In ILM 201625011, the IRS has addressed how depreciation and amortization are calculated for assets subject to the foreign sales corporation (FSC) regime or the extraterritorial income (ETI) exclusion provisions.

Facts

The ILM presents four scenarios in which the IRS determines how depreciation is calculated under Section 167 or Section 168, or how amortization is calculated under Section 167 for an asset subject to either the FSC regime or the ETI exclusion provisions.

In Scenario 1, a taxpayer had a wholly owned subsidiary that qualified as an FSC under former Sections 921-927. The FSC owned tangible property (Asset A) that it leased to an unrelated, non-US entity under a four-year lease entered into on January 1, 1997, and ended on December 31, 2000. The lease contract did not include a purchase option, renewal option or replacement option.

The FSC treated 30% of its foreign trade income as exempt foreign trade income not subject to taxation under Reg. Section 1.923-1T(b)(1)(ii) and former Sections 923(a)(2) and 291(a)(4). The FSC did not deduct expenses allocable to its exempt foreign trade income.

The FSC placed Asset A in service on January 1, 1997. Asset A is a depreciable tangible asset with a class life of five years. The FSC depreciated Asset A under Sections 167(a) and 168(g). The FSC did not use the optional depreciation tables under Section 8 of Revenue Procedure 87-57, 1987-2 C.B. 687, and depreciated the adjusted basis of Asset A under Sections 4, 5 and 6 of Revenue Procedure 87-57. The FSC only deducted 70% of Asset A's total depreciation and did not deduct the 30% depreciation allocated to exempt foreign trade income. Asset A's recovery period ended after December 31, 2000, the expiration of the lease date.

The taxpayer timely filed a Form 3115, Application for Change in Method of Accounting, requesting permission to change FSC's accounting method for Asset A's depreciation allocated to the exempt foreign trade income, beginning January 1, 2015. The FSC proposed to determine the annual depreciation deductions of Asset A under Section 168(g) by reducing its unadjusted basis for the depreciation allocated to the non-exempt foreign trade income. Thus, Asset A's unadjusted basis would be fully recovered.

In Scenario 2, the facts are the same as Scenario 1, except the FSC used the applicable optional depreciation table to determine annual depreciation deductions for Asset A under Section 8 of Revenue Procedure 87-57.

Scenario 3 is the same as Scenario 1, except the lease is for 11 years and ended on December 31, 2007. Asset A's recovery period ended before the end of the lease.

In Scenario 4, the taxpayer owns a motion picture film that qualified for benefits under the ETI exclusion provisions of former Section 114. The taxpayer calculated ETI exclusions based on qualified foreign trade income equal to 30% of its foreign sales and leasing income from the motion picture film and did not reduce its taxable income by deducting expenses allocable to the extraterritorial income.

The taxpayer placed the film in service in 2003 and depreciated the film under the income forecast method under Section 167(g). The taxpayer licensed the motion picture film to an unrelated, non-US entity under a 15-year license that was entered on the film's placed-in-service date (2003). The license contract did not include a purchase option, renewal option or replacement option. The tax year provided in Section 167(g)(1)(C) ended before the expiration of the license.

The taxpayer deducted 70% of the film's total depreciation and did not deduct the film's depreciation (i.e., the other 30%) subject to the ETI exclusion provisions.

The taxpayer timely filed a Form 3115, requesting to change the accounting method for the film's depreciation disallowed under former Section 114(c), beginning January 1, 2015. Under the proposed accounting method, the film's adjusted basis that is allocable to its depreciation disallowed under former Section 114(c) will be recovered under Section 167(g)(1)(c).

Analysis

Depreciation or amortization calculation

In CBS Corp. v. United States, 105 Fed. Cl. 74 (2012), the court ruled that 30% of an aircraft's depreciation deductions were not "allowable" deductions under Section 1016(a)(2) "[b]ecause the FSC regime allocated deductions to exempt foreign trade income and because deductions allocable to tax-exempt income are disallowed under Section 265(a)(1)."

The IRS determined that the depreciation calculation under Section 167 or 168 or amortization calculation under Section 167 for an asset subject to either the FSC regime or ETI exclusion depends on: (1) the type of asset; (2) whether the annual depreciation or amortization deductions are determined by using the asset's adjusted or unadjusted basis; and (3) whether the asset's recovery period or useful life ended before or after the end of the transaction that qualified for FSC or ETI exclusion treatment.

