Proposed regs released December 17, 2019, build on reg. section 1.861-8 guidance to address the allocation and apportionment of deductions to exempt income; allocation and apportionment of stewardship expenses, damages payments, and net operating losses; and treatment of insurance companies’ exempt income and reserve expenses. Generally, the new rules add clarity while resolving open questions.
The proposed regs (REG-105495-19) cover the following eight topics:
the allocation and apportionment of deductions under sections 861 through 865, including research and experimentation expenses and life insurance company deductions;
the definition of financial services income under section 904(d)(2)(D);
the allocation and apportionment of creditable foreign taxes;
the branch loss and dual consolidated loss recapture rules’ interaction with section 904(f) and (g);
the effect of foreign tax redeterminations on the section 954(b)(4) high-tax exception, IRS notification requirements, and penalty provisions;
the definition of foreign personal holding company income under section 954;
the application of the foreign tax credit disallowance under section 965(g); and
the application of the FTC limitation to consolidated groups.
This article discusses new section 1.861-8 rules for allocating and apportioning expenses, all of which are contained in paragraph 3. Subsequent articles will address related topics.
On December 7, 2018, Treasury and the IRS published proposed regs (REG-105600-18) addressing Tax Cuts and Jobs Act changes made to FTC rules. These included updates to reg. section 1.861-8 that clarified its application to the TCJA’s global intangible low-taxed income and foreign-derived intangible income provisions. The proposed regs were finalized in the same December 2019 issue of the Federal Register that published the new proposed regs.
Allocation and Apportionment
Section 861(a) defines U.S.-source gross income while section 861(b) defines U.S.-source taxable income, which is gross income minus expenses, losses, and other deductions apportioned or allocated to gross income. Sections 862(b) and 863(a) have similar guidance for converting U.S.- or foreign-source gross income into taxable income.
Reg. section 1.861-8 generally prescribes rules for allocating and apportioning U.S.- and foreign-source gross income deductions to determine taxable income for several code sections called “operative sections.” Reg. section 1.861-8(f) has a list of 16 operative sections, including sections 904 (determining separate FTC limitations), 871(b) and 882 (determining deductions that reduce effectively connected income), and 954 (determining deductions that reduce foreign base company income).
Reg. section 1.861-8(a) through (d) requires taxpayers to allocate deductions to a class of gross income and then apportion deductions between statutory and residual groupings within the class.
Reg. section 1.861-8(a)(3) cross-references section 61 and lists 15 gross income classes that predictably include typical items like compensation for services, gains from sales, interest, rents, royalties, and dividends.
A statutory grouping is gross income derived from the sources or activities identified in an operative section, while the residual grouping is the remainder of the gross income not in the statutory grouping. A gross income class may consist of items that belong in different groupings. Moreover, some operative sections may cause the statutory or residual grouping to consist of excluded or tax-exempt income.
Allocation and apportionment are not interchangeable. A deduction is allocated to a gross income class when it is “definitely related” to the class based on the factual relationship between the deduction and the income class.
After a deduction has been allocated to a gross income class, it must be apportioned — or distributed proportionately — between the statutory and residual groupings. Deductions can be apportioned by reference to comparative units sold, cost of goods sold, profit contributions, expenses incurred, and gross income amounts.
The regs require interest deductions to be apportioned based on the relative values of assets used to produce the income and taxpayers may apportion other deductions using this method. If the gross income class consists entirely of a single statutory or residual grouping, however, there is no need to apportion the deduction.
Although most deductions will be definitely related to a gross income class, some may be related to all gross income or no gross income. These deductions must be ratably apportioned between groupings based on the same proportion of the deduction that the amount of income in the grouping bears to total gross income.
Some operative sections may cause the statutory or residual grouping to consist of excluded income. Reg. section 1.861-8(d)(2)(i) (by cross-reference to temporary regs) generally provides that exempt income is taken into account in allocating deductions definitely related to a gross income class, but exempt income and assets are not taken into account in apportioning deductions between groupings.
