Editor: Mark G. Cook, CPA, CGMA
Nonautomatic accounting method changes are inconvenient and troublesome for taxpayers. When global intangible low-taxed income (GILTI) was introduced by the enactment of the law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, numerous taxpayers wanted to change the accounting methods of their controlled foreign corporations (CFCs) to more easily comply with GILTI calculations. In particular, many desired to conform their CFCs' depreciation method to the alternative depreciation system (ADS). The IRS acknowledged taxpayers' burden and provided new guidance under Rev. Proc. 2021-26 in May 2021. Under Rev. Proc. 2021-26, for a limited time, the IRS is allowing automatic change procedures for CFCs changing to the ADS method and has clarified the process and certain aspects of audit protection.
Background: ADS depreciation (Sec. 168(g))
Under Sec. 168(g)(1)(A), ADS must be employed for depreciable tangible property mainly used outside the United States. As a result, it is expected that foreign corporations that operate overseas, including CFCs, use the ADS method when computing depreciation for earnings and profits (E&P), tested income, and other items when complying with U.S. tax laws. However, if the adjustments necessary to conform to ADS are not material, a foreign corporation may use a non-ADS depreciation method when calculating E&P (Regs. Secs. 1.952-2(c)(2) and 1.964-1(a)(2)). Non-ADS methods include the depreciation method maintained in its book accounting for shareholders or other methods allowed under U.S. GAAP (Regs. Secs. 1.952-2(c)(2)(i) and (ii)).
A change in depreciation method, recovery period, or convention is considered a change in accounting method per Regs. Sec. 1.446-1(e)(2)(ii)(d)(2)(i). Therefore, changing the CFC's depreciation method to ADS would be considered a change in the method of accounting under Sec. 446 and will require following the appropriate procedures to obtain IRS consent (Sec. 446(e)).
Prior to Rev. Proc. 2021-26, automatic approval by the IRS for this change in accounting method depended on whether the CFC was using an impermissible non-ADS method or a permissible one. Under Rev. Proc. 2015-13 and Rev. Proc. 2019-43, a CFC using an impermissible non-ADS method and requesting a change to ADS was permitted to use the automatic change procedures. However, a CFC using a permissible non-ADS method and desiring a change to ADS was not entitled to automatic consent until Rev. Proc. 2021-26 was issued.
Background: GILTI (Sec. 951A) and QBAI
Taxpayers that opted to not use ADS because of immaterial adjustments were not compelled to conform their CFCs' depreciation methods to ADS until GILTI arrived. Effective for tax years beginning after Dec. 31, 2017, Sec. 951A requires a direct or indirect U.S. shareholder (as defined under Sec. 951(b)) of a CFC (as defined under Sec. 957(a)) to include the shareholder's pro rata share of GILTI in gross income for the year (Regs. Secs. 1.951A-1 and 1.951A-7). To calculate the GILTI inclusion amount, U.S. shareholders must determine the excess of their "net CFC tested income" over their "net deemed tangible income return" (Sec. 951A(b)(1)).
Sec. 951A and related regulations go into specific details of the GILTI formula, but a key component of the "net deemed tangible income return" is the qualified business asset investment (QBAI) (Sec. 951A(b)(2)). Per Sec. 951A(d) and Regs. Sec. 1.951A-3, QBAI is defined as the average of the quarterly aggregate adjusted bases of depreciable specified tangible property used in the tested income CFC's trade or business for those CFCs with tested income. It is important to note that the adjusted bases for QBAI must be determined using the ADS method, unless an election was made for property placed in service before the first year beginning after Dec. 22, 2017 (Sec. 951A(d)(3) and Regs. Sec. 1.951A-3(e)(3)(ii)).
As such, even if the CFCs can use a different depreciation method when computing their E&P and tested income, the CFCs are limited to using the ADS method when computing QBAI for GILTI. Because of this ADS requirement, taxpayers and tax practitioners may want to change to ADS so that E&P, tested income, QBAI, and other computations are consistent.
