the heading to Section 59A(d)(2), “Purchase of Depreciable Property,” further connotes³² that the “acquisition of property” therein refers to a taxable transaction given that a “purchase” generally means a taxable transaction.³³ Thus, we believe that the terms of Section 59A(d)(2) support our belief that the transfer of stock in a nonrecognition transaction should not give rise to any Base Erosion Payment or Base Erosion Tax Benefit.³⁴

It is unclear whether a taxable distribution to a U.S. corporation in liquidation of a foreign corporation described in Section 331 (an “Inbound 331 Transaction”) should give rise to any Base Erosion Payments. Although there is a step up (or step down) in basis of assets in connection with such a transaction (unlike in the case of an Inbound 351 Contribution or an Inbound Asset Reorganization), the overall impact of any Inbound 331 Transaction is that there is an increase in the U.S. tax base, because the foreign corporation's assets and future income have become those of a U.S. corporation without any corresponding assets leaving the U.S. In addition, the same technical analysis as above (relating to the Inbound 332 Transaction) with respect to the questionable existence of a payment, where both the foreign corporation as payee and the foreign corporation's stock disappear immediately after the transaction, applies with equal force to an Inbound 331 Transaction. However, we acknowledge that taxable transactions generally can give rise to Base Erosion Payments under certain circumstances, and we do not take a view regarding whether Inbound 331 Transactions should give rise to Base Erosion Payments.

We also considered whether a taxable transfer of assets to a U.S. corporation in exchange for stock (e.g., a “busted 351”) should be subject to BEAT. A corporation's own stock does not seem to be a payment of value with respect to the corporation for purposes of an acquisition. However, it is clear that deductible payments (such as payments of royalties) can be made with a corporation's own stock, and those transactions are clearly subject to BEAT, and accordingly we agree that transfers of stock in exchange for depreciable assets should constitute Base Erosion Payments. Similarly, in the case of a transfer of assets to a corporation that is partially taxable to the transferor pursuant to Section 351(b) as a result of the receipt of “boot” by the transferor, it would be appropriate to treat the corporation as making a Base Erosion Payment because, at that point, there will have been an acquisition in exchange for property of the U.S. corporation and potentially a basis consequence to the U.S. corporation on account of the payment of boot.

Finally, we considered the issue of assumptions of liabilities in relation to the nonrecognition transactions described above. On the one hand, when a U.S. corporation assumes liabilities, the corporation appears to have given up something of value such that a payment has been made. On the other hand, except where the assumption of liabilities is treated as boot, the carry-over basis of the assets has little reference to the value of the liabilities assumed. We ask Treasury to consider these issues when drawing the lines described above, but we make no recommendation either way in this respect.

To the extent that final regulations adopt the treatment described in the Preamble rather than our recommendations, we request clarification in the text of the final regulations, including by way of examples. In addition, we recommend that if final regulations adopt the treatment described in the Preamble, the exception in Proposed Regulations Section 1.59A-3(b)(3)(iii) should be expanded to provide that where a U.S. corporation exchanges its own stock for depreciable assets that gave rise to ECI in the hands of the payee of the stock, no Base Erosion Payment is treated as being made.

2. Service cost method payments

Section 59A(d)(5) provides that a payment for services that are eligible for the services cost method under Section 482 is not treated as a Base Erosion Payment if the amount of the payment constitutes the total services cost with no markup component. The Preamble notes that Section 59A(d)(5) is ambiguous regarding whether, in the case of a payment a portion of which is eligible for the services cost method but that also includes a markup component, the entire payment is ineligible for the exception or only the markup component is ineligible for the exception.³⁵

The Proposed Regulations provide that where a payment for services includes a markup component, the exception under Section 59A(d)(5) applies to the portion of the payment that does not exceed the total cost of services.³⁶ We believe that this provision sensibly interprets the statutory language by permitting a payment to be disaggregated into different “amounts,” as described in the statute.

3. TLAC securities

Proposed Regulations Section 1.59A-3(b)(3)(v)(A) provides that a portion of the interest paid or accrued on “total loss-absorbing capacity” (“ TLAC”) securities that certain global systemically important banking organizations are required by the Federal Reserve to issue are not treated as Base Erosion Payments. The amount of interest paid or accrued on TLAC securities that is excluded from treatment as a Base Erosion Payment is limited to the product of the amount paid or accrued to foreign related parties with respect to the TLAC securities and the “scaling ratio.”³⁷ The scaling ratio generally equals the ratio of the minimum amount of debt that is required under the TLAC regulations to the sum of the adjusted issue prices of all TLAC securities issued and outstanding by the taxpayer.³⁸

The Preamble explains that “because of the special status of TLAC as part of a global system to address bank solvency and the precise limits that Board regulations place on the terms of TLAC securities and structure of intragroup TLAC funding, it is necessary and appropriate to include an exception to Base Erosion Payment status for interest paid or accrued on TLAC securities required by the Federal Reserve.”³⁹ Because the global system to address bank solvency also has been implemented in jurisdictions outside the United States and could in certain instances give rise to related-party interest expense that is allocable to ECI of issuers that are not U.S. corporations, we believe that it would be appropriate to expand the TLAC exception such that it applies to TLAC securities that are required to be issued pursuant to the TLAC regimes in non-U.S. jurisdictions.

Furthermore, as we stated in the Prior Report, it would be appropriate to expand this exception to interest payments made with respect to certain other types of debt instrument that certain banks are required to issue pursuant to similar regulatory rules.⁴⁰ For example, U.S. subsidiaries of a foreign bank generally are required to hold “high-quality liquid assets,” and such assets are often held in the form of sale-and-repurchase transactions with the foreign parent bank that are treated as secured debt for U.S. tax purposes. There does not appear to us to be any reason to distinguish this sort of debt from TLAC funding if the concept is to exempt regulatory debt from BEAT. As we noted in the Prior Report, such debt is often issued where banks source long-term funding from third parties at the top-tier entity and onlend to branches and subsidiaries as needed, and as we previously recommended, an exception for such debt would be appropriate so long as the ultimate capital provider is not a related party.

In addition, we note that some smaller banks that are not required by the Federal Reserve to issue TLAC securities nonetheless may choose to issue similar securities out of financial prudence, and the Proposed Regulations as drafted may discourage such prudence in the absence of a broader exception. If Treasury were to consider expanding the TLAC exception to apply to such securities, it would be appropriate for the exception to apply where the top-tier entity borrows from third parties.

4. Insurance claims

a) Deductions vs. reductions in gross income

The Preamble notes that in the case of an insurance company other than a life insurance company, claims payments made to a foreign related insurance company pursuant to a reinsurance arrangement may be treated as reductions in gross income under Section 832(b)(3), even though such payments may also be treated as deductions from gross income.⁴¹ By contrast, similar amounts incurred by life insurance companies generally would be treated as deductions from gross income.