Reg. section 1.861-8(d)(2)(ii) defines exempt income and assets as income that is exempt, excluded, or eliminated for tax purposes, and assets that generate exempt income. Exempt income and assets specifically include:
dividends deductible under sections 243(a)(1) or (2) and 245(a) and the underlying stock; and
foreign-derived deduction-eligible income and GILTI inclusions (plus gross-up) in an amount equal to the section 250(a) deduction, and the underlying stock.
Under reg. section 1.861-8(d)(2)(iii), exempt income and assets do not include the following items (and thus expenses may be allocated and apportioned to them):
a foreign taxpayer’s gross income not effectively connected to a trade or business;
gross income of a domestic international sales corporation or foreign sales corporation;
dividends for which a deduction is allowed under section 245A;
foreign earned income defined in section 911; and
inclusions for which a deduction is allowed under section 965(c) (participation exemption for transition tax).
Reg. section 1.861-8(e)(2) through (15) contains rules for allocating and apportioning specific expenses listed in reg. section 1.861-8(e)(1). Specifically, reg. section 1.861-8:
(e)(2) addresses interest expense;
(e)(3) addresses R&E expenses;
(e)(4) addresses stewardship expenses;
(e)(5) addresses legal and accounting expenses;
(e)(6) addresses income taxes;
(e)(7) addresses losses from property sales;
(e)(8) addresses NOL deductions;
(e)(9) addresses deductions requiring ratable apportionment because they are not definitely related to any gross income (specifically interest, real estate taxes, medical expenses, and alimony);
(e)(10) is reserved;
(e)(11) addresses personal exemptions (not taken into account for purposes of allocation and apportionment);
(e)(12) addresses charitable contributions (definitely related and therefore allocable to all gross income);
(e)(13) addresses the section 250(a) deduction for FDII;
(e)(14) addresses the section 250(a) deduction for GILTI inclusions and the section 78 gross-up; and
(e)(15) addresses distributive shares of partnership deductions.
New Rules
New proposed reg. section 1.861-8 directs taxpayers to a comprehensive list of rules governing the allocation and apportionment of expenses via a new sentence at the end of paragraph (a)(1) defining “section 861 regulations” to mean:
reg. section 1.861-8 and -8T (computing U.S.-source taxable income);
reg. section 1.861-9 and -9T (interest expense and asset-based apportionment);
reg. section 1.861-10 and -10T (special interest expense allocation);
reg. section 1.861-12 and -12T (characterization rules and asset adjustments);
reg. section 1.861-13 (characterization of controlled foreign corporation stock);
reg. section 1.861-14 and 14T (affiliated groups’ expenses other than interest);
reg. section 1.861-17 (R&E expenses); and
reg. section 1.861-20 (foreign income taxes).
The most notable revisions to prop. reg. section 1.861-8 itself (as opposed to cross-references) are to the paragraph 1.861-8(d)(2)(ii) rules for allocating and apportioning deductions to exempt income and the paragraph (e) rules for allocating and apportioning its list of specific expenses.
Exempt Income and Assets
New prop. reg. section 1.861-8(d)(2)(ii)(B) replaces a previous cross-reference to reg. section 1.861-8T(d)(2)(ii)(B). It addresses the definition of exempt income and assets for specific stock and dividends and how exempt status affects expense apportionment and allocation.
Exempt income still includes the portion of dividends eligible for the DRD under sections 243(a)(1) or (2) and 245(a) (for dividends from foreign corporations). For apportioning deductions using a gross income method, gross income does not include a dividend giving rise to a DRD under these sections.
Additionally, for apportioning deductions using an asset method, assets do not include the portion of stock value equal to the portion of a dividend that is deductible. For example, if 50 percent of all dividends are deductible under section 243(a)(1), then 50 percent of the underlying stock value is an exempt asset.
However, even though stock that generates dividends deductible under section 243(a)(3) is not an exempt asset, the stock and dividends are still not considered in the apportionment of interest and other expenses under the consolidation rules in reg. section 1.861-11T(c) and 1.861-14T.
