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.