We believe that treating property and casualty losses as outside of the scope of Base Erosion Payments makes sense both (i) in light of the statutory language of Section 832(b)(3) treating losses as not part of gross income (rather than as a deduction) and (ii) given that the premiums received by an insurance company are inbound payments (and the loss claims are effectively the “product” of the business that is sold in exchange for such premiums). In other words, economically, an insurer exchanges the value of claims payments for premium payments (and investment income from investment of reserves); though the rules for determining the net value derived by the insurer for U.S. federal income tax purposes are complex, the insurer, by virtue of the nature of its business, can only derive economic benefit to the extent that the insurer's gross income exceeds its claims payments, and thus, in such situations, the insurer's activities are accretive to the U.S. tax base.

Whether to eliminate payments for claims (including third-party claims) entirely from the denominator of the Base Erosion Percentage is a more difficult question. In other situations, such as with services payments, it is clear that payments to third parties are deductions. If the analysis were strictly based on the statutory language in Section 832(b)(3), it appears that such loss claims would fall outside of the denominator completely, and that could be a valid position. We note, however, that such treatment would likely provide unintended results, as the (proportionately) smaller deductions that remain may not be representative of the overall insurance business. Thus, where a reinsurer has made claims payments that represent economic losses to the reinsurer, eliminating only related party deductions from both the numerator and the denominator of the Base Erosion Percentage might be justified.⁴²

Furthermore, in the Preamble, Treasury requested comments about the distinction between life and non-life insurance businesses. We agree that treating life insurance losses differently from property and casualty losses for purposes of Section 59A makes little sense, and, as a substantive matter, we see little reason to distinguish the businesses. The distinction between them seems to be a quirk of legislative drafting. The fact that Section 801(b) defines “life insurance taxable income” to mean “life insurance gross income, reduced by [ ] life insurance deductions” is an oddity. However, we acknowledge that Section 801(b) is drafted differently from Section 832(b)(3), and sometimes the Code provides for disparate results.

b) Reinsurance — netting

The Preamble states that Treasury requests comments addressing “whether a distinction should be made between reinsurance contracts entered into by an applicable taxpayer and a foreign related party that provide for settlement of amounts owed on a net basis and other commercial contracts entered into by an applicable taxpayer and a foreign related party that provide for netting of items payable by one party against items payable by the other party in determining that net amount to be paid between the parties.”⁴³ We note in particular that in many reinsurance transactions, a “ceding commission” is paid by the reinsurer to the reinsured party (i.e., the risk transferor), and such commission is netted against the premium paid by the reinsured party. We believe that this situation is addressed by the discussion of single economic arrangements in Part III.C.5, below, but we acknowledge that these are difficult lines to draw.

5. Netting

Proposed Regulations Section 1.59A-3(b)(2)(ii) provides that in general, “the amount of any base erosion payment is determined on a gross basis, regardless of any contractual or legal right to make or receive payments on a net basis. For this purpose, a right to make or receive payments on a net basis permits the parties to a transaction or series of transactions to settle obligations by offsetting any amounts to be paid by one party against amounts owed by that party to the other party. For example, any premium or other consideration paid or accrued by a taxpayer to a foreign related party for any reinsurance payments is not reduced by or netted against other amounts owed to the taxpayer from the foreign related party or by reserve adjustments or other returns.”

The Preamble explains that

First, we agree that permitting netting where it is otherwise permitted under the Code and Treasury Regulations is appropriate. However, some clarifying examples may be useful. For example, cost sharing arrangements under 1.482-7 appear to be a situation where netting is permitted,⁴⁵ but confirmation may be useful. In addition, “setoffs” of multiple allocations between controlled taxpayers under Section 482 and Treasury Regulations Section 1.482-1(g)(4) appear to warrant similar treatment.

Second, in some circumstances, contractual netting could be treated as giving rise to a single payment. For example, in the case of a fixed-to-floating swap where a single net payment is made by one party, it appears that disaggregating the payment into two amounts is unnecessary, and to do so only where the relevant contractual arrangements are written in a way that explicitly acknowledges two offsetting notional amounts would elevate form over substance.⁴⁶ In addition, we note that, if contractual netting is not treated as giving rise to a single payment for purposes of determining the denominator of the Base Erosion Percentage, then disaggregation could cause taxpayers not to be subject to the application of BEAT as a result of transactions with unrelated parties that give rise to payments that largely offset each other as an economic matter but that involve large deductions that, if disaggregated, would increase the denominator of each taxpayer's Base Erosion Percentage. However, we acknowledge that the limits of such contractual netting are difficult to draw. One possibility that we suggest Treasury consider would be to treat netting as giving rise to a single payment where the underlying economic arrangement is that parties to a single economic transaction exchange net value in the form of a single payment (as opposed to engaging in multiple value-for-value exchanges and netting contemporaneous cash payments). It is not clear whether the Proposed Regulations adopt such an approach, and thus we request clarification, possibly by way of examples, regarding situations in which netting is permitted.

6. Global dealing allocations and residual profits splits

The Proposed Regulations do not specifically address whether global dealing allocations would be treated as “payments” to related parties for purposes of Section 59A. The proposed regulations that address global dealing allocations generally provide that amounts of income are allocated to a U.S. trade or business based on a sourcing rule that treats each qualified business unit of the applicable global dealing operation as a participant in the operation.⁴⁷ We believe that such allocations are most accurately viewed as allocations of income for U.S. federal income tax purposes, rather than as payments or accruals by any of the applicable entities among each other, and we request clarification to this effect.⁴⁸

Similarly, allocations that result from the use of the profit split methods under Section 482 and Treasury Regulations Section 1.482-6 should be accorded the same treatment where parties are effectively treated as engaging in a single set of operations. We acknowledge that, in some cases, a profit split method may be used to determine the amount of a deductible payment (such as where a foreign related party licenses intellectual property to a U.S. party, and the profit split method is used to determine the amount of the royalty). Other cases, however, may be more similar to the global dealing example, in which case similar treatment would be warranted.

7. Interest expense allocable to ECI

The Prior Report discussed the applicability of BEAT to the interest expense of a U.S. branch (or other activity related to ECI). In the Prior Report, we recommended that (1) regardless of whether the taxpayer uses the “adjusted U.S. booked liabilities” (“AUSBL”) method or the “separate currency pools” method, interest expense on U.S.-booked liabilities (“Branch Interest”) should be treated as paid to the branch's creditor for purposes of BEAT, and (2) the excess amount of a foreign corporation's interest allocated or apportioned to ECI under Treasury Regulations Section 1.882-5 over Branch Interest (such excess amount, “Excess Interest”) should also be subject to BEAT to the extent that the foreign corporation has borrowed from a foreign related party.⁴⁹

The Proposed Regulations generally provide that a foreign corporation that has interest expense allocable under Section 882(c) to ECI is treated as making a Base Erosion Payment to the extent that such interest expense results from a payment or accrual to a foreign related party.⁵⁰ We note, however, that there are several inconsistencies in the Proposed Regulations with respect to the allocation of interest expense to ECI.

a) Treaty allocations to a branch and excess interest

The treatment under the Proposed Regulations of interest expense allocable to ECI pursuant to the business profits provisions of an income tax treaty is inconsistent with the treatment under the Proposed Regulations of interest expense allocable to ECI under Treasury Regulations Section 1.882-5.

