Editor: Annette B. Smith, CPA
The law known as the Tax Cuts and Jobs Act, P.L. 115-97, enacted new Sec. 951A, the global intangible low-taxed income (GILTI) provision, generally effective for tax years beginning after Dec. 31, 2017. In general, each person that is a U.S. shareholder of a controlled foreign corporation (CFC) must include its GILTI for the tax year in gross income. Methods of accounting may be an effective tool in tax planning for GILTI; however, method change procedures for CFCs differ from procedures for domestic taxpayers.
The GILTI inclusion amount for a U.S. shareholder's tax year generally equals the excess of the U.S. shareholder's net CFC tested income over the U.S. shareholder's net deemed tangible income return. That return generally is calculated as 10% of a U.S. shareholder's pro rata share of qualified business asset investment (QBAI) of each CFC over interest expense. QBAI is the average of the aggregate of the CFC's adjusted bases in specified tangible property used in its trade or business that is depreciable under Sec. 167.
Net CFC tested income and net deemed tangible income return are calculated by reference to the CFC's tax year ending with or within the U.S. shareholder's tax year.
Methods of accounting and GILTI
To calculate a U.S. shareholder's net tested income or loss, a CFC's gross income and allowable deductions generally are determined by treating the CFC as a domestic corporation under Regs. Sec. 1.952-2 (Regs. Sec. 1.951A-2(c)(2)(i)). U.S. shareholders must employ methods of accounting established or adopted in computing a CFC's E&P under Regs. Sec. 1.964-1, which also subjects CFCs to the same general rules for methods of accounting that apply to domestic corporations for purposes of adopting or changing methods and determining permissible methods (Regs. Sec. 1.964-1(c)). Because a CFC's tested income is computed using methods of accounting that generally apply to domestic corporations in computing U.S. taxable income, U.S. shareholders may benefit from general accounting methods planning to reduce their GILTI inclusion. For example, changing to accounting
methods that accelerate deductions or defer income may reduce tested income. These method changes include:
- Deducting the cost of internally developed software under Rev. Proc. 2000-50;
- Deducting accrued compensation that is fixed and determinable at year end and paid two and a half months after year end;
- Deferring advance payments under Sec. 451(c);
- Applying the recurring-item exception to satisfy economic performance for certain liabilities, such as rebates and allowances; and
- Deducting prepaid expenses under the 12-month rule of Regs. Sec. 1.263(a)-4(f)(1).
Taxpayers also may increase the basis of specified tangible property and thus increase net deemed tangible income return by increasing costs capitalized to property, plant, or equipment. For example, taxpayers may choose to capitalize otherwise deductible repair costs under the Sec. 263(a) tangible property regulations or additional costs to the basis of self-constructed assets under Sec. 263A.
Accordingly, taxpayers may wish to change certain CFC methods of accounting to seek these benefits. However, the procedural rules for method changes for CFCs differ somewhat from the rules for domestic taxpayers.
Methods of accounting for CFCs
Under Rev. Rul. 90-38, a taxpayer adopts an impermissible method of accounting by treating an item in the same way in determining gross income or deductions in two or more consecutively filed tax returns. A taxpayer adopts a proper method of accounting for an item in the first tax return reflecting the item.
A CFC generally adopts a method of accounting for computing earnings and profits (E&P) when the E&P becomes significant for U.S. tax purposes for its controlling domestic shareholders (Regs. Sec. 1.964-1(c)(6)). A CFC's E&P becomes significant, for example, if its controlling domestic shareholders previously recognized Subpart F income (including the Sec. 965 inclusion for many multinational U.S. corporate taxpayers) or allocated interest under Sec. 861 using the tax basis of assets.
Once E&P is significant, the rules of Rev. Rul. 90-38 are layered on top, and a CFC adopts a proper method once it is used on one tax return and an improper method once it is used on two consecutively filed tax returns. The CFC then uses the adopted method in determining the CFC's gross income and allowable deductions for computing the U.S. shareholder's pro rata share of tested income or loss under Sec. 951A.
Changes in methods of accounting for CFCs
A taxpayer that has adopted a method of accounting must consistently apply that method for all tax years until the taxpayer obtains IRS consent to change the method by filing a Form 3115, Application for Change in Accounting Method.
Regs. Sec. 1.964-1(c) provides administrative procedures for a CFC to adopt or change a method of accounting. The controlling domestic shareholders of the CFC must comply with the rules, such as Sec. 446(e), that apply to domestic corporations and file a statement with their timely filed federal income tax returns that describes the nature of the action and the applicable tax year. A designated shareholder must provide written notice to any other domestic shareholders that describes the action taken and identifies the designated shareholder that retains the jointly executed consent confirming that all the controlling domestic shareholders approved the action. However, no separate statement or notice is needed for a controlling domestic shareholder that is the sole CFC shareholder if the shareholder includes the required information on Form 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations, and on the Form 3115, filed for the CFC and attached to the shareholder's income tax return for the tax year.
For automatic accounting method changes, the designated shareholder must attach the Form 3115 to the timely filed, including extensions, federal income tax return for the shareholder's tax year in which the year of change ends. For nonautomatic accounting method changes, the designated shareholder must file the Form 3115 with the IRS national office in Washington, D.C., on or before the last day of the CFC's tax year of change.
Audit protection for CFCs
To encourage voluntary compliance with proper methods of accounting, the IRS generally provides favorable terms and conditions for a taxpayer-initiated method change, including audit protection for use of the improper method in earlier years. However, no audit protection generally is available if the taxpayer is under examination by the IRS unless an exception applies, including an exception for a taxpayer eligible for a three-month or 120-day "window" (Rev. Proc. 2015-13, §8.02).
Audit protection in connection with method changes for CFCs is more limited than for domestic taxpayers. The restriction for taxpayers under IRS examination generally applies to a CFC if any of its controlling U.S. shareholders are under examination. In this case, the three-month window is not available if the IRS is auditing E&P, foreign taxes deemed paid, distributions, or deemed distributions or inclusions of the CFC, unless it has been auditing any of those issues for more than 24 months and the specific method the CFC wants to change is not under consideration by the IRS. The 120-day window is not available to a CFC.
In addition, no audit protection is provided for a CFC method change for any tax year before the year of change in which any domestic shareholder computed an amount of foreign taxes deemed paid for the CFC that exceeds 150% of the average amount of the foreign taxes deemed paid by the domestic shareholder with respect to the CFC in the shareholder's prior three tax years (the 150% rule). In many instances, the amount of a U.S. shareholder's foreign taxes deemed paid for 2017 or 2018 is significantly higher than the previous three years due to the income inclusion resulting from Sec. 965 (the transition-tax year). If the foreign taxes deemed paid in the transition-tax year exceed 150% of the average amount of the deemed taxes paid with respect to the CFC in the U.S. shareholder's prior three tax years, no audit protection is provided for the transition-tax year.
Taxpayers may apply general accounting method planning techniques in seeking to reduce their GILTI inclusion, but they should be familiar with the special procedures and limitations that apply to accounting method changes for CFCs.
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.
Unless otherwise noted, contributors are members of or associated with PricewaterhouseCoopers LLP.