Firm Comments on Applying BEAT to U.S. Equipment Manufacturers

March 28, 2019

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

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

Michael J. Desmond, Esq.
Chief Counsel
Internal Revenue Service
1111 Constitution Avenue NW
Washington, DC 20224

Re: Follow-up to Comments on Applicability of BEAT to Global Services Provided by U.S. Equipment Manufacturers

Dear Messrs. Kautter, Rettig, and Desmond:

We submit the attached slide deck as a follow-up to our comment letter regarding the applicability of the BEAT to U.S. equipment manufacturers that provide equipment services to worldwide customers. Those services facilitate sales of U.S.-made equipment and spare parts, but providing services at global locations convenient to customers often requires services payments to foreign affiliates. Those payments do not erode the U.S. tax base, yet they are potentially subject to BEAT taxation at U.S. tax rates that can easily exceed 400% (as shown by the typical case described in slide 9 of the attached deck).

To prevent such confiscatory taxation of non-base eroding payments, we recommend a rule excluding from the BEAT any payments for services performed outside the United States directly for the benefit of unrelated purchasers of equipment produced by the U.S. manufacturer or a related party. A manufacturing-linked services rule would:

• Prevent confiscatory U.S. taxation of global services provided by U.S. manufacturers at effective rates that exceed 100%;

• Implement Congressional intent to exclude manufacturing activity from the BEAT, consistent with the structural exclusion of COGS from base erosion treatment;

• Recognize that the global services activities of U.S.-based manufacturers facilitate U.S. manufacturing, enhancing rather than eroding the U.S. tax base;

• Allow U.S. manufacturers to keep the management of their global services operations in the United States;

• Avoid needless controversy over the scope of otherwise-applicable rules limiting BEAT taxation of manufacturing-linked services activities; and

• Ensure consistency with uses of regulatory authority that Treasury and the IRS have already proposed in relation to similar issues under the BEAT.

Highlights of Attached Slide Deck

The attached slide deck supplements our previous comment by providing a number of illustrative examples, (For your reference, we have also attached a copy of our previous comment letter.) As an overview, Slides 3 through 10 illustrate (i) the business model that requires U.S. manufacturers to integrate global services operations with their U.S.-based manufacturing activity; (ii) the economics of the long-term maintenance contracts at issue, which combine sales of replacement parts with the ancillary services needed to ensure ongoing parts sales; (iii) the haphazard applicability of the BEAT to such activities (which unexpectedly depends on the manufacturer's transaction pattern with its unrelated customers); and (iv) the potential structuring alternatives that would allow U.S. manufacturers to avoid confiscatory tax rates, but that are subject to significant downsides. Slides 11 through 17 sketch the manufacturing-linked services rule initially proposed in our previous comment letter, including illustrative examples and consideration of relevant technical and policy considerations. Specific issues addressed by the slides include the following:

Potential Disruption of U.S.-Based Management of Global Services Operations

The slides show that while some of the costs of an integrated global services operation could be treated as “base erosion payments” for BEAT purposes, such costs in fact have no base eroding impact but instead enhance the U.S. tax base by supporting additional U.S. jobs and revenue. In many cases, BEAT taxation will exceed the amount of services income actually earned by the U.S. manufacturer (slide 9), resulting in U.S. taxation at rates of 400% or more.¹ Without relief, taxpayers may be forced to restructure to avoid flowing services payments through the United States, for example by locating profitable services-related management functions elsewhere. Such a solution would be expensive and inefficient, forcing companies to reorganize existing operations that drive competitiveness, but would be economically necessary in the face of confiscatory BEAT taxes that vastly exceed economic income. While Congress no doubt intended the BEAT to impose a penalty on structures that actually erode the U.S. tax base, there is no evidence that Congress meant to penalize U.S. manufacturers that do not base-erode their U.S. manufacturing profits, but instead simply flow their global services income through the United States. Thus, an implementation approach that pressures U.S. manufacturers to shift business functions outside the United States in order to prevent confiscatory U.S. taxation would lead to results that would appear to be the opposite of what Congress intended when it enacted the BEAT.²

Proposal for Narrow, Bright-Line Regulatory Exception

The slide deck notes that certain equipment services payments may be excluded from the BEAT based on the structural exclusion of inventory costs, the exception for SCM-eligible payments, or by application of a conduit or similar common law doctrine. However, each of those rules is subject to potential uncertainty regarding the scope of its application, and in the absence of guidance could cause significant administrative controversy and litigation. A bright-line regulatory rule for foreign-performed manufacturing-linked services would limit controversy while also implementing the Congressional judgment, reflected most clearly in the inventory cost exclusion, that manufacturing activity is outside the scope of the statute's base erosion concerns. Moreover, COGS payments to foreign manufacturing affiliates are categorically excluded from the BEAT, thus making it clear that Congress did not view even foreign-based manufacturing as presenting base erosion concerns. Accordingly, applying the BEAT to U.S.-based equipment makers based on the structure of their integrated global services functions would be particularly inconsistent with the BEAT's statutory framework. The proposed manufacturing-linked services rule would effect Congressional intent by ensuring that the statutory carve-out of manufacturing activity includes services activities that are integrated with U.S.-based manufacturing.³

Proposal is Consistent with Other Exceptions in the Proposed Regulations

Finally, the slides note that implementing the statute in a manner that avoids illogical results and needless controversy is well within the scope of the statute's “necessary or appropriate” regulatory authority. Indeed, the government has already addressed similar problems in several provisions of the proposed regulations. For example, Treasury and the Service appropriately provided relief from double taxation of ECI payments, and adoption of the manufacturing-linked services rule would provide consistent and similarly appropriate treatment for U.S. manufacturers.

Conclusion

In light of the confiscatory tax consequences that will otherwise arise, and Treasury's regulatory authority to address such issues, we respectfully recommend adoption of a manufacturing-linked services rule that backstops the statute's exclusion of inventory costs by excluding from the BEAT payments for services performed outside the United States directly for unrelated purchasers of equipment manufactured by an affiliate of the service provider.

We appreciate your consideration of this letter and would be glad to develop more fully any of the analysis and discussion presented in the letter, in the attached slide deck, or in our previous comment letter.

Sincerely,

Michael J. Caballero

Robert E. Culbertson

Covington & Burling LLP
Washington, DC

cc:
U.S. Department of the Treasury

Internal Revenue Service