On August 1, 2018, the Department of Treasury and the Internal Revenue Service (IRS) issued proposed regulations implementing section 965 of the Internal Revenue Code (Code) (referred to as the “transition tax”). Section 965 was added by Public Law 115-97, commonly referred to as the Tax Cuts and Jobs Act of 2017 (the Act).¹ Section 965 imposes a transition tax on previously untaxed foreign earnings of foreign subsidiaries of US companies by deeming those earnings repatriated. The proposed regulations provide rules for determining the section 965 tax liability of a US shareholder of a foreign corporation with deferred foreign income.

Section 965 imposes a one-time transition tax on a US shareholder with respect to its investment in controlled foreign corporations (CFCs) and certain other foreign corporations (collectively, “specified foreign corporations” or SFCs). The tax is generally imposed on the net aggregate amount of the US shareholder’s pro rata shares of the previously untaxed foreign earnings and profits (E&P) of such SFCs. Foreign earnings held in the form of cash and cash equivalents are taxed at a 15.5% rate, and the remaining earnings are taxed at a rate of 8%.²

Earlier this year, the IRS issued Notice 2018-26 (Notice) to provide taxpayers with interim guidance on planned regulations, certain anti-avoidance rules relating to special elections under section 965, and reporting and payment obligations related to the transition tax. Most notably, the Notice announced plans for regulations that would disregard certain changes in methods of accounting and entity classification elections made by taxpayers in tax years 2017 and 2018 that reduced their section 965 liability. The Notice suggested that certain accounting method changes (i.e., changes made to reduce a US shareholder’s section 965 tax liability) might be disregarded altogether.

However, the proposed regulations appear to soften the government’s position. Specifically, accounting method changes are not disregarded entirely but only for purposes of determining the amounts of any section 965 elements with respect to a US shareholder to the extent the method change alters the amount of any section 965 element with respect to the US shareholder. As such, the accounting method change would be disregarded for section 965 purposes although maintained for other purposes. Thus, while the regulations do not limit a taxpayer’s ability to file an accounting method change, if the method change does impact a section 965 element, then the accounting method change is disregarded. The regulations do not explicitly address how this would be accomplished although presumably, the taxpayer must revise any adjustments to reflect the accounting method change (for example, any section 481(a) adjustment or other amounts to implement an accounting method change) so that these amounts are not included in the US shareholder’s section 965 determination. It would seem that in certain circumstances, these calculations could be complicated. In light of the requirements imposed by these proposed regulations, taxpayers should carefully review any planned (and/or previously filed) accounting method changes to evaluate the regulations’ impact on the amount of a section 965 element. If a change impacts a section 965 element, careful consideration is required to both properly implement the accounting method change and to determine the amount of any transition tax.

Proposed Regulations

Proposed Treas. Reg. § 1.965-4 provides rules that disregard certain transactions for purposes of applying section 965. As addressed in Section 3.04 of the Notice, Treas. Reg. §§ 1.965-4(b) and (c) disregard (1) transactions undertaken with the principal purpose of reducing the section 965 tax liability of a US shareholder, and (2) certain changes in methods of accounting and entity classification elections. Unlike the Notice though, whether the limitation applies is not based on whether there is a reduction in the section 965 tax liability of the US shareholder, rather whether there is a change in the amount of a section 965 element. Proposed Treas. Reg. § 1.965-4(d) defines a section 965 element as, with respect to a US shareholder, the US shareholder’s section 965(a) inclusion amount with respect to a specified foreign corporation, the aggregate foreign cash position of the US shareholder, or the amount of foreign income taxes of a specified foreign corporation deemed paid by the US shareholder under section 960 as a result of the section 965(a) inclusion.

