One canon of statutory construction settles a dispute about the base erosion and antiabuse tax services exception statutory requirement — what we call the “no-markup” requirement.
The BEAT applies to payments from large U.S. subchapter C corporations to foreign related parties. There is an exception for some payments for services. Those payments must be for services that meet three of the four requirements for the services cost method (SCM) in Treasury regulations as well as another new requirement in the statute.
Under one interpretation of the new statutory requirement, only the markup component of specific services is subject to tax. So if a service supplied to a U.S. corporation had $100 of cost and a markup of $9, only $9 of the total payment of $109 would be subject to the BEAT. Under the alternative interpretation, a service with total payments that include any markup would be subject to the BEAT. So, in our example, the total payment of $109 would be subject to the BEAT. Despite arguments to the contrary by many respected authorities, statutory interpretation of the BEAT services exception in section 59A favors the latter view.
The Services Cost Method
The SCM is a taxpayer-friendly provision for taxpayers receiving payment for outbound services who wish to minimize U.S.-source income. If a taxpayer elects to apply the SCM, the amount charged for services will be total service costs with no markup.
The taxpayer must meet four requirements to use this method. The first requirement, the covered services requirement (reg. section 1-482.9(b)(3)), provides the foundation for the SCM. It provides a safe harbor for the 101 back-office and routine (“specified”) services listed in Rev. Proc. 2007-13, 2007-1 C.B. 295. Examples include accounting, human resources, legal, tax, payroll, and IT services. These are generally low-margin, back-office services. If it isn’t specified, a service may also qualify as a covered service if it is deemed a “low-margin” service, that is, if it has comparables with a median markup of no greater than 7 percent.
Another of the four SCM requirements, the business judgment rule, is a backstop to the covered services requirement. It is intended to prevent listed specified services that might have high markups from qualifying for the covered services safe harbor. The business judgment rule — a subjective facts and circumstances test — requires the taxpayer to “reasonably conclude in its business judgment that the service does not contribute significantly to key competitive advantages, core capabilities, or fundamental risks of success or failure in one or more trades or businesses of the controlled group.” That’s a mouthful. As shorthand, we say a service that fulfills this SCM requirement is a “significant” service.
The BEAT Exception for Services
The BEAT became law with enactment of the Tax Cuts and Jobs Act (P.L. 115-97). In general, the BEAT, using a minimum tax mechanism, imposes tax (separate from the income tax) on payments (for example, interest, royalties, and fees) paid by large U.S. subchapter C corporations for inbound loans, use of intellectual property, and provision of some services.
Service payments excepted from the BEAT are described in the statute by cross reference to the requirements for SCM qualification as described in regulations proposed in 2006 (T.D. 9278) and finalized in 2009 (T.D. 9456). To qualify for the BEAT services exception, the taxpayer must satisfy three of the four SCM conditions. First, the service must be a covered service. There are two other requirements that aren’t central to this analysis: The services cannot be on a list of excluded activities (for example, manufacturing, reselling, research, and financial transactions), and the taxpayer must maintain adequate records.
The business judgment rule of the SCM doesn’t have to be satisfied to qualify for the BEAT services exception, which could open the door to high-markup services qualifying for the BEAT. But the statute adds a new (that is, it isn’t in the SCM regulations) statutory requirement we are calling the no-markup requirement. Dropping the business judgment rule (by itself) would mean all covered services qualify for the SCM (as long as documentation requirements are met).
If a taxpayer already elects the SCM for some services, payments for those services would automatically qualify for the BEAT services exception. For income tax purposes, these service payments are charged at cost. For BEAT purposes, they are clearly exempt because they have no markup component. There is no dispute about the BEAT services exemption fully applying to services without a markup component.
By dropping the business judgment rule, the statute effectively creates a new category of services: specified services over and above those services that already qualify for the SCM that may qualify for the BEAT exception. The dispute concerns this category.
The No-Markup Requirement
What we are calling the no-markup requirement is found in section 59A(d)(5)(B):
[The BEAT] shall not apply to any amount paid or accrued by a taxpayer for services if . . . such amount constitutes the total services cost with no markup component.
