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Allocating interest and other expenses under Section 864(e).

Allocating Interest and Other Expenses Under Section 864(e) (*1)

I. INTRODUCTION

The allocation of interest and other expenses between United States and foreign source income has long been the subject of controversy. In an attempt to eliminate perceived distortions and opportunities for taxpayer manipulation, Congress enacted section 864(e) of the Internal Revenue Code as part of the Tax Reform Act of 1986. Generally, under this provision, a U.S. affiliated group must allocate interest as a fungible expense on the basis of its worldwide assets.

Proposed regulations under section 864(e) were released on September 11, 1987, to provide guidance to taxpayers; after receiving much taxpayer input, temporary regulations were issued on September 9, 1988. Unlike the 1987 proposed regulations, the temporary regulations must be followed until, and unless, regulations are issued in final form or the temporary regulations are withdrawn. Generally, the temporary regulations are effective for taxable years after December 31, 1986. One exception, however, is the new rule for "excess controlled foreign corporation (CFC) related-party indebtedness," which is effective for taxable years after December 31, 1987. (The new rule replaces the much criticized proposed CFC debt netting/tracing rule.)

This article explains and compares the temporary and the proposed regulations as they apply to the allocation of interest expense. In addition, the new rules for the allocation of expenses other than interest, such as overhead, are also described.

II. INTEREST COVERED

Any interest expense deductible under section 163 is subject to allocation under section 864(e) according to the regulations. The temporary regulations specifically define the term "interest" as the gross amount of interest expense incurred by a taxpayer in a given tax year. Temp. Reg. [sec.] 1.861-9T(a). This negates any argument that interest expense may be netted with interest income. In addition to what one usually understands to be "interest," such as earnings on time deposits or original issue discount, certain expense and losses related to the time value of money are treated as the equivalent of interest. For example, if a taxpayer borrows gold and immediately sells the gold and contracts to purchase gold at a higher price on the date the taxpayer must return the borrowed gold, the loss will be apportioned in the same manner as interest expense. Temp. Reg. [sec.] 1.861-9T(b)(1). (1)

Whereas the proposed regulations treated any loss on the sale of a receivable generated in the ordinary course of business as an interest equivalent, the temporary regulations apply to any loss on the sale of a trade receivable (factoring) unless at the time of sale of the receivable it bears interest at least equal to 120 percent of the applicable federal rate. If the receivable does not bear interest at the test rate, the loss is bifurcated between the portion attributable to other factors, such as credit risk and the cost of collecting the receivables, and the portion attributable to the time value of money. The time value of money portion is treated as interest and is calculated by discounting the receivable at 120 percent of the applicable federal rate. Temp. Reg. $S 1.861-9T(b)(3).

Similarly, effective for taxable years commencing after December 31, 1988, a loss on a hedged nonfunctional foreign currency borrowing (reduced or increased by the gain or loss on the hedge), will be apportioned in the same manner as interest expense. A nonfunctional currency borrowing will be presumed to be hedged if its interest rate is less than the applicable federal rate and if any forward, future, option, etc., substantially diminishes the interest expense or currency exposure on the borrowing. This presumption can be rebutted by a showing that the hedge arose in response to currency exposure arising in the ordinary course of business. Temp. Reg. [sec.] 1.861-9T(b)(2)(i). (2)

III. GENERAL ALLOCATION

RULES FOR INTEREST

EXPENSE

The temporary regulations are consistent with the main thrust of the proposed regulations, of course, since their principal objective is to implement the requirement, enacted in 1986, that U.S. corporations apportion and allocate interest expense on the basis of assets taking into account all assets of the U.S. affiliated group as if they were one corporation. The guiding principle is that money is fungible and interest expense is attributable to all activities and property regardless of any specific purpose for incurring an obligation. Temp. Reg. [sec.] 1.861-9T(a).

The asset method is described in Temp. Reg. [sec.] 1.861-9T(g). The asset method, which may reflect tax book or fair market value, is substantially the same as described in the proposed regulations. Asset values (book or market) are computed on the basis of the beginning and end of year values, except that for the first taxable year beginning after 1986 a taxpayer may chose to utilize year-end values alone. Temp. Reg. [sec.] 1.861-9T(g)(2)(i).

Where a substantial distortion would result from such averaging (for example, in the event of a major acquisition or disposition), the taxpayer must use a different method of asset valuation that more clearly reflects the weighted average value of assets held during the taxable year. Temp. Reg. [sec.] 1.861-9T(g)(2)(i). The rules for characterizing assets, now contained in Temp. Reg. [sec.] 1.861-9T(g)(3) and supplemented in [sec.] 1.861-12T, are essentially the same as those proposed. Assets are characterized according to the source and type of the income that they generate, have generated, or may reasonably be expected to generate. The physical location of an asset is not relevant for this determination.

Assets are grouped as either: single category assets, multiple category assets, or assets without directly identifiable yield (in other words, those assets that contribute equally to the generation of all the income of the taxpayer, such as assets used in general and administrative functions). Temp. Reg. [sec.] 1.861-9T(g)(3). Single category assets are directly attributable to the relevant grouping of income. The value of multiple category assets is prorated among the relevant income groups on the basis of the proportion of gross income generated by it within each relevant grouping during the taxable year. Assets without directly identifiable yield (headquarter's office building, etc.) must be identified because such asset values are to be disregarded.

For loans between members of an affiliated group (including any receivable), the indebtedness of the member borrower shall not be considered an asset of the member lender. An exception to this rule exists for financial groups (i.e., banking). Temp. Reg. [sec.] 1.861-11T(e)(1).

Regarding interest expense arising between members of an affiliated group, a member borrower shall deduct related-person interest expense using group apportionment fractions. A member lender shall include related-person interest income in the same class of gross income as the class of gross income from which the member borrower deducts the related-person interest payment. Temp. Reg. [sec.] 1.861-11T(e)(2)(i).

The process of interest expense allocation and apportionment may be viewed as a series of steps as follows (condensed with exceptions ignored).

Step One

Assets must be divided into four main categories:

1. Assets Subject to Direct Allocation (See "Exceptions to Fungibility" below).

2. Assets generating U.S. Source Income ("U.S. Assets").

3. Assets Generating Foreign Source Income by Category ("Foreign Assets").

4. Assets Without Identifiable Yield.

(Assets subject to direct allocation and corresponding interest and assets without identifiable yield will be disregarded for the following steps.)