The proposed regs direct taxpayers to reg. section 1.861-8T(g) Example 24 for guidance on exempt income and assets. The two-part example illustrates both the income and asset methods for allocating and apportioning expenses, and how they apply to exempt income and assets.
In part (i) of Example 24, domestic corporation X owns a 25 percent voting interest in each of two domestic and three foreign corporations and incurs $100 in stewardship expenses.
Each of the five subsidiaries pays a $100 dividend and X is allowed an 80 percent DRD on dividends paid by the two domestic subsidiaries. Because tax-exempt income is considered in allocating deductions, X’s $100 stewardship expense is allocated to the class of income consisting of the dividends.
However, because tax-exempt income is not considered in the apportionment of deductions within a gross income class, the gross income of the two domestic companies must be reduced to reflect the DRD. In the apportionment formula, the dividends are $100 each from the three foreign companies and $20 each from the domestic companies, for a total of $340.
Of the $100 in total stewardship expenses, $29.41 is apportioned to each foreign company ($100 * ($100/$340)); and $5.88 is apportioned to each domestic company ($100 * ($20/$340)).
In part (ii) of Example 24, X wholly owns the stock of foreign corporation Y and 49 percent of domestic corporation Z. X has deductible interest expense of $60,000 that it apportions using the required asset method. X has assets worth $1.5 million that generate domestic-source income, including tax-exempt bonds worth $100,000 and stock of Z worth $500,000. Y generates solely foreign-source general limitation income and its stock is worth $2 million.
Because no portion of X’s interest expense is directly allocable solely to identified property, the interest deduction is therefore related to all gross income as a class.
For apportionment, exempt assets are not taken into account, meaning X’s municipal bonds are not considered. In addition, since X can claim an 80 percent DRD under section 243 for dividends received from Z, 80 percent of Z’s stock value ($400,000) is also not taken into account.
X apportions its interest deduction between the foreign-source general limitation income statutory grouping and the U.S.-source income residual grouping based on non-exempt asset values.
X apportions $40,000 interest expense to the foreign-source general limitation income ($60,000 interest * ($2 million foreign nonexempt assets/$3 million total nonexempt assets)).
The remaining $20,000 is apportioned to domestic-source income ($60,000 * ($1 million domestic nonexempt assets/$3 million)).
Specific Expenses
While new proposed reg. section 1.861-8(e) includes several cross-references to revised rules, it specifically addresses only stewardship expenses, legal and accounting fees, and NOLs in revised prop. reg. section 1.861-8(e)(4), (5), and (8). A new paragraph (e)(16) addresses life insurance company reserve expenses. Finally, prop. reg. section 1.861-8(g) contains four examples (15-18) illustrating the new rules in prop. reg. section 1.861-8(e).
Stewardship Expenses
Reg. section 1.861-8(e)(4)(i) provides that expenses related to a corporation that performs a controlled services transaction that benefits a related corporation and charges the recipient a fee for the services are definitely related and allocable to the fee income.
New prop. reg. section 1.861-8(e)(4)(ii) clarifies these rules for stewardship expenses. It provides that stewardship expenses are also definitely related and allocable to dividends and inclusions from the related corporation under sections 78 (gross-up), 951 (subpart F), 951A (GILTI), and 1291, 1293, and 1296 (passive foreign investment companies).
Stewardship expenses are apportioned between statutory and residual groupings based on the relative values of the taxpayer’s stock in each grouping as determined under reg. section 1.861-9T(g) for allocating and apportioning interest expense. Reg. section 1.861-12 and -13 may also be relevant.
Stewardship expenses result from oversight functions undertaken for a corporation’s own benefit as an investor in a related corporation. Stewardship expenses can include “duplicative” activities or “shareholder” activities offered to the related corporation (both are defined in reg. section 1.482-9(l)(3)). Stewardship expenses can be incurred from an activity intended either to protect the corporation’s investment or to facilitate compliance with legal or regulatory requirements.
If a corporation has a foreign department that oversees related foreign corporations and generates foreign- or U.S.-source income like royalties or fees for services, some department-related expenses will be definitely related and allocable to that income.
