Introduced as the Tax Cuts and Jobs Act, the “Act to Provide for Reconciliation Pursuant to Titles II and V of the Concurrent Resolution on the Budget for Fiscal Year 2018,” P.L. 115-97, was signed into law by the President on December 22, 2017. Among the many tax disciplines affected by the new law, a number of the tax reform provisions favorably impact accounting methods for federal income tax purposes. This alert first discusses two tax reform provisions in the Corporate and International tax arena that present unique opportunities for businesses to file accounting method changes to defer income recognition and accelerate deductions in 2017 in order to generate both temporary and permanent tax saving benefits. Next, the alert provides a summary of the more influential tax reform provisions that affect businesses in a favorable manner, for the most part, such as 100 percent full expensing for assets qualifying for bonus depreciation and the expansion of the use of the overall cash method.
One of the major international tax developments arising from tax reform is the transition tax generally requiring U.S. shareholders of “specified foreign corporations” (as specifically defined in section 965) to include as subpart F income their pro rata shares of deferred foreign income of such foreign corporations. Taxpayers are allowed to deduct a portion of the foreign income from the amount of the section 951 inclusion to arrive at a 15.5-percent rate of tax on accumulated post-1986 foreign earnings and profits (“E&P”) held in the form of cash or cash equivalents, and eight percent rate of tax on all other earnings.
In general, the E&P of a foreign corporation is computed under the entity’s method(s) of accounting as provided under the section 964 regulations. Similar to accounting methods utilized for federal income tax purposes, taxpayers that have established a method of accounting for E&P purposes may change their method to maximize tax savings opportunities and/or minimize exposure. Taxpayers that are considering any opportunities for filing accounting method changes to reduce the E&P of foreign corporations for purposes of the transition tax rules should undertake the following steps:
Step 1 – Determine if the E&P of the foreign corporation is significant prior to 2018
The taxpayer must first determine if the foreign corporation has adopted/established an accounting method based on whether the foreign corporation’s E&P is significant for U.S. tax purposes with respect to its controlling domestic shareholder. Under section 1.964-1(c)(6) of the Income Tax Regulations, action by or on behalf of a foreign corporation (other than a foreign corporation subject to tax under section 882) to make an election or to adopt a tax year or method of accounting shall not be required until the due date (including extensions) of the return for a controlling domestic shareholder’s first tax year with or within which ends the foreign corporation’s first tax year in which the computation of its E&P is “significant.” Note that the filing of the information return required by section 6038 shall not itself constitute a significant event. Events that cause a foreign corporation’s E&P to have U.S. tax significance include, without limitation:
1. A distribution from the foreign corporation to its shareholders with respect to their stock.
2. An amount is includible in gross income with respect to such corporation under section 951(a).
3. An amount is excluded from subpart F income of the foreign corporation or another foreign corporation by reason of section 952(c).
4. Any event making the foreign corporation subject to tax under section 882.
5. 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 under section 864(e)(4).
6. A sale or exchange of the foreign corporation’s stock of the controlling domestic shareholders that results in the recharacterization of gain under section 1248.
The determination of “significant event” is applied on a company by company basis (e.g., CFC by CFC).
If the foreign corporation has not previously had one of the events listed above, per the Regulations, then the foreign corporation is able to adopt/establish the appropriate tax methods of accounting on the current year return (i.e., no Form 3115, Application for Change in Accounting Method, is required).
If the foreign corporation has had one of the events listed in the Regulations, then the foreign corporation would be required to file a Form 3115(s) to request IRS consent to change from the present method of accounting to an optimal method of accounting.
Step 2 – Monitor future Treasury and IRS guidance aimed at preventing the impact of E&P reductions through accounting method changes for transition tax purposes
Pursuant to newly enacted section 965(o) of the Internal Revenue Code, Congress has instructed the Treasury Department and the IRS to issue regulations or other guidance to prevent the avoidance of the purposes of the transition tax, including, among other things, changes in accounting methods. Section 965(o) provides:
(o) REGULATIONS.—The Secretary shall prescribe such regulations or other guidance as may be necessary or appropriate to carry out the provisions of this section, including —
(1) regulations or other guidance to provide appropriate basis adjustments, and
(2) regulations or other guidance to prevent the avoidance of the purposes of this section, including through a reduction in earnings and profits, through changes in entity classification or accounting methods, or otherwise.
At this time, it is unclear what form or approach the guidance might take, or when such guidance might be issued. For example, whether the Treasury and IRS may take the approach of negating all accounting methods changes that reduce E&P for transition tax purposes, or only a select list of accounting method changes, remains to be seen. Further, it also remains to be seen whether accounting method changes to remediate improper methods of accounting and/or method changes that would in effect increase E&P would be excepted out of section 965(o). That said, it is critical to understand that although the IRS may accept the Form 3115 filing, the impact of the E&P reduction for transition tax purposes generated from filing accounting method changes could potentially be disregarded or eliminated by the IRS under section 965(o) in future guidance. Accordingly, tax professionals should ensure that taxpayers considering filing E&P method changes are fully informed regarding the possibility of the IRS and Treasury disallowing the favorable impact of implementing such method changes.
Corporate Tax Rate Reduction
For tax years beginning after December 31, 2017, the top corporate tax rate has been permanently reduced by 40 percent — from 35 percent to a flat tax rate of 21 percent. In the first several months of 2018, it is important to evaluate the current methods of accounting established by a taxpayer and determine if there are more optimal methods of accounting available under the Code and regulations. Taxpayers should consider filing a Form 3115, Application for Change in Accounting Method, for a tax years beginning before January 1, 2018, to request IRS consent to accelerate the timing of deducting expenditures and defer the timing of revenue recognition. The benefits of filing accounting method changes include tax savings resulting from reduction of taxable income via a cumulative catch-up adjustment, including a one-time permanent benefit from tax rate reductions in 2018 generated by taking deductions in 2017 at the current higher tax rate and deferring revenue to future years when tax rates are reduced.
Popular accounting method changes that can still be made for the 2017 tax year include, among other things, 1) one-year deferral method for advance payments; 2) accelerating prepaid expenses under the 12-month rule; 3) accelerating software development costs; 4) changing to an optimal recovery period for fixed assets and intangible assets; 5) catching up missed bonus depreciation; 6) accelerating certain accrued expenses; and 7) accelerating accrued sales incentives, rebates, and allowances using the recurring item exception. Please refer to Rev. Proc. 2017-30 for more accounting method change opportunities. To effect an automatic consent change for the 2017 tax year, a Form 3115 must be attached to the timely filed (including extensions) federal income tax return for the year of change and a copy must be mailed to the IRS Covington, KY office no later than the filing date of that return.