The Treasury Department and the Internal Revenue Service (IRS) issued Notice 2018-26, which provides guidance under section 965 of the Internal Revenue Code regarding the “transition tax.” Section 965 imposes a transition tax on the untaxed foreign earnings of foreign subsidiaries of US companies by deeming those earnings to be repatriated. Foreign earnings held in the form of cash and cash equivalents are taxed at a 15.5% rate, and the remaining earnings are taxed at a rate of 8%.
The Notice describes planned regulations, addresses anti-avoidance rules relating to certain special elections under section 965, and provides guidance on the reporting and payment of the transition tax. Importantly, the Notice provides relief to taxpayers from certain estimated tax requirements and penalties arising from the transition tax and changes to existing stock attribution rules.
Section 3 of the Notice describes anti-abuse provisions and explains that transactions with a principal purpose of reducing section 965 tax liability will be disregarded for purposes of determining the section 965 tax liability of a US shareholder. In this regard, a transaction will be disregarded when certain conditions occur: (i) the transaction occurs, in whole or in part on or after November 2, 2017, which is referred to as the “specified date”; (ii) the transaction is undertaken with a principal purpose of reducing the section 965 tax liability of a US shareholder; and (iii) the transaction would reduce the section 965 tax liability of a US shareholder. For this purpose, a transaction reduces the section 965 tax liability if it (i) reduces a section 965(a) inclusion amount of a US shareholder for any specified foreign corporation; (ii) reduces the aggregate foreign cash position of a US shareholder; or (iii) increases the amount of foreign income taxes of any specified foreign corporation deemed paid under section 960 by a US shareholder as a result of section 951(a).
Section 3.04(b) of the Notice announces the government’s plan to issue regulations that will disregard certain changes in method of accounting and entity classification elections made by taxpayers in tax years 2017 or 2018 intended to reduce their section 965 tax liability. Specifically, section 3.04(b) indicates that Treasury and the IRS intend to issue regulations that will disregard, for purposes of determining the section 965 tax liability of a US shareholder, any change in method of accounting made by a specified foreign corporation for a tax year that ends in 2017 or 2018 if such change in method of accounting would otherwise reduce the section 965 tax liability of such shareholder. The regulations will not apply to changes in methods of accounting in the event the taxpayer’s original and/or duplicate Form 3115, Application for Change in Accounting Method, was filed before November 2, 2017, the date on which the House Ways and Means Committee first released a draft of the Tax Cuts and Jobs Act (enacted as “An Act to provide for reconciliation pursuant to titles II and V of the concurrent resolution on the budget for fiscal year 2018”).
In addition to changes in methods of accounting, the Notice also provides that the regulations will disregard any entity classification elections filed on or after November 2, 2017, for purposes of determining the section 965 tax liability of such US shareholder if such election would otherwise reduce the section 965 tax liability of any US shareholder. Even if the election was effective on a date before November 2, 2017, it will be disregarded under the regulations if filed on or after November 2, 2017.
It is important to note that the Notice provides that these rules will apply regardless of whether such change in method of accounting or entity classification is made with a principal purpose of reducing the section 965 liability of a US shareholder. As such, the rules provide a single objective approach to these accounting method changes with no subjective review of the specific circumstances surrounding the accounting method change.
Eversheds Sutherland Perspective
Not only does the Notice describe a potentially broad set of regulations, but there also may be a question about whether there is adequate authority to support the government’s determination that these changes in accounting method or entity classification may be retroactively disregarded using such a broad-brush approach.
As a threshold matter, section 446(e) requires a taxpayer to obtain IRS consent to a change of accounting method. Consent is required so that the IRS is aware of changes being made and also to confirm that appropriate section 481(a) adjustments are being made to avoid the duplication or omission of income due to the change. Although the IRS has discretion regarding which accounting method changes may be approved, that discretion is not unlimited. Rather than apply its discretion about whether a particular accounting method change is proper, the IRS has issued a blanket determination that it will disregard, for purposes of determining the section 965 tax liability of a US shareholder, any change in accounting method seeking to change a company’s earnings and profit (E&P), thereby reducing its section 965 tax liability if the accounting method change was filed after a specified date.
