The latest version of the Build Back Better Act (the BBBA Draft), which the House Rules Committee released on 28 October 2021, includes significant changes to the international tax provisions of the Internal Revenue Code1 (IRC). These and other tax changes are generally intended to fund expanded social programs such as health coverage, affordable housing, universal pre-kindergarten and childcare, clean energy and climate investments, among other proposed spending provisions.
Although largely consistent with the House Ways & Means Committee draft (the HW&M Proposal) released on 13 September 2021, the BBBA Draft contains many important changes to those proposed provisions, such as updates to the effective dates to make proposals prospective only. This Tax Alert describes how the BBBA Draft differs from the HW&M Proposal and provides EY's insight on those differences. For more background on the HW&M Proposal, refer to EY Tax Alert, House Ways and Means Committee Chair proposes comprehensive international tax changes for reconciliation bill, dated 17 September 2021.
The discussion in this Tax Alert, and any reference to the BBBA Draft, also reflects the amendment that was offered by Representative Yarmuth and was released on 3 November 2021 (the Manager's Amendment). As evidenced by the Manager's Amendment, the international provisions remain the subject of negotiation and revision, and additional changes are likely in any finally enacted legislation.
Corporate tax rate and corporate alternative minimum tax
Unlike the HW&M Proposal, the BBBA Draft does not propose an increase in the corporate income tax rate under Section 11(b) (i.e., 21%). However, the BBBA Draft would implement a new 15% corporate alternative minimum tax (CAMT) based on book income for companies that report over US$1 billion2 in profits to shareholders. For more on the proposed CAMT, see EY Global Tax Alert, US: Latest Build Back Better proposal includes 15% corporate minimum tax on book income, dated 2 November 2021.
Proposed changes to the foreign tax credit
The HW&M Proposal would adopt a country-by-country foreign tax credit system, under which a taxpayer would be required to compute its foreign tax credit (FTC) limitation under Section 904 and its deemed paid foreign income taxes under Section 960 on a country-by-country basis. The foreign branch income category would be eliminated. Excess FTCs in the GILTI category (which relate to global intangible low-taxed income, or GILTI) would be eligible to be carried forward, but the 1-year carryback would be eliminated, and the 10-year carryforward period shortened to 5 years. Along the same lines, the statute of limitations on claims for credit or refund under Section 6511(d)(3)(A) would be shortened to five years.
The HW&M Proposal would repeal current Section 904(b)(4) and amend Section 864(e)(3) to treat Section 245A-eligible dividends as "tax-exempt income" (and the corresponding portion of stock of the foreign corporation that relates to the Section 245A-eligible dividend as a "tax-exempt asset") for purposes of allocating and apportioning expenses in computing the FTC limitation. Expenses other than the Section 250 deduction would, for purposes of the FTC limitation, not be allocable to the Section 951A category.
The HW&M Proposal would decrease the haircut on GILTI deemed paid foreign income taxes under Section 960(d) from 20% to 5%. The HW&M Proposal would also provide a GILTI deemed paid credit for tested foreign income taxes of a tested loss controlled foreign corporation (CFC) in certain instances.
Changes from HW&M Proposal
Foreign tax credit limitation
The BBBA Draft would generally retain the framework of the HW&M Proposal for revamping the FTC provisions. The taxable unit definition — critical for purposes of computing the country-by-country FTC limitation — would be broadened under the BBBA Draft. The HW&M Proposal would only have treated a foreign corporation as a separate taxable unit to the extent it was a CFC in which a taxpayer is a United States shareholder (US shareholder). The BBBA Draft would expand upon this to treat any foreign corporation in which a taxpayer is a US shareholder as a separate taxable unit. No explanation was given for the modification, but one effect of the broader definition may be to trace certain foreign income taxes imposed on previously taxed earnings and profits (PTEP) distributions to, or by, non-CFC foreign corporations to particular taxable units.
The BBBA Draft would retain the 10-year carryforward that exists under current law for excess FTCs in the general and passive categories, as well as the 10-year statute of limitations set forth in Section 6511(d)(3)(A). However, excess FTCs in the GILTI category would be subject to a temporary 5-year carryforward for taxes paid or accrued in tax years beginning after 31 December 2022, and before 1 January 2031, after which the carryforward period for such excess GILTI FTCs would extend to 10 years.
Under the HW&M Proposal, only the Section 250 deduction would be allocable to the GILTI category, but it was unclear whether that included the entire Section 250 deduction (including the portion of the deduction for foreign-derived intangible income, or FDII). The BBBA Draft clarifies that only the portion of the Section 250 deduction relating to GILTI (and any state and local income tax imposed on the GILTI amount) would be allocated to the GILTI category. The BBBA Draft also permits Treasury to issue guidance to allocate and apportion any other deductions to the GILTI category that it determines to be directly allocable to that income.
