Tax Court rules on interest income and expense netting for determining deduction allocated between parent and DISC.

• Author: Zink, William J.
• Position: Domestic international sales corporation

U.S.-based multinational taxpayers required to allocate interest expense under various provisions of the Internal Revenue Code may be interested in a recent Tax Court ruling that could produce U.S. tax savings for their companies.

The Tax Court, in Bowater Inc., 101 TC No. 14 (1993), maintained that a U.S. parent company may net interest income against its interest expense in determining the amount of its interest deduction to be allocated and apportioned in computing combined taxable income for domestic international sales corporation (DISC) purposes. The Bowater case, based on an interpretation of regulatory language before 1988 and 1989, may present an opportunity for refund claims in open years concerning foreign tax credit limitations and DISC/FSC (foreign sales corporation) transfer pricing, as well as allow taxpayers required to apportion interest expense to reconsider their positions.

Bowater held that interest income may be netted against interest expense for purposes of determining the interest deduction allocated between a U.S. parent and a DISC for purposes of the safe harbor transfer pricing method. Bowater and its subsidiaries filed a U.S. consolidated income tax return for 1979 and 1980. One of the subsidiaries included in the consolidated income tax return owned a DISC. During these years, the DISC acted as a commission agent for the members of the U.S. affiliated group. Commissions due and owing the DISC were computed under the 50/50 combined taxable income (CTI) method. Under this method, the commission was based on 50% of taxable income related to export sales. For purposes of computing the taxable income, interest expense was to be allocated. In computing interest expense to be apportioned in the computation of the CTI, Bowater netted interest income against interest expenses.

The IRS disallowed the netting of interest income with interest expense. It required Bowater to compute its CTI without the benefit of this netting process, arguing that interest income should be considered separately, and not netted with interest expense.

The Tax Court decided that Bowater was permitted to net interest income against interest expense in determining the amount of interest deductions to be allocated and apportioned in computing the CTI for purposes of the safe harbor method of DISC transfer pricing. Citing the fungibility of money concept embodied in the income tax regulations, the Tax Court held that netting of interest was proper...