On September 1, 2020, the IRS issued final regulations regarding the base erosion and anti-abuse tax (“BEAT”) codified in IRC §59A. These regulations finalize the proposed BEAT regulations published on December 6, 2019 with certain refinements. Among other guidance, the final BEAT regulations provide detailed rules that allow corporate taxpayers to waive deductions for purposes of BEAT. Although waiving deductions will likely result in additional tax costs, the waiver election may be an easier and less costly solution than the alternative of making substantive business model or supply chain changes to mitigate BEAT.
Summary of the Election
Very generally, BEAT potentially applies to corporate taxpayers (i) with 3-year average annual gross receipts of at least $500 million, and (ii) a “base erosion percentage” – meaning base erosion tax benefits (i.e., deductions with respect to BEAT payments) divided by total deductions is at least 3% (2% for banks or securities dealers). A particularly harsh aspect of BEAT is the so-called “cliff effect.” Once a taxpayer’s base erosion tax benefits reach the 3% threshold, all deductions are subject to BEAT, not just deductions in excess of the 3% threshold. In acknowledgement of the impact of the “cliff effect”, the final regulations, like the earlier proposed regulations, allow taxpayers to selectively waive deductions that could be treated as base erosion payments on an annual basis. A waived deduction is not a base erosion payment and therefore is excluded from both the numerator and the denominator of the base erosion percentage and is not added back in determining modified taxable income for BEAT purposes.
The final regulations permit a taxpayer to make the election to waive deductions on its original filed Federal income tax return. In addition, a taxpayer may elect to waive deductions or increase the amount of deductions on an amended Federal income tax return or during the course of an examination of the taxpayer’s income tax return for the relevant taxable year. However, a taxpayer may not decrease the amount of deductions waived under the BEAT waiver election or revoke that election on any amended Federal income tax return or during an examination.
In response to comments requesting that taxpayers be allowed to decrease the amount of waived deductions on an amended return or on audit, the Preamble explains that the purpose of the election is to address the cliff effect of the base erosion percentage—i.e., a marginal amount of base erosion tax benefits having a great effect on overall tax liability—and that an ability to decrease waived amounts would not further the policy goal of addressing this cliff effect. Further, the Preamble notes that Treasury and the IRS were concerned that permitting reductions of waived amounts would increase uncertainty in IRS assessments and decrease the IRS’s ability to efficiently conduct and close examinations.
The election to waive deductions does not constitute a method of accounting under IRC §446, and, accordingly, no IRS consent is required. The election to waive deductions also does not impact the application of IRC §482. Thus, a base erosion payment with respect to which a deduction is waived will presumably still be considered allocable to the US taxpayer that makes the payment for transfer pricing purposes.
To make the election, a taxpayer must complete the appropriate part of Form 8991, Tax on Base Erosion Payments of Taxpayers With Substantial Gross Receipts (or successor), including certain information described in Treas. Reg. §1.59A-3(c)(6)(ii)(B). In contrast to the proposed BEAT regulations, the final regulations require a “description” instead of a “detailed description” of the item or property to which the deduction relates. The final regulations also explicitly state that partial waivers of deductions are allowed. If a taxpayer wishes to make an election or increase the amount of the deduction during an examination, the taxpayer must follow the procedures set forth in IRM section 220.127.116.11.
Observations and Implications for Transfer Pricing
The final regulations’ deduction waiver rule is a welcome development because it provides taxpayers with one clear option for mitigating the base erosion percentage “cliff effect.” This said, it is not an ideal solution because waiving deductions can be costly when compared with other alternatives. It is important to note that the deduction waiver does not impact the taxation of the payment in the hands of the foreign related party. As a result, the relative cost of an election may be particularly high if the amount needed to be waived is large, and/or if significant double taxation would result to the extent the base erosion payments with respect to which deductions are waived are subject to a high rate of tax in the foreign payee’s jurisdiction. The need to fully evaluate this cost and potential alternatives to the waiver is especially important since the final regulations make the waiver effectively irrevocable by precluding taxpayers from decreasing the amount of waived deductions after filing their original return. The irrevocable nature of the waiver also makes it essential to carefully determine the amount of deductions needed to be waived upfront so as to not waive more deductions than necessary.
While in some cases taxpayers may find it optimal to restructure their business models or supply chains in a manner that eliminates or reduces base erosion payments, in other cases taxpayers will likely find the deduction waiver to be cheaper, easier and more practical. The deduction waiver is likely to be particularly useful where the taxpayer’s existing arrangements do not place the taxpayer in a BEAT position on a recurring basis year-after-year, or as a stop-gap measure to avoid the cliff effect on a short-term basis while business model or supply chain changes are further evaluated.
Finally, we would note that another option to avoid the cliff effect may simply be to adjust transfer prices within the framework of the taxpayer’s existing business model. Even if the base erosion payments have already been paid, US taxpayers could still invoke Treas. Reg. §1.482-1(a)(3) to report on its return deductible payments lower than the actual payments if necessary to reflect an arm’s length result. This option to avoid the cliff effect by adjusting transfer pricing should be considered very cautiously since below arm’s length payments could result in significant transfer pricing exposure in the foreign payee’s jurisdiction, as well as the US. Nevertheless, unlike waiving deductions (which does not impact the IRC §482 allocation), adjusting transfer prices may have the key advantage of allowing the taxpayer to avoid double tax to the extent the lower transfer price can be accepted and supported as arm’s length in the foreign payee’s jurisdiction.