IT Council Suggests Changes to Proposed BEAT Regs

February 19, 2019

CC:PA:LPD:PR (REG-104259-18)
Room 5203
Internal Revenue Service
P.O. Box 7604
Ben Franklin Station
Washington, D.C. 20044

Dear Sir or Madam:

The Information Technology Industry Council (ITI) appreciates the opportunity to comment on proposed regulations issued by the U.S. Department of the Treasury and the Internal Revenue Service providing guidance related to the implementation of the Base Erosion and Anti-Abuse Tax (“BEAT”), which was created by the Tax Cuts and Jobs Act (“TCJA”).

ITI represents the global voice of the high-tech community, advocating for policies that advance U.S. leadership in technology, promote innovation, open access to new and emerging markets, protect and enhance consumer choice, and foster increased global competition.¹ Our members are 64 high-tech and tech-enabled companies, including wireless and wireline network equipment providers, computer hardware and software companies, Internet and digital service providers, mobile computing and communications device manufacturers, consumer electronics companies, and network security providers. Many of our members are headquartered or significantly invested in the United States, and their investments have not only propelled economic growth and innovation across the country, but have also launched new global industries.

At ITI, we have long asserted the importance of modernizing and reforming the U.S. tax code to improve the competitiveness of the U.S. economy. While there was some difficulty in comprehensively developing comments given the short time frame to do so and the other proposed regulations also outstanding — which have potentially significant interactions with these proposed rules as well — we hope that the following issues can be addressed as the regulations are finalized.

I. Services Cost Method Exception

The proposed regulations clarify that where the total amount paid for services includes a markup, the cost component is excluded from the BEAT definition of a “base erosion payment” for services that meet the requirements of the Services Cost Method in Treas. Reg. §1.482-9, modified to not apply the “business judgment rule” criteria. Accordingly, only the markup is counted as a “base erosion payment” for purposes of the BEAT. The proposed regulations also allow taxpayers not to separate the cost and markup components of charges into separate accounts, which ensures taxpayers need not take on significant administrative and cost burdens to enjoy the benefit of this exception.

We appreciate the inclusion of this exception and believe the final regulations should affirm this treatment of certain services. However, the fact that payments for other services, including research and development among other business activities, may not be bifurcated and are thus fully subject to the base erosion tax presents real challenges and concerns for our members. It also creates an incentive to move intellectual property (“IP”) and business activities offshore, and a disincentive for companies that have previously done so to repatriate their IP to the United States, which is directly in opposition to what the Tax Cuts and Jobs Act hoped to accomplish. Given changes in international tax norms due to the OECD's Base Erosion and Profit Shifting (BEPS) Action Plan, the stakes are much higher than simply the loss of U.S. tax base if IP is held overseas — companies holding IP outside the U.S. will also need to create DEMPE substance where those IP rights are owned, meaning that managerial jobs will be created outside the U.S. where the IP rights are held or transferred from the U.S. to those foreign locations.

The goals of the TCJA could be better accomplished by applying the services exception to the cost element of any service fee. In limiting the services exception to the cost element, no U.S. tax base erosion results from applying the exception to an expanded range of services. While legislation may be required to fully align an expansion of the SCM exception included in the proposed regulations, we urge Treasury to explore what other options may exist within its legal authority to provide relief for payments for other types of services, including R&D and other business activities.

II. Blended Rate

In §1.59A-5(b)(3), the proposed regulations provide that for taxable years beginning after January 1, 2018, §15 applies to fiscal year taxpayers, requiring a blended rate for tax years beginning in 2018 that takes into account the change in the BEAT rate from 5 percent to 10 percent. For instance, an 11/30 taxpayer would have a blended BEAT rate of 9.58 percent for the tax year ending 11/30/19. This appears inconsistent with the statutory language and past application of §15.

Normally, §15 applies in the case of a change in the rate of tax during the tax year. It is not clear that it should apply in the case of a tax which is first effective in such tax year — in these cases, there has been no “change” because the tax did not previously exist. Furthermore, while §15(b) clearly treats a repeal of a tax as a change to a rate of zero, there is no comparable rule in §15 for the introduction of a new tax.

Moreover, §15(c)(1) specifically provides that if the statute specifies a rate change for taxable years “beginning after” or “ending after” a certain date, the following day is considered the effective date of the change. The language contained in §59A(b)(1)(A) specifying the 5 percent rate provides that the rate is 10 percent with the exception of “5 percent in the case of taxable years beginning in calendar year 2018.” Notably, this language neither uses the “beginning after” language, nor specifies that the change will occur on a “certain date” — meaning that §15 is specifically not invoked, as §59A(b)(1)(A) does not meet the plain language of §15(c)(1). Indeed, for purposes of §59A, language was chosen by Congress that does not invoke §15 until the rate changes from 10 percent to 12.5 percent in taxable years beginning “on or after” December 31, 2025 (which we believe would trigger §15 at that time).

