us & canadian anti-deferral provisions - section 861 expense allocations

FROM PRINCIPLES TO PLANNING

US & Canadian Anti-deferral Provisions - Section 861 Expense allocations

FROM PRINCIPLES TO PLANNING

321

U.S & Canadian Anti-deferral Regimes/ 861 allocations

Canadian FAPI Regime Section 861 AllocationsU.S. Anti-deferral Regime

Bill Armstrong

Subpart F Income

Section 956, Investment in U.S. Property

Tim Bloos

Primer on Canadian taxation of foreign source income

Tom Miller

When does section 861 apply

Allocating and apportioning expenses

Special rules for certain expenses

A Primer on Canada’s System for Taxing Foreign Source Business Income

Tim Bloos, MNP LLP

Canada: Taxation of Foreign Source Income

Foreign Intermediary

CancoCanada

Foreign

Carry on activities directly

in foreign jurisdiction

Taxable on world wide incomeRelief from double tax-treaty

Foreign Tax Credit Rules

Corporation trust

partnership

Ownership % Type ofincome

Jurisdiction

Active Passive

TreatyNon- Treaty

Foreign Affiliate Rules

Foreign Tax Credit Rules ‒ Domestic relief for Canadian taxpayers earning foreign source income

directly

Same relief granted in treaties for treaty countries

‒ Separate: property (non-business income) or business income

Separate out by jurisdictionNon-business claimed before businessBusiness tax credits: c/f 10 years, c/b 3

years, no c/f or c/b for non-business‒ To qualify as a FTC: (1) must be paid by Cdn taxpayer to foreign government;

(2) basis of taxation similar to Canada (income, withholding); or (3) specifically identified in treaty

Foreign Income Earned Directly:Foreign Tax Credit Rules

‒ Character of foreign source income: Active – non-passive, deemed

active, recharacterized as active= Surplus

Passive (interest, dividends, rents, royalties)

= FAPI‒ Distinction between foreign

intermediary CFA – controlled foreign affiliate

(can earn FAPI) FA – foreign affiliate (cannot earn

FAPI)

Foreign Income Earned through Affiliates:The Foreign Affiliate Rules

‒ Surplus balances Tracked for each FA/CFA of a CDN

Taxpayer Exempt Surplus – treaty, active

business or previously taxed FAPI Taxable Surplus – non-treaty, active

business or previously taxed FAPI Hybrid Surplus – exempt/taxable

(capital gain) Pre-acquisition Surplus - ACB

‒ Exempt – no tax when repatriated to Canada

‒ Taxable – tax credit mechanism

The Foreign Affiliate Rules (Exemption/Deferral Mechanism)

FAPI: Foreign Accrual Property Income‒ Consists of: Passive property income (rents, royalties, dividends, interest)

Some is deemed active if “in the business” of earning such income

Some is recharacterized as active (specific rules and specific circumstances)

Includes capital gains from disposition of non-excluded property

‒ Can only be earned by a CFA‒ Income is imputed “as earned” by the Canadian taxpayer when earned by

the foreign intermediary‒ FAPI is net of: FAT – foreign accrual tax and FAPL

‒ Foreign accrual property loss‒ Complex rules around flowing FAPI through surplus accounts once tax paid

at Canadian corporate level

The Foreign Affiliate Rules:FAPI Imputation Regime

‒ Series of special rules dealing with rollover provisions around flowing surplus through FA groups under various circumstances and other changes (recent 2011/2012 amendments to regime) Foreign affiliate mergers First tier liquidations or

dissolutions of FAs Second tier liquidations or

dissolutions of FAs Returns of capital

The Foreign Affiliate Rules: Special Rules

The Foreign Affiliate Rules: Special Rules‒ Also, special rules dealing with anti-

avoidance: Upstream loans 95(6)(b) Hybrid Surplus Rules to prevent generation of

surplus Loss suspension rules

Allocating and Apportioning Expenses under Section 861 for Foreign Tax Credits and Other

Purposes

Tom MillerBKD, LLP

Discussion Topics

– Why/When allocate and apportion expenses– Identifying classes of income– Special rules for certain types of expenses

Section 861 Allocations

When do we need to allocate and apportion expenses?

