With the BEAT - Grappling with Section 59A · 2019 U.S. Cross-Border Tax Conference May 14 – 16,...

2019 U.S. Cross-Border Tax ConferenceMay 14 – 16, 2019

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With the BEAT—Grappling with Section 59A

2© 2019 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved. NDPPS 821761

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The following information is not intended to be “written advice concerning one or more Federal tax matters” subject to the requirements of section 10.37(a)(2) of Treasury Department Circular 230.

The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser.

Notices

AgendaIntroduction and BEAT Background

COGS Exemption

SCM Exception

Common Law Doctrines

Accounting Methods and Election Planning

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Today’s presentersName Title Firm EmailCarol Conjura Partner, WNT (IT&A) KPMG LLP [email protected]

Jesse Eggert Principal, WNT (International) KPMG LLP [email protected]

Prita Subramanian Principal, WNT (EVS) KPMG LLP [email protected]

Introduction and Overview of the BEAT


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— Potential addition to regular tax liability— Targets taxpayers making deductible payments to related parties that

are foreign persons— Two Tier Trigger – BEAT Applies:

— Application effectively reverses a portion of deductions attributable to payments to foreign related parties and certain tax credits- Clawback of otherwise permitted base erosion

— Applies to base erosion payments (discussed below) made in TYBA 12/31/17

BEAT overview

If there is an Applicable Taxpayer and

To the extent the BEAT tax liability

exceeds the regular tax liability


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— A corporation other than a RIC, REIT, or S Corp that: - Has average annual gross receipts for the 3 year period ending with the preceding

taxable year of at least $500MM — Apply rules similar to sections 448(c)(3)(B), (C), and (D) to determine gross receipts— Gross receipts of foreign persons are included only to the extent of ECI

- Has a base erosion percentage (discussed below) of at least 3% (2% for certain financials)— Annual calculation

— Aggregation rules apply for purposes of - determining whether a taxpayer is an Applicable Taxpayer, and - determining the base erosion percentage

— All persons within a 1563 controlled group are treated as 1 person (with foreign members counted only to the extent of ECI

Applicable taxpayer: definition


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— “All deductions” does not include: i. deductions allowed under sections §§172 (NOL), 245A (participation exemption),

or 250 (FDII/GILTI); ii. deductions qualifying for the exception (discussed below) for services

eligible for the services cost method; and iii. deductions for qualified derivative payments that are removed from the

definition of base erosion payments - Applied annually

— BETB = deductions attributable to Base Erosion Payments (next slide)

Base erosion percentageBase erosion tax benefits (“BETB”)

all deductions for the year other than exceptions noted below

Base erosion percentage (“BEPct”)


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—Amounts paid or accrued to a related foreign person that- Are deductible (Does not include COGS and other payments that

result in reduction of gross receipts)- Are for the acquisition of property that gives rise to a depreciation or

amortization deduction- Are premium or other consideration for any reinsurance payments

taken into account under section s 803(a)(1)(B) or 832(b)(4)(A)- Result in a reduction of gross receipts (including COGS) of the

taxpayer if the payments are made to a post-11/9/17 inverted company or a member of its “expanded affiliated group” under section 7874.

Base erosion payment: definition


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— MTI rate is 5% in 2018, 10% from 2019 through 2025, and then 12.5% for TYBA 12/31/25 (1% higher for banks & securities dealers)

— Beneficial treatment of R&E credits and certain applicable section 38 credits eliminated for TYBA 12/31/25

— The effect of reducing the regular pre-credit tax liability by tax credits (other than R&E and a portion of applicable section 38 credits) is that credits (including FTCs) increaseBEAT liability (or increases the likelihood of having a BEAT liability); - BEAT therefore creates a “cliff effect”: for taxpayers with significant foreign tax credits,

crossing the BE% threshold can dramatically increase ETR

Calculating the BEAT

BEMTAModified Taxable Income

all credits – R&E credits –[80%] applicable section

38 credits[10%] 21% x

TI

Addition to regular tax (“Base Erosion Minimum Tax Amount”)

( ( ))


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Proposed regulations released December 2018— Provided some helpful clarification and relief:

- ECI Exception- 0% Base erosion percentage for old NOLs- Favorable treatment of services cost method (SCM) exception- Reduced scope of anti-abuse rule

— But left many questions unanswered and failed to provide relief that many were hoping for:- No exclusion for payments that are Subpart F or GILTI- No guidance on treatment of profit/revenue splits

— Included a few unwelcome surprises- Application of section 15 to BEAT rate changes- Treatment of non-cash consideration and loss transactions

Final regulations expected August/September

Regulatory process?


