IRS Releases Guidance on Accounting Method Changes for Certain Foreign Corporations
The Internal Revenue Service on May 11 issued guidance (Rev. Proc. 2021-26) for certain foreign corporations to obtain the IRS’s automatic consent to change their method of accounting for depreciation to the alternative depreciation system (ADS). The guidance also provides additional terms and conditions applicable with respect to Section 481(a) adjustments and clarifies an existing rule that limits audit protection for certain foreign corporations.
ADS Depreciation Method
Under the existing global intangible low-taxed income (GILTI) rules enacted as part of the Tax Cuts and Jobs Act (TCJA) of 2017, U.S. shareholders of controlled foreign corporations (CFCs) are taxed on their pro rata share of CFC tested income, regardless of whether the income is repatriated. U.S. shareholders are allowed to reduce their share of CFC tested income by a 10% deemed return on certain CFC “qualified business asset investment” (QBAI). The net result, generally, is included in the U.S. shareholder’s taxable income. Tested income for a CFC is generally calculated using the same taxable income principles as if the CFC were a domestic C corporation.
QBAI generally equals the quarterly average adjusted bases of certain tangible property that is used in a CFC’s trade or business and is permitted a deduction for depreciation under IRC Section 167. In determining the adjusted basis in property for purposes of QBAI, ADS is required to be used, regardless of when the property was placed in service or what other depreciation method is used for other calculations, such as computing gross or taxable income (collectively, income) or earnings and profits (E&P).
While Section 168 generally requires that property used predominantly outside the U.S. be depreciated using ADS, a foreign corporation (including a CFC) may use another depreciation method consistent with its books and records or U.S. generally accepted accounting principles (U.S. GAAP) for computing income or E&P if the adjustments required to conform to ADS are not material, which is generally a facts and circumstances test. However, given that use of ADS is required for computing QBAI for GILTI purposes, CFCs may want to change their depreciation method to ADS for purposes of computing income or E&P to align with their QBAI computation.
The determination of the adjusted basis in property for purposes of computing QBAI is not generally a method that is subject to the consent requirement. However, a CFC on an impermissible non-ADS method, as well as a CFC on a permissible non-ADS method, are both subject to the consent requirement, with the former qualifying for automatic consent and the latter being ineligible for automatic consent.
In Rev. Proc. 2021-26, the IRS modifies existing rules, including waiving certain eligibility requirements, to allow, for a limited period of time, a CFC on either an impermissible or permissible non-ADS method to obtain the automatic consent to change its method of depreciation to ADS for purposes of calculating income, as well as E&P.
Applicability Dates
This guidance is effective for Forms 3115 filed on or after May 11, 2021 (for taxable years of CFCs ending before January 1, 2024). Forms 3115 filed before May 11, 2021 under the non-automatic change procedures may be eligible to convert the Forms 3115 to an automatic change, subject to strict procedures and timing considerations outlined in Rev. Proc. 2021-26.
Section 481(a) Adjustments
When a CFC changes its method of accounting, the difference between the CFC’s income under the old and new methods is generally taken into account as a Section 481(a) adjustment as part of the CFC’s computation of income and E&P. To account for the recently enacted GILTI rules, as well as the repeal of foreign base company oil related income as part of the Subpart F regime, Rev. Proc. 2021-26 clarifies that a CFC’s Section 481(a) adjustment as a result of a change in accounting method (including as a result of an automatic change in method of depreciation to ADS, as described above) is generally required to be taken into account for purposes of computing the CFC’s tested income or loss for GILTI purposes, unless the adjustment relates to an item of gross income, or a deduction attributable to an item of gross income, excluded from the computation of tested income or loss (such as Subpart F). Rev. Proc. 2021-26 further clarifies that such Section 481(a) adjustment to tested income or loss for GILTI purposes will also include any Section 481(a) adjustment relating to the repealed foreign base company oil related income, as well as any Section 481(a) adjustment that relates to an item of income or expense arising before the effective date of Section 951A.
In addition, the Section 481(a) adjustment must follow, or be allocated to the class of gross income that has, the same source, separate limitation classification, character, and treatment as the CFC’s income to which the adjustment relates.
Applicability Date
This guidance is effective for Forms 3115 filed on or after May 11, 2021.
Audit Protection Limitations
Generally, a taxpayer will receive audit protection regarding a change in accounting method for an item of income on a valid Form 3115. For accounting method changes made for CFCs or 10/50 corporations (corporations that have U.S. shareholders owning at least 10% but 50% or less), however, such audit protection is typically denied for a tax year before the year the change was requested if one or more of the CFC’s or 10/50 corporation’s U.S. corporate shareholders computed an amount of deemed paid foreign taxes for that year that exceeds 150% of the average amount of deemed paid foreign taxes computed during the U.S. corporate shareholder’s three prior tax years. If audit protection is denied, the IRS has the authority to change the method of accounting for the item of income subject to the Form 3115 for those prior years.
Despite comments suggesting an alternative approach, Rev. Proc. 2021-26 retains the 150% threshold based on the amount of deemed paid foreign taxes in determining whether audit protection for those previous years will be denied.
Applicability Date
This guidance is effective for Forms 3115 filed on or after May 11, 2021.
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