The Dbriefs Federal Tax Series presents:
Accelerating Out of the
Downturn: Recognizing
Income, Deferring
Deductions
Leon Lewis, Deloitte Tax LLP
September 21, 2011
Agenda
Reverse accounting method planning
Accelerating income and deferring
deductions examples
Questions and answers
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Learning Objectives
Upon completion of this session you will be able to:
• Understand why reverse accounting method planning
is applicable in today’s economy.
• Describe opportunities to accelerate income and defer
deductions by analyzing facts, making elections, or
filing accounting method changes.
• Understand the interplay between U.S. and foreign
source income in an accounting methods planning
context.
1
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Reverse Accounting Method
Planning
Why Now? Who is Affected?
• The U.S. is emerging from the recession and many companies
with cumulative loss carryforwards are now profitable or near
breakeven
• Taxpayers may have used prior year NOLs to recover cash
through the 5-year carryback provisions; which may have created
additional FTC carryforwards that are nearing expiration
• Taxpayers may also have historical earnings and profits (E&P) in
their controlled foreign corporations (CFCs) and cash available
for repatriation
• Cash repatriations may have been delayed to avoid wasting the
FTC limitation created by repatriating low tax foreign source
income (FSI)
• Taxpayers may also have general business credit (GBC)
carryforwards that are subject to expiration
2
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Approaches
We can plan with accounting method changes or new facts:
to accelerate U.S. taxable income and at the same time accelerate
low-tax FSI into a single year to create excess FTC limitation
to accelerate U.S. taxable income in order to utilize GBCs and NOLs
3
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Foreign Source Income Planning
• Enter into multi-year pre-paid royalty contract with
CFCs that use U.S. owned intangibles
– Must avoid treatment as a loan or deposit (see Indianapolis
Power and Light Company v. Commissioner); should not be
refundable or bear interest or be recoverable as principal
• Enter into an advance payment for goods contract with
CFCs that purchase goods from the U.S.
– Perfect foreign title transfer, should qualify for IRC § 863(b)
and 50% sourcing as FSI
• Consider repatriation of low-tax CFC dividends
4
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Foreign Planning: Other Issues to
Consider
• Potential financial statement impacts related to
intercompany income recognition
• Foreign jurisdiction tax treatment of intercompany
prepayments
• Prior U.S. accounting method elections to defer advance
payment income; ensure deferral elections have not been
made by the taxpayer under either:
– Treas. Reg. § 1.451-5 (advance payment for goods)
– Rev. Proc. 2004-34 (1-year deferral for advance payments)
• Making annual U.S. elections that can be changed year
over year before making elections that require consent and
5-years to change again
• Business purpose and economic substance issues for the
U.S. and foreign jurisdictions for pre-payment planning
– Consider reasonable discounts
5
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Computation of E&P
The E&P of a foreign corporation is computed substantially as if the
corporation was a domestic corporation:
Prepare P/L statements from books of account regularly
maintained by the corporation for the purpose of
accounting to its shareholders
Make adjustments necessary to conform P/L statement to
U.S. GAAP
Make adjustments necessary to conform P/L statement to
U.S. Tax Accounting Standards
6
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Computation of E&P: Tax Adjustments
Make adjustments necessary to conform P/L statement to
U.S. Tax Accounting Standards including:
•
•
•
•
•
Accounting methods under IRC § 446
Inventories including UNICAP
Depreciation (generally straight-line basis)
Tax elections
Taxable years under IRC §§ 441 and 898
No adjustment is required unless it is material. Materiality
considerations include:
•
•
•
•
•
7
Facts and circumstances
Amount of adjustment
Size relative to corporation’s assets and profit or loss
Consistency of adjustments
Whether recurring or nonrecurring
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Treas. Reg. § 1.964-1: Adoption of Method
or Year Timing
A foreign corporation is not required to adopt an accounting method or period
until the computation of its earnings and profits is significant for U.S. tax
purposes for its controlling domestic shareholders (Treas. Reg. § 1.964-1(c)(6))
Events include:
• A distribution from the foreign corporation to its shareholders
• The inclusion of a subpart F or IRC § 956 amount in the gross income of its
U.S. shareholders
• An amount excluded from subpart F income by reason of IRC § 952(c)
(subpart F recapture)
• Any event making the foreign corporation subject to tax under IRC § 882
• The use by the controlling domestic shareholders of the tax book value
method of allocating interest expense
• A sale or exchange of the foreign corporation’s stock subject to IRC § 1248
8
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Treas. Reg. § 1.964-1: Procedures for
Adoption/Change
9
IRC § 446
Requirements
Satisfy the procedural requirements under IRC § 446 applicable
to changes in accounting method
Consent
Execution
The controlling domestic shareholders must execute a consent
confirming the election, adoption or change has been approved
by them, which is retained by a designated shareholder
Treas. Reg.
