Firm Seeks to Prevent Distortion in Calculation of Tested Income

March 14, 2019

The Honorable David J. Kautter
Assistant Secretary (Tax Policy)
Department of the Treasury
1500 Pennsylvania Avenue, NW
Washington, DC 20220

The Honorable Charles P. Rettig
Commissioner
Internal Revenue Service
1111 Constitution Avenue, NW
Washington, DC 20224

The Honorable William M. Paul
Acting Chief Counsel and Deputy
Chief Counsel (Technical)
Internal Revenue Service
1111 Constitution Avenue, NW
Washington, DC 20224

Re: Treatment of Section 481(a) adjustments under new Section 951A

Dear Messrs. Kautter, Rettig, and Paul,

I am writing to request guidance on the treatment of the adjustments required under Section 481 of the Internal Revenue Code of 1986 (the Code) when a taxpayer changes its method of accounting for purposes of Section 951A of the Code. Specifically, I believe that Treasury should clarify that such adjustments do not form part of the calculation of so-called “tested income” for purposes of Section 951A if the change in accounting method occurred prior to the effective date of Section 951A.¹ This would be consistent with existing court doctrine and with approaches taken by Treasury and the IRS in analogous areas.

As you know, Section 14201 of The Tax Cuts and Jobs Act of 2017 (the TCJA) added Section 951A to the Code and requires certain taxpayers to include in current income their pro rata share of the global intangible low taxed income (GILTI) of controlled foreign corporations (CFCs) in which they are U.S. shareholders. The TCJA significantly reformed the U.S. international tax system by introducing a new participation regime for foreign earnings while simultaneously enacting provisions that would minimize opportunities for long-term deferral of offshore earnings, including enacting Sections 951A and 965, which imposed a one-time tax on accumulated offshore earnings. The TCJA also introduced many other sweeping changes to the international tax system intended to be effective on a go-forward basis.

Under Section 481(a) of the Code, taxpayers that change their method of accounting for an item generally must take into account those adjustments which are determined to be necessary solely by reason of the change in order to prevent amounts from being duplicated or omitted. These adjustments are necessary to ensure that a taxpayer's lifetime income is the same notwithstanding a change in the taxpayer's method of accounting. These rules recognize the need to ensure that an accounting method change does not result in a disadvantage to taxpayers by creating additional income (and triggering more tax) or in an advantage by creating additional deductions beyond what would have happened had the taxpayer been on the new method all along.

Proposed Treasury regulations are silent with respect to the treatment of a Section 481 adjustment for purposes of Section 951A, so it is not entirely clear whether a 481 adjustment should constitute gross income for purposes of Section 951A or even if it does, whether such an adjustment should increase tested income. Proposed Treas. Reg. Section 1.951A-2(c) generally provides that gross tested income of a controlled foreign corporation means gross income determined under the rules of Treas. Reg. Section 1.952-2 minus certain deductions. Treas. Reg. Section 1.952-2(a) provides that gross income of a foreign corporation should be determined by treating the foreign corporation as a domestic corporation and applying the principles of Section 61. It seems as though the IRS has taken the position that a Section 481(a) adjustment should be treated as an item of gross income, and under this approach such an adjustment conceivably would impact the calculation of tested income. However, where the adjustment arises entirely from a year that in fact predates Section 951A, it appears to me that treating the adjustment as an addition, or a subtraction, to tested income is inappropriate and would undermine Congressional intent to have the international tax provisions of the TCJA apply beginning in 2018.

Instead, the Section 481 adjustment should be characterized by reference to the income from which it arises in my view. This approach is consistent with existing court doctrines in analogous areas and makes sense from a tax policy point of view. For example, in MMC Corp. Midwest Inc. v Commissioner (TC Memo 2007-354), the taxpayer argued that a Section 481 adjustment required upon its change from the mark to market to accrual method of accounting for its customer paper required under the Internal Revenue Service Restructuring and Reform Act of 1998 (the RRA) was properly characterized by reference to the periods when the taxpayer originated the customer paper. In MMC, the taxpayer elected mark to market accounting for its customer paper in 1997 and recognized a loss on such paper, but amendments to Section 475 forced the taxpayer back on the accrual method of accounting. As a result, the taxpayer had to take into account a positive 481 adjustment over several years. However, before the taxpayer absorbed all of its 481 adjustments, the taxpayer elected to be treated as an S Corporation and argued that its 481 adjustment should not be treated as built-in gain subject to corporate tax under the S corporation rules. The court held that the 481 adjustments should be characterized as built-in gain because the adjustments related to customer paper that had accrued during a year when the taxpayer was a C corporation. The court relied on a Subchapter S regulation addressing the treatment of 481 adjustments, but also noted that it reached a similar result before Treasury had issued regulations specifically addressing the treatment of 481 adjustments as built-in gain.

The IRS takes a similar position in its published guidance. In Section 7.07 of Revenue Procedure 2015-13, the IRS requires taxpayers to characterize a 481 adjustment for subpart F and foreign tax credit purposes by reference to attributes relating to the year to which the adjustment relates, not the year in which it is taken into account. This approach is appropriate because it characterizes the adjustment by reference to the attributes of the year in which the income or expense was originally created, and not by reference to activities or attributes in another year.