More specifically, where a foreign corporation determines the profits attributable to a permanent establishment based on the assets used, risks assumed and functions performed by the permanent establishment, the Proposed Regulations treat transactions between the permanent establishment and the home office or other branches of the foreign corporation (such transactions, “Internal Dealings”) as being actually paid or accrued for purposes of determining whether there is a Base Erosion Payment.⁵¹ Under Treasury Regulations Section 1.882-5(c)(2)(viii), on the other hand, transactions between separate offices or branches of the same taxpayer are ignored, and the allocation of interest expense for purposes of determining Base Erosion Payments is dependent on the foreign corporation's worldwide borrowings from related foreign parties.

The Preamble explains that the allocation of interest expense under Treasury Regulations Section 1.882-5 is distinct from Internal Dealings, because the former “represents a division of the expenses of the enterprise, rather than a payment between the branch or permanent establishment and the rest of the enterprise,” while Internal Dealings “are priced on the basis of assets used, risks assumed, and functions performed by the permanent establishment in a manner consistent with the arm's length principle.”⁵²

We note that the arm's-length construct described above for characterizing Internal Dealings pursuant to an income tax treaty represents an attempt to fairly apportion the operating results of the U.S. permanent establishment and the home office or other branches of the foreign corporation. This goal is similar to the goal of the allocation rules under Treasury Regulations Section 1.882-5. By drawing a distinction between Internal Dealings and allocations pursuant to Treasury Regulations Section 1.882-5, the Proposed Regulations create a regime that could be more taxpayer-adverse under a treaty as compared with U.S. law in the absence of a treaty.⁵³ Treasury should consider this approach in light of treaty non-discrimination provisions and, in the case of a taxpayer applying both Internal Dealings and allocations under Treasury Regulations Section 1.882-5 for different businesses in the same year, in light of treaty consistency principles.⁵⁴

b) AUSBL method and separate currency pools method

The Proposed Regulations create a discrepancy between taxpayers that use the AUSBL method and taxpayers that use the separate currency pools method. The Proposed Regulations provide that for taxpayers that use the AUSBL method, the amount of interest expense that constitutes a Base Erosion Payment is equal to the sum of (1) “direct allocations” of interest expense or interest expense on U.S.-booked liabilities that is paid or accrued to a foreign related party and (2) interest expense on U.S.-connected liabilities in excess of U.S.-booked liabilities (“Excess U.S.-Connected Liabilities”) multiplied by a fraction representing the percentage of the taxpayer's worldwide liabilities that is owed to a foreign related party.⁵⁵

The Proposed Regulations provide that for taxpayers that use the separate currency pools method, the amount of interest expense that constitutes a Base Erosion Payment is equal to the sum of (1) “direct allocations” of interest expense paid or accrued to a foreign related party and (2) the interest expense in each currency pool multiplied by a fraction representing the percentage of the taxpayer's worldwide liabilities that is owed to a foreign related party for that currency pool.⁵⁶

Thus, under the AUSBL method, only the portion of interest expense on Excess U.S.-Connected Liabilities is multiplied by a fraction, whereas under the separate currency pools method, the entire amount of interest expense in each currency pool is multiplied by a fraction. We acknowledge that this discrepancy is in part a consequence of the distinctions between the methodologies underlying the AUSBL method and the separate currency pools method, but we request clarification regarding whether Treasury believes the discrepancy is justified in the context of Section 59A.

c) Simplifying elections for determining the portion of U.S.-connected liabilities that are paid to a foreign related party

The Preamble notes that certain simplifying elections are available under Treasury Regulations Section 1.882-5 for determining the amount of interest incurred by a foreign corporation that is deductible and requests comments regarding similar simplifying elections for determining the portion of U.S.-connected liabilities that are paid to a foreign related party. It may be appropriate for final regulations to include a rule that permits taxpayers to elect to determine the portion of U.S.-connected liabilities that are paid to foreign related parties based on the ratio of the foreign corporation's liabilities that are owed to foreign related parties to the foreign corporation's total liabilities.

8. Branch interest withholding

Consistent with the language of Section 59A,⁵⁷ the Proposed Regulations provide that if tax is imposed under Section 871 or 881 on a Base Erosion Payment, and the tax is withheld under Section 1441 or 1442, then the Base Erosion Payment is not taken into account as a Base Erosion Tax Benefit.⁵⁸ The exclusion from treatment as a Base Erosion Tax Benefit is reduced ratably (i.e., payments do give rise to Base Erosion Tax Benefits) if the applicable tax imposed by Section 871 or 881 is reduced by an income tax treaty.⁵⁹

The Treasury Regulations under Section 884 provide that the Excess Interest of a foreign corporation with a U.S. branch is subject to tax under Section 881(a) in the same manner as if such Excess Interest were interest paid to the foreign corporation by a wholly owned domestic corporation.⁶⁰ Accordingly, we believe that the exclusion for payments subject to full withholding under the Proposed Regulations should be interpreted to apply to any Excess Interest subject to full withholding under Section 884. To avoid any ambiguities, however, we suggest that final regulations expressly provide that the exclusion for payments subject to withholding applies to any Excess Interest subject to withholding under Section 884 and the Treasury Regulations thereunder.

9. Subpart F income and GILTI

In the Prior Report, we recommended that where a payment by a U.S. corporate taxpayer is made to a controlled foreign corporation (“CFC”) of such taxpayer, and the payment results in a current inclusion to the taxpayer of either Subpart F income or global intangible low tax income (“GILTI”) by a U.S. shareholder under Section 951A, such payment should not be treated as a Base Erosion Payment. Such a rule is necessary because a taxpayer could be a U.S. shareholder of a CFC even though the CFC and the taxpayer are not included in the same Aggregate Group, such that a payment by the U.S. shareholder to the CFC could give rise to a Subpart F or GILTI inclusion while also being treated as a Base Erosion Payment made by the U.S. shareholder. More broadly, payments that give rise to a Subpart F or GILTI inclusion are analogous to payments that give rise to ECI in that such payments do not erode the U.S. tax base.⁶¹ The Preamble and the Proposed Regulations do not address this issue, and we again recommend that an exception be made for amounts that will otherwise be subject to tax in the U.S.

