Abstract- The US Treasury issued, on March 11, 1991, the final income tax regulations stating that deductions, particularly deductions in state taxation of corporate income, are related to the allocation and apportionment of gross income relative to the imposed taxes. The methods of allocation and apportionment use a general presumption that state income taxes are allocable to income from foreign sources when the total amount of taxable income from the state is greater than taxable income from US sources. Companies can elect to either of the two methods: allocation and apportionment of unitary business tax; and allocation and apportionment under safe harbor methods or tax shelters.
Reg. Sec. 1.861-8(g) retains Examples 25 through 29, setting forth the general rules, with relatively minor changes from the prior regulations. New Examples 30 to 33 address consolidated returns, adjustments to state taxable income, and the two elective safe harbor methods.
In the preamble to the regulations, Treasurey rejects arguments from commentators that would apportion state income taxes in a manner inconsistent with the direct factual relationship between a state income tax and the income upon which the state actually imposes the tax. Two U.S. Supreme Court cases, Mobil Oil Corp. v. Commissioner of Taxes and Container Corp. v. Franchise Tax Board, are cited in rejecting arguments that the deductions should be allocated solely to income from sources within the U.S., or that such allocation should be dictated by federal, and not state, tax principles. The general principle underlying the new regulations retains the premise that the deduction for state income taxes is definitely related and allocable to the gross income with respect to which such taxes are imposed. This gross income is determined by reference to the law of the jurisdiction imposing the tax, not on a hypothetical amount of income calculated under federal tax principles.
In California, for example, the tax legislature has rejected the "arm's length" approach inherent in federal income tax principles in favor of a unitary business theory that takes into account the income, assets, and other factors of a group of affiliated corporations. This method of taxation was upheld by the Supreme Court in Container. Example 29 of the regulations provides a specific methodology for taxpayers subject to tax under this unitary theory, and Example 33 applies both safe harbor methods to such taxpayers. The regulations recognize the factual relationship between the unitary tax and the income upon which the tax is imposed, and explicitly prohibit taxpayers from recomputing unitary tax under arm's length, separate company principles.
Similarly, when state law includes foreign source dividends within the meaning of Sec. 862(a) (2) in state taxable income, but does not include factors of the corporation paying such dividends in its apportionment formula, then a portion of the state tax deduction will be considered definitely related and allocable to a class of gross income consisting solely of foreign source dividend income. Specific allocation of foreign source "portfolio dividends" is the first step in each of the methodologies contained in the regulations, including the two safe harbor methods.
Reg. Sec. 1.861-8(e)(6)(ii) requires that the state tax deduction be allocated (and then apportioned, if necessary) to the class of gross income to which the deduction is factually related, by reference to the taxpayer's "state taxable income." Such classes of gross income include the statutory groupings ("baskets") of Sec. 904(d), and a residual grouping of U.S. source income.
In general, the allocation methods employ a presumption that state income taxes are allocable to foreign source income when the total amount of state taxable income, as determined under the local law, exceeds the amount of U.S. source taxable income, as determined under federal law.
To illustrate: Example 25 gives the following fact pattern: a domestic corporation, X, which operates in states A, B, and C, and through a branch in Country Y, has federal taxable income of $1,000,000 (before deduction for state income taxes) of which $200,000 is foreign source general limitation income, and $800,000 is domestic source income, as determined under federal law. States A, B, and C each determine X's income subject to tax within their states by adjusting X's federal taxable income, and apportioning such income on the basis of the relative amounts of X's payroll, property, and sales. None of the three states specifically exempts foreign source income from state taxable income.
Under the presumption, the $800,000 of U.S. source income is subtracted from total state taxable income and the difference, if any, is presumed to be foreign source income subject to state tax.
If X had statutory groupings in addition to the one for "foreign source general limitation gross income," then the deduction apportioned to foreign source income would then be apportioned among the statutory groupings in accordance with the ratios of the taxpayer's total foreign source federal taxable income in each grouping.
It is worth noting that in Example 25, X's total state taxable income is less than its federal taxable income before state taxes. Effectively, $50,000 ($1,000,000--$950,000) of federal taxable income is deemed to be foreign source income not taxed by the states due to the presumption that state taxable income allocable to foreign sources is the difference between state taxable income and U.S. source income. This has the effect of reducing the amount of state taxes allocable to foreign source income, a favorable result.
Some taxpayers, however, are subject to state taxation on more than 100% of their federal taxable income. Besides facing a greater state tax burden, more of their liability is apportioned to foreign source income, due to the presumption above. If the mechanics of the regulations were applied without adjustment, the resulting apportionment might bear little resemblance to the factual relationship between a state's income tax and the income upon which the state imposes its tax.
Example 31 of the regulations describes a situation in which taxpayers may adjust state taxable income by the difference between depreciation allowed for state and federal purposes before using the methodology of Example 25. The regulations give little guidance, however, on what the service will consider permissible adjustments to state taxable income.