1. Determining foreign tax credit1. First determine foreign source income2. Then allocate and apportion expenses to the various classes of income

2. Other uses of section 8611. Section 199 – Domestic production activities deduction

1. Reg 1.199-4 – Requires use of the “section 861 method” and also requires consistency of allocation then the taxpayer must use the same method of allocation and the same principles of apportionment

2. Export Incentives – Domestic International Sales Corporations1. Reg 1.994-1(d((6) references regulation 1.861-8. Note however, it

does not require consistent treatment as Reg 1.199-4 does3. Subpart F Income

1. Reg 1.954-1(c) requires allocation and apportionment under “the principles of sections 861, 864 and 904(d)”


Revisiting the steps to determine the Foreign Tax Credit1. Identify all classes of income

1. Classes of income are different for different calculations1. E.g. foreign source income is not relevant for determining

combined taxable income for a DISC. Similarly, QPAI would have different classes as well

– The regulations use the terms “statutory and residual grouping”– Class of income is not a defined term but generally refers to any

grouping of similar items.• “The classes of income are not predetermined but must be

determined on the basis of the deductions to be allocated .” Reg 1.861-8(b)(1)

• Knowing and understanding your client’s business is key to determining foreign source income and allocating and apportioning expenses.


Procedures for Determining Foreign Source Income2. Determine source of income for each class of income

Identify foreign taxes applicable to each3. Allocate and apportion expenses to each class of income4. Expenses that are not attributable to any class of income are deemed to be attributable to all classes of income and must be apportioned to all classes of income. See Reg. §1.861-8(c)(3)

Section 861 Allocaitons

Regulations under Section 861• 1.861-1 – 1.861-7 and -15 and -16 address sourcing of income• 1.861-8 – Computation of taxable income from sources within the

U.S and from other sources and activities• 1.861-9, – 10, – 11 and –13 address allocation of interest expense• 1.861-12 – characterization rules • 1.861-14 provides special rules for allocating and apportioning

expenses of an affiliated group (other than interest)• 1.861-17 – allocation and apportionment of research and

experimentation activities• 1.861-18 -- classification of computer software


Allocation and Apportionment of Expenses to Foreign Source Income• All expenses must be allocated and apportioned between the

classes of income. – “A taxpayer to which this section applies is required to allocate

deductions to a class of gross income and, then, if necessary to make the determination required by the operative section of the Code, to apportion deductions within the class of gross income between the statutory grouping of gross income and the residual grouping of gross income. “ Reg §1.861-8

– Expenses not attributable to any class of income are allocated to all income

– All deductions must be allocated or apportioned.


Allocation and Apportionment of Expenses Allocation vs apportionment• Allocation – Where an expense applies to some income but not all

income, it must be allocated against the class or classes of income to which it relates • E.g. sales commissions are allocated against the sales to which they relate• Note that the expense is allocated against the class of income even in a year

where there is no income in the class• E.g. stewardship and interest expense are still allocated against dividend income even where

foreign subsidiaries have not paid a dividend

• Apportionment – Expenses that apply to more than one class of income must be apportioned between the classes of income to which they relate.• E.g. – The salary and bonus for the head of global sales would be apportioned

to all sales


Allocation and Apportionment of Expenses to Foreign Source Income• Special rules exist for:

– Interest -- Separate slide– Research and Experimentation Separate slide– Stewardship Expenses –

• Apply to dividends. Not management services but stewardship, as defined in 482 regs. Duplicative in nature. Reg. §1.861-8(e)(4)

• Method of allocations – time spent and related compensation or an allocation based on a comparable factor such as gross receipts, gross income, unit sales volume, etc.

– Legal and accounting fees and expenses –• Ordinarily are definitely related and allocable to a specific class or classes of gross

income or to all gross income. Reg. §1.861-8(e)(5)– Income taxes – Primarily state and local income taxes – Reg. §1.861-

8(e)(6)– Losses on the sale or exchange of property – Reg. §1.861-8(e)(7)– Charitable contributions – Generally definitely related and allocable to

all of a taxpayer’s gross income --Reg. §1.861-8(e)(12)


Allocation and Apportionment of Expenses to Foreign Source Income• Interest – See Regs. §§1.861-9, -9T, -10, -10T, -11, -11T -12 and

-12T– Applies to all items deductible under §163 -- Reg. §1.861-9T(a)

• Gross amount of interest – money is fungible• Applies to losses or expenses which are interest equivalents• Generally, interest expense is allocated to all assets based on

the class of income they produce– Special rules for partnership interests -- Reg. §1.861-9T(e)– Corporations – use the asset method -- Reg. §1.861-9T(f)

• Generally, based on tax basis in assets• May elect to use fair market value method


Allocation and Apportionment of Expenses to Foreign Source Income• Interest (Cont’d)

– Special rule for qualified non-recourse indebtedness – Reg. §1.861-10T(b)

– Affiliated groups – consolidated calculation -- Reg. §1.861-11 and Reg. §1.861-11T• Intercompany interest is eliminated in consolidated return• Loans between affiliates are not treated as an asset for

purposes of the allocation• Related borrowers and related payees treat interest

consistently


Research and Experimentation Expenditures – Reg 1.861-17• Applies to section 174 R&E

• Broader category than section 41 credit for R&E • Generally favorable

• Permits geographic apportionment based on location of R&E activity• So domestic if at least 50% of the R&D claimed is performed in the US

