ABA Section of Taxation ABA Joint CLE Meeting October 21, Accounting Method Opportunities and Issues that Arise as Part of E&P Planning

Transcription

1 ABA Section of Taxation ABA Joint CLE Meeting October 21, 2011 Accounting Method Opportunities and Issues that Arise as Part of E&P Planning Moderator: Wayne Hamilton, Wal Mart Stores, Inc., Bentonville, AR Panelists: Brandon Carlton, Department of Treasury, Washington, D.C. and Colleen O Connor, KPMG, LLP, Washington, D.C. Background Relevance of E&P in Tax Planning The E&P of a foreign corporation plays an important role in how U.S. shareholders are taxed for U.S income tax purposes. Just as the timing of income and expense recognition that results from the application of certain accounting methods for a domestic corporation can increase or decrease taxable income for a particular tax year, the accounting methods used by a foreign corporation to compute its E&P can either increase or decrease E&P each taxable year. A foreign corporation s E&P can impact a number of circumstances in which U.S. shareholders are taxed, including distributions with respect to stock of a foreign corporation that are taxable as a dividend, the amount of deemed paid foreign taxes that may be claimed as foreign tax credits under IRC 902, the amount of income included in subpart F income and the amount subject to tax in a transaction under IRC 367(b) or IRC Examples of how increasing or decreasing E&P can impact the taxation of a U.S. shareholder include: With respect to subpart F income, because subpart F income is taxable as a deemed dividend only to the extent of current E&P, reducing a foreign corporation s E&P could have the effect of reducing subpart F income for the U.S. shareholders. With respect to foreign tax credits, U.S. shareholders are entitled to foreign tax credits against U.S. tax liability for foreign taxes paid by the foreign corporation (that are deemed paid by the U.S. shareholder) on earnings that are distributed, deemed distributed or otherwise taxable to U.S. shareholders. Under the mechanism for computing foreign taxes deemed paid, a reduction in the foreign corporation s current E&P (and consequently its cumulative undistributed post 1

2 1986 E&P) serves to increase the foreign taxes deemed paid and results in additional foreign tax credits. E&P can also be relevant to increasing the foreign tax credit limitation under IRC 904. The foreign tax credit limitation increases by increasing foreign source income. If a CFC uses methods that reduce its E&P, less interest is allocated to foreign source income, thereby increasing net foreign source income and the foreign tax credit limitation. Computing Earnings and Profits ( E&P ) of a Foreign Corporation Foreign corporations include controlled foreign corporations and noncontrolled IRC 902 corporations (referred to as 10/50 corporations ). A controlled foreign corporation (CFC) is a foreign corporation in which more than 50 percent of the total combined voting power of all classes of stock entitled to vote, or the total value of stock, is owned by U.S. shareholders. 1 U.S. shareholders are U.S. persons who own 10 percent or more of the total combined voting power of all classes of stock entitled to vote. 2 A 10/50 corporation is a foreign corporation that is not a CFC but that has U.S. corporate shareholders owning percent of its voting stock. 3 The U.S. shareholders (i.e., those owning a 10 percent or greater interest in a foreign corporation) are taxed on income (referred to as subpart F income ) from a foreign corporation generally in the year the income would be subject to tax if the foreign corporation were subject to U.S. tax, to the extent of the foreign corporation s current year E&P. The E&P (or deficit in E&P) of a foreign corporation is determined in accordance with rules provided under IRC 964(a) and the regulations thereunder. The E&P computation starts with preparing a profit and loss (P&L) statement for the year from the foreign corporation s books of account regularly maintained for purposes of reporting to its U.S. shareholder(s). Adjustments are made to the P&L statement to conform to U.S. GAAP. Any unacceptable practices are eliminated from the P&L statement. Adjustments are then made to conform the P&L statement to U.S. tax principles, including any adjustments necessary to reflect US tax accounting methods permitted under IRC The specific accounting adjustments required to conform a foreign corporation s P&L to accounting principles generally accepted in the U.S. are described in Treas. Reg (b). 1 IRC IRC 951(b). 3 IRC 902(a). 4 Treas. Reg (a)(1). 2

