US & Canadian Anti-deferral Provisions - Section 861 Expense allocations

1. FROM PRINCIPLES TO PLANNING US & Canadian Anti-deferral Provisions - Section 861 Expense allocations

2. U.S & Canadian Anti-deferral Regimes/ 861 allocations U.S. Anti-deferral Regime Canadian FAPI Regime Section 861 Allocations • Bill Armstrong • Subpart F Income • Section 956, Investment in U.S. Property • Tim Bloos • Primer on Canadian taxation of foreign source income • Tom Miller • When does section 861 apply • Allocating and apportioning expenses • Special rules for certain expenses

3. A Primer on Canada’s System for Taxing Foreign Source Business IncomeTim Bloos, MNP LLP

4. Canada: Taxation of Foreign Source Income Canco Canada Foreign Foreign Intermediary Ownership % Jurisdiction Type of income Carry on activities directly in foreign jurisdiction Corporation trust partnership Treaty Non- Treaty Active Passive Taxable on world wide income Relief from double tax-treaty Foreign Tax Credit Rules Foreign Affiliate Rules

5. Foreign Tax Credit Rules Domestic relief for Canadian taxpayers earning foreign source income directly Same relief granted in treaties for treaty countries Separate: property (non-business income) or business income Separate out by jurisdiction Non-business claimed before business Business tax credits: c/f 10 years, c/b 3 years, no c/f or c/b for non-business To qualify as a FTC: (1) must be paid by Cdn taxpayer to foreign government; (2) basis of taxation similar to Canada (income, withholding); or (3) specifically identified in treaty Foreign Income Earned Directly: Foreign Tax Credit Rules

6. Character of foreign source income: Active – non-passive, deemed active, recharacterized as active Surplus Passive (interest, dividends, rents, royalties) FAPI Distinction between foreign intermediary CFA – controlled foreign affiliate (can earn FAPI) FA – foreign affiliate (cannot earn FAPI) Foreign Income Earned through Affiliates: The Foreign Affiliate Rules The Foreign Affiliate Rules (Exemption/Deferral Mechanism) • Surplus balances • Tracked for each FA/CFA of a CDN Taxpayer • Exempt Surplus – treaty, active business or previously taxed FAPI • Taxable Surplus – non-treaty, active business or previously taxed FAPI • Hybrid Surplus – exempt/taxable (capital gain) • Pre-acquisition Surplus - ACB • Exempt – no tax when repatriated to Canada • Taxable – tax credit mechanism

7. FAPI: Foreign Accrual Property Income Consists of: Passive property income (rents, royalties, dividends, interest) Some is deemed active if “in the business” of earning such income Some is recharacterized as active (specific rules and specific circumstances) Includes capital gains from disposition of non-excluded property Can only be earned by a CFA Income is imputed “as earned” by the Canadian taxpayer when earned by the foreign intermediary FAPI is net of: FAT – foreign accrual tax and FAPL Foreign accrual property loss Complex rules around flowing FAPI through surplus accounts once tax paid at Canadian corporate level The Foreign Affiliate Rules: FAPI Imputation Regime

8. Series of special rules dealing with rollover provisions around flowing surplus through FA groups under various circumstances and other changes (recent 2011/2012 amendments to regime) Foreign affiliate mergers First tier liquidations or dissolutions of FAs Second tier liquidations or dissolutions of FAs Returns of capital The Foreign Affiliate Rules: Special Rules The Foreign Affiliate Rules: Special Rules • Also, special rules dealing with anti-avoidance: • Upstream loans • 95(6)(b) • Hybrid Surplus • Rules to prevent generation of surplus • Loss suspension rules

9. Allocating and Apportioning Expenses under Section 861 for Foreign Tax Credits and Other Purposes Tom Miller BKD, LLP

10. Discussion Topics Why/When allocate and apportion expenses Identifying classes of income Special rules for certain types of expenses Section 861 Allocations

11. When do we need to allocate and apportion expenses? Determining foreign tax credit First determine foreign source income Then allocate and apportion expenses to the various classes of income Other uses of section 861 Section 199 – Domestic production activities deduction Reg 1.199-4 – Requires use of the “section 861 method” and also requires consistency of allocation then the taxpayer must use the same method of allocation and the same principles of apportionment Export Incentives – Domestic International Sales Corporations Reg 1.994-1(d((6) references regulation 1.861-8. Note however, it does not require consistent treatment as Reg 1.199-4 does Subpart F Income Reg 1.954-1(c) requires allocation and apportionment under “the principles of sections 861, 864 and 904(d)” Section 861 Allocations

