Supplemental comments on the use of GAAP to calculate the earnings and profits of foreign corporations.

On August 28, 1991, representatives of Tax Executives Institute met with IRS and Treasury representatives to discuss the proposal to use U.S. generally accepted accounting principles (GAAP) in computing the earnings and profits (E&P) of foreign corporations. This letter responds to certain issues raised during that meeting.

1. Effect of the Subpart F

   Rules

   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...