We acknowledge that any exception along the lines discussed above may include certain limitations and exceptions. In considering such limitations and exceptions, it may be illustrative to discuss several alternative cases involving Subpart F income or GILTI.

First, in a case where a payment by a U.S. corporate taxpayer results in a CFC recognizing Subpart F income without any offsetting foreign tax credits arising from the payment, we maintain the position put forth in the Prior Report that it would be reasonable to allow taxpayers to exclude such a payment from Base Erosion Payments and Base Erosion Tax Benefits calculations to the extent of the taxpayer's current year inclusion of such Subpart F income. As explained in the Prior Report, this may require the taxpayer to identify the recipient CFC and the amount of payment excluded from Base Erosion Payments and included in income.⁶²

Similarly, in the case where a payment by a U.S. corporate taxpayer results in the current year inclusion of GILTI without any offsetting foreign tax credit, we maintain our recommendation in the Prior Report that it would be reasonable to allow the taxpayer to exclude such a payment from Base Erosion payments and Base Erosion Tax Benefits calculations to the extent of such current year inclusion of GILTI. We acknowledge, however, that an exclusion for GILTI raises several additional considerations compared to an exclusion for Subpart F income. One such consideration is that, unlike Subpart F income, the amount of GILTI is determined at the shareholder level through the aggregation of the shareholder's pro rata share of CFC-level items such as each CFC's “tested loss” or “tested income.”⁶³ As a result, it may be difficult to attribute GILTI inclusions to particular payments to a CFC, when, for example, the same payment may result in different GILTI inclusions in different years. Thus, it may be appropriate for final regulations to provide that an exclusion for certain payments as discussed above is only available if the payee CFC specifically reports the amount of income that is attributable to such payments and the amount of the inclusions of the applicable U.S. shareholders that is attributable to such income. Another complication arises because GILTI is generally subject to a deduction under Section 250 with respect to certain taxpayers. We maintain our recommendation in the Prior Report that any exception for payments giving rise to GILTI that applies at the U.S. shareholder level should be reduced to the U.S. shareholder's net effective inclusion (i.e., net of the Section 250 deduction).

Third, in the case where foreign tax credits are available to offset current year inclusions of Subpart F income or GILTI that arose as a result of a U.S. person's payment to a CFC, we stated in the Prior Report that no adjustment should be necessary for foreign tax credits associated with such income, because the Subpart F income or GILTI inclusion are included in the Modified Taxable Income of the U.S. shareholder of the CFC and the BEAT is computed without regard to foreign tax credits. In other words, the income will be included properly for BEAT purposes in the hands of the U.S. shareholder of the CFC, and any foreign tax credits associated with that income should be subject to the same treatment for purposes of computing Modified Taxable Income as any other tax credits of the U.S. shareholder.

10. Payments resulting in recognized losses

The Preamble states that “a payment to a foreign related party resulting in a recognized loss” is a Base Erosion Payment, including, for example, “a loss recognized on the transfer of property to a foreign related party.”⁶⁴

We acknowledge that treating any loss recognized in connection with a payment to a foreign related party as giving rise to a Base Erosion Payment is conceptually consistent with the treatment of other payments as Base Erosion Payments to the extent that such payments represent a deductible amount to the taxpayer. However, we believe that where a taxpayer has suffered an economic loss with respect to property, that loss should not be subject to Section 59A. If the loss has been suffered, it does not appear to matter to whom the asset is transferred. Section 267 may defer the loss for related parties, and we believe that that is sufficient protection.⁶⁵

In addition, we note that because a seller's amount realized with respect to a disposition of property is already governed by general tax principles, including Section 482, the amount of a recognized loss should be presumed to be bona fide. Because the cash or property received by the taxpayer in exchange for the property thus has value and income-producing potential commensurate with the property disposed of, it is not clear that such dispositions of property should be treated as giving rise to Base Erosion Payments. Elsewhere in the Preamble and the Proposed Regulations, as well as under Section 59A, it is the movement of depreciable property into the U.S. tax base that is treated as giving rise to potential base erosion; the recognition of a bona fide loss in connection with the transfer of such property out of the U.S. tax base does not necessarily warrant the same treatment.

From a statutory perspective, the “payment” in this case must be the loss property, and the acquired asset or service or other benefit is cash. Such a characterization seems in tension with the statute. Furthermore, even if the property is payment, in order for a transfer of property to constitute a Base Erosion Payment under Section 59A(d)(1), the transfer of such property must be an “amount paid or accrued by the taxpayer to a foreign person which is a related party of the taxpayer and with respect to which a deduction is allowable.” Even though a recognized loss may represent an amount of loss being “accrued” by a taxpayer, it is not clear to us that such amount is accrued “to a foreign person,” because the only value transferred to a foreign person is the value of the property at the time of the transfer (i.e., after the taxpayer's loss has been taken into account). In other words, it is not clear to us that the loss is “with respect to” the “amount paid or accrued,” as the amount paid or accrued is arguably the value of the property transferred and the loss is the excess of the taxpayer's basis over such amount. This standard is in contrast to the statutory rule that governs the amounts that may be included in the denominator of the Base Erosion Percentage, because such amounts may include “the aggregate amount of the deductions . . . allowable to the taxpayer” for the taxable year.⁶⁶

We do appreciate a counterargument, though, to our view that recognized losses on sales to foreign related parties should not be within the ambit of Section 59A. Despite the application of Section 482, the amount realized on such a sale could be viewed as artificial as it is set by related parties. Thus, the amount of the loss suffered by the seller could be viewed as questionable in some circumstances. For example, suppose the seller has a basis of $100 in an asset, which it sells to a foreign related person for $80, recognizing a $20 loss (which may be deferred under Section 267). Suppose the foreign related person sells the asset for $100. A question could be raised as to whether the value of $80 ascribed to the asset by the related parties was correct. Section 482 monitors this issue, but one could argue that it is also the province of Section 59A.

To the extent that final regulations include a rule treating losses as a Base Erosion Payment, it may be helpful for the final regulations to include illustrative examples and to clarify that a loss recognized on the transfer of property to a foreign related party only gives rise to a Base Erosion Payment if the loss is utilized by the taxpayer (such that, for example, a loss that is deferred pursuant to Section 267(f)(2) does not give rise to a Base Erosion Payment while the loss is deferred). In addition, the Proposed Regulations should clarify to what extent a taxpayer is treated as recognizing losses that give rise to Base Erosion Payments where the taxpayer recognizes losses on transfers of property both to foreign related parties and to parties that are not foreign related parties, but the taxpayer's overall deduction for losses is subject to limitation under another provision of the Code (for example, the limitation on capital losses of a corporation under Section 1211(a)). The treatment in Proposed Regulations Section 1.59A-3(c)(4)(ii)(B) of interest deductions that are not limited by Section 163(j) may suggest how to order the relevant deductions for losses in the aforementioned situation.