Step Two

The amount of third-party interest expense of the U.S. affiliated group subject to apportionment will be apportioned against U.S. source income (thereby receiving a full U.S. tax deduction) using the following fraction:

U.S. Assets/U.S. and Foreign Assets X Third-Party Interest Expense

Step Three

The remaining interest expense will be foreign source. It must be apportioned to the various separate section 904(d) limitation categories (i.e., separate baskets of income) where it will be deducted against the income in those categories using the following fraction:

Assets Generating Separate Basket Income/U.S. and Foreign Assets X Third-Party Interest Expense

A loss of one affiliate in a separate section 904(d) limitation category will reduce the income of other members in the same category if a consolidated return is filed. If a consolidated return is not filed or if total consolidated income in a category becomes a loss, losses created through group apportionment in a category must be eliminated and a corresponding amount of income of other members in the same limitation category must be recharacterized. This is done by offsetting such loss against income in other limitation categories. If there is not sufficient foreign income, domestic income will be offset. Temp. Reg. [sec.] 1.861-11T(g).

If a taxpayer has a loss in a separate limitation category in a noncontrolled section 902 company as a result of interest expense apportionment it may elect to allocate interest expense to any other separate limitation category that is in an excess credit position. Temp. Reg. [sec.] 1.861-12T(c)(4)(ii).

IV. TREATMENT OF VARIOUS

ENTITIES

A. CORPORATIONS

Under section 864(e), the assets of all the members of a U.S. affiliated group are to be taken into account as if they were one corporation. Indeed, under the temporary regulations, even certain unaffiliated corporations may be treated as members of the affiliated group. The test for inclusion is if 80 percent of either the vote or value of all outstanding stock is owned directly or indirectly by a member of the affiliated group. Although not expressly stated in the temporary regulations, the term "value" refers to "fair market value." (3) Thus, it is not possible to avoid the interest allocation rules by causing a highly leveraged subisidiary to issue to unrelated parties more than 20 percent of the voting stock when the group retains more than 80 percent of the value of the subsidiary's stock. Temp. Reg. [sec.] 1.861-11T(d)(6) (i).

Even a foreign corporation may be included under the new standard if more than 50 percent of its gross income is effectively connected with a U.S. trade or business. If at least 80 percent of its income is effectively connected income, all its assets and all its interest expense are taken into account for purposes of the interest allocation rules. If between 50 percent and 80 percent of its gross income is effectively connected, only the assets that generate effectively connected income and a percentage of its interest expense are taken into account. Accordingly, the interest expense allocation rules also cannot be avoided by using a foreign subsidiary to conduct a highly leveraged business in the United States. Temp. Reg. [sec.] 1.8611-11T (d)(6) (ii).

B. PARTNERSHIPS

The temporary regulations did not make any significant changes to the rules for partnerships contained in the proposed regulations. A partner's distributive share of partnership interest expense is still apportioned at the partner, not partnership level, using all the income producing activities and assets of the partner. A 10 percent or more corporate partner uses the parthership's inside basis in the partnership assets when using the tax book value method for apportioning interest expense. A partner's percentage interest in the partnership and its pro rata share of assets is determined by reference to the partner's interest in partnership income for the year. Temp. Reg. [sec.] 1.861-9T(e)(2).

The less-than-10 percent corporate general partner and less-than-10 percent limited partner rules also were not changed materially. The interest expense attributable to such partnership interests shall be directly allocated to its distributive share of partnership gross income. Temp. Reg. [sec.] 1.861-9T(e)(4). (The foreign income from less-than-10-percent partnership interests continues to be treated as passive income under Treas. Reg. [sec.] 1.904-7(i)(2)).

If a partnership is a partner in another partnership, the distributive share of interest expense of a lower-tier partnership owned less than 10 percent will not be reapportioned in the hands of any higher-tier partnership. Lower-tier partnerships owned more than 10 percent shall be apportioned by the partner of the higher-tier partnership. Lower-tier partnerships owned more than 10 percent shall be apportioned by the partner fo the higher-tier partnership, taking into account the partner's indirect pro rata share of the lower-tier partnership's income or assets. Temp. Rg. [sec.] 1.861-9T(e)(5).

C. FOREIGN BRANCHES OF

U.S CORPORATIONS

Although understood previously, the temporary regulations expressly declare that all the assets and interest expense of a foreign branch of a domestic corporation are taken into account for purposes of interest expense sourcing. Temp. Reg. [sec.] 1.861-9T(j)(2).

D. CONTROLLED FOREIGN

CORPORATIONS

For purposes of computing Subpart F income and computer earnings and profits for all other federal tax purposes, the interest expense of a controlled foreign corporation may be apportioned using either the asset method or a new modified gross income method. The stock of a CFC shall be characterized in the hands of any U.S. shareholder using the same method--asset or modified gross income method--that is used to apportion the CFCs interest expense. The new modified gross income method is not available if a controlling U.S. shareholder elects to use the fair market value of apportionment. Temp. Reg. [sec.] 1.861-9T(f) (3)(i)(iv).

Under the modified gross income method, the interest expense of a CFC is apportioned based on its gross income. If there is a chain of CFCs, the interest expense of the lowest-iter CFC is allocated and apportioned based on its gross income yielding gross income in each group net of interest expense. The pro rata share of the gross income net of interest expense of such lower-tier CFC is then combined with the income of the next higher-tier CFC and its interest expense apportioned based on the combined income. This cycle is repeated until the interest expense of the entire chain has been apportioned. Although revenue neutral, the elective modified gross income method was sought by many taxpayers as a means to reduce the additional workload imposed by the new rules. The administrative burden is reduced because of CFCs gross income must be calculated for other purposes (e.g., overhead sourcing and Subpart F). Temp. Reg. [sec.] 1.861-9T(j).

The modified gross income method, if elected, must be employed by all CFCs owned by the U.S. group. The election to use one or the other method may be made by either the CFC or its controlling U.S. shareholders. The election is made by filing a written statement pursuant to the section 964 regulations, except that no such written statement or notice is required to be filed or sent before March 13, 1989 (i.e., 180 days after September 9, 1988--the date the temporary regulations were released). Temp. reg. [sec.] 1.861-9T(f)(3)(ii).