For purposes of applying Treas. Reg. §§ 1.965-4(b) and (c), proposed Treas. Reg. § 1.965-4(e) provides guidance with respect to determining whether there has been a change in the amount of a section 965 element. Specifically, the regulation provides that there is a change in the amount of a section 965 element of a US shareholder as a result of a certain transaction, accounting method change or entity classification election, if either event: (1) reduced the US shareholder’s section 965(a) inclusion amount with respect to a foreign corporation; (2) reduced the aggregate foreign cash position of the US shareholder, but only if such amount is less than the US shareholder’s aggregate section 965(a) inclusion amount; or (3) increased the amount of foreign income taxes of a specified foreign corporation deemed paid by the US shareholder under section 960 as a result of a section 965(a) inclusion. A result of defining a change in the amount of a section 965 element this way is that two taxpayers may file identical method changes, and depending on whether the correlating section 481(a) adjustment is positive or negative, may experience different results, i.e., the regulations indicate that a method change with a negative section 481(a) adjustment will be disregarded while the same change resulting in a positive section 481(a) adjustment would be respected.

In response to Notice 2018-26, taxpayers commented that the rule disregarding accounting methods should not apply when changing from an impermissible to a permissible method, and that a principal purpose test should not apply, but these recommendations were not adopted. Rather, the preamble indicates that the proposed Treas. Reg. § 1.9654-4(c)(1) does not affect a taxpayer’s ability to change its method of accounting. Instead, the rule disregarding such method changes applies only for the limited purpose of determining the amount of a taxpayer’s section 965 element. Unfortunately, this may be a difference without distinction. The proposed regulations do not include any guidance regarding how to effect the standard announced in the new rules, which may suggest that the IRS and Treasury failed to appreciate the complexity imposed therein.

The proposed regulations’ approach to disregard certain changes has a number of important consequences. 

First, the proposed regulations establish a rule that treats similar accounting method changes inequitably. Due to the IRS and Treasury’s decision to define a change in the amount of a section 965 element as either a reduction in a US shareholder’s section 965(a) inclusion amount, a reduction in its aggregate foreign cash position or an increase in the amount of deemed foreign taxes paid under section 960 (all of which would generally result in a reduction in the US shareholder’s section 965 tax liability), two identical accounting method changes would receive opposite results, i.e., one approved and one disregarded. 

For example, suppose a US corporation (US1) has a June 30 year-end, as does its (initially) wholly owned CFC. On July 1, 2017, USC sells 40% of the CFC to a different US corporation (US2). A change in accounting method is filed with respect to the CFC for its 2017 tax year that produces a negative section 481(a) adjustment in its 2017 tax year, but results in greater income being earned in its 2018 tax year (including before December 31, 2017). The negative section 481(a) adjustment is greater than the increase in July 1, 2017-December 31, 2017 earnings and profits. Under the proposed regulations, the change in accounting method would be disregarded with respect to US1 because it would result in a decrease in US1’s section 965(a) inclusion amount, while the change in accounting method would be respected with respect to US2, because it increases US2’s section 965 inclusion. 

Second, the proposed regulations discourage full compliance with the accounting method provisions. Some taxpayers have not fully complied with certain tax principles when computing E&P, because either full compliance would have been complex, or it was irrelevant for US tax purposes prior to the enactment of section 965. Consequently, although certain taxpayers may own a multitude of SFCs that have adopted E&P methods, such taxpayers may not have had a need previously to properly calculate E&P for subpart F inclusions, distributions or other transactions for which E&P was relevant. Now that E&P is relevant to all SFCs calculating a transition tax, many taxpayers are conducting E&P analyses to ensure their E&P accounting methods and E&P calculations are accurate. For taxpayers with excess foreign tax credit limitations and/or little debt, the section 965 liability may be the only federal income tax purpose for which E&P is relevant. Nonetheless, the proposed regulations inhibit taxpayers from properly calculating E&P by not allowing E&P to be reduced for section 965 purposes to reflect changes attributable to improper accounting methods. It is a long-established principle that the IRS cannot force a taxpayer to remain on an improper accounting method or to not take into account the related section 481(a) adjustment.³ Thus, while the IRS and Treasury may believe they have not impacted a taxpayer’s ability to file a method change, the result is that taxpayers will choose not to correct improper accounting methods. Because the system relies on voluntary compliance, it is disappointing that a regulation might discourage full compliance. 

