Recovery of FSC and ETI depreciation depends on basis and timing

Plain-English summary

Chief Counsel analyzed four scenarios involving depreciation allocated to exempt foreign trade income under the former foreign sales corporation regime or excluded extraterritorial income. Recovery depends on the asset, whether annual depreciation uses adjusted or unadjusted basis, and whether the asset's recovery period or useful life ends before or after the qualifying lease or license. A tangible asset depreciated from adjusted basis could recover all basis through depreciation when its lease ended before its recovery period, but an asset using an optional table based on unadjusted basis could not recover the exempt portion until disposition. When the recovery period or the income-forecast final year ended while the qualifying transaction remained in effect, the exempt portion of that final year's depreciation also remained until disposition. Changing when these amounts are recovered is a change in method of accounting because it changes timing rather than lifetime taxable income. The change is not on the automatic-change list, so a permissible change requires a nonautomatic Form 3115 under Revenue Procedure 2015-13.

Ruling snapshot

• Question: How are FSC- or ETI-related depreciation amounts recovered, and is changing their recovery timing an automatic accounting method change?
• Outcome: Advice given, results vary by scenario and permissible changes are nonautomatic
• Key authorities: IRC §§ 167, 168, 265(a)(1), 446(e), and 1016(a)(2); former IRC §§ 114(c) and 921(b); Rev. Procs. 87-57, 2015-13, and 2015-14

Full text (IRS public release)

           Office of Chief Counsel
           Internal Revenue Service
           memorandum
           Number: 201625011
           Release Date: 6/17/2016
           CC:ITA:B07:                              Third Party Communication: None
           POSTS-133386-15                          Date of Communication: Not Applicable

 UILC:     167.03-00

  date:    May 03, 2016

     to:   Associate Area Counsel-Los Angeles (Group 2), CC:LBI:CTM:LA:2
           -----------------------------

  from:    Branch Chief, Branch 7, Income Tax & Accounting, CC:ITA:B07


subject:   Request for advice with regard to calculation of depreciation

           This Chief Counsel Advice responds to your request for assistance. This advice may
           not be used or cited as precedent.

           ISSUES

              1) How is depreciation calculated under § 167 or § 168, or amortization calculated
                 under § 167, for an asset under either the foreign sales corporation (“FSC”)
                 regime or the extraterritorial income ("ETI") exclusion provisions?

              2) Is a change in when the depreciation or amortization of such an asset that is
                 allocated to the exempt foreign trade income under the FSC regime or is subject
                 to the ETI exclusion provisions is recovered a change in method of accounting
                 under § 446(e) of the Internal Revenue Code? If it is, is such a change covered
                 by the List of Automatic Changes in Rev. Proc. 2015-14, 2015-5 I.R.B. 450, for
                 which the automatic change procedures in Rev. Proc. 2015-13, 2015-5 I.R.B.
                 419, apply?


           CONCLUSIONS

              1) The determination of how depreciation is calculated under § 167 or § 168, or
                 amortization is calculated under § 167, for an asset subject to either the FSC
                 regime or ETI exclusion provisions hinges on: a) the type of asset, b) whether the
                 annual depreciation or amortization deductions are determined by using the
                 adjusted basis or unadjusted basis of the asset, and c) whether the asset’s
POSTS-133386-15                                      2

        recovery period or useful life ended before or after the end of the transaction(s)
        that qualified for FSC or ETI exclusion treatment, as applicable. Scenarios 1-4
        examine specifically how depreciation is calculated based upon how these three
        factors change.

    2) A change in when the depreciation or amortization of such an asset that is
       allocated to the exempt foreign trade income under the FSC regime or subject to
       the ETI exclusion provisions is recovered is a change in method of accounting.
       This change in method of accounting is not covered by the List of Automatic
       Changes in Rev. Proc. 2015-14 for which the automatic change procedures in
       Rev. Proc. 2015-13 apply.

FACTS

Scenario 1: A taxpayer had a wholly-owned subsidiary that qualified as a FSC under
former §§ 921–927. The FSC owned tangible property (“Asset A”) that it leased to an
unrelated, non-U.S. entity pursuant to a 4-year lease that was entered into on January
1, 1997, and ended on December 31, 2000.1 The contract that gave rise to the lease
did not include a purchase option, renewal option, or replacement option. Under
§ 1.923-1T(b)(1)(ii) and former §§ 923(a)(2) and 291(a)(4), the FSC treated 30 percent
of its foreign trade income as exempt foreign trade income not subject to taxation.
Pursuant to former § 921(b) and to § 265(a)(1), the FSC did not reduce its taxable
income by deducting expenses allocable to the exempt foreign trade income.

The taxpayer’s subsidiary placed in service Asset A, a depreciable tangible asset that
has a class life of 5 years, on January 1, 1997. The subsidiary depreciated this asset
pursuant to §§ 167(a) and 168(g). The subsidiary did not use the optional depreciation
tables pursuant to § 8 of Rev. Proc. 87-57, 1987-2 C.B. 687, and, thus, depreciated the
adjusted basis of Asset A in accordance with §§ 4, 5, and 6 of Rev. Proc. 87-57. The
recovery period of Asset A ended after December 31, 2000, which is the lease
expiration date.

