BEAT and the Services Cost Method Exemption

Read Valuation Insights, Fourth Quarter 2018

With the passage of the Tax Cuts and Jobs Act (“TCJA”) at the end of 2017, a new international tax provision, the Base Erosion and Anti-Abuse Tax (“BEAT”) was introduced. The BEAT requires U.S. taxpayers to pay a tax equal to the base erosion minimum tax amount for the taxable year, with the base erosion minimum tax equal to the excess (if any) of 10%¹ of modified taxable income less regular tax liability on a worldwide basis. Modified taxable income is calculated as taxable income for the U.S. taxpayer excluding certain “base erosion payments”, with base erosion payment generally defined as payments by the U.S. taxpayer to a foreign related party. Note that the BEAT only applies to taxpayers which meet certain threshold requirements² and that the BEAT threshold requirements have a cliff effect, as you are either fully subject to the BEAT or not subject to the BEAT, with no middle ground or partial application of this provision.

While the BEAT does have a fairly broad definition of base erosion payments the provision does designate three types of foreign related party payments which are not to be included in the base erosion payment category.

These three types of payments are:

1. Cost of goods sold
2. Services which meet the requirements for eligibility for the services cost method SCM under § 1.482-9 (determined without regard to the business judgment rule)
3. Qualified derivative payments

Of particular interest and the subject of much discussion for many taxpayers subject to the BEAT is the exclusion for services which meet the eligibility for the services cost method.

The SCM is described at length in the § 1.482-9 regulations and is a specified transfer pricing method for which “covered services” can be charged out at cost, without a markup applied. The SCM is an elective method and Taxpayers are permitted to utilize other methods under the regulations to determine the arm’s length compensation for these covered services.

To apply the SCM as prescribed in the § 1.482-9 regulations several conditions must be met.

The service must be a covered service as defined in the regulations. A Covered Service falls into one of the following two categories:

• Specified Covered Services
• Low Margin Covered Services

Specified Covered Services are defined as controlled services transactions which are specified in Rev. Proc. 2007-13. At a high level, these services have been indicated to be support services common among taxpayers across industry sectors. Rev Proc. describes 101 different services which consist of various types of payroll, accounting, administrative, coordination, tax, treasury, staffing, recruiting, training, information technology and legal services, among others.

Low Margin Covered Services are defined as controlled services transactions for which the median comparable markup on total services costs is less than or equal to seven percent.

In addition, § 1.482-9 also includes a list of excluded activities which are not eligible for use with the SCM, a list of activities often referred to by tax practitioners as the black list. The activities on this list consist of the following:

1. Manufacturing
2. Production
3. Extraction, exploration, or processing of natural resources
4. Construction
5. Reselling, distribution and similar activities
6. Research and development
7. Engineering or scientific activities
8. Financial transactions
9. Insurance or reinsurance

In addition to the aforementioned criteria, the services must not be precluded from constituting a covered service by the business judgment rule described in § 1.482-9. The business judgment rule states that for a service to be considered a covered service under the SCM the taxpayer must reasonably conclude that the service does not contribute significantly to key competitive advantages, core capabilities, or fundamental risk of success or failure in a trade or business of the taxpayer. Note that for services to qualify for the SCM exclusion from base erosion payments with regards to the BEAT provision, the business judgment rule does not need to be considered.

As described above, many U.S. taxpayers may have payments to foreign related parties which could by exempt to the BEAT due to their eligibility for the SCM. However, the identification of these expenses may not be a simple exercise for many taxpayers. Currently many charges made to U.S. taxpayers from foreign related parties may involve a bundling of various types of expenses, only a portion of which may be SCM eligible. Application of the BEAT SCM exemption would require segmenting these expenses to exclude any ineligible expenses pertaining to “black list” activities. This may prove difficult depending on the level of detail captured in the company’s accounting systems. Furthermore, additional research and fact finding may be necessary to identify which expenses would qualify as being categorized as covered services. Firms may need to retool or update their accounting and data collection systems to increase the ease of identifying these expenses in the future.

In addition to the aforementioned criteria, the services must not be precluded from constituting a covered service by the business judgment rule described in § 1.482-9. The business judgment rule states that for a service to be considered a covered service under the SCM the taxpayer must reasonably conclude that the service does not contribute significantly to key competitive advantages, core capabilities, or fundamental risk of success or failure in a trade or business of the taxpayer. Note that for services to qualify for the SCM exclusion from base erosion payments with regards to the BEAT provision, the business judgment rule does not need to be considered.

As described above, many U.S. taxpayers may have payments to foreign related parties which could by exempt to the BEAT due to their eligibility for the SCM. However, the identification of these expenses may not be a simple exercise for many taxpayers. Currently many charges made to U.S. taxpayers from foreign related parties may involve a bundling of various types of expenses, only a portion of which may be SCM eligible. Application of the BEAT SCM exemption would require segmenting these expenses to exclude any ineligible expenses pertaining to “black list” activities. This may prove difficult depending on the level of detail captured in the company’s accounting systems. Furthermore, additional research and fact finding may be necessary to identify which expenses would qualify as being categorized as covered services. Firms may need to retool or update their accounting and data collection systems to increase the ease of identifying these expenses in the future.

Notes:
¹ The applicable tax rate is 5% for one year for taxable years beginning after December 31, 2017 and subsequently increases to the 10% rate previously mentioned. The BEAT rate increases to 12.5% for taxable years beginning after December 31, 2025.
² The BEAT would only apply to taxpayers with $500 million in average annual gross receipts for the three-year period ending with the preceding taxable year and a base erosion percentage of 3% or higher for the taxable year.