The combination of definitions and grammatical structure renders that sentence ambiguous. It is reminiscent of the duck-rabbit illusion. (See Panel A of the table.)
Under one view, which we will call the “taxpayer-friendly interpretation,” the phrase “any amount paid” means any payment — which may be a component of the total transfer price for services — that equals total service cost (so the BEAT would apply only to the markup, if any, over costs). (See Panel B of the table.)
Under a second view, which we will call the “anti-taxpayer” interpretation, the phrase “any amount paid” refers to the total amount paid, as long as the entire amount paid for services has no markup component (so the BEAT would apply to markup plus cost if there is any markup in total payments for a service). (See Panel C of the table.)
Proponents of the taxpayer-friendly view correctly point out that the business judgment rule, as first described in the preamble to the 2006 proposed regulations, targets high-markup services. Presumably, every taxpayer receiving payments for outbound services without a markup will have already adopted the SCM (or the taxpayer will have ascertained that no arm’s-length markup was required using some other method besides the SCM). If this is the case, dropping the business judgment rule from the SCM requirements adds only services with a markup to the section 59A BEAT services exemption. But if the anti-taxpayer interpretation already disqualifies services with any markup, the services added by dropping the business judgment rule would be disqualified anyway. In this case, the dropping of the business judgment rule has no effect; it is meaningless. (See, for example, New York State Bar Association Tax Section, “Report No. 1397 on Base Erosion and Anti-Abuse Tax,” at 17-18 (July 16, 2018); Alan Graf Jr., “Request for Guidance on Application of Base Erosion and Anti-Abuse Tax,” at 7 (July 20, 2018); and Nancy McLernon, “Section 59A,” at 4-7 (July 17, 2018).)
That violates the surplusage canon of statutory interpretation. The non-Latin portion of the surplusage canon, as defined by former Supreme Court Justice Antonin Scalia and Bryan Garner, states:
If possible, every word and every provision is to be given effect. . . . None should be ignored. None should needlessly be given an interpretation that causes it to duplicate another provision or to have no other consequence. (Scalia and Garner, Reading Law: The Interpretation of Legal Texts 174 (2012).)
In Colautti v. Franklin, 439 U.S. 379 (1979), Justice Harry Blackmun referred to the “elementary canon of construction that a statute should be interpreted so as not to render one part inoperative.” Later, writing for the majority in Kungys v. United States, 485 U.S. 759 (1988), Scalia elevated the status of the surplusage cannon, calling it “the cardinal rule of statutory interpretation that no provision should be construed to be entirely redundant.” If the surplusage canon is applied to the outbound provision of services described above, the taxpayer-favorable interpretation prevails over the anti-taxpayer interpretation.
The surplusage canon has already played a role in Treasury’s statutory interpretation of the TCJA. As recently as August 8, in its preamble to the section 199A proposed regulations (REG-107892-18), Treasury cited the avoidance of surplusage for its decision to bypass an interpretation of the “reputation or skill” exception that would make the other stated exceptions redundant. (Prior analysis: Tax Notes, Aug. 13, 2018, p. 915.)
Saved by Zero
The SCM in the 2009 regulations was designed with payments for outbound services in mind. Including the business judgment rule in SCM requirements limits qualification for the SCM when taxpayers receive payments for outbound services. But the BEAT is a tax on amounts paid to foreign related parties for inbound services. To minimize U.S. income tax, it is advantageous for a taxpayer paying for inbound services to use a method other than the SCM.
For example, under one of the five methods listed in reg. section 1.482-9(a) other than the SCM, payments to a foreign related party for inbound services may be determined to include a 20 percent arm’s-length markup over cost. With the advent of the BEAT, it is possible that a taxpayer making payments for a service would meet all the requirements of the SCM except the business judgment rule — that is, in its business judgment, it is impossible for the taxpayer to deny the service is a non-routine, essential service that disqualifies it from the SCM. To put it differently, the only SCM requirements met are that the service with the 20 percent markup is a specified service and isn’t an excluded activity, and that the taxpayer complies with all reporting requirements. An example would be the provision of recruiting services (a specified covered service under Rev. Proc. 2007-13) by a foreign parent to a U.S. subsidiary, both of which are executive recruiting service companies that other companies hire to recruit professionals.