For purposes of calculating taxable income, the subsidiary only deducted 70 percent of
Asset A’s total depreciation consistent with former § 921(b) and with § 265(a)(1). The


1
  For purposes of all four scenarios, assume that all requirements of the FSC regime or the ETI exclusion
provisions, as applicable, have been met, including that the transaction was properly characterized as a
lease, rather than as a financing or a service that would not qualify for either FSC or ETI treatment. See,
e.g., § 924(a) (limiting FSC treatment to certain sales, leases, and services) ; see also Tidewater Inc. and
Subsidiaries and Tidewater Foreign Sales Corporation v. United States, 565 F. 3d 299 (5th Cir. 2009),
aff'g No. 06-875, 2007 U.S. Dist. LEXIS 77147 (E.D. La. October 17, 2007), action on dec., 2010-22
(June 1, 2010) (IRS agreeing with the Fifth Circuit that § 7701(e) applies to determine a single character
for a transaction subject to the FSC regime, but nonacquiescing in the court’s determination under the
§ 7701(e) factors that the transaction at issue (a time charter of an ocean-going vessel) was a sublease
rather than a service).
POSTS-133386-15                              3

subsidiary did not deduct Asset A’s depreciation allocated to exempt foreign trade
income (i.e., the other 30 percent of the asset’s total depreciation).

The taxpayer timely filed a Form 3115, Application for Change in Method of Accounting,
requesting permission to change the subsidiary’s method of accounting for Asset A’s
depreciation allocated to exempt foreign trade income, beginning with the taxable year
beginning January 1, 2015 (year of change). The subsidiary owns Asset A as of
January 1, 2015, the first day of the year of change. Under the subsidiary’s present
method of accounting, the subsidiary determines the annual depreciation deductions of
Asset A under § 168(g) by reducing its unadjusted basis for both the depreciation
allocated to the non-exempt foreign trade income and the depreciation allocated to the
exempt foreign trade income. As a result, the depreciation of Asset A that is allocated
to the exempt foreign trade income (i.e., 30 percent of total depreciation) is not
recovered by the subsidiary until it disposes of Asset A. Under the subsidiary’s
proposed method of accounting, the subsidiary will determine the annual depreciation
deductions of Asset A under § 168(g) by reducing its unadjusted basis for only the
depreciation allocated to the non-exempt foreign trade income (i.e., 70 percent of the
total depreciation). As a result, the unadjusted basis of Asset A is fully recovered by the
subsidiary through depreciation deductions.

Scenario 2: The facts are the same as Scenario 1, except that the subsidiary used the
applicable optional depreciation table to determine the annual depreciation deductions
for Asset A pursuant to § 8 of Rev. Proc. 87-57.

Scenario 3: The facts are the same as Scenario 1, except that the lease was for 11
years and ended on December 31, 2007. Thus, Asset A’s recovery period ended prior
to December 31, 2007, which is the lease expiration date.

Scenario 4: A taxpayer owns a motion picture film that qualified for benefits under the
ETI exclusion provisions of former § 114. Under former §§ 114(a) and (b)
and 941(a)(1)(A), the taxpayer calculated ETI exclusions based on qualified foreign
trade income equal to 30 percent of its foreign sale and leasing income from the motion
picture film. Pursuant to former § 114(c), the taxpayer did not reduce its taxable income
by deducting expenses allocable to the extraterritorial income.

The taxpayer placed the film in service in 2003 and depreciated the film pursuant to the
income forecast method under § 167(g). The taxpayer licensed its motion picture film to
an unrelated, non-U.S. entity pursuant to a 15-year license that was entered into on the
film’s placed-in-service date in 2003. The contract that gave rise to the license did not
include a purchase option, renewal option, or replacement option. The taxable year
provided in § 167(g)(1)(C) ended prior to the expiration of the license.
POSTS-133386-15                                     4

For purposes of calculating taxable income, the taxpayer only deducted 70 percent of
the film’s total depreciation consistent with former § 114(c).2 The taxpayer did not
deduct the film’s depreciation subject to the ETI exclusion provisions (i.e., the other 30
percent of the film’s total depreciation).

The taxpayer timely filed a Form 3115 requesting permission to change its method of
accounting for the film’s depreciation disallowed under former § 114(c), beginning with
the taxable year beginning January 1, 2015 (year of change). The taxpayer owns this
film as of January 1, 2015, the first day of the year of change. Under the taxpayer's
present method of accounting, the adjusted basis of the film that is allocable to its
depreciation disallowed under former § 114(c) (i.e., the other 30 percent of the film’s
total depreciation) is not deducted until the taxpayer disposes of the film. Under the
taxpayer’s proposed method of accounting, the adjusted basis of the film that is
allocable to its depreciation disallowed under former § 114(c) will be recovered in
accordance with § 167(g)(1)(C).

LAW AND ANALYSIS

Issue 1

Section 167(a) provides that there is allowed as a depreciation deduction a reasonable
allowance for the exhaustion, wear and tear, and obsolescence of property used in a
trade or business or held for the production of income.

Section 167(c)(1) provides, in general, that the basis on which exhaustion, wear and
tear, and obsolescence are to be allowed in respect of any property is the adjusted
basis provided in § 1011, for the purposes of determining the gain on the sale or other
disposition of such property. See also § 1.167(g)-1 of the Income Tax Regulations.

