A guide to foreign corporation E&P.

• Author: Lau, Paul C.
• Position: Part 2 - Earnings and profits

EXECUTIVE SUMMARY

* After allocating gross income to the proper baskets, deductions and taxes must be allocated and apportioned to gross income to arrive at E&P for each FTC basket.

* A CFC's related-person interest and other expenses are allocated and apportioned to the gross income of separate baskets in a four-step process.

* Each separate income basket includes the foreign income taxes related to the income in that basket.

This two-part article provides a quick guide to the key steps in computing a foreign corporation's earnings and profits (E&P). Part II discusses the allocation and apportionment of interest, expenses and taxes to the foreign tax credit (FTC) baskets.

A foreign corporation's earnings and profits (E&P) generally must be broken out into 10 foreign tax credit (FTC) income categories. After allocating gross income to the proper baskets, deductions and taxes must be allocated and apportioned to gross income to arrive at the E&P for each FTC basket. Part I of this two-part article, in the May 2004 issue, described the E&P computation, the allocation of income to the FTC baskets and the look-through rules. Part II, below, discusses how to allocate and apportion interest, expenses and foreign taxes to the FTC baskets.

Expense Allocation and Apportionment Rules

Generally, deductions related to a particular income class are subtracted from that income. Under Kegs. Sec. 1.861-8(b)(2), deductions are related if they are incurred as a result of, incident to, or in connection with an activity or property from which the income is derived. Deductions related to all gross income (or not related to any gross income) are ratably apportioned to all gross income under Regs. Sec. 1.8618(b)(1).

After deductions have been allocated to a class of gross income, they are apportioned among separate FTC baskets using an apportionment base that reasonably reflects the factual relationship between expenses and gross income. Potential apportionment bases include unit sales, gross sales or receipts, cost of goods sold, profit contributions, expenses incurred, assets used, salaries paid, space used, time spent and gross income, according to Temp. Regs. Sec. 1.861-8T(c)(1).

Regs. Sec. 1.861-8(e) provides specific allocation and apportionment rules for the following deductions:

* Interest;

* Research and experimental expenditures;

* Stewardship expenses;

* Legal and accounting fees and expenses;

* Income taxes;

* Losses on a sale, exchange or other disposition of property;

* Net operating loss deduction;

* Deductions not definitely related;

* Special deductions; and

* Charitable contributions.

In short, expenses are first allocated to a class of gross income and then apportioned to separate baskets (if appropriate) using one or more apportionment bases that reasonably reflect the factual relationship between the expenses and gross income, subject to specific allocation and apportionment rules for the expenses listed above and identified in Regs. Sec. 1.861-8(e). If an expense is related to all gross income (or not related to any class of gross income), it is ratably apportioned to all income.

CFC Allocations

Regs. Secs. 1.904-5(c) and 1.954-1(c) provide the basic rules for allocating and apportioning a controlled foreign corporation's (CFC's) expenses. Interest paid (or accrued) by a CFC to its U.S. shareholders (or any related person) is first allocated to the CFC's passive income. (15) Under Regs. Sec. 1.904-5(c)(2)(ii)(B)-(E), related-person interest (i.e., interest paid to U.S. shareholders or related persons) and other CFC expenses are allocated and apportioned to the gross income of the separate baskets in four steps:

1. Expenses (other than interest) definitely related to one or more (but not all) classes of gross income are allocated to such related classes and then apportioned to separate baskets. An expense is definitely related to a class of gross income if the CFC incurs it as a result of, incident to, or in connection with an activity or property from which the class of gross income is derived. An example of a definitely related expense is royalty payments, which are directly allocable to the income derived from the use of the technology or know-how. Rental expenses are also directly related to the class of gross income derived from the use of the property.

   Interest expense is not included in this step unless it is unrelated-person interest (i.e., interest not prod to related parties), directly allocable to income from a specific property...