Editor: Annette B. Smith, CPA
As a result of the international provisions of the 2017 U.S. tax reform legislation (P.L. 115-97, commonly referred to as the Tax Cuts and Jobs Act (TCJA)), many multinational companies must determine the earnings and profits (E&P) of their noncontrolled Sec. 902 corporations and controlled foreign corporations (collectively, FCs). Prior to the TCJA, many companies did not need to calculate E&P of their FCs (e.g., for Subpart F inclusions, distributions, or other transactions for which E&P was relevant) and thus may not have fully complied with applicable tax rules inasmuch as full compliance not only was impractical but also irrelevant for U.S. federal income tax purposes.
These applicable tax rules are outlined in Sec. 964 and the regulations thereunder, which generally provide that for computing E&P for tax purposes, an FC should be treated substantially the same as a domestic corporation. Thus, FCs generally should follow the same rules as domestic corporations with respect to determining proper accounting methods, adopting accounting methods, and changing accounting methods. As with domestic corporations, once a method of accounting has been adopted for purposes of computing an FC's E&P, the method must be used consistently unless the IRS consents to change that method.
Rev. Proc. 2015-13 contains the general procedures taxpayers must follow to request tax accounting method changes (generally, through the filing of Form 3115, Application for Change in Accounting Method). To encourage voluntary compliance with proper tax accounting methods, the IRS historically has provided audit protection to taxpayers, which prevents an IRS examination from raising the same issue in an earlier year, once the applicable Form 3115 is filed. However, there are limitations to this general audit protection rule, certain of which apply specifically to FCs.
This item primarily discusses one such limitation on audit protection that arises as a result of Sec. 965, enacted as part of the TCJA, which imposes a one-time "transition" tax on unrepatriated E&P of certain FCs. This limitation effectively prevents FCs from receiving audit protection for method changes filed for years succeeding the applicable transition tax year until the statute of limitation for that year is closed and thus may have the effect of discouraging voluntary compliance with proper E&P methods.
Audit protection windows
For decades, the IRS has issued procedural guidance designed to encourage taxpayers to voluntarily correct impermissible methods of accounting and, in appropriate circumstances, to mitigate exposure to penalties and interest. In particular, the procedures provide certain incentives, including a prospective year of change, a one-year spread for a favorable Sec. 481(a) adjustment, a four-year spread for an unfavorable Sec. 481(a) adjustment, and audit protection (seeRev. Proc. 2015-13 and its predecessors).
That is, under Section 8.01 of Rev. Proc. 2015-13, a taxpayer that voluntarily changes to a permissible method of accounting generally receives audit protection preventing the issue from being raised by examination for prior years. Section 8.02 of Rev. Proc. 2015-13, however, precludes audit protection in certain circumstances. For example, a taxpayer under examination on the date the Form 3115 is filed will not receive audit protection unless one of several exceptions applies. Two exceptions potentially apply in the case of a non-Compliance Assurance Program taxpayer under examination that is changing from an impermissible method with a positive Sec. 481(a) adjustment: the "three-month window" and the "120-day window."
Three-month window: Under the three-month window exception, a taxpayer under examination may secure audit protection if it voluntarily changes its method of accounting for an item that is not an issue under consideration as part of the exam, during the three-month period that begins on the 15th day of the seventh month of the tax year and ends on the 15th day of the 10th month of the tax year (that is, between July 15 and Oct. 15 for a calendar-year taxpayer). The three-month window is available only to domestic taxpayers that have been under examination for at least 12 consecutive months as of the first day of the three-month window.
However, in the case of method changes for FCs, the three-month window generally is available only when all controlling U.S. shareholders that are under exam have been under exam for 24 consecutive months as of the start of the window and either E&P is not under consideration or E&P has been under consideration for 24 months and the method to be changed has not been raised during that time. (E&P for this purpose includes distributions, deemed distributions, or inclusions from the foreign corporation, or the amount of its E&P or foreign taxes deemed paid.) In the authors' experience, many FCs' controlling U.S. shareholders have E&P under consideration, and few examination cycles last more than 24 months, making the applicability of this window period for FCs limited.
120-day window: Under the 120-day window exception, a taxpayer may secure audit protection if it voluntarily changes its method during the 120-day period beginning the day after an examination ends, as long as the item the taxpayer is requesting to change is not under consideration as part of another examination. However, the 120-day window rule is not available at all to FCs.
