The Allocation and Apportionment of Deductions (Portfolio 6640)

Tax Management Portfolio, The Allocation and Apportionment of Deductions, describes and analyzes the rules for allocating and apportioning deductions in various contexts, including in determining a U.S. person's foreign-source taxable income for purposes of the foreign tax credit limitation, a controlled foreign corporation's subpart F income, and the character of payments made to related parties under the foreign tax credit rules.

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In general, deductions must be allocated to the gross income to which they relate (defined as narrowly as possible) and then apportioned among the relevant “statutory” and “residual” groupings of income (e.g., foreign-source income within a particular foreign tax credit “basket” and all other income) within that set of gross income.

Because of the complexity of the rules, a substantial part of the Portfolio focuses on the rules for allocating and apportioning interest deductions and research and experimental deductions. The Portfolio also discusses the rules for allocating and apportioning other deductions, including those for state and local taxes, stewardship and supportive expenses, charitable contributions, losses from the disposition of capital assets, and net operating losses.

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The Allocation and Apportionment of Deductions was authored by the following experts.
Diane L. Renfroe, B.A., Wellesley College, 1968; J.D., Boston College Law School, 1977; admitted to Bar, Massachusetts, District of Columbia; former Adjunct Professor, LLM International Tax Program, Georgetown University Law Center; tax principal, Washington International Tax Group, Deloitte Tax LLP, 2002–2010 (retired); tax partner, International Tax Specialty Team, Arthur Andersen, Washington, D.C., 1988-2002; manager, Arthur Andersen, 1983-1988; formerly Assistant Branch Chief/Attorney-Advisor, Legislation and Regulations Division, Office of Chief Counsel, Internal Revenue Service, 1977-1982; member, Commissioner's Advisory Group, 1990-1992; author, numerous articles on international tax issues and developments; frequent speaker at seminars on international tax issues.

James Gannon, B.S., University of Illinois; B.A., accountancy, M.A., public accounting-tax, University of Texas at Austin; tax partner, Washington International Tax Group, Deloitte Tax LLP, 2002–present; partner, Arthur Andersen, 1998-2002, staff, Arthur Andersen, 1987-1998; member, AICPA and Illinois Society of CPAs.

Daniel S. Lange, B.B.A., 1981, M.S., taxation, 1983, University of Wisconsin; managing partner, U.S. International Tax practice, Deloitte Tax LLP, 2002–present; tax partner, International Tax Specialty Team, Arthur Andersen, Milwaukee, Wisconsin, 1992-2002, manager, 1986-1991, staff, 1983-1985; member AICPA, WICPA; speaker, international tax issues; author, numerous articles on international tax issues.

Richard A. Gordon, B.A., New York University, 1964; LL.B., Duke University, 1967; tax principal, Washington International Tax Group, Deloitte Tax LLP, 2002-2005 (retired); tax partner, Director of International Specialty, Arthur Andersen, Washington, D.C., 1985-2002; Deputy Chief of Staff and International Tax Counsel, Joint Committee on Taxation, United States Congress, 1981-1985; Special Counsel for International Taxation, Internal Revenue Service, and Assistant to the Commissioner of Internal Revenue Service, Washington, D.C., 1979-1981; Associate, White & Case, Washington, D.C., 1976-1979; Attorney-Advisor, Office of International Tax Counsel, Office of Assistant Secretary of the Treasury (Tax Policy), 1972-1976; Attorney-Advisor, Legislation and Regulations Division, Office of the Chief Counsel, Internal Revenue Service, 1970-1972; Associate, Reynolds, Richards, LaVenture, Hadley & Davis, New York, 1967-1970; member, ABA; author and speaker on international tax issues.

Andrew C. Newman, B.B.A., University of Wisconsin, 1980; tax partner, International Tax Service Line, Deloitte Tax LLP, Chicago, Illinois, 2002-present; Arthur Andersen, 1980-2002; member, AICPA, Illinois CPA Society, International Fiscal Association, Chicago Counsel on Foreign Relations; author, numerous articles on international tax matters; frequent speaker at seminars on international tax issues.

