Tax Court in Brief | AptarGroup, Inc. v. Comm’r | Foreign Tax Credits and Interest Expense Allocation and Apportionment
The Tax Court in Brief – March 14th – March 18th, 2022
Freeman Law’s “The Tax Court in Brief” covers every substantive Tax Court opinion, providing a weekly brief of its decisions in clear, concise prose.
Tax Litigation: The Week of March 14, 2022, through March 18, 2022
- Hamilton v. Comm’r, T.C. Memo. 2022-21 | March 15, 2022 |Urda, J. | Dkt. No. 139-19L
- Pickens Decorative Stone, LLC v. Comm’r, T.C. Memo. 2022-22 | March 17, 2022 |Lauber, J. | Dkt. No. 13614-20
Short Summary: AptarGroup, Inc. (“Aptar”), a U.S. corporation, owned 100% of AptarGroup Holdings, an entity organized under the laws of France (“AGH France”). Aptar owned, directly or indirectly—through AGH France or a later-formed foreign holding company—controlled foreign corporations (“CFC”). The CFCs held assets that generated foreign source income, and some also held assets that generated U.S. source income. Aptar paid or accrued interest expense, and claimed a foreign tax credit of $3,539,543 with respect to similar taxes paid by the CFCs. The IRS disallowed the foreign tax credit. The issue presented to the Tax Court regards the apportionment of interest expense with respect to AptarGroup’s stock in CFCs for purposes of computation of foreign tax credit.
- AptarGroup’s method of allocation of interest expense was inconsistent with the method for allocation election made by the CFC with respect to the interest expense in issue. Thus, AptarGroup’s position was an improper application of Reg. § 1.861-9T.
- For the apportionment of interest, two methods are available: the asset method and the modified gross income method. Generally, domestic corporations must use the asset method, and CFCs are permitted to choose either method subject to certain consistency requirements. See id. 1.861-9T(g). However, under section Treas. Reg. § 1.861-9T(f), a CFC’s election of the modified gross income method binds the U.S. shareholder to that method. This is a consistency requirement that is a condition of the CFC’s election, and AptarGroup did not use the modified gross income method.
Key Points of Law:
- The U.S. taxes its citizens and domestic corporations on worldwide income. To avoid double taxation, the Code allows U.S. citizens and domestic corporations a credit for income tax paid to a foreign country. See 26 U.S.C. § 901(a). A domestic corporation may also claim a credit for tax that it is deemed to have paid or accrued. at § 960.
- The extent to which a taxpayer is entitled to a foreign tax credit is determined by applying U.S. tax law; thus, the source of income depends on how U.S. tax law categorizes such income. The Code limits the amount of a foreign tax credit to prevent taxpayers from using foreign tax to reduce U.S. tax on their U.S. source income.
- The allowable foreign tax credit for a taxable year is the lesser of foreign tax paid or accrued or the foreign tax credit limitation (“FTC limitation”) calculated pursuant to § 904(a).
- In the case of an affiliated group of corporations, the foreign tax credit is determined on a consolidated basis. Treas. Reg. § 1.1502-4(c). Where a taxpayer has more than one category of income as listed in section 904(d) (a “limitation category”), the FTC limitation must be computed separately for each limitation category. at § 904(d)(1). The FTC limitation is computed and totaled for the affiliated group. Treas. Reg. § 1.1502-4(d).
- To compute the FTC limitation, the taxpayer must determine the source for its gross income. After determining the source of the gross income, the taxpayer must allocate each loss, expense, and other deduction to a class of gross income and then, if necessary, apportion that determined amount within the class of gross income between a statutory grouping and a residual grouping. See Reg. § 1.861-8(a)(2). For purposes of the foreign tax credit, each limitation category is a statutory grouping, and a taxpayer claiming the credit must determine the foreign source taxable income in each limitation category in which it has income.
- In general, expenses are allocated and apportioned on the basis of the factual relationship of the expense to gross income in accordance with Treas. Reg. § 1.861-8. Expenses are allocated to the class of gross income to which they definitely relate. Some expenses are not definitely related to a class of gross income or are related to all gross income and thus must be ratably allocated to all gross income. Then, if necessary, expenses are apportioned between the statutory and residual groupings. at § 1.861-8(c)(3).
- Special rules exist for allocation and apportionment of interest expense in Temporary Treasury Regulation § 1.861-9T.
- For the allocation, interest expense is treated as related to all income-producing activities and assets regardless of the specific purpose for the borrowing. § 1.861-9T(a). For this reason, interest expense must be ratably allocated to all gross income.
- For the apportionment of interest, two methods exist: the asset method and the modified gross income method. Domestic corporations must use the asset method, and CFCs are permitted to choose either method subject to certain consistency requirements. See id. 1.861-9T(g). The asset method requires taxpayers to apportion interest expense to the various statutory groupings on the basis of the average total value of assets assigned to each grouping for the year. Id. To apply the asset method, the taxpayer divides the value of its assets among the relevant statutory groupings, a process the regulations define as “characterizing” the assets. See id. § 1.861-9T(g)(1)(i), (3)-(3)(iii).
- The regulations provide a special consistency rule regarding the characterization of CFC stock owned by a U.S. shareholder. Specifically, section § 1.861-9T(f)(3)(iv) provides: “Pursuant to [Treas. Reg. § 1.861-12T(c)(2)], the stock of a controlled foreign corporation shall be characterized in the hands of any United States shareholder using the same method that the controlled foreign corporation uses to apportion its interest expense.”
- Reg. § 1.861-12T(c)(3) describes two methods for characterizing CFC stock—the asset method and the modified gross income method—and imposes the same consistency rule: “Stock in a controlled foreign corporation whose interest expense is apportioned on the basis of assets shall be characterized in the hands of its United States shareholders under the asset method described in paragraph (c)(3)(ii). Stock in a controlled foreign corporation whose interest expense is apportioned on the basis of gross income shall be characterized in the hands of its United States shareholders under the gross income method described in paragraph (c)(3)(iii).” Treas. Reg. § 1.861-12T(c)(3)(i) (flush text).
- Under section Reg. § 1.861-9T(f), a CFC’s election of the modified gross income method binds the U.S. shareholder to that method—the consistency requirement is a condition of the election. Id. at § 1.861-9T(f)(3)(iv) (imposing the consistency requirement), 1.861-12T (supplementing § 1.861-9T and its consistency requirement).
Insights: This case illustrates the careful attention that a U.S. corporation taxpayer should put forth when allocating and apportioning interest expense for purposes of a foreign tax credits associated with ownership of shares in a CFC. Treas. Reg. § 1.861-9T, as supplemented by Treas. Reg. § 1.861-12T, should be closely evaluated and applied so that the consistency requirements applicable to elections for the foreign tax credit are met between or among the U.S. taxpayer and the CFCs.