An additional limitation on audit protection applies to an FC in any tax year when the foreign taxes deemed paid with respect to the FC exceed 150% of the average amount of the foreign taxes deemed paid for the prior three tax years (the 150% rule). Specifically, Section 8.02(5) of Rev. Proc. 2015-13 provides:
In the case of a change in accounting method being made on behalf of a [controlled FC (CFC)] or 10/50 corporation, the IRS may change the method of accounting for the same item that is the subject of a Form 3115 filed under [Rev. Proc. 2015-13] for taxable years prior to the requested year of change in which any of the CFC or 10/50 corporation's domestic corporate shareholders computed an amount of foreign taxes deemed paid under [Secs.] 902 and 960 with respect to the CFC or 10/50 corporation that exceeds 150 percent of the average amount of foreign taxes deemed paid under [Secs.] 902 and 960 by the domestic corporate shareholder with respect to the CFC or 10/50 corporation in the shareholder's three prior taxable years.
Example: Assume that a calendar-year taxpayer files an accounting method change under the automatic change procedures on behalf of its CFC effective for 2018 by the extended due date of Oct. 15, 2019. In this case, the IRS may propose an adjustment for the CFC's impermissible method of accounting for 2017 if it determines that the taxpayer's foreign taxes deemed paid with respect to the CFC in 2017 exceed 150% of the average amount of the deemed taxes paid from the prior three tax years, 2014 through 2016.
It is the authors' understanding that the IRS imposed the 150% rule to prevent taxpayers from proactively changing a method of accounting to materially affect the amount of foreign taxes deemed paid. (Before enactment of the TCJA, taxpayers used the "pooling" approach under Secs. 902 and 960 to compute their deemed paid foreign tax credits associated with foreign dividends.) The 150% rule prevented a controlling U.S. shareholder from (1) recognizing a foreign dividend with respect to E&P that was computed using an impermissible method that inappropriately inflated the amount of foreign taxes deemed paid, and (2) subsequently insulating the benefit of the inflated foreign tax credits through the audit protection that ordinarily would accompany an accounting method change.
While the 150% rule was intended to address this narrow issue, the transition tax under Sec. 965 significantly expands its reach. The transition tax requires certain U.S. shareholders of FCs (generally, CFCs) to include in income an amount determined by reference to the post-1986 E&P of the corporations. Application of Sec. 965 results in an increased inclusion under Subpart F for U.S. shareholders of deferred foreign income corporations.
As a result, the U.S. shareholders also are entitled to deemed paid foreign tax credits under Secs. 902 and 960. In many instances, the amount of their foreign taxes deemed paid for the transition-tax year of 2017 (or, as applicable, 2018) is significantly higher due to the income inclusion resulting from Sec. 965. Therefore, the foreign taxes deemed paid in the transition-tax year may exceed 150% of the average amount of the deemed taxes paid in the prior three tax years.
As part of complying with international tax reform, the taxpayer's analysis of the accounting methods used to calculate E&P may identify one or more impermissible methods. Normally, once an impermissible method is identified, the taxpayer can voluntarily request a method change and receive audit protection for prior years. However, due to the impact of the transition tax on foreign taxes deemed paid, the 150% rule may apply to prevent FCs with U.S. shareholders affected by the transition tax from receiving audit protection for the transition tax year with respect to method changes filed in succeeding tax years.
While an in-depth discussion of Sec. 965 is beyond the scope of this item, it is worth noting that U.S. shareholders generally did not file accounting method changes on behalf of their FCs for the transition tax year when the 150% rule may not have applied because proposed regulations under Sec. 965 prohibited all method changes from being taken into account for purposes of the transition tax. As a result, taxpayers now are faced with trying to correct the impermissible methods of their FCs in the tax years subsequent to the transition tax year, and thus the 150% rule becomes a concern.
Audit protection limits
Taxpayers that have identified impermissible methods of accounting for purposes of calculating their FC's E&P and currently are considering whether to change those methods on behalf of their FCs should be aware of the risk that the taxpayers may not receive audit protection due to limited applicability of the window periods and the impact of the transition tax on the 150% rule. Taxpayers should work with their tax advisers to analyze their facts and determine whether these limitations may adversely affect the ability to obtain audit protection for impermissible-to-permissible CFC method changes.
Annette B. Smith, CPA, is a partner with PricewaterhouseCoopers LLP, Washington National Tax Services, in Washington, D.C.
For additional information about these items, contact Ms. Smith at 202-414-1048 or firstname.lastname@example.org.
Contributors are members of or associated with PricewaterhouseCoopers LLP.