United States: The BEAT Proposed Regulations: Use Of Common Law Doctrines

With its new reach, the Base Erosion and Anti-Abuse Tax ("BEAT") under Section 59A has now come into sharp focus for many large corporate taxpayers, particularly in light of the phase in of the 10% BEAT rate for taxable years beginning in 2019. While labeled an "inbound provision," the BEAT may apply most harshly to U.S. based multinational corporations. This is because of the adverse treatment under the BEAT rules of U.S. tax attributes, such as net operating loss ("NOL") carryovers and foreign tax credits ("FTCs") for foreign taxes imposed on foreign source income. Many corporate taxpayers who previously sheltered regular tax liability with NOLs or FTCs may find themselves facing a BEAT liability. Taxpayers engaged in services or other industries with primarily "below-the-line" deductions also are likely to be hit hard by the BEAT

In December 2018, the IRS and Treasury issued proposed regulations on the BEAT. Although the proposed regulations contain a few unfavorable surprises, they also are helpful in providing clear guidance on several BEAT interpretive questions. As with most of the Tax Reform-related regulatory projects, the proposed regulations are intended to be effective as of the first year of BEAT's applicability, which is for taxable years beginning after January 1, 2018. In light of the relatively clear guidance provided by the BEAT Proposed Regulations, taxpayers can now begin planning in earnest to mitigate potential BEAT exposure. Several areas of key issues that face taxpayers and require interpretation are set out below.

Use of Common Law Doctrines

One area left open for consideration by the Proposed Regulations is the treatment of various shared expenses or pooled revenue of the U.S. corporation and foreign affiliates. For example, assume that a foreign affiliate pays third-party expenses and then embeds the reimbursement for this expense to the U.S. subsidiary in an intercompany fee. For example, in the pharmaceuticals sector, a foreign entity in the group may pay third-party clinical testing expenses directly for the benefit of a U.S. affiliate. As another example, a foreign parent or affiliate might pay for informational technology, supplies and other third-party costs that benefit the group and seek reimbursement for part of that expense from a U.S. affiliate. From a regular tax perspective, the taxpayer may not have cared whether the payment by the U.S. subsidiary to its foreign affiliate was characterized as a direct reimbursement of the third-party expense or a separate intercompany charge deductible to the U.S. subsidiary and includible in income by the foreign affiliate. For BEAT purposes, however, such a distinction makes a major difference in whether or not such expenses are included in the U.S. subsidiary's base erosion payments. Analogous questions also arise on the revenue side in determining, for example, whether a global services agreement executed by the U.S. company and its foreign affiliates establishes a prime contractor–subcontractor relationship or rather an agreement to directly share revenue from the third-party customer

The BEAT Proposed Regulations do not directly address such questions, deferring instead to the common law doctrines such as assignment of income, the reimbursement doctrine, and conduit case law. As noted in the Preamble, the characterization of such arrangements has other tax effects, so that Treasury and IRS concluded that it was inappropriate to provide a special characterization for BEAT purposes only. The character of a transaction as a separate payment or conduit for third-party revenue or expense—a critical distinction for BEAT purposes—will turn on general common law principles.

As others have noted in the context of qualified cost-sharing arrangements, Reg. §1.482-7(j)(3) seems to provide favorable treatment of cost-sharing transaction payments by deeming each payor to have incurred the expenses at the location where the work was performed. CST payments received by the payor of intangible development costs (IDCs) are deemed to be a reduction of its deductible payments. As the IRS advised in connection with the 1995 cost-sharing regulations, "R&E cost-sharing payments are not income to the recipient, but reduce the amount of deductible R&E expense of the recipient subject to allocation. ... [A] CFC in a cost-sharing arrangement directly incurs and deducts a portion of the section 174 R&E expenses."¹

Outside the specialized regulations for qualified R&D cost-sharing, taxpayers seeking to reduce their base erosion payments will need to dust off a mass of old and sometimes varied case law.

