Form 5471 generally requires US GAAP (Generally Accepted Accounting Practices) conversion of foreign financial statements for the purposes of reporting book income, because foreign accountants usually prepare these statements based on a different foreign standard. While Treas. Reg. Reg. §1.964-1(a)(2) contains a limited exception to the US GAAP conversion adjustments for “non-material” items (the same exception applies to tested/income loss calculation for GILTI purposes; see Treas. Reg. §1.951A-2(c)(2) (which refers to Treas. Reg. §1.952-2, which, in turn, mention the “materiality” rules of the §964 regulation)), the translation of foreign financial statements to US GAAP is a common problem for tax professionals who deal with Form 5471.
In this article, I will outline the most common issues related to the conversion of foreign financial statements to US GAAP.
US GAAP Conversion Issues: Depreciation
At the top of the US GAAP adjustments are different methods of depreciation and amortization. These differences cover pretty much all types of depreciable assets: fixed assets and intangible assets (including goodwill).
When we at Sherayzen Law Office prepare Forms 5471 for our clients, it is our standard practice to request that foreign accountants provide a detailed depreciation report, including amounts and dates concerning the purchase/sale of assets, the amortization/depreciation conventions used in foreign financial statements and the methods of accounting for increase/decrease in the value of depreciable assets.
US GAAP Conversion Issues: Inventory
Another very common area of US GAAP adjustments involves inventory. Here there could be an array of variations from FIFO/LIFO to expense capitalization methods and valuation of inventory. Common problems arise when the inventory valuation adjustments result from related-party transactions.
For example, in one of our cases, our client had contracts of sale drafted between the head office in the United States and a foreign branch office (due to the foreign country’s requirements), making it impossible to directly rely on the foreign branch’s financial statements to determine the Cost of Goods Sold (COGS) due to varying mark-ups on tens of thousands of items.
US GAAP Conversion Issues: Valuation of Assets
One highly-problematic area for US GAAP adjustments is the valuation of assets in the foreign financial statements. Oftentimes and in a large number of tax jurisdictions, historic cost of assets is replaced with another valuation method allowed by a local accounting standard but not by US GAAP.
We see this problem appear often in tax jurisdictions as varied as Czech Republic, Jamaica, Nigeria, Pakistan, Poland, et cetera.
US GAAP Conversion Issues: Mergers, Dissolutions and Acquisitions
Mergers, dissolutions and acquisitions may result in a bewildering array of differences between foreign financial statements and US GAAP requirements: from income recognition to asset valuation, treatment of reserve, E&P calculations and so on. Sometimes, there may be a break in the continuity of financial statements due to a dissolution of one entity and creation of another entity for US GAAP purposes while entities are treated as one entity in a foreign jurisdiction. I remember one case from Pakistan and one case from Poland where we had to make just an enormous amount of changes to bring these financial statements into compliance with US GAAP precisely due to the issues of mergers and acquisitions.
US GAAP Conversion Issues: Hyperinflation
Hyperinflation may present a US international tax attorney with its own challenges. As it is especially common in Latin America, local financials would incorporate inflationary adjustments that are incompatible with US GAAP. An international tax lawyer has to identify these adjustments, reverse them and, if necessary, replace with adjustments required by GAAP.
US GAAP Conversion Issues: Reserves
Finally, the last most common area of problems has to do with reserves. The problem usually arises in situations where local accounting rules permit allocation of certain reserves in a manner incompatible with US GAAP rules.
US GAAP Conversion Issues: Special Case of Consolidated Financial Statements
In a situation where a US parent company of a foreign subsidiary prepares consolidated financial statements, problems may arise with respect to whether these statements provide all relevant information needed to create a GAAP-compliant Form 5471. There are four main areas of concern in this type of cases: artificial consolidations through check-the-box rules, foreign currency fluctuations, deductions related to pensions and transfers within the group. I will discuss these issues in more detail in a future article.
E&P Adjustments
I want to mention here that, in addition to GAAP adjustments to local financial statements, Form 5471 also requires E&P adjustments to GAAP-compliant financial statements. I will explore this topic in a future article.
Contact Sherayzen Law Office For Professional Help with Form 5471 Preparation and Offshore Voluntary Disclosures
If you are a US person who owns (fully or partially) a foreign corporation and you need to prepare a Form 5471 for a current year or any previous years, then you should contact Sherayzen Law Office for professional help.
Our international tax team, led by an international tax attorney and founder of Sherayzen Law office, Mr. Eugene Sherayzen, is a group of highly experienced and creative tax professionals with profound knowledge of US international tax law and US international tax accounting rules. We have filed hundreds of Forms 5471 in the past helping clients around the globe with their current US tax compliance as well as offshore voluntary disclosures related to prior Form 5471 noncompliance. We can help You!
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