Interest allocation: the dog days of summer.

• Author: Wells, Bret

What a difference a summer makes! Earlier this year, many had high hopes that the United States would finally correct the most significant tax mistake facing U.S. multinationals, namely the current method for allocating and apportioning interest expense among U.S. and foreign assets.

From its inception, section 864(e) of the Internal Revenue Code was intended to be a revenue-raising provision that was not based on sound policy. (1) As such, it has created substantial harm. (2) Congress has known for years that section 864(e) is flawed, but has been unsuccessful in building enough support to amend the provision. (3) Last year, Congress passed H.R. 2488 -- which would have substantially modified section 864(e)'s interest expense allocation rules (4) -- but the legislation was vetoed by President Clinton. (5) With the advent of a new Administration earlier this year, the tax community was optimistic that legislation would be passed again and, this time, actually signed. (6)

A consensus exists within the U.S. Department of Treasury, Congress, and the tax community that section 864(e) is flawed. Notwithstanding this broad-based agreement, however, pragmatic politics of budget economics continues to stymie reform. The first blow came with Treasury's decision to seek tax relief only for individuals to ensure that some tax bill actually passed this year. (7) Administration officials hinted that corporate tax relief would come in the fall. (8) Individual tax reform, set forth in Public Law No. 107-16, encountered greater than expected opposition but was finally signed into law by President Bush as the Senate passed to Democratic control. (9)

With the slow-down in the U.S. economy, the tide has turned. (10) Now, a growing opposition in Congress has coalesced. (11) The Congressional Budget Office projected that H.R. 2488's amendment to section 864(e) would cost more than $25 billion. (12) Although Congress is considering a massive economic stimulus bill to jump start the economy, international tax reform is not among the items listed for enactment. (13) Thus, even though many argue that section 864(e) should be reformed, Congress may still not be able to muster the political will to act.

Given that a legislative overhaul of section 864(e) appears unlikely in the near term, Treasury should reexamine its existing temporary regulations to correct the most serious shortfalls. To the government's credit, the Internal Revenue Service issued Notice 2001-59 requesting comments on whether the U.S. interest expense allocation and apportionment rules should be modified. (14) This article argues that Treasury has the regulatory authority to correct some important flaws contained in the current application of section 864(e). This article also argues that sound tax policy would be advanced if Treasury exercised that authority.

1. The Interest Expense Allocation Rules Should Further the Policy Goals of the Foreign Tax Credit Limitation Regime

   Under the foreign tax credit limitation rules, foreign income is separately categorized under section 904 and then expenses are allocated and apportioned between domestic and the various separate limitation categories of foreign income to determine the U.S. taxpayer's net foreign income in each category. With several important exceptions, section 864(e) generally seeks to make this allocation by allocating a U.S. taxpayer's consolidated U.S. interest expense ratably among the U.S. and foreign assets held by the U.S. consolidated group. (15) Again, this allocation of interest expense is important because the United States allows foreign tax credits to be claimed if and only if there is sufficient net foreign income in the separate category to which the credits relate. Thus, the U.S. interest allocation rules are a significant component to determine the amount of net foreign source income in each respective basket. To the extent that U.S. expenses are allocated against foreign-source income, a taxpayer will lose the ability to claim foreign tax credits to offset its residual U.S. tax liability. When a taxpayer cannot use these credits to offset its U.S. tax on foreign earnings, international double taxation is created.

   Under the original income tax laws of 1909 and 1913, (16) the United States provided no foreign tax credit relief, but, because the income tax rates were admittedly small, the lack of relief was not significant. With the advent of World War I, however, tax rates increased sharply in the United States and other countries. With the increasing tax rates, international double taxation became a significant expense to U.S. multinationals. As a result, in 1918 Congress adopted a regime that would allow U.S. taxpayers to claim foreign tax credits with respect to foreign income taxes. (17) The objective in allowing such credits is to prevent worldwide double taxation on the same earnings; this would be the result if both the host country and the United States attempted to assert taxing jurisdiction over the same income. (18) It is not clear why Congress chose to limit foreign tax credit relief to situations where the foreign tax is an income tax.

