Reconciliation bill could limit BEAT application to inbounds
November 24, 2021
Amparo Mercader is a Principal in PwC’s National Transfer Pricing practice and the Transfer Pricing Leader for US inbounds (foreign-owned companies operating in the US market).
Marco Fiaccadori is a Principal in PwC’s National Transfer Pricing practice.
Inbound companies should be actively analyzing the significant international and business tax changes contained in major tax legislation that the US Congress is now considering. The ‘Build Back Better’ bill, as passed November 19 by the US House of Representatives, includes modifications of certain provisions related to the base erosion and anti-abuse tax (BEAT) dealing with payments made by US corporations to foreign companies. These changes could prove particularly complex for foreign companies operating in the United States, particularly if they transact (directly or indirectly) with countries with lower effective tax rates (ETRs). In contrast, the proposed modifications to the BEAT, taken together, would appear to have the effect of both excluding most if not all US-based multinationals from BEAT liability, and bringing many more inbound (foreign-owned) companies within the scope of the BEAT.
These modifications in the House-passed bill are described below. Some provisions in the House bill are expected to be modified by the Senate, which would require additional action by the House. A final identical version of the legislation must be approved by both the House and the Senate before it can be signed by President Biden.
The Senate is expected to take up the bill in December.
Modifications to the BEAT rates
The BEAT rate — which can be thought of as being similar to a minimum tax for companies with significant base eroding payments — currently is 10% for tax years beginning through December 31, 2025, increasing to 12.5% for tax years beginning after that date. Under the proposed changes, a 10% rate would apply to tax years beginning after December 31, 2021, and ending before January 1, 2023; a 12.5% rate would apply to tax years beginning after December 31, 2022, and ending before January 1, 2024; a 15% rate would apply to tax years beginning after December 31, 2023, and ending before January 1, 2025; and a 18% rate would apply to tax years beginning after December 31, 2025.
The changes to the BEAT also include an exception based on the ETR of the foreign recipient of the payment. Under that exception, an amount would not be treated as a base erosion payment if the taxpayer establishes to the satisfaction of the Treasury Department that such amount was made to a foreign related person that is subject to an effective rate of foreign income tax that is at least equal to the lesser of 15% or the applicable BEAT rate for the tax year in which the amount is paid or accrued.
Observation: Such a foreign ETR exception would broadly align the BEAT with an interpretation of the undertax payment and global minimum tax rules discussed in the context of the Pillar Two OECD forum. Inbound companies currently subject to BEAT or expecting to be subject to BEAT should consider what impact, if any, a higher tax rate could have on their US operations.
Elimination of the base erosion percentage test
Under the current rules, the BEAT applies to corporations that qualify as an ‘applicable taxpayer,’ which requires the corporation to meet both a gross receipts test and a base erosion percentage test. The gross receipt test would remain unchanged (average aggregate annual gross receipts of at least $500 million over a three-year period). However, it eliminates the base erosion percentage whereby a taxpayer generally satisfies the base erosion percentage test if it has a base erosion percentage (calculated under certain aggregation rules) of 3% or more. The bill would eliminate the base erosion percentage test for tax years beginning after December 31, 2023.
Observation: Many inbound companies have been able to either conduct their operations or waive deductions in order not to be treated as an applicable taxpayer under the base erosion percentage test. Removing the base erosion percentage threshold to apply the BEAT could increase significantly the number of inbound corporations that would be subject to the BEAT rules.
Calculation of base erosion minimum tax amount (BEMTA)
Under current law, an applicable taxpayer’s BEMTA equals the excess, if any, of (i) the taxpayer’s modified taxable income multiplied by the applicable BEAT rate over (ii) the taxpayer’s regular tax liability, reduced by all income tax credits except for the research credit and a certain portion of other Section 38 credits. Under the bill, an applicable taxpayer calculating its BEMTA for a particular tax year would not reduce its amount of regular tax liability by any credits. The bill also would amend Section 38(c)(1), which generally provides that the amount of credits allowed for general business credits under Section 38(a) is limited, in part, by the taxpayer’s ‘net income tax’ for the year, so as to include a taxpayer’s BEAT liability in the amount of its ‘net income tax’ for purposes of such limitation.
Observation: The change in the calculation of an applicable taxpayer’s BEMTA to use a pre-credit regular tax liability is a favorable provision that potentially could reduce or eliminate a taxpayer’s BEAT liability for inbound companies that have a significant amount of credits (including foreign tax credits). The change also would benefit inbound companies as it would increase their ‘net income tax’ amount, as determined under Section 38(c)(1), which is the taxpayer’s base for determining the amount of general business credits that are allowed for a particular tax year.
Elimination of exceptions for COGS and payments with respect to inventory
The bill would expand the definition of a base erosion payment by (i) including indirect costs that are paid or accrued to a foreign related party and must be capitalized into inventory under Section 263A (e.g., a royalty payment by a US corporation to its foreign parent for the right to produce inventory property would be considered a base erosion payment); and (ii) limiting the cost of goods sold (COGS) exclusion for inventory acquired from a foreign related party to the sum of such foreign person’s (a) direct costs and (b) indirect costs to the extent they are paid to a US person or an unrelated foreign person or otherwise are subject to US tax in the hands of the recipient.