V. TAX BOOK VALUE

When applying the asset method, the value of assets may be established using the "tax book value" method or the fair market value method. Temp. Reg. [sec.] 1.861-9T(g)(1)(ii).

For taxpayers using the tax book value method, the basis of investment in stock of 10-percent owned non-consilidated companies must be adjusted for accumulated earnings and profits. The basis must be increased by the amount of earnings and profits attributable to such stock during the period held by the taxpayer and reduced (but not below zero) by any deficit in earnings and profits occurring during such period. The temporary regulations specify that generally the rules of section 1248 must be used to determine earnings and profits. Temp. Reg. [sec.] 1.861-12T(e)(2)(i). Nevertheless, there is an exception for investments in foreign corporations. For tax years beginning before 1987, financial earnings (or losses) of a foreign corporation computed using U.S. generally accepted accounting principles may be substituted for earnings and profits to make the adjustment. Temp. Reg. [sec.] 1.861-12T(c)(iv).

Interestingly, it is difficult to find a definition of "tax book value" in the temporary regulations. The proposed regulations defined "tax book value" simply as "adjusted basis" in Prop Reg. [sec.] 1.861-8(e)(2)(viii)(2). This definition is not contained in the temporary regulations.

The term "tax book value" is not found in the Internal Revenue Code. Section 1.861-8(e)(2)(v) of the old interest expense sourcing regulations defined "tax book value" as "original cost for tax purposes less depreciation allowed for tax purposes." The term "U.S. tax book value" appears in Treas. Reg. [sec.] 1.882-5 which deals with the allowance of deductions for interest expense to foreign corporations doing business in the United States. "U.S. tax book value" is defined therein as "adjusted basis for determining gain or loss from sale or other disposition." In Technical Advice Memorandum 8531009, dated April 29, 1985, the IRS stated that the definition in Treas. Reg [sec.] 1.882-5 of "U.S. tax book value" was "not meant to reflect a different meaning than the term "tax book value" as used in Treas. Reg. [sec.] 1.861-8(e)(2)(v). Rather, the description of the term "U.S. tax book value" given in Treas. Reg. [sec.] 1.882-5 was meant to make the meaning of the term clearer." Accordingly, in the Technical Advice Memorandum, the IRS held that "the phrase 'tax book value' as used in [sec.] 1.861-8(e)(2)(v) of the regulations means adjusted basis for tax purposes."

It seems, however, that the old definition in Treas. Reg. [sec.] 1.861-8(e)(2)(v) can no longer be cited as authority. In the preamble to the Temporary Regulations, certain amendments to the existing regulations were adopted. Ine such amendment involved Treas. Reg. [sec.] 1.861-8(e)(2). The regulation was reserved and taxpayers told to look for guidance in Temp. Reg. [sec.] 1.861-8T(e)(2), which simply states that "the rules concerning the allocation and apportionment of interest expense and certain interest equivalents are set forth in [sec.] 1.861-9T through [sec.] 1.861-13T." It follows that section [sec.] 1.861-8(e)(2)(v) of the old regulations can no longer be cited with confidence for the definition of tax book value.

In light of the foregoing, are there grounds for arguing that "tax book value" is anything other than "adjusted tax basis?" The answer is clearly "no." Section 864(e) requires that interest expense shall be allocated and apportioned "on the basis of assets." The legislative history of the Tax Reform Act of 1986 indicates that Congress was aware of the accepted Treas. Reg. [sec.] 1.861-8(e)(2)(v)'s definition of "tax book value." The language of Section 864(e)(4), regarding the adjustment for earnings and profits to the basis of stock in certain corporations, implies that the adjusted basis of any asset is to be used to apportion interest expense except in the case of such stock. Example 1 of Temp. Reg. [sec.] 1.861-9T(g)(1)(v), illustrating the asset method, uses "adjusted basis" to mean "tax book value." Lastly, Treas. Reg. [sec.] 1.882-5's definition of "U.S. tax book value," while not binding authority, still may be referred to with confidence.

It seems the fact that a clear definition of "tax book value" was not included in the temporary regulations was just an oversight or perhaps the Treasury intends to expand the definition to make it clearer. In either case, for purposes of complying with the temporary regulations, one should assume that "tax book value" means adjusted basis except for stock subject to the adjustment for earnings and profits.

VI. FAIR MARKET VALUE

Regarding the fair market value method, Temp. Reg. [sec.] 1.861-9T(h) contains new rules that must be used to determine the "fair market value" of a corporation's assets. The first step is a valuation of a group's total assets. For publicly traded corporations, this is deemed to be equal to the aggregate year-end trading value of the corporation's stock, increased by the corporation's year-end liabilities to unrelated persons and its pro rata share of year-end liabilities of all related persons owed to unrelated persons. For corporations that are not publicly traded, the total value of the group's assets is determined by capitalizing corporate earnings (in accordance with Rev. Rul. 68-609). Temp. Reg. [sec.] 1.861-9T(h)(1).

The next step is the valuation of tangible assets that "shall be made using generally accepted valuation techniques." Temp. Reg. [sec.] 1.861-9T(h)(1)(ii). After the value of tangible assets is determined, the value of intangible assets (i.e., goodwill and going-concern value) is determined by substracting the value of tangible assets from the corporation's total value, as determined above. Temp. Reg. [sec.] 1.861-9T(h)(1)(iii). These intangible assets are then apportioned in proportion to the group's net income before interest expense and including the group's pro rata share of the net income before interest expense of each related person held by the taxpayer. Net income for this purpose excludes passive income and is determined before reduction for income taxes. Temp. Reg. [sec.] 1.861-9T(h)(2). The value of stock in a related person is determined in the same manner. Temp. Reg. [sec.] 1.861-9T(h)(4).

If the parent of the U.S. grou or a substantial portion of the affiliated group used the fair market value method prior to 1987, such a taxpayer may use either the fair market value or the tax book value method for its tax year commencing in 1987 and may use either method in its tax year commencing in 1988. The use of the fair market method in 1988, however, shall act as a binding election requiring the continued use of the fair market value method by the taxpayer and all related persons unless the Commissioner expressly authorizes a change. Temp. Reg. [sec.] 1.861-9T(g)(1)(ii).