Section 1011 provides, in general, that the adjusted basis for determining the gain or
loss from the sale or other disposition of property, whenever acquired, shall be the basis
(determined under § 1012 or other applicable sections of subchapters O, C, K, and P),
adjusted as provided in § 1016.

Section 1012 provides, in general, that the basis of property shall be the cost of such
property.

Section 1016(a)(2) provides, in part, that proper adjustment in respect of the property
shall be made for the exhaustion, wear and tear, obsolescence, amortization, and
depletion, to the extent of the amount: (A) allowed as deductions in computing taxable
income, and (B) resulting (by reason of the deductions so allowed) in a reduction for any

2
  The legislative history explained: “Because U.S. income tax principles generally deny deductions for
expenses related to exempt income, otherwise deductible expenses that are allocated to qualifying
foreign trade income generally are disallowed.” S. Rep. No. 106-416, p.6 (2000)
POSTS-133386-15                                    5

taxable year of the taxpayer's taxes under subtitle A of the Code, but not less than the
amount allowable under subtitle A of the Code or prior income tax laws.

In CBS Corp. v. United States, 105 Fed. Cl. 74 (2012), the petitioner had two wholly-
owned FSCs, each of which purchased an airplane and leased such airplane to an
unrelated third party. As such, 30 percent of the depreciation deductions taken by the
FSCs were allocable to exempt foreign trade income and were disallowed for purposes
of calculating taxable income. Later, each FSC sold its airplane to an unrelated third
party and calculated its gain by subtracting from the airplane’s basis both the
depreciation allocated to non-exempt foreign trade income and the depreciation
allocated to exempt foreign trade income. The petitioner then sought a refund, claiming
that it had incorrectly reduced the adjusted basis in the airplane by the depreciation
amounts allocated to exempt foreign trade income (but correctly reduced the adjusted
basis in the airplane by the depreciation amounts allocated to the non-exempt foreign
trade income).

Because the FSC regime allocated deductions to exempt foreign trade income and
because deductions allocable to tax-exempt income are disallowed under § 265(a)(1),
the court held that 30 percent of the aircraft’s depreciation deductions were not
“allowable” deductions under § 1016(a)(2). Thus, each airplane’s adjusted basis is not
reduced by the 30 percent of the airplane’s depreciation deductions allocated to exempt
foreign trade income under the FSC regime. Rather, the adjusted basis of each
airplane should be reduced under § 1016(a)(2) by only the 70 percent of the airplane’s
depreciation deductions allocated to non-exempt foreign trade income under the FSC
regime.

Both the FSC and ETI exclusion provisions provide tax benefits with respect to
foreign trading gross receipts. See generally former §§ 114; 921-927; and 941-943.
The FSC Repeal and Extraterritorial Income Exclusion Act of 2000 (“ETI Act”) repealed
the FSC provisions and enacted the ETI exclusion provisions. Pub. L. No. 106-519, 114
Stat. 2423, §§ 2 and 3 (2000). Section 5(a) of the ETI Act provides that the ETI
exclusion provisions generally apply to “transactions after September 30, 2000” (“ETI
effective date”). The legislative history further clarifies that the ETI exclusion provisions
are “effective for transactions entered into after September 30, 2000.” (emphasis
added). S. Rep. No. 106-416, p.20 (2000); see also §§ 2.02 and 6.03 of Rev. Proc.
2001-37, 2001-1 C.B. 1327. For purposes of the FSC and ETI exclusion
provisions, “transaction” means any sale, exchange, or other disposition; lease3 or
rental; and furnishing of services. Former §§ 927(d)(2)(A) and 943(b)(1).

Section 5(c)(1) of the ETI Act contains transition rules that delay the application

3
  As used in this memorandum, the term “lease” includes rentals, subleases, licenses, and sublicenses.
See § 1.924(a)-1T(a)(2) of the temporary Income Tax Regulations; see also S. Rep. No. 106-416, p.8
(“Gross receipts from the lease or rental of qualifying foreign trade property include gross receipts
from the license of qualifying foreign trade property.”).
POSTS-133386-15                                    6

of the ETI exclusion provisions to certain transactions notwithstanding the ETI effective
date. Section 5(c)(1) of the ETI Act provides in relevant part:

                In the case of a FSC (as so defined) in existence on
                September 30, 2000, and at all times thereafter, the
                amendments made by this Act shall not apply to any
                transaction in the ordinary course of trade or business
                involving a FSC which occurs—

                (A) before January 1, 2002. . . .

Section 5(c)(2) of the ETI Act allows a taxpayer to elect to apply the ETI exclusion
provisions to any transaction that would have been subject to the FSC provisions by
reason of § 5(c)(1) of the ETI Act. The § 5(c)(2) election applies on a transaction-by-
transaction basis and is “effective for the taxable year for which made and all
subsequent taxable years. . . .” See also § 6.04 of Rev. Proc. 2001-37.

The American Jobs Creation Act of 2004 (“AJCA”) generally repealed the ETI
exclusion provisions. Pub. L. No. 108-357, 118 Stat. 1418, § 101(a) and (b). Section
101(c) of the AJCA provides that the general repeal of the ETI exclusion provisions
“shall apply to transactions after December 31, 2004” (“ETI repeal date”).