11. Mark-to-market transactions

Proposed Regulations Section 1.59A-3(b)(2)(iii) states that “[f]or any transaction with respect to which the taxpayer applies the mark-to-market method of accounting for federal income tax purposes,” the Mark-to-Market Rule “applies to determine the amount of base erosion payment.” This language might be read to suggest that mark-to-market losses may be treated as Base Erosion Payments. The only category of Base Erosion Payment that is potentially relevant in the case of mark-to-market losses is that applicable to deductible amounts paid or accrued by the taxpayer to a foreign related party. However, a mark-to-market loss is treated under Section 475 as arising from a deemed sale or other disposition of the relevant security to an “unrelated person.”⁶⁷ Because a mark-to-market loss is treated as arising from a sale to an unrelated person, it is not clear why Proposed Regulations Section 1.59A-3(b)(2)(iii) would cross-reference the Mark-to-Market Rule in determining the amount of Base Erosion Payments, unless Treasury's intention is to treat an amount that otherwise would not be considered a Base Erosion Payment under the general definition of that term to be considered a Base Erosion Payment simply by virtue of the fact that the amount was derived from a transaction that is marked to market. It is not apparent from a policy perspective why that would be the case. Further, as described in Part III.C.10 above, we are recommending that a loss recognized on an actual sale of property to a foreign related party not be considered a Base Erosion Payment; mark-to-market losses generally should be treated in the same manner as losses on actual sales of property for this purpose, such that we recommend that a mark-to-market loss should not be treated as a Base Erosion Payment even if the loss were treated as arising from a sale to a foreign related party.

We also note that most transactions giving rise to mark-to-market losses would not result in Base Erosion Payments, because such transactions are either (i) derivatives eligible for the exclusion from Base Erosion Payment treatment for “qualified derivative payments” as defined in Section 59A(h)(2) (a “Qualified Derivative Payment”) or (ii) the ownership of physical securities (such that changes in value giving rise to mark-to-market losses generally do not involve related counterparties). Under the Proposed Regulations as drafted, the one category of related party transactions that could give rise to mark-to-market losses not eligible for the Qualified Derivative Payment exclusion is securities lending transactions. For the reasons discussed in Part III.F.1, below, we recommend that securities lending transactions generally be considered derivatives eligible for the Qualified Derivative Payment exclusion, in which case deductions (including mark-to-market losses) arising from such transactions would not be treated as Base Erosion Payments. In this regard, it would seem inappropriate for mark-to-market losses on securities lending transactions to give rise to Base Erosion Payments when mark-to-market losses on holding the underlying physical securities do not give rise to Base Erosion Payments.

For the reasons set forth above, we recommend that the rule in Proposed Regulations Section 1.59A-3(b)(2)(iii) be withdrawn. If Proposed Regulations Section 1.59A-3(b)(2)(iii) is not withdrawn, we recommend that the government explain how that rule coordinates with the general treatment of mark-to-market losses as being recognized in transactions with unrelated parties.

D. Proposed Regulations Section 1.59A-4

1. Modified taxable income

Section 59A(c) defines “modified taxable income” (“Modified Taxable Income”) to be the taxable income of the taxpayer computed under Chapter 1 of the Code but “determined without regard to” (i) any base erosion tax benefit with respect to any Base Erosion Payment and (ii) the Base Erosion Percentage of any net operating loss (“NOL”) deduction allowed under Section 172 for the taxable year ((i) and (ii), collectively, the “BEAT Deductions”). As explained in the Prior Report, there are generally two possible approaches to interpreting the requirement that Modified Taxable Income be determined “without regard to” the BEAT Deductions: the BEAT Deductions could merely be added back to taxable income or taxable income could be recalculated as though the BEAT Deductions did not exist. In defining Modified Taxable Income, Proposed Regulations Section 1.59A-4 provides that the relevant computation is performed on an add-back basis, rather than on a recomputation basis. The Preamble welcomes comments on the approach adopted by the Proposed Regulations and the practical effects of a recomputation-based approach.⁶⁸

We set forth our views on this subject in detail in the Prior Report, and accordingly we suggest that Treasury consider the relevant discussion on pages 35–40 of the Prior Report. In addition, regardless of the approach that is adopted in final regulations, we believe that it would be helpful for Treasury to provide a more detailed explanation of its decision.

2. Pre-2018 disallowed interest

The Proposed Regulations provide that business interest expense that is not allowed as a deduction under Section 163(j)(1), and that resulted from a payment or accrual to a foreign related party that is carried forward from a taxable year beginning before January 1, 2018, is not a Base Erosion Payment.⁶⁹ The Preamble notes that this treatment is consistent with excluding interest paid or accrued before January 1, 2018 from treatment as a Base Erosion Payment.⁷⁰ We agree with this conclusion, which is consistent with our view as described in the Prior Report.⁷¹

3. Vintage-year approach to NOLs

The Proposed Regulations provide that for purposes of adding the Base Erosion Percentage of any NOL deduction back to taxable income in order to compute Modified Taxable Income, the appropriate Base Erosion Percentage to use is that of the year in which the NOL arose (the “Vintage Year”),⁷² rather than the year in which the NOL is utilized. The Preamble explains that the Vintage Year approach is appropriate because the Base Erosion Percentage from the Vintage Year reflects the amount of the NOL that was composed of Base Erosion Payments. In addition, the Preamble notes that because the vintage year Base Erosion Percentage is a fixed percentage, taxpayers will have greater certainty with respect to the amount of an NOL that will be added back in years after the NOL arises. As we explained in the Prior Report, we agree that the Vintage Year approach is appropriate.⁷³

We note that because the relevant Base Erosion Percentage in the Vintage Year is the Base Erosion Percentage for the Aggregate Group that is used to determine whether the taxpayer is an Applicable Taxpayer (rather than a separate determination of the Base Erosion Percentage computed solely by reference to the single taxpayer or its consolidated group),⁷⁴ it is possible that the Base Erosion Percentage that is used could take into account deductions of U.S. branches of foreign corporations that are not otherwise included in a taxpayer's return (for example, in the case of a U.S. corporation that is under common control with a foreign corporation that has a U.S. branch). It thus could be the case that a branch incurred significant losses in the Vintage Year even though the relevant U.S. corporation did not incur significant losses in the Vintage Year, such that the Aggregate Group's Vintage Year Base Erosion Percentage could be lower than the U.S. corporation's own Vintage Year Base Erosion Percentage would have been. Although Treasury's approach to this question is mechanically straightforward, we question whether a more precise determination of the taxpayer's Vintage Year Base Erosion Percentage may be appropriate.