Prop. reg. section 1.861-8(g) Example 18 illustrates how rules for exempt assets overlap with rules for allocation of stewardship and other supportive expenses.
Domestic corporation USP manufactures and sells product A in the United States and wholly owns domestic subsidiary USSub and three CFCs (CFC1, CFC2, and CFC3). USP and USSub file separate U.S. tax returns but are members of the same affiliated group under section 243(b)(2). USSub and the CFCs perform similar functions in the United States and foreign countries T, U, and V, respectively. The tax book value of each of USP’s four subsidiaries is $10,000.
USP’s supervision department incurs total expense of $1,500 supervising the four subsidiaries and supporting USP’s foreign operations through three types of activities:
providing services outside the United States to benefit CFC2 in exchange for receipt of a foreign-sourced $1,000 fee equal to $900 cost plus $100 markup;
providing services that cost $60 and are related to license agreements between USP and CFC1 and CFC2 that generate $1,000 of foreign-source royalty income; and
providing shareholder oversight activities that cost $540; they duplicate the four subsidiaries’ own employee activities and so do not provide them with an additional benefit.
USP’s income includes $2,000 of passive category subpart F income, a $2,000 GILTI inclusion (reduced by a $1,000 section 250 deduction), $1,000 of service fees from CFC2, and $1,000 of royalties from CFC1 and CFC2.
Under reg. section 1.861-9T(g)(3), USSub owns assets that generate income in the U.S.-source income residual group. USP uses the asset method in reg. section 1.861-12T(c)(3)(ii) to characterize its CFC stock.
After application of reg. section 1.861-13(a), USP determines that of the $10,000 total stock value of each CFC, $5,000 is assigned to the section 951A GILTI category in the non-section 245A subgroup (50 percent of which, or $2,500, is an exempt asset); $2,000 is assigned to the general category in the section 245A subgroup; and $3,000 is assigned to the passive category in the non-section 245A subgroup.
Of the $30,000 total CFC stock value, USP has $7,500 in the GILTI non-section 245A group; $7,500 in exempt assets; $6,000 in the general category section 245A subgroup; and $9,000 in the passive category non-section 245A subgroup.
The first two types of services are not stewardship expenses because they are not incurred solely to protect USP’s investment in its subsidiaries or to facilitate compliance with regulatory requirements. The third activity is shareholder oversight, is duplicative, and is therefore a stewardship expense.
Allocation of USP’s $1,500 of deductions is as follows:
$900 for services provided to CFC2 is definitely related and allocable to the fees USP receives from CFC2;
$60 of expenses related to licensing agreements with CFC1 and CFC2 are definitely related and allocable to the royalties received from CFC1 and CFC2; and
the stewardship deduction of $540 is definitely related and allocable to dividends and inclusions received from all the subsidiaries.
No apportionment of the $900 deduction for CFC2’s services is necessary because the class of gross income to which the deduction is allocated (the $1,000 service fee income) consists entirely of a single statutory grouping — foreign-source general category income.
Similarly, no apportionment of the $60 deduction for licensing services is necessary because the class of gross income to which the deduction is allocated (the $1,000 royalty income) also consists entirely of foreign-source general category income.
To apportion the $540 in stewardship expenses, the FTC limitation statutory groupings are foreign-source general category income, foreign-source passive category income, and foreign-source GILTI income. The residual grouping is U.S.-source income.
The deduction is apportioned using the same value of USP’s stock in its subsidiaries that is used for purposes of allocating and apportioning USP’s interest expense. However, the $10,000 of USSub stock value is eliminated because USSub generates dividends that are deductible under section 243(a)(3).
Although USP may be allowed a section 245A DRD for the CFCs’ dividends, their stock value is not eliminated because the section 245A DRD does not cause exempt income or assets. Therefore, the only asset values USP uses to apportion stewardship expenses are the CFCs’ stock values.