The Service interprets the ETI effective date such that the FSC provisions
generally apply to transactions entered into before October 1, 2000, and the ETI
exclusion provisions generally apply to transactions entered into after September 30,
2000, subject to various other rules. Accordingly, in the case of a lease entered into
before October 1, 2000, that met all the requirements under the FSC regime, all of the
income received from that lease qualifies for FSC treatment regardless of when it is
received. Similarly, in the case of a lease entered into after September 30, 2000, but
before January 1, 2005,4 that met all the requirements under the ETI exclusion
provisions, all of the income received from that lease qualifies for ETI exclusions
regardless of when it is received (except in the case of a lease entered into before
January 1, 2002, which would not qualify for ETI exclusions unless an election is made
pursuant to § 5(c)(2) of the ETI Act and which, in the absence of such election, would
qualify for FSC treatment provided that all the requirements of the FSC regime are met).
The determination of when a sale or lease is entered into within the meaning of § 5(a) of
the ETI Act requires an analysis of the surrounding facts and circumstances on a case-
by-case basis.



4
 Notably, in the case of transactions entered into during 2005 or 2006 and not pursuant to a binding
contract meeting certain requirements, income from such transactions qualifies for only a reduced
exclusion and only to the extent that the income is recognized during those years. See Pub. L. No. 108-
357, 118 Stat. 1418, § 101(d).
POSTS-133386-15                             7

Scenarios 1, 2, and 3

The depreciation deduction provided by § 167(a) for tangible property placed in service
after 1986 generally is determined under § 168. This section prescribes two methods of
determining depreciation allowances. One method is the general depreciation system
in § 168(a) and the other method is the alternative depreciation system in § 168(g).
Under either depreciation system, the depreciation deduction is computed by using an
applicable depreciation method, recovery period, and convention.

Rev. Proc. 87-57 provides guidance in computing depreciation allowances for tangible
property under § 168. This revenue procedure describes the applicable depreciation
methods, applicable recovery periods, and applicable conventions that must be used in
computing depreciation allowances under § 168. Sections 2-7 of this revenue
procedure prescribe the manner of computing depreciation allowances. Section 8 of the
revenue procedure contains various tables that may be used by certain taxpayers in lieu
of computing allowances in the manner described in §§ 2-7.

Section 6.03 of Rev. Proc. 87-57 provides that the depreciation allowance for a full
taxable year (that is, a taxable year of 12 full months) is computed by applying the
applicable depreciation rate to the unrecovered basis of the property for each taxable
year. For this purpose, the unrecovered basis of the property is the cost or other basis
of the property adjusted for depreciation previously allowed or allowable and for all other
applicable adjustments under § 1016 or any other provision of law. The determination
of the applicable depreciation rate under each applicable depreciation method is
described in §§ 6.04 (declining balance method), 6.05 (straight line method), and 6.06
(declining balance method switching to straight line method) of Rev. Proc. 87-57.

Section 8 of Rev. Proc. 87-57 allows taxpayers to use optional depreciation tables in
computing annual depreciation allowances under § 168. Pursuant to § 8.01 of Rev.
Proc. 87-57, the optional depreciation tables may be used for any item of property
placed in service in a taxable year. Section 8.01 of Rev. Proc. 87-57 also provides that
for all items of property placed in service in a taxable year for which the optional
depreciation tables are not used, depreciation allowances must be computed in the
manner prescribed in §§ 2-7 of Rev. Proc. 87-57.

Section 8.02 of Rev. Proc. 87-57 provides that the optional depreciation tables specify
schedules of annual depreciation rates to be applied to the unadjusted basis of property
in each taxable year. If a taxpayer uses a table to compute the annual depreciation
allowance for any item of property, the taxpayer must use the table to compute the
annual depreciation allowances for the entire recovery period of such property.
However, a taxpayer may not continue to use the table if there are any adjustments to
the basis of the property for reasons other than (1) depreciation allowed or allowable or
(2) an addition or an improvement to such property that is subject to depreciation as a
separate item of property. Taxpayers use the appropriate table for any property based
POSTS-133386-15                                      8

on the depreciation system, the applicable depreciation method, the applicable recovery
period, and the applicable convention.

Under Scenarios 1, 2, and 3, the taxpayer had a wholly-owned subsidiary that was a
FSC. This subsidiary placed in service Asset A, a depreciable tangible asset, on
January 1, 1997, and leased Asset A to an unrelated, non-U.S. entity pursuant to a
lease that was entered into on January 1, 1997. This subsidiary depreciated Asset A
pursuant to §§ 167(a) and 168(g) using a recovery period of 5 years, which is Asset A’s
class life.5 For purposes of calculating taxable income, the subsidiary only deducted 70
percent of Asset A’s total depreciation. The subsidiary did not deduct Asset A’s annual
depreciation deductions allocable to exempt foreign trade income (i.e., the other 30
percent of the asset’s total depreciation). Pursuant to CBS Corp., Asset A’s
depreciation deductions allocable to exempt foreign trade income are not “allowable” for
purposes of § 1016(a)(2) and, therefore, do not reduce Asset A’s unadjusted basis.
Rather, the unadjusted basis of Asset A is reduced only by the depreciation deductions
allocable to the asset’s non-exempt foreign trade income (i.e., 70 percent of the asset’s
total depreciation).