VII. EXCEPTIONS TO

FUNGIBILITY

Temp. Reg. [sec.] 1.861-10T contains three exceptions to the rule that requires the apportionment and allocation of interest expense applying the fungibility principle: Qualified Nonrecourse Debt, Integrated Financial Transactions, and Related Controlled Foreign Corporation Debt (i.e., the new CFC debt netting rule).

A. QUALIFIED NONRECOURSE

DEBT

1. Cash Flow From The Property

In the preamble to the temporary regulations, qualified nonrecourse indebtedness is referred to as "purchase money financing of certain assets that can reasonably be expected to self-finance. In order for a loan to qualify, the creditor's rights must extend only to the asset purchased, and the property may not involve significant activity on the part of the owner in order to generate income." In other words, there is a new emphasis on whether the "cash flow from the property" will be sufficient to service the interest and principal repayments.

Under the proposed regulations, whether nonrecourse debt qualified for direct allocation of interest expense to the source of income of the project being financed depended on the "facts and circumstances." Prop. Reg. [sec.]1.861-8(e)(2)(iv). One of the listed factors was whether there was sufficient cash flow from the property. Temp. Reg. [sec.] 1.861-10T(b)(3) makes "cash flow from the property" a separate requirement. New explanatory language and examples make it clear that "cash flow" is now the predominant test to qualify nonrecourse debt and that the new test willr rarely be satisfied.

"Cash flow" for purposes of the temporary regulation is cash receipts, substantially all of which must be derived directly from the property, reduced by cash disbursements other than debt service. Temp. Reg. [sec.] 1.861-10T(b)(3)(iii). Cash flow does not include revenue derived from sales, labor, services, or the use of other property or revenue derived in part from performing services that are not ancillary and subsidiary to the use of the property. Revenue derived from the sale or lease of inventory is specifically excluded. Temp. Reg. [sec.] 1.861-10T(b)(3)(i). Essentially, only passive investments will qualify. This is illustrated by the examples in Temp. Reg. [sec.] 1.861-10T(b)(3)(v). There, debt incurred to acquire a hotel that the taxpayer operates, even where the debt is secured only by the hotel, does not qualify because of the "services incidental to the occupancy of hotel rooms." Similarly, the expenditures for labor or raw materials required to operate a factory would disqualify non-recourse debt incurred for its construction. This is because the income from the hotel and the factory is considered not to constitute a return on or from the property since it is tainted by the services, labor, and raw material necessary for its generation.

The only example in the regulations of a project with adequate "cash flow from the property" is the purchase of an apartment building. Although services are provided to tenants, the services are ancillary and subsidiary to the occupancy of the apartments. Accordingly, the rents received are part of "cash flow from the property." In the example, because the rental income is reasonably expected to be sufficient to service the annual debt service plus taxes on the building and other deductible expenses, there is adequate "cash flow from the property." Temp. Reg. [sec.] 1.861-10T(b)(3)(v), Example 1.

A new proposed regulation would quantify the amount of services that can be provided without tainting all of the revenue from the project. Under the proposed regulations, if operating costs other than interest exceed 15 percent of the total income derived from the property, then a significant portion of revenue shall be considered to be derived from sales, labor, services, or the use of other property. "Operating costs" for this purpose only includes expenses that are deductible solely under section 162. Prop. Reg. [sec.] 1.861-10(b)(iv).

The new "cash flow from the property" requirement is effective retroactively back to taxable years beginning after December 31, 1986. Temp. Reg. [sec.] 1.861-8T(h).

2. General Requirements for Nonrecourse Debt

Putting aside the question whether a project can reasonably be expected to generate sufficient "cash flow from the property," the project itself must be permissible. To qualify, nonrecourse borrowing must be (i) incurred for the purpose of purchasing, constructing, or improving identified property that is either depreciable tangible personal property or real property with a useful life of more than one year or (ii) be for the purpose of purchasing amortizable intangible personal property with a useful life of more than one year. Temp. Reg. [sec.] 1.861-10T(b)(2)(i).

"Maintaining" property is not a permissible purpose. This is a change from the old 1977 regulations which did allow "maintaining." Treas. Reg. [sec.] 1.861-8(e)(2)(iv)(1). Another change is that the temporary regulations add "constructing" to the list of permissible activities. Construction was not included as an acceptable purpose in the proposed regulations.

The temporary regulations specifically provide that purchases of inventory or financial assets, including stock, partnership interests, or a debt obligation, cannot qualify. This makes it impossible to obtain qualifying nonrecourse debt to finance leveraged buyouts of stock. Temp. Reg. [sec.] 1.861-10T(b)(4)(iv)(v).

The debt must be, of course, nonrecourse. The creditor can look only to the identified property (or any lease or other interest therein) as security for payment of the principal and interest on the loan and there must be restrictions in the loan agreement on the disposition or use of the property consistent with the assumptions that the property serves as security for payment. The proceeds must actually be applied to the purchase, construction, or improvement of the identified property. Temp. Reg. [sec.]1.861-10T(b).

3. Credit Enhancement and Cross Collateralization

Any transaction that lacks economic significance or involves cross collateralization or credit enhancement will not qualify. As in the proposed regulations, a "credit enhancement" is any device, including a contract, letter of credit or guaranty, that expands the creditor's rights, directly or indirectly beyond the identified property and thus effectively provides as security for a loan the assets of any person other than the borrower. There is a special rule for leveraged leases: an unrelated person may guarantee without recourse to the lessor the lessor's payments of principal and interest. Temp. Reg. [sec.' 1.861-10T(b)(7).

The temporary regulations provide that a "syndication of credit risk" constitutes a prohibited credit enhancement but a "sale of loan participations" does not. The term "syndication of credit risk" refers to an arrangement in which one primary lender secures the promise of a secondary lender to bear a portion of the primary lender's credit risk on a loan. This constitutes credit enhancement because the primary lender can look to secondary lenders for payment of the loan, notwithstanding limitations on the amount of the secondary lender's liability. An example would be where a bank issues a nonrecourse letter of credit and syndicates its obligations. The term "sale of loan participations" refers to an arrangement in which one primary lender divides a loan into several portions, sells and assigns all rights with respect to one or more portions to participating secondary lenders, and does not remain at risk in any manner with respect to the portion assigned. This is permissible because the holder of each portion of the loan can look solely to the asset securing the loan and not to the credit or other assets of any other person. Examples would include typical sales of loan participations as well as syndications of funded loans. Temp. Reg. [sec.] 1.861-10T(b)(7)(iii).

