Rev. Proc. 79-39

Section 1. Purpose

The purpose of this Revenue Procedure is to amplify and clarify Rev. Proc. 77-19, 1977-1 C.B. 584, to reflect the following with respect to certain controlled foreign corporations: (1) the time for filing Form 3115 (Application for Change in Accounting Method) to change to the "full absorption" method of inventory costing; and (2) the year of change.

Sec. 2. Background

.01 Rev. Proc. 77-19 sets forth procedures to be followed in applying the full absorption method of inventory costing rules of section 1.471-11 of the Income Tax Regulations in determining the earnings and profits of a controlled foreign corporation, as defined in section 957(a) of the Internal Revenue Code of 1954.

.02 Section 1.471-11 of the regulations provides rules for the costing of inventories by manufacturers and processors. Section 1.471-11(a) provides, in part, that in order to conform as nearly as may be possible to the best accounting practices and to clearly reflect income, both direct and indirect production costs must be taken into account in the computation of inventoriable costs in accordance with the full absorption method of inventory costing.

.03 Section 1.471-11(e)(1)(i) of the regulations provides, in part, that a taxpayer not using the full absorption method of inventory costing must change to that method.

.04 Section 1.471-11(e)(1)(ii) of the regulations provides a special election during a 2-year transitional period in which a taxpayer may request to change to the full absorption method of inventory costing and elect to take any adjustment required by section 481 of the Code with respect to any inventory being revalued under the full absorption method into account ratably over a period designated by the taxpayer at the time of election, not to exceed the lesser of 10 taxable years commencing with the year of change or the number of taxable years the taxpayer has been on the method from which the taxpayer is changing. Section 1.471-11(e)(3)(i). If such taxpayer uses the LIFO method of inventory identification it may either employ the transition rules of section 1.471-11(e)(3)(i) or a cut-off method. Section 1.471-11(e)(3)(ii) and Rev. Proc. 74-21, 1974-2 C.B. 475.

.05 The special election was provided in section 1.471-11(e) of the regulations to encourage taxpayers to voluntarily change to the full absorption method of inventory costing. In order to employ the transition procedures and adopt the transition benefits provided in that section of the regulations, a taxpayer was required to make the general election during the first 180 days of any taxable year beginning on or after September 19, 1973, and before September 19, 1975. However, under Rev. Proc. 75-34, 1975-2 C.B. 560, as clarified by Rev. Proc. 75-40, 1975-2 C.B. 571, as modified by Rev. Proc. 75-53, 1975-2 C.B. 594, the time for requesting the change to the full absorption method of inventory costing and to use the transition procedures was extended until January 27, 1976, or the end of the 180-day period referred to in section 1.471-11(e)(1)(ii), whichever was later.

.06 Section 1.964-1(a) of the regulations provides, in part, that, for purposes of sections 951 through 964 of the Code, the earnings and profits of a foreign corporation shall be determined under rules substantially similar to those applicable to domestic corporations.

.07 Section 1.964-1(a)(1), (2), and (3) of the regulations prescribes the procedures to be followed in computing a foreign corporation's earnings and profits. Section 1.964-1(a)(1) requires that a profit and loss statement be prepared from the books of account regularly maintained by the corporation for the purpose of accounting to its shareholders; section 1.964-1(a)(2) requires the making of adjustments necessary to conform such statement to accounting principles described in section 1.964-1(b); and section 1.964-1(a)(3) requires the making of further adjustments necessary to conform such statement to the tax accounting standards described in section 1.964-1(c).

.08 Section 1.964-1(c)(1)(ii) of the regulations provides that inventories shall be taken into account in accordance with the provisions of sections 471 and 472 of the Code and the regulations thereunder.

.09 Section 1.964-1(c)(1)(iv) of the regulations provides, in part, that effect shall be given to any election made in accordance with an applicable provision of the Code and the regulations thereunder and these regulations (regulations under section 964 of the Code).