The $540 of stewardship expenses is apportioned as follows:
$180 is apportioned to GILTI category income ($540 expense * ($7,500 stock value in GILTI category/$22,500 total nonexempt stock value));
$144 is apportioned to general category income ($540 * $6,000 stock value in general category/$22,500)), with section 904(b)(4)(B)(i) applying to the $144 in the general category’s section 245A subgroup; and
$216 is apportioned to passive category income ($540 * $9,000 stock value in passive category/$22,500)).
Again, under reg. section 1.861-8(e)(4)(i), stewardship expenses are definitely related and allocable to dividends received from related corporations, reflecting that these expenses are intended to protect the shareholder’s investment and are factually related to the investment’s income.
Before the TCJA, U.S. taxpayers often recognized foreign-source income of foreign subsidiaries only when distributed. The section 951A GILTI inclusions and section 245A DRD now cause taxpayers to recognize foreign-source income on a current basis or not at all. Some taxpayers may interpret “dividends received, or to be received” in prop. reg. section 1.861-8(e)(4)(ii) to exclude the section 78 gross-up amount and subpart F and GILTI inclusions even though stewardship expenses may be factually related to these income items. The new proposed regs make clear that stewardship expenses should be allocated to these items and PFIC inclusions.
As for apportionment, the proposed regs contain an explicit rule providing that stewardship expenses should be apportioned based on the relative values of a taxpayer’s stock. The proposed regs now require taxpayers to characterize and value their stock assets using the same method for allocating and apportioning both their interest and stewardship expenses, and also some damages payments.
Treasury and the IRS have requested comments on exceptions to the general rules for allocation and apportionment of stewardship expenses when the expenses seem definitely related to a more limited class of gross income; for example, when ownership of a particular asset requires the expense because an entity’s jurisdiction has unique compliance requirements. Stewardship expenses should arguably reduce only income from that entity.
Legal Fees and Damages
The rules in reg. section 1.861-8(e)(5) for allocation and apportionment of legal and accounting fees do not address damage awards, prejudgment interest, or settlement payments. Prop. reg. section 1.861-8(e)(5)’s application is expanded beyond legal and accounting fees to damages awards, prejudgment interest, and settlement payments.
These expenses are definitely related and allocable to the income class generated by the sales of the product or service that caused the damage or injury. If the claims arise from an event incident to providing products or services rather than from damage or injury caused by the product or service, the expenses are still definitely related to income produced by assets used to provide products or services. The deductions may be apportioned among the statutory and residual groupings based on the relative values of the assets in each grouping.
If claims are made by investors against a corporation arising from negligence, fraud, or malfeasance, then the expenses are definitely related and allocable to all of the corporation’s income and are apportioned based on the relative value of assets in each grouping. Groupings are determined based on where the income would be assigned if it were recognized in the tax year the deduction is allowed.
Prop. reg. section 1.861-8(g) Examples 15, 16, and 17 illustrate the allocation and apportionment of settlement and damages payments. Domestic corporation USP designs, manufactures, and sells product A in the United States and in country X through foreign disregarded entity FDE. USP earns $300 of U.S.-source income from sales in the United States and $100 of gross income from sales in country X, of which $80 is U.S.-source income from USP’s manufacturing activities and $20 is U.S.-source income from FDE’s distribution activities. FDE’s $100 of income is in the foreign branch category.
After product A harms a customer, FDE is sued in country X and makes a deductible settlement payment. FDE’s payment is allocable to the gross income class from sales in country X that consists solely of U.S.-source income. Therefore, none of that income is included in the statutory grouping of foreign-source foreign branch category income, and the deduction reduces USP’s residual U.S.-source income grouping.
Example 16 assumes the same facts as Example 15, but the claim arises from an event incident to producing product A. An employee’s negligence causes a disaster at FDE’s warehouse in country X. Product A inventory is destroyed, and FDE’s employees and neighbors are injured. FDE pays $80 in damages to injured parties.
The damages are allocable to the gross income class of items produced within the warehouse, or income from product A sales. As in Example 15, no apportionment of the $80 is necessary because the gross income class consists solely of U.S.-source income.
Example 17 also assumes the same facts as Example 15, except that FDE manufactures and sells product A in country X in 2015, before enactment of the section 904(d)(1)(B) separate category for foreign branch income. FDE is sued in 2016 after product A harms a country X customer, and it pays damages to the customer under a court judgment in 2019.
