Interest Expense Allocation and Apportionment Options for FTC Calculations

The U.S. foreign tax credit (FTC) is designed to prevent double taxation when the same income is subject to tax in two countries. The Sec. 904 FTC limitation is generally intended to prevent taxpayers from claiming U.S. benefits for foreign taxes at a rate that exceeds their U.S. tax rate. Generally, the limitation is computed by taking the ratio of the taxpayers foreign-source income to its worldwide income and multiplying it by the taxpayers pre-FTC tax liability; see Sec. 904(a). To compute the ratio requires characterizing income and expense as either foreign- or U.S.-source. This item discusses the rules for characterizing interest expense for this purpose.

Overview

Temp. Regs. Sec. 1.861-9T(a) requires allocation and apportionment of interest expense in computing the FTC limitation. This approach is based on the principle that money is fungible. Interest deductions are generally attributable to all of a taxpayers activities and property, regardless of any specific purpose for incurring the obligation on which interest is paid. The fungibility approach recognizes that all activities require funds and their use, and that management has a great deal of flexibility as to source and use. Generally, when money is borrowed for a specific purpose, such borrowing will free other funds for other purposes.

The fungibility concept implies that interest expense relates more closely to the amount of capital used or invested in a business, than to the gross income generated from it. Thus, interest expense of domestic corporations must be apportioned on the basis of asset values, not gross income. Under this approach, an affiliated group is treated as a single taxpayer; interest expense is apportioned on the basis of all group members; see Temp. Regs. Sec. 1.861-11T.

However, the fungibility concept generally stops at the U.S. border, as the definition of an affiliated group does not include foreign corporations. Rather, under Temp. Regs. Sec. 1.861-9T, the related foreign entitys stock is used for the interest allocation. Under Temp. Regs. Sec. 1.861-9T(g)(i), a taxpayer may elect to value assets on the basis of tax book value or fair market value (FMV), or on an alternative tax book value method, when allocating and apportioning interest expense.

FMV

Under Temp. Regs. Sec. 1.861-9T(g) and (h), a taxpayer may elect to use the FMV method. In general, use of this method constitutes an accounting method that may not be changed without the IRSs permission.

Tax Book Value

Historically, the most commonly used method has been the tax book value method, under which interest expense is allocated based on the relative tax basis of the taxpayers assets. Tax book value generally is the assets adjusted basis, under Temp. Regs. Sec. 1.861-9T(g).

Taxpayers have complained that this method caused disparities between the basis of domestic assets and foreign assets of unincorporated and flow-through foreign entities, due to the use of accelerated depreciation methods for domestic-use assets and the straight-line alternative depreciation system (ADS) method used for foreign-use assets.

Alternative Tax Book Value

In 2004, the IRS addressed complaints on the use of tax book value and provided final and temporary regulations on an alternative tax book value method of valuing assets; see Temp. Regs. Sec. 1.861-9T(i). The new elective method allows taxpayers to determine the tax book value of all their tangible property, both foreign and domestic, subject to depreciation, by using the straight-line method, conventions and recovery periods of the ADS method, thereby closing the gap on the disparity between domestic- and foreign-use assets.

AJCA Rules

An interest expense allocation provision under American Jobs Creation Act of 2004 (AJCA) Section 401(c) allows taxpayers to close the gap between domestic and foreign assets even further, by allowing them to elect to use their worldwide assets as the basis for allocation, rather than the value of the stock or the investment of affiliated foreign corporations; see Sec. 864(f)(1)(A).

This election, applicable for tax years beginning after 2008, would allow a taxpayer to allocate interest on a worldwide basis (i.e., as if all members of the worldwide affiliated group were a single corporation). Such foreign assets would be subject to the ADS depreciation method in determining tax book value.

Until 2009, taxpayers have three options available to allocate and apportion interest expensethe FMV method, tax book value method and alternative tax book value method. Thereafter, the new worldwide asset method will also be available. Implementation or full consideration of this method will require extensive data-gathering and a review of previous elections.

From Bill Zink, CPA, Washington, DC