Howard S. Engle, B.S., University of Illinois; M.S., taxation, DePaul University; partner, Deloitte Tax LLP, Chicago, Illinois (retired); Visiting Lecturer, Graduate Tax Program, University of Illinois; frequent speaker on international tax issues; editor, International Tax Developments column, Journal of Corporate Taxation; author, numerous articles on international tax.

Karen E. Cederoth, B.S., Eastern Illinois University; M.A., taxation, DePaul University; tax partner, International Tax Service Line, Deloitte Tax LLP, Chicago, Illinois; formerly with Arthur Andersen, Chicago; formerly with Container Corporation of America, responsible for international compliance; Instructor, DePaul University, Masters in Tax Program.


Detailed Analysis

I. Introduction

A. A Note on Terminology

1. Expenses and Deductions

2. Allocation and Apportionment

B. Background

C. Historical Development of the Allocation and Apportionment Rules

1. 1957 Regulations

2. 1977 Regulations

3. 1986 Code Changes

4. 1995 Regulations on the Allocation and Apportionment of R& E Expense

5. 1999 and 2001 Regulations

D. Structure of the Current Regulations

1. Overview

2. Expenses Specifically Addressed by the Regulations

II. General Principles

A. Basic Definitional Concepts

1. Class of Gross Income

2. Statutory Grouping of Gross Income

3. Residual Grouping of Gross Income

4. Allocation and Apportionment

5. Operative Sections Giving Rise to Statutory Groupings

a. Introduction

b. Operative Sections

(1) Foreign Tax Credit Limitations

(2) Qualified Production Activities Income

(3) Foreign Base Company Income and Related Provisions

(4) Effectively Connected Income

(5) DISC/FSC Combined Taxable Income and ETI Exclusion Foreign Trade Income

(6) Other Operative Sections

B. General Principles of Allocation

1. Definitely Related Deductions

2. Definitely Related to All Gross Income

3. Not Definitely Related Deductions

4. Supportive Functions

C. General Principles of Apportionment

D. Steps for Allocating and Apportioning Deductions

E. General Rules Applicable to Both Allocation and Apportionment

1. Consistency in Method

2. Allocation and Apportionment of Expenses of an Affiliated Group

3. Effect of Excludible, Exempt, or Eliminated Income on the Allocation Base

4. Application of the Allocation Rules to More than One Operative Section

5. Adjustments Made Under Other Code Sections

6. Verification of Allocations and Apportionments

a. Required Record Keeping - IRS Perspective

b. Required Record Keeping - Taxpayer Perspective

(1) Cost Study

(2) Statistical Sampling

7. Treaties

a. Treaty Provisions Concerning Deductibility of Expenses

(1) Treaty Provisions for Branch Operations

(2) Treaty Provisions for a Foreign Subsidiary

(3) Interaction of Domestic Tax Law and Treaty Provisions

b. Competent Authority Cases

III. Allocation and Apportionment of Interest Expense

A. Legislative and Regulatory Background

1. Pre-Tax Reform Act of 1986 Methods of Allocation and Apportionment

a. Pre-1977 Allocation and Apportionment of Interest Deductions

b. 1977 Regulations

2. Changes Made by the Tax Reform Act of 1986

3. Effective Date of Tax Reform Act of 1986 Changes

4. Post-2008 Worldwide Fungibility Election

B. In General

C. Definition of Interest Expense

1. General Rule

2. Interest Equivalents

a. Non-Interest Expenses and Losses

b. Certain Nonfunctional Currency (Section 988) Transactions

(1) Scope of Transactions Giving Rise to Currency Gain or Loss

(2) Exchange Gain or Loss Treated as an Adjustment to Interest under § 988

(3) Nonfunctional Currency Amounts Borrowed Below the Applicable Federal Rate

c. Losses on the Sale of Trade Receivables

d. Rent Expense

e. Bond Premium

f. Certain Financial Products

(1) Financial Products Provisions That Have Sunset

(2) Financial Products That Alter the Effective Cost of Borrowing

3. Interest Expense That Is Not Deductible

a. Section 265

b. Section 263A

c. Section 163(d)

d. Sections 163(e), 163(j), and 267(a)(3)

e. Section 469

D. Individuals

1. In General

2. Trade or Business Interest Expense

3. Investment Interest Expense

4. Passive Activity Interest Expense

5. Qualified Residence Interest

6. Personal Interest

7. Nonresident Aliens

E. Domestic Corporations

1. Asset Method of Interest Apportionment

a. Overview

(1) In General

(2) Determining the Value of Assets

(3) Average Value of the Assets

(a) General Rule

(b) Treatment of Certain Financial Derivatives Transactions as an Adjustment to Asset Values

