Comments on capitalization of interest in the foreign context.

Comments on Capitalization of Interest in the Foreign Context

On April 13, 1990, Tax Executives Institute submitted the following comments to the U.S. Department of the Treasury concerning the administrative and compliance burdens engendered by Notice 88-99 which deals with the capitalization of interest in the foreign context under section 263A(f) of the Internal Revenue Code. The Institute's submission, which followed up on the Institute's February 16 liaison meeting with Treasury officials, took the form of a letter from TEI President William M. Burk to Philip D. Morrison, the Treasury Department's International Tax Counsel. Preparation of the letter was coordinated by the Institute's International Tax Committee whose chair is Bernard J. Jerlstrom.

During the Institute's liaison meeting with the Office of Tax Policy on February 16, 1990, and during a follow-up meeting with Peter Barnes and you on March 6, 1990, we discussed the capitalization of interest in the foreign context under section 263A(f) of the Internal Revenue Code. This letter supplements those discussions.

Section 263A(f) provides that interest paid or incurred with respect to the production of certain property must be capitalized as part of the cost of such property. The statute authorizes the Treasury Department to issue regulations to prevent the use of related parties to avoid the application of section 263A. I.R.C. section 263A(i)(1). Notice 88-99, 1988-2 C.B. 422, extends the application of section 263A(f) to the interest expense of all parties related to the taxpayer, including foreign subsidiaries outside the consolidated group.

As we pointed out in our liaison meeting agenda, Notice 88-99 imposes extensive administrative and compliance burdens for U.S. companies, principally in the computation of indirect foreign tax credits under section 902 of the Code. In addition, we stated that the rules are fictive: they presume, for example, that a company has borrowed by (and secured by the assets of) a second, related company - even though the operations of the two companies (located in different countries, continents, or even hemisphere) are completely unrelated.

During our March 6 follow-up meeting, the suggestion was made that section 263A(f) generally benefits taxpayers by increasing their foreign-source income in the year of allocation (i.e., by increasing the amount of interest capitalized rather than deducted against foreign-source income). You asked for our reaction to that statement as well as additional information concerning the administrative and compliance burdens engendered by Notice 88-89.

Initially, while we agree that section 263A(f) reduces the amount of interest to be allocated againnst foreign-source income, this reduction benefits only those taxpayers with excess foreig tax credits. To taxpayers that are not in an excess credit position, therefore, the statute imposes a tax cost.

Notice 88-89 imposes significant administrative burdens on all taxpayers. More fundamentally, where the interest to be capitalized is not based in the U.S. company, Notice 88-89 creates a substantial compliance burdenn that generates, at most, nominal revenue for the government. For example, assume that a U.S. parent owns foreign subsidiaries in Italy and Germany. The German company has substantial production property with no debt, while the Italia company incurs substantial interest expense. Under Notice 88-89, the interest expense of the Italian company must be allocated to, and capitalized over the life of, the German assets. Such calculations - especially for multinational corporations that may have dozens (or even hundreds) of constructionn projects and debt instruments in myriad countries - cannot be accomplished with a mere flick of a computer switch. The compliannce burden imposed on these companies under Notice 88-89 is mind-numbing.

Because the allocation will produce little, if any, effect on the parent's U.S. tax liability, it is difficult to see how Notice 88-89 vindicates the purpose underlying section 263A(f). Consequently, we renew our recommendation that controlled foreign corporations be exempted from the reach of the related-party rules. At a minimum,, loans between "sister" CFCs should be excluded.

If you have any questions, please do not hesitate to call Bernard J. Jerlstrom, chair of TEI's International Tax Committee, at [phone], extension 2163, or the Institute's professional staff (Timothy J. McCormally or Mary L. Fahey) at [phone].