The HW&M Proposal also left unclear the treatment of expenses (including, for example, interest and stewardship) that would have otherwise been allocated and apportioned to the GILTI category. Were those expenses allocable to other income and, if so, how? Under the BBBA Draft, expenses that would have otherwise been allocated and apportioned to the GILTI category would, for purposes of the FTC limitation, be allocated and apportioned to US-source income. As a result, those expenses would not reduce a taxpayer's FTC limitation in the general or passive categories.
The BBBA Act clarifies that separate limitation losses, computed on a country-by-country basis, would first proportionally offset separate limitation income in the general or passive category before proportionately offsetting separate limitation income in the GILTI category. For example, assume that a domestic corporation has (i) a separate limitation loss in the Country A passive category equal to $10, and (ii) separate limitation income equal to (a) $25 in the GILTI category in Country A, (b) $20 in the general category in Country B, and (c) $30 in the general category in Country C. In that case, $4 (20/50 x 10) of the Country A passive limitation loss would offset Country B general limitation income, and $6 (30/50 x 10) would offset Country C general limitation income. None of the Country C passive limitation loss would offset the Country A GILTI limitation income.
Finally, the BBBA Draft also would direct Treasury to issue regulations addressing the treatment of base differences (which, under current law, are assigned to the foreign branch income category by reason of a scrivener's error).
These changes generally would apply to tax years beginning after 31 December 2022. The changes to the FTC carryover rules would apply to foreign income taxes paid or accrued in tax years beginning after 31 December 2022.
Deemed paid foreign income taxes
For purposes of computing the amount of GILTI deemed paid foreign income taxes, particularly with respect to tested foreign income taxes incurred by a tested loss CFC, the BBBA Draft would compute a US shareholder's inclusion percentage without regard to tested losses. For example, assume that a US shareholder directly owns 100% of the stock of two CFCs organized, and with activities, in Country A. CFC1 earns tested income of $100 and CFC2 recognizes a $50 tested loss. Neither CFC has qualified business asset investment (QBAI). Under the HW&M Proposal, the US shareholder's inclusion percentage would be 50%, resulting in a proportionate reduction in the amount of tested foreign income taxes that are incurred by both CFC1 and CFC2 and treated as GILTI deemed paid foreign income taxes (before application of the 5% haircut) with respect to the US shareholder's GILTI. Under the BBBA Draft, the US shareholder would have an inclusion percentage of 100% in this example. These changes generally would apply to tax years beginning after 31 December 2022.
On the other hand, the BBBA Draft would extend the haircut on GILTI deemed paid taxes to also apply to foreign income taxes paid or accrued (or deemed paid under Section 960(b)) with respect to distributions of GILTI PTEP. The haircut would mirror the GILTI haircut in effect, so that a distribution of PTEP for a tax year beginning in 2022 would be subject to a 20% haircut, and a distribution for a tax year beginning in 2023 would be subject to a 5% haircut. Thus, the US shareholder in the prior example would only be eligible to claim 95% of a foreign withholding tax imposed by Country A on GILTI PTEP distributed by CFC1 as an FTC. This change generally would apply to tax years beginning after the date of enactment.
Other FTC provisions in the BBBA Draft generally remain unchanged from their introduction by the HW&M Proposal but would be subject to a different effective date under the BBBA Draft. Changes to Sections 901(a), 905(c) and 6511(d)(3), regarding claims for credit or refund of an overpayment of US tax attributable to a "change in the liability" for any foreign income tax that is claimed as an FTC, would take effect 60 days after the enactment of the BBBA. Rules extending the principles of Section 338(h)(16) to any "covered asset disposition" would be effective for transactions occurring after the date the BBBA is enacted, unless the transaction occurs under a written binding contract that was in effect on 13 September 2021, and is not materially modified thereafter.
The BBBA Draft retained the HW&M Proposal's provision eliminating the Section 78 gross-up for foreign income taxes deemed paid under Section 960(b). However, this rule would only apply to tax years beginning after 31 December 2021, whereas the HW&M Proposal would have retroactively applied it to tax years beginning after 31 December 2017. The BBBA Draft also would eliminate the retroactive off-Code technical change related to the interaction of Sections 78 and 965 for purposes of applying the Section 245A dividends-received deduction (the Section 245A DRD) proposed by the HW&M Proposal.
