Allocation and Apportionment of State Income Taxes to Foreign Source Income: Final Regulations under Sec. 861

By Johnsen, Karla M.; Sapperstein, Eric L. | The CPA Journal, September 1991 | Go to article overview

Allocation and Apportionment of State Income Taxes to Foreign Source Income: Final Regulations under Sec. 861


Johnsen, Karla M., Sapperstein, Eric L., The CPA Journal


On March 11, 1991, Treasury issued final income tax regulations with varying effective dates relating to the allocation and apportionment of deductions for state income taxes. The new regulations adopt the general principles of the temporary regulations issued in December 1988, stating that such deductions are definitely related, and thus allocable, to the gross income with respect to which those taxes are imposed. Such allocation is necessary in computing the foreign tax credit limitation under Sec. 904 and the consolidated foreign tax credit under Reg. Sec. 1.1502-4. The issue of subsequent recomputations of state income tax has not yet been addressed.

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, Treasury 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.

General Method of Allocation and Apportionment

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. …

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