Proposed GAAP-E & P regulations.

On October 8, 1992, Tax Executives Institute filed the following comments with the Internal Revenue Service on proposed regulations relating to the computation of the earnings and profits (E&P) of foreign corporations. The proposed regulations would simplify the computation of the foreign corporations' E&P by largely eliminating required book-to-tax adjustments attributable to depreciation and to the uniform capitalization rules of section 263A of the Code. The Institute's comments were prepared under the aegis of its International Tax Committee, whose chair is Lisa Norton of Ingersoll-Rand Company. Earlier comments on the subject were reprinted in the March-April 1991 and November-December 1991 issues of The Tax Executive.

On June 30, 1992, the Internal Revenue Service issued proposed regulations under sections 952 and 964 of the Internal Revenue Code, relating to the computation of the earnings and profits of foreign corporations. The regulations were published in the Federal Register on June 30, 1992 (57 Fed. Reg. 29246), and in the July 27, 1992, issue of the Internal Revenue Bulletin (1992-30 I.R.B. 24).

For simplicity's sake, the proposed regulations are referred to as the "proposed regulations." Specific provisions are cited as "Prop. Reg. [section]." References to page numbers are to the proposed regulations (and preamble) as published in the Internal Revenue Bulletin.

Background

Tax Executives Institute is the principal association of corporate tax executives in North America. Our 4,700 members represent more than 2,000 of the leading corporations in the United States and Canada. TEI represents a cross-section of the business community, and is dedicated to the development and effective implementation of sound tax policy, to promoting the uniform and equitable enforcement of the tax laws, and to reducing the cost and burden of administration and compliance to the benefit of taxpayers and government alike. As a professional association, TEI is firmly committed to maintaining a tax system that works -- one that is administrable and with which taxpayers can comply.

Members of TEI are responsible for managing the tax affairs of their companies and must contend daily with the provisions of the tax law relating to the operation of business enterprises. We believe that the diversity and professional training of our members enable us to bring an important, balanced, and practical perspective to the issues raised by the proposed regulations under sections 964 and 952 of the Code, relating to the computation of the earnings and profits of foreign corporations.

Overview

The proposed regulations eliminate the need to adjust financial statements prepared in accordance with U.S. generally accepted accounting principles (GAAP) with respect to uniform capitalization (UNICAP) and depreciation for purposes of computing the earnings and profits (E&P) of a foreign corporation. In March 27, 1991, and October 21, 1991, letters to the IRS, TEI endorsed the proposal. We continue to believe that the use of readily available financial information to calculate a foreign corporation's E&P will substantially reduce complexity and result in a significant decrease in compliance burdens for the taxpayer and the government alike.

TEI commends the IRS for recognizing the need for simplification in this area. The proposed regulations provide what we hope is the first step in the development of a simplified method for computing E&P that will significantly

reduce the existing compliance burden. Hence, we believe that the ability to use the GAAP E &P method should be broadened beyond the limited items enumerated in the proposed regulations. For example, the new method would ease the compliance burden of a substantially larger group of taxpayers if the method were permitted for purposes of computing Subpart F income.

The preamble to the proposed regulations requests comments on specific adjustments that are particularly burdensome to compute and unlikely to involve material amounts. 1992-30 I.R.B. at 25. TEI recommends that the IRS eliminate adjustments for several additional items that create timing differences, such as de minimis expensed items. TEI also recommends that the regulations provide specific guidance on other issues, including the definition of a foreign corporation and of materiality in specific contexts.

Moreover, TEI recommends that the new E&P method be elective rather than mandatory. This is especially important if the new method is not made available in respect of Subpart F income. Finally, we recommend that taxpayers be afforded an election to take the entire section 481 net adjustment into income over one year, rather than six years.

Specific Comments

Effect on Subpart F

In the preamble, the IRS states that there is no comparably broad regulatory authority to modify the domestic rules applicable in computing the taxable income of a foreign corporation under Subpart R It invites comments on the extent to which the proposed regulations will achieve a real burden reduction in light of the continuing requirement to compute taxable income in accordance with the domestic rules. 1992-30 I.R.B. at 25.