Delaying the HW&M Proposal's country-by-country FTC system, which poses administrative and compliance challenges for all taxpayers, would provide welcome relief. On the other hand, rules addressing covered asset dispositions are proposed to be effective after the BBBA is enacted, potentially causing difficulties in connection with taxpayers' current transactions and future planning to prepare for the new regime.
Further, the combined effect of maintaining the current US corporate income tax rate, reducing the Section 250 deduction, reducing the "haircut" on GILTI deemed paid foreign income taxes to 5%, and limiting expenses allocable to the GILTI category is that US shareholders of CFCs have no residual US tax liability on GILTI from countries whose effective foreign tax rate is at least 15.8%.
Repeal of election for one-month deferral under Section 898(c)
The HW&M Proposal would repeal the one-month deferral election currently available under Section 898(c)(2), which permits a CFC to elect a tax year beginning one month earlier than the majority US shareholder year. Under a transition rule, a CFC's first tax year beginning after 30 November 2021, would end at the same time as the first required year (the majority US shareholder year) ending after that date.
Changes from HW&M Proposal
The BBBA Draft would delay the effective date of the repeal to a CFC's tax years beginning after 30 November 2022. The BBBA Draft would also direct Treasury to issue rules for allocating foreign income taxes that accrue in the first tax year due to the repeal. Thus, for a CFC that has a majority US shareholder year ending on 31 December and elected the one-month deferral year ending on 30 November, the repeal of Section 898(c)(2) would result in the CFC having a short tax year from 1 December 2022, to 31 December 2022. Foreign income taxes accrued by the CFC on 31 December 2022 (which would generally be based on a 12-month foreign tax year ending on that date), and otherwise taken into account only in that short tax year, would be allocated between the CFC's tax year ending 30 November 2022, and the short year ending on 31 December 2022, based on rules issued by Treasury.
Under the HW&M Proposal, foreign income taxes paid or accrued in the short tax year under the transition rule would generally have exceeded income in the same period. As a result, it would not have been possible to claim deemed paid foreign income taxes under Section 960(a) or (d) for taxes taken into account in that short tax year in the absence of a subpart F income inclusion or GILTI amount. The BBBA Draft addresses this problem by directing Treasury to issue regulations allocating those taxes between the two periods.
Proposed changes to GILTI and subpart F income
The HW&M Proposal's change to the corporate rate, coupled with changes to the Section 250 deduction (discussed later) and the GILTI FTC haircut, would have subjected GILTI to a 16.5625% effective rate (17.43% after taking into account the GILTI FTC haircut). The HW&M Proposal would have required US shareholders to compute GILTI (including QBAI, NDTIR and tested interest) on a country-by-country basis using a "CFC taxable units" concept. This change would also have included rules to (i) carry over net tested losses to succeeding tax years but treat those amounts as a pre-change loss under Section 382; and (ii) reduce NDTIR on QBAI from the current 10% to 5%. These changes to adopt a per-country GILTI regime were proposed to generally apply to tax years beginning after 31 December 2021.
The HW&M Proposal would also grant Treasury broad regulatory authority under Section 951A and clarify the interaction of the GILTI rules with the existing provisions of subpart F (including Section 961(c)). Those rules were proposed to generally apply retroactively to tax years beginning after 31 December 2017.
The HW&M Proposal would have significantly changed the determination of a US shareholder's "pro rata share" of subpart F and tested income from a CFC. Specifically, the proposal would have prevented certain dividends paid by a CFC from reducing the shareholder's pro rata share of the CFC's subpart F income and tested income if the dividends were paid (1) in the same tax year as certain changes in the CFC's ownership and (2) to non-US persons or persons eligible for the Section 245A DRD. This rule would have applied retroactively to distributions made after 31 December 2017.
The HW&M Proposal would have also expanded Section 961(c), which provides for basis adjustments to lower-tier CFC stock held by an upper-tier CFC to account for both subpart F income and GILTI inclusions with respect to the stock, and for distributions of PTEP on the stock.
Finally, the HW&M Proposal would have reinstated former Section 958(b)(4), which prevented "downward attribution" of foreign corporation stock to US persons and was removed in 2017. Instead, the proposal would have added a new provision, Section 951B, to replicate certain income inclusions for US shareholders that resulted from the repeal of Section 958(b)(4) without replicating all the consequences of repeal. The HW&M Proposal to re-enact Section 958(b)(4) and to enact Section 951B would have been retroactive to the foreign corporation's last tax year beginning before 1 January 2018.
Changes from HW&M Proposal
The BBBA Draft largely adopts the HW&M Proposal's country-by-country approach. Maintaining the current corporate rate and changing the Section 250 deduction would yield a 15% GILTI rate (15.8% after taking into account the GILTI FTC haircut).
