Foreign Corporations: Procedures and Pitfalls in Adopting and Changing Methods of Accounting for Purposes of Determining E&P

Editor: Mindy Tyson Weber, CPA, M.Tax.

Foreign Income & Taxpayers

Although neither the Code nor the regulations clearly define the term “method of accounting,” both do provide that a change in method of accounting involves the change in treatment of any “material item.” A material item involves the proper time for the inclusion of the item in income or the deduction of the item as an expense (Regs. Sec. 1.446-1(e)(2)(ii)(a)). Thus, a “method of accounting” generally refers to any consistent practice for determining when to recognize items of income and expense. Established not only for a taxpayer’s overall practice of computing taxable income (e.g., the cash or accrual method), methods of accounting also relate to specific items of income and expense (e.g., compensation expenses or advance payments). Though more than one method of accounting may exist for a specific item, a taxpayer’s method must clearly reflect income to be considered a permissible method (Sec. 446(b)).

A taxpayer can generally adopt a method of accounting for an item on the tax return for the period when the item first exists. Although establishing an accounting method generally requires consistent treatment, if a taxpayer treats an item in a way that is permissible, an accounting method for that item is deemed established after only one year. However, if a taxpayer treats an item impermissibly, the impermissible treatment must occur for at least two consecutive tax years before the taxpayer will be treated as having established an accounting method for the item (see Rev. Rul. 90-38).

Regardless of whether a taxpayer adopts a permissible or impermissible method of accounting, once a method is established, the taxpayer must continue to apply that method unless and until it receives IRS consent to change the method (Regs. Sec. 1.446-1(e)(2)(i)). Thus, an accounting method may not be changed or corrected through an amended return. Instead, the taxpayer must generally request IRS consent through filing Form 3115, Application for Change in Accounting Method, and must apply the change prospectively (although a catch-up adjustment is generally required to ensure that items of income or expense are not duplicated or omitted as a result of the change) (see Sec. 481(a)).

Many U.S. taxpayers have an interest in one or more foreign corporations that are not required to file U.S. federal tax returns (e.g., controlled foreign corporations (CFCs) and 10/50 corporations that do not engage in U.S. business activities). For these taxpayers, an often-overlooked issue is the establishment (and changing) of such a foreign corporation’s methods of accounting for purposes of determining earnings and profits (E&P). Like domestic taxpayers, foreign corporations are subject to the general rules regarding the adoption of permissible accounting methods for items of income and expense, subject to certain rules in Regs. Sec. 1.964-1 (see Regs. Sec. 1.964-1(c)(1)).

Further, since taxpayers adopt accounting methods on a trade or business basis (see Regs. Sec. 1.446-1(d)), a foreign corporation’s accounting methods generally do not need to conform to the method(s) of its controlling domestic shareholders. This item provides a high-level discussion of the general timing for certain foreign corporations’ (i.e., CFCs and 10/50 corporations) adoption of methods of accounting for purposes of determining E&P, the procedural rules regarding how such foreign corporations change their method of accounting, and the importance of understanding when and how a method is adopted in light of the increased limitations such foreign corporations may face in changing methods.

When and How Does a Foreign Corporation Adopt a Method of Accounting?

The regulations under Sec. 964 provide guidance for a foreign corporation’s adoption of accounting methods for purposes of determining E&P. Since Sec. 964 and its regulations provide that the E&P of a foreign corporation is to “be computed . . . substantially as if such corporation were a domestic corporation” by making, in part, tax adjustments that take into account the foreign corporation’s accounting methods (which must reflect the provisions of Sec. 446 and its regulations), the foreign corporation’s accounting methods (and method changes) can increase or decrease E&P. Thus, the adoption of one or more methods of accounting has a significant impact on a foreign corporation’s E&P (Regs. Secs. 1.964-1(a) and (c)(1)(i)). While this can present U.S. tax planning opportunities, it can also create pitfalls for taxpayers that inadvertently establish unfavorable accounting methods for their foreign corporations.