E. Proposed Regulations Section 1.59A-5

1. Application of Section 15

Section 59A(b)(1) provides that, with certain exceptions, the “base erosion minimum tax amount” with respect to an applicable taxpayer for any taxable year is the excess of (A) an amount equal to “10 percent (5 percent in the case of taxable years beginning in calendar year 2018)” (which this discussion refers to as the “BEAT Tax Rate”)⁷⁵ of the modified taxable income of such taxpayer for the taxable year over (B) the regular tax liability of the taxpayer for the taxable year, with certain reductions for tax credits.

In the case of an Applicable Taxpayer with a calendar taxable year, the BEAT Tax Rate would clearly be 5% for the first full year, both under the statute and the Proposed Regulations. This is because the Applicable Taxpayer's taxable year “beginning in calendar year 2018” starts on January 1, 2018 and would be the first year it is potentially subject to BEAT, with the BEAT Tax Rate being 5%. For taxable years thereafter, the rate would be 10% (until the BEAT Tax Rate increases to 12.5% for the Applicable Taxpayer's taxable year beginning January 1, 2026⁷⁶). However, with respect to the taxable year “beginning in calendar year 2018” of an Applicable Taxpayer with a fiscal, rather than a calendar, taxable year, Proposed Regulations Section 1.59A-5 takes the position that Section 15 applies such that the Applicable Taxpayer will have a blended BEAT Tax Rate. Specifically, Proposed Regulations Section 1.59A-5(c)(1) provides that the BEAT Tax Rate is (i) 5% for taxable years “beginning in calendar year 2018,” and (ii) 10% for taxable years beginning after December 31, 2018 through taxable years beginning before January 1, 2026. Proposed Regulations Section 1.59A-5(c)(3) then provides that, while Section 15 does not apply to any taxable year that includes January 1, 2018, “[f]or a taxpayer using a taxable year other than the calendar year,” Section 15 applies to any taxable year beginning after January 1, 2018.

Section 15(a) provides that “[i]f any rate of tax imposed by [Chapter 1 of the Code] changes, and if the taxable year includes the effective date of the change (unless that date is the first day of the taxable year),” then (i) tentative taxes are computed by applying the rate for the period before the effective date of the change and the rate for the period on and after that date, to the taxable income for the entire taxable year; and (ii) the tax for such taxable year is the sum of the proportion of each tentative tax which the number of days in each period bears to the number of days in the entire taxable year. Put more simply, if Section 15(a) applies, then a taxpayer's tax for the taxable year in which a rate of tax changes during the middle of the year is determined using a blended rate of tax that is based on the number of days in the taxable year before and after the change. Section 15(c) provides rules for determining the “effective date” of the change in the rate of tax:

The statement in Proposed Regulations Section 1.59A-5(c)(3) that for a taxpayer using a fiscal year, “section 15 applies to any taxable year beginning after January 1, 2018” appears to be premised on two subsidiary conclusions: (1) there is a change in the BEAT Tax Rate (from 5% to 10%) and (2) the effective date of this change is January 1, 2019. Although (1) is indisputably correct, we question whether (2) is correct. Rather, the statutory language of Section 59A(b)(1)(A) — “5 percent in the case of taxable years beginning in calendar year 2018 — implies that the 5% BEAT Tax Rate applies for the entirety of a fiscal taxpayer's taxable year that begins in calendar year 2018. Note that rather than specifying an increase in the BEAT Tax rate, the statute sets the rate at 10% and then carves out a 5% rate for taxable years beginning in 2018.⁷⁷ The most natural reading of Section 59A(b)(1)(A) is that Section 15 does not apply at all (and does not need to apply) with respect to any taxpayer, as there is no “effective date,” within the meaning of Section 15, of the change in the BEAT Tax Rate: Section 59A(b)(1)(A) prescribes a 5% rate for a specified taxable year, and does not anywhere refer to a “certain date” that can be properly characterized as an “effective date” for purposes of Section 15. Alternatively, one could read Section 59A(b)(1)(A) as providing that the “effective date” of the change in the BEAT Tax Rate to 10% with respect to any given taxpayer is the first day of that taxpayer's taxable year that begins in calendar year 2019 (i.e., the first day of its taxable year that begins after the end of its taxable year date that begins in calendar year 2018).⁷⁸ But the result under either interpretation is that the BEAT Tax Rate for a fiscal year taxpayer for its taxable year that begins in calendar year 2018 is 5% for the entire taxable year, and Treasury should so provide in final regulations.

Section 15 itself supports this conclusion. As noted above, Congress provided specific rules for determining the effective date of a change in tax rates in Section 15(c) in a case where a change in a tax rate was to be effective for particular taxable years. Those rules appear to apply only if the relevant statutory language that implements the change contains the precise language set off in quotation marks in Section 15(c)(1) and (2) — “beginning after,” “ending after,” or “beginning on or after” — in reference to a “certain date.” Section 59A(b)(1)(A) does not use any of this language (it uses the phrase “beginning in calendar year 2018”), and it does not refer to a “certain date” (it refers to “calendar year 2018”), for the change in the BEAT Tax Rate from 5% to 10%. If Congress had intended for Section 15 to apply to the change in the BEAT Tax Rate from 5% to 10%, it could have used the prescribed form of words in Section 15(c). Congress did not do so.

It is important to note that, elsewhere in the TCJA, Congress did in fact use the prescribed form of language to bring Section 15 into play in other provisions in which it changed a rate of tax — even within the BEAT itself. For example, section 13001(a) of the TCJA amended Section 11(b) to change the rates of federal corporate income tax imposed by Section 11(a) from the pre-TCJA rates to 21%. Section 13001(c)(1) provides generally that “the amendment[ ] made by [section 13001(a)] shall apply to taxable years beginning after December 31, 2017.” This is the form of words  — using the phrase “beginning after” and specifying a “certain date” — prescribed by Section 15(c), such that Section 15(a) applies, as the IRS has properly recognized.⁷⁹ Even more directly relevant, Section 59A(b)(2) provides for an increase in the BEAT Tax Rate from 10% to 12.5% “[i]n the case of any taxable year beginning after December 31, 2025.” Again, this is the form of words to which Section 15(c), and thus Section 15(a), apply. The fact that Congress, even within the BEAT itself, used the specific language prescribed in Section 15(c), but pointedly did not do so in Section 59A(b)(1)(A), suggests that Congress did not intend Section 15 to apply for purposes of the change in the BEAT Tax Rate from 5% to 10%.

