Recently released Revenue Procedure 2021-26 (the Revenue Procedure) provides taxpayers with guidance regarding accounting method changes made on behalf of foreign corporations. The Revenue Procedure:

• Allows controlled foreign corporations (CFCs) to obtain automatic consent to change depreciation methods to use the alternative depreciation system under section 168(g) (ADS) (or to change the convention or recovery period under ADS) for purposes of calculating taxable income and earnings and profits (E&P).
• Updates the rules for the computation of section 481(a) adjustments resulting from method changes made by CFCs to take into account the new global intangible low-taxed income (GILTI) regime.
• Clarifies the “150 percent rule” that limits audit protection for CFCs and certain other foreign corporations (10/50 corporations) that have a 10% United States shareholder (US shareholder) based on the amount of foreign taxes deemed paid by US shareholders with respect to such corporations.

Background

Under ADS, depreciation is generally determined by using the straight-line method of depreciation, an applicable convention, and a specified recovery period based on the nature of the asset being depreciated.¹ US shareholders of CFCs have long been generally required to use ADS to depreciate tangible property predominantly used outside of the US, including such property held by a CFC. However, a CFC may nonetheless use either its depreciation method used for financial accounting purposes or a method consistent with US Generally Accepted Accounting Principles (GAAP) (collectively, a non-ADS method) for purposes of computing its taxable income or E&P, as long as ADS-conforming adjustments are not material.² Materiality is a facts and circumstances inquiry, dependent upon the adjustment’s size relative to total assets, consistency of the practice, and whether the item to which the adjustment relates is recurring or non-recurring.³ Not surprisingly, many taxpayers historically have taken the position that such adjustments would not be material and have accordingly used non-ADS methods for purposes of calculating the taxable income and E&P of their CFCs.

Tax Cuts and Jobs Act (TCJA), enacted in 2017, did not disturb those rules, but did introduce the GILTI regime, which imposed new requirements on taxpayers to apply ADS with respect to CFCs. Under the GILTI rules, a US shareholder generally is required to include in its US taxable income the GILTI of its CFCs. Very simply stated, GILTI is the excess of the net tested income of all of the US shareholder’s CFCs over a 10 percent return on the CFCs’ qualified business asset investments (QBAI), taking into account only CFCs with positive tested income and with an adjustment for certain interest expense. Net tested income generally is the net income of the CFCs determined under US tax principles, except for subpart F income and certain other exempt income. QBAI is the average aggregate adjusted bases in depreciable tangible property that is used in the CFC’s trade or business to produce tested income.⁴ To compute the adjusted basis in property for purposes of calculating QBAI, taxpayers are required to use ADS, even if the adjustments required to conform the taxpayer’s non-ADS method to ADS would not be material under the standard relevant to taxable income and E&P determinations.⁵

Accounting Method Changes for Depreciation       

Because the GILTI rules require the use of ADS for purposes of calculating QBAI, CFCs not otherwise required to use ADS to compute income and E&P may seek to change to ADS for such purposes to conform the taxable income, E&P, and QBAI computations. The straight-line method, convention, and recovery period required by ADS constitute methods of accounting under section 446, meaning that each time a taxpayer wants to change one of those components, the Commissioner’s advance consent for the change is required.⁶ In contrast, the determination of adjusted bases for purposes of computing QBAI is not a method of accounting.

Previously, CFCs using impermissible non-ADS methods could change to ADS under the automatic accounting method change procedure, but a change by CFCs on a permissible non-ADS method did not qualify as an automatic change. To resolve this disparity, the Revenue Procedure expands the automatic consent procedures under Rev. Proc. 2019-43 to encompass such changes. This revision eases the burden on taxpayers seeking to conform their computations of CFCs’ taxable income and E&P to their QBAI computations. However, such relaxation is only available with respect to method changes for taxable years of CFCs ending before January 1, 2024.

