Tax Court rules on interest income and expense netting for determining deduction allocated between parent and DISC.
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; it "avoids unequal treatment of taxpayers with the same amount of actual interest cost, just as the fungibility of interest concept avoids unequal treatment of taxpayers whose indebtedness is structured differently."
The court further argued on Bowater's behalf that netting interest expense and interest income was similar to the fungibility concept in the income tax regulations because, rarely, if ever, does the amount and timing of business borrowings directly correlate to specific investments. The court stated that, for example, a business might borrow sufficient funds to finance operations for the coming quarter. The business would typically incur debt in a single transaction, while its cash requirements were spread out over a period of time. As a result, a business will have at least some borrowed funds on hand that are not required immediately but which may be required in the near future. To reduce the cost of holding these funds until actually needed, the business could invest in short-term interest-bearing instruments. Alternatively, the court indicated that a business might decide to finance its operations by issuing long-term bonds or other securities. Because of the impracticalities of retiring these obligations prior to maturity, the business would typically invest any cash surplus to offset the cost of carrying its long-term debt. In either case, the total cost of borrowing is the interest expense on the debt incurred, reduced by the interest earned on the investments on any temporary cash surplus.
It should be noted that at the time this issue arose, the interest expense allocation and apportionment regulations described the interest expense as the aggregate of deductions, while the regulation today refers to the interest expense to be allocated as the gross amount. After a review of the various Treasury decisions that led to the change in the wording of this regulation, it remains unclear why the wording was changed. Thus, at the very least, the Bowater decision can produce U.S. tax savings for those U.S. taxpayers with open years with respect to foreign tax credit limitations and DISC/FSC transfer pricing when the former regulatory wording was relevant. On the other hand, for the more aggressive taxpayer wishing to challenge the wording revisions in the current regulation, Bowater may have application when the latter wording is applicable.
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|Title Annotation:||domestic international sales corporation|
|Author:||Zink, William J.|
|Publication:||The Tax Adviser|
|Date:||Feb 1, 1994|
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