The BBBA Draft would delay the effective date for the per-country GILTI rules to tax years generally beginning after 31 December 2022. The expanded grant of regulatory authority, and rules clarifying the interaction of the GILTI rules with the existing provisions of subpart F, would generally apply to tax years beginning after enactment of the BBBA. The BBBA Draft indicates that the proposed delay should not create any inference about the proper application of the IRC to tax years beginning before the tax years to which the amendments apply.
The BBBA Draft likewise adopts the other HW&M Proposal's changes but would apply those changes to (i) to tax years beginning after 31 December 2021, for the pro rata share and Section 961(c) proposals, and (ii) tax years beginning after the enactment date for the proposals under Sections 958(b)(4) and 951B. With respect to the expansion of Section 961(c), the BBBA Draft would apply those changes only for purposes of Sections 951 and 951A, rather than for all purposes of the IRC.
The deferral of the country-by-country GILTI rules represents a welcome change to the HW&M Proposal, allowing taxpayers additional time to adjust to a complex — and administratively challenging — new system. The grant of expanded regulatory authority would have given Treasury and the IRS retroactive authority for the disqualified basis rules, which were issued to prevent certain planning during the "GILTI gap period." While the BBBA Draft indicates that taxpayers should not draw inferences from the delay, the absence of a general grant of regulatory authority under Section 951A before the enactment of the BBBA likely means that questions will persist regarding the validity of the disqualified basis rules.
The prospective application of the Section 958(b)(4) reinstatement and corresponding addition of Section 951B, as compared to the retroactive application of those rules under the HW&M Proposal, would significantly reduce administrative burdens and uncertainties.
Proposed changes to Section 250 and FDII
The changes proposed in the BBBA Draft to Section 250, including the deduction for foreign-derived intangible income (FDII), are similar to those in the HW&M Proposal. Yet there are important differences.
Similar to the HW&M Proposal, the BBBA Draft would reduce the percentages a domestic corporation currently uses to compute its Section 250 deduction in a tax year. The BBBA Draft, however, would achieve greater alignment between the deduction percentages imposed on FDII and GILTI. The BBBA Draft, like the HW&M Proposal, would repeal the taxable income limitation under Section 250(a)(2) and allow the Section 250 deduction to be taken into account in computing a corporation's net operating loss (NOL), as well as in the rate at which NOLs are utilized in carryover years. The BBBA Draft would further restrict the scope of a domestic corporation's deduction eligible income (DEI) by excluding the income categories identified in the HW&M Proposal as well as an additional category of gross income.
The modifications in the BBBA Draft would generally be effective for tax years beginning after 31 December 2022 — a one-year delay when compared to the HW&M Proposal. The additional DEI exclusion categories would apply only prospectively (to tax years beginning after the date of enactment), whereas the HW&M Proposal would have applied retroactively to the introduction of Section 250 in 2018.
Changes from HW&M Proposal
Modification of Section 250 deduction percentages
Under the BBBA Draft, the Section 250(a)(1) deduction percentages would be 24.8% for FDII and 28.5% for GILTI and the corresponding Section 78 gross-up. These percentages compare to 21.875% and 37.5%, respectively, in the HW&M Proposal. Similar to the HW&M Proposal, blended percentages would apply for taxpayers with a tax year that straddles 31 December 2022 (e.g., corporations with a fiscal tax year).
Elimination of taxable income limitation and inclusion of Section 250 deduction in NOL
Current Section 250(a)(2) reduces a domestic corporation's FDII and GILTI amounts for purposes of calculating the corporation's Section 250 deduction to the extent that the sum of those two amounts exceeds the corporation's taxable income (computed without regard to Section 250).
The BBBA Draft would eliminate the taxable income limitation in current Section 250(a)(2). Further, it would amend Section 172 to take into account the Section 250 deduction in computing a domestic corporate taxpayer's NOL. As a result, the Section 250 deduction could cause, or increase, an NOL in a loss year and increase the amount of an NOL carryover available for utilization in a carryover year. In these respects, the BBBA Draft is identical to the HW&M Proposal.
Additional exclusions from DEI
To derive a taxpayer's DEI under current law, certain categories of gross income are excluded from the taxpayer's total gross income. The HW&M Proposal would add three new DEI exclusion categories, effective retroactively to 2018. In substance, the BBBA Draft would add the same three new categories — as well as a fourth. Under the BBBA Draft, however, these new DEI exclusion categories would apply only prospectively, to tax years beginning after the date of enactment.
