Use of U.S. GAAP to calculate the earnings and profits of foreign corporations.Use of U.S. GAAP GAAP
See: Generally Accepted Accounting Principles
See generally accepted accounting principles (GAAP). to Calculate the Earnings and Profits of Foreign Corporations
This letter responds to your request for Tax Executives Institute's comments on the use of U.S. generally accepted accounting principles The standard accounting rules, regulations, and procedures used by companies in maintaining their financial records.
Generally accepted accounting principles (GAAP) provide companies and accountants with a consistent set of guidelines that cover both broad accounting (GAAP) to calculate the earnings and profits (E&P) of foreign corporations. Specifically, you asked the Institute to discuss the permanent and temporary (or timing) differences that could result from such a change.
In general, TEI 1. (communications) TEI - Terminal Endpoint Identifier.
2. (text, project) TEI - Text Encoding Initiative. wholeheartedly whole·heart·ed
Marked by unconditional commitment, unstinting devotion, or unreserved enthusiasm: wholehearted approval.
whole endorses the use of U.S. GAAP in the calculation of a foreign corporation's E&P.(1) By allowing taxpayers to use financial information gathered for legitimate, non-tax reasons, the IRS An abbreviation for the Internal Revenue Service, a federal agency charged with the responsibility of administering and enforcing internal revenue laws. can substantially reduce reporting burdens. The resulting simplicity would ease the administrative burdens of taxpayers and the government alike.
As a practical matter, some companies may already be applying U.S. GAAP for E&P purposes; these companies compute To perform mathematical operations or general computer processing. For an explanation of "The 3 C's," or how the computer processes data, see computer. their E&P based on their financial books. In many cases, foreign subsidiaries make only minor adjustments beyond the general restatement Restatement
A revision in a company's earlier financial statements.
The need for restating financial figures can result from fraud, misrepresentation, or a simple clerical error. of their financial statements to accord with U.S. GAAP principles. The U.S. GAAP E&P method simply bows to this reality. In addition, companies generally cannot predict U.S. GAAP income; thus, the proposal would not prompt "gaming" of the system for tax planning Tax planning
Devising strategies throughout the year in order to minimize tax liability, for example, by choosing a tax filing status that is most beneficial to the taxpayer. purposes. Indeed, the U.S. GAAP standard may well be subject to less control by the taxpayers than current law, given the absence of tax accounting elections. Finally, publicly held companies generally wish to maximize their earnings and, consequently, have little incentive to underreport un·der·re·port
tr.v. un·der·re·port·ed, un·der·re·port·ing, un·der·re·ports
To report (income or crime statistics, for example) as being less than actually is the case. the amount of financial income.
We caution, however, that the use of U.S. GAAP principles will materially reduce complexity only if the required adjustments of U.S. GAAP income are insubstantial. Obviously, the greater the number of adjustments, the less attractive the proposal becomes. At a minimum, no adjustment from U.S. GAAP should be required in respect of the following three items:
* The tax depreciation rules;
* The uniform capitalization capitalization n. 1) the act of counting anticipated earnings and expenses as capital assets (property, equipment, fixtures) for accounting purposes. 2) the amount of anticipated net earnings which hypothetically can be used for conversion into capital assets.
rules of section 263A of the
* The translation of foreign financial
The inclusion of these components within the U.S. GAAP E&P method - i.e., providing that the financial accounting treatment of these items should govern for E&P purposes - is critical to achieving real simplification in this area. Indeed, we believe that if U.S. GAAP principles were applied only with respect to these three items, meaningful simplification would be attained.
Notwithstanding our concern about the possible proliferation proliferation /pro·lif·er·a·tion/ (pro-lif?er-a´shun) the reproduction or multiplication of similar forms, especially of cells.prolif´erativeprolif´erous
n. of required adjustments, there are two important differences between the financial and tax accounting rules that could dissuade TO DISSUADE, crim. law. To induce a person not to do an act.
2. To dissuade a witness from giving evidence against a person indicted, is an indictable offence at common law. Hawk. B. 1, c. 2 1, s. 1 5. taxpayers from electing an absolute U.S. GAAP E&P method. These differences are discussed below in Part IV.