The 2019 payment is definitely related and allocable to the gross income class from product A sales in country X. Although that income in 2015 was foreign-source general category income, in 2019 the income is U.S.-source foreign branch category income. No apportionment is necessary because this gross income class is solely U.S.-source income.
Net Operating Losses
Rules in reg. section 1.861-8(e)(8) provide that a NOL deduction is allocated and apportioned in the same manner as the deductions comprising the NOL, but do not specify how the statutory and residual grouping components of an NOL are determined. The proposed regs provide that the NOL is assigned to the groupings by reference to the losses in each grouping (without regard to section 904(b) adjustments) that did not reduce income in a different grouping in the tax year of the loss.
Prop. reg. section 1.861-8(e)(8) provides more detailed guidance on allocating and apportioning NOLs. An NOL is assigned to statutory or residual groupings by reference to the losses in each grouping that did not reduce income in the year the loss was incurred. An NOL deduction under section 172 is allocated and apportioned to groupings by reference to its components. With some exceptions, a partial NOL is treated as ratably comprising its components.
For section 904, the source and components of an NOL are determined by reference to the amounts of separate limitation loss and U.S.-source loss not allocated to reduce income under section 904(f) and (g) in the year the NOL arose.
Comments to March 6, 2019, proposed regs under section 250 requested guidance on treatment of NOLs arising before the TCJA if deducted in a post-TCJA year when section 250 is the operative section. These comments will be addressed as part of the finalization of the section 250 proposed regs.
Insurance Provisions
Prop. reg. section 1.861-8(d)(2)(v) (addressing exempt income and assets) and -8(e)(16) (allocating and apportioning reserve expenses) add two new rules that apply to insurance companies. Prop. reg. section 1.861-8(d)(2)(v)(B) has two examples that illustrate the new rules.
By way of background, subchapter L requires a nonlife insurance company to recognize underwriting income, or premiums minus losses and expenses. Proration rules reduce losses by the “applicable percentage” of income from tax exempt interest and deductible dividends. For a life insurance company, the proration rules reduce the closing balance of reserve items by the “policyholder’s share” of tax-exempt interest. The policyholder’s share is a fixed percentage intended to represent the portion of the company’s tax-exempt investment income that funds its obligation to policyholders.
Similarly, a life insurance company is allowed a DRD for dividends from nonaffiliates for the “company’s share” of the dividends but not the policyholders’ shares. Fully deductible dividends from affiliates are excluded from proration by life insurance companies if the dividends are not distributed from tax-exempt interest or deductible dividend income.
Although the mechanics of proration differ depending on whether a company is a life insurance or nonlife insurance company, and on whether the prorated item is tax-exempt interest or deductible dividends, the purpose of proration is the same. The policyholders’ shares of deductible dividends and tax-exempt interest should not cause a double tax benefit by being free of tax while also reducing income via increased unpaid losses and reserves.
Proration mechanics do not change the fact that tax-exempt interest and (for nonlife insurance companies) deductible dividends remain exempt from U.S. tax. Including these exempt amounts and corresponding assets in the apportionment formula would effectively apportion reserve deductions to exempt U.S.-source income.
Rules in reg. section 1.861-8T(d)(2) and -14T(h) already provide some guidance. However, they do not provide rules for tax-exempt interest of a life insurance company or DRDs and tax-exempt interest of a nonlife insurance company. This is because if a policyholder’s share is accounted for as either a reserve adjustment or a reduction to incurred losses, no further modification is necessary to ensure that the right amount of expense is apportioned to U.S.-source income.
Nonetheless, the proposed regs clarify the effects of some deduction limitations on the treatment of insurance company income and assets generating DRDs and tax-exempt interest. For insurance companies, exempt income includes deductible dividends and tax-exempt interest without regard to the proration rules.
