Much of the focus of Tax Cuts and Jobs Act (“TCJA” or the “Act”) discussions has been squarely on the international pieces of the Act. Some early attention had been paid to new and modified domestic rules, but it may be fair to say that those discussions were generally framed in the purely domestic context. The thought appeared to be—there are international provisions and there are domestic provisions, and rarely shall the twain meet. In actuality, while the international provisions of the TCJA are daunting in and of themselves, those rules frequently require careful consideration of their interaction with numerous other areas of the Internal Revenue Code.
The ultimate goal of this installment of our Fundamentals of Tax Reform series is underscoring the need for multidisciplinary coordination in fully exploring the various planning considerations presented by the new international tax rules. We do so by debunking five myths arising from the domestic provisions of the TCJA and their interaction with the Act’s international provisions.
Myth #1: Section 199 is Dead
To paraphrase Mark Twain, the rumors of the death of IRC Section 199 are somewhat exaggerated (at least for now). True, the domestic production activities deduction (DPAD) is no more, effective for tax years beginning after 2017. Importantly, however, the DPAD is (or was) not an accounting method. As such, taxpayers can still claim the DPAD benefit for any open tax year through the filing of an amended return.
Taxpayers who had to pay the “transition tax” of IRC Section 965 for the 2017 tax year may be on the lookout for ways to at least partially offset that unexpected tax cost. Former IRC Section 199 may be one avenue for doing so. Understanding the basic framework of former IRC Section 199 will be useful in at least surveying the potential benefits remaining in prior tax years to determine whether this is a potentially fruitful avenue to explore in greater depth.
At a high level, IRC Section 199 provided a tax deduction equal to a specified percentage of the lower of the taxpayer’s net income from qualifying domestic production activities during the tax year or its taxable income for that year. The deduction was capped at one-half of the taxpayer’s production related W-2 wages. The IRC Section 199 benefit is maximized by identifying all qualifying revenue streams from eligible activities (domestic production gross receipts, or DPGR) and/or by minimizing the expenses that must be subtracted from those gross receipts to compute the taxpayer’s qualifying net income (its qualifying production activities income, or QPAI).
DPGR could derive from a wide range of domestic activities, including the manufacture, production, growth, or extraction (MPGE) of tangible personal property, software, or sound recordings. Qualifying gross receipts also could arise from dispositions of certain films as well as from the sale of electricity, natural gas, or potable water, as well as from construction, engineering, and architectural services.
Computing the DPAD required subtracting from DPGR the expenses incurred in producing those gross receipts. Allocable expenses generally were those treated as production costs under IRC Section 263A, as well as those allocated and apportioned to the taxpayer’s DPGR using the principles of IRC Section 861. The taxpayer compared the resulting QPAI with its taxable income, and except for oil and gas related activities, computed the DPAD for 2017 as 9 percent of the lower of those two amounts.
The benefits of former IRC Section 199 could be substantial for taxpayers. In some cases, however, due to the manner in which IRC Section 199 was phased in beginning in 2005, some taxpayers took a “back of the envelope” approach to their initial IRC Section 199 computations, and never followed that up with a more comprehensive scrub of potentially qualifying revenue streams and/or more advantageous expense allocation methodologies. As a result, quite a few taxpayers never fully maximized the permanent tax savings offered by IRC Section 199.
The potential DPAD benefit left on the table in prior years may now provide an unexpected “nest egg” that can be recouped to offset at least a portion of the transition tax arising from IRC Section 965. As a result, notwithstanding that IRC Section 199 has been repealed beginning in 2018, one final scrub of the company’s IRC Section 199 position (including both revenue streams and expense allocations) for 2017 and earlier open tax years may be in order.
Myth #2: ‘Full Expensing’ Temporarily Eliminates the Need for Fixed Asset Reviews
Notwithstanding the ability to claim 100 percent bonus depreciation on many types of depreciable property placed in service through 2022, fixed asset reviews will continue to play an important role in the company’s international tax planning.