Finally, the legislative history to Section 59A arguably supports the view that Section 15 does not apply to the change in the BEAT Tax Rate from 5% to 10%. In the text of the Conference Report, the conferees refer to the 10% BEAT Tax Rate, and then in a footnote state that “[a] 5 percent rate applies for one year for base erosion payments paid or accrued in taxable years beginning after December 31, 2017.” The footnote's reference to “for one year” supports the view that a blended Section 15 rate was not intended. It is arguable, on the other hand, that the reference to “one year” was a statement of the general impact, true for calendar year taxpayers, and not necessarily meant to capture the impact for all taxpayers, but that reading would in turn raise the question what “taxable years” the footnote refers to (i.e., why was the plural “years” used if only the calendar year was meant to be referred to?). It is also arguably notable that the footnote, unlike the statute, uses the language prescribed in Section 15(c) — “taxable years beginning after December 31, 2017” — but this is arguably not significant as December 31, 2017 is not a relevant date for the change in BEAT Tax Rate from 5% to 10%.

We acknowledge that the distinction drawn between the language used in Section 59A and the language set off in quotation marks in Section 15 is arguably formalistic, and we do not rule out the possibility that Section 15(a) could apply in the case of a change in the rate of tax with respect to which Congress specified an effective date, in relation to a taxable year, that did not use the precise form of words specified in Section 15(c). However, in this case, the fact that Congress did not use in Section 59A(b)(1)(A) the precise form of words specified in Section 15(c) (despite using the precise language later in the same Code section), and the statement in the legislative history cause us to believe that Treasury should not try to bring Section 59A(b)(1)(A) within the scope of Section 15 — in essence, by rewriting Section 59A(b)(1)(A) to include both the prescribed form of words in Section 15(c) and to refer to a specific date (e.g., “5 percent in the case of taxable years beginning on or after January 1, 2018”) — as opposed to simply giving effect to the words that Congress wrote in Section 59A(b)(1)(A).

F. Proposed Regulations Section 1.59A-6

1. Qualified derivative payments

Proposed Regulations Section 1.59A-3(b)(3)(ii) provides that the term Base Erosion Payment generally excludes any “qualified derivative payment” as defined in Section 59A(h)(2) (a “Qualified Derivative Payment ”).⁸⁰ Proposed Regulations Section 1.59A-6(b)(1) defines a Qualified Derivative Payment to be a payment made by a taxpayer to a foreign related party pursuant to a derivative with respect to which the taxpayer recognizes gain or loss as if the derivative were sold for its fair market value on the last business day of the taxable year (and any additional times as required by the Code or the taxpayer's method of accounting); treats any gain or loss so recognized as ordinary; and treats the character of all items of income, deduction, gain or loss with respect to a payment pursuant to the derivative as ordinary. Proposed Regulations Section 1.59A-6(d) defines “derivative” for this purpose and contains an exception whereby “a derivative contract does not include any securities lending transaction, sale-repurchase transaction, or substantially similar transaction.”⁸¹ The Preamble explains that any payment that would be treated as a Base Erosion Payment if it were not made pursuant to a derivative, such as a payment of interest on a debt instrument, is explicitly excluded from Qualified Derivative Payment status under Section 59A(h)(3) and (4).

For the reasons discussed below, we believe that (i) repurchase premium and rebate interest amounts paid with respect to securities lending transactions and sale-repurchase transactions (also known as “repos”) should be excluded from the definition of Qualified Derivative Payment and (ii) securities loans should be treated as “derivatives” for purposes of Section 59A that accordingly may give rise to Qualified Derivative Payments.

For example, consider a transaction in which a taxpayer owns a security and either enters into a repo transaction to sell and repurchase the security or otherwise simply lends the security to another person. The taxpayer receives either a cash purchase price (in the case of the repo) or cash collateral (in the case of the security loan), and the taxpayer pays either repurchase premium (in the case of the repo) or rebate on the cash amount (in the case of the security loan), both of which amounts should be treated as interest for tax purposes. In either case, it seems that regardless of whether the transaction is a “derivative,” the payments treated as interest should not be Qualified Derivative Payments, by application of Section 59A(h)(3)(A) (i.e., a payment, including interest, that would be treated as a Base Erosion Payment if it were not made pursuant to a derivative). To this extent, the statement in the Preamble that “sale-repurchase transactions and securities lending transactions are economically similar to each other” is accurate as a policy matter and as a technical matter. As we believe these interest payments are not Qualified Derivative Payments under the statutory language, we believe that the Proposed Regulations should clarify that Section 59A(h)(3)(A) applies to prevent the Qualified Derivative Payment exclusion from applying to interest on a repo or cash collateral posted in respect of a securities loan.

The rule in the Proposed Regulations providing that securities lending and sale-repurchase transactions are not derivatives for purposes of section 59A has, however, created uncertainty about whether substitute payments that arise in connection with those transactions will be treated as Qualified Derivative Payments. Where the taxpayer either purchases and resells a security in a repo transaction or borrows a security from another person, payments made by the taxpayer may include substitute payments with respect to the underlying security and possibly fees for borrowing the security. In these cases, the appropriate treatment for repos and for transactions treated as securities loans may be different from one another.

If the transaction is a repo that is treated as debt held by the taxpayer for tax purposes, then the “substitute payment” is actually not a substitute payment — it is just a transfer to the seller of the security of an amount that is considered income earned directly by the seller for tax purposes (because the seller is viewed for tax purposes as continuing to own the security). In principle, the purchaser in such a repo transaction should have no income when the purchaser receives the distribution on the underlying security and no deduction when the purchaser transfers that amount to the seller, such that the amount of the substitute payment should not be treated as “paid or accrued” at all for purposes of Section 59A where the substitute payment is made with respect to a repo that is treated as debt for tax purposes.

By contrast, in the case of a securities loan or a repo that is treated as a securities loan for tax purposes, the borrower of the security has income from any payment received on the security and a deduction with respect to any substitute payment made to the security lender.

There has been disagreement among practitioners and taxpayers as to whether substitute payments made to a related party qualify as Qualified Derivative Payments under the Proposed Regulations. We recommend that Treasury revise Proposed Regulations Section 1.59A-6(d) to clarify that substitute payments on securities loans (and transactions treated as securities loans) are Qualified Derivative Payments because substitute payments are inherently derivative payments and would not be treated as Base Erosion Payments (and would not be made at all) if not made pursuant to a derivative. Such payments are necessarily part of the derivative component, rather than the non-derivative component, of a transaction. As a result, we recommend that Treasury withdraw the rule excluding securities lending and sale-repurchase transactions from the definition of derivative (and instead address the concern discussed above regarding repurchase premium and rebate interest amounts paid with respect to securities lending transactions and sale-repurchase transactions in a different manner). In this regard, with respect to securities loans, we believe it is significant that:

• When a taxpayer acquires securities with an obligation to return those securities and makes substitute payments, the taxpayer has posted cash collateral to the counterparty but has not received cash. This transaction is not a cash borrowing-type transaction with respect to the taxpayer (the specific concern expressed in the Preamble when describing why securities lending transactions were excluded from the definition of derivative). Moreover, economically, the taxpayer has not obtained additional resources, because the cash posted by the taxpayer has a value equal to or greater than the value of the security borrowed by the taxpayer.⁸² Thus, even if the taxpayer sells the borrowed securities, the taxpayer has not increased the taxpayer's net cash position.