I believe that the MMC line of cases and the “lookthrough” principles of Revenue Procedure 2015-13 present a compelling model for whether to characterize a 481 adjustment as tested income or not. In particular I believe these authorities support defining tested income to exclude a 481 adjustment that relates to a transaction that occurred during a period before Section 951A was effective. The activities and facts that gave rise to the adjustment relate to a year in which Section 951A did not exist and therefore the adjustment should not create (or reduce) tested income. This approach is not biased toward taxpayers or the government, since it would apply regardless of whether the 481 adjustment is positive or negative. Obviously, taxpayers with negative 481 adjustments would prefer to include the adjustment in the calculation of tested income, while those with positive 481 adjustments would prefer to exclude the adjustment. I believe the correct answer is to exclude such adjustments, positive or negative, from tested income or loss if they relate to periods that pre-date the effective date of Section 951A. To do otherwise would give taxpayers with large negative adjustments a potential windfall or create a significant unanticipated burden on those taxpayers with positive adjustments, even though they originated in years when the concept of GILTI did not exist. While the legislative history to Section 951A provides no guidance regarding the treatment of 481 adjustments, I do not believe that Congress intended for tested income to be impacted by events predating the effective date of the statute.

The government took a similar approach in defining Qualified Business Income (QBI) for purposes of Section 199A. Treasury Reg. Section 1.199A-3(b)(1)(iii) generally provides that Section 481 adjustments (whether positive or negative) are taken into account for purposes of computing QBI, but only if the adjustment arises in taxable years ending after December 31, 2017. Thus, a 481 adjustment will affect QBI only if it arises in years to which Section 199A generally applies, which one might argue reflects a policy decision that 481 adjustments that arise in years prior to the effective date of 199A should not form part of the QBI calculation. Treasury and the IRS again adopted a similar approach in proposed Treasury Reg. Section 1.59A-3(b)(3), which excludes from the definition of base erosion payment deductions allowed after December 31, 2018 if they relate to pre-2018 payments. Thus, the notion that 481 adjustments relating to a pre-TCJA should not affect a calculation required under a statutory provision enacted by the TCJA seems very consistent with the approach Treasury and the IRS have already taken to administer other provisions of the TCJA.

Moreover, I believe that ensuring that a pre-TCJA 481 adjustment does not form part of tested income furthers the general policy goals that the 481 adjustment seeks to achieve. Taxpayers are required to take into account adjustments, either positive or negative, upon a change in accounting method in order to ensure the change in method does not result in a double deduction or double counting of income. In other words, the goal of the adjustment is to ensure that the taxpayer's lifetime income is the same regardless of the method used. Treating a 481 adjustment that arises in a pre-TCJA year as tested income in a post-TCJA year would violate this principle because in that event the accounting method change could result in a different amount of tested income over the lifetime of the taxpayer than if the taxpayer had not experienced the accounting method change. Indeed, a 481 adjustment that is intended to be a timing difference becomes transformed into a permanent difference if pre-TCJA 481(a) adjustments are included into tested income.

For these reasons I believe that Treasury and the IRS should adopt a rule that is consistent with the approach they have already taken in other analogous regulations. Under this approach, a pre-TCJA 481 adjustment would not increase or decrease tested income but would instead be characterized as the type of income it would have been in the year in which it arises. For example, a positive pre-TCJA 481 adjustment carried to a post TCJA year might be characterized as Subpart F income because it would have been treated as Subpart F income (taking into account exceptions to subpart F) in the pre-TCJA year to which the adjustment relates. Similarly such an adjustment would be taken into account in calculating the E&P of a CFC and might be treated as additional non-subpart F income, but not tested income, if it would have been so treated in the year to which it relates. It is especially inequitable to include a 481 adjustment in tested income because, unlike E&P which is a cumulative calculation, tested income is an annual calculation with no carryforwards. Adding a 481 adjustment from another year would take tested income closer to a cumulative concept and not likely what Congress intended.

The general thrust of my approach is that no portion of the 481 adjustment should be treated as tested income or loss where the 481 adjustment relates in its entirety to years that pre-date Section 951A. To do otherwise would distort the calculation of tested income or loss by allowing income or loss from transactions in pre-TCJA years to impact a calculation that did not exist during the years which gave rise to items form the entirety of the 481 adjustment.

If there is concern that this treatment would allow positive 481 adjustments to go untaxed because they may be characterized as earnings and profits that would support a dividend deductible under new Section 245A of the Code, Treasury could require that taxpayers take into account 481 adjustments that relate to pre-TCJA years as part of their transition tax calculation under Section 965 to the extent that such adjustment would have resulted in additional non-Subpart F earnings and profits. A positive 481 adjustment from a pre-TCJA tax year that would have formed part of non-Subpart F income would generally have been taken into account as part of the transition tax. While many taxpayers have already calculated their transition tax, allowing taxpayers with a positive 481 adjustment to take such adjustment into account under the transition tax (by filing amended returns) could provide taxpayers with a way to ease the burden of having to treat a 481 adjustment entirely as a component of tested income.

Conclusion

In sum, many taxpayers have 481 adjustments that originated from pre-TCJA years and need certainty on how to treat such adjustments for purposes of Section 951A. I believe it appropriate to clarify that such adjustments do not affect tested income or loss under Section 951A and that such an approach would be consistent with existing authorities and would also further the tax policy goals of Section 481 and the TCJA.

I hope this information is helpful. If there is any further information that might be of assistance to you, your Department, or the IRS in implementing this or any other aspects of the new law, I would be very happy to try to obtain and provide it. You or your staff may contact me at any time.

Very truly yours,

Ramon Camacho
Principal, Washington National Tax
RSM US LLP
ramon.camacho@rsmus.com
Washington, DC

cc:
Gary Scanlon, Esq.,
Office of the International Tax Counsel