Similar to domestic taxpayers, foreign corporations must adopt methods of accounting that reflect the provisions of Sec. 446 and the regulations thereunder (Regs. Sec. 1.964-1(c)(1)). While a domestic taxpayer generally adopts a method of accounting in the first tax year for which the item appears on the taxpayer’s tax return (subject to the special two-year rule for an impermissible method), under Regs. Sec. 1.964-1(c)(6), a foreign corporation is not required to adopt an accounting method for purposes of computing E&P until the year in which the foreign corporation’s E&P becomes “significant” for U.S. tax purposes with respect to its controlling domestic shareholders (Regs. Sec. 1.964-1(c)(6)).

The controlling domestic shareholders of a foreign corporation are generally the U.S. shareholders that, in the aggregate, own more than 50% of the total combined voting power of all classes of the foreign corporation’s voting stock and that undertake to act on its behalf (see Regs. Sec. 1.964-1(c)(5) for an expanded definition of controlling domestic shareholders). For this purpose, a U.S. shareholder is a U.S. person that owns 10% or more of the voting stock of the foreign corporation or a U.S. person that owns any stock in a foreign corporation that has certain insurance income (see Secs. 951 and 953(c)).

The regulations provide the following examples of situations where a foreign corporation’s E&P will become significant for U.S. tax purposes: (1) upon a distribution from the foreign corporation to its shareholders with respect to their stock; (2) when an amount is includible in the shareholders’ gross income as subpart F income of the foreign corporation under Sec. 951(a); (3) when an amount is excluded from subpart F income of the foreign corporation or another foreign corporation by reason of Sec. 952(c); (4) upon any event making the foreign corporation subject to tax under Sec. 882; (5) upon the use by the foreign corporation’s controlling domestic shareholders of the tax book value (or alternative tax book value) method of allocating interest expense under Sec. 864(e)(4); or (6) upon a sale or exchange of the foreign corporation’s stock by the controlling domestic shareholders that results in the recharacterization of gain under Sec. 1248 (Regs. Secs. 1.964-1(c)(6)(A)–(F)).

The mere filing of an information return does not, in and of itself, represent a significant event. Thus, a foreign corporation may exist for several years before its E&P becomes significant for U.S. tax purposes, requiring it to adopt methods of accounting. The regulations under Sec. 964 provide guidance regarding certain statements and other requirements necessary to adopt or change a method of accounting for a foreign corporation for purposes of determining the foreign corporation’s E&P (Regs. Sec. 1.964-1).

Procedures for Requesting a Change in Method of Accounting

As discussed above, a taxpayer (including a foreign corporation, once its E&P becomes significant for U.S. tax purposes) generally adopts an accounting method upon initial treatment (if permissible) or upon consistent treatment for two consecutive tax years (if impermissible) (Rev. Rul. 90-38). A foreign corporation may generally request a change in method of accounting by following the Sec. 964 requirements, as well as the administrative procedures generally applicable to domestic taxpayers. For instance, under Regs. Sec. 1.964-1(c)(3), to adopt or apply for a change in accounting method, each controlling domestic shareholder of the foreign corporation must include a statement with its tax return that describes the nature of the action taken on behalf of the foreign corporation and identifies the designated shareholder that retains a jointly executed consent confirming that the action has been approved by all of the controlling domestic shareholders. However, this statement is not required in the case of a controlling domestic shareholder that is the sole shareholder of the foreign corporation (Regs. Sec. 1.964-1(c)(3)(ii)).

The designated shareholder that retains the jointly executed consent must also, on behalf of the foreign corporation, complete the Form 3115 and file the form with the IRS National Office (or, if applicable, with the IRS service center in Ogden, Utah) in accordance with the general administrative procedures applicable to all taxpayers (see Regs. Secs. 1.446-1(e)(3)(i) and (ii); and Rev. Proc. 2011-14, §6.02(3)(b)).