(4) Characterization of Assets

b. Application of Tax Book Value Method

(1) In General

(2) Special Rules for Foreign Branches

(a) Profit and Loss Branches

(b) Branches Using Dollar Approximate Separate Transactions Method

(3) Adjustments for Certain Types of Indebtedness

(4) Assets in Intercompany Transactions

(5) Adjustments to Stock of Nonaffiliated 10%-Owned Subsidiaries

(a) Definition of Nonaffiliated 10%-Owned Corporation

(b) General Rule

(c) Determination of Earnings and Profits

(d) Redemptions Taxable as Dividends

c. Alternative Tax Book Value Method

(1) Background

(2) General Rule

(3) Method of Making the Election

(4) Special Rules

d. Application of Fair Market Value Method

(1) General Rule

(2) Ability to Make Retroactive Fair Market Value Election

(3) Determination of Values

(a) Valuation of Group Assets

(b) Valuation of Tangible Assets

(c) Valuation of Intangible Assets

(4) Apportionment of Intangible Asset Value

(5) Valuing Stock in Related Persons

(6) Special Rule for Foreign Branches

e. Characterization of Assets

(1) Overview

(2) Categorization of Assets

(a) Single Category Assets

(b) Multiple Category Assets

(c) Assets Without Identifiable Yield

(d) Coordination with General Asset Account Rules of § 168(i)(4)

(3) Characterization of Stock

(a) In General

(b) Characterization of Stock of Controlled Foreign Corporations

(c) Characterization of Stock of a 10/50 Corporation

(i) Rules Applicable before the 1997 Act

(ii) Rules Applicable after the 1997 Act

(iii) Rules Applicable after the American Jobs Creation Act of 2004

(d) Treatment of Stock in § 936 Corporations

(e) Characterization of Stock of a Domestic Nonaffiliated 10%-Owned Corporation

(4) Characterization of Notes

(a) In General

(b) Notes of Controlled Foreign Corporations

(5) Portfolio Securities

(6) Other Special Rules

2. Allocating and Apportioning Interest Expense of an Affiliated Group

a. General Rule

b. Definition of Affiliated Group

(1) General Rule

(2) Expanded Group

(3) Treatment of § 936 Corporations

(4) Life Insurance Companies

(5) Treatment of Certain Financial Corporations

(a) General Rule

(b) Bank Holding Companies

(6) Stapled Entities

(7) Corporation Becomes or Ceases to Be a Member of Group During the Year

c. Determination of Group Apportionment Factors

d. Loans Between Members of the Affiliated Group

(1) General Rule

(2) Loans Between Financial and Non-Financial Affiliated Corporations

(3) Interest Expense Between Members of the Affiliated Group

(a) General Rule

(b) Interest Expense Between a Financial and Non-Financial Affiliated Corporation

(4) Back-to-Back Loans

(5) Interest Expense Subject to High Withholding Tax

e. Losses Created Through Apportionment

(1) Background

(2) General Rule

(3) Mechanics of Computation

(4) Example

(5) Interaction with § 904(i)

3. Special Allocation Rules

a. In General

b. Qualified Nonrecourse Debt

(1) Background

(2) Requirement for Qualified Nonrecourse Indebtedness

(a) Specifically Related to Specified Property

(b) Use of Proceeds

(c) Repayment Recourse

(d) Sufficient Cash Flow from the Property

(e) Restrictions on Use or Disposition

(3) Nonqualifying Debt

(a) Related Party Debt

(b) Cross Collateralization

(c) Credit Enhancements

(d) Other Nonqualifying Debt

(4) Other Special Rules

(a) Arrangements Which Do Not Constitute Cross Collateralization or Credit Enhancement