   Between 1918 and 1921, there were no limitations on the use of foreign tax credits. As a result, taxpayers could utilize the credits to fully reduce their residual U.S. tax liability on both domestic-source and foreign-source income. Thus, the ability to apply excess foreign tax credits against the tax liability of net domestic-source income created an erosion of the U.S. tax base. Allowance of foreign tax credits is consistent with capital-export neutrality since that approach would support the allowance of a refund even where foreign tax credits exceed the U.S. tax on foreign income. (19) To protect the U.S. tax jurisdiction of U.S. territorial income, however, in 1921 Congress limited the use of foreign tax credits such that taxpayers could utilize these credits only to the extent that they otherwise had a U.S. tax liability on net foreign-source income. (20) Thus, Congress has had a longstanding intent with respect to the U.S. foreign tax credit regime to prevent international double taxation except to the extent necessary to protect against erosion of the U.S. taxing jurisdiction of domestic-source income.

   The U.S.'s willingness to subordinate the goals of capital-export neutrality in order to protect its taxing jurisdiction was further exemplified in 1976. Prior to that date, taxpayers that incurred start-up foreign losses in one year and foreign income in a later year were not required to net these foreign losses against foreign income arising in later years. And yet, the foreign losses in early years could be claimed as deductions and reduce the U.S. tax liability on domestic-source income. Without recapturing this loss, the allowance of a tax credit against the future income created the ability to deduct foreign losses against U.S. domestic-source income and never pay U.S. tax on the future income. (21) In 1976, Congress enacted legislation that requires foreign-source income to be reclassified as domestic-source income (and thus excluded from the computation of the taxpayer's overall foreign tax credit limitation) to the extent that foreign-source losses had been deducted against domestic-source income in earlier years. (32) Accordingly, the United States has made a conscious choice to deviate from capital-export neutrality in order to protect its right to tax domestic-source income.

   In 1986, Congress expressed a further desire to raise revenue by limiting the ability of U.S. taxpayers to use foreign tax credits to offset U.S. residual taxation on foreign income. In this regard, Congress decided to further limit cross-crediting of foreign taxes against low-taxed foreign income. (23) Thus, Congress's purpose with respect to the U.S. foreign tax credit regime, as redefined in 1986, is to further deviate from capital-export neutrality to the extent necessary to prevent an inappropriate loss of residual U.S. taxation on low-taxed foreign earnings.

   The existence of the foreign tax credit and limitation regimes of sections 904(a), (d), and (f) can be summarized as follows: The foreign tax credit regime is intended to prevent worldwide double taxation except to the extent necessary to protect the U.S. taxing jurisdiction on domestic-source income and to the extent necessary to protect against cross-crediting of taxes against low-taxed foreign-source income. (24) If the foreign tax credit regime allows international double taxation for a reason other than these objectives, then Congress's expressed objectives are frustrated.

   It is important to recognize the fundamental choices that Congress has made with respect to the foreign tax credit regime because those decisions should be the guideposts for determining whether the interest expense allocation rules are achieving appropriate results. Several approaches have been articulated that might preserve these congressional choices. This author has advocated that a modified water's edge fungibility approach is probably the correct general rule from a policy perspective. Others believe that a "worldwide fungibility approach" is the better view. (25) Regardless of which view one holds, a consensus exists that the current rules work unfairly and that special factual situations exist where interest expense should be allocated on a separate affiliated group basis.

   In this regard, Congress provided several important exceptions to the allocation of U.S. consolidated interest expense on a consolidated basis. Congress provided an exception for banks under section 864(e) to treat these entities as a separate affiliated group for purposes of the interest expense allocation rules and provided Treasury authority to expand this exception to include bank holding companies and nonbank financial subsidiaries. (26) Treasury has exercised that authority to encompass bank holding companies and nonbank...