Supplemental comments on the use of GAAP to calculate the earnings and profits of foreign corporations.
I. Effect of the Subpart F
During the August 28 meeting, a question was raised concerning the interaction of the U.S. GAAP E&P proposal with Subpart F. It was suggested that, because a taxpayer would still be required to compute taxable income for Subpart F purposes, adoption of the U.S. GAAP E&P proposal would not result in a significant reduction in complexity. We strongly disagree.
Under section 952(c) of the Code, the Subpart F income of a controlled foreign corporation is generally limited to the amount of its earnings and profits for the taxable year. Thus, the amount of a CFC's E&P -- however computed for the year -- essentially acts as a "cap" on its Subpart F income inclusion. For this reason, many corporations simply compute the CFC's E&P for the year and report that figure as Subpart F income on the consolidated return. Furthermore, for subsidiaries that are not operating companies, the computation of Subpart F income is relatively simple because the amount of passive income (essentially dividends, interest, and royalties) will be a gross income figure. To the extent the use of the U.S. GAAP E&P method affects the amount of a CFC's earnings and profits (either "upward" or "downward") under section 954(c), the amount of the Subpart F inclusion will be similarly affected. We do not believe, however, that the overall effect of the proposal on Subpart F inclusions would be substantial. We certainly do not believe the Subpart F/taxable income issue should stand as a roadblock to the real simplification that could be achieved under the U.S. GAAP E&P proposal.
More fundamentally, we believe that there are real benefits in recognizing (and sanctioning) the "real world" compliance procedures that taxpayers may already be employing. As we explained in our March 27, 1991, letter, some companies may already be effectively using U.S. GAAP for E&P purposes. These companies compute their E&P based on their financial books, making only minor adjustments beyond the general restatement of their financial statements to accord with U.S. GAAP principles. Formal adoption of this approach would make the tax law simplier for all taxpayers.
We recognize that adoption of the U.S. GAAP E&P proposal is not a "perfect" solution. We submit, however, that the proposal constitutes "rough justice" for both the IRS and the taxpayer. The U.S. GAAP E&P proposal would reduce compliance burdens without violating sound tax policy goals. Highly technical concerns should not be permitted to impede its implementation.
II. Computation of Gain or
Loss upon Disposition of
During the meeting, a question was raised concerning the disposition of a depreciable asset. We believe that if U.S. GAAP principles are used for computing depreciation for E&P purposes, then U.S. GAAP should also be used to compute gain or loss upon the disposition of an asset. An adjustment under section 481 may be necessary to ensure consistency with respect to the calculation of E&P for years prior to the change.
With respect to the disposition of stock, the U.S. GAAP proposal may affect the computation of gain or loss in such circumstances because of the treatment of equity in earnings for financial accounting purposes. This difference, however, could be easily adjusted for. In addition, there may be a difference between GAAP and tax accounting rules with respect to hedged investments in foreign subsidiaries. In cases where the hedging is done by the U.S. parent (which would seem more likely), this difference would not affect the E&P of the foreign subsidiary.
The U.S. GAAP proposal would also affect the allocation and apportionment of expenses under section 861. Under the proposal, a taxpayer allocating and apportioning interest expense under Treas. Reg. & 1.861-8 on an asset basis would use the U.S. GAAP asset basis. The effect of this allocation would be tempered, however, because other methods (such as the gross income or cost-of-sales method) are generally used for non-interest expenses. The specific effect on any given taxpayer would depend upon the relative "mix" of expenses to be allocated and apportioned.
III. The Effect of the DASTM
In our March 27, 1991, submission, TEI suggested that no adjustment from U.S. GAAP should be required in respect of three items, including the translation of foreign financial statements. TEI's comments were filed before the issuance of the dollar approximate separate transaction method (DASTM) regulations on July 16, 1991. During the meeting, a question was raised whether the DASTM regulations were sufficiently similar to FAS No. 52 to make any variance immaterial.
TEI agrees that, with the issuance of the DASTM regulations, the translation of foregin financial statements under FAS No. 52 is no longer significantly different from the tax treatment. Our members have suggested, however, certain modifications to these regulations, including: (1) to permit the specific allocation of the entire transaction gain or loss with respect to certain liabilities to the "basket" from which it was generated; (2) to clarify the inclusion of DASTM currency gain or loss as part of gross income for purposes of gross income-based calculations; and (3) to clarify that section 988 assets and liabilities are translated at the year-end exchange rate in accordance with U.S. GAAP principles. We suggest that, because the differences between FAS No. 52 and the DASTM regulations are relatively minor (especially if the section 988 issue is clarified), the IRS should consider outright adoption of the financial accounting standard.
IV. Timing Differences
In our March 27 comments, TEI listed (on pages 7-8) several temporary (or timing) differences between financial and tax accounting rules. During the August 28 meeting, a question was raised concerning how many of these differences are routinely adjusted for. It is difficult to generalize in this area because the adjustments made by each taxpayer will vary according to the "materiality" of a specific item. With this caveat in mind, we believe that taxpayers routinely adjust for depreciation, uniform capitalization, retirement funding, reserves, foreign taxes, and consolidation.
V. Availability of GAAP
During the August 28 meeting, a question was raised concerning the availability of functional currency GAAP financial statements on a company-by-company basis.
To respond to this question, TEI recently surveyed members of its International Tax Committee and its 45 chapters. The overwhelming majority of the respondents stated that functional currency or U.S. dollar GAAP financial statements are available on a company-by-company basis. In general, members who do not currently have such information available believed that they could obtain such data without much difficulty from controlled foreign corporations; obtaining such information from noncontrolled section 902 companies may be more problematic. With very few exceptions, however, the respondents favored the use of U.S. GAAP to compute E&P for foreign corporations.
The Institute continues to strongly endorse the U.S. GAAP E&P proposal. 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. Indeed, one of our members estimates that the adoption of such a proposal would annually save his company two-to-three staff weeks per CFC; another estimates a total savings of 10,000 staff hours per year. We believe that the IRS could also enjoy substantial savings in its audit resources (to the extent the computation of E&P is currently being audited). Although the anticipated savings may be anecdotal (and not easily measurable), our members expressed no hesitancy concerning the bottom line: they overwhelmingly support the adoption of the U.S. GAAP E&P proposal.
At the recent hearings on tax simplification before the Senate Finance Committee, you rightly stated that current tax laws, rules, and IRS procedures "are frustrating taxpayers to the point where it may become too difficult, too expensive, and too time-consuming for taxpayers to comply." There should be no need for a large multinational to prepare voluminous tax package instructions for its foreign subsidiaries on how to report earnings and profits under section 964. The adoption of the U.S. GAAP E&P proposal under the IRS's and Treasury's regulatory authority would substantially reduce this compliance burden. As you noted before the Finance Committee, we should not "hide behind a veil of 'blame it on Title 26'."
Tax Executives Institute appreciated the opportunity to meet with IRS and Treasury representatives to discuss our views. If you have any questions, please do not hesitate to call Raymond G. Rossi, chair of TEI's International Tax Committee, at (408) 765-1193 or Mary L. Fahey of the Institute's professional staff at (202) 638-5601.