Tax Update. Are New Rules on the Horizon for Accounting Method Changes? speakers corner. in this issue.

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1 March 2007 Are New Rules on the Horizon for Accounting Method Changes? The American Institute of Certified Public Accountants (AICPA) and the American Bar Association (ABA) recently submitted suggestions to the Associate Chief Counsel of Income Tax and Accounting (IT&A) regarding improvements in the accounting method change procedures. Currently, section 446(e) of the Code requires that taxpayers must obtain the consent of the Secretary prior to changing a method of accounting used to report items of income and expense for tax purposes. Because a method change can result in large swings in the timing of income and deductions, the IRS carefully analyzes requests. Depending on the type of method change requested, a taxpayer may secure consent either automatically or non-automatically. Generally, under the procedures for automatic method change requests, most notably Revenue Procedure , the taxpayer attaches an accounting method change request to its timely filed tax return, and the method change request is approved with its filing. For non-automatic method change requests, the taxpayer files the request with the Internal Revenue Service s National Office and must await formal approval prior to implementing the accounting method change. in this issue 1 Are New Rules on the Horizon for Accounting Method Changes? 3 IRS Issues Guidance for CFC Look-Through Rules 5 Foreign Bank Accounts and Multinational Corporations Are You Reporting Correctly? speakers corner Christian Wood spoke on a panel titled Proposed Section 263(a) Tangible Property Regulations at the Federal Bar Association in Washington, D.C. on March 9, Roderick Gagné spoke on Pennsylvania Taxes Affecting Nonprofits at the Annual Health Law institute on March 13, Timeliness Is a Problem In recent years, it has become increasingly difficult to secure timely approval for non-automatic accounting method change requests, because the IRS National Office has intensified its review of requests and IRS Exam has begun scrutinizing and challenging accounting methods even if they already have received the approval of the IRS National Office. As a result of these problems, both the AICPA and the ABA suggested that the IRS National Office adopt a twotrack system for processing accounting method change requests. For non-automatic method changes the two-track approach permits taxpayers to choose to receive either a detailed and specific ruling regarding its accounting method change or an accelerated but less detailed ruling. Both groups suggested that the automatic approval process be retained, and the ABA even suggested that the scope of automatic method changes should be expanded. If these recommendations are implemented, taxpayers may benefit in several ways: accelerated approval of accounting method changes; minimized Exam scrutiny of accounting methods; and increased certainty regarding a taxpayer s implementation of its accounting method. Accelerated Track Under an accelerated track approach, the IRS National Office would process accounting method change requests without consideration of the detailed application of the

2 proposed accounting method to particular transactions. In return, the taxpayer would not need to provide as much detailed information about the proposed method as required under existing practices. Under the accelerated track, the National Office would issue a standard consent letter providing the taxpayer with audit protection, barring challenges to the taxpayer s prior method for any period prior to the year of change. In the case of an accounting method change filed under the accelerated track approach, the only type of ruling protection that the taxpayer would obtain would be the assurance that the overall proposed method described in the change request was legally acceptable. Any challenge by an IRS Examining Agent of the underlying accounting method would require a technical advice request to revoke the consent letter. Standard Track The standard track would be available for a taxpayer seeking greater assurance that the National Office agreed with the detailed procedures that the taxpayer intends to employ with its accounting method. If a taxpayer elects to follow the standard track approach when it submits an accounting method change request, the taxpayer would obtain not only audit protection, but also complete ruling protection. Thus, absent fraud or failure to disclose all of the material facts the examination team could not challenge the propriety of the application of the taxpayer s new method retroactively for any year prior to the current year. The only exceptions to the foregoing conclusions would be in situations where the National Office s consent letter specifically carved out factual issues the consideration of which the National Office specifically reserved for the examination process. Examining Agent Restrictions One of the better suggestions by the ABA and the AICPA deals with how exam agents would treat imperfect requests. Under the recommended procedures, if the proposed accounting method is a permissible method, the procedures would only permit an examining agent to make adjustments to properly apply that permissible method to the taxpayer s facts. This new approach would prevent agents from requiring the taxpayer to change back to the old method or to a different method selected by the exam agent. Differences The biggest difference between the AICPA and ABA recommendations is that the ABA recommends all accounting method change requests be made automatic, unless (i) the Service specifically has provided in published guidance that the change is non-automatic; and (ii) automatic consent requests are not mutually exclusive of non-automatic consent requests, which is the current IRS practice. For automatic method change requests, taxpayers would be given the option to receive a detailed and comprehensive ruling regarding an accounting method change. This recommendation permits additional certainty for taxpayers seeking a higher degree of confidence regarding an accounting method change question. The AICPA, while recommending expedited approval, recommended continuation of the current practice that all method change requests are non-automatic unless the Service specifically designates that a method change can be made automatically. The AICPA also suggested a continuation of the mutual exclusive nature of the requests types. In other words, taxpayers could not elect to use the advance consent procedures for the accounting method changes that have been designated for automatic consent under the AICPA s suggestions. Pepper Perspective In November of 2006, the Associate Chief Counsel, IT&A raised the subject of the timeliness of the National Office s approval process for accounting method change requests. Counsel indicated that when he took charge of IT&A, he became aware of the sizeable backlog of pending accounting method change requests. He solicited suggestions that the National Office might adopt to accelerate processing. Because of the significant amounts involved in many method changes, taxpayers with a preference as to the process may want to chime in as new rules are being considered. Author: Christian T. Wood woodc@pepperlaw.com -2-

