U.S. Shareholder's Treatment of CFC Stock Must Match CFC's Apportionment Method

(Parker Tax Publishing April 2022)

The Tax Court held that a domestic corporation which was a U.S. shareholder of a controlled foreign corporation (CFC) that apportioned interest expense under the modified gross income method was required by the consistency requirement in Reg. Sec. 1.861-9T(f)(3)(iv) and Reg. Sec. 1.861-12T(c)(3) to characterize its stock in the CFC using the same method that the CFC used to apportion its interest expense. The court rejected the taxpayer's argument that Reg. Sec. 1.861-12T limits the application of the consistency rule, and found that Reg. Sec. 1.861-12T provides supplemental rules for the characterization of CFC stock. Aptargroup Inc. v. Comm'r, 158 T.C. No. 4 (2022).

Background

Aptargroup Inc. is a U.S. corporation that filed a consolidated income tax return for 2014. In December 2014, Aptargroup restructured its ownership of its foreign subsidiaries. Before the restructuring, Aptargroup directly owned 100 percent of AptarGroup Holdings, an entity organized under the laws of France (AGH France), which served as a global holding company for most of Aptargroup's foreign subsidiaries. Aptargroup owned, directly or indirectly, 42 controlled foreign corporations (CFCs) and also directly owned stock in other foreign corporations. As part of the restructuring, Aptargroup transferred ownership of substantially all of its foreign subsidiaries including AGH France to a Luxembourg holding company, AptarGroup Global Holding (AGH Lux). After the restructuring, Aptargroup wholly owned AGH Lux, which wholly owned, directly and indirectly, 32 CFCs. The CFCs held assets that generated foreign source income, and some also held assets that generated U.S. source income.

During 2014, Aptargroup paid or accrued interest expense or was deemed to have done so. On its 2014 return Aptargroup claimed a foreign tax credit of $3,539,543. In 2020, the IRS issued a notice of deficiency to Aptargroup for 2014 disallowing the foreign tax credit in its entirety and applying an accuracy-related penalty. Aptargroup objected and took its case to the Tax Court. Aptargroup and the IRS filed cross motions for partial summary judgment with respect to Aptargroup's method of apportioning interest expense for purposes of calculating the foreign tax credit.

Code 901(a) allows U.S. citizens and domestic corporations a credit for income tax paid to a foreign country. Under Code Sec. 904(a), the allowable foreign tax credit for a tax year is the lesser of (1) foreign tax paid or accrued, or (2) the foreign tax credit limitation (FTC limitation). The FTC limitation is computed by multiplying total U.S. tax on worldwide income by a fraction with the numerator being the foreign source taxable income and the denominator being worldwide taxable income. Where a taxpayer has more than one category of income as listed in Code Sec. 904(d) (limitation category), the FTC limitation must be computed separately for each limitation category under Code Sec. 904(d)(1).

To compute the FTC limitation, the taxpayer must determine the source for its gross income using the sourcing rules in the regulations under Code Sec. 861. Reg. Sec. 1.861-8(a)(2) provides that, after determining the source of the gross income, the taxpayer must allocate each loss, expense, and other deduction (collectively, expense) to a class of gross income and then, if necessary, apportion the expense within the class of gross income between (or among) a statutory grouping and a residual grouping. For purposes of the foreign tax credit, each limitation category is a statutory grouping, and a taxpayer claiming the credit must determine the foreign source taxable income in each limitation category.

Expenses are generally allocated and apportioned on the basis of the factual relationship of the expense to gross income. For interest expense, there are two methods for apportionment: the asset method described in Reg. Sec. 1.861-9T(g) and the modified gross income method described in Reg. Sec. 1.861-9T(j). Domestic corporations must use the asset method. CFCs are permitted to choose either method, subject to certain consistency requirements. As a domestic corporation, Aptargroup apportioned its interest expense using the asset method. To apply the asset method, therefore, Aptargroup was required to divide the value of its assets among the relevant statutory groupings, a process the regulations define as "characterizing" the assets. At issue in this case was Aptargroup's method for characterizing its AGH Lux stock under these rules.

Reg. Sec. 1.861-9T(g)(3) sets out general asset characterization rules for purposes of applying the asset method. However, the regulations also provide a special consistency rule regarding the characterization of CFC stock in the hands of any U.S. shareholder. Specifically, Reg. Sec. 1.861-9T(f)(3)(iv) provides: "Pursuant to [Reg. Sec. 1.861-12T(c)(2)], the stock of a controlled foreign corporation shall be characterized in the hands of any United States shareholder using the same method that the controlled foreign corporation uses to apportion its interest expense." Reg. Sec. 1.861-12T(c)(3) describes two methods for characterizing CFC stock, which are referred to as the asset method and the modified gross income method, and imposes the same consistency rule. Under the consistency rule, stock in a CFC whose interest expense is apportioned on the basis of assets must be characterized in the hands of its U.S. shareholders under the asset method described in Reg. Sec. 1.861-12T(c)(3)(ii). Stock in a CFC whose interest expense is apportioned on the basis of gross income must be characterized in the hands of its U.S. shareholders under the gross income method described in Reg. Sec. 1.861-12T(c)(3)(iii).

AGH Lux elected to apportion interest expense using the gross income method, as it was entitled to do under Reg. Sec. 1.861-9T(f)(3)(i). But in characterizing its AGH Lux stock, Aptargroup did not apply the special characterization rules of Reg. Sec. 1.861-9T(f)(3)(iv) and Reg. Sec. 1.861-12T(c)(3) that require consistency. Rather, Aptargroup relied on the general characterization rules of Reg. Sec. 1.861-9T(g)(3). This choice allowed Aptargroup to reduce the amount of interest expense that it apportioned to foreign source income thereby increasing its foreign source taxable income and increasing its foreign tax credit.