One of the new DEI exclusion categories in the HW&M Proposal is income "of a kind which would be foreign personal holding company income" (FPHCI) (as defined in Section 954(c)). In lieu of this new FPHCI exclusion category, the BBBA Draft generally would exclude from DEI passive income within the meaning of Section 904(d)(2)(B)(i) or (ii). The BBBA Draft is substantively the same as the HW&M Proposal but defined by reference to Section 904.
The BBBA Draft also would add a "new" DEI exclusion category: "except as otherwise provided by the Secretary," income and gains from the sale or other disposition (actual or deemed) of property giving rise to rents or royalties from the active conduct of a trade or business.
The BBBA Draft's prospective application of the additional DEI exclusions is a welcome change. Similarly, its reformulation of the FPHCI exclusion category in the HW&M Proposal — by defining the exclusion by reference to the definition of passive income in Section 904(d)(2)(B)(i) — is helpful in that the exclusion would appear to incorporate any elaborations on this definition of passive income under the Section 904 Regulations.
In this respect, Prop. Reg. Section 1.904-4(b)(2)(i)(A) (which would apply retroactively) confirms that the reference to "income of a kind that would be FPHCI as defined in Section 954(c)" takes into account any exception thereunder. Thus, income would not be considered passive under Section 904(d)(2)(B)(i) if, for example, the Section 954(c)(6) "look through" exception would apply if the domestic corporation were a CFC.
In addition, Treas. Reg. Section 1.904-4(b)(2)(iii) provides that certain rents and royalties derived in the active conduct of a trade or business do not constitute passive income (determined without regard to the related-party restriction under Section 954(c)(2)(A) and taking into account the activities of affiliates). Thus, it would appear that the DEI exclusion would not apply to royalties or rents that satisfy the requirements of Treas. Reg. Section 1.904-4(b)(2)(iii). The House Ways and Means Committee Report supports this conclusion, citing to Treas. Reg. Section 1.904-4(b)(2)(iii) as an example of income that is not considered passive and therefore subject to the DEI exclusion.
Absent regulatory guidance, the BBBA Draft's potentially expansive DEI exclusion for income and gains from the sale or other disposition (actual or deemed) of property giving rise to rents or royalties derived in the active conduct of a trade or business would appear to apply to a sale or other disposition of licensed IP, even if the related royalties constituted active income. It is unclear, however, what transactions the language regarding income or gains from deemed sales or other dispositions is intended to target.
Proposed changes to Sections 245A, 957 and 1059
The HW&M Proposal would have limited the availability of the 100% Section 245A DRD to dividends received by a domestic corporation from a CFC with respect to which the domestic corporation is a US shareholder (provided other conditions are met). Under current law, the Section 245A DRD is available to a domestic corporation that is a US shareholder of a foreign corporation even if the foreign corporation is not a CFC (i.e., a so-called 10/50 company).
The HW&M Proposal would have also limited the benefits provided by the Section 245A DRD by expanding the application of Section 1059 to "purchased" E&P. More specifically, the HW&M Proposal included new Section 1059(g), which would have required a US shareholder to reduce its basis in stock in a foreign corporation (and potentially recognize gain) on which it received a disqualified CFC dividend. For this purpose, a disqualified CFC dividend is a Section 245A DRD-eligible dividend that is paid by a CFC and attributable to E&P earned (or attributable to gain that accrued) while (i) the foreign corporation was not a CFC or (ii) the shares on which the dividend was paid were not held by a US shareholder (such E&P, disqualified E&P).
Finally, the HW&M Proposal would have provided an election to treat a foreign corporation as a CFC (the CFC election).
Under the HW&M Proposal, the changes to Sections 245A and 1059 would have applied to distributions made after the date of enactment. The CFC election would have applied retroactively to the last tax year beginning before 1 January 2018, and each subsequent tax year of the foreign corporation.
Changes from HW&M Proposal
The BBBA Draft retains the changes to Section 245A and the CFC election in Section 957.
The BBBA Draft also retains proposed Section 1059(g), albeit with a few modifications: First, E&P is not treated disqualified E&P if the E&P earned with respect to shares held by a US shareholder during a CFC-period even if the E&P is attributable to gain that accrued during a non-CFC period or gain that accrued while the shares were not held by a US shareholder. Section, it would treat as disqualified E&P any E&P earned by a CFC during a period when the foreign corporation was treated as a CFC solely because of the repeal of Section 958(b)(4) (as discussed previously). Finally, it would not treat domestic partnerships or certain trusts as US shareholders.
Consistent with the HW&M Proposal, the BBBA Draft would apply the changes to Sections 245A and 1059 to distributions made after the date of enactment. Unlike the HW&M Proposal, however, the CFC election in the BBBA Draft would apply to a foreign corporation's tax years beginning after the enactment date (and to tax years of US persons in which or with which the foreign corporation's tax years end).