Pursuant to Rev. Proc. 87-57, the annual depreciation deductions for tangible property
under § 168(g) are determined by using the property’s unrecovered basis or its
unadjusted basis, depending on whether the taxpayer is using an optional depreciation
table to determine the depreciation for that property. For this purpose, § 6.03 of Rev.
Proc. 87-57 provides that the unrecovered basis of the property is the cost or other
basis of the property adjusted for depreciation previously allowed or allowable and for
all other applicable adjustments under § 1016 or any other provision of law. In other
words, unrecovered basis is the same as adjusted basis.

Scenario 1 Depreciation Calculation

Under Scenario 1, the FSC determined the annual depreciation deductions for Asset A
under § 168(g) in accordance with §§ 4, 5, and 6 of Rev. Proc. 87-57 and, thus, did not
use the optional depreciation tables pursuant to § 8 of Rev. Proc. 87-57. As a result,
the annual depreciation deductions of Asset A are determined by using Asset A’s
unrecovered (adjusted) basis. Because the unrecovered basis of Asset A for each
taxable year takes into account only those depreciation deductions that are allowed or
allowable under § 1016(a)(2), the unrecovered basis of Asset A is not reduced by the 30
percent of its annual depreciation deductions allocable to exempt foreign trade income.
Further, because the recovery period of Asset A ended after the expiration of the lease
(i.e., after December 31, 2000), the FSC is able to fully recover the unadjusted basis of
Asset A through depreciation deductions. Example 1 in the ATTACHMENT illustrates
the calculation of these annual depreciation deductions.


5
    For purposes of Scenarios 1 through 3, assume § 168(g)(3)(A) does not apply.
POSTS-133386-15                            9

Scenario 2 Depreciation Calculation

Under Scenario 2, the FSC determined the annual depreciation deductions for Asset A
under § 168(g) by using the applicable optional depreciation table pursuant to § 8 of
Rev. Proc. 87-57. Section 8.01 of Rev. Proc. 87-57 provides that the optional
depreciation tables specify schedules of annual depreciation rates to be applied to the
unadjusted basis of the property. Because the unadjusted basis of the property does
not take into account depreciation deductions regardless of whether they are allowed or
allowable under § 1016(a)(2), the depreciation amounts allocable to exempt foreign
trade income are not recovered under the optional depreciation tables.

Section 8.02 of Rev. Proc. 87-57 provides that if a taxpayer uses an optional
depreciation table to compute the annual depreciation allowance for any item of
property, the taxpayer must use the table to compute the annual depreciation
allowances for the entire recovery period of such property unless there are any
adjustments to the basis of the property for reasons other than, among other things,
depreciation allowed or allowable. In this case, the subsidiary reduces the unadjusted
basis of Asset A for both the depreciation allocable to the non-exempt foreign trade
income and the depreciation allocable to the exempt foreign trade income. In effect, the
subsidiary treats both the depreciation allocable to the non-exempt foreign trade income
and the depreciation allocable to the exempt foreign trade income as the depreciation
allowable under § 1016(a)(2). Now, the subsidiary wants to treat only the depreciation
allocable to the non-exempt foreign trade income as the depreciation allowable under
§ 1016(a)(2) in accordance with CBS Corp. As a result, the subsidiary is changing the
amount of depreciation allowable for Asset A. Accordingly, the subsidiary must
continue to use the optional depreciation table to compute the annual depreciation
deductions for Asset A.

Thus, even though the subsidiary only deducted 70 percent of the asset’s total
depreciation pursuant to former § 921(b) and to § 265(a)(1), the adjusted basis
allocable to depreciation disallowed under former § 921(b) and under § 265(a)(1) may
not be recovered until the subsidiary disposes of Asset A. Example 2 in the
ATTACHMENT illustrates the calculation of these annual depreciation deductions.

Scenario 3 Depreciation Calculation

Just as in Scenario 1, any depreciation deductions excluded under former § 921(b) and
under § 265(a)(1) do not constitute allowable depreciation deductions for purposes of §
1016(a)(2) so that an asset's basis under § 1011 is not reduced by the depreciation
deductions allocable to exempt foreign trade income. In Scenario 3, however, Asset A’s
recovery period ended prior to the expiration of the lease (i.e., before December 31,
2007). Accordingly, there is no opportunity to recover the depreciation deductions
allocable to exempt foreign trade income for the final year of the recovery period
through a depreciation deduction. As a result, the depreciation deduction for the final
year of Asset A’s recovery period that is allocable to exempt foreign trade income is not
POSTS-133386-15                            10

recovered until the subsidiary disposes of Asset A. Example 3 in the ATTACHMENT
illustrates the calculation of these annual depreciation deductions.

Scenario 4

Section 167(g) allows a taxpayer to determine the depreciation deduction allowable
under § 167(a) for the property listed in § 167(g)(6) by using the income forecast
method. A taxpayer using the income forecast method under § 167(g) generally
computes the depreciation allowances each year based upon the ratio of current year
income to forecasted total income from the property. Section 167(g)(1)(C) provides that
the depreciation deduction under the income forecast method for the 10th taxable year
beginning after the taxable year in which the property was placed in service shall be
equal to the adjusted basis of such property as of the beginning of such 10th taxable
year. Section 167(g) generally applies to property placed in service after September 13,
1995.

