IRS issues guidance for changing CFC depreciation methods
TAX ALERT |
The IRS recently published Rev. Proc. 2021-26, providing an automatic method change for certain foreign corporations – controlled foreign corporations (CFCs) and 10/50 corporations - to change their methods of accounting to the alternative depreciation system (ADS) under section 168(g). Importantly this method change covers both impermissible to permissible and permissible to permissible depreciation changes. The revenue procedure also prescribes additional terms and conditions related to the cumulative catch-up (section 481(a)) adjustment and its impact on other global intangible low-taxed income (GILTI) calculations. Finally, the IRS clarified existing rules that limit audit protection with respect to certain foreign corporations.
Automatic method change
For a limited period, a CFC can file an automatic change in method of accounting for depreciation of property used predominately outside of the United States. This change is applicable to items of property owned by the CFC at the beginning of the year of change to the permissible depreciation method, convention and recovery period. This change can be applied regardless of whether the current depreciation method is permissible or impermissible. Before Rev. Proc. 2021-26, a permissible to permissible change to use ADS was a non-automatic change.
Special rules are in place for assets placed into service in the preceding year to the method change. The method of accounting for these assets, or ‘one-year property’, can be changed if the designated shareholder files a Form 3115 and the section 481(a) adjustment attributable to the one-year property is included on the Form 3115. Alternatively, if the prior method was impermissible for one-year property all U.S. shareholders of the CFC may file an amended federal income tax return for the placed-in-service year to move to ADS, provided such amended return is filed prior to the date the shareholder files the federal income tax return for the succeeding taxable year.
Like other depreciation changes, the method of accounting is determined at each item of property, and a taxpayer may file concurrent automatic changes for multiple items of property on a single Form 3115. Unlike other depreciation changes though, the section 481(a) adjustment may not be netted, and a separate section 481(a) adjustment is required for each item of property being changed.
Companies may have pending non-automatic changes for permissible to permissible methods of depreciation. For example, a company may have desired conformity in depreciation methods for qualified business asset investment (QBAI), earnings and profits (E&P) and CFC income and filed a non-automatic change to get conformity. For a company that has a pending non-automatic change, there is the ability to convert to an automatic change if two conditions are met: (1) the CFC is otherwise eligible to use the automatic change procedures and (2) the Form 3115 was filed before May 11, 2021 and is pending with the national office on May 11, 2021. The designated shareholder must notify the national office contact person for the Form 3115 of their intent to convert their non-automatic change to the new automatic change. If this is done timely and properly, the designated shareholder will receive a letter acknowledging the request with a return of the fee submitted with the Form 3115.
The designated shareholder must then resubmit a Form 3115 that conforms to the automatic change procedures, with a copy of the national office letter sent acknowledging the request to convert, by the earlier of (1) the 30th calendar day after the date of the national office’s letter acknowledging the request to convert or (2) the date the designated shareholder is required to file the original Form 3115.
Terms and Conditions
If the above change is being made on behalf of a CFC or a noncontrolled 10% owned foreign corporation (10/50 corporation) the following additional terms and conditions apply:
- If the functional currency of the foreign corporation is not the U.S. dollar, the section 481(a) adjustment must be stated in the functional currency of the foreign corporation and not in U.S. dollars.
- Section 954(b)(3)(A) de minimis or section 954(b)(3)(B) full inclusion rules apply after the characterization of the positive or negative section 481(a) adjustments.
For each taxable year of the section 481(a) adjustment period beginning with the year of change, the appropriate amount of the section 481(a) adjustment must generally be taken into account in determining the CFC’s tested income or tested loss (either as gross tested income if the section 481(a) adjustment is positive, or as a deduction properly allocable to the CFC’s gross tested income if the section 481(a) adjustment is negative). In addition, the section 481(a) adjustment must be taken into account in determining the foreign corporation’s gross and taxable income under section 1.952-2 as well as its E&P under sections 964 and 986(b) and the regulations thereunder.
In the case of a change in method of accounting made on behalf of a CFC or 10/50 corporation, the IRS may change the method of accounting for the same item that is the subject of a Form 3115 filed under this revenue procedure for taxable years prior to the requested year of change in which any of the CFC’s or 10/50 corporation’s domestic corporate 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% of the average amount of foreign taxes deemed paid under sections 902 and 960 by the domestic corporate shareholder with respect to the CFC or 10/50 corporation in the shareholder’s three prior taxable years.
Generally, taxpayers that voluntarily change to a permissible method of accounting receive audit protection preventing the issue from being raised by examination for prior years. However, Rev. Proc. 2021-26 clarifies the pre-existing CFC or 10/50 corporation audit protection rules and states that the deemed paid determination is made without regard to the amount of the domestic corporate shareholder’s allowable foreign tax credit in the taxable year the foreign taxes are deemed paid or in any other taxable year.
A covered taxpayer should discuss with their tax advisor the impact of these changes and whether it may be beneficial to file a permissible to permissible accounting method change to conform income, E&P and QBAI depreciation methods.