II. Effect of U.S. GAAP in the
Foreign Tax Area
In one sense, the Tax Reform Act of 1986 simplified the computation of E&P by prescribing a single method to be used for all purposes. The new method is essentially the method set forth in Treas. Reg. [sub section] 1.964-1(a) through (c) (commonly referred to as the "partial section 964" method). In so doing, the 1986 Act eliminated the section 902 E&P method, as well as the steps relating to relating to relate prep → concernant
relating to relate prep → bezüglich +gen, mit Bezug auf +acc unrealized foreign currency gains and losses under Treas. Reg. [sub section] 1.964-1(d) and (e).
On the other hand, because E&P must now be computed annually for purposes of the interest expense allocation rules under section 864(e), the 1986 Act made the calculation of E&P more onerous on·er·ous
1. Troublesome or oppressive; burdensome. See Synonyms at burdensome.
2. Law Entailing obligations that exceed advantages. . The new interest allocation rules are based upon assets of the affiliated group, including stock in foreign corporations, with the value of the stock being its adjusted basis (increased by the E&P of the foreign corporation and its subsidiaries). Calculations of E&P (requiring pooling for post-1986 years) U.S. tax accounting principles are now a mandatory part of the interest expense allocation regime.(2)
TEI believes that the mandatory pooling of E&P under the 1986 Act should make the U.S. GAAP E&P method appealing to both taxpayers and the government. For tax years prior to 1987, if U.S. GAAP were permitted for E&P purposes, the resulting change in the calculation of income or deductions could have a significant effect on the deemed paid foreign tax credit. (The increased E&P in the denominator denominator
the bottom line of a fraction; the base population on which population rates such as birth and death rates are calculated.
denominator of the section 902 credit formula could substantially distort the foreign tax credit.) With the pooling of E&P for post-1986 years, however, this generally adverse effect is lessened. Moreover, under a U.S. GAAP E&P standard, timing differences could reverse over several years, minimizing their effect. Accordingly, the pooling of E&P under the 1986 Act enables the U.S. GAAP E&P proposal to be adopted without substantial adverse effect on either taxpayers or the IRS.
The calculation of E&P is used not only for purposes of the deemed paid foreign tax credit, but also for determining the dividend portion of a distribution from a foreign corporation, gain taxable as a dividend under section 1248, the limitations on subpart F Subpart F
Special category of foreign-source "unearned" income that is currently taxed by the IRS whether or not it is remitted to the US inclusions, and the increased investments in U.S. property under section 956. In each of these cases, TEI believes that the U.S. GAAP E&P method could be effectuated without material adverse consequences.
III. Election to Use U.S. GAAP
The use of U.S. GAAP principles to compute the E&P of foreign corporations should be conditioned on an election by the taxpayer. An election regime would be especially important if the Institute's recommendations (as discussed in Part IV) concerning the adjustment of two items (certain basis adjustments and leasing transactions) were not adopted.
An election to use the U.S. GAAP E&P method would constitute a method of accounting under section 446, which could not be revoked without the consent of the Commissioner. TEI recommends that the IRS develop a revenue procedure under which taxpayers would be given automatic consent to adopt the method. The revenue procedure should also address the extent to which a section 481(a) adjustment will be required (or permitted) in respect of electing taxpayers. In general, section 481 adjustments for differences between U.S. GAAP and tax accounting rules should be required only if they are material.
The revenue procedure should provide that taxpayers may make the election on their return. Because use of the U.S. GAAP E&P method would be elective elective
non-urgent; at an elected time, e.g. of surgery.
elective adjective Referring to that which is planned or undertaken by choice and without urgency, as in elective surgery, see there noun Graduate education noun , we assume that the proposal would be applied on a prospective-only basis. A retroactive Having reference to things that happened in the past, prior to the occurrence of the act in question.
A retroactive or retrospective law is one that takes away or impairs vested rights acquired under existing laws, creates new obligations, imposes new duties, or attaches a application of the U.S. GAAP E&P proposal that would require the recalculation re·cal·cu·late
tr.v. re·cal·cu·lat·ed, re·cal·cu·lat·ing, re·cal·cu·lates
To calculate again, especially in order to eliminate errors or to incorporate additional factors or data. of deemed paid foreign tax credits claimed in prior years would produce tremendous compliance and auditing burdens.
