Bret Wells (Houston; Google Scholar), Revisiting the Interest Expense Deduction and the Foreign Tax Credit, 26 Fla. Tax Rev. __ (2022):
When the deduction allowance rules and the foreign tax credit limitation rules work appropriately, these two regimes work in combination to avoid a double benefit: the benefit of a U.S. deduction to reduce U.S. taxation of gross foreign income and then a foreign tax credit benefit on the very same gross foreign income. To prevent the allowance of both a deduction benefit and a foreign tax credit benefit on the generation of the same item of gross foreign income, appropriate matching is required of the U.S. interest expense disallowance/allowance regime with the foreign tax credit limitation regime. The design challenge for the tax system is to coordinate the interest deduction allowance/disallowance regime with the foreign tax credit limitation regime so that the two regimes create harmonized and appropriate results.
Unfortunately, the current interaction of these two regimes fails to achieve appropriate outcomes. The organizing principle can be simply stated: the foreign tax credit limitation should take into account (and be reduced by) properly allocable and apportionable U.S. expenses so that the allowable amount of foreign tax credit available for usage only offsets net foreign source income. By reducing the foreign tax credit limitation by the amount of the properly allocable deduction benefit, a foreign tax credit is utilized only to the extent that the net foreign income is in excess of the already garnered U.S. deduction benefit. The organizing principle can also be stated in the negative: the foreign tax credit limitation regime should not allow usage of a foreign tax credit to the extent that the item of gross foreign income has already been offset by a deduction or else a double benefit would result.
The coordination of the deduction benefit regime with a credit benefit regime must utilize proxies to match the two regimes. This article demonstrates that the most appropriate proxy for allocating and apportioning U.S. interest expense is one that first identifies the incremental U.S. deduction benefit attributable to the inclusion of foreign income into the Section 163(j) computation. The reason that approach is now the best proxy for allocating and apportioning U.S. interest expense is because Section 163(j) determines the interest deduction benefit and does so in a manner where the incremental deduction benefit attributable to foreign income can be readily ascertained. Said differently, it is now possible to perform the required Section 163(j) computation and then to recompute the Section 163(j) limitation calculation excluding all foreign income in the hypothetical recomputation exercise. By comparing the actual Section 163(j) limitation to the recomputed hypothetical Section 163(j) computation (where foreign income is excluded from the limitation calculation), one can then determine the positive interest deduction benefit attributable to the inclusion of foreign income into the Section 163(j) computation. Now that the positive Section 163(j) limitation enhancement attributable to the inclusion of foreign income can be readily determined, the allocation and apportionment regime should allocate that amount of U.S. interest expense (and only that amount) because that methodology actually matches the amount of the allocation and apportionment of U.S. interest expense to the actual interest deduction benefit derived from the inclusion of foreign income whereas the asset-based apportionment methodology utilized in the Section 861 regulations does not.
Section 163(j) attempts to define the interest deduction benefit and does so by treating various forms of foreign income differently. Section 861 attempts to allocate and apportion U.S. interest expense to various baskets of foreign income using a proxy that has no relationship to the actual interest deduction benefit calculation determined under Section 163(j). The U.S. interest expense allowance/disallowance regime of Section 163(j) and the allocation and apportionment rules for U.S. interest expense have evolved divergently, creating asymmetrical and incoherent impacts on the foreign tax credit limitation that are unmoored to the actual interest expense deduction benefit attributable to the inclusion of foreign income into the taxpayer’s U.S tax return. Said differently, the determination of the interest deduction benefit and the limitation on the foreign tax credit benefit are not harmonized, and the lack of symmetry in these two regimes creates incoherent outcomes. Given that Section 163(j) now provides a robust allowance/disallowance regime for regulating the benefit of a U.S. interest deduction and given that the incremental deduction benefit attributable to foreign income can be readily ascertained by looking to the incremental deduction benefit that foreign income has on that Section 163(j) computation, it is now time to reform the proxy utilized to allocate and apportion U.S. interest expense so that the deduction benefit and the corresponding reduction to the foreign tax credit limitation are matched appropriately.