First, “qualified business asset investment”—QBAI—plays a central role in computing the company’s foreign derived intangibles income (FDII) under IRC Section 250 as well as its global intangible low-taxed income (GILTI) liability under IRC Section 951A. Detailed discussions of the mechanics of computing FDII and GILTI may be found in previous articles in this Fundamentals series. For purposes of both provisions, QBAI is defined as the average of the company’s aggregate adjusted tax bases in certain tangible property as of the close of each quarter of a tax year, computed using the alternative depreciation system (ADS) of depreciation. At a high level, in computing the FDII benefit, the taxpayer will want to minimize its aggregate tax basis in tangible property (thereby minimizing QBAI-based amounts pulled out of potential FDII benefits, into income taxed at the normal 21 percent rate), while in computing its GILTI, it will want to maximize that tax basis (consequently maximizing QBAI-based amounts pulled out of potential GILTI liability, and into participation exemption).
FDII and GILTI both rely heavily on the QBAI concept, but there is not complete overlap. In computing FDII, QBAI looks to the tangible property of domestic corporations claiming the IRC Section 250 deduction. On the other hand, QBAI for GILTI purposes looks to the depreciable property owned by controlled foreign corporations (CFCs). Related companies may each select their own tax accounting methods. For this purpose, the assignment of Modified Accelerated Cost Recovery System (MACRS) lives to individual assets is treated as an accounting method, meaning that MACRS determinations made by one entity should not bind the determinations made by other, related entities. Nonetheless, holistically reviewing a global enterprise’s approach to QBAI determinations may be prudent.
Given the central importance of QBAI, international practitioners seeking to balance these as well as other related tax provisions may benefit from close consultation with practitioners well-versed in the nuances of IRC Section 168 and related depreciation authorities. A careful review of the manner in which the company determines the MACRS class lives of production-related assets may directly affect the average aggregate basis of its depreciable assets in a given year. A shorter class life will reduce and eventually eliminate an asset’s tax basis (shrinking QBAI—beneficial for FDII) much faster. The converse obviously results from an asset having a longer MACRS class life, preserving tax basis (maximizing QBAI—beneficial for GILTI) over a more prolonged period.
While taxpayers do not have unfettered discretion in assigning an asset’s MACRS class life, carefully reviewing the company’s fixed asset records may reveal misclassifications whose correction through an accounting method change might directly impact the company’s QBAI (and hence its FDII or GILTI positions) for a given period. At the same time, because the 100 percent “bonus depreciation” available for certain categories of assets through 2022 will effectively eliminate any tax basis for many new acquisitions, carefully analyzing how the bonus depreciation rules apply to new acquisitions is an equally important component of the taxpayer’s FDII planning. (Bonus depreciation generally is unavailable for property predominantly used outside the United States, reducing its importance for GILTI planning.)
An additional wrinkle is that some taxpayers might have to add back to their fixed asset ledgers assets that have already been fully depreciated under the MACRS general depreciation system (and so removed from the taxpayer’s accounting system), but that would have remaining depreciable basis under the longer recovery periods and straight-line recovery method required by ADS. Identifying and placing these assets back on the tax books might prove challenging in many cases.
The bottom line is that a thorough fixed assets review by practitioners well versed in the nuances of this area is a critical element of TCJA planning.
Another area where depreciation schedules are critical is the base erosion anti-abuse tax (BEAT, addressed in the second article of the Fundamentals series). One type of base erosion tax benefit targeted by the BEAT is depreciation or amortization of assets acquired from related foreign persons. Very generally, BEAT liability arises when and to the extent that depreciation or amortization is taken on the U.S. acquiror’s tax return. The respective tax benefits (or costs) will vary depending on a person’s tax profile in one year versus another. Careful consideration must be given to whether the taxpayer would benefit more from a larger current depreciation deduction that might, e.g., edge the taxpayer over the BEAT application threshold or accelerate expenses into tax years to which lower BEAT rates apply or, alternatively, from deferring depreciation to later years to allow more time for BEAT mitigation planning. A fixed asset analysis should take all of the various, and potentially conflicting, domestic and international tax considerations into account when determining the strategic direction any given taxpayer should take.