Before the BEAT took effect, a taxpayer making payments for inbound services wouldn’t want any part of the SCM (because the taxpayer wants to maximize deductions from U.S.-source income for income tax purposes). But dropping the business judgment rule could open the door to qualification for the BEAT services exception even though the taxpayer cannot reasonably deny that the services contribute significantly to the controlled group’s key competitive advantages, core capabilities, or fundamental risks of success or failure in the group’s business. What does prevent this from occurring is an anti-taxpayer interpretation of the no-markup requirement of section 59A(d)(5)(B).
If the anti-taxpayer interpretation holds, it alone subjects these services to the BEAT: No other part of the statute does so. The services meet the requirements to qualify for the SCM when the SCM is modified to exclude the business judgment rule. Because the service has a 20 percent markup, the anti-taxpayer interpretation of section 59A(d)(5)(B) isn’t meaningless. Subparagraph (d)(5)(B) isn’t surplusage: It kicks high-markup services out of the BEAT services exception.
Subparagraph (d)(5)(B) under an anti-taxpayer interpretation is simply a substitute for the business judgment rule. Yes, it is despised by taxpayers and it creates an inelegant cliff effect between zero-markup and 0.1 percent markup services. But based on the statutory language, it cannot be ruled out. Nor is it unreasonable when one recalls that Congress in its final negotiations was acutely sensitive to the practical political necessity of not surpassing the self-imposed deficit targets in its congressional budget resolution. To that end, it might have decided to replace the squishy business judgment rule with a tougher rule that allowed fewer services to escape the BEAT.
Another Pro-Taxpayer Interpretation
Some authors have argued that if there are no zero-markup services in the additional services category, the overall result of the limited exception interpretation could be achieved far more easily by simply requiring that the BEAT services exception be available only to taxpayers who actually elect the SCM. (Prior analysis: Tax Notes, Feb. 12, p. 933.)
But if electing the SCM qualifies the taxpayer for the BEAT services exception, inbound providers of specified services with a profit margin could disqualify themselves from the BEAT by exercising their business judgment that the service was not a significant service. The business judgment rule is a subjective standard under which considerable deference is given to the taxpayer’s opinion. The business judgment rule, which is a backstop to the income tax for outbound services, would be an escape valve from the BEAT for inbound services. The anti-taxpayer interpretation does not allow for this possibility, so it isn’t the same as a rule under which qualification for the BEAT services exception is election of the SCM. It is consistent with drafters believing — rightly or wrongly — that the business judgment rule might sometimes be overgenerous and that applying a stricter rule was a good way to meet the need to raise more revenue.
Surplusage Again but Different
So far, the rebuttals presented here to pro-taxpayer arguments by others tell us only that these arguments don’t preclude an anti-taxpayer interpretation. If that is the case, we return to square one: ambiguity. But there is a statutory interpretation that supports rejection of the taxpayer-friendly view. Under this interpretation, a critical phrase in the statute is shown to have no meaning if the taxpayer-friendly view is adopted. Therefore, the surplusage canon tells us to adopt the alternative interpretation.
To repeat, the statute says that the BEAT “shall not apply to any amount paid or accrued by a taxpayer for services if . . . such amount constitutes the total services cost with no markup component.” If the drafters intended that a total service payment could be bifurcated into a separable total service cost component and a markup component, and only the markup component would be subject to the BEAT, the phrase “with no markup component” serves no purpose. The BEAT-free amount is total service cost, period.
