Foreign tax credit requires consistency

By James A. Beavers, CPA, CGMA, J.D., LL.M.

Under the consistency rule in Temp. Regs. Sec. 1.861-9T(f)(3)(iv), for purposes of calculating its foreign tax credit, a taxpayer could not use the asset method to characterize the shares it held in a controlled foreign corporation (CFC) because the CFC used the modified gross income method to apportion its interest expense.

Background

Before a restructuring of its foreign subsidiaries in December 2014, AptarGroup Inc. directly owned 100% of AptarGroup Holdings, a French entity (AGH France), which was a global holding company for most of AptarGroup's foreign subsidiaries. AptarGroup owned, directly or indirectly, 42 CFCs and also directly owned stock in other foreign corporations that were noncontrolled foreign corporations under Sec. 902 (before its repeal by the law known as the Tax Cuts and Jobs Act, P.L. 115-97). In the restructuring, AptarGroup transferred ownership of substantially all of its foreign subsidiaries, including AGH France, to AptarGroup Global Holding, a Luxembourg holding company (AGH Lux). Afterward, AptarGroup wholly owned AGH Lux, which in turn wholly owned, directly and indirectly, 32 CFCs. These CFCs held assets that generated foreign-source income; and some of the CFCs also held assets that generated U.S.-source income. AptarGroup remained the direct owner of five CFCs after the restructuring.

For 2014, AGH Lux apportioned its interest expense under the modified gross income method. AptarGroup, in determining the amount of its foreign tax credit, characterized its stock in AGH Lux using the asset method. AptarGroup claimed a foreign tax credit of $3.54 million on its 2014 tax return.

Foreign tax credit

The United States subjects its citizens and domestic corporations to tax on their worldwide income. To prevent double taxation, a domestic corporation is allowed a credit for foreign tax paid under Sec. 901 and a credit for foreign taxes deemed paid or accrued under Sec. 960.

However, the foreign tax credit a taxpayer may take is limited to prevent taxpayers from using foreign tax to reduce U.S. tax on their U.S.-source income. The foreign tax credit limitation (FTC limitation) is calculated by multiplying the taxpayer's total U.S. tax on worldwide income by a fraction with a numerator of the taxpayer's foreign-source taxable income and a denominator of the taxpayer's worldwide taxable income. Where a taxpayer has more than one category of income as listed in Sec. 904(d) (limitation category), the FTC limitation must be computed separately for each limitation category.

Sourcing rules

To calculate the FTC limitation, the taxpayer must determine the source for its gross income, using the sourcing rules in the regulations under Sec. 861. After sourcing gross income, a taxpayer must allocate losses, expenses, and other deductions (collectively, expenses) to a class of gross income and, if necessary, then apportion the expense within that class between a statutory grouping or a residual grouping. 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.

Expenses generally are allocated and apportioned on the basis of their factual relationship to gross income. Expenses are allocated to the class of gross income to which they definitely relate. If not definitely related to a class of gross income or related to all gross income, an expense must be ratably allocated to all gross income. After allocation, if needed, expenses are apportioned between the statutory and residual groupings.

Special rules for interest expense

In general, interest expense is treated as related to all income-producing activities and assets regardless of the specific purpose for the borrowing. Thus, interest expense must be ratably allocated to all gross income.

Regarding the apportionment of interest for these purposes, Temp. Regs. Sec. 1.861-9T provides that interest may be apportioned either using the asset method or the modified gross income method. However, domestic corporations must use the asset method. CFCs, on the other hand, are permitted to choose either method subject to certain consistency requirements.

Asset characterization

In calculating its foreign tax credit limitation, a domestic corporation can characterize assets it holds using the asset method or the gross income method. However, with respect to CFC stock held by a domestic corporation, a consistency rule applies. Under both Temp. Regs. Secs. 1.861-9T(f)(3)(iv) and 1.861-12(3)(i), a U.S. shareholder of a CFC must characterize the CFC stock it holds under the same method the CFC used to apportion its interest expense.

AptarGroup disregards special characterization rules

AptarGroup, as required, allocated its interest expense to all its income-producing assets and activities. Because it is a domestic corporation, the company apportioned its interest expense using the asset method. AGH Lux, as a CFC, under Temp. Regs. Sec. 1.861-9T(f)(3)(i) could elect to use either the asset method or the modified gross income method, and it elected to apportion interest expense using the latter method.