• The taxpayer is also not in the economically equivalent position to a borrower of cash; the taxpayer is exposed to risk with respect to changes in value of the security. For example, if the taxpayer uses the borrowed security to carry out a short sale, the taxpayer is fully exposed to changes in value of the security, and the obligation to make substitute payments represents a part of the taxpayer's exposure to the return on the security. Such an arrangement is not the equivalent of a debt instrument.⁸³

• As a statutory matter, a securities borrowing fits within the definition of the term “derivative” as provided in Section 59A(h)(4)(A) as either a “short position” or other contract the value of which is determined by reference to the value of stock or indebtedness, and a securities loan is also a derivative in the ordinary sense of the word and serves the same functions as other types of derivatives.

While much of this analysis applies even in the case of substitute payments with respect to an uncollateralized securities borrowing of relatively risk-free debt, such transactions raise additional concerns. For example, assume that a taxpayer borrows short-term Treasury bills and posts no collateral; the taxpayer immediately sells the Treasury bills for cash; and, after 3 months (during which time the taxpayer pays any coupon on the Treasury bills to the lender as well as a borrowing fee reflecting the risk the lender has taken by lending on an uncollateralized basis), the taxpayer buys even shorter-term Treasury bills and redelivers them to the lender. Such a transaction may be viewed as economically equivalent to borrowing money, with the taxpayer exposed to the relatively small risk of changes in the value of the Treasury bills. In such case, it may be appropriate to treat payments made by the securities borrower (and in particular the borrowing fee paid by the securities borrower that reflects the credit risk of the securities borrower) as ineligible for the Qualified Derivative Payment exclusion, as these payments bear a strong resemblance to interest. In any event, we believe that such a rule should not alter the general treatment that we recommend of substitute payments as Qualified Derivative Payments.⁸⁴

We request clarification regarding the application of the definition of Qualified Derivative Payment in respect of the types of transactions discussed above.

G. Proposed Regulations Section 1.59A-7

1. Aggregate approach to partnerships

Proposed Regulations Section 1.59A-7(b)(1) provides that Section 59A is applied at the partner level. The Preamble explains that the Proposed Regulations “generally apply an aggregate approach in conjunction with the gross receipts test for evaluating whether a corporation is an applicable taxpayer and in addressing the treatment of payments made by a partnership or received by a partnership for purposes of section 59A.”⁸⁵ Thus, payments made by a partnership are generally treated as paid or accrued by each partner based on the partner's distributive share of items of deduction of the partnership, and payments made to a partnership are generally treated as paid or accrued to each partner based on the partner's distributive share of items of income or gain of the partnership.⁸⁶

As discussed in the Prior Report, we believe that treating a partnership as an aggregate of its partners is consistent with the purposes of Section 59A. However, the language in the Preamble stating that a “partnership is treated as acquiring . . . property in exchange for an interest in the partnership under section 721” is misguided. To the extent that there is a base eroding transaction when property is contributed to a partnership under Section 721, it is the acquisition of a proportionate share of new property by the existing partners from a contributing partner, rather than an acquisition by the partnership in exchange for issuing its own interest. Further, in such a transaction, the existing partners would have paid for the new property with a proportionate share of the existing assets of the partnership. In that case, the contributing partner could equally be acquiring a proportionate share of the partnership's existing assets. In the case of a Section 721 contribution, relatedness should be tested at the level of the partners, and base erosion amounts can be passed through based upon allocations of depreciation deductions. The language in the Preamble relating to an acquisition in exchange for partnership interests appears to us to be misleading and in need of clarification.

2. De minimis exception

Proposed Regulations Section 1.59A-7(b)(4) provides that for purposes of determining a partner's Base Erosion Tax Benefits, a partner does not take into account its distributive share of any partnership amount of Base Erosion Tax Benefits for the taxable year if the partner's interest in the partnership represents less than ten percent of the capital and profits of the partnership at all times during the taxable year; the partner is allocated less than ten percent of each partnership item of income, gain, loss, deduction and credit for the taxable year; and the partner's interest in the partnership has a fair market value of less than $25 million on the last day of the partner's taxable year, determined using a reasonable method. We support the inclusion of this exception in final regulations.

H. Overall approach

The statutory language for Section 59A, a statute without precedent, emerged late in the drafting process for the TCJA, primarily from the Senate Finance Committee staff. We observed in the Prior Report that Section 59A contained, in our view, certain wording choices that appeared inconsistent with the statute's perceived purposes. Among the more obvious examples of this phenomenon was that the concepts underlying the application of the Gross Receipts Test and the Base Erosion Percentage Test and the definition of Base Erosion Payment needed to be consistently interpreted. And yet, the effectively connected income limitation in Section 59A(e)(2) applied only to the Gross Receipts Test, and the aggregation rule of Section 59A(e)(3) applied only to the Gross Receipts Test and the Base Erosion Percentage Test. The Proposed Regulations perform a commendable service in properly interpreting these provisions to give effect to legislative purpose. As we said above, we agree and appreciate this as the correct approach and correct interpretation of the statutory language. As another example, as discussed above, the Mark-to-Market Rule appropriately eliminates the double-counting of deductions that represent a single economic loss for purposes of the Base Erosion Percentage, even though Treasury elsewhere interprets Section 59A to require that the gross amount of deductible payments be taken into account.⁸⁷

In other areas of the Proposed Regulations, however, Treasury's interpretations appear to be guided primarily by the words of the statute, without reference to the broader principles of reducing erosion of the U.S. tax base. For example, the Proposed Regulations interpret the add-back of net operating losses to Modified Taxable Income pursuant to Section 59A(c)(1)(B) as being limited to the Base Erosion Percentage of the net operating loss derived not with reference to the actual taxpayer or consolidated return but rather to the Base Erosion Percentage of the Applicable Taxpayer. As discussed above, the definition of Applicable Taxpayer in the Proposed Regulations often includes the U.S. branches of a foreign corporation whose financial results may be very different from, and not included in, the results of the related U.S. taxpayer or consolidated return members. This approach could produce planning opportunities that might dilute the effectiveness of the statute. In addition, as discussed above, Section 59A(c)(2)(C)(i) specifically excludes from the definition of Base Erosion Tax Benefit any payments that are subject to U.S. withholding tax pursuant to Sections 871 or 881. However, under the Proposed Regulations, payments of Excess Interest that are subject to U.S. withholding tax under Section 884(f)(1)(B) are not eligible for the same exclusion.⁸⁸