Tax Accounting Methods Pose Challenges for Controlled Foreign Corporations
Accounting Methods & CFCs
The Tax Cuts and Jobs Act (TCJA) created the global intangible low-taxed income (GILTI) rules under Internal Revenue Code Section 951A applicable to controlled foreign corporations (CFC). In general, the GILTI rules require a CFC to compute “tested” income using U.S. tax principles and accounting methods to determine the amount of GILTI income U.S. taxpayers should report.
A CFC’s tested income is determined by treating the CFC as if it were a domestic corporation. The tested income of the CFC is based on the books and records maintained by the foreign corporation’s shareholders. When calculating tested income for purposes of §951A, U.S. tax accounting standards must be applied, thereby resulting in book-to-tax adjustments such as:
- Accounting methods – The accounting method shall reflect the provisions of §446 and the regulations thereunder.
- Inventories – Inventories shall be taken into account in accordance with the provisions of §471 and §472 and the regulations thereunder.
- Depreciation – If less than 20 percent of the gross income from all sources of the foreign corporation is derived from sources within the U.S., depreciation shall be computed in accordance with §167 and the regulations thereunder.
Adoption of Accounting Methods by a CFC
In general, a CFC is not required to elect or adopt an accounting method until the year in which the computation of the CFC’s earnings and profits (E&P), i.e., taxable income, is significant for U.S. tax purposes with respect to it controlling domestic shareholders. Events that cause a foreign corporation’s E&P to have U.S. tax significance include, without limitation, the following:
- A distribution from the foreign corporation to its shareholders on their stock
- An amount is includible in gross income for the corporation under §951(a) as Subpart F income
- An amount is excluded from Subpart F income of the foreign corporation or another foreign corporation under the E&P limitation under §952(c)
- Any event making the foreign corporation subject to U.S. tax as a result of engaging in a U.S. trade or business and subject to tax under §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
- A sale or exchange of controlling domestic shareholders’ stock of the foreign corporation that results in the recharacterization of gain under §1248
The filing of Form 5471, Information Return of U.S. Persons with Respect to Certain Foreign Corporations, is not a significant event. In addition, no adjustment is required in computing taxable income unless it is material. Whether an item is material depends on the particular case’s facts and circumstances, including the adjustment amount, 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 or merely nonrecurring nature.
In general, once an election, adoption or change in accounting method is made on behalf of the foreign corporation, the election of a tax accounting method must be reflected in the taxable income calculation to the extent it affects the domestic shareholders’ U.S. tax liability. Such an action binds both the foreign corporation and its domestic shareholders for that taxable year and subsequent taxable years unless a change is allowed by the commissioner.
When Must a CFC Adopt U.S. Tax Accounting Methods?
If no significant event has occurred with respect to a CFC and its U.S. shareholder, the CFC is not required to adopt a method of accounting. In the absence of a significant event in prior years such as Subpart F income, the first significant event of a CFC subject to deemed repatriation under §965 would be the last taxable year of the CFC that began before January 1, 2018. As such, the CFC would have been required to adopt the U.S. tax accounting methods for that year. Therefore, the CFC must properly apply U.S. tax accounting methods in calculating its accumulated post-1986 deferred foreign income inclusion under §965.
The CFC’s last taxable year that began before January 1, 2018, would be the first relevant year for tax accounting method purposes. The second relevant year to establish consistency would be the next tax year. This would generally be the year in which §951A would require the CFC’s U.S. shareholder to include in income any GILTI produced by the CFC.
In the case of a CFC that was an E&P deficit corporation for its last taxable year beginning before January 1, 2018, and the CFC’s E&P was not previously significant, the CFC would not have been required to elect or adopt an accounting method for that year. Accordingly, the E&P deficit corporation’s E&P would not have significance until the next year in which it has either tested income or tested loss (the first year beginning after January 1, 2018) and could then initially adopt an accounting method in that year for material items. The E&P of a deficit corporation would likely be considered significant whereby the E&P deficit was used to offset the accumulated E&P of a deferred foreign income corporation under §965(b) and owned by the same U.S. shareholder.