Additionally, from a policy perspective, applying §15 to provide for increased rates for fiscal year taxpayers misaligns the Global Intangible Low-Taxed Income (“GILTI”), Foreign-Derived Intangible Income (“FDII”), and BEAT regimes, which we believe Congress intended to have function as a cohesive unit. Prematurely increasing the BEAT rate on fiscal year taxpayers does not appear to serve that goal.

Accordingly, we believe that the blended BEAT rate for fiscal year taxpayers should be eliminated in the final regulations, as it is not aligned with either the clear statutory language of §59A or the intended operation of §15.

III. Definition of a “Base Erosion Payment” and “Base Erosion Tax Benefit”

A. Nonrecognition Transactions

Under §59A, an “amount paid or accrued” to a foreign related party for the “purchase” of property constitutes a “base erosion payment.”

The regulations take a broad view of what constitutes a “base erosion payment.” The proposed regulations (§1.59A-3(b)(2)(i)) provide that the types of consideration that may be treated as an “amount paid or accrued” include not only payments made in cash and property, but also stock or assumption of a liability, which can often arise in the context of certain nonrecognition transactions. Additionally, any amortization or depreciation deduction with respect to a base erosion payment gives rise to a base erosion tax benefit, which can cause the taxpayer to incur BEAT liability, and can arise in the context of nonrecognition transactions, including liquidations and reorganizations. This is the case even though there may be little or no correlation between the value or cost of the stock issued or extinguished and the depreciation or amortization deduction, which is a function of adjusted tax basis on the books of the transferor.

For instance, if a domestic corporation wholly owns a foreign corporation and the foreign corporation liquidates pursuant to Section 332, existing regulations provide that the assets of the liquidating foreign corporation are treated as full payment in exchange for the stock of the liquidating corporation. The proposed BEAT regulations, according to the preamble, would treat that deemed exchange of the stock of the liquidating corporation as a “base erosion payment” to the extent that the domestic corporation receives depreciable or amortizable property in the liquidation.

We believe that it is not clear that Treasury has the statutory authority to take such a broad view of what constitutes a “base erosion payment” such that these payments may arise in the context of a nonrecognition transaction. In particular, §59A requires an “amount paid or accrued,” and these transactions do not involve an “amount paid or accrued” under the clear statutory language. The expansive view of a “base erosion payment” taken in the proposed regulations is also overly broad, such that it would include many transactions that would not be considered abusive or base-eroding, such as an arms-length merger or acquisition where property is acquired and later needs to be moved into the United States.

Accordingly, we recommend that payments only be treated as “payments” for BEAT purposes if they arise from an actual payment or accrual. Additionally, we believe that issuance of equity should not be included as a “payment” for BEAT purposes.

We believe this is an especially sensible result in the case of §332 transactions, given that under the proposed regulations, both the amount deemed to be paid or accrued (the stock in the liquidating corporation) and the recipient of the amount (the liquidating corporation) no longer exist for tax purposes once the transaction is completed. However, we believe that no nonrecognition transactions should result in adding back amortization of acquired assets to the BEAT calculation.

Importantly, nonrecognition transactions are often used in post-acquisition restructurings to align a target's legal structure with that of the acquirer, and in other internal restructurings to better align a multinational's legal structure with its commercial operations. The nonrecognition transaction itself does not allow the recognition of a loss, so there is no tax benefit associated with the deemed “payment or accrual” in these situations, suggesting that these transactions are not eroding the U.S. tax base. Moreover, nonrecognition transactions are often used to bring intellectual property into the U.S., which makes providing relief from the outcome under the proposed regulations especially critical. By treating nonrecognition transactions as constituting BEAT payments, the regulations would provide a significant disincentive to move IP and other income-producing assets to the United States. The resulting exclusion of the related income from the U.S. tax base would far outweigh the resulting reduction of the depreciation or amortization allowed and frustrate the goals of the legislation.

Additionally, as discussed above in the context of the SCM exception, evolving international tax norms mean that more substantive functions related to intellectual property — including a number of managerial jobs — will need to be located where the intellectual property is owned. This means that creating disincentives to repatriate intellectual property will have significant consequences beyond just where income is taxed.

We also note that the proposed regulations are unclear that a deduction allowed in a taxable year beginning after December 31, 2017 is not a “base erosion tax benefit” if it relates to a nonrecognition transaction that occurred in a taxable year beginning before January 1, 2018. This appears to already be the case from the proposed regulations, but clarification would be useful in the event that our comment suggesting that nonrecognition transactions be excluded from being considered a “base erosion payment” is not accepted.

B. Outbound Transfers of Property to a Foreign Related Party at a Loss

Under the proposed regulations, an outbound transfer of property to a foreign related party at a loss can also be treated as a “base eroding payment.” The rule treats the loss as a “'payment' to a foreign related party,” when in fact a loss recognized on the transfer of property to a foreign related party would typically involve a “payment” from (not to) such party.