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BEAT Planning has generally focused on four key areas:— Income/expense classification:

- COGS treatment- SCM eligibility- Common law doctrines

— Accounting methods and elections:- Income acceleration and deferral planning- Capitalization of expenses

— Operational restructuring- Modification of intercompany (and 3rd party) contracts- Check-the-box planning- FTC Planning

— Disallowance/surrender of deductions (e.g. affirmative hybrid instruments)

Planning prioritization

COGS exception


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The uniform capitalization rules require the capitalization of all direct and indirect costs allocable to:— Real or tangible personal property produced by the taxpayer; and— Property (either real or personal property) acquired by the taxpayer for resaleTwo points here:1. COGS recovered through a reduction of gross income, not as a deduction2. The same logic does not apply to cost of services or the cost of leasing

(below the line deductions)- Therefore, you first need to determine whether, under normal tax principles, the taxpayer is

engaged in a sales transactions- If the commercial arrangement involves multiple transactions, they must be bifurcated

and examined separately

COGS overviewSection 59A(c)(2)(A). In general, the term “base erosion tax benefit” means –(i) Any deduction described in subsection (d)(1) which is allowed…with respect to any base erosion payment…


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— Direct Costs- Producers: direct materials and direct labor costs (“hammers in hands”)- Resellers: acquisition costs of property acquired for resale

— Indirect Costs- “Directly benefits or incurred by reason of” the performance of production or resale activities- Treas. Reg. §1.263A-1(e)(3)(ii) lists 23 types of indirect costs that are subject to capitalization

— Sales-Based Costs - Indirect costs may directly benefit or be incurred by reason of the performance of production or

resale activities even if the costs are calculated as a percentage of revenue or gross profit from the sale of inventory, are determined by reference to the number of units of property sold, or are incurred only upon the sale of inventory. Treas. Reg. §1.263A-1(e)(3)(i)(A)

— Section 174 costs are carved out by §263A

Types of costs required to be capitalized


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COGS – indirect costs

• Indirect Labor Costs• Officers' Compensation• Pension and Other Related

Costs• Employee Benefit Expense• Indirect Material Costs• Purchasing Costs• Handling Costs• Storage Costs• Cost Recovery• Depletion• Rent• Taxes (Excluding Income-

Based)

• Insurance• Utilities• Repairs and Maintenance• Engineering and Design

Costs (not 174)• Spoilage• Tools and Equipment• Quality Control• Bidding Costs• Licensing and Franchise

Costs• Interest• Capitalizable Service Costs

Required to Be Capitalized• Selling and Distribution Costs• Research and Experimental Costs• Section 179 Costs• Section 165 Losses• Cost Recovery Allowances• Income Taxes• Strike Expense• Warranty and Product Liability• On-Site Storage Costs• Unsuccessful Bidding Expenses• Deductible Service Costs

Not CapitalizedIndirect Costs – Examples


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The availability of the COGS exclusion eases the burden of the BEAT on manufacturing and distribution businesses, so it is critical for companies to evaluate which expenses are included. A few things to keep in mind with respect to royalties:— Key question is whether the royalty is a cost of producing goods that are being sold.

- Production-related royalties are capitalized (and may be COGS) even if they are not imposed until the goods are actually sold.

- Royalties that do not have any connection to production (e.g. marketing/advertising rights) however, are not COGS.

— Royalties may be bundled: READ THE LICENSE AGREEMENT to see if the parties assigned values to the individual purposes for which the license is being used. If not, may need to arrive at an allocation. EVS can help.

— Change in method of accounting may be required if royalties were not previously treated as COGS— This change in treatment has effects beyond BEAT:

- Can change timing of recovery of cost (depending on whether a portion must be capitalized into ending inventory), but any withholding will still be a current expense

- Consider interaction with customs rules (including 1059A limitation on COGS) and get trade & customs involved

COGS – Royalties

SCM exception


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The proposed regulations provide that the services cost method (“SCM”) exception is available even if a markup is charged. However, the portion of a payment that exceeds the “total services cost” is a base erosion payment. The proposed regulations do NOT require a taxpayer to maintain separate accounts to bifurcate the cost and markup components.Overview— US Co pays FP $110 for various services, which includes a mark-up — Need to split the services into categories:

