§ 1.861-9T: Allocating and Apportioning Interest Expense

Treasury Regulation § 1.861-9T provides the framework for allocating and apportioning interest expense for U.S. tax purposes. It dictates how a taxpayer’s interest deduction is divided between U.S. and foreign source income, which is a foundational calculation for the foreign tax credit limitation under Internal Revenue Code Section 904. At the heart of the regulation is the principle that money is fungible. This concept treats borrowing as supporting all of a taxpayer’s operations collectively, so the interest expense is allocable to all gross income. This prevents taxpayers from artificially tracing debt to domestic activities to maximize their foreign tax credit.

The Fungibility Principle of Interest Expense

The fungibility principle treats money and credit as interchangeable. For example, a multinational corporation might borrow from a U.S. bank for a new domestic warehouse. The regulation assumes this borrowing frees up the company’s other capital for potential investment in a foreign subsidiary. Consequently, the interest expense on the U.S. loan is deemed to relate to all of the corporation’s assets and activities, both domestic and foreign, and must be spread across all income streams.

The Asset Method for Apportionment

The default method for apportioning interest expense is the asset method, which is based on the average value of the assets that generate income. Taxpayers must value their assets using the tax book value, which is the asset’s adjusted basis for tax purposes.

The next step is to characterize the assets, dividing them between U.S. source and various foreign source income categories. Stock in a domestic corporation is a U.S. source asset, while the characterization of stock in a foreign corporation depends on the entity type. For stock in a Controlled Foreign Corporation (CFC), a U.S. shareholder characterizes the stock based on the CFC’s own apportionment method, and partnership interests also require a look-through approach.

Finally, the taxpayer calculates the average value of its assets for the year. The total interest expense is then multiplied by a fraction where the numerator is the average value of assets in a specific source category and the denominator is the average value of total assets. For instance, if a company has $200,000 in interest expense, $30 million in foreign source assets, and $100 million in total assets, $60,000 of its interest expense would be apportioned to foreign source income.

Direct Allocation Exceptions to Fungibility

While fungibility is the general rule, the regulations contain exceptions where interest expense is directly allocated to the income from a particular asset. This direct allocation removes both the interest expense and the associated asset from the broader apportionment calculation. The most prominent exception is for interest related to Qualified Nonrecourse Indebtedness (QNI).

For a loan to be classified as QNI, it must satisfy several strict requirements:

• The loan was incurred to acquire, construct, or improve an identifiable property.
• The loan documents prevent the proceeds from being used for any other purpose.
• The property is the sole security for the debt, and the lender has no other recourse.
• The cash flow from the property is reasonably expected to be sufficient to service the debt.
• There are restrictions on the disposal of the property.

If all conditions are met, the interest expense on the QNI is allocated directly against the income produced by the secured property. For example, if a company obtains a $5 million nonrecourse loan to purchase a building in a foreign country that meets all QNI criteria, the interest is allocated directly to that building’s rental income. This interest expense and the building’s value are then excluded from the company-wide apportionment pool.

Special Rules for Affiliated Groups

The rules for apportioning interest expense are more complex for a U.S. corporation that is part of an affiliated group, as defined under Internal Revenue Code Section 1504. The regulations mandate that the interest apportionment calculation be performed on a group-wide basis, treating the entire U.S. affiliated group as a single corporation. This approach requires aggregating the interest expense of all domestic members into one pool.

This combined interest expense is then apportioned based on the total assets of all domestic members of the group. To prevent distortion, interest on loans between members of the affiliated group is disregarded. The intercompany debt creates interest expense for the borrower and interest income for the lender, which offset each other for apportionment purposes, and the underlying intercompany loans are eliminated from the group’s asset base.

The impact of this group-wide approach can be significant. For instance, a parent company might hold only domestic assets but incur all of the group’s third-party debt. If its subsidiary holds only valuable foreign assets but has no debt, the parent’s interest expense would be apportioned against the foreign source income generated by the subsidiary’s assets, reducing the group’s overall foreign tax credit limitation.

The Modified Gross Income Method Election

As an alternative to the asset method, certain foreign corporations, such as Controlled Foreign Corporations (CFCs), can elect to apportion interest expense using the modified gross income method. U.S. corporations cannot use this method. Once made, this election is generally binding and requires IRS consent to change.

This method apportions interest expense based on the relative amounts of gross income in different source categories, rather than on the value of assets. The taxpayer calculates the proportion of its total gross income that is U.S. source versus foreign source, and the total interest expense is apportioned using these same proportions.

A foreign corporation might prefer this method if its asset values are not proportional to the income they generate. For example, a corporation owning highly valuable but low-income-producing foreign land would attract significant interest apportionment under the asset method. Under the modified gross income method, since the asset produces little gross income, less interest expense would be apportioned to it, potentially resulting in a more favorable foreign tax credit limitation.