3 IRS Issues Guidance for CFC Look-Through Rules On January 11, the IRS issued Notice to provide guidance on the application of recently enacted Code Section 954(c)(6). 956(c)(6) operates so that active income of a payor CFC will not be transformed into Subpart F income when received by a related CFC in the form of a dividend or other passive income. Background on Section 954(c)(6) As discussed in Pepper s October 2006 Tax Update, Section 954(c)(6) provides look-through treatment for certain payments between related controlled foreign corporations (CFCs). 1 Section 954(c)(6) generally provides that dividends, interest, rents and royalties received by one CFC from another related CFC will not be treated as foreign personal holding company income (FPHCI) if the payment is not attributable to Subpart F income or effectively connected income of the payor CFC. Absent this rule, even if the payor CFC had only active business income, unless the payor and the recipient qualified for the same country exception, a dividend payment from the payor CFC made to a recipient CFC would become FPHCI in the hands of the recipient CFC (and thus, Subpart F income). In other words, 956(c)(6) operates so that active income of a payor CFC will not be transformed into Subpart F income when received by a related CFC in the form of a dividend or other passive income. This new provision only applies to taxable years of foreign corporations beginning after December 31, 2005, and before January 1, Section 954(c)(6) is not elective if it applies, it applies. Provisions of Notice Notice provides specific guidance on the application of Section 954(c)(6), pending the issuance of new regulations. The Notice provides clarification on the definition of a dividend and on interest attribution, and provides several illustrative examples of the antiabuse provision contained in the new Section. Highlights include: Dividends: The Notice clarifies that the payor and payee CFCs need only be related CFCs at the time that the dividend is appropriately included in the income of the recipient CFC. It is not required that the underlying E&P be accumulated during periods when the payor CFC is a CFC or when the recipient payee CFC is a related person with respect to the payor CFC. Interest: The Notice provides specific guidance on how to allocate interest in circumstances where the payor CFC has both interest that would qualify for the Section 954(c)(6) exception and other interest. Anti-Abuse Rules: Although the list is specifically non-exhaustive, the Notice describes certain abusive transactions for which look-through treatment will not be allowed under Section 954(c)(6). These include transactions involving factoring of receivables, dividends that would allow avoidance of Section 956, options related transactions and transactions that change the character of the underlying income via use of a conduit entity. A particular example of the anti-abuse rules is as follows: USP, a U.S. corporation, owns CFC1 and CFC2. USP sells inventory to CFC1 in exchange for receivables. USP sells the CFC1 receivables to CFC2 at a discount, and CFC2 makes a profit on the collection of the receivables. The Notice concludes that the income earned by CFC2 on the receivables is related person factoring income under Section 864(d) and, therefore, is treated as interest received on a loan from CFC2 to CFC1. It generally would be excluded from Subpart F income pursuant to Section 954(c)(6). However, because CFC2 acquired the CFC1 receivables from USP at a discount, resulting in a loss for USP, the deemed interest is not eligible for look-through treatment under Section 954(c)(6) and thus is FPHCI income as to CFC2. The IRS was also concerned about taxpayers avoidance of Section 956 in certain transactions. For example: USP owns CFC1, which owns CFC2. CFC2 loans $100 to USP in exchange for a note. During year 1, CFC2 earns $100 non-subpart F E&P. Shortly before year-end, CFC2 distributes $100 to CFC1. The Notice concludes that the --