3 The specific adjustments required for U.S tax purposes include methods of accounting consistent with the requirements of IRC 446 and the regulations thereunder; computing inventory in accordance with IRC 471 and 472, as applicable; determining depreciation under IRC 167 or Treas. Reg , as applicable; any applicable elections made under the Internal Revenue Code and Treasury Regulations; and taxable years determined in accordance with IRC Adjustments to the foreign corporation s P&L statement to conform to U.S. GAAP and/or U.S. tax principles are only required to the extent the adjustments are material, however the threshold for materiality is not defined. 6 The regulations explain that materiality depends on the facts and circumstances, including the amount of the adjustment, its size relative to the general level of the corporation s total assets and annual profit or loss, the consistency with which the practice has been applied, and whether the item to which the adjustment relates is of a recurring nature. E&P is generally determined and maintained in the foreign corporation s functional currency, determined under IRC 985. A foreign corporation s functional currency is generally the U.S. dollar, or, for a qualified business unit, it is the currency of the economic environment in which a significant part of the unit s activities are conducted and which is used in keeping the unit s books and records. Where a foreign corporation uses a functional currency other than the U.S. dollar, IRC 986(b) and 989(b) provide guidance for translating distributions or inclusions of the foreign corporation s E&P into U.S. dollars. Adopting or Changing a Method of Accounting for a Foreign Corporation When is a Foreign Corporation Required to Adopt Methods? Accounting methods are generally adopted by a foreign corporation for the taxable year in which its E&P becomes significant for U.S. tax purposes. Treas. Reg (c)(6) provides that action by or on behalf of a foreign corporation to make an election or to adopt a method of accounting must be taken no later than the due date (including extensions) of the return for a controlling domestic shareholder s first taxable year with or within which ends the foreign corporation s first taxable year in which the computation of its E&P is significant for U.S. tax purposes with respect to its controlling domestic shareholders. Treas. Reg (c)(6) provides a non exclusive list of events that cause a foreign corporation s E&P to be significant for U.S. tax purposes, including: 5 Treas. Reg (c)(1). 6 Treas. Reg (a)(2). 3

4 A distribution from the foreign corporation to its shareholders with respect to their stock; An amount is includible in gross income with respect to such corporation under IRC 951(a); An amount is excluded from subpart F income of the foreign corporation or another foreign corporation by reason of IRC 952(c); Any event making the foreign corporation subject to tax under IRC 882; 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 IRC 864(e)(4); and A sale or exchange of the foreign corporation s stock of the controlling domestic shareholders that results in the recharacterization of gain under IRC A foreign corporation s E&P does not become significant merely because an information return (Form 5471) reflecting methods used to compute the foreign corporation s E&P is filed pursuant to IRC Therefore, reporting the foreign corporation s information on Form 5471 does not result in the adoption of methods. 7 While a foreign corporation is not required to adopt accounting methods until its E&P is significant, a foreign corporation may adopt accounting methods prior to that time if the controlling domestic shareholders elect to do so. If methods have not yet been adopted by a foreign corporation either because the E&P is not yet significant or the controlling domestic shareholder(s) have not adopted methods, a minority shareholder required to compute E&P may do so if it computes E&P as if no elections have been made and any methods requiring an election had been adopted. This action by the minority shareholders does not result in the foreign corporation being considered to have adopted methods of accounting. The foreign corporation is permitted to make elections and adopt methods in subsequent years as long as the elections and methods adopted are done properly and timely. 8 If a foreign corporation does not make an election or adopt methods in the time required by Treas. Reg (c)(6) (in the year the foreign corporation s E&P is significant and by the time prescribed), and the failure is shown to the satisfaction of the Commissioner to be due to reasonable cause, an extension to make the election or adopt methods may be provided. Otherwise, the foreign corporation is considered to have adopted the methods of accounting reflected in its books of account for the purpose of reporting to its shareholders and is assumed to not have made any elections. 9 If any of the methods that are adopted by default are not permissible for U.S. federal income tax purposes, accounting method changes will be required. 7 Treas. Reg (c)(6). 8 Treas. Reg (c)(4)(iii). 9 Treas. Reg (c)(4)(ii). 4

5 How Do Foreign Corporations Make Elections and/or Adopt or Change Methods? Actions Required by Controlling Domestic Shareholders Elections and/or adopting or changing methods of accounting are made for a foreign corporation by its controlling domestic shareholder(s). The controlling domestic shareholders of a controlled foreign corporation are its controlling U.S. shareholders. Controlling U.S. shareholders are defined as those U.S. shareholders (as defined in IRC 951(b) or IRC 953(c)) who, in the aggregate, own (within the meaning of IRC 958(a)) more than 50 percent of the total combined voting power of all classes of stock of the foreign corporation entitled to vote and who undertake to act on the foreign corporation s behalf. 10 In the event that U.S shareholders of the controlled foreign corporation do not own, in the aggregate, more than 50 percent of the total combined voting power of all classes of stock of the foreign corporation entitled to vote, the controlling U.S shareholders are those U.S. shareholders who own stock of the foreign corporation (as determined under IRC 958(a)). 11 For a 10/50 corporation, the controlling domestic shareholders are the majority domestic corporate shareholders. The majority domestic corporate shareholders are those corporations that own 10 percent or more of the voting stock of a 10/50 corporation (or the first tier foreign corporation that is a member of the same qualified group as the 10/50 corporation), that in the aggregate, own directly or indirectly more than 50 percent of the combined voting power of all of the voting stock of the 10/50 corporation that is owned directly or indirectly by all domestic corporations that own 10 percent or more of the voting stock of the 10/50 corporation (or a relevant first tier foreign corporation). 12 With respect to making elections and/or adopting or changing methods of accounting, the controlling domestic shareholder(s) are responsible for such actions as filing necessary forms, executing consents, requesting permission from the Commissioner to change accounting methods, and maintaining books and records Treas. Reg (c)(5). 11 Treas. Reg (c)(5). 12 Treas. Reg (c)(5)(ii). 13 Treas. Reg (c)(3)(i)(A.) 5

6 When taking action on behalf of the foreign corporation, the controlling domestic shareholder(s) are also required to file a statement with the tax return setting forth (1) the name, country of organization, and U.S. tax identification number (if applicable) of the foreign corporation; (2) the name, address, stock interests, and U.S. tax identification number (if applicable) of each controlling domestic shareholder (or, if applicable, the controlling domestic shareholder s common parent) approving the action; and (3) the names, addresses, U.S. tax identification numbers, and stock interests of all other domestic shareholders notified of the action taken. 14 The statement must also (1) describe the nature of the action taken on behalf of the foreign corporation; (2) state the taxable year for which the action is taken; and (3) identify a designated shareholder who retains a jointly executed consent confirming that the action has been approved by all of the controlling domestic shareholders and that also includes the signature of a principal officer of each such shareholder (or its common parent). Each controlling domestic shareholder is required to include the statement with its tax return for the tax year the accounting method is adopted or changed. 15 In circumstances where a controlling domestic shareholder is the sole shareholder of a foreign corporation, no separate statement is required to be included with the tax return as long as the information described above is provided in the Form Controlling domestic shareholder(s) are also required to provide to all other persons known to be shareholders of the foreign corporation written notice of the election made or accounting method adopted or changed. However, failure to provide such notice to a person required to be notified does not invalidate the election made or the accounting method adopted or changed. 16 The rules for determining tax adjustments with respect to E&P (specifically those provided in Treas. Reg (c)(1)(v) through (c)(6)) are effective for tax years ending on or after April 20, For tax years beginning after April 25, 2006 and ending before April 20, 2009, the rules provided in the temporary regulations, Treas. Reg T(c)(1)(v) through (c)(6), apply. However, taxpayers are permitted to apply the final regulations in lieu of the temporary regulations for periods where the temporary regulations apply provided that appropriate adjustments are made to avoid potential duplication of benefits for taxable years that are closed by statute. 14 Treas. Reg (c)(3)(i)(B) and (c)(3)(ii). 15 Treas. Reg (c)(3)(ii). 16 Treas. Reg (c)(3)(iii). 6

7 Accounting Method Change Procedures Like domestic taxpayers, foreign corporations change accounting methods by filing Form 3115 either under the automatic consent (Rev. Proc ) or advance consent (Rev. Proc ) procedures, depending on the particular type of change requested. The automatic change revenue procedure has recently been updated and includes procedural rules specific to foreign corporations, including the following: Under exam. A foreign corporation that is not required to file a federal income tax return is under exam if any of its controlling domestic shareholders is under exam for a taxable year in which it was a U.S. shareholder of the foreign corporation. A foreign corporation is no longer considered to be under exam when the controlling domestic shareholders are no longer under examination, as defined in 3.08 of Rev. Proc Issue under consideration. A CFC s or 10/50 corporation s method of accounting for an item is an issue under consideration if any of the corporation s controlling domestic shareholders receives 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. 18 IRC 481(a) adjustment: If the functional currency of the foreign corporation is not the U.S. dollar, the IRC 481(a) adjustment must be stated in the foreign corporation s functional currency. 19 A taxpayer unfavorable (positive) adjustment must take the same source, separate limitation classification, character and treatment for purposes of subpart F as the foreign corporation s gross income that was offset by the expense in the prior year(s) as well as the treatment for purposes of subpart F that the foreign corporation s income would have had in the prior year(s). Likewise, a taxpayer favorable (negative) adjustment is allocated to the class of gross income that has the same source, separate limitation classification, character, and treatment for purposes of subpart F as the foreign corporation s income that would have been offset by the expense in the prior year(s) as well as the treatment for purposes of subpart F as the foreign corporation s income had in the prior year(s). 20 For each taxable year of the IRC 481(a) adjustment period beginning with the year of change, the appropriate amount of the adjustment must be taken into account in computing 17 Rev. Proc , I.R.B. 330, Section 3.08(3). 18 Rev. Proc , Section 3.09(4). 19 Rev. Proc , Section 5.06(1). 20 Rev. Proc , Section 5.06(2). 7

8 the foreign corporation s subpart F income under IRC 952 and its E&P under IRC 964 and 986(b). 21 If a foreign corporation loses its status as a CFC or 10/50 corporation, any remaining balance of the IRC 481(a) adjustment must be taken into account in computing subpart F income under IRC 952 and E&P under IRC 964 and 986(b) on the final day on which it is a CFC or 10/50 corporation. 22 Each U.S. shareholder of a CFC (or the common parent) must comply with its obligations to report changes in ownership of the CFC on Form 5471 during the adjustment period. 23 The remaining balance of the IRC 481(a) adjustment must also be taken into account if, in the case of any disposition of stock of the foreign corporation that is owned directly or indirectly by a U.S. person, ten percent or more of the total value of the stock of the foreign corporation is disposed of or results in the person no longer meeting the ownership requirements of IRC 6046(a)(2) with respect to the foreign corporation. This condition does not apply if the disposed of stock continues to be owned by a member of the U.S. consolidated group of which the former shareholder is a member. 24 Statement required by Treas. Reg (c)(3)(i) and (ii). The written statement must be filed by each controlling domestic shareholder (or common parent) with its tax return for its taxable year with or within which ends the foreign corporation s year of change. 25 Books and Records. The shareholder(s) of the foreign corporation are required to maintain books and records with respect to the foreign corporation in conformity with IRC 905(b) and 964(c). 26 Foreign divisions and partnerships. Similar requirements with respect to the IRC 481(a) adjustment and reporting requirements apply in circumstances where a foreign division of a domestic corporation or foreign partnership changes a method of accounting. 27 Filing Procedures. For CFCs and 10/50 corporations that are not required to file a return, the controlling domestic shareholders that want to change the foreign corporation s accounting method must satisfy the requirements in Treas. Reg (c)(3). The designated shareholder that holds 21 Rev. Proc , Section 5.06(3). 22 Rev. Proc , Section 5.06(6). 23 Rev. Proc , Section 5.06(7). 24 Rev. Proc , Section 5.06(8). 25 Rev. Proc , Section 5.06(4). 26 Rev. Proc , Section 5.06(5). 27 See Rev. Proc , Sections 5.07 and

9 the jointly executed consent must complete and file the Form 3115, attach the application to its tax return for its tax year with or within which ends the tax year of the foreign corporation and file the copy of the Form 3115 with the IRS National Office and/or IRS office in Ogden, Utah, depending on the particular type of change. All other controlling domestic shareholders also are required to attach a copy of the application to their federal income tax returns Rev. Proc , Section 6.02(3)(b). 9