With the new year beginning and companies shifting their focus to the tax provision and FIN 48 (Financial Accounting Standards Board Interpretation No. 48) processes, we thought we’d review some of the most common issues or mistakes that we see in the practical application of some of the more complicated provisions of the expense allocation and apportionment rules under Internal Revenue Code Section 861.
Common Mistake #1: Using different allocation or apportionment methodologies for the same expense when making computations for more than one “operative section.”
The expense allocation and apportionment rules of IRC Section 861 apply in many areas, such as the determination of the foreign tax credit limitation, as well as the calculation of effectively connected income, foreign base company income and production activities income. The regulations under Section 861 provide that if the expense allocation and apportionment rules of Section 861 apply to more than one area (an “operative section”), the same method of allocation and apportionment must be used for all the relevant computations made in the same year. The mistake of not conforming methodologies may be more prevalent now that, in many tax departments, the computation of the IRC Section 199 deduction is performed by a different area of the department than the individuals who prepare the company’s foreign tax credit or other foreign compliance.
Common Mistake #2: Not allocating expenses to the relevant class of gross income before apportionment.
In an effort to simplify computations, companies may skip the step in the regulations that provides for the allocation of expenses before apportionment. Many types of foreign-source income — such as intercompany interest income or dividend income from a foreign affiliate — may not require as much time and expense for the taxpayer to manage as other types of operating income. Not making a factual relationship between expenses and the types of income that are generated by those expenses may result in an overall reduction of net foreign-source income.
Common Mistake #3: Not appropriately eliminating intracompany items before determining the amount of expense subject to the allocation and apportionment rules.
A simple example may help to illustrate this common mistake. Assume that the U.S. taxpayer maintains a branch in Country X that helps the taxpayer market its products in Country X. For Country X tax purposes, the branch is required to earn a profit equal to 110 percent of its costs. In 20XX, the costs of the branch were 100u; consequently, the branch reported 110u of income on its Country X tax return, resulting in taxable income of 10u.
At first glance, this looks like an easy way to generate foreign-source income. However, for U.S. income tax purposes, the 110u of income reported by the branch does not result in additional income to the taxpayer because any income reported by the branch would be fully offset by the associated expense incurred by the home office. The expense incurred by the taxpayer is the expense of 100u incurred by its branch. As noted, this expense is allocable to the sales that the taxpayer has made (or expects to make) in Country X and therefore may be an expense that reduces foreign-source income if the taxpayer’s sales to Country X customers generate foreign-source income.
Common Mistake #4: Netting interest income and interest expense before determining the amount of expense subject to apportionment.
This one might seem a little basic, but it is not uncommon for taxpayers to record interest income and interest expense on the same line in their financial statements. The regulations define interest expense very broadly and do not allow any of the expense to be offset by interest income before apportionment. So, if you are a taxpayer that has inadvertently made this error, you are not alone.
Common Mistake #5: Increasing both the third-party debt of the U.S. taxpayer and the loans to related controlled foreign corporations (CFCs) without considering the “CFC netting rule.”
The CFC netting rule is contained in Treasury Regulation Section 1.861-10(e). The computations under this provision include many definitions and may be confusing or cumbersome. Although the regulations contain certain safe harbors, most companies that have significant debt between the U.S. group and their foreign affiliates will need to make at least some computations to determine whether a portion of their foreign-source intercompany interest income could be resourced to U.S.-source income under this provision.
Common Mistake #6: Improperly computing the amount of assets for the apportionment base.
The mistakes in this area depend upon the valuation method elected by the taxpayer, but a few common ones include:
- Using book basis to compute assets as opposed to either the tax basis or fair market value, if applicable;
- Not including a portion of the assets used to generate IRC Section 863(b) income as foreign assets;
- Including assets that either do not produce income or produce tax-exempt income in the apportionment fraction; and
- Including the improper asset value of a related entity (e.g., use of the investment in a greater than 10 percent owned partnership rather than the partner’s pro rata share of the partnership assets).
Common Mistake #7: Limiting the amount of R&E subject to allocation and apportionment to “qualifying research expenses” used in the computation of the R&D credit under IRC Section 41.
Section 861 regulations require taxpayers to allocate and apportion research and experimental (R&E) expenses currently deductible under IRC Section 174. Because the amount of Section 174 expenses generally is greater than the amount of qualifying research expenses under Section 41, this mistake likely results in an understatement of expenses allocated and apportioned to foreign-source income.
Common Mistake #8: Not including relevant sales of uncontrolled parties in the apportionment base.
Although this may seem a little far-reaching, the R&E expense apportionment regulations require taxpayers to include product sales of “uncontrolled parties” in their apportionment fraction if the uncontrolled party (1) purchased or licensed intangible property from the taxpayer and (2) “can reasonably be expected to benefit directly or indirectly” from the R&E expense connected with the product category being apportioned. If the taxpayer does not know the sales amount of the uncontrolled party, the regulations require the taxpayer to make a computation to reasonably estimate the needed amount.
Common Mistake #9: Allocating state income taxes to U.S.-source income.
The regulations provide detailed rules for the allocation and apportionment of state income tax expense that can be difficult to implement for many taxpayers. For example, if perfectly applied, the regulations could require the taxpayer to recompute its state taxable income in many jurisdictions in which it files — and even some in which it does not file. The computations may also require the computation of new state apportionment fractions to make the fractions more uniform across jurisdictions. Although the regulations contain two “safe harbor” methodologies, for many large multinational companies, the computations required under either of these methodologies are far from simple to implement.
Common Mistake #10: Not allocating stewardship expenses to foreign-source income.
As a practical matter, many U.S. multinational companies employ people in their headquarters who perform functions that either benefit the entire organization or support some of the foreign subsidiaries owned by the company. Some of these expenses may have been charged out to the various companies in the group; however, some expenses may have stayed behind to be deducted against the company’s consolidated taxable income in the United States. New regulations under IRC Section 482 dealing with controlled services transactions contain more detailed provisions regarding the amount of services that must be charged to affiliates and the appropriate pricing for these services. Although the regulations under Section 861 have long contained special rules dealing with the allocation of “stewardship” expenses, the IRS issued new Treasury Regulation Section 1.861-8T(e)(4) in conjunction with controlled services regulations to conform these rules to transfer pricing regulations.
Alvarez & Marsal Taxand Says:
Whether you are estimating the amount of foreign tax credits you can use for your year-end provision or evaluating your need for additional FIN 48 reserves, remember that the regulations under Section 861 require many computations — some of which can be extremely detailed and complicated. Now may be a good time to review your company’s current Section 861 methodologies. Remember that this review may also yield opportunities to lessen the amount of expense allocated and apportioned to foreign-source income. As one of my wise clients once told me, “you can never have enough friends, money or foreign-source income.”
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Sam Tae, Senior Associate, contributed to this article.
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