Many taxpayers are reviewing cumulative earnings and profits (E&P) associated with their controlled foreign corporations in connection with the transition tax under the Tax Cuts and Jobs Act (TCJA). The IRS recently released Revenue Procedure 2017-59, addressing changes in accounting periods and in methods of accounting under Section 404A. Taxpayers should consider this new guidance in assessing the potential benefit of a method change for the treatment of pension expense in E&P.

Background

Under Section 404A of the Internal Revenue Code, an entity may elect to take a current tax deduction (which reduces E&P) for: (i) actual cash contributions made to the trust of a qualified foreign plan or (ii) for the reasonable additions to the reserve for unfunded foreign plans. For more information on Section 404A, see Tax Alert 2016-969.

To deduct actual cash contributions to foreign employer-sponsored defined benefit pension plans, a US taxpayer must make an affirmative election under Section 404A for each plan for which a deduction under Section 404A is desired. If an election is not made, the deductible amount is only that which is paid out of the plan to retirees under Section 404(a)(5). For a deduction to be allowed under Section 404(a)(5), however, the funded plan must have separate accounts for participants, a feature that is not typical for defined benefit arrangements. Absent this requirement for a funded plan, there is risk that, upon IRS audit, the deduction under Section 404(a)(5) could be denied.

An election to apply Section 404A to determine an entity's deduction for amounts contributed to an existing foreign pension plan, however, is a non-automatic change in method of accounting, consistent with Prop. Treas. Reg. Section 1.404A-6, and requires the filing of a Form 3115, Application for Change in Accounting Method (i.e., when the election is made in a tax year after the tax year in which the plan was adopted). Filing a Form 3115 can provide the applicant with the opportunity to recover missed deductions in open and closed tax years through a "catch-up" negative (decrease to income) Section 481(a) adjustment. Section 404A(g)(5) provides that any increase or decrease in accumulated E&P that is taken under Section 481 must be applied over 15 years.

Newly adopted non-US pension plans may make a Section 404A election without filing a Form 3115, but it must be in accordance with Prop. Treas. Reg. Section 1.404A-6 and is limited to plans maintained by a foreign branch, controlled foreign corporation (CFC), or non-CFC.

Updated guidance

Revenue Procedure 2015-13 (see Tax Alert 2015-204) updated the principal procedures that a taxpayer may use to obtain automatic and non-automatic consent for changes in accounting methods. Generally, and with some exceptions, a Section 481(a) adjustment that is favorable (i.e., a decrease to income) to the taxpayer is reflected in the year of the method change, whereas a Section 481(a) adjustment that is unfavorable (i.e., an increase to income) to the taxpayer is reflected over four years (two years if the taxpayer is under exam). This approach differs from the requirements of Section 404A(g)(5), which specifies a 15-year period for adjustments associated with Section 404A elections. Specifically, Section 404A(g) (5) provides that, for purposes of Section 481, an election under Section 404A is treated as a change in method of accounting; an election under Section 404A is made under Section 404A(e)(3), and, if applicable, Section 404A(f)(2). Section 404A(g)(5) further provides that, in applying Section 481 with respect to any such election, the period for taking into account any increase or decrease in accumulated profits, E&P, or taxable income resulting from the application of Section 481(a)(2) shall be the year for which the election is made and the 14 succeeding years. Accordingly, and as noted, the IRS released Revenue Procedure 2017-59, which clarified that the Section 481(a) adjustment for a Section 404A election is the 15-year period provided in Section 404A(g)(5).

Implications

Although reductions in E&P associated with a method change may need to be spread over 15 years, there still are a number of benefits to making a Section 404A election through filing for a method change:

— Noncompliance with the new guidance could create tax compliance issues.

— If funded pension plans are not in accordance with Section 404(a)(5), the IRS could deny deductions for all benefits paid to retirees.

— IRS approval of a method change filing generally would provide audit protection if filed in accordance with audit protection guidance under Revenue Procedure 2015-13. However, CFCs making method changes generally require extra attention, as opportunities for audit protection are more limited. For example, a CFC will not be able to obtain audit protection for any prior year in which any of its domestic shareholders are deemed to pay foreign taxes under Sections 902 and 960 with respect to the CFC in excess of 150% of the prior three-year average. Other potential limitations on audit protection may apply.

— The reduction to E&P in future years would also provide taxpayers with a potential tax benefit, albeit at a lower tax rate.

Companies should also consider acceleration of deductions for US qualified pension plans, or acceleration of bonus accruals through a corporate action to make such bonuses fixed and determinable as of the close of the relevant tax year of the proposed method change. Taxpayers considering such strategies for 2017 tax years should consider the effects on the Section 199 domestic production deduction, if applicable. There may be opportunities to reduce the impact on the Section 199 deduction by identifying expenses related to pre-Section 199 enactment periods.

More broadly, E&P automatic and non-automatic accounting method change opportunities exist for a broad range of income and expense items (as well as depreciation and inventory) in both an automatic and non-automatic method change context. Accounting methods are directly relevant to the assessment of E&P implications of the Tax Cuts and Jobs Act. Specifically, in the near term, companies should be working on determining their tax liability for transition tax purposes, including reviewing historic E&P and tax pools, determining cash and cash equivalent balances to be included as of the relevant dates, assessing their foreign tax credit (FTC) and utilization positions (including OFLs), and assessing the availability of attributes (e.g., existing or carryforward FTCs, NOLs or other credits) to offset their transition tax liabilities.

———————————————