.10 Section 1.964-1(c)(6) of the regulations provides, in part, that notwithstanding any other provision of section 1.964-1(c), action by or on behalf of a foreign corporation (other than a foreign corporation subject to tax under section 882 of the Code) to make an election or adopt a method of accounting shall not be required until 180 days after the close of the first taxable year for which one of the significant events enumerated therein occurs. Where the action necessary to make an election or to adopt a method of accounting is undertaken by or on behalf of the foreign corporation in accordance with this subparagraph, such election shall be deemed to have been made, or such adoption of accounting method effected, for the first taxable year of the foreign corporation beginning after December 31, 1962, in which such corporation is a controlled foreign corporation.

.11 Section 1.902-1(g)(1) of the regulations provides, in part, that for purposes of section 902 of the Code, the earnings and profits of a foreign corporation for any taxable year beginning after December 31, 1962, other than a taxable year to which section 963 applies, may be determined, under the rules provided by section 1.964-1(a) thru (c).

.12 Rev. Proc. 75-40 sets forth certain procedures to be used by the Internal Revenue Service with respect to taxpayers that are changing to, or have changed to, the full absorption method of inventory costing under section 1.471-11(e) of the regulations and that, under their proposed method of full absorption costing, have or will exclude from inventoriable costs any or all of the indirect production costs listed in or subject to section 1.471-11(c)(2)(iii). Specifically, that Revenue Procedure requires certain representations to be made for the purpose of determining whether or not the proposed treatment of indirect production costs under section 1.471-11(c)(2)(iii) is inconsistent with generally accepted accounting principles.

.13 Rev. Proc. 77-19 provides that in the case of a controlled foreign corporation not engaged in a trade or business within the United States that has had a significant event within the meaning of section 1.964-1(c)(6) of the regulations, although the period prescribed in section 1.471-11(e)(1)(ii) (as extended by Rev. Proc. 75-40 and Rev. Proc. 75-53) for making an election to change to the full absorption method of inventory costing pursuant to section 1.471-11(c)(1)(ii) has expired, the Internal Revenue Service would accept Form 3115 making such election filed by or on behalf of a foreign corporation until 120 days after June 13, 1977. In IR-1892, the Internal Revenue Service announced an extension of time for filing Form 3115 requesting consent for a controlled foreign corporation to change to the full absorption method, until 60 days after a Revenue Procedure explaining the necessary procedures was issued.

Sec. 3. Application

.01 Whenever earnings and profits of a foreign corporation engaged in manufacturing or processing operations are determined under the rules provided by section 1.964-1 of the regulations, the mandatory provisions of section 1.471-11(e)(1)(i) are applicable.

.02 Section 1.471-11(e)(1)(i) of the regulations requires taxpayers not using the full absorption method of inventory costing to change to that method. However, such regulations do not specify the time when a controlled foreign corporation not engaged in a trade or business in the United States must change.

.03 Section 1.964-1(c)(6) of the regulations deals specifically with the time to make an election or to adopt a method of accounting by foreign corporations (other than those subject to tax under section 882 of the Code). That regulation authorizes the deferral of the making of such an election or the adoption of the method until 180 days after the close of the first taxable year in which a significant event occurs.

.04 Where the earnings and profits of a foreign corporation are determined under the rules provided by section 1.964-1 of the regulations, if, pursuant to section 1.964-1(c)(6), such foreign corporation has adopted, before the date of the publication of this Revenue Procedure, a method of accounting for inventory costing for federal income tax purposes for a taxable year beginning before September 19, 1973, a request may be made by or on behalf of such corporation to change to the full absorption method of inventory costing by filing a Form 3115 with the Commissioner, Attention T:C:C, Washington, D.C. 20224, within 120 days after the date this Revenue Procedure is published in the Internal Revenue Bulletin.

.05 For the situation described in section 3.04 above, a timely filed Form 3115 will be considered an indication that the foreign corporation desires to change to the full absorption method of inventory costing under the transition rules of section 1.471-11(e) of the regulations beginning with the foreign corporation's first taxable year ending after the date this Revenue Procedure is published in the Internal Revenue Bulletin.