§ 1.964-1(c)(3)(ii)
Statement
Each controlling domestic shareholder generally must file the
statement required by Treas. Reg. § 1.964-1(c)(3)(ii) describing
the nature of the action taken on behalf of the foreign corporation
with its timely filed return for the taxable year with or within
which ends the taxable year of the foreign corporation for which
the election, adoption, or change is made
Written Notice
The controlling domestic shareholders must provide written
notice of the action taken on behalf of the foreign corporation to
all non-controlling domestic shareholders. Treas. Reg. § 1.9641(c)(3)(iii)
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Treas. Reg. § 1.964-1: Effect of
Inaction/Untimely Action
Inaction
Untimely Action
The election, adoption or change in accounting method or
tax year is invalid if the procedural requirements (except
notice to non-controlling domestic shareholders) are not
satisfied
If timely action is not taken on behalf of the CFC, E&P is
“computed as if no elections had been made and any
permissible accounting methods not requiring an election
and reflected in the books of account regularly
maintained by the [CFC] for the purpose of accounting to
its shareholders had been adopted.” Treas. Reg. § 1.9641(c)(4)(ii)
• Exception if inaction due to reasonable cause
10
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Procedures for Accounting Method
Changes
Automatic Consent
Advanced Consent
Rev. Proc. 2011-14:
Provides the procedures by which a
taxpayer may obtain automatic
consent for a change in method of
accounting described in the Rev. Proc.
(“Automatic Consent”)
Rev. Proc. 97-27:
Provides the procedures by which a
taxpayer may obtain advance consent
for a change in method of accounting
not described in other published
guidance (“Advanced Consent”)
Under both procedures, back year audit protection is provided upon filing the
Form 3115
• IRS may not raise the issue on examination in earlier years
• May result in remediation of UTP
11
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Determining if a CFC is Under Examination
CFC under examination? Method of accounting an issue under
consideration?
If any of its controlling
domestic shareholders is
under examination for a
taxable year(s) in which it
was a United States
shareholder of the foreign
corporation, a CFC is
under examination
12
If any of the corporation’s controlling domestic
shareholders receives notification that the
treatment of a distribution, or deemed distribution
from the foreign corporation, or the amount of its
earnings and profits or foreign taxes deemed paid,
is an issue under consideration by the IRS, a
CFC’s method of accounting for an item is an issue
under consideration
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Accelerating Income and
Deferring Deductions
Examples
Changing Facts/Elections:
Defer :
Consider:
Elect:
• Prepaying
liabilities
• Making charitable
contributions
• Funding of
pension or
defined benefit
plans
• Paying bonuses
until later than 2
½ months after
year-end
• Placed-in-service
date and review
fixed asset
accounting
methods
• Sale-leaseback
transactions
• Ability to forgo
deductions under
IRC §§ 162, 163,
and 167 (period
expenses only)
• Under Treas. Reg. § 1.263(a)-4(f)(7) not
to apply the 12-month rule to similar
items incurred during the tax year (e.g.,
prepaid expenses including insurance,
warranty, and service contracts)
• Out of bonus depreciation and elect ADS
lives for current year additions
• Under IRC § 59(e) to capitalize research
& development costs
− Will also increase net FSI since it
reduces the allocation of R&D to FSI in
the current year
− Can be designated dollar amount
• Under IRC § 266 to capitalize taxes and
carrying charges
13
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Changing Methods
Change from lower of cost or market (LCM)
Minimize last-in, first-out (LIFO) deduction
Change to more disadvantageous UNICAP methods; Consider U.S. ratio method
(Notice 88-104) or Interest capitalization using substitute cost method (Notice 88-99)
Remediate exposures (e.g., bad debt, inventory, warranty, or other expense reserve
deductions and bonus plan deductions)
Current inclusion of advance payments (vs. deferral under Rev. Proc. 2004-34 or
Treas. Reg. § 1.451-5); Cost of sales offset not required (PLR 200638015)
Capitalize: package design costs, certain R&E expenses (under IRC § 174(b)), and/or
software development costs (vs. expense under Rev. Proc. 2000-50)
Change from percentage of completion method to accrual method for services
(where billings exceed earnings under PCM)
Defer rents - increasing rents (generally straight-line accounting for book purposes)
