On Thursday of last week, the IRS released proposed regulations on the base erosion and anti-abuse tax (BEAT). This guidance provides answers to several outstanding questions regarding this new minimum tax, but notably does not address one of the most highly anticipated areas, the question regarding the cost of goods sold (COGS) analogue for services companies.
A critique of certain statutory language in the new BEAT regime is that it unfairly discriminates against companies that sell services and in favor of companies that sell products by allowing the latter a major exception from BEAT for the cost of goods sold, while denying an analogous exception to the services sector for the cost of services sold. While that seemed to be the result produced by the language of the statute, many believed that the IRS had sufficient authority to carve out a similar exception for service providers in the regulations; and, therefore, services companies have been anxiously awaiting these regulations in hopes of that relief. In short, these regulations dash those hopes.
On the positive side, the proposed regulations do provide welcome clarification surrounding certain other areas of taxpayer concern. The following is a brief overview of some of the highlights, the first two of which provide benefits to services companies.
- Services Cost Method Exception: The proposed regulations clarify that the Services Cost Method (SCM) exception is not “all or nothing.” The cost portion of a qualifying payment is not a base erosion payment while the markup component is. Thus, charging a markup does not disqualify the entire payment from the SCM exception. To qualify, payments must meet the standard requirements under section 482 for the SCM method other than the business judgment rule, the exclusion of which generally broadens the availability of the SCM exception.
- Existing Rules Apply Regarding Beneficial Ownership, Agency, Etc.: Companies providing services globally to their customers often use a business model where one group company contracts with the third-party customer and subcontracts out all or a portion of the work to other group companies. Where the contracting entity is a U.S. company, it may bill and collect from the customer for services provided by the other group companies. In that case, payments by the U.S. company to the other group companies could be treated as “deductions,” causing them to be taxable under the BEAT. The preamble to the proposed regulations contains some language that appears to acknowledge a planning opportunity for situations where the intra-group relationship is structured such that the U.S. group company is acting as a billing and collection agent for the other group companies, in which case the payments to the other group companies would not give rise to deductions; rather, they would never be included in gross receipts in the first instance, and so would not be subject to BEAT.