12. Revisiting the steps to determine the Foreign Tax Credit Identify all classes of income Classes of income are different for different calculations E.g. foreign source income is not relevant for determining combined taxable income for a DISC. Similarly, QPAI would have different classes as well The regulations use the terms “statutory and residual grouping” Class of income is not a defined term but generally refers to any grouping of similar items. “The classes of income are not predetermined but must be determined on the basis of the deductions to be allocated .” Reg 1.861-8(b)(1) Knowing and understanding your client’s business is key to determining foreign source income and allocating and apportioning expenses. Section 861 Allocations

13. Procedures for Determining Foreign Source Income 2. Determine source of income for each class of income Identify foreign taxes applicable to each 3. Allocate and apportion expenses to each class of income 4. Expenses that are not attributable to any class of income are deemed to be attributable to all classes of income and must be apportioned to all classes of income. See Reg. §1.861-8(c)(3) Section 861 Allocaitons

14. Regulations under Section 861 1.861-1 – 1.861-7 and -15 and -16 address sourcing of income 1.861-8 – Computation of taxable income from sources within the U.S and from other sources and activities 1.861-9, – 10, – 11 and –13 address allocation of interest expense 1.861-12 – characterization rules 1.861-14 provides special rules for allocating and apportioning expenses of an affiliated group (other than interest) 1.861-17 – allocation and apportionment of research and experimentation activities 1.861-18 -- classification of computer software Section 861 Allocations

15. Allocation and Apportionment of Expenses to Foreign Source Income All expenses must be allocated and apportioned between the classes of income. “A taxpayer to which this section applies is required to allocate deductions to a class of gross income and, then, if necessary to make the determination required by the operative section of the Code, to apportion deductions within the class of gross income between the statutory grouping of gross income and the residual grouping of gross income. “ Reg §1.861-8 Expenses not attributable to any class of income are allocated to all income All deductions must be allocated or apportioned. Section 861 Allocations

16. Allocation and Apportionment of Expenses Allocation vs apportionment Allocation – Where an expense applies to some income but not all income, it must be allocated against the class or classes of income to which it relates E.g. sales commissions are allocated against the sales to which they relate Note that the expense is allocated against the class of income even in a year where there is no income in the class E.g. stewardship and interest expense are still allocated against dividend income even where foreign subsidiaries have not paid a dividend Apportionment – Expenses that apply to more than one class of income must be apportioned between the classes of income to which they relate. E.g. – The salary and bonus for the head of global sales would be apportioned to all sales Section 861 Allocations

17. Allocation and Apportionment of Expenses to Foreign Source Income Special rules exist for: Interest -- Separate slide Research and Experimentation Separate slide Stewardship Expenses – Apply to dividends. Not management services but stewardship, as defined in 482 regs. Duplicative in nature. Reg. §1.861-8(e)(4) Method of allocations – time spent and related compensation or an allocation based on a comparable factor such as gross receipts, gross income, unit sales volume, etc. Legal and accounting fees and expenses – Ordinarily are definitely related and allocable to a specific class or classes of gross income or to all gross income. Reg. §1.861-8(e)(5) Income taxes – Primarily state and local income taxes – Reg. §1.861-8(e)(6) Losses on the sale or exchange of property – Reg. §1.861-8(e)(7) Charitable contributions – Generally definitely related and allocable to all of a taxpayer’s gross income --Reg. §1.861-8(e)(12) Section 861 Allocations

18. Allocation and Apportionment of Expenses to Foreign Source Income Interest – See Regs. §§1.861-9, -9T, -10, -10T, -11, -11T -12 and -12T Applies to all items deductible under §163 -- Reg. §1.861-9T(a) Gross amount of interest – money is fungible Applies to losses or expenses which are interest equivalents Generally, interest expense is allocated to all assets based on the class of income they produce Special rules for partnership interests -- Reg. §1.861-9T(e) Corporations – use the asset method -- Reg. §1.861-9T(f) Generally, based on tax basis in assets May elect to use fair market value method Section 861 Allocations

19. Allocation and Apportionment of Expenses to Foreign Source Income Interest (Cont’d) Special rule for qualified non-recourse indebtedness – Reg. §1.861-10T(b) Affiliated groups – consolidated calculation -- Reg. §1.861-11 and Reg. §1.861-11T Intercompany interest is eliminated in consolidated return Loans between affiliates are not treated as an asset for purposes of the allocation Related borrowers and related payees treat interest consistently Section 861 Allocations