Let’s take a quick look at some analogous examples. Suppose it is written: “Any amount paid for services will not incur tax if that amount constitutes U.S. dollars with no foreign currency component.” On its face, this is another rabbit-duck ambiguity. Is only the foreign currency component subject to tax, or does the foreign currency component contaminate the entire payment? Applying the surplusage canon can give us direction. If the drafters wanted to tax only foreign currency, they could have simply dropped the last prepositional phrase. Because they didn’t, they must have intended it to change the meaning of the simpler construction.
| Covered Services | Excluded Activities | |||
|---|---|---|---|---|---|
SCM | Additional Services Qualifying for BEAT Services Exception | ||||
Not SCM | |||||
No Markup | No Markup | With Markup | |||
Qualifies for SCM (using business judgment, service is considered significant) | Not Qualified for SCM’ | ||||
Panel A. The Dispute: Ambiguity in the statute | |||||
BEAT? | None | None | Just markup or sum of cost + markup? | Cost + markup | |
Panel B. Taxpayer-friendly interpretation | |||||
BEAT? | None | None | Only markup | Cost + markup | |
Panel C. Anti-taxpayer interpretation | |||||
BEAT? | None | None | Cost + markup | Cost + markup | |
Panel D. Argument against anti-taxpayer interpretation (in Panel C). Valid in outbound case. Any specified services that can be deemed routine will already qualify for SCM (and therefore have a zero markup). Any other service deemed not routine will surely have a markup. Therefore, anti-taxpayer interpretation means dropping of the business judgment rule is meaningless because it does not expand the exception to any additional services. | |||||
BEAT? | None | None | (Null set.) | Cost + markup | |
Panel E. Rebuttal to argument in Panel D. Anti-taxpayer interpretation is meaningful. In the case of payments for inbound services, there are specified services with markup that qualify for SCM’ that are shut out of the BEAT by subparagraph 59A(d)(5)(B). | |||||
BEAT? | None | None | Cost + markup. | Cost + markup | |
Panel F. Hypothetical alternative. Require SCM election for BEAT services exception. Not the same as Panel C because under this alternative, the BEAT is too easy to avoid by asserting business judgment that specified services with markup are not significant. | |||||
BEAT? | None | None | Cost + markup. | Cost + markup | |
The phrase “with no markup component” would have meaning if somehow the term “total service cost” wasn’t well understood or, more specifically, could be construed to include a markup. But in the context of the decades-long examination of how to set transfer prices for services, it seems unlikely that the concepts of markup and cost have been construed to overlap each other. Further, nothing in the paragraph-long definition of total services costs in reg. section 1-482.9(j) can be construed to include any markup component or element of profit.
The surplusage canon, like all other canons of statutory interpretation, isn’t absolute. Scalia and Garner explain: “Sometimes drafters do repeat themselves and do include words that add nothing of substance, either out of a flawed sense of style or to engage in the ill-conceived but lamentably common belt-and-suspenders approach.” But the surplusage canon is well known in legal circles, and certainly the drafters for Congress are especially aware of it. Given the apparent absence of other guidance in the statutory text, taxpayers shouldn’t be surprised if Treasury uses the surplusage canon and concludes that the anti-taxpayer interpretation is consistent with the interpretation of the statutory text.
In comment letters to Treasury, taxpayers have provided a long list of legitimate gripes about the BEAT. There are unwieldy cliff effects: For example, there is a radical difference between the treatment of taxpayers with gross receipts of $499 million and those with gross receipts of $501 million, and between the treatment of taxpayers with base erosion percentages of 2.99 percent and 3.01 percent. There are traps for the unwary — for example, a U.S. parent corporation that acquires a product from a third party through a foreign subsidiary acting as an intermediary is treated much more harshly than if it had bought the same product directly from the same third-party foreign supplier. And the statute provides radically different treatment of an economically equivalent transaction: For example, a manufacturer that purchases component parts for assembly from a foreign related party is treated much more favorably than a software designer that purchases software and coding services from a foreign related party. Taxpayers have also objected strenuously to any notion that covered services provided by foreign affiliates should be taxed on anything more than the markup on those services.
These letters have the wrong addressee. Congress writes the laws, and it is Congress’s job to fix perceived flaws.