Many companies are experiencing decreased cashflow during the present economic downturn and as a result are evaluating options to raise cash to fund ongoing business operations. One option that U.S. multinational corporations may consider is repatriation of earnings from related foreign corporations (FCs).
To the extent of the FC’s positive current or accumulated earnings and profits (E&P), the repatriated amount is generally regarded as a dividend under Sec. 316. Dividend treatment may be beneficial, assuming foreign tax credits are triggered to offset the U.S. tax thereon (subject to certain limitations). Thus, the company must determine how to calculate the FC’s E&P. Since E&P is a U.S. tax concept, determining E&P—including adoption or change of tax accounting methods—should be made in accordance with U.S. tax law.
What Is an Accounting Method?An accounting method affects when an item of income or deduction is recognized. That is, accounting methods generally result from temporary (not permanent) differences to lifetime income, and these differences reverse in the succeeding tax year or years. Nevertheless, companies should monitor these differences with respect to their FCs because they likely will affect the determination of actual or deemed dividends for repatriations in a particular tax year.
How Does a CFC Adopt or Change a Method of Accounting?The rules for determining how a controlled foreign corporation (CFC) adopts or changes a method of accounting are provided under Regs. Sec. 1.964-1(c) and more specifically under Temp. Regs. Sec. 1.964-1T(c). It is important to note that the IRS did not finalize these temporary regulations, and they sunset in April 2009 under Sec. 7805. At the time of publication, however, these temporary regulations are expected to be finalized, possibly with only minor modifications. Moreover, much of the analysis presented in this item is also applicable to the rules promulgated in the final regulations under Sec. 964 prior to the publication of the temporary regulations. For these reasons, the item focuses on the temporary regulations even though they are no longer effective.
Temp. Regs. Sec. 1.964-1T(c)(2) provides that for a CFC, the controlling domestic shareholders—i.e., U.S. shareholders who own directly or indirectly, in the aggregate, more than 50% of the total combined voting power of all classes of CFC stock who are entitled to vote and undertake to act on its behalf—may make an election, or adopt or change an accounting method, on behalf of the CFC (without regard to any other different methods or elections previously used to prepare its books and financial statements). Any method adopted or election made must be used consistently for all tax years in the calculation of the CFC’s E&P unless and until IRS consent to change the method is obtained.
To adopt or change a method on behalf of a CFC under the temporary regulations, a controlling domestic shareholder must comply with the applicable requirements in the Code or regulations, including Secs. 442 and 446 and the regulations thereunder. These requirements include filing forms, executing consents, securing IRS permission, and maintaining books and records in a particular manner. Thus, in general, once the accounting method is adopted, the controlling domestic shareholders must follow the method change procedures set forth in either Rev. Proc. 97-27 (nonautomatic method changes) or Rev. Proc. 2008-52 (automatic method changes), as applicable, to change that method.
Note: In general, the accounting method change procedures cited above provide favorable terms and conditions applicable to most voluntary accounting method changes made by either a domestic or a foreign corporation, including a current year of change for adjustments to income (rather than amending returns), a four-year spread for positive changes (inclusions into income), one-time inclusion for negative changes in the year of change, and audit protection for positions taken in prior tax years. Depending on the item, the taxpayer may have to pay a user fee and obtain advance IRS consent in order to change its method of accounting.
When Must Action Be Taken to Adopt a Method?Under the temporary regulations (but not the final regulations), actions to adopt a method do not have to be taken until the due date (including extensions) of the U.S. controlling shareholder’s return for the first tax year within which ends the CFC’s first tax year in which the computation of its E&P is significant for U.S. tax purposes (Temp. Regs. Sec. 1.964-1T(c)(6)).
Events that cause an FC’s E&P to have U.S. tax significance include, but are not limited to:
- A subpart F inclusion;
- An exclusion of an amount that would have been included in the U.S. shareholder’s income as subpart F income but for the E&P limitations; and
- The use by the CFC’s controlling domestic shareholders of the tax book value (or alternative tax book value) method of allocating interest expense.
If action by or on behalf of the CFC is not undertaken timely to adopt a method, a taxpayer, upon showing reasonable cause, may be granted an additional 30- day period from the demonstration to take the appropriate action. If the taxpayer cannot demonstrate reasonable cause for failure to satisfy the above requirements, the computation of E&P should be made as if no elections had been made and any otherwise permissible accounting methods not requiring an election had been adopted.
Observation: In conducting an E&P study in anticipation of repatriating earnings, a U.S. company may discover that it had unknowingly adopted a method of accounting affecting E&P. For example, in computing E&P to determine a subpart F inclusion, the FC may have included all advance payments received during the tax year. On discovery of a method adoption for a particular item, if the company determines that a different permissible accounting method would be more desirable, the company should request a method change for that item from the IRS by filing a Form 3115, Application for Change in Accounting Method.
Annette Smith is with Price-waterhouseCoopers LLP, Washington National Tax Services, in Washington, DC.
Unless otherwise noted, contributors are members of or associated with Pricewater-houseCoopers LLP.
For additional information about these items, contact Ms. Smith at (202) 414-1048 or firstname.lastname@example.org.