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Implications of New Interest Expense Rules for US Multinationals

by dsstransky

Internal Revenue Code ("Code") section 864(e), implemented
through Temp. Treas. Reg. Sec. 1.861-11T, requires all members of
a "domestic affiliated group" to be treated as one corporation
for purposes of allocating interest expense between domestic and
foreign source income. Therefore, by applying this rule, the
foreign-source income derived from a foreign entity that incurs
its own interest expense can be reduced twice: once by the
foreign entity's own actual interest payments and second by the
imputed interest paid by the domestic group that is apportioned
to the asset that earned the foreign-source income.

The new rule under Code section 864(f)(1) creates a new
comparison of the "worldwide affiliated group's" third-party
interest, which is apportioned to foreign-source income based on
a ratio of foreign assets to total assets, less the third-party
interest incurred by the foreign members that would be allocated
to foreign sources under the new rule's principles (an example to
this rule is provided below). As such, there will be no
apportionment of domestic group interest to the foreign-source
income if the foreign members incur their pro rata portion of the
worldwide affiliated group's debt.

Note that intercompany debt will not be taken into account for
purposes of this rule.

The composition of the worldwide affiliated group starts with
the same affiliated group under Code section 1504(a), and adds to
it foreign corporations that are: (1) CFCs and (2) are owned by
the domestic group members in the aggregate at a level that meets
the 80 percent vote and value test of Section 1504(a)(2), as
modified by certain look-through rules.

Therefore, the new rule does not remove the exclusion of foreign
corporations generally, but only adds the group of foreign
corporations that are CFCs of which are 80 percent owned by the
domestic group. Intercompany stock will not be taken into account
under the new rules for purposes of determining assets.

For example, Assume a worldwide affiliated group consists of X,
Y, and Z (the CFC). Each has $100 of third-party interest
expense, and each is of equal size for purposes of the interest
allocation regimes.

Under the current regime, Z would be allocated one third or
$66.66 ($200 interest expense of the domestic affiliated group
multiplied by 1/3) of the domestic interest, and thus its income
would be burdened by $166.66 of interest expense for purposes of
the Code section 904 computation (its $100 of third-party
interest expense and its $66.66 allocated portion of the domestic
interest expense).

The new regime would tentatively allocate to Z $100 of the
worldwide interest ($300 of total interest expense of the
worldwide affiliated group multiplied by the ratio of which the
foreign assets of Z bear to all of the assets of the worldwide
affiliated group), but since Z incurred $100 of the worldwide
interest, in the end no additional interest will be allocated and
Z 's income will be burdened only by its own $100 of interest
expense for purposes of the Code section 904 computation.

The election to allocate interest on a worldwide basis is a
one-time election and may be made only by the common parent of
the domestic affiliated group that is part of the worldwide
affiliated group, and may be made only for the first taxable year
beginning after December 31, 2008 in which a worldwide affiliated
group exists that includes the domestic affiliated group and a
foreign subsidiary that could be in the worldwide affiliated
group.

The election must be made by the due date (including extensions)
for filing the federal tax return for the first year to which the
election applies.

DISCLAIMER: This article does not, and is not intended to,
constitute legal, tax, or accounting advice. You should consult
an attorney, tax advisor, or accountant for individual advice
regarding your own situation. Furthermore, this article is not
intended or written to be used, and it cannot be used, for the
purpose of avoiding tax-related penalties under the Internal
Revenue Code.

Mr. Stransky is a partner in the Boston law firm of Sullivan &
Worcester LLP. He specializes in international tax planning for
U.S. companies with foreign investments. Mr. Stransky can be
reached at dstransky@sandw.com or you can find further
information at <a
href="http://www.sandw.com/professionals-277.html">Sullivan &
Worcester</a>

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