We believe that outbound transfers of property to foreign related parties at a loss are an overly expansive application of the BEAT rules and should be excluded. In these instances, the loss is a function of the adjusted tax basis of the asset, rather than an effort to erode the U.S. tax base.

C. §301 Transactions

The preamble indicates that no base erosion payment arises where a taxpayer that owns stock in a foreign related party receives depreciable property from that party as an in-kind distribution under §301. However, it is not sufficiently clear from the proposed regulations that this is the case.

Inbound nonrecognition transactions are U.S. tax base-enhancing in that they bring income-producing assets into the U.S. tax system with no outflow of value. Unlike a purchase, these nonrecognition transactions provide for a carryover basis and do not create a stepped-up U.S. tax basis to depreciate or amortize. The result in the proposed regulations frustrates a significant policy objective of the legislation: to encourage investment in income-producing property in the U.S. economy.

We recommend that the final regulations explicitly provide that no base erosion payment arises in a distribution to which §301 applies, including §302(d) redemptions.

D. Exempt Income

Under Prop. Reg. §1.59A-3(b)(3)(iii), if a foreign affiliate payment is subject to current U.S. taxation as effectively connected with the conduct of a trade or business in the United States, it is excluded from being considered a “base erosion payment.” Similarly, payments that are picked up as Fixed or Determinable Annual or Periodical income (“FDAP”) are also exempt under the statute from being considered “base erosion payments” because they are subject to withholding taxes (§59A(c)(2)(B)).

Payments that are picked up as Subpart F income (including as GILTI) and thus are also taxed currently as U.S. income are not similarly exempted from being considered “base erosion payments” for BEAT purposes under the proposed regulations. These payments are, by definition, not eroding the U.S. tax base, because they are subject to current U.S. taxation under the law.

Accordingly, we recommend that payments that are picked up under Subpart F — including as GILTI income — be exempted from being considered “base erosion payments.”

E. Leasing and Financing Transactions

Under §1.59A-3(b)(ii), in certain situations, depreciation deductions taken on assets being sold or leased to end users by captive finance companies are considered “base erosion tax benefits,” triggering a requirement to add these deductions back for purposes of BEAT. As a result, these deductions may not only count toward triggering BEAT liability, but are also added back for purposes of the actual BEAT calculation, contributing to increased BEAT liability for a company subject to the tax. This is the case even though these leasing or financing arrangements create U.S. taxable income in excess of any depreciation deductions enjoyed and the fact that the value of the deductions are typically passed on to customers in the form of lower financing costs.

Under certain kinds of financing arrangements, the asset is considered owned by the captive finance company and is depreciated by that company for U.S. tax purposes. In the case of a foreign-headquartered company selling or leasing products to U.S. customers, the asset is customarily purchased by the U.S.-based captive finance company at a price agreed-upon through an Advanced Pricing Agreement approved by both the IRS and the appropriate foreign government's tax authority. In turn, the product is either financed or leased to the end customer in the United States. The revenue created from the sale or leasing of the asset is attributable to the captive finance company, and therefore is U.S. taxable income taken into account on a cash basis.

For a captive finance company, there is a unique and direct correlation between the equipment being leased (and hence the depreciation deduction attributable to that equipment) and the rental income (cash-basis taxable income) generated by the lease of the equipment. In other words, it is the leased equipment itself which directly generates the taxable income of a captive finance company. Given this direct correlation that is unique to captive finance companies, the cost of the leased equipment (and hence its depreciation) is the "cost of goods" which specifically generates taxable income. On this basis, we recommend that a depreciation deduction attributable to leased equipment of a captive finance company be constituted as a "reduction of income" (or "cost of goods sold") for purposes of BEAT and hence be excluded from the BEAT addback.

IV. Optionality of Deductions

Under the proposed regulations, it is not clear whether a taxpayer has the ability to decline to take certain deductions and thereby have those deductions excluded from the calculation of the base erosion percentage. In general, most advisors agree that deductions are effectively optional in that taxpayers can choose not to take them. However, it is not clear from the regulations whether a taxpayer declining to take certain deductions also excludes those deductions from the base erosion percentage computation. Given the cliff nature of BEAT, it would provide taxpayers with more certainty if the final regulations confirmed that to the extent a taxpayer elects not to take a deduction, that deduction is not included in the “base erosion percentage” calculation.

Accordingly, we recommend that the final regulations clarify that to the extent that a taxpayer declines to take deductions that would otherwise be considered “base erosion tax benefits,” those deductions are not included in the calculation of the “base erosion percentage” for purposes of determining BEAT liability.

We appreciate the opportunity to provide feedback on these proposed regulations and look forward to answering any additional questions to the extent helpful.

Sincerely,

Sarah Shive
Senior Director, Government Affairs

Information Technology Industry Council (ITI)
1101 K Street NW, Suite 610
Washington, DC 20005
202-626-5745
www.itic.org