Section 861: adoption of alternative tax book value method for depreciation expense: September 17, 2004.
On March 25, 2004, the U.S. Department of the Treasury and Internal Revenue Service issued temporary and proposed regulations under section 861 of the Internal Revenue Code, relating to the use of an alternative tax book value method for allocating and apportioning interest expense. The temporary and proposed regulations were published in the March 26, 2004, issue of the FEDERAL REGISTER, 69 FED. REG. 15673, 15753, and a hearing was held on July 19, 2004.
TEI commends the IRS and Treasury for seeking to simplify the section 861 rules by adopting an alternative tax book value method for depreciation expense. Indeed, we believe that there are other areas (such as goodwill) where distortions may occur that would benefit from similar rules.
Tax Executives Institute is the preeminent association of business tax executives in North America. Our more than 5,400 members represent 2,800 of the leading corporations in the United States, Canada, and Europe. TEI represents a cross-section of the business community, and is dedicated to developing and effectively implementing sound tax policy, to promoting the uniform and equitable enforcement of the tax laws, and to reducing the cost and burden of administration and compliance to the benefit of taxpayers and government alike. As a professional association, TEI is firmly committed to maintaining a tax system that works--one that is administrable and with which taxpayers can comply in a cost-efficient manner.
Members of TEI are responsible for managing the tax affairs of their companies and must contend daily with the provisions of the tax law relating to the operation of business enterprises. We believe that the diversity and professional training of our members enable us to bring an important, balanced, and practical perspective to the issues raised by the proposed regulations under section 861, relating to the allocation and apportionment of interest expense.
The Alternative Tax Book Value Method
a. Depreciation. Section 864(e) of the Code provides the allocation and apportionment of interest expense to be made on the basis of assets rather than gross income. Taxpayers may choose to calculate the value of their assets by using either the tax book value (TBV) or fair market value (FMV) method under Temp. Reg. [double section] 1.861-8T(c)(2) and 1.861-9T(g)(1)(ii). Permission is not required to adopt the FMV method, but permission is required to change from FMV to TBV.
Taxpayers generally prefer to use the TBV method of allocating interest expense because it is administratively easier to use than the FMV method, which requires annual appraisals and could lead to more audit disputes. The TBV of domestic assets may, however, be significantly lower than the TBV of foreign assets, causing a disproportionate amount of interest to be allocated to income from foreign sources. This result limits the appeal of the TBV method of valuation. A consistent allocation between foreign and domestic assets is key to ending the distortive effect.
One of the major items causing distortion in the value of domestic and foreign assets is depreciation. Domestic assets are generally depreciated using an accelerated method, while foreign assets must be valued using the ADR/class lives system of section 168(g) of the Code. In TEI's view, consistency in the use of methods would lessen this disparity and produce a more equitable result. The Institute met with IRS and Treasury representatives last year to discuss ways in which to decrease the distortive effects of the TBV method for foreign and domestic assets.
To address these concerns, the Treasury Department and IRS have issued Prop. Reg. [section] 1.861-9(g)(1)(ii), which would introduce an election to permit taxpayers to use an alternative method for determining the TBV of assets for purposes of the section 861 interest allocation rules. The alternative would permit taxpayers to determine the TBV of all tangible property subject to a section 168 depreciation deduction by using the straight-line method conventions, as well as the recovery periods of the alternative depreciation system under section 168(g)(2). The new method is intended to minimize the basis disparities between foreign and domestic assets that may arise when taxpayers use adjusted tax basis to value assets under the TBV method.
TEI commends the Treasury Department and IRS for seeking an administratively feasible method for determining the TBV of foreign and domestic assets. The new alternative would decrease complexity and provide greater certainty for both taxpayers and the government. It would also save resources by eliminating the need for taxpayers to elect the FMV method, which often results in the preparation of costly annual valuation studies and disputes between taxpayers and the government.
b. Automatic Consent. In the preamble to the regulations, the Treasury Department and IRS announced an intent to issue a revenue procedure to provide temporary rules for granting taxpayers automatic consent to change from the FMV method to the alternative TBV method. The government anticipates that the procedure will apply to changes made during a two-year period after March 26, 2004, with the automatic consent applying to taxable years beginning on or after that date, and for which the taxpayer has not already filed an income tax return. Comments were requested concerning the procedure including the propriety of the two-year time period.
TEI agrees that an automatic consent procedure is appropriate and that the proposed two-year time period is reasonable.
c. Effective Date. The regulations are effective with respect to any taxable year beginning on or after March 26, 2004. Thus, calendar-year taxpayers will be able to elect to use the new method beginning with their 2005 return. Given the government's desire to encourage taxpayer to use the alternative TBV method, TEI recommends that taxpayers be permitted to elect to apply the new rules to all open years. At a minimum, the election should be available for returns that have not yet been filed.
d. Goodwill. The Treasury Department and IRS also requested comments regarding whether additional modifications to the TBV method may be appropriate to address disparities arising from other cost recovery provisions. One such item is the treatment of U.S. goodwill, i.e., the disparity in treatment between foreign and U.S. affiliates. Under the TBV method, the value of a foreign affiliate equals the taxpayer's basis in the foreign affiliate's stock. The U.S. affiliate is valued by looking through to the U.S. affiliate's tax basis in its assets. This disparity creates a distortion.
Consider the following example:
A U.S. taxpayer borrows $50 to purchase the stock of a foreign company, and borrows another $50 to purchase the stock of a U.S. company. The U.S. taxpayer's basis in the stock of the foreign company is $50, and this foreign company will be considered a $50 foreign asset for interest expense apportionment purposes.
The treatment of the U.S. company should mirror that of the foreign company, but it doesn't. Assume that, of the $50 purchase price of the U.S. company, $20 is attributable to the underlying assets and $30 is treated as goodwill.
For purposes of interest expense apportionment, the U.S. company will be considered a $20 U.S. asset (the basis of the underlying assets); goodwill is ignored. (1)
In this example, the debt of the purchasing U.S. taxpayer relates equally to both purchases of the companies. The interest expense associated with these purchases, however, will not be treated equally. Approximately 71 percent of the interest expense will be apportioned to foreign sources ($50 foreign asset/S70 total assets) and only 29 percent apportioned to U.S. source income. This distortion makes the FMV method more attractive to taxpayers that acquire overseas assets. Thus, TEI recommends that the treatment of goodwill be harmonized for U.S. and foreign assets.
Tax Executives Institute appreciates this opportunity to present its views on the proposed regulations relating to the use of an alternative tax book value method for allocating and apportioning interest expenses under section 861 of the Internal Revenue Code. If you have any questions, please do not hesitate to call John J. Herson, chair of TEI's International Tax Committee, at 678.518.3216, or Mary L. Fahey of the Institute's professional staff at 202.638.5601.
(1) This example assumes that the taxpayer has made a section 338(h)(10) election.
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|Date:||Sep 1, 2004|
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