Prohibited "cross collateralization" refers to the pledge of any asset of the borrower other than the identified property (i.e., purchased, constructed, or approved with the loan proceeds) or the pledge of any asset belonging to any related person. Temp. Reg. [sec.] 1.861-10T(b)(6). A new proposed regulation, [sec.]1.861-10(b)(12), would disqualify any transaction involving "excess collateralization," which would be present if the principal amount of the loan is less than 60 percent of the value of the identified property (purchase price or construction cost in the case of self-constructed assets). If the principal amount of the loan is greater than 80 percent of such value, then the loan will not have excess collateralization. If the loan is between 60 to 80 percent of the value of the identified property, whether the loan involves "excess collateralization" shall be based on facts and circumstances. The proposed rule would be effective for taxable years after December 31, 1989. Evidently the Treasury is concerned that some taxpayers might be willing to sufficiently capitalize a project so that the necessary financing and corresponding loan payments would be small enough that the property could generate adequate cash flow to service the loan.

Temp. Reg. [sec.] 1.861-10T(b)(8) lists five arrangements that do not constitute cross collateralization or credit enhancement:

a. Integrated Projects: A pledge of multiple assets of an integrated project (i.e., functionally related and geographically contiguous assets that, as to the taxpayer, are used in the same trade or business).

b. Insurance: A taxpayer's purchase of third-party casualty and liability insurance on the collateral or a taxpayer's bearing, by contract, the risk of loss associated with destruction of the collateral or from attachments of third-party liability claims.

c. After-Acquired Property: Extension of a creditor's security interest to improvements made to the collateral will not disqualify a loan provided that the extension does not constitute excess collateralization. (4)

d. Warranties of Completion and Maintenance: A taxpayer may warranty to a creditor that it will complete construction or manufacture of the collateral or that it will maintain the collateral in good condition.

e. Substitution of Collateral: A right to substitute collateral under any loan contract will not disqualify the indebtedness until and unless the right is exercised. Temp. Reg. [sec.] 1.861-10T(b)(8).

4. Refinancings

Under the temporary regulations, if a taxpayer refinances qualified nonrecourse indebtedness, the new indebtedness will continue to qualify as long as the principal amount of the new indebtedness does not exceed by more than five percent the remaining principal amount on the old indebtedness and the term of the new debt does not exceed the remaining term of the original debt by more than six months. Temp. Reg. [sec.] 1.861-10T(b)(9). The proposed regulations did not permit any increase in debt levels or extension of the remaining term. Prop. Reg. [sec.] 1.861-8(e)(2)(iv)(C).

5. Post-Construction Permanent Financing

The temporary regulations liberalize the proposed rule permitting debt that is obtained after the completion of constructed property. Prop. Reg. [sec.] 1.861-8(e)(2)(iv)(D). The financing must be obtained within one year after the constructed property or substantially all of a constructed integrated project is placed in service and the financing cannot exceed the cost of construction (including construction period interest). The proposed requirements that the proceeds of the financing had to be used to repay construction period loans and that the borrower owned the property when it was first placed in service were eliminated. Temp. Reg. [sec.] 1.861-10T(b)(10).

B. INTEGRATED FINANCIAL

TRANSACTIONS

Temp. Reg. [sec.] 1.861-10T(c) contains a new rule for integrated financial transactions that allocates interest expense directly to income from an investment funded with amounts borrowed for the purpose of acquiring the investment. The following requirements must be met:

* The debt, when incurred, must be identified as incurred to acquire an identified term investment and that investment must be made within ten days.

* The investment income must be interest, OID, or income equivalent to interest.

* The return on the investment must be reasonably expected to be sufficient throughout the term of the investment to service the debt. For purposes of this evaluation, it appears that both the income and the expense should be measured on a pre-tax basis.

* The debt and the investment must mature within 10 days of each other.

* The investment must not relate to, or be made in the normal course of, the trade or business of the taxpayer or any related person (which includes any contribution or loan to an employee stock ownership plan defined in section 4975(e)(7) or other qualified plan under section 401(a)).

* The borrower must not be a financial services entity (as defined in section 904). Temp. Reg. [sec.] 1.861-10T(c).

One example of an integrated financial transaction would be a manufacturer who borrows to buy stock which it then agrees to sell in a forward contract. Provided the return on the deal is sufficient to pay the interest on the debt, the interest expense will be directly allocated. Temp. Reg. [sec.] 1.861-10T(c)(4), Example (1).

1. Related-Party Transactions

The temporary regulations continue the rule that debt between related parties, or incurred from unrelated persons to purchase property from a related person, cannot qualify as nonrecourse debt or as an integrated financial transaction. The rule is now broadened so that debt incurred to purchase property that is leased to a related person also cannot qualify. Temp. Reg. [sec.] 1.861-10T(d)(1).

2. Asset Adjustment in the Event of Direct Allocation

If interest expense is directly allocated under either the nonrecourse debt rule or the integrated financial transaction rule, the year-end value of the asset purchased with the debt shall be reduced by the percentage of the principal amount of indebtedness outstanding at year-end equal to the percentage of all interest on the debt for the taxable year that is directly allocated. For example, if 60 percent of interest expense on a debt is directly allocated, then the asset's value will be reduced by 60 percent of the outstanding principal balance of the debt. If 100 percent of the interest is directly allocated, then the asset value shall be reduced by 100 percent of the outstanding balance of the debt. Temp. Regs. [sec.] 1.861-10T(d)(2) and [sec.] 1.861-9T(g)(2)(iii).

