Medical Products Company Finds Faults With Proposed Branch Currency Transaction Regs

Baxter International Inc. wishes to submit the enclosed comments with respect to the 2006 proposed section 987 regulations. We understand these regulations are in the process of being reviewed for adoption. As a result, our team at Baxter has prepared an attachment which provides a practitioner's perspective on these proposed regulations. Please feel free to contact either Mr. Andrew Gore at (847) 948-4670 or Mr. Thomas Rozanski at (847) 948-2467 if you have any questions or wish to discuss this matter further.

The purpose of this letter is to comment on certain tax compliance difficulties that would be associated with the implementation of the historical FX rate accounting required under the current proposed section 987 regulations (2006 Regulations).

Background

The withdrawn 1991 proposed section 987 regulations would have required taxpayers to compute earnings and profits (E&P) in a branch's functional currency and then translate it into the home office's E&P using the average exchange rate in effect for the year in question (P&L Method). The 2006 Regulations would require that, in determining a branch's E&P, deductions allowable with respect to certain "historic" assets such as depreciation on machinery, be translated into the owner's functional currency using historical FX rates.

Summary of Comments

The requirement of using historical FX rates for certain items in computing branch E&P would place enormous burdens on taxpayers with manufacturing branches and increase the likelihood of computational error with respect to Forms 5471 reporting manufacturing branch activity. This would substantially increase both compliance costs and the risk of penalties for filing incorrect Forms 5471.

Discussion

The 2006 Regulations ignore the impact of depreciation expense in a manufacturing environment. They assume depreciation expense is necessarily a period cost and therefore currently deductible. Under section 263A, which requires a similar methodology to the full absorption method under US GAAP, manufacturers are required to capitalize all inventoriable costs (including production-related depreciation) on the balance sheet. This method also applies for purposes of computing branch E&P under section 987. Such capitalized, inventoriable costs are not charged to the P&L until the inventory is sold. The 2006 Regulations would require taxpayers having manufacturing branches to run additional, highly burdensome calculations in order to split the current year's depreciation expense, which is translated at historical FX rates, between inventory that is sold and inventory that remains on the balance sheet. This would be far more complicated than the calculations required under the 1991 proposed regulations and would render the branch's local-currency books largely useless as a basis for calculating the branch's E&P under section 987. In effect, the taxpayer would have to create a new and unique set of books to calculate depreciation, account for inventory and recalculate the gain or loss on asset dispositions, all under historical FX rate conventions, purely for purposes of complying with the 2006 Regulations.

While such adjustments could be manageable when a branch has a handful of assets, as illustrated in the examples in the 2006 Regulations, the actual work involved becomes considerably more difficult with respect to larger operations. For example, Baxter has several large manufacturing branches subject to section 987. These branches employ thousands of people and hold thousands of fixed assets. They routinely acquire production-related assets throughout the year. For these branches, complying with the historical FX rate accounting required by the 2006 Regulations would involve an extremely onerous level of record keeping. Capitalizing the related depreciation expense under Section 263A into inventory and then tracking the disposition of the inventory would require additional significant resources. In order to do these calculations, Baxter would need to implement costly new additional accounting systems and hire additional personnel. The IRS would need additional resources to audit these complex calculations as well.

Without guidance from Treasury as to how to handle the "cap and roll" of inventory costs, taxpayers with manufacturing branches would have to either create new accounting systems or make assumptions (such as inventory turns) in order to keep track of how much depreciation expense is charged to the P&L as a component of cost of goods sold (COGS), and how much remains on the balance sheet as inventory. Taxpayers would not be able to rely on GAAP or local statutory COGS because these accounting methods do not use historical FX rate conventions for calculating depreciation expense. We understand that, in crafting the 2006 Regulations, Treasury sought clarity in computing the E&P and 987 gain or loss calculations, but in doing so, it has merely closed one door and opened another, unaccounted for mathematical problem. Compliance with historical FX rate accounting for fixed assets will place substantial burdens on U.S. tax departments and local country finance teams. For example, using Baxter as an example, each of Baxter's CFCs prepares a summary balance sheet and P&L that gets uploaded into a global financial reporting system. This upload not only serves as the foundation of Baxter's SEC filings, but it is also used to prepare Baxter's Forms 5471. In Baxter's global financial reporting system summary P&L, the level of COGS detail needed to meet the requirements of the 2006 regulations does not exist because the global financial reporting system does not show the portion of COGS related to salaries, materials or overhead (lights, power, depreciation expense, etc). Likewise, on the summary balance sheet, fixed assets appear with minimal detail. Generally, the global financial reporting system does not provide a tax department the detailed information to the underlying fixed asset systems that compute the related annual depreciation expense. Such detail related to COGS or depreciation is held at the ledger level of accounting (i.e. locally, in the foreign country) and not at the summary corporate level which drives a global reporting system. Even if a tax department did have such visibility to a fixed asset system, the tax department would still have to make educated guesses for their manufacturing branches as to the inventoriable costs charged to COGS vs. that held over in inventory. In order to implement the 2006 Regulations, tax departments would have to capture data that their global financial reporting system does not provide. Local country finance teams would have to implement historical FX rate accounting for their fixed asset systems, compute the depreciation expense by year of asset acquisition and translate it using historical FX rates for the various years of acquisition. Similar calculations would have to be performed for assets disposed during the year. This would require a completely separate depreciation system. Tax departments would also have to develop an entirely separate inventory tracking system in order to properly capitalize historical FX rate tax depreciation into inventory and track the disposition of inventory for purposes of the E&P calculation.

Given the enormous complexity associated with implementation of the historical FX rate accounting, it is highly likely, if not certain, that many taxpayers with manufacturing operations would attempt to adopt reasonable short cuts or otherwise use estimated approaches in good faith efforts to comply with the 2006 Regulations' requirements. This would necessarily result in imperfect Form 5471 filings and thus a higher risk of taxpayer penalties, which can be substantial.

Conclusion: Baxter believes that the use of the P&L Method of computing QBU E&P continues to be the best method and does not create significant complexity or raise myriad unanswered questions. Also, the degree of additional complexity and cost that would be associated with implementation of the historical FX rate requirement in the 2006 Regulations runs contrary to the spirit of Executive Order 13563, issued just last January, which requires agencies to reconsider where the appropriate regulatory balance lies between efficacy and burden.