(b) Refinancings

(c) Assumption of Pre-existing Qualified Nonrecourse Indebtedness

c. Integrated Financial Transactions

(1) General Rule

(2) Definition of Integrated Financial Transaction

(3) Additional Requirements for an Integrated Financial Transaction

(4) Examples

d. Special Rules Applicable to Qualified Nonrecourse Indebtedness and Integrated Financial Transactions

(1) Non-Applicability to Related Person Transactions

(2) Reductions in Asset Value or Income when Interest Expense Is Directly Allocated

e. The CFC "Netting" Rule

(1) Background

(2) 1992 Final Regulations

(a) Background

(b) Detailed Computations

(i) Step 1 - Determination of Excess Related Group Indebtedness (ERGI)

(A) Step 1A - Determine the Amount of Related Group Indebtedness (RGI)

(I) Classification of Stock of Certain Related CFCs as RGI

(II) Stock Recharacterization for Hybrid Interests

(III) No Imputation of Interest

(B) Step 1B - Compute Allowable RGI

(C) Step 1C - Determination of ERGI

(ii) Step 2 - Determination of Excess U.S. Shareholder Indebtedness (ESI)

(A) Step 2A - Determine the Amount of U.S. Shareholder Unaffiliated Indebtedness

(B) Step 2B - Compute the Amount of "Allowable Shareholder Indebtedness"

(C) Step 2C - Determine the Amount of ESI

(iii) Step 3 - Direct Allocation of Third-Party Interest Expense

(A) Step 3A - Determination of Allocable RGI

(B) Step 3B - Amount of Third-Party Interest Expense Subject to Direct Allocation

(C) Step 3C - Apportionment of Amount of Third-Party Interest Expense Subject to Direct Allocation to Foreign Tax Credit Baskets

(D) Step 3D - Adjustment of Asset Values

(c) Special Rules Relating to Corporate Events

(i) Initial Acquisition of a CFC

(ii) Incorporation of a U.S. Shareholder

(iii) Acquisition of Additional Corporations

(iv) Disposition of Stock

(v) Section 355 Transactions

(d) Effect of Regulations on Certain Transactions

(i) Section 304 Transactions

(ii) Increased Indebtedness in CFCs

(e) Examples

f. Interest Expense of Financial Asset Securitization Investment Trusts (FASITs)

(1) Background

(2) Allocation of FASIT Interest Expense

g. Potential Expansion of Direct Allocation Rules to Other Types of Financial Transactions

4. Transitional Rules

5. Allocation and Apportionment of Interest Expense of Affiliated Group on Worldwide Basis

a. Background

b. Election to Allocate Interest Expense on Worldwide Basis

c. Allocation and Apportionment of Interest Expense to Worldwide Affiliated Group

d. Ancillary Rules

(1) Allocation and Apportionment of Other Expenses

(2) Treatment of Tax-Exempt Assets and Stock of Nonaffiliated 10%-Owned Companies

e. Application to Certain Financial Corporations

(1) Default Rule

(2) Election for Financial Corporations Group

(3) Anti-Abuse Rules

(4) Effective Date

f. Regulatory Authority

F. Partnerships

1. General Rule

2. Ten Percent or More Interest (Aggregate Approach)

a. Corporate Partner

b. Individual Partner

3. Limited Partners and Corporate General Partners with Less than 10% Ownership (Entity Approach)

4. Apportioning Outside Interest Expense of a Partner

a. Interest Expense of Less than 10% Limited Partners and Less than 10% General Corporate Partners

b. Interest Expense of Corporate Partners, Individual General Partners, and Individual Limited Partners Owning 10% or More