Third, the proposed regulations may require complicated calculations in certain circumstances. The preamble accompanying the proposed regulations provides that “the rule disregarding any accounting method change is relevant only for the limited purpose of determining the amount of a taxpayer’s section 965 elements.” Presumably, when the section 965 liability is determined, the taxpayer is required to remove the portion of any section 481(a) adjustment and corresponding annual costs affecting a section 965 element from that liability. However, it would appear that these amounts would remain in the taxpayer’s systems for all other purposes. There is no guidance regarding how this calculation would be accomplished in a consolidated context, or with respect to depreciation or inventory determinations. Because many large multinationals are affected by this provision, these questions should have been anticipated.  Further, there is no guidance for unique section 481(a) adjustments, such as those made on a cut-off basis or a shortened time frame. Because none of these issues were addressed in the regulations, it is not clear that the IRS and Treasury fully considered how taxpayers would comply with these requirements. 

Fourth, the proposed regulations set forth a very broad standard, and there may be a question about whether there is adequate authority to support the government’s approach and determine that these changes in accounting methods may be retroactively disregarded for purposes of determining the amounts of any section 965 elements with respect to a US shareholder. The IRS has discretion regarding which accounting method changes may be approved although that discretion is not unlimited.⁴ The Commissioner’s determination cannot be arbitrary or capricious, and in order to be a proper exercise of discretion, must have an adequate basis in law or fact.⁵ Instead of applying the Commissioner’s discretion about how the accounting method change provisions should apply to a particular taxpayer’s circumstances, a blanket determination has been made that changes will be disregarded for purposes of determining the amounts of any section 965 elements with respect to a US shareholder to the extent the method change changes the amount of any section 965 element with respect to the US shareholder. Because the change is prohibited without an evaluation of the taxpayer’s specific facts and circumstances, there may be an argument that this broad brush approach is an abuse of discretion. Under this approach, for any taxpayer seeking an accounting method change that has a subsidiary consequence of impacting a section 965 element, the applicable change will be disregarded, even if the change is from an improper method to a proper one.⁶ Further, by setting forth this determination on, at times, a retroactive basis, the IRS appears to apply its discretion inequitably. Taxpayers are discovering long after the “specified date” that certain changes will be disregarded for purposes of determining the amounts of any section 965 elements with respect to a US shareholder.
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¹ 131 Stat. 2054 (December 22, 2017).
  
² Section 965(c)(1).
  
³See e.g., SoRelle v. Comm’r, 22 TC 459, 469 (1954) (acq.), finding the IRS could not use discretion under the statutory predecessor of section 446(e) to compel a taxpayer to remain using an accounting method where the taxpayer had elected to change the method to better reflect the nature of the business.
  
⁴See Prudential Overall Supply v. Comm’r, 83 T.C.M. (CCH) 1545 (T.C. 2002), finding that the IRS abused its discretion when it required the taxpayer to change from a method that was based on a reasonable relation to its business practice; see also, Computer Scis. Corp. v. United States, 50 Fed. Cl. 388, 393 (2001), dismissed, 79 F. App’x 430 (Fed. Cir. 2003), finding that the IRS committed abuse of discretion by treating similarly situated taxpayers differently based solely on the date that a tax return was filed.
  
⁵See Mingo v. Comm’r, 105 T.C.M. (CCH) 1857 (T.C. 2013), aff'd, 773 F.3d 629 (5th Cir. 2014), finding that the IRS did not abuse its discretion by requiring the taxpayer to change the accounting method where its decision had a “sound basis” in fact or law.
  
⁶See Kansas City S. Indus., Inc. v. Comm’r), 98 T.C. 242, in which the court ruled that the Commissioner had abused its discretion in denying the taxpayer permission to revoke an earlier election regarding its treatment of certain expenses when the change was filed to take advantage of favorable case law precedent that permitted an alternative treatment.

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