When a foreign corporation is not required to file a U.S. federal income tax return, the designated controlling domestic shareholder may file a Form 3115 on behalf of the foreign corporation under the automatic consent procedures of Rev. Proc. 2011-14, as modified by Rev. Proc. 2012-39 (if automatic consent is available), or the nonautomatic consent procedures of Rev. Proc. 97-27, as amplified, clarified, and modified (if automatic consent is not available). For automatic Forms 3115, an original application must be attached to the designated shareholder’s (or its common parent’s) timely filed, original federal income tax return for its tax year with, or within, which ends the year of change of the foreign corporation. In addition, a copy of the application must be filed with the IRS National Office (or with the IRS service center in Ogden, Utah, as applicable) on or before the date the designated shareholder (or its common parent) files the original form with its federal income tax return. Any other controlling domestic shareholder (or its common parent) must also attach a copy of the application to its federal income tax return for its tax year with, or within, which ends the year of change (see Regs. Secs. 1.446-1(e)(3)(i) and (ii); and Rev. Proc. 2011-14, §6.02(3)(b)). With respect to nonautomatic Forms 3115, the designated shareholder (or its common parent) must file the form on or before the last day of the tax year with, or within, which ends the year of change of the foreign corporation, and it (and the other controlling domestic shareholders or their common parent) must attach a copy of the consent letter to its federal income tax return (see Rev. Proc. 2009-39, §3.02, modifying and clarifying Rev. Proc. 97-27).

Favorable terms and conditions that apply to domestic-taxpayer-initiated method changes also apply to foreign corporations, including: (1) a four-tax-year spread for an unfavorable Sec. 481(a) adjustment (i.e., an increase to E&P) and a one-year spread for a favorable Sec. 481(a) adjustment (i.e., a decrease to E&P) (see, e.g., Rev. Proc. 2011-14, §5.04); and (2) audit protection for prior-year treatment (see, e.g., Rev. Proc. 2011-14, §7.01). Although beyond the scope of this item, foreign corporations may also be subject to involuntary changes (i.e., changes the IRS initiated) if the present accounting method fails to clearly reflect income (see Regs. Sec. 1.446-1(a)(2) and Rev. Proc. 2002-18). Involuntary changes generally do not provide the benefits of voluntary changes and may result in the foreign corporation being subject to a less-favorable method.

In most instances, a taxpayer under examination may not request a voluntary accounting method change (subject to certain limited exceptions, as discussed below). If not required to file a federal income tax return, a foreign corporation is considered under exam for this purpose if any of its controlling domestic shareholders are under exam for a tax year in which the shareholder was a U.S. shareholder of the foreign corporation (i.e., the foreign corporation’s Form 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations, was included in the U.S. shareholder’s tax return under exam). An exam begins on the date a representative of the IRS contacts the taxpayer in any manner for the purpose of scheduling any type of exam of a federal income tax return (see, e.g., Rev. Proc. 2011-14, §3.08(1)). Conversely, a foreign corporation is considered no longer under exam when none of the controlling domestic shareholders are under exam (see, e.g., Rev. Proc. 2011-14, §3.08(3)).

Although taxpayers are generally precluded from requesting an accounting method change if under exam, certain exceptions may nonetheless allow a taxpayer to file a Form 3115 to request a change in its foreign corporation’s method of accounting. Such exceptions include filing during one of two designated window periods—the “90-day window period” and the “120-day window period” (see, e.g., Rev. Proc. 2011-14, §6). Other exceptions include obtaining director consent to file, filing for changes that lack audit protection, filing for a change where the method is an issue pending as part of an exam or an issue under consideration before appeals or a federal court, or filing for a change where the specific method change expressly waives all or some of the scope limitations (see, e.g., Rev. Proc. 2011-14, §6).