Myth #3: CFCs Are Unaffected by the Revisions to Section 451
The TCJA profoundly changed the manner in which taxpayers recognize income for federal tax purposes under IRC Section 451. Historically, as the Supreme Court affirmed in Thor Power Tool Co. v. Commissioner, a taxpayer’s treatment of an item of income or expense for tax purposes is not determined by its financial accounting treatment of the item. In other words, even though tax and books might reach similar results, the methods required for determining when to accrue income for purposes of tax and books are not identical. Although as a practical matter more than a few companies historically have done so, tax generally cannot simply “follow books.”
For tax purposes, an accrual method taxpayer recognizes income under the all events test of IRC Section 451 only when all of the events fixing the taxpayer’s right to the income have occurred, and the amount of that income is reasonably determinable. The two-pronged all events test generally is satisfied upon the earlier of the income item being earned, due, or received. The timing of that revenue inclusion for book purposes historically has not determined the tax treatment.
This bedrock principle of federal tax accounting changed with the TCJA amendments to IRC Section 451. Under revised IRC Section 451(b), the all events test is now satisfied no later than the tax year in which an item of income is taken into account as revenue for financial accounting purposes—regardless of when the two-prong all events test would otherwise have been satisfied under prior law. As a result, in some sense, tax now does follow books in determining when to recognize income. This conformity only operates in one direction, though. The book treatment of an item might accelerate the income for tax purposes, but will not defer tax recognition past the year in which the all events test is otherwise satisfied, even if books does so.
Importantly, the new book conformity requirement does not change how a taxpayer determines when to deduct an item of expense. The TCJA did not modify the all events test or the economic performance requirement IRC Section 461, preserving the independence of tax and book methods for purposes of accruing expenses. Thus, even if books accelerates the recognition of an expense item, the timing of that deduction for tax purposes remains subject to the long-standing tax rules.
This new rule for accruing income is as important for CFCs as it is for domestic corporations. CFCs are subject to the same tax accounting rules that apply to domestic corporations. Failure to use a “proper” accounting method once the CFC’s earnings and profits have become significant (or relevant) can have significant consequences. As a result, CFCs also need to pay close attention to this new book conformity requirement.
In doing so, CFCs need to keep in mind recent changes in the financial accounting requirements for recognizing revenue from customer contracts. The new so-called “revenue recognition” or “rev rec” rules are applicable to corporations using either generally accepted accounting principles (GAAP) or International Financial Reporting Standard (IFRS). In many cases, the new standard will require recognizing contract revenue earlier for financial accounting purposes than might have been the case under the prior book standards. As such, all CFCs earning revenue from customer contracts already should have reviewed the extent to which, if any, the new standard will accelerate the recognition of revenue for book purposes. That review presumably included identifying the extent to which—if any—the company’s federal income tax accounting methods were affected by the change in financial accounting treatment of customer revenue.
Prior to the TCJA, many companies whose tax methods were not tied to their financial accounting methods (i.e., the company’s tax methods did not follow books) concluded that their tax treatment of income items was unchanged, regardless of the acceleration of that revenue for book purposes. Many of those companies may also have permanently reinvested their foreign earnings, leaving their CFCs’ income largely untested. The TCJA amendments to IRC Section 451, however, place a premium on reexamining that conclusion, particularly as the new GILTI rules will result in current inclusion of a much larger portion of CFC income than ever before. Now, if books recognizes revenue in an earlier year under the new rev rec standards, the tax department needs to be aware of that acceleration and conform its treatment for federal income tax purposes—regardless of whether tax otherwise follows books.
Because CFCs are subject to the same tax accounting rules as are domestic corporations, they too must develop a strategy for complying with this federal tax accounting requirement. Particularly for large companies in which CFCs and domestic entities may be within separate parts of the tax organization, the company must develop a plan for ongoing coordination between the domestic tax, international tax, and financial accounting groups. Doing so allows the tax department to understand which current revenue items are being affected by the new rev rec standard and may now require changing the company’s tax accounting method for that item. Such coordination also allows the tax department to know how books will account for new revenue streams in the future.
