Interest expense allocation and apportionment options for FTC calculations.

• Author: Zink, Bill
• Position: Foreign tax credit

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 taxpayer's foreign-source income to its worldwide income and multiplying it by the taxpayer's 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 taxpayer's 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 entity's 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 IRS's...