TEI believes that, despite the Subpart F carve-out in the proposed regulations, taxpayers will experience a significant reduction in compliance burden, particularly where (1) the taxpayer's Subpart F income consists solely of foreign personal holding company income, or (2) the taxpayer has not elected the U.S. ratio method for purposes of the UNICAP rules. The compliance burden for many taxpayers, however, will continue to be substantial, unless the GAAP E&P method is permitted to be used for purposes of calculating Subpart F income, particularly foreign base company sales and services income.(1) For this reason, we strongly recommend that the GAAP E&P method be extended to the calculation of Subpart F income under Prop. Reg. [section] 1.952-2. We believe this can be done under the current law.

Under section 952(c)(1) of the Code, a taxpayer's Subpart F income is limited to the foreign corporation's current E&R This rule implies that calculations made under section 964 -- where the IRS's regulatory authority is unambiguous -- have direct application under Subpart F. Moreover, we suggest that, to the extent that Treas. Reg. [section] 1.952-2(b) requires Subpart F income to be based on taxable income, the IRS possesses the regulatory authority to amend that regulation. Finally, if the IRS concludes that it does not possess sufficient regulatory authority to address the Subpart F issue, it should seek such authority from Congress.

Non-Inventory Assets

Prop. Reg. [section] 1.964-1(c)(1)(ii)(B) provides that inventories shall be taken into account in accordance with the provisions of sections 471 and 472 of the Code, except that the UNICAP rules shall not apply. The proposed regulations thus eliminate application of section 263A only with respect to inventories.

There is no compelling reason to distinguish between inventories and other assets subject to section 263A. the Institute therefore recommends that the rule be extended to non-inventory assets (such as self-constructed assets).

Material Difference in Basis

Prop. Reg. [section] 1.964-1(c)(1)(iii)(D) provides that a taxpayer may compute its basis for depreciable assets using U.S. GAAP principles, unless the difference between the taxpayer's book and tax basis is "material." If the difference is material, the taxpayer must use the asset's tax accounting basis. The only examples provided in the proposed regulations concerning when a material difference exists are where (1) the taxpayer has made a section 338 election with respect to the foreign subsidiary, and (2) push-down accounting has been used to determine basis for financial accounting purposes.

TEI urges the IRS to provide an objective definition of materiality in the final regulations. For example, the regulations could provide that tax basis must be used where undepreciated book basis is not within 10 percent of the undepreciated tax basis. Alternatively, the regulations could set a lower, safe harbor percentage threshold of materiality (say, five percent).

Effective Date

The proposed regulations seemingly require the taxpayer to use the U.S. GAAP E&P method.(2) Under Prop. Reg. [section] 1.964-1(c)(1)(ii), the GAAP E&P method would be effective for a taxpayer's first taxable year beginning after December 31, 1991.

TEI submits that the GAAP E&P method should be elective. To combat IRS concerns about "cherry-picking," such an election could be required to apply in respect of all foreign subsidiaries and any changes could be prohibited without the consent of the Commissioner. If the use of the GAAP E&P method is not elective, many taxpayers will be forced to keep two sets of books. An election is particularly important if the GAAP E&P method is not extended to the computation of income under Subpart R At a minimum, the final regulations should clarify whether the GAAP E&P method is elective or mandatory.

In addition, TEI recommends that taxpayers be permitted to elect to apply the GAAP E&P method retroactively for an open years beginning after December 31, 1986. At a minimum, such an election should be provided with respect to foreign subsidiaries that have not made dividend distributions (or deemed distributions) since 1986. Retroactive application of the new method will simplify the computation of section 481 adjustments for some taxpayers.

Section 481 Adjustments

Prop. Reg. [section] 1.964-1(c)(1)(v) provides that the adoption of the GAAP E&P method will constitute a change of accounting method for an existing foreign corporation and automatically grants consent to such change if the net adjustments are taken into account ratably over six years.

For many taxpayers, the additional recordkeeping and computational burden of spreading the adjustment over six years may substantially offset any reduction in compliance burden. Because of the pooling of E&P, the effect of such an adjustment would be the same, whether the adjustment is spread over six years or one year. TEI therefore recommends that taxpayers be permitted to elect to take the entire net adjustment into account in the year for which the change is made without obtaining IRS consent.

Application to Noncontrolled Foreign Corporations

Although the regulations are promulgated under section 952 and 964 of the Code (which relate to controlled foreign corporations), the preamble refers to the application of the proposed regulations to "foreign corporations." 1992-30 I.R.B. at 24. This term, however, is not defined in either the regulations or the preamble.