In Scenario 1, the IRS concluded Asset A's annual depreciation deductions should be determined by using Asset A's unrecovered (adjusted) basis. The IRS also determined that Asset A's unrecovered basis should not be reduced by the 30% of its annual depreciation deductions allocable to exempt foreign trade income because the unrecovered basis for each tax year takes into account only those depreciation deductions that are allowed under Section 1016(a)(2). Because Asset A's recovery period ended after December 31, 2000, which was after the lease expired, the IRS concluded that the FSC may fully recover Asset A's unadjusted basis through depreciation deductions.

In Scenario 2, the IRS determined that the depreciation amounts allocable to exempt foreign trade income may not be recovered under the optional depreciation tables in Section 8 of Revenue Procedure 87-57 because Asset A's unadjusted basis did not take into account depreciation deductions regardless of whether they are allowed under Section 1016(a)(2). Because the FSC wants to treat only the depreciation allocable to the non-exempt foreign trade income as the depreciation allowable under Section 1016(a)(2), the IRS concluded the FSC must continue to use the optional depreciation table to compute the annual depreciation deductions for Asset A. Therefore, the adjusted basis allocable to depreciation disallowed under former Section 921(b) and Section 265(a)(1) may not be recovered until the FSC disposes of Asset A, even though the FSC only deducted 70% of Asset A's total depreciation.

The IRS concluded, in Scenario 3, that the FSC may not recover depreciation deductions allocable to exempt foreign trade income for the final year of the recovery period through a depreciation deduction because Asset A's recovery period ended before the expiration of the lease. Therefore, the depreciation deduction for the final year of Asset A's recovery period that is allocable to exempt foreign trade income may not be recovered until the FSC disposes of Asset A.

In Scenario 4, the IRS determined that, in accordance with CBS Corp., the film's depreciation deductions allocable to excluded ETI are not allowable for purposes of Section 1016(a)(2). Thus, those deductions do not reduce the film's unadjusted basis; instead, the film's unadjusted basis is reduced by 70% of the film's total depreciation.

Because the 10th tax year beginning after the tax year the film was placed in service ends before the expiration of the film's license, the IRS concluded that "there is no opportunity to recover the depreciation deductions allocable to excluded ETI for that taxable year through a depreciation deduction." Accordingly, the depreciation deduction for the 10th tax year that is allocable to excluded ETI may not be recovered until the taxpayer disposes of the film.

The ILM includes an attachment that contains examples of how to calculate the annual depreciation deductions.

Change in accounting method

When the recovery of depreciation or amortization of an asset that is allocated to exempt foreign trade income under the FSC regime or subject to the ETI exclusion provisions changes, the IRS concluded that the change is a change in accounting method and is not covered by the list of automatic changes in Revenue Procedure 2015-14.

In Scenarios 1, 3 and 4, the IRS concluded that the taxpayer is requesting a change to a permissible accounting method and must file Form 3115 under the non-automatic method change procedures in Revenue Procedure 2015-13. In Scenario 2, the IRS determined that the taxpayer is requesting a change to an impermissible accounting method.

Implications

Since the CBS Corp. case was decided, taxpayers have made efforts to recover basis related to previously disallowed depreciation deductions using general asset accounting and certain method change filings. In this ILM, the IRS has provided some clarity on how it views appropriate depreciation for films and other depreciable property when the CBS Corp. case may apply to a taxpayer that did not fully recover basis due to FSC or ETI deduction disallowance provisions. While most of the examples in the ILM suggest situations in which a method change would not be available to accelerate the recovery of the basis related to FSC or ETI disallowance of prior-year depreciation deductions, the guidance suggests that it may be possible for taxpayers to file non-automatic method changes to properly recover certain depreciation (or amortization) deductions that were disallowed under the FSC or ETI rules in the past. Taxpayers interested in filing such non-automatic method changes to accelerate recovery of such basis (rather than recovering it upon disposition of the asset) should carefully consider their current depreciation methods to determine whether the change would be approved, given the various considerations highlighted in the ILM.

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