Thus, the Notice focuses on two things: the result of the method change (whether it reduces section 965 tax liability), and when the accounting method change was filed (before or after the specified date). Under this approach, for any taxpayer seeking to change to a method that reduces section 965 tax liability, even if the reduced tax liability is a subsidiary consequence, the applicable change will be disregarded and it will be disregarded even if the change is from an improper method to a proper one. Further, by setting forth this determination on a retroactive basis, the IRS is applying its discretion inequitably. Taxpayers are discovering long after the “specified date” that certain method changes will be disregarded.
More importantly, the IRS is setting forth a rule that forces adverse selection. Because the rule only applies to taxpayers seeking an accounting method change that reduces section 965 tax liability, two identical accounting method changes (one that increases section 965 tax liability and one that reduces it) would receive opposite results, i.e., one approved and one disregarded. For example, suppose a US corporation (US1) has a June 30 year-end, as does its wholly owned CFC. On July 1, 2017, USC sells 40% of CFC to a different US corporation (US2). A change in accounting method is filed with respect to CFC for its 2017 tax year that produces a negative section 481(a) adjustment in its 2017 tax year, but results in greater income being earned in its 2018 tax year (including before 12/31/17). The negative section 481(a) adjustment is greater than the increase in July 1, 2017-December 31, 2017 earnings & profits. Under the Notice, the change in accounting method is disregarded with respect to US1, because it would reduce US1’s section 965 tax liability with respect to CFC, but the change in accounting method is respected with respect to US2, because it increases US2’s section 965 tax liability.
Another concern is the retroactive nature of this Notice. Accounting method changes are available on a prospective basis only, and for this reason, the IRS has a long-standing practice of announcing accounting method change availability on a prospective basis. Announcing that any accounting method change will be disregarded on a retroactive basis, long after the time when such a change was a possibility, could be a disadvantageous trend. The IRS encourages taxpayers to correct improper methods so that IRS agents do not have to correct them in an Exam context. Reducing the availability of specific changes, especially on a retroactive basis, is at odds with the IRS goal of soliciting voluntary changes to minimize IRS Exam compliance burden.
Further, the suggestion that regulatory guidance will be available on a retroactive basis is particularly concerning in light of section 7805(b)(1)(C), which prohibits any regulation from applying to any taxable period ending before the date on which any notice substantially describing the expected contents of the regulation is issued to the public. For taxpayers that have already filed changes in methods of accounting that affect their E&P and, therefore, potentially affect associated section 965 tax liability, but failed to file such changes before November 2, 2017, the Notice’s stated retroactive application adversely impacts the ability of those taxpayers to make such changes in methods of accounting and fairly compete with competitors that were able to file such changes prior to the specified date.
Most critically, the Notice imposes a presumption that any change in accounting method or entity classification election is presumed to have a principal purpose of reducing section 965 tax liability. This broad conclusion does not comport with the wide array of situations that may result in such changes. For example, assume CFC earns $100 of income in 2017, a portion of which is subpart F income. A change in accounting method is made for the CFC that results in fewer of CFC’s expenses being allocated to subpart F income, so that it has $40 of subpart F income for 2017 instead of the $20 it would have had without the method change. CFC’s US shareholder includes $40 of subpart F income on its return. Absent the Notice, the US shareholder would have included the remaining $60 of 2017 income in its section 965 calculation. The Notice requires the US shareholder to include $80 of 2017 earnings in its section 965 calculation because the change in accounting method that would reduce the section 965 inclusion is disregarded. An unintended consequence of the Notice appears to be partial double taxation of the $20, which is both included as subpart F income, and included in the section 965 calculation. While certain taxpayers may engage in transactions to circumvent the transaction tax, that type of behavior should not be a presumption for all changes in accounting method or entity classification. A better approach would be a more thorough review of such changes to ensure fair application of the accounting method change rules.