In characterizing its assets for foreign tax credit purposes, AptarGroup disregarded the special characterization rules for CFC stock held by a U.S. shareholder in Temp. Regs. Secs. 1.861-9T(f)(3)(iv) and 1.861-12(3)(i), characterizing its stock in AGH Lux using the asset method. It used the asset method because that method allowed it to reduce the amount of interest expense that it apportioned to foreign-source income, thereby increasing its foreign-source taxable income and consequently increasing its foreign tax credit.

The IRS in 2020 issued a notice of deficiency to AptarGroup for 2014, disallowing the foreign tax credit taken by the company in its entirety. The IRS determined that AptarGroup was not permitted to use the asset method under the special characterization rule in Temp. Regs. Sec. 1.861-9T(f)(3)(iv) because AGH Lux had used the gross income method to apportion its interest expense.

AptarGroup, in response, challenged the IRS's determination in Tax Court. AptarGroup and the IRS filed cross-motions for partial summary judgment with respect to whether AptarGroup could use the asset method to apportion interest expense for purposes of calculating its foreign tax credit.

The Tax Court's decision

The Tax Court granted the IRS's motion for partial summary judgment, agreeing with the Service that AptarGroup was not permitted to use the asset method to characterize its AGH Lux stock in calculating its foreign tax credit for 2014.

Before addressing the substance of AptarGroup's arguments, the Tax Court explained that under the canons of statutory interpretation, a court is required to give the text of a regulation its plain meaning and, in doing so, look at the particular text of the regulation at issue and the design of the regulation as a whole. Also, a court should interpret the text to avoid conflict with the statute.

AptarGroup claimed that in its situation, the consistency rule did not apply. It first argued it did not apply because the election of the modified gross income method to apportion interest expense by a CFC is an exception to the consistency requirement. Considering Temp. Regs. Sec. 1.861-9T(f)(3) in its entirety, the Tax Court found it clear that the election is not an exception to the consistency requirement but rather the consistency requirement is a condition of the election. According to the court, the modified gross income method is an exception to the general rule that the asset method must be used for asset characterization, and the consistency requirement is imposed because an election to use the modified gross income method for interest expense apportionment is allowed.

AptarGroup also argued that whether the consistency requirement applied in its case depended on whether the then-existing version of Temp. Regs. Sec. 1.861-12T applied. The Tax Court disagreed, finding that Temp. Regs. Sec. 1.861-12T only supplemented Temp. Regs. Sec. 1.861-9T(f)(3), which imposed an independent consistency requirement.

Additionally, the Tax Court rejected AptarGroup's further argument that Temp. Regs. Sec. 1.861-12T only applied to Sec. 904(d) apportionment, based on the first sentence of Temp. Regs. Sec. 1.861-12T(a). That sentence states that it applies to "[apportion] expenses under an asset method to income in the various separate limitation [i.e., foreign source] categories under section 904(d) and supplement other rules provided in [sections -9T], 1.861-10T, and 1.861-11T." According to AptarGroup, the language of the first clause of the sentence means that Temp. Regs. Sec. 1.861-12T did not apply where, as in its situation, the stock of a CFC produces U.S.-source income, because U.S.-source income is not income in a separate limitation category under Sec. 904.

The Tax Court, however, found that this interpretation was belied by the second clause of the sentence referring to "supplemental other rules," which the court concluded establishes a purpose independent of Sec. 904, a conclusion that it found was bolstered by changes made to Temp. Regs. Sec. 1.861-12T in T.D. 9882 that clarify that the regulation applies for all operative sections, not just Sec. 904(d).

Thus, the Tax Court determined that AptarGroup's use of the asset method to characterize its AGH Lux stock was inconsistent with the proper application of Temp. Regs. Sec. 1.861-9T. Because AGH Lux elected to use the modified gross income method to apportion interest expense, AptarGroup was required to characterize its AGH Lux stock using the modified gross income method.

Reflections

As this case shows, the distinction between a regulatory amendment that adds something to a regulation that was not already there and one that merely clarifies existing language can be murky. AptarGroup argued in its brief that the changes to Temp. Regs. Sec. 1.861-12T expanded the coverage of the regulation so that it applied to more than just Sec. 904(d) apportionment. The Tax Court, on the other hand, took the position in its opinion that the changes merely clarified that it applied to supplement other operative sections.

AptarGroup Inc., 158 T.C. No. 4 (2022)

 

Contributor

James A. Beavers, CPA, CGMA, J.D., LL.M., is The Tax Adviser’s tax technical content manager. For more information on this column, contact thetaxadviser@aicpa.org.

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