The treatment of depreciation deductions under the ETI exclusion provisions is
materially similar to the treatment of depreciation deductions under the FSC regime.
Whereas under the FSC regime former § 921(b) required allocation of a portion of
depreciation deductions to exempt foreign trade income and those deductions were
then disallowed pursuant to § 265(a), under the ETI exclusion provisions, former
§ 114(c) both allocated a portion of depreciation deductions to extraterritorial income
that is excluded from gross income and disallowed those deductions. Thus, the court's
analysis in CBS Corp. similarly applies to depreciation deductions allocable to excluded
ETI. Accordingly, any depreciation deductions excluded under former § 114(c) do not
constitute allowable depreciation deductions for purposes of § 1016(a)(2). As a result,
an asset's basis under § 1011 is not reduced by the depreciation deductions allocated
to excluded ETI under former § 114(c).

Under Scenario 4, the taxpayer owns a motion picture film that qualified for benefits
under the ETI exclusion provisions. The taxpayer placed the film in service in 2003, and
licensed it to an unrelated, non-U.S. entity pursuant to a 15-year license entered into on
the film’s placed-in-service date. The taxpayer depreciated the film pursuant to the
income forecast method under § 167(g). For purposes of calculating taxable income,
the taxpayer only deducted 70 percent of the film’s total depreciation consistent with the
allocation required by former § 114(c). The taxpayer did not deduct the film’s
depreciation allocable to excluded ETI (i.e., the other 30 percent of the film’s total
depreciation). Pursuant to CBS Corp., the film’s depreciation deductions allocable to
excluded ETI are not “allowable” for purposes of § 1016(a)(2) and, therefore, do not
reduce the film’s unadjusted basis. Rather, the unadjusted basis of the film is reduced
only by 70 percent of the film’s total depreciation.

Pursuant to § 167(g)(1)(C), the depreciation deduction under the income forecast
method for the 10th taxable year beginning after the taxable year in which the property
was placed in service shall be equal to the adjusted basis of such property as of the
POSTS-133386-15                             11

beginning of such 10th taxable year. As a result, the depreciation deductions under the
income forecast method that are allocable to exempt foreign trade income under the
FSC regime or excluded ETI are recovered through depreciation deductions for the 10th
taxable year beginning after the taxable year in which the property was placed in
service. However, if such taxable year ends prior to the expiration of the transaction(s)
that qualified for FSC or ETI exclusion treatment, as applicable, the depreciation
deduction for that final year is subject to the FSC or ETI exclusion provisions, as
applicable, and, as a result, the depreciation deduction for that final year that is
allocable to exempt foreign trade income or excluded ETI is not recovered until the
property is disposed of.

Under Scenario 4, the 10th taxable year beginning after the taxable year in which the
film was placed in service ends prior to the expiration of the license of the motion picture
film. Accordingly, there is no opportunity to recover the depreciation deductions
allocable to excluded ETI for that taxable year through a depreciation deduction. As a
result, the depreciation deduction for the 10th taxable year beginning after the taxable
year in which the film was placed in service that is allocable to excluded ETI is not
recovered until the taxpayer disposes of the motion picture film. Example 4 in the
ATTACHMENT illustrates the calculation of these annual depreciation deductions.

Issue 2

Section 446(e) and § 1.446-1(e)(2)(i) provide, in general, that a taxpayer who changes
the method of accounting on the basis of which the taxpayer regularly computes its
income in keeping its books shall, before computing its taxable income under the new
method, secure the consent of the Commissioner of Internal Revenue.

Section 1.446-1(e)(2)(ii)(a) provides that a change in the method of accounting includes,
in relevant part, a change in the treatment of any material item used in the taxpayer’s
overall plan of accounting. Section 1.446-1(e)(2)(ii)(a) further provides that a material
item is any item that involves the proper time for the inclusion of the item in income or
the taking of a deduction. In determining whether a taxpayer’s accounting practice for
an item involves timing, generally the relevant question is whether the practice
permanently changes the amount of the taxpayer’s lifetime taxable income. If the
practice does not permanently affect the taxpayer’s lifetime taxable income, but does or
could change the taxable year(s) in which the item is taken into account, it involves
timing and is therefore a method of accounting. See § 2.01(1) of Rev. Proc. 2015-13.

Section 1.446-1(e)(2)(ii)(b) provides that a change in method of accounting does not
include correction of mathematical or posting errors, or errors in the computation of tax
liability (such as errors in computation of the foreign tax credit, net operating loss,
percentage depletion, or investment credit).
POSTS-133386-15                             12

A taxpayer recovers the unadjusted basis of a depreciable or amortizable asset through
depreciation or amortization deductions, and if not fully depreciated or amortized, upon
the disposition of the asset.

Under Scenarios 1-4, the taxpayer has a depreciable asset with an adjusted basis
remaining after the end of the asset’s recovery period or useful life. This adjusted basis
is the amount of the asset’s total depreciation deductions that were disallowed under
former § 114(c) or former § 921(b) and under § 265(a)(1). The taxpayer currently
recovers that adjusted basis upon the disposition of the asset. Except for Scenario 2,
the taxpayer can change to recover some of, or all, the asset’s adjusted basis through
depreciation deductions and, where the taxpayer can recover only some of the asset’s
adjusted basis through depreciation deductions, the taxpayer will recover the remaining
adjusted basis upon the disposition of the asset. As a result, the taxpayer’s lifetime
taxable income is not permanently affected and, thus, the taxpayer’s requested change
is a change in method of accounting.