IV. Differences Between U.S.
GAAP and Current Tax
Rules that Should Be
Retained in Computing computing - computer E&P
Although the effect of timing differences between financial and tax accounting rules will tend to dissipate dis·si·pate
v. dis·si·pat·ed, dis·si·pat·ing, dis·si·pates
1. To drive away; disperse.
2. over time through the pooling of E&P, there are two differences between U.S. GAAP and the corresponding tax rules that could cause substantial distortion in the deemed paid foreign tax credit. We believe the following adjustments required by the tax rules should be retained as E&P adjustments. These differences are:
1. Corporate Reorganizations, Mergers, and Divestitures. Using U.S. GAAP income in computing E&P is not appropriate where basis differentials arise from corporate reorganizations, mergers, and acquisitions. TEI believes that the following basis adjustments should be retained under the U.S. GAAP E&P proposal.
* Section 338(g) Elections. Under
section 338(g) of the Code, a
purchasing corporation may
elect to treat certain stock acquisitions
as asset acquisitions,
thereby receiving a step-up in
the basis of the target corporation's
assets. A taxpayer making
such an election is required
to maintain tax books Tax books
Records kept by a firm's management that follow IRS rules. The books follow Financial Accounting Standards Board rules. which
may include different asset values
from those reflected on its
U.S. GAAP books. Any such differences
would also produce depreciation
differences. This, in
turn, could distort the taxpayer's
foreign tax credit.
* Section 304 Transactions. A
section 304 transaction is treated
as the payment of a dividend
for tax purposes, but is normally
treated under U.S. GAAP as
a intercompany transaction Intercompany transaction
Transaction carried out between two units of the same corporation.
with no gain or loss. The selling
company would normally
have substantially more income
under U.S. tax concepts than
under U.S. GAAP. Additionally,
the purchasing company's U.S.
tax basis in the purchased company
carries over from the selling
company. Therefore, any
subsequent transactions related
to the purchased company's
stock produces different results
for U.S. tax and U.S. GAAP
* Section 367(a) Transactions.
Certain section 367(a) transactions
may be treated as "cost
basis" contributions of capital
under U.S. GAAP, but as taxable
transfers for U.S. tax purposes.
in the foreign subsidiary
currently result in U.S. GAAP
and tax accounting differences.
TEI believes these differences should be retained under the U.S. GAAP E&P method to prevent a distortion of the taxpayer's foreign tax credit. Because the transactions do not occur that frequently, adjusting for such items would not generally cause undue administrative burdens.
2. Leasing Transactions. Under U.S. GAAP, certain leasing transactions are treated as a "sale and/or financing" of property, even though the tax law
requires recognizing these transactions as leases. Although technically a timing difference, many leases have such long terms that they create what amounts to a "permanent" difference between U.S. GAAP and tax accounting. TEI believes that these transactions should be treated as leases under the U.S. GAAP E&P method.
Under Financial Accounting Statement No. 13, manufacturers or dealers account for certain leasing transactions as "sales" of property at the initiation of the leases, recognizing gain at that time. For tax purposes, however, such a transaction would constitute a leasing transaction, with the rents (less tax depreciation) properly representing the transaction's economic profits over the term of the lease.
TEI believes that this difference should be retained under the U.S. GAAP E&P proposal. Absent such an adjustment to financial accounting results, a CFC CFC
See: Controlled foreign corporation would recognize the "gain" on the sale for E&P purposes, thereby significantly distorting the E&P pool. Accordingly, TEI recommends that a U.S. taxpayer be allowed to continue to calculate E&P by treating such transactions as leases generating rental income Noun 1. rental income - income received from rental properties
income - the financial gain (earned or unearned) accruing over a given period of time , rather than as "sales and/or financing."
V. Differences Between U.S.
GAAP and Current Tax
Rules that Should Not Be
Retained in Computing E&P
As stated in our Overview, TEI believes significant benefits will accrue To increase; to augment; to come to by way of increase; to be added as an increase, profit, or damage. Acquired; falling due; made or executed; matured; occurred; received; vested; was created; was incurred. 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. Consequently, with the exception of the two items discussed in the preceding section, TEI believes a taxpayer electing the U.S. GAAP E&P method should not be required or permitted to make any adjustments with respect to other permanent or temporary (or timing) differences. Specifically, we believe the optimal method would not require any adjustments in respect of the following items:(3)
A. Permanent Differences
1. Foreign Currency Translation. The U.S. GAAP rules for foreign currency translation, prescribed pre·scribe
v. pre·scribed, pre·scrib·ing, pre·scribes
1. To set down as a rule or guide; enjoin. See Synonyms at dictate.
2. To order the use of (a medicine or other treatment). by FAS Statement No. 52, differ somewhat from the tax rules. For example, the temporary regulations require that, under the dollar approximated separate transactions method, bad debt reserves be translated at the average daily exchange rate for the entire taxable year Taxable year
The 12-month period an individual uses to report income for income tax purposes. For most individuals, their tax year is the calendar year. , while U.S. GAAP translates bad debt reserves at the current rate. In general, however, the post-1986 tax rules are based on FAS 52 concepts. In addition, there may be differences arising from non-functional currency transactions that are not covered not covered Health care adjective Referring to a procedure, test or other health service to which a policy holder or insurance beneficiary is not entitled under the terms of the policy or payment system–eg, Medicare. Cf Covered. by FAS 52.