- Services cost method qualified (e.g., HR, Back office, Purchasing, etc.)- SCM qualified but for the business judgment rule

(e.g., IT and middle office)- The above two categories (likely) would not be subject to BEAT

on the cost of the services but would be subject to BEAT on any markup above cost

- The third category would be services not eligible for SCM (e.g., R&D, production, manufacturing)

- The payment attributable to these services would be subject to BEAT

SCM exception – identifying eligible services

FP

US Co

$110 fee for services, incl. $10 mark-up

(payment for “whitelist”

accounting services and blacklist R&E

services)


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The proposed regulations provide that all of the requirements of §1.482-9(b) must be satisfied, except that: — The requirements of §1.482-9(b)(5) (i.e., the business judgement rule) do not apply; and— Adequate books and records must be maintained as described in §1.59A-3, instead of as

described in §1.482-9(b)(6).Thus in order to be eligible for the SCM exception all the following must be satisfied: — The service is a covered service (i.e., a low margin

covered service or a specified covered service (i.e., a whitelist service);

— The service is NOT an excluded activity (i.e., blacklist service); and

— Adequate books and records are maintained (as defined in §1.59A-3)- See below

SCM exception – eligibility considerations

FP

US Co



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Covered Service— Rev Proc 2007-13 – lists 101 qualifying services assumed to be low-value (whitelist services)— Services not listed can still qualify (other than excluded blacklist activities) if the median

comparable markup is less than or equal to 7%Excluded activities: — Manufacturing; Production; Extraction, exploration, or

processing of natural resources; Construction; Reselling, distribution, acting as a sales or purchasing agent, or acting under a commission or other similar arrangement; Research, development, or experimentation; Engineering or scientific; Financial transactions, incl. guarantees; Insurance or reinsurance

SCM exception – eligibility considerations

FP

US Co



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SCM exception – adequate books and records requirement

Permanent books of account and records must be maintained for as long as the costs with respect to the services are incurred by the renderer. The books and records must be adequate to permit verification by the Commissioner of the amount charged for the services and the total services costs incurred by the renderer,including a description of the services in question, identification of the renderer and the recipient of the services, calculation of the amount of profit mark-up (if any) paid for the services, and sufficient documentation to allow verification of the methods used to allocate and apportion the costs to the services in question in accordance with §1.482-9(k).

BEAT SCM books and records requirement

Permanent books of account and records are maintained for as long as the costs with respect to the covered services are incurred by the renderer. Such books and records must include a statement evidencing the taxpayer's intention to apply the services cost method to evaluate the arm's length charge for such services. Such books and records must be adequate to permit verification by the Commissioner of the total services costs incurred by the renderer, including a description of the services in question, identification of the renderer and the recipient of such services, and sufficient documentation to allow verification of the methods used to allocate and apportion such costs to the services in question in accordance with paragraph (k) of [1.482-9].

482 SCM books and records requirement

Common language Unique to 482 language Unique to 59A language


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The stakes are often high for the determination of whether a service is eligible for the SCM exception. In the example to the right, whether $100 is treated as a Base Erosion Payment could make the difference between US Co having a base erosion percentage above the threshold and therefore being an applicable taxpayer— Given the stakes, taxpayers should prepare robust

documentation. For example, taxpayers should consider whether a service can be documented as both a low margin covered service AND a specified covered service.

— Taxpayers must carefully allocate and apportion costs to derive total services costs.

SCM exception – documentation and cost allocation

FP

U.S. Co


Common law doctrines


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Outbound payments accounted for on a gross basis (i.e., no netting allowed) unless otherwise permitted under U.S. tax law‒ Note that for a qualified cost-sharing arrangement, Reg. § 1.482-7

generally requires the netting of an inbound cost-sharing payment against the recipient’s deductions for the intangible development costs that it incurred directly.

‒ No guidance on profit splits, revenue splits, etc. - general principles for allocation of gross income will apply

‒ But general tax principles still apply

Operating rules for base erosion payments


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Overview— USP has a CSA with a foreign affiliate (“Irish Co.”). USP

and Irish Co. split rights geographically (US for USP, non-US for Irish Co).

— USP RAB = 50%, Irish Co RAB = 50%— A foreign affiliate (“UK Co”) performs all of the

R&D for the group. — In first instance, USP compensates UK Co for

100% of its research costs. Then, Irish CSA payment to USP for its portion of costs based upon its RAB.