Section 951A and the Section 481(a) Adjustment

Under section 481(a) and related rules, adjustments are made to a taxpayer’s taxable income and E&P as necessary to prevent amounts from being duplicated or omitted as a result of an accounting method change.⁷ The adjustment is equal to the difference between the CFC’s income and E&P as computed pursuant to the old method compared to what such amounts would have been had the taxpayer historically applied the new method.⁸

The Revenue Procedure updates the related rules with respect to CFCs to take into account the new GILTI rules. Specifically, it provides that a CFC’s section 481(a) adjustment must be taken into account in determining the CFC’s tested income or tested loss, except to the extent the adjustment prevents the duplication or omission of an item of gross income or expense that would not be tested income or loss (e.g., subpart F gross income). Thus, even if the adjustment relates to an item that was taken into account prior to the adoption of the GILTI regime, the adjustment will be taken into account in determining tested income or tested loss unless it relates to an excluded category. The Revenue Procedure explains that this approach was adopted because if prior items that affected the section 965 transition tax were not generally taken into account in calculating tested income or tested loss, this permits income to escape US taxation or alternatively result in the double taxation of the same income.

Although other similar accounting method changes allow aggregate adjustments for multiple properties (rather than adjustments made on an item of property basis) and also permit netting of the section 481(a) adjustments,⁹ these simplifying measures were not allowed for CFCs in the Revenue Procedure. CFCs with many properties may find the determination on a per property basis tedious. The Department of the Treasury has acknowledged that recommendations for simplifying conventions would be appreciated.

Availability of Audit Protection

Under Rev. Proc. 2015-13, a taxpayer generally receives audit protection with respect to an item that is subject to an accounting method change when it timely files a Form 3115, Application for Change in Accounting Method. Audit protection means that the IRS will not require a taxpayer to change its method of accounting for the same item for a taxable year prior to the requested year of change. A taxpayer under examination or one coming under IRS examination may find audit protection beneficial. As a result, audit protection is frequently an incentive that encourages a taxpayer to file an accounting method change. However, for an accounting method change made on behalf of a CFC or a 10/50 corporation, Rev. Proc. 2015-13 either limits audit protection, or even denies it altogether.¹⁰ Although the Revenue Procedure clarifies terminology regarding audit protection limitations for a CFC or a 10/50 corporation, the Revenue Procedure leaves such audit protection limitations unchanged.

Specifically, the Revenue Procedure denies audit protection for taxable years before the requested year of change in which at least one of the CFC’s or 10/50 corporation’s US shareholders computed an amount of foreign taxes deemed paid under sections 902 and 960 with respect to the CFC or 10/50 corporation that exceeds 150 percent of the average amount of foreign taxes deemed paid under sections 902 and 960 by the US shareholder with respect to the CFC or 10/50 corporation in the US shareholder’s three prior taxable years (the “150 percent threshold”).

Foreign income taxes of a foreign corporation that are properly attributable to amounts included in a domestic corporate shareholder’s income are deemed paid regardless of whether the shareholder elects to deduct or credit foreign income taxes in the year of the inclusion, and regardless of the extent to which section 904(d) or other limitations limit the allowable amount of the foreign tax credit (“FTC”) in the year of inclusion or other years.¹¹ The 150 percent threshold denies audit protection for an improper method of accounting that affects the calculation of the foreign corporation’s income for US tax purposes, which may improperly inflate the amount of foreign taxes deemed paid with respect to an income inclusion from that corporation.¹²

Because taxpayers are provided ten years to elect to credit foreign income taxes, and to carry excess FTCs with respect to subpart F income to other taxable years, the IRS views the 150 percent threshold as appropriately applied on the basis of the amount of foreign taxes deemed paid and not on the allowable amount of the associated FTC. To clarify this proposition, the Revenue Procedure modifies Rev. Proc. 2015-13 and states that the 150 percent threshold is computed with respect to the amount of the foreign corporation’s foreign taxes deemed paid, regardless of the extent to which a FTC is allowed.

The Department of the Treasury is currently evaluating whether audit protection should be made more widely available to CFCs by loosening the existing limitations. In this regard, comments have been requested about how the audit protection standards for CFCs should be revised. 

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