Allocating interest and other expenses under Section 864(e).

• Author: Richey, Keith S.

Allocating Interest and Other Expenses Under Section 864(e) (*1)

1. INTRODUCTION

   The allocation of interest and other expenses between United States and foreign source income has long been the subject of controversy. In an attempt to eliminate perceived distortions and opportunities for taxpayer manipulation, Congress enacted section 864(e) of the Internal Revenue Code as part of the Tax Reform Act of 1986. Generally, under this provision, a U.S. affiliated group must allocate interest as a fungible expense on the basis of its worldwide assets.

   Proposed regulations under section 864(e) were released on September 11, 1987, to provide guidance to taxpayers; after receiving much taxpayer input, temporary regulations were issued on September 9, 1988. Unlike the 1987 proposed regulations, the temporary regulations must be followed until, and unless, regulations are issued in final form or the temporary regulations are withdrawn. Generally, the temporary regulations are effective for taxable years after December 31, 1986. One exception, however, is the new rule for "excess controlled foreign corporation (CFC) related-party indebtedness," which is effective for taxable years after December 31, 1987. (The new rule replaces the much criticized proposed CFC debt netting/tracing rule.)

   This article explains and compares the temporary and the proposed regulations as they apply to the allocation of interest expense. In addition, the new rules for the allocation of expenses other than interest, such as overhead, are also described.

2. INTEREST COVERED

   Any interest expense deductible under section 163 is subject to allocation under section 864(e) according to the regulations. The temporary regulations specifically define the term "interest" as the gross amount of interest expense incurred by a taxpayer in a given tax year. Temp. Reg. [sec.] 1.861-9T(a). This negates any argument that interest expense may be netted with interest income. In addition to what one usually understands to be "interest," such as earnings on time deposits or original issue discount, certain expense and losses related to the time value of money are treated as the equivalent of interest. For example, if a taxpayer borrows gold and immediately sells the gold and contracts to purchase gold at a higher price on the date the taxpayer must return the borrowed gold, the loss will be apportioned in the same manner as interest expense. Temp. Reg. [sec.] 1.861-9T(b)(1). (1)

   Whereas the proposed regulations treated any loss on the sale of a receivable generated in the ordinary course of business as an interest equivalent, the temporary regulations apply to any loss on the sale of a trade receivable (factoring) unless at the time of sale of the receivable it bears interest at least equal to 120 percent of the applicable federal rate. If the receivable does not bear interest at the test rate, the loss is bifurcated between the portion attributable to other factors, such as credit risk and the cost of collecting the receivables, and the portion attributable to the time value of money. The time value of money portion is treated as interest and is calculated by discounting the receivable at 120 percent of the applicable federal rate. Temp. Reg. $S 1.861-9T(b)(3).

   Similarly, effective for taxable years commencing after December 31, 1988, a loss on a hedged nonfunctional foreign currency borrowing (reduced or increased by the gain or loss on the hedge), will be apportioned in the same manner as interest expense. A nonfunctional currency borrowing will be presumed to be hedged if its interest rate is less than the applicable federal rate and if any forward, future, option, etc., substantially diminishes the interest expense or currency exposure on the borrowing. This presumption can be rebutted by a showing that the hedge arose in response to currency exposure arising in the ordinary course of business. Temp. Reg. [sec.] 1.861-9T(b)(2)(i). (2)

3. GENERAL ALLOCATION

   RULES FOR INTEREST

   EXPENSE

   The temporary regulations are consistent with the main thrust of the proposed regulations, of course, since their principal objective is to implement the requirement, enacted in 1986, that U.S. corporations apportion and allocate interest expense on the basis of assets taking into account all assets of the U.S. affiliated group as if they were one corporation. The guiding principle is that money is fungible and interest expense is attributable to all activities and property regardless of any specific purpose for incurring an obligation. Temp. Reg. [sec.] 1.861-9T(a).

   The asset method is described in Temp. Reg. [sec.] 1.861-9T(g). The asset method, which may reflect tax book or fair market value, is substantially the same as described in the proposed regulations. Asset values (book or market) are computed on the basis of the beginning and end of year values, except that for the first taxable year beginning after 1986 a taxpayer may chose to utilize year-end values alone. Temp. Reg. [sec.] 1.861-9T(g)(2)(i).