C. TREATMENT OF CERTAIN

RELATED CFC

INDEBTEDNESS

Under Prop. Reg. [sec.] 1.861-10(c)(4), U.S. affiliated groups that made loans to their CFCs were, in general, required to directly expense against the interest income earned on the CFC loans. This was part of the notorious "CFC Debt Netting Rule." After receiving criticism from commentators and most industry groups that the proposed rule was contrary to the fundamental theory of the new law and congressional intent, the proposed "CFC Debt Netting Rule" has been eliminated and replaced with a new rule and a new concept equally unfounded under the statute. Generally, the new rule requires direct obligations to foreign sources of all or part of the interest expense of the U.S. affiliated group when a substantially disproportionate amount of the indebtedness of the worldwide group to unrelated third parties is incurred by the U.S. affiliated group. Temp. Reg. [sec.] 1.861-10T(e).

To implement the new concept, the temporary regulations require a taxpayer to go through a tortuous six-step formula which is not a model for future rule-making. Step 3 should be 4 or 5 and possibly the most far reaching aspect of the formula is hidden in a provision which is located after the formula and after the definitions (i.e., the reclassification of CFC stock as CFC debt in Temp. Reg. [sec.]1.861-10T(e)(3)).

Step 1: Compute the debt-to-asset ratio of the related U.S. shareholder. "Related U.S. shareholder" refers to the entire affiliated group of a U.S. incorporated company owning shares in a CFC. Temp. Reg. [sec.] 1.861-10T(e)(2)(i). Regarding debt, only debt owed to third parties or unaffiliated companies (e.g., CFCs) is included; interaffiliate debt must be eliminated.

Step 2: Compute the aggregate debt-to-asset ratio of all related CFCs. A "related CFC" is any CFC owned more than 50 percent by the U.S. shareholder. Temp. Reg. [sec.] 1.861-10T(e)(2)(ii). Regarding debt, only debt owed to third parties is included; debt owed to the U.S. group or related CFCs is excluded.

Step 3: Compute aggregate related person debt of all related CFCs.

Step 4: Compute the excess related-person indebtedness and compute income therefrom.

Step 5: Determine the aggregate amount of related CFC obligations held by the related U.S. shareholder in each limitation category.

Step 6: Directly allocate the U.S. shareholder's third-party interest expense.

In step 4, if the ratio computed under Step 2 (the CFC ratio) is less than the "applicable percentage" of the Step 1 ratio (the U.S. shareholder's ratio), then the taxpayer adds to the aggregate third-party indebtedness of all related CFCs that portion of the related-person indebtedness computed under Step 3 so that the ratio computed under Step 2 is equal to the applicable percentage of the ratio computed under Step 1. The "applicable percentage" is 50 percent for taxable years beginning in 1988, 65 percent for 1989, and 80 percent for 1990 and thereafter. There is no percentage for 1987 because the provision is effective for taxable years commencing after December 31, 1987. Please note that that makes this one of the few provisions in the temporary regulations which is not retroactive back to January 1, 1987.

Briefly, this formula works, as follows. First, one must determine whether one has "substantially disproportionate indebtedness." This is accomplished by comparing the debt-to-asset ratio of the U.S. affiliated group with the debt-to-asset ratio of all related controlled foreign corporations (CFCs). If the CFC debt-to-asset ratio is equal to or more than 80 percent (or 65 percent in 1989 or 50 percent in 1988) of the U.S. group's debt-to-asset ratio, then one does not have substantially disproportionate indebtedness, and no portion of the interest expense of the U.S. affiliated group must be directly allocated to foreign sources. In this case, the taxpayer would not need to go any further in its analysis.

But if one has "substantially disproportionate indebtedness" under this test, a portion of the interest expense of the U.S. group must be directly allocated to foreign sources. The amount of interest expense subject to such direct allocation, conceptually, is equal to the interest expense accruing on the amount of debt it would take to bring the CFC debt-to-asset ratio up to 80 percent (or 65 percent or 50 percent) of the U.S. group's debt-to-asset ratio (assuming such debt were being taken from the U.S. group's total).

The temporary regulations say that only excess related-party indebtedness" is subject to such direct allocation and that, generally, this is equal to the CFC debt owed to the U.S. group. This is just lip service, however, since if a taxpayer does not have sufficient CFC debt to the U.S. group to satisfy the formula, a special rule causes certain CFC stock held by the U.S. group to be treated as related-party indebtedness. Such stock includes:

* Any stock in a CFC that is treated as debt under the law of any foreign country that allows a deduction for interest or OID on such stock;

* Any stock of CFC that holds stock in a CFC whose stock is treated as debt; or

* Any stock in a CFC that has made a loan to be related CF to the extent of the principal amount of such loans. Temp. Reg. [sec.] 1.861-10T(e)(3)(ii).

Because multinationals often have significant levels of CFC-to-CFC debt, application of the formula goes beyond the proposed regulations' scope of recharacterizing loans from the U.S. group of CFCs. In fact, even if a taxpayer had no loans from the U.S. group to its CFCs, interest expense could be directly allocated to foreign sources if its CFCs made loans to one another. The following example illustrates the concept.

Assume a taxpayer's U.S. affiliated group has $2 million of assets and $1 million of third-party debt on which it pays $100,000 of interest. Thus, its unadjusted ratio is one over two or 0.5. The year is 1990 so the applicable percentage is 80 percent; thus, the adjusted U.S. ratio is 80 percent of 0.5 or 0.4.

The taxpayer's CFCs have assets of $500,000, and third-party debt of $100,000 on which $10,000 of interest is paid. Thus, the CFC ratio is one over five, or 0.2.

Since the CFC ratio, 0.2, is less than the adjusted U.S. ratio, 0.4, the taxpayer has substantially disproportionate indebtedness. Thus, the CFCs are deemed to have "excess related-party indebtedness." Assuming the CFCs, in the aggregate, had borrowed $50,000 from the U.S. group, on which $5,000 of interest is paid, the full U.S. CFC debt, $50,000, would be treated as excess related-party indebtedness. Temp. Reg. [sec.] 1.861-12T(j), Example 2. This would bring the CFC ratio up to 0.3 (150,000/500,000), which would still not be adequate to satisfy the formula. Accordingly, assuming that the CFCs had made inter-CFC loans of $75,000, stock of the CFCs making such loans would be treated as excess related-party indebtedness in the amount of $50,000, which would be sufficient to bring the CFC ratio to 0.4 (200/500).