To lessen the need to trace and calculate the foreign related party’s indirect costs, the bill provides a safe harbor that would allow the taxpayer to treat as indirect costs 20% of the amount paid or incurred by the taxpayer to the related party to purchase the inventory. Accordingly, the taxpayer would treat as a base erosion payment the costs that exceed the sum of the direct costs and certain indirect costs incurred by the foreign related party. For purposes of the indirect costs, the taxpayer could use the safe harbor and treat 20% of its purchase price as indirect costs incurred by the foreign related party that are not base erosion payments.
Observation: The proposed changes expanding the definition of base erosion payment to include some payments that are included in COGS would be unfavorable to inbound companies that import product into the United States by sales to a US affiliate. The proposal also would add an additional layer of complexity by requiring inbound companies to analyze (i) which portion of the inventory’s purchase price refers to direct or indirect costs incurred by the foreign related seller, and (ii) whether the foreign related party’s indirect costs are related to amounts paid or accrued to a US person or an unrelated foreign person or otherwise are subject to US tax in the hands of the recipient. The 20% safe harbor could reduce the administrative complexity required in tracing all of the foreign related party’s indirect costs for purposes of determining how much of the indirect costs are not base erosion payments; however, the particular facts and circumstances of each taxpayer will determine whether the safe harbor would be beneficial.
Exceptions for payments subject to a sufficient rate of foreign tax or US tax
The bill would add two new exceptions to the definition of a base erosion payment. In general, the proposed rule would expand the ‘subject to US tax’ exclusion by providing that an amount shall not be treated as a base erosion payment if US federal income tax is imposed with respect to such amount.
According to the Joint Committee on Taxation staff report on the bill, this exception would apply to US tax imposed on either the payor or the payee, “without regard to whether the income related to such payments was eligible for a reduced rate of tax,” including outbound payments to a related party that are included in the computation of GILTI or FDII (without regard to the Section 250 deduction), subject to US income and withholding tax, or taxable as effectively connected with the conduct of a US trade or business to the recipient. This exception, which as described by the Budget Committee report also would apply to amounts included in the computation of subpart F, could largely cause many US multinationals not to have a BEAT liability.
Observation: The bill’s changes to the BEAT would cause the BEAT provisions to become primarily a tax imposed only on inbound companies, as a US multinational’s foreign income would be taxed per the GILTI, FDII, subpart F, and other international tax provisions impacting US companies.
Observation: This exception also could benefit inbound companies that have controlled foreign corporations in their structure. Moreover, the bill would codify the exception contained in the current BEAT regulations that applies to effectively connected income (ECI), which is subject to tax in the hands of the foreign recipient on a net basis as if the foreign recipient were a domestic person.
As discussed above, the other exception to the definition of a base erosion payment applies to an amount that is subject to ‘sufficient foreign tax,’ that is, an amount that was subject to an ETR of foreign income tax (determined under the US foreign tax credit rules) that is not less than the applicable BEAT rate for the year in which the amount is paid or accrued (i.e., 10%, 12.5%, or 15%, depending on the tax year). The provision would allow taxpayers to determine the foreign income ETR based on the applicable financial statements.
It is important to note that the proposed changes would allow the ability to look past the immediate payment recipient in evaluating the ETR. More specifically, a payment made to a foreign related party which in turns pays a second foreign related party that does not satisfy the foreign ETR threshold (the ‘funding rule’) could be subject to the BEAT.
Observation: Compared to current law and notwithstanding some expansions to the BEAT under the proposal, this aspect of the bill could provide an exception from the BEAT that is otherwise not available based on the effective tax to the recipient. The inclusion of an exception for amounts subject to ‘sufficient foreign tax,’ together with the potential increase of the BEAT rate to 15%, would better align the BEAT with the OECD’s Pillar Two proposal.
10-year continued applicable taxpayer status
This proposed rule would subject any taxpayer that is an applicable taxpayer for any tax year after December 31, 2021, to BEAT for 10 years, regardless of any decrease in gross receipts. In particular, a taxpayer that is below the base erosion percentage threshold for one of the tax years before 2024 would not be able to avail itself of the safe harbor even though the base erosion percentage test is still in effect pre-2024.
The takeaway
Taken together, the bill’s changes to the BEAT described above could significantly reduce the circumstances in which US-headquartered companies would be subject to the BEAT. Specifically, the exemption from base erosion payments for amounts that are subject to US tax (including ECI, as well as amounts subject to tax under subpart F or GILTI) likely could result in US multinationals not having any significant base erosion payments.
For foreign-owned companies, however, the proposed changes to the BEAT would require careful examination. Because the proposed changes would be effective for tax years beginning after December 31, 2021, taxpayers may also consider taking immediate action in assessing their potential impact.
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