It has now been 30 years since the US Congress enacted Section 404A to “rescue” US taxpayers with global operations maintaining large foreign pension plans through branches, disregarded entities, partnerships or controlled foreign corporations. Section 404A was intended to allow a deduction or a reduction in earnings and profits (E&P) as applicable, in a manner that would mirror what would apply had the foreign pension plan instead been a US-qualified pension plan under Section 401(a). However, without an affirmative election by the US taxpayer under Section 404A, in most instances the deduction or reduction in E&P is seriously compromised.
A US-based multinational corporation, with a branch in Germany covering German nationals in an unfunded defined benefit plan, elects Section 404A and receives a US$1 billion deduction for accumulated vested accruals. If the corporation had not elected Section 404A, then no deduction would be available, despite the fact that Generally Accepted Accounting Principles (GAAP) would show an expense for the accruals.
A US-based multinational corporation, with a UK subsidiary covering UK nationals in a funded combination defined benefit and defined contribution plan, elects Section 404A and receives a reduction of E&P of US$400 million. If the corporation had not elected Section 404A, then no E&P reduction would be available for the contributions to the defined benefit plan, and only the vested contributions to the defined contribution plan would reduce E&P, despite the fact that GAAP would show a current expense for both.
The flow chart summarises the reductions in E&P in the case of US companies with foreign subsidiaries and the deductions for US companies with foreign branches or disregarded entities.
Note that the results in the previous examples, of not making a Section 404A election, are always less advantageous regardless of the type of plan-whether funded (trust) or not funded, or whether a defined contribution or defined benefit type, except to the extent that a taxpayer’s tax planning calls for higher E&P or taxable income in the relevant location.
Click here to view flow chart.
Why is GAAP wrong absent a Section 404A election? For both direct deductions and reductions in E&P, a US employer must operate under US tax rules and these rules do not allow a benefit on the tax return until amounts are actually paid to employee participants (absent a Section 404A election). Amounts are considered actually paid to participants only when cash is actually received or the employee has a vested benefit in a creditor proof trust.
In preparing US tax returns, employers start from GAAP income and expenses and make adjustments. The problem is that most US companies do not in fact make an adjustment to the GAAP expenses for accrued liability under plans covering foreign employees. Under GAAP, ASC 715-30 (formerly FAS 87) would show an expense for any kind of accrued expense related to defined benefit plans or defined contribution plans (whether funded or not), and the required expense is totally unrelated to the proper tax deduction. In short, whether or not a Section 404A election is made, the GAAP expense could be significantly lower or significantly higher than what the US tax rules allow, depending on the type of plan that is maintained.
Change in Accounting Method
The deductions or reductions in E&P for foreign pension plans are cumulative back to the year in which the plan was first adopted, even if the year is closed. Section 404A provides that an election under Section 404A is a change in accounting method and requires a spread of the Section 481 adjustment over 15 years. However, the position of the Internal Revenue Service (IRS) in granting a request for a change in accounting method has been to permit a favourable spread over one year and an unfavourable spread over four years.
Earnings and Profits Planning Opportunities
In addition to the goals of ensuring proper compliance and not overpaying US tax as a result of overstated E&P or income, US-based multinationals might consider whether Section 404A elections (and nonelections) with respect to various foreign subsidiaries might be used selectively to increase or decrease the levels of E&P in the various subsidiaries. This could be done as needed to accomplish the company’s broader international tax planning objectives, such as those relating to repatriation and foreign tax credit planning.
It is clear that the election of the Section 404A method of tax accounting not only can reap very significant tax benefits but also may serve in some cases to shift a company from a non-compliant method of tax accounting to a compliant one (in view of the apparently common practice of simply following FAS 87 for tax reporting purposes). For those US taxpayers that did not timely elect and follow section 404A consistently since a foreign deferred compensation plan was adopted, filing for a change in accounting method with the National Office of the IRS may be the smartest choice. In addition, taxpayers may wish to consider whether selective Section 404A elections with respect to different foreign subsidiaries might be a useful tool in a US-based multinational’s general international tax planning.