For purposes of the formula, interest income would be inputed to the CFC stock treated as excess related-party indebtedness equal to the interest that would be computed on an equal amount of indebtedness under section 1274 (i.e., the applicable federal rate described in the OID rules). Temp. Reg. [sec.] 1.861-10T(e)(3). (Assume the AFR was 10 percent resulting in $5,000 of inputed interest income on the $50,000 CFC stock treated as excess related-party indebtedness).

Third-party interest expense of the U.S. group equal to the amount of interest income received on the excess related-person indebtedness would then be allocated among the various separate limitation categories in proportion to the relative aggregate amount of related CFC obligations held by the U.S. group in each category. Temp. Reg. [sec.] 1.861-10T(e)(1)(vi).

Thus, in this example, $10,000 of interest expense of the U.S. group would be directly allocated against foreign source income in the various categories determined by the categorization of the stock of the CFCs having debt to the U.S. group and the stock of the CFCs holding debt of other CFCs. Temp. Reg. [sec.] 1.861-10T(e)(1)(v). In apportioning interest expense, the value of assets in each separate category would be reduced (but not below zero) by the principal amount of third-party indebtedness of the U.S. group allocated to each category. Temp. Reg. [sec.] 1.861-10T(e)(4).

An elective quadratic formula is available to reflect such asset reductions during the calculation of excess related-party indebtedness. Temp. Reg. [sec.] 1.861-10T(e)(1)(iv)(B). The quadratic formula, shown in the accompanying box, is intended to calculate the smallest amount of excess related-party indebtedness (symbolized here as E).

Using the facts of the example, the equation is as follows: 1,000,000 - E / 2,000,000 - E X .8 = 100,000 + E / 500,000

The quadratic formula will always help the taxpayer because it effectively reduces the U.S. group's third-party indebtedness and assets equally as each dollar of deemed excess related-party indebtedness is recast as CFC third-party debt. This reduces the U.S. debt-to-asset ratio, thereby reducing the amount of CFC third-party debt necessary to bring the CFC debt-to-asset ratio into line.

In this example, after doing the calculations described in detail in Temp. Reg. [sec.] 1.861-12T(j), Example 2, E is $90,519. The result is that only $40,519 of CFC stock must be characterized as excess related-party indebtedness, instead of $50,000 and, correspondingly, the amount of actual and deemed interest income on such excess related-party indebtedness is reduced from $10,000 to $9,052 ($5,000 on the $50,000 U.S. group to CFC loans and $ 4,052 arising from the CFC to CFC loans). Temp. Reg. [sec.] 1.861-12T(j), Example 2.

Regardless of what the result is under the quadratic formula or under the unadjusted mechanical formula, excess party indebtedness can never exceed the aggregate amount of related CFC indebtedness (i.e., actual CFC to the U.S. group debt and certain CFC stock described above).

To calculate the debt-to-asset ratios, the following definitions apply:

* The debt numerator in the debt-to-asset ratio is the average month-end debt level for the taxable year owing to unrelated parties only. Temp. Reg. [sec.] 1.861-10T(e)(1)(i)(ii).

* The asset denominator of the fraction is either the tax book or fair market value of the assets owned by the U.S. affiliated group including stockholdings and obligations of CFCs but excluding stockholdings and obligations of members of the U.S. group. (All assets owned by the U.S. group are included, including foreign assets owned by foreign branches of U.S. incorporated companies.)

* For the CFC group, the asset number is the aggregate value of the assets of the CFCs excluding stockholdings and obligations of the U.S. group or other related CFCs. Temp. Reg. [sec.] 1.861-10T(e)(1)(i)(ii). (The asset totals should not be confused with the asset figures used for overall U.S./foreign apportionment).

* The tax book or fair market value of assets used in the denominator is calculated using the general rules. The value of assets is an average computed on the basis of the values of assets at the beginning and end of the year. Temp. Reg. * 1.861-11T(e)(2)(iii) and [sec.] 1.861-9T(g)(2)(i).

The CFC debt section of the temporary regulations contains two provisions giving the IRS discretionary authority to override the mechanical formula. First, Temp. Reg. [sec.] 1.861-10T(e)(5)(i) gives the IRS discretion to exclude a CFC from other related CFCs in applying the formula where--

* the CFC has obligations owing to the U.S. shareholder;

* the CFC has a greater proportion of passive assets than the proportion of passive assets held by the U.S. group;

* such passive assets are held in liquid or short-term investments; and

* there are frequent cash transfers between the CFC and the U.S. group.

Evidently, this is intended to give the IRS a weapon to stop tax planning intended to draw an allocation of interest expense against passive income by having a CFC with a loan from the U.S. group acquire passive assets.

The second provision giving the IRS discretionary authority is of the "heads we win, tails you lose" variety. Under Temp. Reg. [sec.] 1.861-10T(e)(5)(ii), if it is determined that, in the aggregate, the application of the mechanical CFC debt formula increases a taxpayer's foreign tax credit, the Commissioner may choose not to apply it.

VII. TRANSITION RULES FOR

GRANDFATHERED DEBT

A full explanation of the transition rules, which are quite complicated, is beyond the scope of this article. Temp. Reg. [sec.] 1.861-13T will contain the transition rules for grandfathered debt (i.e., incurred before November 16, 1985). This section of the temporary regulations is reserved because the technical corrections bill containing certain transition rules for interest allocation was not enacted before the temporary regulations were promulgated on September 9, 1988.

In the preamble to the September 9, 1988, Temporary Regulations, the IRS stated that it anticipates the temporary regulation, when issued, will be in a form that is substantially similar to proposed regulation [sec.] 1.861-11. The primary anticipated changes concern:

* The addition of a rule to clarify that, in computing the various transition amounts under Prop. Reg. [subsec.] 1.861-11(b) and (c), any indebtedness the interest on which is directly allocated to identified property under Treas. Reg. [sec.] 1.861-8(e)(2)(iv) shall not be taken into account.

* The incorporation of a rule regarding the averaging of end-of-month debt levels in Prop. Reg. [sec.] 1.861-11(c)(7) for the purpose of computing the amount of a paydown.

* The modification of the rule of Prop. Reg. [sec.] 1.861-11(g) to provide for the proration of transition attributes between a transferor and a transferee in the year of transfer.