20. Research and Experimentation Expenditures – Reg 1.861-17 Applies to section 174 R&E Broader category than section 41 credit for R&E Generally favorable Permits geographic apportionment based on location of R&E activity So domestic if at least 50% of the R&D claimed is performed in the US Two methods Sales method Permits 50% geographic apportionment Gross Income method Permits 25% geographic apportionment Must choose and retain same method for 5 years Note that geographic apportionment is for foreign source income only If using a DISC, exclusive apportionment does not apply to determine combined taxable income Section 861 Allocations

21. Allocation and Apportionment of Expenses to Foreign Source Income Manner of apportioning income There is not a requirement that the allocation method be the “best method” as there is for determining a transfer price under section 482. The regulation requires “Such attribution must be accomplished in a manner which reflects to a reasonably close extent the factual relationship between the deduction and the grouping of gross income.” Reg 1.861-8T(c)(2) Allocation or apportionment methods are not accounting methods and may be changed from year to year Section 861 Allocations

22. Allocation and Apportionment of Expenses to Foreign Source Income Supportive Expenses -- Expenses that are supportive in nature can be allocated or apportioned to the gross income to which they support. It is also permissible to allocate them based on the expenses to which they relate. Reg 1.861-8(b)(3) E.g. Overhead, supervisory, general and administrative expenses Expenses that do not bear a definite relationship to any class of gross income is treated as related to all gross income. Reg 1.861- 1(b)(3) Examples cited in the regs include The deduction for interest expense, The deduction for real estate taxes on a personal residence, The deduction for medical expenses allowed under section 213 and The deduction for alimony payments under section 213. In practice, most business expenses would generally relate to some class of gross income, whether or not income is actually generated, or, more likely, it is allocable to all gross income. Section 861 Allocations

23. Allocation and Apportionment of Expenses for Subpart F Income First determine adjusted gross foreign base company income Allowing for the de minimis rule Allowing for the 70% full inclusion rule Consider the E&P limitation of 952(c) Then determine net foreign base company income Determine the gross amount of each item of income Aggregate non-passive foreign personal holding company income items by type Aggregate active amounts that fall within a single category of foreign base company income Foreign base company sales income Foreign base company services income Foreign base company shipping income Foreign base company oil related income Full inclusion foreign base company income Section 861 Allocations

24. Allocation and Apportionment of Expenses for Subpart F Income Allocate and/or apportion expenses that relate to less than all gross income Passive foreign personal holding company income is reduced by related person interest expense allocable to passive income All other expenses are allocated and/or apportioned Losses reduce subpart F income only through operation of the E&P limitation 1. Losses in one category do not reduce subpart F income in other categories Section 861 Allocations

25. Allocation and Apportionment of Expenses Examples -- Allocation of expenses to determine foreign source income and subpart F income Facts ABC Company, a US C corporation, manufactures and sells widgets. ABC owns 100% of a UK company. ABC produces in the US and sells domestically, into Canada and Mexico and, through its UK CFC, throughout Europe.(So UK has subpart F income) ABC also purchases goods from a 3rd party and resells to its customers in the US and outside the US. UK CFC purchases for resale directly from the 3rd party. ABC has interest expense. ABC receives a royalty from an Australian company who produces the widgets and sells them throughout Asia Pacific based on a license agreement agreement Questions What classes of gross income does ABC have? What expenses will ABC need to allocate and apportion? How does ABC determine the amount of subpart F income from UK CFC? Section 861 Allocations

26. Allocation and Apportionment of Expenses to Foreign Source Income Examples -- Allocation of expenses to determine foreign source income and subpart F income Answers What classes of gross income does ABC have? Domestic income from sales of US produced goods Domestic and foreign source income from sales of US produced goods sold to foreign customers where title transfers outside the U.S. (including sales to UK CFC) Distribution income for sales of goods purchased from 3rd party and sold domestically or to foreign customers (foreign to the extent of foreign title passage) Royalty income Dividend income (subpart F income or regular dividend) What expenses will ABC need to allocate and apportion? Interest expense Stewardship expenses Research and Experimentation SG&A expenses State and local income taxes Section 861 Allocations

27. Allocation and Apportionment of Expenses to Foreign Source Income Examples -- Allocation of expenses to determine foreign source income and subpart F income Answers How does ABC determine the amount of subpart F income from UK CFC? Determine CFC’s gross income Determine gross foreign base company income Check for passive type of income – miscellaneous interest etc. Foreign base company sales income from gross income on purchases of goods from ABC company and sold outside of the UK Apply de minimisand full inclusion rules Compute net foreign base company income Identify expenses allocable to less than all of the CFC’s gross income Consider related person interest expense allocable to foreign personal holding company income Allocate/apportion remaining expenses against all income Determine if high tax exception applies Section 861 Allocations

28. Tom Miller Partner, International Tax Services BKD, LLP 317-383-3751 tjmiller@bkd.com