5. Tiered Partnerships

6. Foreign Partners

a. Foreign Corporate Partners

(1) Rules Applicable to Taxable Years Before June 6, 1996

(2) Rules Applicable to Current Taxable Years

b. Nonresident Alien Partners

7. Example

G. Controlled Foreign Corporations

1. General

2. Section 954(b)(5) Netting Rule

3. Election of Modified Gross Income Method

H. Foreign Corporations Engaged in U.S. Trade or Business

I. Noncontrolled § 902 Corporations

J. Extraterritorial Income, Foreign Sales Corporations, and Domestic International Sales Corporations

1. Methodology

2. Example

IV. Allocation and Apportionment of R& E Expense

A. Overview

B. The 1995 Final Regulations

1. General Approach to Allocate and Apportion R& E Expenditures

2. Allocation of Qualified R& E Expenditures Among Product Categories

a. In General

b. Product Categories

(1) In General

(2) Multiple Product Categories

(3) Product Categories Not Identifiable

(4) Limitations on Wholesale Trade and Retail Trade Categories

c. Treatment of Affiliated Groups

d. Definition of Qualified R& E Expenditures

3. Government Mandated R& E Expenditures

a. In General

b. Qualification for Government Mandated Expenditure Exception

4. Apportionment of Non-Mandated R& E Expenditures

a. Exclusive Apportionment to Location Where Expenditures Incurred

(1) General Rule

(2) Facts and Circumstances Test for Increasing the Exclusive Apportionment Amount

(a) Limited Sale of Products Outside Location Where Research Is Performed

(b) Delayed Application of Research Findings Abroad

b. Apportionment of Remaining R& E Expenditures

(1) Sales Method

(a) Sales of Uncontrolled Parties

(i) Definition of Uncontrolled Party

(ii) Determination of the Sales Amount Derived from Licensed or Sold Intangibles

(b) Sales of Controlled Parties

(i) Requirement That Controlled Party Benefit from Research Expenditures

(ii) Definition of Corporation Controlled by the Taxpayer

(iii) Amount of Controlled Party's Sales That Must Be Considered

(2) Optional Gross Income Methods

(a) In General

(b) Gross Income Method - Option 1

(c) Gross Income Method - Option 2

c. Special Rules for Partnerships

d. Binding Election

C. Computational Examples

D. Special Rules for ETI, FSCs, and DISCs

1. In General

2. Rev. Rul. 86-144

3. St. Jude Medical

4. Boeing Co.

E. Other Special Rules

1. Interaction with Separate Foreign Tax Credit Limitations

2. Section 936 Companies

V. Allocation and Apportionment of Other Deductions

A. Stewardship and Supportive Expenses

1. Overview

2. Definitions

a. Stewardship Expenses

b. Supportive Expenses

c. Expenses for Services Performed for the Benefit of a Related Party

3. Deductibility Under § 162

a. General Rule

b. Young & Rubicam

c. TAM 8806002

4. Allocation and Apportionment Rules

a. Services Rendered to a Related Corporation for a Fee

b. Stewardship Expenses

(1) Allocation to Related Classes of Gross Income

(2) Acceptable Methods of Apportionment

c. Supportive Function Expenses

5. Affiliated Group Rules

a. General Rule

b. Stewardship Expenses

c. Supportive Function Expenses

B. Legal and Accounting Fees and Expenses

1. General Rules

2. Allocation of Legal and Accounting Fees

3. Apportionment of Legal and Accounting Fees

4. Affiliated Groups

a. General Rule

b. Example

C. State and Local Taxes

1. Background

2. Policy - The Debate Continues

3. General Principles for Allocating and Apportioning State Income Taxes

a. State Taxes Definitely Related to Gross Income

b. State Law Concepts of Income Control Allocation

c. Acceptable Methods

d. Consistency of Use

e. Use of Other Methods

f. Other Modifications

g. Effect of Use of Authorized Methods

h. Effect of Redetermination of Tax After Allocation and Apportionment of the Original Deduction for State and Local Taxes