* The revision of Prop. Reg. [sec.] 1.861-11(g)(3) to provide that, when a transferee acquires stock of a corporation and the transferee or any member of its affiliated group assumes the transition qualified indebtedness of an acquired corporation, such indebtedness will continue to be transition qualified until such time as the transferee disposes of the acquired corporation, but shall thereafter cease to be transition qualified.

IX. ALLOCATION AND

APPORTIONMENT OF

EXPENSES OTHER THAN

INTEREST

Section 864(e)(6) contains the following pertinent language for the allocation and apportionment of expenses other than interest:

Expenses other than interest which are not directly allocable and apportioned to any specific income-producing activity shall be allocated and apportioned as if all members of the affiliated group were a single corporation.

In addition, two new general rules on apportionment of all expenses came into existence: (1) tax exempt assets are not taken into account, and (2) for an allocation on the basis of assets, the basis of 10-percent or more owned corporations not included in the affiliated group shall be adjusted for earnings and profits.

To summarize the effect of the 1986 Act, the U.S. affiliated group is treated as one taxpayer. Taxpayers are, in effect, to disregard stock of affiliates and interaffiliate debt. According to the General Explanation of the Tax Reform Act of 1986 prepared by the staff of the Joint Committee on Taxation:

Congress believed that this intended result may be achieved under regulations that, for example, retain the separate company method of allocation of prior law but that, unlike prior law, treat stock in domestic subsidiary corporations as a foreign asset to the extent the domestic corporation (or its subsidiaries on a "look-through" basis) owns assets that produce foreign source income. Treating a U.S. group as if it were one taxpayer for expenses that are not directly allocable, however, does not change the prior law rules governing whether expenses are directly allocable. As under prior law, expenses that a corporation at the lowest corporate tier (one with no subsidiaries) incurs only to earn its own income (and not to help affiliates earn income) are allocated to its income only for purposes of these rules.

Interpreting this mandate, the temporary regulations require that in applying the gross income method of apportionment, interaffiliate dividends, interest, gross income from sales or services, and other interaffiliate gross income should be eliminated. Similarly, where a taxpayer uses another basis for apportionment such as units sold or gross sales, interaffiliates sales must be eliminated. Temp. Reg. [sec.] 1.861-14T(c)(i).

Similar to the old 1977 regulations, expenses related to supportive functions, research and experimental expenses, stewardship expenses, and legal and accounting expenses are generally to be allocated and apportioned by determining the class of gross income to which the expense relates and then allocating the deduction to such class of gross income. Normally the apportionment fraction must take into account the factors contributed by all members of the affiliated group. An exception exists for certain expenses relating to fewer than all members that may be apportioned according to apportionment fractions of only some (but fewer than all) members of the affiliated group. This "sub or mini-group" method may only be used if the expense is considered allocable to gross income of at least one member other than the member incurring the expense (but fewer than all members of the affiliated group.) Temp. Reg. [sec.] 1.861-14T(c) and [sec.] 1.861-14T(e). Accordingly, the general rule is that allocations are made on an affiliated group basis, although a "mini-group" may be used if the expenses of a member relate to at least one other member but fewer than all members of the group.

Another exception is suggested in Temp. Reg. [sec.] 1.861-14T(e)(ii). If a taxpayer can affirmatively establish that an expense is definitely related to a class of gross income derived solely by the member incurring the expense, such expense may be directly allocated to such income.

Regarding research and development expenses, Temp. Reg. [sec.] 1.861-14T(e) (2)(i) requires a consolidated or single taxpayer allocation of R&D expenses. R&D expenses also qualify for the "sub-grouping" allocating rules described above. (5)

Temp. Reg. [sec.] 1.8618T(c)(2) indicates that a taxpayer may apportion other deductions (other than interest expense) based on assets provided such method reflects a factual relationship between the deduction and the groupings of income.

The new allocation and apportionment rules clarify that they are not intended to supercede the application of section 482 (i.e., arms-length dealings between related businesses). Thus, any reallocation or recharacterization under section 482 shall be taken into account before application of section 864(e). There may be less here than meets the eye, however, inasmuch as the affiliated group approach of the new temporary regulations would appear to negate the effect of a prior section 482 allocation. Temp. Reg. [sec.] 1.861-14T(c)(3).

(*1) This article is adapted from materials prepared by the author in connection with Michael J. Bernard's presentation to Tax Executives Institute's 43rd Annual Conference in Maui, Hawaii, in November 1988.

(1) Interest capitalized under the uniform capitalization rules is added to the basis of the asset to which it is capitalized and is not subject to the interest expense sourcing rules. I.R.C. [sec.] 263A; Temp. Reg. [sec.] 1.861-9T(c)(2).

(2) In the preamble to the temporary regulations, the Internal Revenue Service stated it was considering the adoption of a prospective rule requiring the apportionment of a lessee's rent expense in the same manner as interest expense in the case of transactions which qualify as leases for tax purposes but are similar to financing transactions. Taxpayers are invited to comment. Temp. Reg. [sec.] 1.861-9T(b)(4).

(3) See H.R. Rep. No. 861, 98th Cong., 2nd Sess., 832 (1984) in which the Conference Committee defined "value" as used in the same context in Code Section 1504(a) as amended by the Deficit Reduction Act of 1984 to mean "fair market value." The key valuation ruling is Rev. Rul. 59-60, 1959-1 C.B. 237, as amended and supplemented by Rev. Rul. 68-609, 1968-2 C.B. 327; Rev. Rul. 80-123, 1980-2 C.B. 101; 83-120, 1983-2 C.B. 170.

(4) The temporary regulations contain a typographical error in that they refer to "excess collateralization" but contain a cross reference to the rule against cross collateralization shall be determined by taking into account the value of improvements at the time the improvements are made and the value of the original property at the time the loan was made.

(5) The R&D allocation rules are inapplicable during the Pub. L. No. 98-369 R&D moratorium period; presumably, the 1986 extension of the moratorium also suspends Temp. Reg. [sec.] 1.861-14T(e)(2) for 1987. Assuming Congress does not enact a new R&D moratorium, taxpayers will apparently be thrown-back to the 1977 regulations for R&D allocation purposes, with the "single taxpayer" rule applicable.
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Author:Richey, Keith S.
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Date:Mar 22, 1989
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