4 USP note held by CFC2 is United States property under 956(c)(1)(C). Therefore, USP would have income of $100 under Section 951(a)(1)(B), if not for the Applicable Earnings limitation under 956(b)(1). As a result of the $100 dividend to CFC1, CFC2 has no Applicable Earnings for the year of the investment in U.S. property, thus there is no Section 956 amount. With a zero Section 956 amount, there is no Section 951(a)(1)(B) inclusion by USP with respect to the note. Under the Section s anti-abuse provisions, because the dividend to CFC1 was used to reduce CFC2 s Applicable Earnings for purposes of Section 956, the dividend is not eligible for Section 954(c)(6) look-through treatment. As a result, unless CFC1 and CFC2 can meet the same country exception, the dividend received by CFC1 is FPHCI and is subject to inclusion by USP under Section 951(a)(1)(A). If CFC1 and CFC2 meet the same country exemption, 2 the dividend to CFC1 would reduce CFC2 s Applicable Earnings, and the receipt of the dividend by CFC1 would not be FPHCI to CFC1. If CFC1 and CFC2 cannot meet the same country exception, Section 954(c)(6) will not be applicable, and thus the dividend from CFC2 to CFC1 would be FPHCI. Pepper Perspective A Treasury Department official speaking at a recent ABA meeting reinforced that Section 954(c)(6) is not an elective provision. Taxpayers with interests in CFCs must, therefore, understand the application of these rules. Notice provides specific guidance, and may provide specific guidance on how to apply Section 954(c)(6) to a fact pattern your corporation is experiencing. Although Section 954(c)(6) is meant to be taxpayer friendly, taxpayers are faced with learning how to apply and implement its provisions, which could involve collecting and analyzing a tremendous amount of data. Finally, because 954(c)(6) applies only to CFC years beginning after December 31, 2005, and before January 1, 2009, any implementation procedures put in place may, unfortunately, be short-lived. Endnotes Authors: Todd B. Reinstein reinsteint@pepperlaw.com Benjamin M. Hussa hussab@pepperlaw.com 1 Prior issues of Pepper s Tax Update can be found on 2 Generally, to meet the requirement, CFC1 and CFC2 must be considered related persons that are created or organized in the same country and have a substantial part of their assets used in a trade or business located in the same foreign country. See generally Treas. Reg. Section (b)(4)(i). Subscribe to Future Issues Did someone forward you this newsletter? Receive an electronic or hard copy of the monthly newsletter directly by returning this form by , facsimile or by mail to be added to our mailing list or to update your information. Send to Pepper Hamilton llp, Hamilton Square, 600 Fourteenth Street, N.W., Washington, D.C , Attn: Homeira Ghorbani. (Fax or ghorbanih@pepperlaw.com) Name Title Company Address Phone Fax -4-

5 Foreign Bank Accounts and Multinational Corporations Are You Reporting Correctly? Schedule N of Form 1120 requires reporting of foreign bank accounts in which the domestic corporation has a financial interest or over which it has signing authority. Determining if the corporation has a financial interest may not be intuitive. Failure to report the account, and failure to file the disclosure required on form TD F can lead to significant monetary and potential criminal penalties. Corporate Reporting On an annual basis, a U.S. corporation that has a financial interest in or signing authority over a non-u.s. financial account that exceeds $10,000 is required to file a form TD F by June 30 for the prior year. The corporation also is obligated to disclose the same information on Schedule N of form The disclosure on Schedule N does not excuse the filing of form TD F , and the filing of the form does not excuse disclosure on Schedule N. The law with respect to the reporting is sparse. 1 Most of the requirements are developed through the instructions to the form. The definition section of form TD F provides that a U.S. corporation has a financial interest in each foreign financial account for which such corporation is the owner of record or has legal title. That s pretty obvious. What s less obvious is that a U.S. corporation has a financial interest in any foreign financial account in which the owner of record title is a subsidiary in which the U.S. corporation owns, directly or indirectly, a more than 50 percent interest (a 50 percent subsidiary). 2 Thus, a U.S. corporation with a more than 50 percent owned foreign subsidiary needs to report on the form TD F the non-u.s. financial accounts held by the foreign subsidiary, whether or not the U.S. corporation has signing power over the account. The ownership test is direct or indirect, so if the top-tier foreign subsidiary has subsidiaries of its own, and they have non-u.s. financial accounts, the U.S. corporation needs to report those as well. There is a provision for consolidated reporting a U.S. corporation may file a consolidated report on behalf of itself and any entities in which it owns a more than 50 percent interest, thereby relieving the other U.S. subsidiaries of the obligation to file a report. If the U.S. corporation has a financial interest in more than 25 non-u.s. bank accounts, either directly or indirectly, it may note the total number of accounts on line 20 of the form and omit the information otherwise required by Part II of the form. Compliance with this section, however, also requires that the U.S. corporation maintain records of the information otherwise includible in Part II of the form so that such information is available upon request of the IRS. The information required by Part II of the form includes the type of account, the maximum value of the account, the account number, the name of the financial institution with which the account is held and the country in which the account is held. Individual Reporting The rules require that a U.S. individual report an interest in a foreign bank account if he or she has signing authority over the account or has a financial interest in the account. The reporting obligation of a U.S. individual that has signing authority over a foreign financial account is that person s individual obligation. The form TD F needs to be filed timely, and the individual has to disclose the authority or interest on Schedule B of form There is an exception, however, to this individual obligation that is applicable to officers and employees of certain corporations. The exception provides that officers and employees of a domestic corporation are not required to file Form TD if: 1. the domestic corporation has equity securities that are listed on a national securities exchange or has assets exceeding $10 million and 500 or more shareholders of record, 2. the officer or employee has no personal financial interest in the account (that is, he is not free to withdraw money for his personal use), and -5-

