Use of U.S. GAAP to calculate the earnings and profits of foreign corporations

Tax Executive, The, March-April, 1991 by Fred T. Goldberg, Jr.

Use of U.S. GAAP to Calculate the Earnings and Profits of Foreign Corporations

This letter responds to your request for Tax Executives Institute's comments on the use of U.S. generally accepted accounting principles (GAAP) to calculate the earnings and profits (E&P) of foreign corporations. Specifically, you asked the Institute to discuss the permanent and temporary (or timing) differences that could result from such a change.

I. Overview

In general, TEI wholeheartedly endorses the use of U.S. GAAP in the calculation of a foreign corporation's E&P.(1) By allowing taxpayers to use financial information gathered for legitimate, non-tax reasons, the IRS can substantially reduce reporting burdens. The resulting simplicity would ease the administrative burdens of taxpayers and the government alike.

As a practical matter, some companies may already be applying U.S. GAAP for E&P purposes; these companies compute their E&P based on their financial books. In many cases, foreign subsidiaries make only minor adjustments beyond the general restatement of their financial statements to accord with U.S. GAAP principles. The U.S. GAAP E&P method simply bows to this reality. In addition, companies generally cannot predict U.S. GAAP income; thus, the proposal would not prompt "gaming" of the system for tax planning purposes. Indeed, the U.S. GAAP standard may well be subject to less control by the taxpayers than current law, given the absence of tax accounting elections. Finally, publicly held companies generally wish to maximize their earnings and, consequently, have little incentive to underreport the amount of financial income.

We caution, however, that the use of U.S. GAAP principles will materially reduce complexity only if the required adjustments of U.S. GAAP income are insubstantial. Obviously, the greater the number of adjustments, the less attractive the proposal becomes. At a minimum, no adjustment from U.S. GAAP should be required in respect of the following three items:

* The tax depreciation rules;

* The uniform capitalization

rules of section 263A of the

Code; and

* The translation of foreign financial

statements.

The inclusion of these components within the U.S. GAAP E&P method - i.e., providing that the financial accounting treatment of these items should govern for E&P purposes - is critical to achieving real simplification in this area. Indeed, we believe that if U.S. GAAP principles were applied only with respect to these three items, meaningful simplification would be attained.

Notwithstanding our concern about the possible proliferation of required adjustments, there are two important differences between the financial and tax accounting rules that could dissuade taxpayers from electing an absolute U.S. GAAP E&P method. These differences are discussed below in Part IV.

II. Effect of U.S. GAAP in the

Foreign Tax Area

In one sense, the Tax Reform Act of 1986 simplified the computation of E&P by prescribing a single method to be used for all purposes. The new method is essentially the method set forth in Treas. Reg. [sub section] 1.964-1(a) through (c) (commonly referred to as the "partial section 964" method). In so doing, the 1986 Act eliminated the section 902 E&P method, as well as the steps relating to unrealized foreign currency gains and losses under Treas. Reg. [sub section] 1.964-1(d) and (e).

On the other hand, because E&P must now be computed annually for purposes of the interest expense allocation rules under section 864(e), the 1986 Act made the calculation of E&P more onerous. The new interest allocation rules are based upon assets of the affiliated group, including stock in foreign corporations, with the value of the stock being its adjusted basis (increased by the E&P of the foreign corporation and its subsidiaries). Calculations of E&P (requiring pooling for post-1986 years) U.S. tax accounting principles are now a mandatory part of the interest expense allocation regime.(2)

TEI believes that the mandatory pooling of E&P under the 1986 Act should make the U.S. GAAP E&P method appealing to both taxpayers and the government. For tax years prior to 1987, if U.S. GAAP were permitted for E&P purposes, the resulting change in the calculation of income or deductions could have a significant effect on the deemed paid foreign tax credit. (The increased E&P in the denominator of the section 902 credit formula could substantially distort the foreign tax credit.) With the pooling of E&P for post-1986 years, however, this generally adverse effect is lessened. Moreover, under a U.S. GAAP E&P standard, timing differences could reverse over several years, minimizing their effect. Accordingly, the pooling of E&P under the 1986 Act enables the U.S. GAAP E&P proposal to be adopted without substantial adverse effect on either taxpayers or the IRS.

The calculation of E&P is used not only for purposes of the deemed paid foreign tax credit, but also for determining the dividend portion of a distribution from a foreign corporation, gain taxable as a dividend under section 1248, the limitations on subpart F inclusions, and the increased investments in U.S. property under section 956. In each of these cases, TEI believes that the U.S. GAAP E&P method could be effectuated without material adverse consequences.