One area outside BEAT where the reimbursement doctrine has previously been an area of focus is where one party reimburses another party for an expense that is non-deductible for U.S. federal income tax purposes, such as employee meal and entertainment subject to Code Sec. 274 (hereafter, "M&E expense").

In two cases, the Tax Court and Eighth Circuit addressed the proper assignment of the tax detriment of M&E expense in the context of employee leasing arrangements. In the cases, one company, the leasing company, hired truck drivers and was responsible for their payroll, including reimbursement of employee per diems and other M&E expense. The leasing company then contracted with a trucking company to provide the drivers to it on a full-time basis in return for a fee that provided the leasing company a profit on its costs. At issue was whether the trucking company or leasing company was subject to the Code Sec. 274(n) limitation on deduction of M&E expense. In Beech Trucking Co., Inc., ² the Tax Court held that application of the Code Sec. 274(n) depended on which party was the common law employer of the drivers who incurred the M&E expenses. The Tax Court concluded in Beech Trucking that the trucking company was the common law employer, which accordingly bore the tax detriment of the M&E expense, while the leasing company was effectively treated as a conduit for payment of the M&E expense.

In a subsequent case, Transport Labor Contract/Leasing, Inc., ³ the Tax Court again held that the Code Sec. 274(n) limitation applied to the common law employer, but in this case found that the leasing company filled that role. As a result, the leasing company was whipsawed by including the portion of the service fee that related to M&E in gross income, while being limited in its deduction of the reimbursed expense. On appeal, however, the Eighth Circuit reversed. The Eighth Circuit held that the leasing company's contract with the trucking company was a bona fide reimbursement arrangement that shifted the incidence of the Code Sec. 274(n) limitation to the trucking company, stressing "there is a difference between compensating a vendor for its services, and reimbursing the vendor for a specific expense incurred in providing those services." Facts the Eighth Circuit cited in this determination were that the trucking company set the drivers' wages and per-diem rates for M&E before services were rendered and that the leasing company's invoice segregated amounts for driver compensation and per-diem reimbursements. The court noted that expense reimbursement arrangements allow for some flexibility as to how the arrangement is documented.

Finally, in Rev. Rul. 2008-23, the IRS revised its position on M&E reimbursements in addressing three employee leasing situations. The revised positions give significant credence to the form of an expense reimbursement arrangement. In situation No. 1, the client pays the leasing company a lump sum periodically, with no itemized statement of wages as compared to M&E reimbursements. In this case, the leasing company bears the M&E expense, and the client is viewed as paying a service fee. In situations 2 and 3, the client was viewed as reimbursing the expenses of the leasing company where the underlying reimbursed expenses are itemized to the client either directly by the driver or by the leasing company. In situation No. 2, this result obtains even though the client makes a lump sum payment to the leasing company, and receives a statement of the M&E expenses after payment. In all situations, the leasing company charges the client a fee that includes a profit element on the salary, driver M&E expenses and other expenses of the leasing company

Similar weight was given to the form of the transaction between related parties in TAM 9237003. There, the Service addressed service charges between a U.S. Corporation and its Foreign Parent for employee travel and related M&E expenses under Code Sec. 274. Where employees of the U.S. subsidiary traveled to Foreign Parent, the U.S. subsidiary charged Foreign Parent a service fee that included a separate statement and accounting for employee travel and M&E expense. Conversely, where Foreign Parent employees traveled to the United States, the Foreign Parent invoiced the U.S. subsidiary for a single undivided fee with no itemized statement of M&E expense. The IRS National Office respected this differential invoicing pattern, so that Foreign Parent was treated as reimbursing the U.S. subsidiary's employees' M&E, while U.S. subsidiary was treated as paying a service fee to Foreign Parent that did not include any reimbursement of expense.

There are clearly lessons to be learned from the above case law and rulings insofar as identifying a reimbursement arrangement for BEAT purposes. As noted by the Court in Transport Leasing, there is important but perhaps form-driven distinction between the vendor being paid for its services and passing through an expense incurred in performing those services. Separate itemization of the reimbursed expenses and ability of the reimbursing party to control the amount and timing of such expenses would be desirable in seeking to establish a reimbursement arrangement.

The reimbursement doctrine has also been applied in a variety of other settings outside of Code Sec. 274. Some of these other authorities, in a manner more consistent with the Tax Court's focus on identifying the common law employer in Beech Trucking, have tried to discern the true incidence of the expense, in addition to analyzing the form of the arrangement. Very recently, in LTR 201904004,⁴ the IRS found an expense reimbursement where the foreign affiliate reimbursed its U.S. subsidiary for a branded prescription drug (BPD) fee imposed under the Affordable Care Act (ACA). Under the ACA, all affiliates in the group were jointly and severally liable for the BPD Fee. The U.S. subsidiary directly paid the BPD fee, but under the group's transfer pricing served as a limited risk distributor. Importantly, the intercompany distribution agreement provided that the foreign affiliate that manufactured the drugs and earned residual profits from the drug sale was responsible for the BPD and similar fees. The IRS ruled privately that the U.S. subsidiary had no accession to wealth when it received the reimbursement payment from the Foreign affiliate under a legal obligation to pay it over to the government. It seemed important, however, that the foreign affiliate reimbursing the expense economically bore the expense as the entrepreneurial entity in the structure

In the private ruling, the IRS relied on Seven-Up Co., ⁵ where Seven-Up Company managed a pool for advertising funds for its distributors. Although Seven-Up held the pooled funds in a general account commingled with its other funds, the Tax Court found them to be held in a constructive trust in which Seven-Up was obliged to use them to pay for the distributors' advertising campaign. A written agreement provided for the use of the funds for common advertising expenses. Importantly, the distributors also economically benefited from the advertising expenses paid by Seven-Up out of the shared pools.

Two other interesting authorities concern reimbursement for overhead or general and administrative expenses. Rev. Rul. 84-138 concerned a parent mutual fund company that charged its subsidiary for a broad share of overhead expenses, including personnel costs. For purposes of determining parent's status as a Regulated Investment Company ("RIC"), the IRS ruled that the payments received from the subsidiary were reimbursements excluded from gross income rather than additional gross income that might imperil the parent's RIC qualification. In support of the ruling, the IRS noted that the Parent "was not engaged in the business of receiving compensation for services of the type that were reimbursed." On the other hand, in Andrew Jergens Co., ⁶ the Board of Tax Appeals found payments received by a parent from a subsidiary for use of its manufacturing plant and related services were included in gross income. The parent owned the plant, depreciated the equipment and earned the income from the facilities. Therefore, the Board found the subsidiary's payment to the parent, although calculated as an allocation of the Parent's expenses, was a service fee, not reimbursement expenses. Considering the Parent's ownership of the relevant facilities that were leased, the Board found it more appropriate to characterize the reimbursement of expenses as gross income from the parent's conduct of business.

In applying these authorities in the BEAT context, the form of the arrangement is important, but it may also be necessary to make a deeper analysis of the economic relationships between the parties. However, as noted by the Eighth Circuit in Transport Leasing the concept of a "reimbursement arrangement" is by its nature somewhat flexible, leaving room for appropriate planning.

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Footnote

1 CCA 200243020 (July 16, 2002) (emphasis added).

2 Beech Trucking Co., Inc., 118 TC 428, Dec. 54,753 (2002).

3 Transport Labor Contract/Leasing, Inc., 123 TC 154, Dec. 55,714 (2004), rev'd by CA-8, 461 F3d 1030 (2006).

4 LTR 201904004 (Oct. 29, 2018).

5 Seven-Up Co., 14 TC 965, Dec. 17,656 (1950).

6 40 BTA 868 119.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.