Final regulations: CFC netting rule.

The IRS issued final regulations on directly allocating unrelated party interest expense to interest income from related controlled foreign corporations (CFCs). This is commonly referred to as the CFC netting rule. The regulations are effective for taxable years beginning after December 31, 1991, but may be applied on an elective basis to all taxable years beginning after December 31, 1987.

The United States allows taxpayers to take a U.S. tax credit for foreign taxes paid or incurred, or deemed so. However, this credit is limited to the amount of U.S. tax attributable to the taxpayer's foreign source income.

In order to determine net foreign source income, the taxpayer must allocate expenses between U.S. and foreign sources. In particular, a U.S. affiliated group of corporations generally must allocate interest expense based on the relative value of foreign and U.S. assets.

The CFC netting rule was intended to stop abuse of this rule when U.S. taxpayers borrowed from unrelated entities to make loans to related CFCs rather than have the CFCs borrow directly. This shift in financing resulted in an increase in the net foreign source income of the U.S. affiliated group (and, therefore, an increase in its foreign tax credit limit).

Under the final regulations, an abuse is considered to have occurred when the U.S. group has both an increase in the amount of loans to related CFCs, relative to the value of CFC assets, and an increase in the amount of borrowings from unrelated parties, relative to the value of U.S. group assets. Whether an increase has occurred is determined by comparing these debt-to-asset ratios for the current year with a five-year average.

If an abuse exists, the U.S. group must directly allocate a portion of its unrelated party interest expense to foreign source income.

Specifically, the amount allocated must equal the interest income on an amount of related CFC debt equal to either the increase in CFC debt or the increase in U.S. group debt, whichever is less.

Observation: Although the IRS somewhat liberalized the CFC netting rules compared to temporary regulations issued in 1988, taxpayers may find the new regulations still have harsh consequences.

Edited by Andrew R. Biebl, CPA, Biebl, Ranweiler & Co., New Ulm, Minnesota (small business); Robert Willens, CPA, senior vice-president at Lehman Brothers, New York City (corporate); Marianne Burge, CPA, director of international tax services, Kenneth Kral, CPA, international tax partner, and Jack Serota, Esq., international tax consultant, at Price Waterhouse, New York City (international).