Rev. Proc. 2021-26
The IRS wishes to alleviate the inconvenience on all CFCs wishing to conform to ADS when calculating gross and taxable income under Regs. Sec. 1.952-2 and E&P under Secs. 964 and 986(b) and related regulations. Under the guidance of Rev. Proc. 2021-26, a CFC using either an impermissible or a permissible non-ADS method is now eligible for a limited time for automatic consent when changing its method of accounting to ADS. Rev. Proc. 2015-13 prevented taxpayers from being eligible for automatic change procedures if they were engaged in a liquidation/reorganization, were in their final year of a trade or business, or had an overall method change or change for the same item in the last five years (ending with the year of change). However, Rev. Proc. 2021-26 removed these eligibility restrictions.
Automatic change procedures: A taxpayer must typically file Form 3115, Application for Change in Accounting Method, when requesting any accounting method change (Regs. Sec. 1.446-1(e)(3)). A short Form 3115, as filed under this revenue procedure, is also permissible. The designated automatic accounting method change number to use when filing Form 3115 is 248. Rev. Proc. 2021-26 is effective for a Form 3115 filed on or after May 11, 2021, for any CFC's tax year ending before Jan. 1, 2024. The taxpayer may convert any Form 3115 filed under nonautomatic change procedures before May 11, 2021, that is still pending to an automatic request as described under Rev. Proc. 2021-26.
Sec. 481(a): A Sec. 481(a) adjustment is required when making this method of accounting change and is disclosed on Form 3115. When changing accounting methods, there will be a difference in the CFC's income and E&P between the old method and the new method. That difference is considered the Sec. 481(a) adjustment, which must be taken into account to avoid duplication or omission of amounts resulting from the change (Regs. Sec. 1.481-1(d)).
Each component of the Sec. 481(a) adjustment must take or be allocated to the class of gross income with the same source, character, separate limitation classification, and treatment as it would have in prior year(s). As a result, the Sec. 481(a) adjustment will retain its original nature and be properly allocable to Subpart F, tested income or loss, etc. Rev. Proc. 2021-26 clarifies that, in general, the Sec. 481(a) adjustment must be taken into account in determining the CFC's tested income or loss, except to the extent it prevents the duplication or omission of an item of gross income described in, or is a deduction properly allocable to an item of gross income described in, Secs. 951A(c)(2)(A)(i)(I) through (V), which include Subpart F and certain other types of income. Rev. Proc. 2021-26 also clarifies that when determining the CFC's tested income or loss, a positive Sec. 481(a) adjustment should be included as gross tested income, and a negative Sec. 481(a) adjustment should be included as a deduction properly allocable to the CFC's gross tested income.
Audit protection: Usually, audit protection with respect to the accounting change is provided to taxpayers that timely file Form 3115. However, for an accounting method change made on behalf of a CFC, Rev. Proc. 2015-13 denies audit protection for the tax year before the requested year of change if one or more of a domestic corporate shareholders' foreign taxes deemed paid under Secs. 902 and 960 of the CFC exceed 150% of the average amount of foreign taxes deemed paid with respect to the CFC in the three prior years.
Taxpayers and tax practitioners had questioned whether taxes deemed paid should be limited to the amount of foreign tax credit claimed when determining the 150% threshold. The IRS answered this question with Rev. Proc. 2021-26, which clarifies that the 150% threshold is appropriately applied on the basis of the amount of foreign taxes deemed paid and not on the allowable amount of the associated foreign tax credit.
Observations
For CFCs wishing to simplify their tested income, E&P, and GILTI computations, Rev. Proc. 2021-26 is a welcome change. It outlines and clarifies the automatic change procedures, as well as modifies and removes restrictions from previous revenue procedures. The effective period for Rev. Proc. 2021-26 is limited, so taxpayers and tax practitioners should review their CFC's situation to determine if making the depreciation accounting method change to ADS is beneficial.
EditorNotes
Mark G. Cook, CPA, CGMA, MBA, is the lead tax partner with SingerLewak LLP in Irvine, Calif.
For additional information about these items, contact Mr. Cook at 949-623-0478 or mcook@singerlewak.com.
Contributors are members of SingerLewak LLP.
