In a Legal Advice, Chief Counsel discusses how to allocate and apportion deferred compensation expense relating to services provided before the effective date of Code Sec. 250 when calculating foreign-derived intangible income (FDII).
Allocation and apportionment.
According to the Legal Advice, when determining FDII taxpayers must first determine the factual relationship between a deduction and a class of gross income. Then, the taxpayer must determine how to apportion that deduction to a statutory and residual income grouping within that gross income class. (Code Sec. 861)
The taxpayer’s apportionment method must closely reflect the factual relationship between the deduction and gross income grouping. (Temp Reg §1.861-8T(c)(1))
Deferred compensation expense.
Although a deferred compensation expense (DCE) may relate to gross income derived by the taxpayer in a prior tax year, it must be allocated to a class of gross income, and apportioned based upon the relevant grouping (or groupings) within the class that exists in the tax year the deductions are taken.
Under general federal income tax principles, the law in effect for the tax year in which deductions are taken is applied when determining how deductions relate to a class of gross income. This includes determining which statutory groupings are relevant to apportionment of expenses within such class and the manner of apportionment.
Corporation is an accrual basis taxpayer with a calendar tax year. Corporation’s sole class of gross income is sales of Product A. Beginning in 2018, Corporation claimed the Code Sec. 250 FDII deduction.
For purposes of the FDII deduction, the majority of Corporation gross income in 2018 and later is deduction eligible income (DEI). The corporation claims a significant portion of that DEI income as foreign-derived deduction eligible income (FDDEI).
Since 2014 Corporation has compensated employees with stock-settled restricted stock units (RSUs). Corporation RSUs are designed to reward and retain employees over several years and vest after four years of continuous service. The terms of the RSU provide that delivery of substantially vested shares will occur on the date the vesting condition is satisfied.
Corporation claims that some portion of the deductible RSU expenses for 2018 and later factually relate to a tax year prior to Code Sec. 250’s effective date and, therefore, may be allocated to residual income.
Based on the above facts, Chief Counsel determined that Corporation’s DCE deductions must be apportioned between DEI and FDDEI because those are the classes of gross income to which the 2018 DCE deduction relates and any other approach would violate the requirements in the temporary reg. By claiming that its DCE expense may be allocated solely against residual income, rather than apportioned, Corporation is attempting to apply the federal income tax law of an earlier period to such expense, which distorts the amount of FDDEI.
In an analysis of the Legal Advice released May 24, international tax professionals at PricewaterhouseCoopers noted that the new guidance renders the IRS’s previous position from 2009 obsolete.
The 2009 guidance dealt with the allocation and apportionment of deferred compensation expense for purposes of computing a taxpayer’s qualified production activity income deduction under Code Sec. 199. This new guidance is the result of “reconsidered advise” of the Office of the Associate Chief Counsel International, but does not expound on specific reasons for the change in position.
According to PwC, the Legal Advice “rejects the position that a deduction for an expense which factually relates to a class of gross income recognized in an earlier tax year should only reduce gross income in the residual grouping and not reduce gross income in the statutory grouping (e.g., RDEI or FDDEI).”
PwC also questioned the necessity of the memorandum, arguing that that Section 861 regs “have not changed since 2009 in a manner materially relevant …” While IRS Legal Advice is not binding, PwC advised taxpayers to nonetheless to consider the new position’s “application to any open years which” Section 199 deductions were taken. Further, companies should reassess their allocation and apportionment of deferred compensation for FDII deduction purposes to anticipate how the guidance may affect their business.
PwC did not immediately respond to Checkpoint’s request for comment.
To continue your research on apportionment of deductions, see FTC 2d/FIN ¶ O-11004.
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