Prop. reg. section 1.861-8(d)(2)(v) repeats the temporary regs’ rules regarding the exempt status of a life insurance company’s stock and adds two new examples. Exempt income still includes deductible dividends without regard to any disallowance under section 805(a)(4)(A)(ii) of the policyholder’s share of dividends or any similar disallowance under section 805(a)(4)(D). Exempt income also includes tax-exempt interest without reduction for the policyholder’s share that reduces the closing balance of items in section 807(c) as provided under section 807(a)(2)(B) and 807(b)(1)(B).
New prop. reg. section 1.861-8(e)(16) has a new rule for allocating and apportioning life insurance company reserve expenses. It provides that a life insurance company’s reserve expenses equal to a DRD that is disallowed as attributable to a policyholder’s share is treated as definitely related to the dividends.
Example 1 addresses tax-exempt interest income. It assumes domestic life insurance company USC has $300 of total gross income consisting of $100 of foreign-source general category income and $200 of U.S.-source passive category interest income. $100 of the interest income is tax exempt under section 103 (municipal bonds).
USC’s section 807(c) reserve opening balance is $50,000 and its closing balance is $50,130. Under section 807(b)(1)(B), USC’s closing balance is reduced by the policyholder’s share of tax-exempt interest — 30 percent (or $30) under section 812(b).
Therefore, under sections 803(a)(2) and 807(b), USC’s reserve deduction is $100 ($50,130 closing balance - $30 policyholder’s share of tax-exempt interest - $50,000 opening balance). USC has no other income or deductions.
Under section 818(f)(1), USC’s reserve deduction cannot be definitely allocated to a gross income class and is therefore treated as allocable to all of USC’s gross income under reg. section 1.861-8(b)(5). Under reg. section 1.861-8(c)(3), the reserve deduction is ratably apportioned between the statutory grouping (foreign-source general category income) and the residual grouping (U.S.-source income) on the basis of relative amounts of gross income in each grouping.
Under section 1.861-8T(d)(2)(i), exempt income is not taken into account in apportioning deductions, and the new proposed regs include tax-exempt interest of an insurance company without regard to any reduction for the policyholder’s share. Of USC’s $200 of interest income, $100 is tax exempt without reduction for the policyholder’s $30 share that reduces the section 801(c) closing balance.
The gross income taken into account in apportioning USC’s reserve deduction is $100 of foreign-source general category income and $100 of U.S.-source gross income. The $100 reserve deduction is apportioned equally to each category ($100 * $100/$200).
Example 2 addresses the DRD. It assumes USC has $300 total gross income consisting of $100 foreign-source general category income and $200 of U.S.-source general category income eligible for the 50 percent DRD under section 243(a)(1). Under section 805(a)(4)(A)(ii), USC is allowed a 50 percent DRD on the company’s share of the dividend received. Under section 812(a), the company’s share is equal to 70 percent of the dividend income eligible for the DRD, resulting in a DRD of $70 (70% * 50% * $200); and under section 812(b), the policyholder’s share is the remaining 30 percent, or $30.
USC is allowed a $130 deduction for increasing its life insurance reserves under sections 803(a)(2) and 807(b). But unlike a policyholder’s share of tax-exempt interest income, a policyholder’s share of tax-exempt dividends does not cause an adjustment to USC’s reserve deduction under section 807(b)(1)(B).
Again, under section 818(f)(1), USC’s reserve deduction cannot be definitely allocated to an item or class of gross income. Under prop. reg. section 1.861-8(e)(16), however, a life insurance company’s reserve expenses are definitely related to its dividend income in an amount equal to a DRD that is disallowed because it is attributable to the policyholder’s share of dividends.
Of USC’s $130 reserve deduction, $30 is directly allocated and apportioned to U.S.-source dividend income, and the remaining $100 is allocable ratably to the statutory and residual groupings. Exempt income is not taken into account and includes dividends deductible under section 805(a)(4) without regard to any reduction to the DRD for the policyholder’s share. Thus, the gross income taken into account in apportioning the remaining $100 of USC’s reserve deduction is $100 of foreign-source general category income and $100 of U.S.-source income, so that $50 of the deduction is allocated to the two groupings ($100 * $100/$200).