   Where a substantial distortion would result from such averaging (for example, in the event of a major acquisition or disposition), the taxpayer must use a different method of asset valuation that more clearly reflects the weighted average value of assets held during the taxable year. Temp. Reg. [sec.] 1.861-9T(g)(2)(i). The rules for characterizing assets, now contained in Temp. Reg. [sec.] 1.861-9T(g)(3) and supplemented in [sec.] 1.861-12T, are essentially the same as those proposed. Assets are characterized according to the source and type of the income that they generate, have generated, or may reasonably be expected to generate. The physical location of an asset is not relevant for this determination.

   Assets are grouped as either: single category assets, multiple category assets, or assets without directly identifiable yield (in other words, those assets that contribute equally to the generation of all the income of the taxpayer, such as assets used in general and administrative functions). Temp. Reg. [sec.] 1.861-9T(g)(3). Single category assets are directly attributable to the relevant grouping of income. The value of multiple category assets is prorated among the relevant income groups on the basis of the proportion of gross income generated by it within each relevant grouping during the taxable year. Assets without directly identifiable yield (headquarter's office building, etc.) must be identified because such asset values are to be disregarded.

   For loans between members of an affiliated group (including any receivable), the indebtedness of the member borrower shall not be considered an asset of the member lender. An exception to this rule exists for financial groups (i.e., banking). Temp. Reg. [sec.] 1.861-11T(e)(1).

   Regarding interest expense arising between members of an affiliated group, a member borrower shall deduct related-person interest expense using group apportionment fractions. A member lender shall include related-person interest income in the same class of gross income as the class of gross income from which the member borrower deducts the related-person interest payment. Temp. Reg. [sec.] 1.861-11T(e)(2)(i).

   The process of interest expense allocation and apportionment may be viewed as a series of steps as follows (condensed with exceptions ignored).

   Step One

   Assets must be divided into four main categories:

   1. Assets Subject to Direct Allocation (See "Exceptions to Fungibility" below).

   2. Assets generating U.S. Source Income ("U.S. Assets").

   3. Assets Generating Foreign Source Income by Category ("Foreign Assets").

   4. Assets Without Identifiable Yield.

   (Assets subject to direct allocation and corresponding interest and assets without identifiable yield will be disregarded for the following steps.)

   Step Two

   The amount of third-party interest expense of the U.S. affiliated group subject to apportionment will be apportioned against U.S. source income (thereby receiving a full U.S. tax deduction) using the following fraction:

   U.S. Assets/U.S. and Foreign Assets X Third-Party Interest Expense

   Step Three

   The remaining interest expense will be foreign source. It must be apportioned to the various separate section 904(d) limitation categories (i.e., separate baskets of income) where it will be deducted against the income in those categories using the following fraction:

   Assets Generating Separate Basket Income/U.S. and Foreign Assets X Third-Party Interest Expense

   A loss of one affiliate in a separate section 904(d) limitation category will reduce the income of other members in the same category if a consolidated return is filed. If a consolidated return is not filed or if total consolidated income in a category becomes a loss, losses created through group apportionment in a category must be eliminated and a corresponding amount of income of other members in the same limitation category must be recharacterized. This is done by offsetting such loss against income in other limitation categories. If there is not sufficient foreign income, domestic income will be offset. Temp. Reg. [sec.] 1.861-11T(g).

   If a taxpayer has a loss in a separate limitation category in a noncontrolled section 902 company as a result of interest expense apportionment it may elect to allocate interest expense to any other separate limitation category that is in an excess credit position. Temp. Reg. [sec.] 1.861-12T(c)(4)(ii).

4. TREATMENT OF VARIOUS

   ENTITIES

   1. CORPORATIONS

      Under section 864(e), the assets of all the members of a U.S. affiliated group are to be taken into account as if they were one corporation. Indeed, under the temporary regulations, even certain unaffiliated corporations may be treated as members of the affiliated group. The test for inclusion is if 80 percent of either the vote or value of all outstanding stock is owned directly or indirectly by a member of the affiliated group. Although not expressly stated in the temporary regulations, the term "value" refers...