Potential Alternative Structure— Restructure the billing mechanism to have UK Co directly

bill Irish Co in first instance and then USP will make a CSA payment to Irish Co based on its RAB. This would have the effect of limiting the cost subject to BEAT to only USP’ RAB portion of the cost incurred by UK Co.

Further Considerations— DEMPE— IT Systems

Qualified cost sharing payments

Payment for all of UK Co.’s contract R&D cost CSA payment

based upon USP 50% RAB.

UK Co (contract R&D

provider)

Payment for 100% of UK Co.’s contract R&D

Potential base-erosion tax on payment but less than original structure

CSA payment based upon Irish Co’ 50% RAB

Potential base-erosion tax on entire payment from USP to UK Co

Irish Co

USP


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Taxpayers subject to the BEAT should consider the applicability of common law doctrines to determine the proper characterization of their payments. Relevant doctrines include:— Agency– for e.g., may be helpful in situations where a payment to a related person will be passed on

to an unrelated person, including (in contrast to many of the other doctrines) when the intermediary earns a profit for its role as an intermediary. Beware of enhanced requirements to treat a related party as an agent under Bollinger and National Carbide

— Reimbursement– may apply to eliminate deductions for payments to a related person when another person ultimately will bear the cost. Generally not available if a markup on the cost is charged to the “reimbursing” party

— Trust Doctrine (e.g. 7-up)– advances received from another person that can only be used for a narrowly defined purpose do not give rise to gross income, or, more importantly, to offsetting deductions when the amounts are expended for the narrow use. The recipient of the advance cannot profit (e.g., charge a markup) from the activity

— Conduit Doctrine– generally an anti-avoidance doctrine raised by the IRS; not clear if taxpayers can assert affirmatively. Unlikely to apply if a markup is charged.

— Tenants-in-common– if two parties jointly earn income, the payment of the other party’s share is not a deductible payment. BEWARE– this doctrine is not well-developed; using a revenue-sharing transfer pricing method is NOT enough.

The “devil is in the details”…common law doctrines are highly fact specific!

Don’t forget…general tax principles (and the limits on those principles)


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Overview— US-parented multinational corporation (“USP”) uses a foreign affiliate

(“India Co.”) to provide non-SCM services to the global affiliated group.— USP compensates India Co for its services (on a cost-plus basis) and

then re-bills the non-US portion of the costs to the other members of the group.

— Assume that (i) USP does not receive a fee or mark-up in respect of its cost pooling function from its non-US affiliates and (ii) the reimbursement amounts from non-US affiliates are known / knowable by tax year end.

Consideration of common law doctrines regarding exclusions from gross income— If the reimbursement doctrine were to apply, only the US portion

of the service payment from USP to India Co would be a base erosion payment

— Note: As with other common-law doctrines, consideration whether the reimbursement doctrine applies is a very fact-intensive analysis- Critical factual considerations include (but not limited to): (1) whether

the procurement provider is entitled to a service fee / commission relating to the procurement function and (2) whether a fixed right to reimbursement is known or knowable by the end of year.

Cost pooling – common law doctrines

Query whether entire service payment from USP to India Co (not just US portion) is a potential base-erosion payment

Reimbursement of non-U.S.

benefiting cost

Payment for all of India Co.’s cost for services to global affiliates

Non-U.S. Global

AffiliatesIndia Co.

USP

Accounting methods and election planning


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Accounting methods and elections planning

**Planning techniques in red may be evaluated on an annual basis (e.g., these have the ability to be ‘turned on and off’)

The planning techniques above represent common options available to many taxpayers. However, application of these methods andelections are fact-based and subject to confirmation based on each taxpayer's facts and circumstances.

During Tax Year Change compensation & benefit policies to defer recognition Matching of related party interest expense Defer other payments where deductibility is

on a cash method

Trigger unrealized gains Evaluate non-automatic accounting method changes

Pre-Tax Return Filing Elect to capitalize R&D expenses under IRC §59(e) or 174(b)

Defer deductions by allocating defined pension plan contributions Elect out of bonus depreciation

Elect to capitalize facilitative costs related to intangibles

Defer payment of bonuses / vacation post March 15

Elect deferral of IRC §404(a) accrued compensation Defer payments related to recurring item

exception / file return early

Defer payments related to IRC §461(h) / 1.461-4(g) liabilities Elect ADS depreciation method Do not elect Section 280C for research

credits Capitalize repair and maintenance costs

Defer bad debt deductions Capitalize IRC §266 costs Defer deduction related to prepaids that meet 12 month rule