2. Goodwill Amortization. This deduction is allowable for financial books, but not for tax purposes.
3. Push-Down Accounting. When a company makes a cash purchase of another company, the purchase price may be allocated under U.S. GAAP to the assets of the acquired firm, but that allocation may be different for tax purposes.
4. Nonqualified and Incentive Stock Options. The tax treatment of nonqualified and incentive stock options under sections 83 and 421 of the Code differs from the treatment of these items under U.S. GAAP. Under the federal tax rules, a company is permitted to deduct de·duct
v. de·duct·ed, de·duct·ing, de·ducts
1. To take away (a quantity) from another; subtract.
2. To derive by deduction; deduce.
v.intr. as compensation the difference between the option price and the fair market value of the stock at the time the employee exercises the option (the bargain element of the option or its "spread") or makes a disqualifying disposition disqualifying disposition
The sale, gift, or exchange of stock acquired through an employee stock purchase plan within two years of enrollment or one year of the purchase date. A disqualifying disposition results in ordinary income for tax purposes. . Under U.S. GAAP, however, the bargain element is generally computed as of the date of the grant of the option. Such a measurement typically results in a much smaller bargain element (or possibly no bargain element at all).
B. Temporary (or Timing) Differences
1. Depreciation. U.S. GAAP depreciation differs from tax depreciation and will produce timing differences.
2. Uniform Capitalization. The uniform capitalization rules under section 263A vary from the corresponding rules under U.S. GAAP.
3. Economic Performance. Under U.S. GAAP, the economic performance rules of section 461(h) do not apply.
4. Reserves. Certain reserves that are maintained on the financial books are generally not permitted as deductions in computing E&P under the current tax rules. These include inventory reserves, spares reserves, loss reserves (e.g., relating to environmental contingencies environmental contingencies (en·vīˑ·rn·menˈ·t ), vacation pay reserves, bad debt reserves not deductible That which may be taken away or subtracted. In taxation, an item that may be subtracted from gross income or adjusted gross income in determining taxable income (e.g., interest expenses, charitable contributions, certain taxes). under section 166, and warranty reserves.
5. Research and Development Expenses. Research and development expenses may be capitalized for financial accounting purposes, but are currently deductible for tax purposes.
6. Retirement Funding. U.S. GAAP requires accrual accrual,
n continually recurring short-term liabilities. Examples are accrued wages, taxes, and interest. of pension liabilities Pension liabilities
Future liabilities resulting from pension commitments made by a corporation. Accounting for pension liabilities varies widely by country. for foreign retirement plans, while current tax rules permit an E&P deduction only on an exceptional basis, subject to a section 404A election.
7. Post-Retirement Medical Benefits. Under recent U.S. GAAP rules, accrual of post-retirement medical benefits will be required as of 1993. Tax rules do not allow a current deduction.
8. Inventory. LIFO/FIFO differences would exist when the financial and tax inventory treatments of foreign subsidiaries do not conform.
9. Consolidation. Subsidiaries may be consolidated for U.S. GAAP purposes, but not for tax purposes.
10. Equity-in-Earnings. The equity-in-earnings of noncontrolled entities would be recognized under U.S. GAAP, but tax concepts mandate actual dividends.
11. Foreign Taxes. The amount of foreign taxes paid or accrued ac·crue
v. ac·crued, ac·cru·ing, ac·crues
1. To come to one as a gain, addition, or increment: interest accruing in my savings account.
2. on the financial books (the tax provision) generally differs from the amount of such taxes reported for tax purposes. Over time, these differences will reverse. If they arise as a result of timing differences, they reverse when timing differences reverse; if they arise as a "tax reserve," they reverse when the exposure actually arises or when the tax year in question is no longer open to audit.