The addition of Section 1059(g), and particularly the addition of the special rule related to periods during which Section 958(b)(4) was repealed, would create yet another layer of E&P for taxpayers to track and manage.
Proposed changes to BEAT
The BBBA Draft generally retains the framework to compute the BEAT liability under Section 59A, with some modifications to the changes proposed by the HW&M Proposal. It retains taxpayer-favorable provisions such as the HW&M Proposal's exceptions to base erosion payment, the allowance of general business credits under Section 38 to offset the BEAT tax liability, and the rule for computing BEAT liability, which would not require the regular tax liability to be reduced by credits. It also retains less favorable provisions of the HW&M Proposal such as the expanded definition of base erosion payments relating to inventory and the repeal of the base erosion percentage threshold for any tax year beginning on or after 1 January 2024.
The BBBA Draft would make several significant changes to the HW&M Proposal. These include accelerating the increased BEAT rates and adding a new rule that could subject a taxpayer, and its successors, to BEAT for 10 consecutive years if a taxpayer were an applicable taxpayer for any tax year beginning after 31 December 2021. The two exceptions to the definition of base erosion payment that were introduced in the HW&M Proposal would also be modified. Consistent with the HW&M Proposal, the changes to BEAT proposed in the BBBA Draft would generally be effective for tax years beginning after 31 December 2021.
Changes from HW&M Proposal
Increased BEAT rates
The HW&M Proposal would have expedited the increase to the current BEAT rate from 10% to 12.5% for tax years beginning after 31 December 2023, and then from 12.5% to 15% for tax years beginning after 31 December 2025. The BBBA Draft further accelerates the increase in the BEAT rates from 10% to 12.5% for tax years beginning after 31 December 2022, from 12.5% to 15% for tax years beginning after 31 December 2023, and then to 18% for tax years beginning after 31 December 2024.
New 10-year applicable taxpayer rule
The BBBA Draft would add a new rule that would treat a taxpayer, and any of its successors, as an "applicable taxpayer" (and thus subject to BEAT) for each of the 10 succeeding years if a taxpayer were an applicable taxpayer for any tax year beginning after 31 December 2021.
Exceptions for payments subject to US tax or a sufficient rate of foreign tax
The HW&M Proposal contained two new exceptions to the definition of a base erosion payment that are retained with some modifications in the BBBA Draft. First, consistent with HW&M Proposal, the BBBA Draft includes proposed Section 59A(i)(1)(A), which generally provides that an amount is not treated as a base erosion payment if US tax is imposed on that amount. The Manager's Amendment clarifies that this exception may also apply if the US tax was imposed at the time of payment or accrual.
The BBBA Draft would also add Section 59A(i)(1)(B), which would treat US tax as imposed without regard to any deduction allowed under Sections 241 through 250. Consistent with the HW&M Proposal, Section 59A(i)(1)(C) would determine amounts that are not treated as base erosion payments under this exception by reference to rules similar to former Section 163(j)(5), as in effect before the Tax Cuts and Jobs Act. The cross-reference to former Section 163(j)(5) implies that in some circumstances only a proportionate amount may be excluded from the definition of base erosion payment under the exception for payments on which tax is imposed. The House Rules Committee report notes, however, that the BBBA Draft provides an exception for payments "subject to US tax."
Second, the HW&M Proposal would not treat an amount as a base erosion payment to the extent the taxpayer establishes that the amount is subject to an effective rate of foreign income tax that is not less than the BEAT rate in effect for that tax year. The BBBA Draft would refine this exception to except amounts from treatment as base erosion payments if they were subject to an effective foreign income tax rate that is not less than the lesser of (i) 15%, or (ii) the BEAT rate in effect for that tax year. As such, a 15% effective rate of foreign income tax would be considered "sufficient foreign tax" even when the BEAT rate increases to 18% in tax years beginning after 31 December 2024.
The BBBA Draft would add an anti-abuse provision that would apply "to the extent provided by the Secretary in regulations." In particular, this rule would apply to certain payments where a payment to a foreign related person funds a payment to a second foreign related person. Specifically, this rule would require treatment of any amount paid to a foreign related party as paid to another foreign related party (i) if the second foreign related party were subject to an effective rate of foreign tax that was less than the lesser of 15% or the BEAT rate in effect for that tax year, and (ii) "to the extent the amount so paid directly or indirectly funds a payment to such second foreign person." It is not clear to what extent taxpayers would be required to trace an amount to determine whether it "directly or indirectly funds" a payment made to another foreign related party. Moreover, the statutory text does not appear to limit the type of payments that would be subject to this rule.