This change in method of accounting, however, is not described in the depreciation
automatic changes listed in §§ 6.01 and 6.17 of Rev. Proc. 2015-14 or in §§ 6.01 and
6.17 of the APPENDIX of Rev. Proc. 2011-14, 2011-4 I.R.B. 330, the predecessor to
Rev. Proc. 2015-14. While § 6.01 of Rev. Proc. 2015-14 (i.e., designated automatic
accounting method change number 7) covers changes in methods of accounting for
depreciation, it does not apply in Scenarios 1-4 because the taxpayer is not making a
change in method of accounting under § 1.446-1(e)(2)(ii)(d). Instead, the taxpayer is
making a change in method of accounting under § 1.446-1(e)(2)(ii)(a). Further, § 6.01
of Rev. Proc. 2015-14 does not apply in Scenario 4 because the property is subject to §
167(g). Sections 6.01(1)(a)(ii) and (1)(c)(iv) of Rev. Proc. 2015-14. Section 6.17 of
Rev. Proc. 2015-14 (i.e., designated automatic accounting method change number 107)
does not apply in Scenarios 1-4 because the taxpayer has not disposed of the
depreciable asset. Further, § 6.17 of Rev. Proc. 2015-14 does not apply in Scenarios 2-
4 because the taxpayer did not claim less than the depreciation allowable for the asset.
Sections 6.17(2)(a)(i) and (ii) of Rev. Proc. 2015-14. No other automatic method
change in Rev. Proc. 2015-14 or in the Appendix of Rev. Proc. 2011-14 describes the
change in method of accounting being made by the taxpayer in Scenarios 1-4.

SUMMARY

Scenario 1: The taxpayer is requesting to change the subsidiary’s method to a
permissible method of accounting and has to file a Form 3115 under the non-automatic
method change procedures in Rev. Proc. 2015-13.

Scenario 2: The taxpayer is requesting to change the subsidiary’s method to an
impermissible method of accounting.

Scenario 3: The taxpayer is requesting to change the subsidiary’s method to a
permissible method of accounting provided the depreciation deduction for the final year
POSTS-133386-15                               13

of the asset’s recovery period that is allocable to exempt foreign trade income is not
recovered until the subsidiary disposes of the asset. The taxpayer has to file a Form
3115 under the non-automatic method change procedures in Rev. Proc. 2015-13.

Scenario 4: The taxpayer is requesting to change to a permissible method of
accounting provided the depreciation deduction for the final year of the asset’s useful
life (i.e., for purposes of § 167(g), it is the 10th taxable year beginning after the taxable
year in which the film was placed in service) that is allocable to excluded ETI is not
recovered until the taxpayer disposes of the asset. The taxpayer has to file a Form
3115 under the non-automatic method change procedures in Rev. Proc. 2015-13.

CASE DEVELOPMENT, HAZARDS AND OTHER CONSIDERATIONS

An examining agent must consider two key factors in determining whether any
depreciation or amortization deductions allocable to exempt foreign trade income under
former § 921(b) or allocable to excluded ETI under former § 114(c) may be recovered
before the disposition of the asset. The first factor is whether the annual depreciation
deductions are determined by using the unadjusted basis or adjusted basis of the asset.
If the asset is depreciated under former § 168 (ACRS), we note that the annual
depreciation deductions are determined by using the unadjusted basis of the asset,
pursuant to former § 168(b)(1) and (f)(2), as applicable. The second factor is whether
the recovery period or useful life of the asset expired before or after the end of the
transaction(s) that qualified for FSC or ETI exclusion treatment, as applicable.

In addition, if the asset is depreciated under the income forecast method of § 167(g),
the examining agent must take into account the application of § 167(g)(1)(C).
Moreover, if the asset is depreciated under § 167 (and not under § 167(f) or (g), § 168,
or former § 168), the examining agent must ascertain that the taxpayer has not
depreciated the asset below its salvage value. See § 1.167(a)-1(a) and (c).

An examining agent also should determine, as a threshold matter, if all of the
requirements of the FSC regime or the ETI exclusion provisions, as applicable, have
been met, including that the transaction was properly characterized as a lease or
license, rather than as a financing or a service that would not qualify for either FSC or
ETI exclusion treatment. If the agent determines that the requirements were not met,
then the depreciation analysis would change, and income adjustments may be
appropriate.

This writing may contain privileged information. Any unauthorized disclosure of this
writing may undermine our ability to protect the privileged information. If disclosure is
determined to be necessary, please contact this office for our views.

