Analysis of and reflections on recent cases and rulings.

• Author: Beavers, James A.
• Position: TAX TRENDS

Foreign Income & Taxpayers

Foreign tax credit requires consistency

Under the consistency rule in Temp. Regs. Sec. 1.861-9T(f)(3)(iv), for purposes of calculating its foreign tax credit, a taxpayer could not use the asset method to characterize the shares it held in a controlled foreign corporation (CFC) because the CFC used the modified gross income method to apportion its interest expense.

Background

Before a restructuring of its foreign subsidiaries in December 2014, AptarGroup Inc. directly owned 100% of AptarGroup Holdings, a French entity (AGH France), which was a global holding company for most of AptarGroup's foreign subsidiaries. AptarGroup owned, directly or indirectly, 42 CFCs and also directly owned stock in other foreign corporations that were noncontrolled foreign corporations under Sec. 902 (before its repeal by the law known as the Tax Cuts and Jobs Act, P.L. 115-97). In the restructuring, AptarGroup transferred ownership of substantially all of its foreign subsidiaries, including AGH France, to AptarGroup Global Holding, a Luxembourg holding company (AGH Lux). Afterward, AptarGroup wholly owned AGH Lux, which in turn wholly owned, directly and indirectly, 32 CFCs. These CFCs held assets that generated foreign-source income; and some of the CFCs also held assets that generated U.S.-source income. AptarGroup remained the direct owner of five CFCs after the restructuring.

For 2014, AGH Lux apportioned its interest expense under the modified gross income method. AptarGroup, in determining the amount of its foreign tax credit, characterized its stock in AGH Lux using the asset method. AptarGroup claimed a foreign tax credit of $3.54 million on its 2014 tax return.

Foreign tax credit

The United States subjects its citizens and domestic corporations to tax on their worldwide income. To prevent double taxation, a domestic corporation is allowed a credit for foreign tax paid under Sec. 901 and a credit for foreign taxes deemed paid or accrued under Sec. 960.

However, the foreign tax credit a taxpayer may take is limited to prevent taxpayers from using foreign tax to reduce U.S. tax on their U.S.-source income. The foreign tax credit limitation (FTC limitation) is calculated by multiplying the taxpayer's total U.S. tax on worldwide income by a fraction with a numerator of the taxpayer's foreign-source taxable income and a denominator of the taxpayer's worldwide taxable income. Where a taxpayer has more than one category of income as listed in Sec. 904(d) (limitation category), the FTC limitation must be computed separately for each limitation category.

Sourcing rules

To calculate the FTC limitation, the taxpayer must determine the source for its gross income, using the sourcing rules in the regulations under Sec. 861. After sourcing gross income, a taxpayer must allocate losses, expenses, and other deductions (collectively, expenses) to a class of gross income and, if necessary, then apportion the expense within that class between a statutory grouping or a residual grouping. For purposes of the foreign tax credit, each limitation category is a statutory grouping, and a taxpayer claiming the credit must determine the foreign-source taxable income in each limitation category in which it has income.

Expenses generally are allocated and apportioned on the basis of their factual relationship to gross income. Expenses are allocated to the class of gross income to which they definitely relate. If not definitely related to a class of gross income or related to all gross income, an expense must be ratably allocated to all gross income. After allocation, if needed, expenses are apportioned between the statutory and residual groupings.

Special rules for interest expense

In general, interest expense is treated as related to all income-producing activities and assets regardless of the specific purpose for the borrowing. Thus, interest expense must be ratably allocated to all gross income.

Regarding the apportionment of interest for these purposes, Temp. Regs. Sec. 1.861-9T provides that interest may be apportioned either using the asset method or the modified gross income method. However, domestic corporations must use the asset method. CFCs, on the other hand, are permitted to choose either method subject to certain consistency requirements.

Asset characterization

In calculating its foreign tax credit limitation, a domestic corporation can characterize assets it holds using the asset method or the gross income method. However, with respect to CFC stock held by a domestic corporation, a consistency rule applies. Under both Temp. Regs. Sees. 1.861-9T(f)(3)(iv) and 1.861-12(3)(i), a U.S. shareholder of a CFC must characterize the CFC stock it holds under the same method the CFC used to apportion its interest expense.

AptarGroup disregards special characterization rules

AptarGroup, as required, allocated its interest expense to all its incomeproducing assets and activities. Because it is a domestic corporation, the company apportioned its interest expense using the asset method. AGH Lux, as a CFC, under Temp. Regs. Sec. 1.861-9T(f)(3)(i) could elect to use either the asset method or the modified gross income method, and it elected to...