In addition to this new anti-abuse rule, the BBBA Draft would retain the more general anti-abuse rule in the HW&M Proposal (Section 59A(i)(1)(D)) that would authorize Treasury to issue regulations that "may require that any transaction or series of transactions among multiple parties be recharacterized as one or more transactions directly among any two or more of such parties where the Secretary determines that such recharacterization is appropriate to carry out, or prevent avoidance of, the purposes of this section."
COGS and payments with respect to inventory
The BBBA Draft retains the HW&M Proposal's expanded definition of base erosion payments relating to inventory. Specifically, proposed Section 59A(d)(5) would treat certain payments with respect to inventory as base erosion payments and, therefore, exclude them from COGS for purposes of determining the applicable taxpayer's "modified taxable income" (MTI) (thereby increasing MTI).
Subject to the exceptions described earlier (i.e., for an amount on which tax is imposed, or where payments are subject to sufficient foreign income tax), the expanded definition of base erosion payment continues to include:
Instead of "looking through" to the actual indirect costs the foreign related party incurred to determine the amount described in (2)(ii), taxpayers could use a safe harbor, which would provide that 20% of the amount paid or incurred by the taxpayer to the related party to purchase the inventory would be indirect costs excludible from the definition of base erosion payments. The safe harbor contained in the BBBA Draft is identical to the safe harbor in the HW&M Proposal.3
As noted, amounts attributable to direct costs would generally not be subject to BEAT. Direct costs paid or incurred by one foreign related party to another foreign related party, however, would not be subject to BEAT only to the extent ultimately attributable to amounts paid or accrued (directly or indirectly) to a US person or an unrelated person, or otherwise subject to US tax.
The BBBA Draft would also add a new provision that would apply rules similar to the rules of proposed Section 59A(i)(1)(B) and (C) (relating to the exception for amounts on which tax is imposed) for purposes of determining whether an amount paid or incurred to a foreign related party with respect to a purchase of inventory is a base erosion payment.
The Manager's Amendment would further amend current Section 59A(d)(2) to include as a base erosion payment any amount that is paid or accrued to a foreign related party and capitalized to depreciable property produced by the taxpayer (self-constructed assets) under Section 263A, including payments for indebtedness (interest) or services. Further, the Amendment clarifies that the depreciation related to any amount that is paid to a foreign related party, capitalized to the basis of depreciable assets and included in taxpayer's inventory costs under Section 263A also is a base erosion payment (so the depreciation would be excluded from COGS when determining MTI). Additionally, the Manager's Amendment would redefine the "base erosion tax benefit" to bring within its scope deductions allowed for the proposed new base erosion payment definition described in Section 59A(d)(2)(B). Thus, this rule would treat deductions associated with the new base erosion payments under Section 59A(d)(2) (regarding amounts capitalized to self-constructed assets) as base erosion tax benefits under Section 59A(c)(2)(B).
Base erosion percentage test
The BBBA Draft would retain the HW&M Proposal's prospective repeal of the base erosion percentage test but slightly modify the statutory language. Specifically, the BBBA Draft would determine, for any tax year beginning before 1 January 2024 (thereafter the test would be repealed), the base erosion percentage under the rules in effect before the BBBA's enactment date. Thus, the base erosion percentage test, which is one of the thresholds for determining whether a taxpayer is an applicable taxpayer, would be computed without regard to the changes contemplated to BEAT by the BBBA Draft.
A taxpayer's base erosion percentage depends largely on the amount of its base erosion tax benefits. Under current Section 59A and its underlying regulations, amounts included in COGS are generally not base erosion payments and are not base erosion tax benefits. The BBBA Draft did not change the definition of "base erosion tax benefit"; as such, both the numerator and denominator of the base erosion percentage would continue to exclude amounts included in COGS.4 For tax years beginning after 31 December 2021, however, an applicable taxpayer's MTI would exclude certain inventory payments that are recovered as COGS and that are base erosion payments under proposed Section 59A(d)(5), as previously discussed.
Special rule for banks and securities dealers
The BBBA Draft would retain the rules broadening the scope of taxpayers subject to the higher BEAT rate for banks and securities dealers (and their affiliates) but would terminate the application of this higher rate for any tax year beginning after 31 December 2024. Therefore, for tax years beginning after 2024, the same generally applicable BEAT rate would apply to banks and securities dealers as other applicable taxpayers.