The TCJA’s new income recognition standard creates significant hazards for companies unaware of the new requirement as well as for tax departments not working closely enough with their financial accounting counterparts. Lack of coordination can result in an understatement of the company’s taxable income for the tax year into which books accelerates the revenue. In addition, because the company’s pre-TCJA tax accounting method may no longer be “proper,” not following the Internal Revenue Service’s accounting method change procedures to conform to the new tax requirements risks having the IRS impose that method change on audit. Such “involuntary” method changes are imposed on much less favorable terms and conditions than are available through the “voluntary” method change process.
Myth #4: In Computing BEAT, COGS Is a Static Concept—It Is What It Is
While a company’s cost of goods sold (COGS) is governed by a number of complex provisions of the Code and regulations, it is not immutable. Instead, carefully reviewing the company’s current inventory accounting practices might identify a number of options for optimizing COGS for BEAT purposes.
Preliminarily, it is important to recognize costs that are never COGS. As its name clearly states, COGS is the company’s costs incurred in selling goods. Despite a common misunderstanding by some who do not work in this area frequently, COGS does not include a company’s costs of providing services.
Excluding the cost of providing services from COGS is unavoidable, regardless of the perceived inequity of providing preferential treatment under IRC Section 59A to companies engaged in the sale of goods as compared to those engaged in providing services. Instead, a company’s costs of providing services—including labor, overhead, and incidental materials and supplies provided ancillary to services—generally are deductible as ordinary and necessary business expenses. Unlike production or acquisition costs incurred by manufacturers and retailers (for example), most costs incurred in a service business generally cannot be capitalized as production costs and recovered as COGS through an inventory accounting method. A limited exception may be available for service providers who also sell merchandise as an adjunct to their service business (for example, the sale of caskets by funeral homes).
Companies producing or reselling goods likely already are familiar with at least the basic mechanics of computing COGS. The uniform capitalization rules of IRC Section 263A (UNICAP) apply to companies engaged in producing real or tangible personal property, or in acquiring for resale any real or personal property. Those rules require the taxpayer to capitalize as production costs not only the direct costs of labor and materials, but also an allocable portion of any indirect costs incurred in producing or acquiring the goods (some of which are referred to as “service costs,” but not to be confused with a service provider’s costs of doing business). Production costs capitalized by IRC Section 263A eventually are recovered as COGS through the company’s inventory accounting method (such as LIFO or FIFO) as the goods are sold or otherwise disposed of.
The UNICAP regulations provide a number of alternative methodologies by which a taxpayer can determine how much of its indirect costs relate to production or resale activities and must be recovered through COGS rather than deducted currently. These include several allocation methods of varying degrees of specificity, the results of which may differ (i.e., some methods treat a larger percentage of indirect costs as production costs than do others). Historically many taxpayers elected UNICAP allocation methods by reference to the relative simplicity of the method compared to the amount of costs that the method would require to be capitalized rather than recovered immediately.
Previously, most taxpayers sought to minimize the amounts capitalized as UNICAP costs, preferring instead to currently deduct those items rather than potentially deferring their recovery until some point in the future. The advent of BEAT, however, changes that calculus, by converting the choice of allocation method from “just timing” into a decision affecting a permanent tax item. As such, given the complexity and arcane rules embodied in the UNICAP and inventory accounting area, comprehensive BEAT planning requires close coordination with practitioners well-versed in these areas to review the pros and cons of the alternatives as well as making any accounting method changes that may be required to implement the approach chosen.
Second, a company potentially can adjust its COGS by reviewing its classification of specific expenditures either as production costs or as current expenses under its existing UNICAP methods. Such a review frequently identifies costs that the taxpayer should have been treating as a production cost rather than as a current expense (or vice versa). Changing the taxpayer’s UNICAP computational methodology (such as changing the taxpayer’s methodology for allocating indirect costs) generally requires IRS consent through the accounting method change process. Simply changing the “geography” of a particular expenditure from being a below-the-line deduction to an above-the-line COGS element arguably does not require IRS consent if the change does not affect the timing of any item of income or expense. The IRS view, however, is that some timing element is likely impacted even by such a change in return geography, and so generally is a method change requiring IRS consent.