With respect to a foreign corporation, the 90-day window period begins on the first day of the foreign corporation’s tax year as long as all of the controlling domestic shareholders under exam have been under exam for at least 12 consecutive months as of the first day of that tax year. Alternatively, the 120-day window period begins on the day following the date an examination of each of the foreign corporation’s controlling domestic shareholders ends (Rev. Proc. 2011-14, §6.03(3) and Rev. Proc. 97-27, §6.01, as amplified, clarified, and modified). Despite the relief the two window periods can provide, however, neither window period is available if the method for the item being changed is an issue under consideration as part of a controlling shareholder’s exam (see, e.g., Rev. Proc. 2011-14, §6.03(1)).

A method of accounting for an item is treated as an issue under consideration if the taxpayer receives written notification from the exam agent specifically citing the treatment of the item as an issue under consideration as part of the exam (see, e.g., Rev. Proc. 2011-14, §3.09). In a rule specific to foreign corporations, the accounting method change procedures provide that a foreign corporation’s method of accounting for an item represents an issue under consideration if “any of the [foreign] corporation’s controlling domestic shareholders receives [written] notification . . . that the treatment of a distribution or deemed distribution from the foreign corporation, or the amount of its [E&P] or foreign taxes deemed paid, is an issue under consideration” (Rev. Proc. 2011-14, §3.09(4)). As a result, all methods will be considered issues under consideration for the foreign corporation if any of the foreign corporation’s U.S. shareholders receive notification that the treatment of the foreign corporation’s distributions, E&P, or deemed-paid taxes is an issue under consideration by exam. This rule drastically limits the ability of a foreign corporation to change its accounting method in one of the window periods under the automatic or nonautomatic procedures.

Conclusion

Because a foreign corporation is not required to adopt an accounting method for purposes of determining E&P until its E&P becomes significant for U.S. tax purposes (which may occur several years after the foreign corporation first comes into existence), it is critical that controlling domestic shareholders of foreign corporations have a clear understanding of when the foreign corporation’s E&P becomes significant within the meaning of Regs. Sec. 1.964-1. A taxpayer unaware of the rules governing when a foreign corporation adopts accounting methods could inadvertently adopt unfavorable or even impermissible tax accounting methods. As discussed above, once a method of accounting is adopted, a taxpayer (including a foreign corporation) must generally obtain IRS consent before it is able to change the method of accounting, regardless of whether the present accounting method is impermissible.

A designated controlling domestic shareholder may request a change in method of accounting on behalf of a foreign corporation and may receive the general benefits that come along with voluntary method changes, including the four-year spread of an unfavorable Sec. 481(a) adjustment and audit protection. As discussed above, the ability to request a change in a foreign corporation’s method of accounting can be severely limited when one or more of the foreign corporation’s controlling domestic shareholders are under IRS exam at the time the Form 3115 would otherwise be filed.

If a controlling domestic shareholder of a foreign corporation is under exam, the likelihood of a foreign corporation’s method of accounting being an issue under consideration is significantly higher than in the case of a domestic taxpayer. In that situation, the controlling domestic shareholder cannot amend prior-year returns to correct or change the foreign corporation’s method since once a method is established, the ability to amend prior-year returns to change the treatment is eliminated. Thus, a foreign corporation (and its U.S. shareholders) could be in a position where an improper method of accounting has been identified but must be continued until a Form 3115 may be filed, thereby creating additional risk for the U.S. shareholders.

Taxpayers that understand when a foreign corporation will be in a position to adopt methods of accounting can take steps to plan for the adoption of favorable methods, and even taxpayers that determine that unfavorable or impermissible methods of accounting for purposes of determining E&P have already been established may be able to limit exposure and adopt proper methods through the filing of one or more Forms 3115.

EditorNotes

Mindy Tyson Weber is a senior director, Washington National Tax, for McGladrey LLP.

For additional information about these items, contact Ms. Weber at 404-373-9605 or mindy.weber@mcgladrey.com.

Unless otherwise noted, contributors are members of or associated with McGladrey LLP.