What Is Treas. Reg. 1.861-8 for Allocating Deductions?

Treasury Regulation 1.861-8 provides the rules for allocating and apportioning expenses, losses, and other deductions between U.S. and foreign sources. This process applies to U.S. corporations and individuals with foreign operations or investments. The main application of these rules is calculating the foreign tax credit limitation under Internal Revenue Code Section 904.

The foreign tax credit is designed to mitigate double taxation on income taxed by both the U.S. and a foreign country. The credit is limited to the U.S. tax liability on a taxpayer’s foreign source income, which prevents the credit from reducing U.S. tax on U.S. source income. Treasury Regulation 1.861-8 provides the required methodology for this calculation, ensuring deductions are matched against the income they help generate.

The Core Two-Step Framework

Treasury Regulation 1.861-8 mandates a two-step process for assigning deductions. The first step is allocation, which is the process of associating a deduction with a specific “class of gross income” to which it is factually and directly related. A class of gross income can be an item such as compensation for services, sales income, or royalty income.

The relationship between the deduction and the income must be factual. For example, the cost of goods sold is allocable to the gross income from the sales of those goods. In some instances, a deduction may be related to all of a taxpayer’s gross income and is therefore allocated to all gross income. A deduction can be allocated to a class of gross income even if that class produces no income in a particular year.

Once a deduction has been allocated to a class of gross income, the second step, apportionment, must be performed if that class contains income from different geographic sources. Apportionment involves dividing the allocated deduction between a “statutory grouping” of income and a “residual grouping” of income. For a taxpayer calculating their foreign tax credit limitation, the statutory grouping is foreign source income, while the residual grouping is U.S. source income.

For example, a general and administrative expense allocated to all of a company’s gross income must be apportioned if the company has both U.S. and foreign sales. This division must be done on a basis that reflects the factual relationship between the deduction and the income. The result of this process is the determination of taxable income from U.S. and foreign sources.

Apportionment Methods and Bases

The regulations provide several methods for apportionment, and the chosen method must reflect the factual relationship between the expense and the income. The selection of an apportionment basis depends on the nature of the deduction being analyzed.

The asset method is mandatory for apportioning interest expense. This method divides the deduction based on the relative value of the assets that generate U.S. and foreign source income. Taxpayers can value assets using either their tax book value or their fair market value. The tax book value is the original cost of the asset less any depreciation allowed for tax purposes, while the fair market value is the price the asset would sell for on the open market. Once a valuation method is chosen, it must be used consistently and can only be changed with IRS consent.

Another common approach is the gross income method. This method apportions deductions based on the ratio of foreign source gross income to total gross income within the relevant class. For example, if 40% of a company’s worldwide sales income is from foreign sources, then 40% of the general and administrative expenses allocated to sales income would be apportioned to the foreign source statutory grouping. This method is often used for deductions broadly related to earning income.

A sales method may be the most appropriate basis for certain expenses, such as research and experimental (R&E) expenditures. Other specific bases can be used if they accurately reflect the connection between the expense and income, including units sold, cost of goods sold, or employee time spent on an activity. The taxpayer bears the burden of proving their chosen apportionment method is reasonable.

Treatment of Specific Deductions

Interest expense is treated as related to all of a taxpayer’s income-producing activities and assets. Therefore, it is not allocated to a specific class of income but is apportioned across all gross income. This apportionment must be done using the asset method, based on the average value of the taxpayer’s U.S. and foreign assets.

Research and experimental (R&E) expenditures are subject to special rules. For tax years beginning after December 31, 2021, these costs must be capitalized and amortized over five years for U.S.-based research and fifteen years for foreign-based research. The annual amortization amount is the deduction that is allocated and apportioned under specific R&E regulations. These rules require a portion of the amortization deduction to first be apportioned to the geographic source where the R&E activities occurred, with the remainder apportioned by a sales or gross income method.

Stewardship expenses are costs a parent company incurs to oversee its investment in a subsidiary. These are allocated and apportioned to the dividends or income from that subsidiary. In contrast, supportive or duplicative expenses are costs for services the parent provides that benefit the subsidiary, like centralized accounting. These are allocated to the class of income they benefit.

Legal and accounting fees are allocated based on the specific activity to which they relate. For instance, legal fees incurred in the acquisition of a foreign corporation are allocated to foreign source income. If the fees relate to activities that generate both U.S. and foreign income, they must be apportioned between the two.

The deduction for state and local income taxes is related to the gross income on which the taxes are imposed. The state tax deduction is apportioned between U.S. and foreign sources based on the sourcing of the income that the state taxed. For example, if a state taxes a company’s income from both U.S. sales and foreign royalties, the state tax deduction would be apportioned between U.S. and foreign source income.

Required Documentation and Reporting

Taxpayers must maintain detailed records to substantiate the methods used for allocating and apportioning deductions. This documentation must demonstrate the factual relationship between an expense and the income class it was allocated to. It must also justify the basis chosen for apportionment.

These records should include workpapers showing the calculations for each step of the process. The burden of proof rests on the taxpayer to show that their methodology is compliant with the regulations.

The figures from these calculations are reported on the forms used to calculate the foreign tax credit. Corporations use Form 1118, Foreign Tax Credit—Corporations, while individuals, estates, and trusts use Form 1116, Foreign Tax Credit. On these forms, taxpayers report their foreign source taxable income, which is foreign source gross income minus the apportioned deductions.

Part II of Form 1118 requires a corporation to list its deductions and apportion them between foreign and U.S. source income. The form has dedicated lines for different types of deductions. The final apportioned amounts for each category are entered here, directly reflecting the outcome of the 1.861-8 analysis.