• Two methods • Sales method

• Permits 50% geographic apportionment• Gross Income method

• Permits 25% geographic apportionment• Must choose and retain same method for 5 years• Note that geographic apportionment is for foreign source income only

• If using a DISC, exclusive apportionment does not apply to determine combined taxable income


Allocation and Apportionment of Expenses to Foreign Source IncomeManner of apportioning income• There is not a requirement that the allocation method be the “best

method” as there is for determining a transfer price under section 482. The regulation requires “Such attribution must be accomplished in a manner which reflects to a reasonably close extent the factual relationship between the deduction and the grouping of gross income.” Reg 1.861-8T(c)(2)

• Allocation or apportionment methods are not accounting methods and may be changed from year to year


Allocation and Apportionment of Expenses to Foreign Source Income• Supportive Expenses -- Expenses that are supportive in nature can

be allocated or apportioned to the gross income to which they support. It is also permissible to allocate them based on the expenses to which they relate. Reg 1.861-8(b)(3)– E.g. Overhead, supervisory, general and administrative expenses

• Expenses that do not bear a definite relationship to any class of gross income is treated as related to all gross income. Reg 1.861- 1(b)(3)– Examples cited in the regs include– The deduction for interest expense, – The deduction for real estate taxes on a personal residence, – The deduction for medical expenses allowed under section 213 and– The deduction for alimony payments under section 213.– In practice, most business expenses would generally relate to some class of

gross income, whether or not income is actually generated, or, more likely, it is allocable to all gross income.


Allocation and Apportionment of Expenses for Subpart F Income1. First determine adjusted gross foreign base company income

1. Allowing for the de minimis rule2. Allowing for the 70% full inclusion rule3. Consider the E&P limitation of 952(c)

2. Then determine net foreign base company income1. Determine the gross amount of each item of income 2. Aggregate non-passive foreign personal holding company income items by

type3. Aggregate active amounts that fall within a single category of foreign base

company income1. Foreign base company sales income2. Foreign base company services income3. Foreign base company shipping income4. Foreign base company oil related income5. Full inclusion foreign base company income


Allocation and Apportionment of Expenses for Subpart F Income

3. Allocate and/or apportion expenses that relate to less than all gross income

4. Passive foreign personal holding company income is reduced by related person interest expense allocable to passive income

5. All other expenses are allocated and/or apportioned6. Losses reduce subpart F income only through operation of the E&P

limitation1. Losses in one category do not reduce subpart F income in other categories


Allocation and Apportionment of Expenses Examples -- Allocation of expenses to determine foreign source income and subpart F

incomeFacts• ABC Company, a US C corporation, manufactures and sells widgets.• ABC owns 100% of a UK company.• ABC produces in the US and sells domestically, into Canada and Mexico and, through

its UK CFC, throughout Europe.(So UK has subpart F income)• ABC also purchases goods from a 3rd party and resells to its customers in the US and

outside the US. UK CFC purchases for resale directly from the 3rd party.• ABC has interest expense.• ABC receives a royalty from an Australian company who produces the widgets and

sells them throughout Asia Pacific based on a license agreement agreement

Questions• What classes of gross income does ABC have?• What expenses will ABC need to allocate and apportion?• How does ABC determine the amount of subpart F income from UK CFC?


Allocation and Apportionment of Expenses to Foreign Source IncomeExamples -- Allocation of expenses to determine foreign source income and subpart F incomeAnswers

What classes of gross income does ABC have?• Domestic income from sales of US produced goods• Domestic and foreign source income from sales of US produced goods sold to

foreign customers where title transfers outside the U.S. (including sales to UK CFC)• Distribution income for sales of goods purchased from 3rd party and sold

domestically or to foreign customers (foreign to the extent of foreign title passage)• Royalty income• Dividend income (subpart F income or regular dividend)What expenses will ABC need to allocate and apportion?• Interest expense• Stewardship expenses• Research and Experimentation• SG&A expenses• State and local income taxes


Allocation and Apportionment of Expenses to Foreign Source IncomeExamples -- Allocation of expenses to determine foreign source income and subpart F incomeAnswersHow does ABC determine the amount of subpart F income from UK CFC?

1. Determine CFC’s gross income2. Determine gross foreign base company income

• Check for passive type of income – miscellaneous interest etc.• Foreign base company sales income from gross income on purchases of goods from ABC

company and sold outside of the UK3. Apply de minimis and full inclusion rules4. Compute net foreign base company income

• Identify expenses allocable to less than all of the CFC’s gross income• Consider related person interest expense allocable to foreign personal holding company

income• Allocate/apportion remaining expenses against all income

5. Determine if high tax exception applies


Tom MillerPartner, International Tax Services

BKD, LLP317-383-3751

[email protected]

us & canadian anti-deferral provisions - section 861 expense allocations

Documents