Foreign corporations: procedures and pitfalls in adopting and changing methods of accounting for purposes of determining E&P.

• Author: Abdoo, Kate
• Position: Earnings and profits

Although neither the Code nor the regulations clearly define the term "method of accounting," both do provide that a change in method of accounting involves the change in treatment of any "material item." A material item involves the proper time for the inclusion of the item in income or the deduction of the item as an expense (Regs. Sec. 1.446-1 (e)(2)(ii)(a)). Thus, a "method of accounting" generally refers to any consistent practice for determining when to recognize items of income and expense. Established not only for a taxpayer's overall practice of computing taxable income (e.g., the cash or accrual method), methods of accounting also relate to specific items of income and expense (e.g., compensation expenses or advance payments). Though more than one method of accounting may exist for a specific item, a taxpayer's method must clearly reflect income to be considered a permissible method (Sec. 446(b)).

A taxpayer can generally adopt a method of accounting for an item on the tax return for the period when the item first exists. Although establishing an accounting method generally requires consistent treatment, if a taxpayer treats an item in a way that is permissible, an accounting method for that item is deemed established after only one year. However, if a taxpayer treats an item impermissibly, the impermissible treatment must occur for at least two consecutive tax years before the taxpayer will be treated as having established an accounting method for the item (see Rev. Rul. 90-38).

Regardless of whether a taxpayer adopts a permissible or impermissible method of accounting, once a method is established, the taxpayer must continue to apply that method unless and until it receives IRS consent to change the method (Regs. Sec. 1.446-l(e)(2)(i)). Thus, an accounting method may not be changed or corrected through an amended return. Instead, the taxpayer must generally request IRS consent through filing Form 3115, Application for Change in Accounting Method, and must apply the change prospectively (although a catch-up adjustment is generally required to ensure that items of income or expense are not duplicated or omitted as a result of the change) (see Sec. 481(a)).

Many U.S. taxpayers have an interest in one or more foreign corporations that are not required to file U.S. federal tax returns (e.g., controlled foreign corporations (CFCs) and 10/50 corporations that do not engage in U.S. business activities). For these taxpayers, an often-overlooked issue is the establishment (and changing) of such a foreign corporation's methods of accounting for purposes of determining earnings and profits (E&P). Like domestic taxpayers, foreign corporations are subject to the general rules regarding the adoption of permissible accounting methods for items of income and expense, subject to certain rules in Regs. Sec. 1.964-1 (see Regs. Sec. 1.964-1 (c)(1)).

Further, since taxpayers adopt accounting methods on a trade or business basis (see Regs. Sec. 1.446-l(d)), a foreign corporation's accounting methods generally do not need to conform to the method(s) of its controlling domestic shareholders. This item provides a high-level discussion of the general timing for certain foreign corporations' (i.e., CFCs and 10/50 corporations) adoption of methods of accounting for purposes of determining E&P, the procedural rules regarding how such foreign corporations change their method of accounting, and the importance of understanding when and how a method is adopted in light of the increased limitations such foreign corporations may face in changing methods.

When and How Does a Foreign Corporation Adopt a Method of Accounting?

The regulations under Sec. 964 provide guidance for a foreign corporation's adoption of accounting methods for purposes of determining E&P. Since Sec. 964 and its...