4. Examples of Methods of Apportionment

a. Presumptive Approach

b. No State Exempts Foreign Income - Example 25

c. Some States Exempt Foreign Income - Example 26

d. State Imposes No Income Tax - Example 27

e. State Taxes Attributable to Portfolio Dividends - Example 28

f. Unitary Taxation - Example 29

g. Taxpayer Has a Foreign-Source Loss - Example 30

h. Modifications to State Taxable Income - Examples 31 and 32

(1) Example 31

(2) Example 32

(3) Other Modifications

5. Safe Harbors

a. Overview

b. Method One

c. Method Two

d. Example 33 - Illustration of Safe Harbors

(1) Method One

(2) Method Two

6. State Franchise Taxes

a. Prior IRS Rulings

(1) Rev. Rul. 79-186

(2) Rev. Rul. 87-64

(3) Rev. Rul. 87-65

b. Treatment Under the Temporary and Final Regulations

D. Charitable Contributions

1. General Rules

2. Former Regs. § 1.861-8(e)(9)(iv) and Withdrawn Prop. Regs. § 1.861-8(e)(12)

3. Regs. § 1.861-8T(e)(12)

4. Affiliated Group Apportionment of Charitable Contributions - Regs. § 1.861-14T(e)(6)

5. Treaty Authorized Deductions

6. Final 2005 Regulations on Deduction for Charitable Contributions

E. Losses Recognized with Respect to Personal Property

1. Introduction

2. Regulations Under § 865(j)

a. Regulatory History and Effective Dates

b. Losses Attributable to Personal Property Other Than Stock

(1) General Rule - Losses Mirror Gains

(a) Loss Attributable to a Foreign Office

(b) Loss Recognized by a U.S. Citizen or Resident with a Foreign Tax Home

(c) Partnership Losses

(d) Allocation of Losses Under § 904(d)

(2) Special Rules

(a) Depreciable Property

(b) Contingent Payment Debt Instruments

(3) Exceptions

(4) Anti-Abuse Rules

c. Losses with Respect to Stock

(1) General Rule

(a) Loss Attributable to Foreign Office

(b) Loss Recognized by U.S. Citizen or Resident with Foreign Tax Home

(c) Stock of U.S. Real Property Holding Corporation

(d) Allocation of Losses Under § 904(d)

(2) Exceptions

(a) Dividend Recapture Rule

(i) General Rule

(ii) Exceptions to Dividend Recapture Rule

(iii) Example

(b) Inventory and Stock in S Corporations

(3) Anti-Abuse Rules

VI. Allocation of Expenses at the Controlled Foreign Corporation Level

A. Background

B. Allocation and Apportionment Rules for Interest and Other Expenses

1. Overview

2. Step 1 - Determine Gross Income by Separate Limitation and Foreign Base Company Categories

a. Items of Foreign Base Company Income Other than Passive FPHCI

b. Items of Passive FPHCI

c. Non-Subpart F Income

d. Impact of Look-Through

e. Priority Rules

3. Step 2 - Directly Allocable Expenses

4. Step 3 - Direct Allocation of Related Person Interest Expense to Passive FPHCI

5. Step 4 - Allocation of Excess Related Person Interest Expense

a. Asset Method

b. Modified Gross Income Method

c. Comparison of Asset Method and Modified Gross Income Method

6. Step 5 - Allocation of Interest Expense Other Than Definitely Related Interest and Related Person Interest

a. In General

b. Asset Method

c. Modified Gross Income Method

7. Step 6 - Other Not Directly Allocable Expenses

C. Modified Gross Income Method

1. In General

2. Single-Tier Controlled Foreign Corporation

3. Multiple-Tier Controlled Foreign Corporations

4. Example of Modified Gross Income Calculation for Multiple-Tier Controlled Foreign Corporations

5. Making the Election

D. Look-Through Rules

1. Applicability and Purpose

2. Look-Through Rule for Rent and Royalty Payments

3. Look-Through Rule for Interest Payments

4. Look-Through Rule for Dividends

5. Look-Through Rule for Subpart F Inclusions

6. Ordering Rules for Look-Through Payments

7. Examples of Look-Through

E. Special Allocation Rules

1. Allocation of Income and Withholding Taxes

a. Overview

b. Taxes Related to a Separate Category of Income

c. Allocation and Apportionment Rules

d. Withholding Taxes

e. Treatment of Deemed Paid Taxes

f. Examples

2. Allocation of Expenses and Taxes to Determine Subpart F High-Tax Exception

a. Application of Subpart F High-Tax Exception to Income Other than Passive Basket Income

b. Application of Subpart F High-Tax Exception to Passive Basket Income

(1) Grouping Rules

(2) Allocation of Expenses

(3) Allocation of Taxes


Working Papers

Table of Worksheets

Worksheet 1 Application of the CFC Debt Offset Rule Final Regulations Flowchart

Worksheet 2 History of 1987 Proposed and 1988 Temporary CFC Netting Rule

Worksheet 3 History of Prior Research and Experimentation Expense Rules

Worksheet 4 Regs. § 1.861-8(e)(7) and Case Law





Rev. Procs. and Rev. Ruls.: