Just BEAT it
29 May 2018
The BEAT element of the recent US Tax Reform has attracted much attention, industry participants discuss how it will affect the securities lending
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The base erosion anti-abuse tax (BEAT) element of recent US tax reform has attracted much attention in specialist outlets popular with accountants and lawyers. Both sets of professionals can normally be relied upon to produce extended reports of new accounting and law measures, and they have not disappointed here. Indeed, we are indebted to them for making available their detailed thoughts for educational use.
The underlying dryness of the subject matter and its arcane complexity cause the eyes of normal mortals to glaze over, at some speed. To the untrained longstanding market observer, it has elements that sound very much like a 21st-century attempt at reducing the impact of over- or under-invoicing between different members of an international group operating in different legal and tax jurisdictions.
BEAT could have some impact on securities lending, suggests Fran Garritt, director of securities lending at the Risk Management Association. He states that the essence of BEAT has to do with intercompany payments where the US administration is trying to stop firms from using such payments to reduce or avoid US taxes.
This impacts brokers more than any other individual subset in the international financial services industry, he says. They could be forced to source offshore, that is, away from US markets and US tax authorities.
He cites an utterly fictitious example: “A borrower hits its limit for inter-company transfers under BEAT, and a London branch needs to source 100 shares of IBM.”
“Let’s say the US parent in New York has those 100 shares. Then the cheapest and most efficient borrow (especially for capital purposes) would be from the New York parent. The branch may be forced to source those 100 shares from somewhere else as the inter-company transfer would be subject to the BEAT. Without the tax, the cheapest supply would be internal; with the tax, the best source may be from an agent in Europe.”
“As a general statement, interest rates are expected to rise over the upcoming one- to two-year horizon. Embedded within the rebate of a securities lending transaction is a benchmark rate (for example, overnight bank funding rate (OBFR). All else being equal, if interest rates rise, the intercompany loan could become more expensive. As a result, a firm could encroach on its tax threshold more quickly.”
In expressing such opinions, he is ahead of the pack. A surprising number of very senior figures in the industry have readily professed that they do not even know what it is. A spokesperson for a large financial institution that could have been expected to contribute, explained: “I’m afraid we don’t have anyone confident enough on the topic to speak.”
Another major custodian replied: “Nobody in our group, including myself, has heard of BEAT so we don’t have an expert on the securities lending side that can give you any information.”
Amanda Varma and Brigid Kelly, partner and associate, respectively, at Washington-based law firm Steptoe & Johnson LLP, suggest, in a blog post, that BEAT has to be seen in the broader context in which it sits, the new US tax law (P.L. 115-97), often referred to as the Tax Cuts and Jobs Act of 2017.
One of the most striking elements of the act is the reduction it mandates in the headline corporation tax rate to a flat 21 percent, compared with a previous notional 35 percent.
It has dramatically modified the US international tax provisions, impacting both US and non-US headquartered companies, Varma and Kelly say.
The duo adds: “Amongst other things, the act creates a base erosion minimum tax (informally referred to as BEAT), generally designed to curtail excessive base erosion payments, namely, deductible payments to foreign affiliates.”
These rules ensure that a US corporation pays at least a 10 percent tax (5 percent in 2018 and 12.5 percent beginning in 2026) on its taxable income after adding back these base erosion payments. Payments included in the cost of goods sold or otherwise treated as reductions to gross receipts are generally not base erosion payments.
Varma and Kelly explain that the base erosion minimum tax amount is the excess of 10 percent (or other applicable rate) of the taxpayer’s “modified taxable income” (generally, taxable income adding back base erosion payments and certain other amounts) for the taxable year over an amount equal to the taxpayer’s regular tax liability, reduced by credits other than the research credit and an amount not exceeding 80 percent of “applicable section 38 credits”.
The applicable section 38 credits include the low-income housing credit and certain energy credits. The special treatment of the section 38 credits appear responsive to concerns that the minimum tax could have negatively impacted the renewable energy and low-cost housing markets. However, such special treatment is eliminated beginning in 2026.
The minimum tax applies to US corporations, other than regulated investment companies, real estate investment trusts, or S corporations, with average annual gross receipts for the three preceding years of at least $500 million. The tax does not apply, however, unless the foreign-related party deductible payments made by a US corporation are 3 percent or more of the corporation’s total deductible payments.
The minimum tax contains several special rules for banks and registered securities dealers. They are subject to a one percentage point higher rate: 6 percent for 2018, 11 percent for 2019-2025, and 13.5 percent thereafter. In addition, the 3 percent threshold for foreign-related party deductible payments mentioned above is reduced to 2 percent.
Further, add Varma and Kelly, there is an exception from the definition of base erosion payments for “qualified derivative payments” for taxpayers that annually recognise ordinary gain or loss on such instruments.
If the devil is in the detail, he is to be found on the subject if one is determined to do so. Melissa Geiger, a partner and head of international tax at KPMG in the UK, explains the BEAT feature as a clawback provision, which effectively applies a 10 percent minimum tax for taxable income adjusted for base erosion payments.
In a thought piece on the KPMG website, Geiger notes that as the tax only affects businesses where US gross receipts are in excess of $500 million (aggregated on a global group basis) it has limited application for multinational groups without a significant US presence.
In addition, echoing Varma and Kelly, she notes that costs of goods sold (COGS) are generally excluded from the definition of base erosion payments.
For its part, Deloitte tackles the topic in an 84-page US Tax Reform Report. A base erosion payment generally means any amount paid or accrued by a taxpayer to a foreign person that is a related party of the taxpayer and with respect to which a deduction is allowable, including any amount paid or accrued by the taxpayer to the related party in connection with the acquisition by the taxpayer from the related party of property of a character subject to the allowance of depreciation (or amortisation in lieu of depreciation).
A base erosion payment also includes any amount that constitutes reductions in gross receipts of the taxpayer that is paid to or accrued by the taxpayer with respect to: (1) a surrogate foreign corporation which is a related party of the taxpayer, but only if such person became a surrogate foreign corporation after 9 November last year, and (2) a foreign person that is a member of the same expanded affiliated group as the surrogate foreign corporation. A surrogate foreign corporation has the meaning given in section 7874(a)(2) of the act, it adds.
The road to understanding the provisions of the law will not be an easy one, according to Mike Urse, PwC’s international tax services leader, in a recent blog entry on the topic. Companies are facing a whole host of complexities in order to comply with the new law, let alone change their businesses because of it. What’s clear for everyone at the forefront is that there is a lot of work that must be done, he explains.
Some might find the detail difficult to digest, but certain universal principles persist. Where there are attempts to impose new rules and regulations, long experience has shown, there are opportunities to be identified and exploited by sophisticated market practitioners.
When new laws are introduced, which create possible arbitrage manoeuvres that did not previously exist, who can blame the bright and the ambitious from attempting to exploit them?
The law of unintended consequences always seems to operate most effectively when the government, any government, of any political shade and nuance imaginable, tries to stop ordinary people from doing things, especially, when there is a profit motive involved.
In such a climate, it is possible to identify and focus upon one undoubted certainty. Uncertainty will be rampant until a sufficient body of experience and expertise has been built that will allow market participants to see more clearly the direction they ought best to follow.
If one thing is sure, it is that the outlook is unclear—very unclear. That is encapsulated in this closing comment from Mati Greenspan, senior market analyst at social trading platform, eToro.
Greenspan notes: “Both elements of this story, the US tax reform and securities lending, border on the impossible for most people to understand.”
“Even securities lending industry officials are professing utter ignorance of the BEAT factor in the equation and conceding that they have thus not been able to think about its potential impact. It will be fascinating to observe how this unfolds, one way or the other.”
The underlying dryness of the subject matter and its arcane complexity cause the eyes of normal mortals to glaze over, at some speed. To the untrained longstanding market observer, it has elements that sound very much like a 21st-century attempt at reducing the impact of over- or under-invoicing between different members of an international group operating in different legal and tax jurisdictions.
BEAT could have some impact on securities lending, suggests Fran Garritt, director of securities lending at the Risk Management Association. He states that the essence of BEAT has to do with intercompany payments where the US administration is trying to stop firms from using such payments to reduce or avoid US taxes.
This impacts brokers more than any other individual subset in the international financial services industry, he says. They could be forced to source offshore, that is, away from US markets and US tax authorities.
He cites an utterly fictitious example: “A borrower hits its limit for inter-company transfers under BEAT, and a London branch needs to source 100 shares of IBM.”
“Let’s say the US parent in New York has those 100 shares. Then the cheapest and most efficient borrow (especially for capital purposes) would be from the New York parent. The branch may be forced to source those 100 shares from somewhere else as the inter-company transfer would be subject to the BEAT. Without the tax, the cheapest supply would be internal; with the tax, the best source may be from an agent in Europe.”
“As a general statement, interest rates are expected to rise over the upcoming one- to two-year horizon. Embedded within the rebate of a securities lending transaction is a benchmark rate (for example, overnight bank funding rate (OBFR). All else being equal, if interest rates rise, the intercompany loan could become more expensive. As a result, a firm could encroach on its tax threshold more quickly.”
In expressing such opinions, he is ahead of the pack. A surprising number of very senior figures in the industry have readily professed that they do not even know what it is. A spokesperson for a large financial institution that could have been expected to contribute, explained: “I’m afraid we don’t have anyone confident enough on the topic to speak.”
Another major custodian replied: “Nobody in our group, including myself, has heard of BEAT so we don’t have an expert on the securities lending side that can give you any information.”
Amanda Varma and Brigid Kelly, partner and associate, respectively, at Washington-based law firm Steptoe & Johnson LLP, suggest, in a blog post, that BEAT has to be seen in the broader context in which it sits, the new US tax law (P.L. 115-97), often referred to as the Tax Cuts and Jobs Act of 2017.
One of the most striking elements of the act is the reduction it mandates in the headline corporation tax rate to a flat 21 percent, compared with a previous notional 35 percent.
It has dramatically modified the US international tax provisions, impacting both US and non-US headquartered companies, Varma and Kelly say.
The duo adds: “Amongst other things, the act creates a base erosion minimum tax (informally referred to as BEAT), generally designed to curtail excessive base erosion payments, namely, deductible payments to foreign affiliates.”
These rules ensure that a US corporation pays at least a 10 percent tax (5 percent in 2018 and 12.5 percent beginning in 2026) on its taxable income after adding back these base erosion payments. Payments included in the cost of goods sold or otherwise treated as reductions to gross receipts are generally not base erosion payments.
Varma and Kelly explain that the base erosion minimum tax amount is the excess of 10 percent (or other applicable rate) of the taxpayer’s “modified taxable income” (generally, taxable income adding back base erosion payments and certain other amounts) for the taxable year over an amount equal to the taxpayer’s regular tax liability, reduced by credits other than the research credit and an amount not exceeding 80 percent of “applicable section 38 credits”.
The applicable section 38 credits include the low-income housing credit and certain energy credits. The special treatment of the section 38 credits appear responsive to concerns that the minimum tax could have negatively impacted the renewable energy and low-cost housing markets. However, such special treatment is eliminated beginning in 2026.
The minimum tax applies to US corporations, other than regulated investment companies, real estate investment trusts, or S corporations, with average annual gross receipts for the three preceding years of at least $500 million. The tax does not apply, however, unless the foreign-related party deductible payments made by a US corporation are 3 percent or more of the corporation’s total deductible payments.
The minimum tax contains several special rules for banks and registered securities dealers. They are subject to a one percentage point higher rate: 6 percent for 2018, 11 percent for 2019-2025, and 13.5 percent thereafter. In addition, the 3 percent threshold for foreign-related party deductible payments mentioned above is reduced to 2 percent.
Further, add Varma and Kelly, there is an exception from the definition of base erosion payments for “qualified derivative payments” for taxpayers that annually recognise ordinary gain or loss on such instruments.
If the devil is in the detail, he is to be found on the subject if one is determined to do so. Melissa Geiger, a partner and head of international tax at KPMG in the UK, explains the BEAT feature as a clawback provision, which effectively applies a 10 percent minimum tax for taxable income adjusted for base erosion payments.
In a thought piece on the KPMG website, Geiger notes that as the tax only affects businesses where US gross receipts are in excess of $500 million (aggregated on a global group basis) it has limited application for multinational groups without a significant US presence.
In addition, echoing Varma and Kelly, she notes that costs of goods sold (COGS) are generally excluded from the definition of base erosion payments.
For its part, Deloitte tackles the topic in an 84-page US Tax Reform Report. A base erosion payment generally means any amount paid or accrued by a taxpayer to a foreign person that is a related party of the taxpayer and with respect to which a deduction is allowable, including any amount paid or accrued by the taxpayer to the related party in connection with the acquisition by the taxpayer from the related party of property of a character subject to the allowance of depreciation (or amortisation in lieu of depreciation).
A base erosion payment also includes any amount that constitutes reductions in gross receipts of the taxpayer that is paid to or accrued by the taxpayer with respect to: (1) a surrogate foreign corporation which is a related party of the taxpayer, but only if such person became a surrogate foreign corporation after 9 November last year, and (2) a foreign person that is a member of the same expanded affiliated group as the surrogate foreign corporation. A surrogate foreign corporation has the meaning given in section 7874(a)(2) of the act, it adds.
The road to understanding the provisions of the law will not be an easy one, according to Mike Urse, PwC’s international tax services leader, in a recent blog entry on the topic. Companies are facing a whole host of complexities in order to comply with the new law, let alone change their businesses because of it. What’s clear for everyone at the forefront is that there is a lot of work that must be done, he explains.
Some might find the detail difficult to digest, but certain universal principles persist. Where there are attempts to impose new rules and regulations, long experience has shown, there are opportunities to be identified and exploited by sophisticated market practitioners.
When new laws are introduced, which create possible arbitrage manoeuvres that did not previously exist, who can blame the bright and the ambitious from attempting to exploit them?
The law of unintended consequences always seems to operate most effectively when the government, any government, of any political shade and nuance imaginable, tries to stop ordinary people from doing things, especially, when there is a profit motive involved.
In such a climate, it is possible to identify and focus upon one undoubted certainty. Uncertainty will be rampant until a sufficient body of experience and expertise has been built that will allow market participants to see more clearly the direction they ought best to follow.
If one thing is sure, it is that the outlook is unclear—very unclear. That is encapsulated in this closing comment from Mati Greenspan, senior market analyst at social trading platform, eToro.
Greenspan notes: “Both elements of this story, the US tax reform and securities lending, border on the impossible for most people to understand.”
“Even securities lending industry officials are professing utter ignorance of the BEAT factor in the equation and conceding that they have thus not been able to think about its potential impact. It will be fascinating to observe how this unfolds, one way or the other.”
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