Review and implement all applicable unfavorable changes in Rev. Proc. 2011-14
14
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IRC § 59(e): Optional 10-Year Writeoff of
Certain Tax Preferences
• Election to capitalize qualified expenditures and amortize over 10-years,
beginning with taxable year expenditure is incurred
• Qualified expenditures include amounts deductible under:
IRC §
Expenditure
173
Circulation (Note: Amortize over 3 years)
174(a)
Research and experimental
263(c)
Intangible drilling and development (Note: Amortize over 5 years)
616(a)
Development
617(a)
Mining exploration
• Election statement must:
– Be attached to timely filed original return (including extensions) for taxable
year in which the expenditure is incurred
– Include the type and amount of qualified expenditures that the taxpayer
elects to capitalize/amortize (can be a portion of the qualified expenditures)
• Election is made at partner or S Corp shareholder level
• Revocation of election will be granted by IRS only in rare and unusual
circumstances
15
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IRC § 266: Election to Capitalize Taxes and
Carrying Charges
• Under Treas. Reg. § 1.266-1(b), depending on type of property (real,
personal, unimproved or unproductive real property), may apply to:
interest on loan/mortgage, certain taxes, carrying charges, and certain
necessary expenditures
• If election is made, it applies to all expenses of that type for a particular
project
• Election is effective only for year for which it is made and for certain
property is effective until construction complete or until put into use by
taxpayer
• Election statement must:
– Be attached to timely filed original return (including extensions) for taxable
year in which the election is made
– Include the item or items the taxpayer elects to treat as chargeable to a
capital account
• UNICAP is applied before IRC § 266
16
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Election out of Bonus Depreciation
Example: $7M asset (office furniture, fixtures & equipment, class #00.11)
$M (rounded)
Yr 1
100% Bonus
$(7)M
MACRS
2
3
4
5
6
7
8
(1)M
(1.7)
(1.2)
(0.9)
(0.6)
(0.6)
(0.6)
(0.4)
MACRS SL
(0.5)M
(1)
(1)
(1)
(1)
(1)
(1)
(0.5)
ADS
(0.35)M
(0.7)
(0.7)
(0.7)
(0.7)
(0.7)
(0.7)
(0.7)
9
10
11
(0.7)
(0.7)
(0.35)
• Elect out of bonus
• Elect MACRS straight line or ADS:
MACRS Straight Line
IRC § 168(b)(5) & IRC § 168(b)(3)(D)
Elect on Form 4562
Irrevocable
Class by class election
Alternative Depreciation System (ADS)
IRC § 168(g)(7)
17
Automatic 9100 relief
IRS Publication 946
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Recent IRS Guidance
Economic Substance and Transaction Costs
Economic Substance – Legislative
Summary
• Section 7701(o) – enacted March 30, 2010, “clarifies and enhances” the
application of the common law economic substance doctrine (“ESD”)
– Statute provides uniform definition of “economic substance,” eliminating differences in
the definition as developed by various federal courts
• Section 7701(o) provides that in the case of any transaction to which the
economic substance doctrine is relevant, a transaction is treated as having
economic substance only if:
– It changes in a meaningful way (apart from federal income tax effects) the taxpayer’s
economic position, and
– The taxpayer has a substantial purpose (apart from federal income tax effects) for
entering into the transaction
• Sections 6662(b)(6) imposes a strict liability penalty of 20% (or 40% if not
adequately disclosed) if tax benefits are disallowed by reason of a transaction
lacking economic substance within the meaning of section 7701(o)) or failing to
meet the requirements of any any other similar rule of law (e.g., step transaction
doctrine, business purpose, substance over form, or sham transaction)
• The provisions are effective for transactions entered into after March 30, 2010
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Economic Substance – Recent Guidance
• IRS Notice 2010-62 (Sept. 13, 2010)
– Indicates that codification will not change the IRS’s approach to analyzing
application of the ESD, rather it confirms that both tests must be satisfied
– On relevance, the notice says that the IRS will continue to respect authorities
that have previously held that the ESD was not relevant and anticipates
continued development of case law determining whether the ESD is relevant
• LMSB-20-0910-024 (Sept. 14, 2010)
– Provides that examiners cannot assess accuracy related penalties under
§6662 relating to transactions lacking economic substance without prior
review and approval by the appropriate Director of Field Operations (“DFO”)
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Economic Substance – Recent Guidance
(cont.)