The IRS argued that Aptargroup was not permitted to use the general characterization rules because Reg. Sec. 1.861-9T(f)(3)(iv) and Reg. Sec. 1.861-12T(c)(3)(i) required it to characterize its stock in AGH Lux using the modified gross income method described in Reg. Sec. 1.861-12T(c)(3)(iii). Aptargroup disagreed, arguing that Reg. Sec. 1.861-9T(f)(3)(iv) and Reg. Sec. 1.861-12T(c)(3)(i) did not apply to the facts of this case. According to Aptargroup, the modified gross income method is an exception to the consistency requirement and the reference to Reg. Sec. 1.861-12T in Reg. Sec. 1.861-9T(f)(3)(iv) limits the application of the consistency requirement. In addition, Aptargroup argued that it was excused from the consistency requirements of Reg. Sec. 1.861-9T by the introductory sentence of Reg. Sec. 1.861-12T(a), which states: "these rules are applicable to taxpayers in apportioning expenses under an asset method to income in various separate limitation categories under section 904(d), and supplement other rules provided in" Reg. Secs. 1.861-9T, -10T, and -11T.

Analysis

The Tax Court agreed with the IRS and held that Aptargroup's position was inconsistent with the proper application of Reg. Sec. 1.861-9T(f)(3)(iv), which requires the U.S. shareholder of a CFC to characterize the stock of the CFC using the same method that the CFC used to apportion its interest expense and which is not limited by Reg. Sec. 1.861-12T.

The court found that Reg. Sec. 1.861-9T(f), after setting forth the asset method as the general rule, allows a CFC to elect to use the modified gross income method and expressly states the consequences of the election: the U.S. shareholder of a CFC must characterize the CFC stock using the same method that the CFC used to apportion interest expense. Thus, the court determined that under Reg. Sec. 1.861-9T(f), the CFC's election of the modified gross income method binds the U.S. shareholder to that method.

The court rejected Aptargroup's argument that the modified gross income method is an exception to the consistency requirement. Rather, the court said that when it read Reg. Sec. 1.861-9T(f)(3) in its entirety, it is clear that the election is not an exception. The court did not read the reference to Reg. Sec. 1.861-12T in Reg. Sec. 1.861-9T(f)(3)(iv), as Aptargroup argued, as limiting the application of the consistency requirement. Rather, the court found that it refers to Reg. Sec. 1.861-12T as providing supplemental rules for the characterization of CFC stock. Moreover, the court found that the introductory sentence of Reg. Sec. 1.861-12T(a) establishes an additional purpose of the Reg. Sec. 1.861-12T rules independent of Code Sec. 904(d) apportionment. The court noted that in 2019, the IRS amended Reg. Sec. 1.861-12T to clarify that it applies for all operative sections, not just Code Sec. 904(d).

The court said that, first and most significant, the consistency requirement of Reg. Sec. 1.861-9T(f)(3)(iv) does not depend on whether Reg. Sec. 1.861-12T applies. It imposes an independent consistency requirement for purposes of interest expense apportionment by a CFC that elected to use the modified gross income method. Furthermore, the court did not agree that Reg. Sec. 1.861-12T on its face provides the limitation sought by Aptargroup. Rather, the court concluded that it was intended to supplement other rules, including the Reg. Sec. 1.861-9T provisions at issue in this case.

For a discussion of the foreign tax credit calculation for corporations, see Parker Tax ¶101,850.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

Parker Tax Pro Library - An Affordable Professional Tax Research Solution. www.parkertaxpublishing.com

We hope you find our professional tax research articles comprehensive and informative. Parker Tax Pro Library gives you unlimited online access all of our past Biweekly Tax Bulletins, 22 volumes of expert analysis, 250 Client Letters, Bob Jennings Practice Aids, time saving election statements and our comprehensive, fully updated primary source library.

Try Our Easy, Powerful Search Engine

A Professional Tax Research Solution that gives you instant access to 22 volumes of expert analysis and 185,000 authoritative source documents. But having access won’t help if you can’t quickly and easily find the materials that answer your questions. That’s where Parker’s search engine – and it’s uncanny knack for finding the right documents – comes into play

Things that take half a dozen steps in other products take two steps in ours. Search results come up instantly and browsing them is a cinch. So is linking from Parker’s analysis to practice aids and cited primary source documents. Parker’s powerful, user-friendly search engine ensures that you quickly find what you need every time you visit Our Tax Research Library.

Dear Tax Professional,

My name is James Levey, and a few years back I founded a company named Kleinrock Publishing. I started Kleinrock out of frustration with the prohibitively high prices and difficult search engines of BNA, CCH, and RIA tax research products ... kind of reminiscent of the situation practitioners face today.

Now that Kleinrock has disappeared into CCH, prices are soaring again and ease-of-use has fallen by the wayside. The needs of smaller firms and sole practitioners are simply not being met.

To address the problem, I’ve partnered with a group of highly talented tax writers to create Parker Tax Publishing ... a company dedicated to the idea that comprehensive, authoritative tax information service can be both easy-to-use and highly affordable.

Our product, the Parker Tax Pro Library, is breathtaking in its scope. Check out the contents listing to the left to get a sense of all the valuable material you'll have access to when you subscribe.

Or better yet, take a minute to sign yourself up for a free trial, so you can experience first-hand just how easy it is to get results with the Pro Library!

Sincerely,

James Levey

Parker Tax Pro Library - An Affordable Professional Tax Research Solution. www.parkertaxpublishing.com