6 3. the officer or employee has been advised in writing by the chief financial officer of the corporation that the corporation has filed a current report that includes that account. 3 In order to relieve its officers and employees from their reporting requirements, the U.S. corporation must provide the information required in Part II of the form. Consequently, relieving its officers and employees of the individual obligation to report signature authority requires that the U.S. corporation not elect to use the exception for corporations with a financial interest in more than 25 foreign financial accounts as to the account over which the individuals have signing authority. Endnotes 1 The law requiring the disclosure is found at 31 CFR The rules test whether the corporation owns a more than 50 percent interest in a subsidiary corporation by reference to the value of the subsidiary corporation. 3 This exception also covers those officers and employees of a domestic subsidiary regarding which the reporting corporation has filed a consolidated report. The reporting corporation must notify these officers and employees, in writing, that it has filed a current report that includes the respective accounts. Penalties There is a $10,000 penalty for the failure to disclose the signing authority or financial interest in the non-u.s. financial account if the $10,000 threshold is met, whether or not the failure was willful. It can be abated if there is reasonable cause for the failure to report, but the burden of showing reasonable cause is on the taxpayer. If the failure to disclose and file the form TD F is willful, there is a civil penalty of at least $25,000, and up to the greater of $100,000 or 50 percent of the amount in the account. The willful failure is also a misdemeanor. It may be elevated to a felony if the failure occurs while also engaging in illegal activities involving transactions of more than $100,000 in a 12-month period. If the violation is found to be part of a pattern of illegal activity, the fine can increase to $500,000 and jail time of up to 10 years. Finally, if a taxpayer files a tax return or form TD F on which he states that he does not have an interest in a non-u.s. financial account when he knows that he does, he has violated Code Section 7206(l) and may be subject to criminal prosecution. Author: Joan C. Arnold arnoldj@pepperlaw.com -6-

7 Pepper Hamilton llp Tax Practice Group Federal and International Tax Issues Annette M. Ahlers Joan C. Arnold James W. Barson Gordon R. Downing W. Roderick Gagné Howard S. Goldberg Benjamin M. Hussa Ellen McElroy* Lisa B. Petkun Todd B. Reinstein Joan M. Roll Leonard Schneidman Laura D. Warren Christian T. Wood R. D. David Young State and Local Tax Issues Philip E. Cook, Jr Lance S. Jacobs Charles L. Potter, Jr Employee Benefits Issues Jonathan A. Clark David M. Kaplan Andrew J. Rudolph Eric R. Stern *Admitted in Colorado only; supervision by principals of Pepper Hamilton llp who are members of the DC Bar. For more information about any of our tax professionals listed, please visit our Web site, The material in this publication is based on laws, court decisions, administrative rulings and congressional materials, and should not be construed as legal advice or legal opinions on specific facts. Berwyn Boston Detroit Harrisburg New York Orange County Philadelphia Pittsburgh Princeton Washington, D.C. Wilmington 2007 Pepper Hamilton llp. All Rights Reserved. This publication may contain attorney advertising. -7-