Breach-of-contract damages not allocable to U.S.-source income.

• Author: Laffie, Lesli S.
• Position: Foreign Income & Taxpayers

A Corp. and B Corp., multinational corporations, entered 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 deduction 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...