For example, assume that in Example 25, X has most of its property and payroll in states B and C, most its sales in state A, and that all three states follow the same three-factor formula method in apportioning net income. If X were to relocate its operations from state A to say, Iowa, which uses a single one-factor sales formula, then X might be subject to some double state taxation and, therefore, be taxed on more than 100% of its federal taxable income. Without an adjustment to state A taxable income, the additional tax levied by Iowa would be sourced to foreign income under the presumption in the regulations. would it be permissible to reduce state taxable income by the amount of income subject to taxation in more than one state? It appears that such an adjustment would not be inconsistent with the regulations' intent that state tax liability be apportioned based on the factual relationship between the tax and the income upon which the state actually imposes the tax. However, this issue is not specifically addressed in the examples.
Interestingly, there is no indication in the regulations that the District Director might rebut the presumption illustrated in Example 25. With prudent state tax planning, therefore, a taxpayer might consistently be able to reduce state taxable income well below 100% of its federal taxable income, and in so doing reduce or even eliminate the amount of state tax liability attributable to foreign source income.
Example 29 addresses the complexities of apportioning state income taxes levied on a unitary basis. In this example, state F levies a unitary tax.
As in the temporary regulations, the taxpayer, P, is required to determine whether the net result of the state's unitary tax is to tax income from affiliated corporations and, if so, to determine whether the tax reaches any affiliates with significant foreign source income.
The basic methodology involves two steps in which P must determine hypothetical separate company taxable income and hypothetical water's edge taxable income using the income and factors of each company. Step 1 is the determination of state F taxable income (after adjustment for portfolio dividends and other income which, under separate accounting, would have been attributed to other members of the unitary group) on a non-unitary basis. If non-unitary taxable income is greater than unitary state taxable income, then the unitary tax does not reach P's affiliates and P must apply the methodology of Example 25. If non- unitary taxable income is less than unitary state taxable income, the taxpayer must proceed to Step 2, wherein taxable income is determined using only the income and factors of entities with significant U.S. operations the ("water's edge group"). To the extent that water's edge taxable income exceeds non-unitary taxable income, the difference is attributed to U.S. affiliates and the tax on this difference is sourced to the U.S. To the extent unitary taxable income exceeds water's edge taxable income, the difference is attributed to foreign affiliates and "80/20" companies, and the tax on this difference is sourced to foreign income. The remaining non-unitary taxable income computed in Step 1 is attributed to P's own foreign and domestic operations, and the tax on this amount is apportioned using the methodology of Example 25.
As an alternative to the method used in Example 25, corporations can elect to apply one of the safe harbor methods outlined in the regulations. The election is made on a timely filed tax return by attaching to the return a statement that the company has elected to use the safe harbor method provided in either Reg. Sec. 1.861- 8(e)(6)(ii)(D)(2) or (3), as appropriate. The election is effective for the taxable year for which it was made, and all subsequent taxable years, and can be revoked only with the consent of the Commissioner.
If either of the safe harbor methods are applied to the facts in Example 25, the state tax deduction allocated to foreign source income would decrease substantially from the $10,895 computed above. As shown below, by electing a safe harbor method, X would allocate to foreign source income $5,084 under Method One, and only $2,179 under Method Two.
It should be noted that under the appropriate fact pattern, both safe harbor methods would require X to make specific allocations for foreign source portfolio dividends, and to adjust its U.S. source taxable income by activities conducted in states that do not impose an income tax using "any reasonable method" to attribute taxable income to X's activities in such states. Such modifications result in what the regulations terms "adjusted state taxable income" and "adjusted U.S. source federal taxable income." Neither of these steps were required by the fact pattern in Example 25, however.
Method Two. Under safe harbor Method Two, X would compare its adjusted state taxable income of $950,000 with its adjusted U.S. source federal taxable income of $800,000. Because the state income figure exceeds the U.S. source figure, X would apportion its deduction between U.S. and foreign source income. This apportionment is accomplished in two steps.
The first step is to apportion state tax to U.S. source income using the methodology in Example 25. The second step is to apportion the remainder between foreign and domestic source income in the same proportion, as such income bears to total federal taxable income.
Thus, the remainder amount of $10,895 computed in Example 25 would be apportioned as shown below: Portion of remainder apportioned to foreign source income: $10,895 x ($200,000/$1,000,000) $2,179. Remaining deduction to be apportioned to U.S. source income: $10,895 x ($800,000/$1,000,000) $8,716. Thus, the total deduction apportioned to sources within the U.S. would be $66,821 (i.e., $58,105 + $8,716), and the total apportioned to foreign source income would be $2,179.
3. The safe harbors placate taxpayers because less of the state deduction is apportioned to foreign source income than would otherwise be required by a strict analysis of the factual relationship between the state tax deduction and the income subject to state tax.
While taxpayers are not required to use the methods illustrated in the examples, those using an alternative method must describe the method in an attachment to the federal return and, upon examination, may be required to prove that the alternative method more accurately reflects the factual relationship between the state income tax and the income on which it is imposed.