Had a CFC’s E&P been significant prior to the application of either §951A or §965, and that previously significant E&P was calculated using improper tax accounting methods, any change in accounting method with respect to a material item would require the commissioner’s consent. Consent would ordinarily be obtained by filing Form 3115, Application for Change in Accounting Method, with the U.S. shareholder’s income tax return on behalf of the CFC in the first tax year to which the change would apply. Failure to obtain such consent would not provide for audit protection upon examination.
Effect of Accounting Methods on GILTI
The TCJA created the GILTI rules under §951A applicable to CFCs. In general, the GILTI rules require a CFC to compute “tested” income using U.S. tax principles and accounting methods. Tested income is reduced by 10 percent of qualified business asset investment adjusted for specified interest. The resulting GILTI income is taxed to U.S. shareholders owning at least 10 percent of the vote or value of the CFC’s shares. In general, U.S. shareholders may claim a 50 percent deduction pursuant to §250 (37.5 percent in years beginning after 2025) with respect to GILTI income to the extent the U.S. shareholder has taxable income. In addition, a U.S. shareholder can claim a foreign tax credit (FTC) equal to 80 percent of foreign tax paid or accrued with respect to the GILTI income. Importantly, the GILTI rules do not allow for carryforward or carryback of losses or unused FTCs. Moreover, GILTI income must be accounted for in its own separate category for purposes of determining the FTC limitation under §904.
Under the GILTI rules, U.S. C corporation taxpayers will be taxed at a 21 percent rate, which is further reduced to a 10.5 percent rate after claiming the §250 deduction. If the CFC is operating in a jurisdiction with a tax rate in excess of 13.125 percent (16.5 percent for years beginning after 2025), then a U.S. taxpayer may be able to offset the GILTI tax liability with FTCs. Thus, the GILTI rules are designed to tax CFCs operating in low-taxed jurisdictions.
Mismatch of U.S. & Foreign Accounting Methods
Although the GILTI rules were designed to apply to low-taxed foreign income, differences between U.S. and foreign tax accounting methods can result in significant tax consequences to U.S. taxpayers.
Local country taxing jurisdictions will not, in many cases, tax CFCs on the same basis as U.S. taxpayers. Examples include:
- Local country allows carryforwards of net operating losses (NOL), while the GILTI rules do not.
- U.S. interest deductions may be subject to §163(j) limitations, while interest may be subject to thin capitalization rules in the local country.
- The U.S. applies alternative depreciation system class lives and the straight-line method for purposes of computing fixed asset depreciation, while local countries may have other statutory depreciation methods.
- The U.S. has numerous tax accounting requirements, including but not limited to §263A for inventory, §461 economic performance rules and §460 contract accounting rules, which may differ significantly in the local jurisdiction.
Assume a CFC recognizes a loss of $100 in year one and earns $100 in year two. Also, assume the local jurisdiction has a high tax rate (30 percent) but allows for the carryforward of NOLs. In this case, the CFC will have no tested income in year one but will have $100 of tested income in year two. In year two, the U.S. taxpayer will recognize a $100 GILTI inclusion and receive a 50 percent §250 deduction. The resulting $50 of additional taxable income will be taxed at a 21 percent rate for a $10.50 tax liability. No foreign tax credits will be available because the local country offsets year two taxable income with NOL carryforwards. Hence, the U.S. taxpayer’s overall effective tax rate is increased. Furthermore, the U.S. taxpayer would not qualify for the GILTI high-tax exception, which will be applicable to taxpayers once GILTI regulations are finalized.
What Tax Planning Is Available to U.S. Taxpayers?
- Review your U.S. tax accounting methods for each CFC to assess whether you’re using permissible methods.
- Consider differences between U.S. tax accounting and local jurisdiction tax reporting and identify differences.
- Taxpayers with multiple CFCs should take into account the effect of all CFC tested income, losses and associated FTCs.
- Consider the impact of accounting method changes.
- Consider the effect of local country NOLs.
- Planning for Subpart F income in high-tax jurisdictions, in connection with the Subpart F high-tax exception, may mitigate any potential U.S. tax liability as a result of GILTI.
- Noncorporate U.S. shareholders of CFCs should evaluate potential tax savings that could result from an election under §962 to be taxed as a domestic corporation.
- Consider potential new book-to-tax differences that may result from a company’s adoption of the new lease accounting standards under Accounting Standards Codification (ASC) 842 and the new revenue recognition standards under ASC 606.
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