As discussed in the Overview, the Institute believes that the use of U.S. GAAP in computing the E&P of foreign corporations will produce meaningful simplification only if adjustments are kept to a minimum. If adjustments are necessary, TEI recommends that a threshold be created under which the effects of timing differences (and possibly some permanent differences) could be disregarded in computing E&P. Such a de minimis An abbreviated form of the Latin Maxim de minimis non curat lex, "the law cares not for small things." A legal doctrine by which a court refuses to consider trifling matters. rule could be based on either (i) the period of time anticipated for the timing difference to turn around, or (ii) the relative effect of the timing difference measured as a percentage of either gross or net income. We acknowledge, however, that a de minimis rule would increase the U.S. GAAP E&P method's complexity.
VI. Reliance on Taxpayer's
Books and Records
In implementing a U.S. GAAP E&P standard, examining agents should not challenge the financial accounting treatment of book items, especially where the financial statements have been audited, certified See certification. , and filed with U.S. government agencies such as the Securities and Exchange Commission. The accounting treatment has already been scrutinized - and sanctioned - by independent auditors Independent Auditor
An external auditor with a certified public accounting designation that qualifies him or her to provide an auditor's report.
These auditors aren't affiliated with the company being audited. , thereby assuring their accuracy. In addition, the materiality MATERIALITY. That which is important; that which is not merely of form but of substance.
2. When a bill for discovery has been filed, for example, the defendant must answer every material fact which is charged in the bill, and the test in these cases seems to test of Treas. Reg. [section] 1.964-1(a) would continue to apply. Finally, companies are potentially subject to criminal penalties for filing false or misleading financial reports.(4)
We believe that reliance on the taxpayer's accounting books and records would be in accord with the approach taken by the IRS in implementing the book untaxed Adj. 1. untaxed - (of goods or funds) not taxed; "tax-exempt bonds"; "an untaxed expense account"
nontaxable, exempt - (of goods or funds) not subject to taxation; "the funds of nonprofit organizations are nontaxable"; "income exempt reported profits provision of the alternative minimum tax. During the development of AMT See vPro. regulations, IRS officials assured taxpayers that examining agents would not second-guess the accounting firms. Rather, the IRS would proceed from the view that "the books are the books" and would strive to make as few changes in the books as possible in applying the book income provision. We believe that the taxpayers and the government would benefit from adopting a similar approach with respect to the U.S. GAAP E&P method.
In addition, TEI urges that, to the extent that unallocated or post-closing adjustments in consolidation occur during a financial audit, adjustments attributable to a foreign corporation should be permitted in the computation of U.S. GAAP E&P of that corporation. Moreover, where a foreign government makes an audit adjustment to a tax return, companies frequently run the adjustment in tax through the current year. TEI recommends that the IRS accept this treatment for purposes of the U.S. GAAP E&P method.
Tax Executives Institute appreciates this opportunity to present our views on the proposal to use U.S. GAAP principles in computing the earnings and profits of foreign corporations. 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 the Institute's professional staff (Timothy J. McCormally or Mary L. Fahey) at (202) 638-5601.
(1) Presumably pre·sum·a·ble
That can be presumed or taken for granted; reasonable as a supposition: presumable causes of the disaster. , the U.S. GAAP E&P proposal would affect only foreign corporations not directly subject to U.S. tax. Foreign corporations directly subject to U.S. tax should compute taxable income Under the federal tax law, gross income reduced by adjustments and allowable deductions. It is the income against which tax rates are applied to compute an individual or entity's tax liability. The essence of taxable income is the accrual of some gain, profit, or benefit to a taxpayer. in the same manner as domestic companies.
(2) With respect to pre-1987 taxable years, TEI has supported the use of GAAP principles for computing E&P of a foreign corporation in determining the "tax book value" of stock in non-consolidated companies in which a 10-percent or greater interest is held. See Prop. Reg. [section] 1.861-10(b)(5)(ii) (issued Sept. 8, 1987).
(3) As previously stated, we believe it is imperative that no adjustments be required in respect of three items (tax depreciation rules, the uniform capitalization requirements, and the translation of foreign financial statements). Requiring adjustments in respect of other items may affect taxpayers' willingness to elect the method.
(4) In cases where local financial statements are not prepared in accordance with U.S. GAAP, an approach similar to Temp. Reg. [section] 1.56-1T(c)(1), which assigns priorities to various types of financial statements for alternative minimum tax purposes, could be developed.