The BBBA Draft's modifications to BEAT, which are largely consistent with the framework of the HW&M Proposal, suggest that the Stopping Harmful Inversions and Ending Low-Tax Developments (SHIELD) proposal set forth by Treasury in the Green Book is no longer being contemplated. Nevertheless, the BBBA Draft appears to incorporate some elements of the SHIELD proposal into BEAT. For example, a new anti-abuse rule could treat a payment as paid to another foreign related person if that payment funds a payment to the second foreign related person and that person is subject to an effective rate that is below the required threshold. This rule is similar to the secondary rule that was proposed under SHIELD, which would partially subject payments made to group members that were not in low-tax jurisdictions to SHIELD to the extent that other group members were subject to an effective rate of tax below a designated minimum tax rate. According to the BBBA Draft, this anti-abuse rule would apply to the extent provided in regulations, so further guidance would be required to prescribe whether and how the rule would apply.
Some of the BBBA Draft's modifications may be adverse to taxpayers, such as the accelerated increase in the BEAT rates and the 18% BEAT rate that would apply after 2024. The 10-year rule contained in the BBBA Draft would expand the BEAT base by treating a taxpayer (and its successors) as an applicable taxpayer for 10 consecutive years if the taxpayer qualified as an applicable taxpayer after 2021. On the other hand, the termination of the higher BEAT rate applicable to banks and securities dealers after 2024 may be a welcome change for taxpayers that would otherwise be subject to higher BEAT rates under the HW&M Proposal.
Proposed changes to Section 163 interest expense limitation
The HW&M Proposal would add new Section 163(n), which would limit the deductibility of interest expense of a "specified domestic corporation" (SDC) that is part of an international financial reporting group that prepares consolidated financial statements (an IFRG). The limitation would preclude deductions for net interest expense from exceeding the product of 110% of the SDC's "allowable percentage." Section 163(n) would not, however, apply to interest expense to the extent of the SDC's interest income.
Generally, the proposal is intended to limit the deduction for interest expense to the SDC's proportionate share of the overall IFRG's interest expense, based on the SDC's relative earnings before interest income and interest expense, taxes, depreciation, depletion, and amortization (EBITDA) compared to that of the group as a whole.
The new limitation would apply in conjunction with current Section 163(j), so that interest deductions could not exceed whichever limitation is more restrictive. Under the HW&M Proposal, any interest disallowed under either Sections 163(n) or 163(j) following the effective date could be carried forward up to five years.
The HW&M Proposal's version of Section 163(n) would apply to tax years beginning after 31 December 2021.
Changes from the HW&M Proposal
The BBBA Draft retains the same operative mechanics as the HW&M Proposal for computing the limitation under Section 163(n). However, the BBBA Draft would make two important changes: First, the BBBA Draft would eliminate the five-year carryforward limitation under Section 163(o)(2). As a result, any disallowed interest expense deductions under either Section 163(n) or 163(j) may be carried forward indefinitely (consistent with current law). Second, the BBBA Draft would extend the proposed effective date of the provision by one year, to tax years beginning after 31 December 2022.
In addition, the BBBA Draft would expand the grant of regulatory authority to include guidance on (i) treating a CFC's subpart F income and any related interest expense as income and interest expense of the domestic corporation, (ii) preventing the omission, inclusion or duplication of any interest income or expense, and (iii) domestic corporations that own interests in fiscally transparent entities.
The Manager's Amendment clarifies that an SDC's EBITDA would be computed on a standalone basis, disregarding intragroup distributions. The Amendment would also modify (in comparison to the HW&M Proposal) Treasury's regulatory authority by treating just interest income characterized as subpart F income (as opposed to all subpart F income) and related interest expense as the SDC's income and interest expense.
The elimination of the five-year carryforward limitation for disallowed business interest expense, which would remove the possibility of permanently losing the attribute, would be a welcome development for taxpayers and could lessen the impact of Section 163(n). Moreover, the extension of the effective date provides taxpayers with greater opportunity to plan for and model the potential impact of Section 163(n). Although the BBBA Draft, like the HW&M Proposal, leaves several questions unanswered (such as how proposed Section 163(n) would interact with other provisions limiting interest expense deductions other than Section 163(j) or whether the rule applies on a consolidated basis), taxpayers may take the opportunity provided by the delayed effective date to holistically evaluate their capital structures to determine the most optimal financing structure.
For additional information with respect to this Alert, please contact the following:
Ernst & Young LLP (United States), International Tax and Transaction Services
Ernst & Young LLP (United States), Foreign Tax Credits and GILTI
Ernst & Young LLP (United States), Subpart F, IRC Sections 245A and 1059
Ernst & Young LLP (United States), IRC Section 250 and FDII
Ernst & Young LLP (United States), BEAT
Ernst & Young LLP (United States), IRC Section 163