On Dec. 6, 2019, the U.S. Treasury Department and the Internal Revenue Service issued final and proposed regulations (the final BEAT regulations) under tax code Section 59A on the Base Erosion Anti-abuse Tax (BEAT).
The Final BEAT Regulations
Some notable exceptions aside (mostly related to the exclusion from the definition of Base Erosion Payments (BEPs) of any amount transferred to or exchanged with a foreign related party in a specified non-recognition transaction), the final BEAT regulations did not contain many surprises with respect to the identification of BEPs when compared to the previously proposed BEAT regulations released Dec. 13, 2018 (the 2018 proposed regulations). (For a detailed discussion on the final BEAT regulations see this EY Tax alert)
An important element of the 2018 proposed regulations that carried into the final BEAT regulations is the partial or complete exclusion from the definition of BEPs for services that are eligible for the service cost method (SCM) (Section 59A(d)(5) of the statue and Treasury Regulation 1.59A-3(b)(3)(i) of the final BEAT regulations). The final BEAT regulations impose specific eligibility and compliance requirements on taxpayers who would like to benefit from this exclusion (the BEAT SCM Exclusion). The purpose of this article is to review these requirements and compare them to the requirements under Treas. Reg. §1.482-9(b) (the services regulations) for applying the SCM. An important point to keep in mind when discussing the respective requirements is that the SCM election under the services regulations is typically made for outbound services, whereas Section 59A only applies to inbound services. In practice this means that taxpayers who have both inbound and outbound services will have to make very little adjustments to their analysis and documentation approach to apply the BEAT SCM exclusion, as we will show below.
The BEAT SCM Exclusion
As the applicability of the BEAT SCM exclusion is important for many taxpayers facing the possibility of paying BEAT under Section 59A, it is also critical to understand the requirements under the final BEAT regulations and how they compare to the similar SCM related requirements under the services regulations.
Eligibility for the SCM under the services regulations and the BEAT SCM Exclusion
The SCM, is a specified method that “evaluates whether the amount charged for certain services is arm’s length by reference to the total services costs with no mark-up”. Under the services regulations the following four conditions must be satisfied in order to apply the SCM:
(1) the service should be a covered service as defined in paragraph (b)(3) of the relevant section (i.e., the service should either meet the definition of specified covered service or should be a low margin covered service),
(2) the service should not be an excluded activity as defined in paragraph (b)(4) of the relevant section,
(3) the service should not be precluded from constituting a covered service by the business judgment rule, and
(4) adequate books and records should be maintained as described in paragraph (b)(6) of the relevant section.
In summary, the SCM is a safe harbor that allows taxpayers to charge for certain low value services at cost. Taxpayers have the option to apply the SCM when the requirements are met but are not required to do so.
The final BEAT regulations, like the 2018 proposed regulations, provide an exclusion from the definition of BEPs for amounts payable to foreign related parties for services eligible for the SCM under the services regulations, without regard to the business judgment rule under Treas. Reg. 1.482-9(b)(5). The BEAT SCM Exclusion applies to the total service cost, but not to any markup applied (See Treas. Reg. 1.59A-3(b)(3)(i)(A)).
This means that regardless of whether taxpayers elect to apply the SCM to eligible services, the cost portion (but not the markup) of any payment for inbound services that qualify for the SCM would not be considered a BEP. This would apply even if the services are the main activity of the foreign related service provider receiving the payments from the U.S. taxpayer (business judgment rule).
Documentation for applying the SCM and the BEAT SCM Exclusion
Due to the lack of detailed guidance, taxpayer approaches vary in their effort to substantiate the eligibility for the SCM method under Section 1.482-9(b). The level of effort may depend on the industry in which the taxpayer operates: for example, industries that rely heavily on related party services tend to prepare more detailed documentation than companies in industries where such services are less prevalent. Additionally, taxpayers that operate with a large variety of related party services are more likely to put more effort into their documentation than others that deal with a more standardized set of services (which are, arguably, easier to document).
Some taxpayers choose the “short and sweet” approach and analyze the applicability of the SCM mostly at a high-level, usually reaching a conclusion on the nature of a particular service (high or low value) based on general account name descriptions. Others also take a high-level approach, but with more focus on whether their transactions are covered services as defined in the services regulations and—importantly—whether they fall within the scope of excluded services (see Revenue Procedure 2007-13 for covered services and Treas. Reg. 1.482-9(b)(4) for excluded activities).
Finally, some taxpayers perform an in-depth analysis of the nature of their related party services by cost-center and of the allocation of costs to the different related parties based on arm’s length principles. They then use this information to document why their services are in fact SCM eligible and what exact amounts are being charged for them. Based on our experience, we strongly urge taxpayers to adopt this robust approach, particularly as we have seen financial auditors requiring this level of detail.
Because the in-depth analysis is our recommended approach under the services regulations, we consider that a similar approach to the BEAT SCM exclusion eligibility would be equally beneficial. This is true especially considering the similarities between the books and records requirements under the services regulations and those under the final BEAT regulations that we have outlined below.
Mandatory BEAT SCM books and records requirements
The BEAT SCM books and records requirements are mandatory rather than optional, if taxpayers want to qualify for the BEAT SCM Exclusion. The language under Treas. Reg. 1.59A-3(b)(3)(i)(B)(2) is very clear: “Adequate books and records must be maintained as described in paragraph (b)(3)(i)(C) of this section, instead of as described in §1.482-9(b)(6)” [emphasis added].