Please call (202) 317-7005 if you have any further questions.
POSTS-133386-15   14
   POSTS-133386-15                            15

                                     ATTACHMENT

                       EXAMPLES FOR THE FOUR SCENARIOS


   Example 1 -- Scenario 1:

   A calendar year taxpayer qualified as a FSC, placed a depreciable tangible asset with a
   basis of $1,000 in service on January 1, 1997, and leased it to an unrelated, non-U.S.
   entity pursuant to a 4-year lease entered into on January 1, 1997, and ended on
   December 31, 2000. Assume all requirements of the FSC regime have been met,
   including that this transaction was properly characterized as a lease. The taxpayer
   depreciated this asset under § 168(g) by using a recovery period of 5 years, the half-
   year convention, and the straight line method. Also assume that the taxable year 1997
   is a taxable year of 12 full months, that the property remains in service through the end
   of 2002, that § 168(g)(3)(A) does not apply, and that the taxpayer did not use the
   optional depreciation tables pursuant to § 8 of Rev. Proc. 1987-57.

                                                                               Unrecovered
                                                                   Tax-           Basis
         Unrecovered Depreciation   Yearly            Taxable     exempt       Remaining in
Year        Basis       Rate      Depreciation         70% *       30%          the Asset

1997        1,000.00        10.00%          100.00       70.00        30.00            930.00

1998          930.00        22.22%          206.65      144.66        61.99            785.34

1999          785.34        28.57%          224.37      157.06        67.31            628.28

2000          628.28        40.00%          251.31      175.92        75.39            452.36

2001**        452.36        66.67%          301.59      301.59             -           150.77

2002**        150.77       100.00%          150.77      150.77             -                   0

                                                      1,000.00                                 -

        * The percentage changes from 70% to 100% when the FSC regime does not apply.

   ** The FSC regime does not apply because the lease had expired on December 31,
   2000.
  POSTS-133386-15                            16

  Example 2 -- Scenario 2:

  The facts are the same as in Example 1, except that the taxpayer used the applicable
  optional depreciation table to determine the annual depreciation deductions of the asset
  pursuant to § 8 of Rev. Proc. 87-57.

                                                                             Unrecovered
                                                                 Tax-           Basis
         Unadjusted Depreciation   Yearly          Taxable      exempt       Remaining in
Year       Basis       Rate      Depreciation       70% *        30%          the Asset

1997     1,000.00         10.00%          100.00      70.00        30.00             930.00

1998     1,000.00         20.00%          200.00     140.00        60.00             790.00

1999     1,000.00         20.00%          200.00     140.00        60.00             650.00

2000     1,000.00         20.00%          200.00     140.00        60.00             510.00

2001**   1,000.00         20.00%          200.00     200.00              -           310.00

2002**   1,000.00         10.00%          100.00     100.00              -           210.00

                                                     790.00                          210.00

    * The percentage changes from 70% to 100% when the FSC regime does not apply.

  ** The FSC regime does not apply because the lease had expired on December 31,
  2000.
  POSTS-133386-15                            17


  Example 3 -- Scenario 3:

  The facts are the same as Example 1, except that the lease ended on December 31,
  2007. As a result, Asset A’s recovery period ended prior to the expiration of the lease.
  Thus, the FSC regime applies for all years of Asset A’s recovery period.

                                                                               Unrecovered
                                                                   Tax-           Basis
       Unrecovered Depreciation   Yearly             Taxable      exempt       Remaining in
Year      Basis       Rate      Depreciation          70%          30%          the Asset

1997       1,000.00        10.00%          100.00       70.00        30.00             930.00

1998         930.00        22.22%          206.65      144.66        61.99             785.34

1999         785.34        28.57%          224.37      157.06        67.31             628.28

2000         628.28        40.00%          251.31      175.92        75.39             452.36

2001         452.36        66.67%          301.59      211.11        90.48             241.25

2002         241.25       100.00%          241.25      168.88        72.37              72.37

                                                       927.63                           72.37
   POSTS-133386-15                            18

   Example 4 -- Scenario 4:

   The taxpayer placed in service in 2003 a motion picture film and licensed it to an
   unrelated, non-U.S. entity pursuant to a 15-year license entered into on the film’s
   placed-in-service date. Assume all requirements of the ETI exclusion provisions of
   former § 114 have been met, including that this transaction was properly characterized
   as a license. The taxpayer depreciated the film pursuant to the income forecast method
   in § 167(g). Assume that the yearly depreciation amount below is the amount of
   depreciation as determined under § 167(g). The taxpayer only deducted 70 percent of
   the film’s total depreciation subject to the allocation required by former § 114. The 10th
   taxable year beginning after the taxable year in which the film was placed in service, as
   provided in § 167(g)(1)(C), ended prior to the expiration of the license. Thus, the ETI
   exclusion provisions apply to all of these taxable years.

                                                                       Adjusted Basis
       Unadjusted       Yearly                         Tax-exempt     Remaining in the
Year     Basis        Depreciation    Taxable 70%         30%              Asset

2003       1,000.00         400.00           280.00         120.00               720.00

2004       1,000.00         400.00           280.00         120.00               440.00

2005       1,000.00         200.00           140.00           60.00              300.00

2006       1,000.00         150.00           105.00           45.00              195.00

2007       1,000.00         100.00            70.00           30.00              125.00

2008       1,000.00           50.00           35.00           15.00               90.00

2009       1,000.00           40.00           28.00           12.00               62.00

2010       1,000.00           30.00           21.00            9.00               41.00

2011       1,000.00           20.00           14.00            6.00               27.00

2012       1,000.00           20.00           14.00            6.00               13.00

2013       1,000.00           13.00            9.10            3.90                 3.90
                                             996.10                                 3.90