Myth #5: All Royalties Are COGS, or No Royalties Are COGS
A common pitfall in identifying COGS for BEAT purposes is the search for a one-size-fits-all conclusion for various categories of expenditures. One type of cost in particular—royalties—presents this temptation.
Whether a royalty is a production cost that will be recovered through COGS or instead as a current expense is determined using the same UNICAP standards as any other cost. The crucial question is whether the royalty “directly benefits or is incurred by reason of” a production activity (using “production” loosely to include any activity within the scope of the UNICAP rules). If so, the royalty is a production cost to be recovered as COGS. If, on the other hand, the royalty is strictly a function of the company’s post-production sales or marketing activities, it is not related to production and cannot be included in COGS.
One type of royalty in particular seems to cause confusion—so-called “sales-based royalties.” Some practitioners infer from its description that any such royalty relates to the company’s sales activity, rather than to its production activity, and as such cannot be included in COGS. The Second Circuit’s decision in Robinson Knife Mfg. Co. v. Commissioner, contributes to that confusion, notwithstanding that the IRS effectively nullified the applicability of that case by amending the UNICAP regulations shortly after it was decided. Treasury Regulation Section 1.263A-1(e)(3)(i); Treas. Reg. Section 1.263A-1(e)(3)(ii)(U).
As a practical matter, many royalties are referred to as “sales-based” royalties because the royalty affixes only at the time of sale or is computed by reference to the number of units sold or the selling price of those units. Even in those situations, however, if the royalty “directly benefits or is incurred by reason of” a production activity, the royalty is a production cost that must be recovered through COGS. As a result, whether a royalty can be included in COGS depends on its role in the enterprise’s overall business, rather than what it is called or how it is computed.
For example, assume that a domestic manufacturer licenses from its foreign parent a particular formula to be used in producing the company’s product. The item cannot be manufactured without the formula. The manufacturer owes the foreign parent a stated amount for each unit sold, irrespective of how many are produced. Because the royalty is incurred in order to secure the ability to use the formula in the manufacturing process, the royalty directly benefits and is incurred by reason of the production process. As such, it must be capitalized as a production cost and recovered through COGS in accordance with the manufacturer’s inventory method of accounting.
On the other hand, assume the same manufacturer pays a royalty to the foreign owner of certain comic book characters. The manufacturer secures the right to use the image of the comic book characters in its print and broadcast advertising. In that case, because the royalty is incurred by reason of the manufacturer’s sales and marketing activities—rather than its production activities—the costs are deducted currently as advertising expenses, and cannot be included in COGS.
The UNICAP regulations apply a special rule to sales-based royalties capitalized as production costs. The special rule has particular relevance for BEAT planning purposes. As a general rule, once the UNICAP rules determine that a cost must be capitalized as a production cost, the taxpayer’s inventory accounting method (e.g., LIFO, FIFO) then applies to determine how much of that capitalized cost is recovered in the current year, as opposed to remaining capitalized as a cost of the inventory remaining on hand at year end. Under a special rule, however, sales-based royalties treated as production costs under the UNICAP rules are immediately recovered in full as COGS in the same year. Treas. Reg. Section 1.263A-1(e)(3)(ii)(U)(2). This creates a best-of-both-worlds situation for BEAT purposes. UNICAP declares the production-related sales-based royalty to be COGS—producing a favorable result for BEAT purposes—while also allowing immediately recovery of the entire amount.
The fundamental changes made by the TCJA to the international tax regime are many and complex. As with so much in the tax code, however, they are best understood and comprehensively analyzed through close consultation with practitioners in various other disciples with which they intersect. This discussion has offered just five of the many ways in which the international and domestic provisions intersect in light of the TCJA as a means of demonstrating the synergies to be gained from taking a multidisciplinary approach to the new international tax provisions.
Kimberly Majure is a principal with the international tax group of the Washington National Tax practice of KPMG LLP and also serves as the inbound tax services lead for KPMG U.S.; she is based in the firm’s Washington, D.C. office.
James Atkinson is a principal at KPMG LLP. He practices in the area of federal income taxation, with a focus on federal tax accounting issues.