Even though the provision differentiates the requirements under the services regulations from those listed under the final BEAT regulations, the rules are almost identical. Under both set of rules, the books and records need to be maintained for as long as the costs with respect to the services are incurred by the renderer. Additionally, the requirements are substantively very similar. The comparative table below illustrates that similarity:
There are only two notable differences when supporting the applicability of the SCM under the final BEAT regulations and the Service Regulations, namely:
(1) The services regulations require a statement as to the taxpayer’s intention to apply the SCM. The final and proposed regulations do not require that taxpayers elect to apply the SCM to be eligible for the BEAT SCM Exclusion; and
(2) Due to the different treatment of cost base and markup for BEAT purposes, the BEAT SCM documentations must include a separate calculation of the amount of the profit mark-up (where one is applied).
Obviously, there is significant overlap between the requirements under the services regulations and the final and proposed regulations, and thus the necessary analysis is already very familiar to many taxpayers. In fact, considering the detailed documentation requirements under Treas. Reg. 1.6662-6, a complete U.S. transfer pricing documentation report (6662 documentation), including a thorough analysis of the SCM eligibility and a detailed and careful allocation of these costs in line with Treas. Reg. 1.482-9(k) will be sufficient to support the BEAT SCM exclusion. It is by no means clear that separate documentation needs to be created to meet final BEAT regulations requirements.
This remains true when taxpayers opt to apply a markup for inbound low value services that are otherwise eligible for SCM, as is usually done to comply with foreign tax authorities’ expectations in line with the OECD Transfer Pricing Guidelines recommendations, such as the paragraph below:
“D.2.4. Profit mark-up
7.61 In determining the arm’s length charge for low value-adding intra-group services, the MNE provider of services shall apply a profit mark-up to all costs in the pool with the exception of any pass-through costs as determined under paragraphs 2.99 and 7.34. The same mark-up shall be utilised for all low value-adding services irrespective of the categories of services. The mark-up shall be equal to 5% of the relevant cost as determined in Section D.2.2. The mark-up under the simplified approach does not need to be justified by a benchmarking study. The same mark-up may be applied to low value-adding intra-group services performed by one group member solely on behalf of one other group member, the costs of which are separately identified under the guidance in paragraph 7.57. It should be noted that the low value-adding intra-group services mark-up should not, without further justification and analysis, be used as benchmark for the determination of the arm’s length price for services not within the definition of low value-adding intra-group services, nor for similar services not within the elective, simplified scheme.”
In those cases, we recommend that taxpayers pay attention to the phrasing they use when analyzing the best method to benchmark the services. They should make sure not to state that the services are not eligible for SCM, when in fact they are merely opting out of applying the SCM method.
In summary, if the taxpayer elects not to apply SCM to otherwise eligible service transactions, the taxpayer will not be obligated to comply with the requirements of the services regulations. However, the taxpayer should be able to meet the BEAT SCM requirement by using a template compliant with the services regulations, as described above and including a separate calculation of the amount of the profit mark-up.
Importantly, a separate calculation is not necessary in all cases. Many taxpayers are undertaking the SCM eligibility analysis and cost calculation using statistical sampling (see Rev. Proc. 2011-42). This is particularly important in cases when there are so many individual intercompany charges that each one of them cannot be fully analyzed in detail. Giving taxpayers the option to focus on a subset of the expenses (i.e., the representative sample selected) allows them to generate high-quality documentation substantiating the SCM eligibility requirements.
Timing of the books and records requirement
An interesting question arises regarding the timing of this regulation. As mentioned above, the books and records under both the Services and the final BEAT regulations need to be maintained for as long as the costs with respect to the services are incurred by the renderer. As explained, many taxpayers meet the books and records requirement by simply completing their 6662 documentation by the time they file their federal corporate income tax return. Although there is no clear requirement as to the timing of the SCM or the BEAT SCM books and records requirement, there seems to be a consensus amongst practitioners that the documentation will need to be presented—at the latest—upon a request at audit. Arguably, it would be needed at the time of preparing form 8991 (Tax on Base Erosion Payments of Taxpayers with Substantial Gross Receipts). It is probably best practice to prepare the supporting books and records as the intracompany costs are being booked.
Conclusion: Using the 6662 documentation is a practical solution
From a practical perspective, diligent taxpayers are (as always) encouraged to have transfer pricing documentation covering service payments to related parties, thoroughly analyzing SCM eligibility (when elected) and supporting the applied mark-up if any. Taxpayers that have included an SCM eligibility type-analysis (as part of their 6662 documentation) may add a section to their reports indicating that this transfer pricing documentation is meant to ensure compliance with the books and records requirement under final BEAT regulations and thus satisfy the requirements for the BEAT SCM Exclusion. Taxpayers that have not done so—for example because they only had inbound services—may still avail of this practical option by simply adding a section to their 6662 documentation supporting the SCM eligibility (without regard to the business judgement rule) and including a calculation of the profit mark-up amount.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Kenneth Christman, Managing Director (Retired), Transfer Pricing, EY*
Carlos Mallo, Managing Director, Transfer Pricing, EY*
Joana Dermendjieva, Manager, Transfer Pricing, EY*
* The views expressed are those of the authors and are not necessarily those of Ernst & Young LLP or other members of the global EY organization