.06 Under the transition rules of section 1.471-11(e) of the regulations, for purposes of computing earnings and profits, a foreign corporation described in sections 3.04 and 3.05 above, may elect to take any adjustment computed under section 481 of the Code with respect to any inventory being revalued under the full absorption method into account ratably over a period commencing with the year of change not to exceed the lesser of (a) 10 taxable years or (b) the number of years the foreign corporation has been on the method from which it is changing.

.07 In applying the transition rules of section 1.471-11(e) of the regulations, for purposes of computing earnings and profits, a foreign corporation described in sections 3.04 and 3.05 above, may, in lieu of applying section 3.06 above, elect to compute any adjustment with respect to any inventory being revalued under the full absorption method by applying the principles of section 481(b)(2) of the Code in the manner set forth below. This election may be made only where the adjustment computed under section 481(a) would otherwise increase earnings and profits by more than $3,000. Under this election the section 481(a) adjustment shall be reduced for purposes of sections 1248, 952(a) and 952(c) by the portion attributable to prior taxable years with respect to which the earnings and profits are not taken into account under the particular section for which earnings and profits are being determined. For example, for purposes of determining earnings and profits under section 1248, the reduction of the section 481(a) adjustment, with respect to a foreign corporation that has been a controlled foreign corporation continuously since its first taxable year beginning after December 31, 1962, shall be an amount equal to the portion of the section 481(a) adjustment attributable to taxable years beginning before January 1, 1963. The resulting modified section 481(a) adjustment for these particular purposes shall be treated as includible in full in the year of change unless the Commissioner determines that a distortion of earnings and profits would result. If the Commissioner so determines, then the adjustment shall be taken into account ratably over a period commencing with the year of change, not to exceed the lesser of (a) 10 taxable years or (b) the number of years the foreign corporation has been on the method from which it is changing. For all other purposes the full section 481(a) adjustment shall be taken into account in the year of change, unless the Commissioner determines that a distortion of earnings and profits would result. If the Commissioner so determines, then the adjustment shall be taken into account ratably over a period commencing with the year of change, not to exceed the lesser of (a) 10 taxable years or (b) the number of years the foreign corporation has been on the method from which it is changing.

.08 Where the earnings and profits of a foreign corporation are determined under the rules provided by section 1.964-1 of the regulations, if, pursuant to section 1.964-1(c)(6), such foreign corporation has not adopted, before the date of the publication of this Revenue Procedure, a method of accounting for inventory costing for federal income tax purposes for a taxable year beginning before September 19, 1973, the transition rules of section 1.471-11(e) shall not apply, because such foreign corporation cannot be said to be electing to change to the full absorption method of inventory costing form any other method. Such foreign corporation must timely adopt the full absorption method of inventory costing, in order to conform as nearly as possible to the best accounting practices and to clearly reflect income.

.09 Where the earnings and profits of a foreign corporation are determined under the rules provided by section 1.964-1 of the regulations, if, pursuant to section 1.964-1(c)(6), such foreign corporation has not adopted a method of accounting for inventory costing for federal income tax purposes for a taxable year beginning before September 19, 1973, but has adopted a method of accounting for inventory costing for federal income tax purposes other than the full absorption method for a taxable year beginning after September 18, 1973, such foreign corporation must change to the full absorption method. In such case Rev. Proc. 70-27, 1970-2 C.B. 509, as modified by Rev. Proc. 74-51, 1974-2 C.B. 507, and clarified by Rev. Proc. 75-18, 1975-1 C.B. 687, shall apply. However, in applying the preceding sentence, the Commissioner may, within his discretion, provide that the adjustment computed under section 481 of the Code, is to be taken into account ratably over a period commencing with the year of change not to exceed the lesser of (a) 10 taxable years or (b) the number of years the foreign corporation has been on the method from which it is changing.

Sec. 4. Effect on Other Documents

Rev. Proc. 77-19 is amplified and clarified and, as amplified and clarified, is superseded.

Sec. 5. Inquiries

Inquiries in regard to this Revenue Procedure should refer to its number and be addressed to the Commissioner of Internal Revenue, Attention: T:C:C, Washington, D.C. 20224.