• LB&I-04-0711-015 (July 15, 2011)
– Provides guidance to examiners on when to seek the approval of the DFO in
order to raise the ESD, and sets forth a series of inquiries an examiner must
develop and analyze in order to seek approval for the application of the ESD
– Provides that, until further guidance is issued, the ESD penalty will be limited
to transactions that lack economic substance, and may not be imposed due
to the application of any other “similar rule of law” or judicial doctrine (e.g.,
step transaction doctrine, substance over form, or sham transaction)
– Lists four situations in which examiners are directed to not raise ESD:
• Cases in which the choice between capitalizing a business with debt or equity
exists;
• A U.S. person’s choice between utilizing a foreign corporation or a domestic
corporation to make a foreign investment;
• The choice to enter into a transaction or a series of transactions that constitute a
corporate organization or reorganization under subchapter C;
• The choice to utilize a related-party entity in a transaction, provided that the arm’s
length standard of §482 and other applicable concepts are satisfied.
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Revenue Procedure 2011-29 – Safe harbor
election for allocating success-based fees
• Revenue Procedure 2011-29 provides a safe harbor election for
allocating a success-based fee between activities that facilitate a
covered transaction and activities that do not facilitate a covered
transaction
– Not applicable to non “covered transactions”
• Permits electing taxpayers to treat 70% of the success-based fee as an
amount that does not facilitate the transaction
– The remaining portion of the fee must be capitalized as an amount that
facilitates the transaction
• Applies to a taxpayer that:
– Pays or incurs a success-based fee in taxable years ending on or after April
8, 2011 for services performed in the process of investigating or otherwise
pursuing a “covered transaction” and
– Makes the safe harbor election
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Revenue Procedure 2011-29 – Safe harbor
election for allocating success-based fees
(cont.)
Safe Harbor Election
• The Service will not challenge a taxpayer's allocation of a successbased fee between activities that facilitate a transaction and activities
that do not facilitate the transaction if the taxpayer:
– Treats 70% of the amount of the success-based fee as an amount that does
not facilitate the transaction;
– Capitalizes the remaining 30% as an amount that does facilitate the
transaction; and
– Attaches a statement to its original federal income tax return for the taxable
year the success-based fee is paid or incurred
• Stating that the taxpayer is electing the safe harbor,
• Identifying the transaction, and
• Stating the success-based fee amounts that are deducted and
capitalized.
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Revenue Procedure 2011-29 – Safe harbor
election for allocating success-based fees
(cont.)
Further Considerations
• Irrevocable election
• Applies only to the transaction for which the election is made
• Applies with respect to all success-based fees paid or incurred by the
taxpayer in the transaction for which the election is made
– Analysis of other transaction costs still required
• Election generally does not constitute a change in method of accounting
for success-based fees, and thus a §481(a) adjustment is neither
permitted nor required
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Question and Answer
Contact info
Bob Kilinskis
202 879 4995
rkilinskis@deloitte.com
Leon Lewis
313 396 3543
leolewis@deloitte.com
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This presentation contains general information only and Deloitte is not, by means of this
presentation, rendering accounting, business, financial, investment, legal, tax, or other
professional advice or services. This presentation is not a substitute for such professional advice
or services, nor should it be used as a basis for any decision or action that may affect your
business. Before making any decision or taking any action that may affect your business, you
should consult a qualified professional advisor. Deloitte shall not be responsible for any loss
sustained by any person who relies on this presentation.
Copyright © 2011 Deloitte Development LLC. All rights reserved.