Breach-of-Contract Damages Not Allocable to U.S.-Source Income

A Corp. and B Corp., multinational corporations, en-tered into a merger agreement. Relying on the agreement, B reacquired shares of its stock held by another corporation. A then unilaterally canceled the agreement; B filed suit against A seeking breach-of-contract damages in the amount it expended to reacquire its shares in anticipation of the merger. TS, T Corp.'s wholly owned subsidiary, then acquired all of A's outstanding stock; A merged into TS. After the merger, B was awarded breach-of-contract damages, and pre- and postjudgment interest. Subsequently, TS and B's successor, C, entered into settlement agreement under which TS paid C the damages and pre- and postjudgment interest.

T deducted the postjudgment interest as interest on T's and TS's consolidated return and apportioned the postjudgment interest to both foreign- and U.S.-source income. T deducted the damages and prejudgment interest and allocated those amounts solely to U.S.-source income as a personal property stock loss.

Analysis

Taxable income attributable to gross income from domestic and foreign sources is determined by deducting the expenses, losses and other deductions properly allocated or apportioned to such income, and a ratable part of any expenses, losses and other deductions that cannot definitely be allocated to some item or class of gross income.

Generally under Regs. Sec. 1.861-8(a)(2), an expense must be allocated and apportioned on the basis of the factual relationship of the expense to gross income. The allocation of a de-duction is first made by determining the activity from which the deduction resulted, or the property for which the deduction was incurred. The deduction is then allocated to the class of gross income generated by that activity or property. If a deduction has no factual relationship to a class of gross income constituting less than all of a taxpayer's gross income, it is allocated to all of that gross income.

Regs. Sec. 1.865-1 and -2 apply to a deduction attributable to a loss on the sale, exchange or other disposition of a capital asset or other personal property, including stock. Under these regulations, deductions are allocated to the class of gross income to which gain from the sale of that personal property would give rise in the seller's hands. Thus, under these regulations, consistent with the Sec. 865 rule that gain recognized on the disposition of personal property is sourced generally to the seller's residence, loss from a personal property sale is similarly sourced. The U.S. is T's residence; thus, the proper allocation and apportionment of a deduction turns on the deduction's nature and its factual relationship, if any, to a class of gross income.

In T's case, the settlement payment resulted from A's breach of contract with B. The settlement payment was in lieu of the judgment amount (i.e., the amount B expended to reacquire its shares) plus interest. B reacquired those shares in reliance on the merger agreement; the damages sought to place B in the same position as before the breach, by paying it the exact amount expended on unnecessarily reacquiring the shares plus interest.

T suffered no loss on the abandoned merger. The damages settlement amount TS paid does not represent a loss from a capital asset, personal property or any other asset. The only loss suffered was the loss B bore when A canceled the merger agreement, the measure of damages being the cost B incurred to reacquire its stock. Accordingly, the damage payment is not a stock loss, but represents a reimbursement by TS to B to restore it to its pre-breach position. Thus, T's exclusive allocation of the damages paid under the settlement agreement to U.S.-source income by analogizing it to a stock loss was incorrect. The payment for actual damages is properly treated as a business expense deduction allocated under Regs. Sec. 1.861-8(b)(5).

The damages payment arose from A's breach of the merger agreement with B. TS never owned any of the property from which the damages derived (i.e., B's stock or assets). TS presumably agreed to the settlement conditions and the damages payment to avoid the possibility of having to pay a larger amount as a result of the continuing litigation. Because the damages payment was made in an attempt to preserve all of TS's remaining assets and income, the damages payment is not factually related to a class of gross income constituting less than all of T's gross income.

Based on these facts, it is reasonable to allocate the portion of the deduction attributable to the damages payment to all gross income under Regs. Sec. 1.861-8(b)(5). Once allocated to all of T's gross income, Regs. Sec. 1.861-8(c)(3) provides that the damages payment must be apportioned ratably between the applicable statutory grouping(s) and the residual grouping(s) within that class.

Field Service Advice 200234020 (5/13/02)