We suggest that applying the GAAP E&P method to noncontrolled section 902 corporations would significantly simplify the calculation of E&P for those corporations. We therefore recommend that the final regulations clarify that the GAAP E&P method applies to such corporations, as well as to controlled foreign corporations.

Other Adjustments

The preamble to the proposed regulations invites comments on other specific adjustments that are particularly burdensome to compute but unlikely to involve material amounts. 1992-30 I.R.B. at 25. TEI believes significant benefits will accure to both taxpayers and the IRS by using U.S. GAAP in computing E&P, and those benefits will be maximized by limiting the adjustments required or permitted. We recommend that the GAAP E&P method permit taxpayers to start with their financial statements and limit adjustments to those items that are likely to be material.(3) In particular, no adjustments to GAAP financial statements be required in respect of the following temporary differences:

(1) Foreign Currency Translation.

Although post-1986 tax rules

relating to foreign currency

translation were generally intended

to conform to FAS 52

concepts, some differences between

U.S. tax rules and

GAAP remain. In our March

27, 1991, submission, we identified

foreign currency translation

as one of three items

that, at a minimum, should

not be adjusted for under the

GAAP E&P proposal. Although

the issuance of the

dollar approximate separate

transaction method (DASTM)

regulations on July 16, 1991,

substantially reduced the differences

between the tax and

financial accounting treatment

of this item, we continue

to believe that taxpayers

should not be required to

make any adjustment for foreign

currency translation.

TEI submits that, because the

differences between FAS No.

52 and the DASTM regulations

are so minor, the IRS

should consider outright

adoption of the financial accounting

standard.(4)

(2) Economic performance. Adjustments

for the economic performance

rules under section

461(h) should not be required.

Such adjustments generally

create relatively short-term

timing differences, but nonetheless

impose substantial recordkeeping

burdens.

(3) Inventory. The preamble to

the proposed regulations

states that the elimination of

the UNICAP adjustment was

intended to "permit increased

reliance on the taxpayer's

method of accounting for inventories

for financial accounting

purposes." 1992-30

I.R.B. at 25. The UNICAP

adjustment, however, is not

the only difference between

tax and financial accounting

for inventories. We suggest

that significant simplification

would be achieved by permitting

the use of U.S. GAAP for

inventory, adjusted to FIFO 

where LIFO is used for purposes

of foreign financial

statements or tax returns.

(4) De Minimis Expensed Items.

Under U.S. GAAP, taxpayers

may be permitted to expense

certain nonmaterial items

that would otherwise have to

be capitalized for financial (as

well as tax) purposes. TEI

recommends that no adjustment

be required for such de

minimis amounts.

(5) Research and Development Expenses.

No adjustment should

be required for research and development

expenses where the

U.S. GAAP and tax treatment

are different.

Conclusion

Tax Executives Institute appreciates this opportunity to present our views on the proposed regulations under sections 964 and 952 of the Code, relating to the computation of earnings and profits of foreign corporations. If you have any questions, please do not hesitate to call Lisa Norton, chair of TEI's International Tax Committee, at [phone] or Mary L. Fahey of the Institute's professional staff at [phone]. (1) Indeed, absent its application to Subpart F, the proposed regulations may increase the administrative burden of compliance in respect of controlled foreign corporations (CFCs) that have manufacturing or sales activity and generate Subpart F income in some, but not all, years. For those years in which the CFC generates Subpart F income, the taxpayer would determine its cost of sales for Subpart F purposes only by going back to all non-subpart F years and recomputing the cost of sales applying section 263A. (2) The preamble to the proposed regulations states that taxpayers "may" use GAAP recovery methods and useful lives in computing depreciation adjustments. 1992-30 I.R.B. at 25. The proposed regulations, however, require the use of GAAP methods and lives. (3) Because the Tax Reform Act of 1986 now requires taxpayers to pool their E&P for post-1986 years, the elimination of adjustments for most temporary (or timing) differences (i.e., those which tend to reverse over a period of time) will not result in significant income tax distortions. Permanent and temporary differences between tax and financial accounting requirements were more fully discussed in our March 27, 1991, submission, beginning at page 5. (4) In some circumstances (e.g., long-term debt), foreign currency translation may result in a permanent difference. Even in those cases, we believe that the U.S. GAAP figures should be used for E&P purposes.