Individual Addresses FDII and Allocation of Interest Expense

July 19, 2019

Re: FDII and allocation of interest expense under section 250(b)(3)(A)(ii)

Dear Jason Yen and Gary Scanlon,

This is a follow up to our call this afternoon about my May 6, 2019 comment to Proposed Regulations under Section 250 (REG-104464-18),¹ where we discussed the interaction of the section 250(b)(3)(A)(ii) allocation of interest expense to FDII with the section 163(j) limitation of deductible interest expense to 30% of adjusted taxable income (ATI). Assuming that section 250(b)(3)(A)(ii) requires the allocation of only deductible interest expense, the interaction between the various provisions can be addressed as follows.

Let FDII be the gross FDII and n equal the interest allocation factor to FDII. The number n should be ≤ 1.0 and may be the ratio of gross FDII to total gross income as adjusted under section 861 regulations.

The simultaneous equations for the actual section 250 deduction (D) under the section 250(a)(2) taxable income limitation and the maximum interest expense (I) under section 163(j) is based on FDII, n, taxable income before both deductions (TI), and any ATI addbacks (Δ):

D = 37.5% min[(FDII - nI), (TI - I)]

I = 30% (TI - D + Δ)

Since the first equation has a minimum function, the analysis should continue on two paths, one where FDII - nI > TI - I and one where FDII - nI < TI - I.

(1) In the case of FDII - nI > TI - I, the two equations become:

D = 37.5% (TI - I)

I = 30% (TI - D + Δ)

The system of two equations, two unknowns (D and I), and two constants (TI and Δ) can be solved as:

D = 29.6% TI - 12.7% Δ

I = 21.1% TI + 33.8% Δ

The taxpayer may enter its four constants to arrive at D and I.

(2) In the case of FDII - nI < TI - I=, the two equations become:

D 37.5% (FDII - nI)

I = 30% (TI - D + Δ)

The system of two equations, two unknowns (D and I), and four constants (TI, FDII, n, and Δ) can be solved as:

The taxpayer may enter its four constants to arrive at D and I.

Whichever system (1) or (2) that produces the smaller D is the relevant system of simultaneous equations that applies to the taxpayer, in order to determine its actual section 250 deduction (D) and maximum deductible interest expense (I).

For example, assume that a taxpayer has $800 FDII, $1,000 TI, n = 0.90, and no ATI addbacks (Δ = 0). The first system (1) results in:

D = 29.6% TI - 12.7% Δ = $296

I = 21.1% TI + 33.8% Δ = $211

The second system (2) results in:

The taxpayer's actual section 250 deduction is the lesser of the two D amounts, or $221. The taxpayer's maximum deductible interest expense is limited to the corresponding I of $234. The results can be checked to confirm that the $800 gross FDII is reduced by $211 (0.90 * $234 total deductible interest expense) of allocated interest expense to $589 of net FDII, which is allowed a 37.5% section 250 deduction of $221.

If the taxpayer has a lesser amount of actual interest expense, then the simultaneous equation limitations would not apply.

Similar computations can be applied when there are three or more unknowns.

Libin Zhang