IRS Streamlines Automatic Consent Procedures for CFC Depreciation Method Changes, Clarifies Treatment of Catch-Up Adjustment

June 2021

BY

Connie Cunningham, National Accounting Methods Co-Technical Leader | Chris Armstrong, Senior Manager, National Accounting Methods | Tiffany Ippolito, Senior Manager, National International Tax

On May 11, 2021, the IRS and Treasury released Rev. Proc. 2021-26, which provides streamlined filing procedures for certain foreign corporations to obtain automatic consent to change their methods of accounting for depreciation to the alternative depreciation system (ADS) under Section 168(g). The guidance also provides additional terms and conditions applicable to Section 481(a) adjustments arising from accounting method changes of certain foreign corporations (CFC) and clarifies the applicability of an existing rule that limits audit protection with respect to certain foreign corporations.
 

New Streamlined Procedures

 Generally, a CFC is required to calculate its earnings and profits (E&P) and GILTI tested income as if it were a domestic corporation, including consideration of book to tax adjustments as determined under the corporation’s methods of accounting. With respect to depreciation methods specifically, Section 168(g)(1)(A) requires all taxpayers, including CFCs, to use ADS to depreciate tangible property predominantly used outside of the United States during the taxable year. CFCs must also use ADS to calculate their qualified business asset investment (QBAI) on a quarterly basis.
 
As noted in the preamble to the final GILTI regulations, many CFCs have historically followed their book method of determining depreciation. While IRS consent is not required to properly compute QBAI using ADS, CFCs that have not previously calculated depreciation using ADS for E&P or income purposes must file an accounting method change (Form 3115) to do so going forward. Rev. Proc. 2021-26 provides a new automatic method change (designated change No. 248) that allows a CFC on an impermissible or permissible non-ADS method to obtain automatic consent to change its method of depreciation for certain property to ADS for income and E&P purposes. Additionally, for items placed in service in the taxable year immediately preceding the year of change (“1-year property”), the CFC may correct its depreciation for such depreciable property via filing a Form 3115, rather than having to file an amended return, as is usually the case when an improper treatment occurs for only one tax year.
 
In lieu of filing a standard Form 3115, Rev. Proc. 2021-26 provides for reduced reporting requirements available to any CFC making this change. These reduced reporting requirements require taxpayers to fill out only certain sections of the Form 3115, which can help reduce the administrative burden associated with implementing an accounting method change. A signed copy of the original completed short Form 3115 must be filed on the CFC’s behalf by the designated shareholder with the IRS in Ogden, Utah no earlier than the first day of the requested year of change and no later than the date the designated shareholder files the original short Form 3115 with the CFC’s federal income tax return for its taxable year in which or with which the requested year of change ends.
 
In an effort to make it easier for CFCs to obtain automatic consent to change their method of accounting, certain scope limitations that would normally preclude a taxpayer from making an automatic accounting change have been temporarily waived, including filing Form 3115 in the final year of a taxpayer’s trade or business and filing Form 3115 within five years of making a method change for the same item.
 
Rev. Proc. 2021-26 is effective for a Form 3115 filed on or after May 11, 2021, for a taxable year of a CFC ending before January 1, 2024. Additionally, the revenue procedure also provides guidance for a taxpayer that has a Form 3115 pending with the IRS National Office on May 11, 2021, and was properly filed under the non-automatic change procedures in Rev. Proc. 2015-13 before May 11, 2021.
 

Section 481(a) Adjustment

CFCs implementing an accounting method change under Rev. Proc. 2021-26 must compute a cumulative Section 481(a) “catch-up” adjustment, which is calculated as the difference between depreciation expense determined under the present versus proposed methods. The guidance updates the terms and conditions related to a CFC’s Section 481(a) adjustment, clarifying that a CFC’s Section 481(a) adjustment must be taken into account in determining its tested income or loss, unless the adjustment applies to an item of income that is excluded from such calculation (e.g. Subpart F income). This also includes Section 481(a) adjustments relating to foreign base company oil related income, as well as Section 481(a) adjustments related to an item of income arising prior to the effective date of Section 951A.
 
Similar to existing automatic change procedures related to depreciation, change No. 248 allows a taxpayer to file the accounting method change for more than one item of depreciable property on a single Form 3115. However, to ensure that each component of the Section 481(a) adjustment is allocated to the appropriate separate limitation categories, the guidance explicitly states that the filer must provide a separate Section 481(a) adjustment with respect to each item of property included in the requested change.
 

Audit Protection

 Under Rev. Proc. 2015-13, a CFC or 10/50 corporation (which is a foreign corporation with U.S. shareholders owning at least 10% but no more than 50% of the corporation) does not receive audit protection from filing a method change if one or more of the domestic corporate shareholders of the CFC or 10/50 corporations computes an amount of deemed paid taxes (under Sections 902 and 960) for that year that exceeds 150% of the average amount of deemed paid taxes computed by the domestic corporate shareholder(s) in the prior three taxable years. This general rule effectively prevents most CFCs or 10/50 corporations that were subject to the transition tax under Section 965 from receiving audit protection for method changes filed prior to their 2021 tax year. Without audit protection, the IRS can require the taxpayer to change its method of accounting for the same item that is the subject of the Form 3115 for those previous years, and potentially assess interest and penalties associated with any underpayment of tax related to the historical improper treatment.
 
Rev. Proc. 2021-26 retains this general rule denying audit protection but clarifies that the 150% threshold is computed with respect to the amount of the foreign corporation’s foreign taxes deemed paid, regardless of the extent to which a foreign tax credit is allowed. As such, CFCs should carefully consider the implications of the audit protection rule when determining the optimal tax year for changing depreciation methods.