Change method for recognition of Sec. 467 leases

Adopt direct reallocation method and other IRC §263A methods

Do not apply 3 1/2 month rule for ratable service contracts

Ensure interest capitalization rules are followed for tax purposes

Accelerate revenue recognition (e.g., full inclusion method)

Analyze character of costs to ensure COGS appropriately classified

Capitalize software development expenses under Rev. Proc. 2000-50

Capitalize non-incidental materials and supplies Evaluate other automatic method changes

The following planning ideas can be used to increase taxable income


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Accounting methods and elections planning

*Planning techniques in red may be evaluated on an annual basis (e.g., these have the ability to be ‘turned on and off’)

The planning techniques above represent common options available to many taxpayers. However, application of these methods andelections are fact-based and subject to confirmation based on each taxpayer's facts and circumstances.

The following planning ideas can be used to decrease taxable income and use “BEAT cushion”.


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Overview— In certain circumstances, taxpayers are provided discretion as to whether to claim current deductions with respect to

certain expenses or to elect to capitalize and amortize such costs.— In particular, taxpayers are provided significant flexibility to decide whether to currently deduct or capitalize R&E

expenditures and software development costs. - For BEAT purposes, such optionality is relevant since, e.g., R&E expense is not eligible for the SCM exception.

R&E Expenditures— Section 174(b) capitalizes Sec. 174 costs (i.e., R&E expenditures) over a period of not less than 60 months

(taxpayer can choose for longer period).— Section 59(e) capitalizes Sec. 174 costs over 10 year period.

- Note: Section 59(e) explicitly provides taxpayer-favorable discretion to cherry-pick which Sec. 174 costs to capitalize (i.e., the taxpayer may elect to capitalize all US outbound related-party Sec. 174 costs and to currently deduct any Sec. 174 costs that would not result in a BETB).

- Software Development— Rev. Proc. 2000-50 applies to software development and may deduct over 36 or 60 month period.Other Considerations — If considering strategic 59(e) election, must consider potential FTC implications relating to Reg. 1.861-17

(i.e., be careful to avoid risk of losing exclusive apportionment benefit). — Consider total population of applicable costs, the start of the amortization period, the method of electing,

the potential reversal of the election, and the scope of the election.

Capitalization – research costs and/or software development


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Overview— Taxpayers subject to section 263A must capitalize all direct and certain indirect costs

properly allocable to property produced or property acquired for resale- “Produce” is broadly defined to include the following:

— Construct, build, install, manufacture, develop, improve, create, raise, or grow.— Also includes property produced by another party pursuant to a contract

with the taxpayer.- “Property” includes self-constructed assets that are produced by the

taxpayer for use in its trade or business— Types of costs subject to section 263A:

- Direct Costs – direct materials and labor costs- Indirect Costs – indirect labor costs, employee benefits, rent, taxes, etc.- Service Costs – subset of indirect costs

Capitalization – overview of applicable provisions of section 263A


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Service costs— Can be specifically identified with a service department or function; or— Directly benefits or are incurred by reason of a service department or function.— Example of service costs – personnel, accounting, security, finance, legal, etc.— Mixed Service Costs – relate to both production/resale and non-production/resale activities

(i.e., capitalizable and deductible activities)Allocation of mixed service costs— Reg. § 1.263A-1(g)(4) provides that the Direct Reallocation Method is one method that can be used to

allocate MSCs between production or resale and non-production or non-resale activities— Under the direct reallocation method, total costs of mixed service departments are allocated only to

production/resale departments or costs centers— A change in method of accounting to the direct reallocation method is an automatic change that is

implemented via a cumulative adjustment for prior years (IRC § 481(a))— The IRC § 481(a) adjustment must take into account any cumulative difference in income after 1986— Generally, a change to discontinue the direct reallocation method could not be made within the

next 5 tax years; however, Rev. Proc. 2018-56 waives the 5 year scope limitation for changes made in 2018, 2019, or 2020

Capitalization – overview of applicable provisions of section 263A (continued)

Questions

Thank you

© 2019 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved. NDPPS 821761

The KPMG name and logo are registered trademarks or trademarks of KPMG International.

The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser.

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With the BEAT - Grappling with Section 59A · 2019 U.S. Cross-Border Tax Conference May 14 – 16,...

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