Worldwide Interest Expense Apportionment—A Provision Worth Keeping

The tax code Section 864(f) worldwide interest expense apportionment rules generally became effective Jan. 1, 2021, and create an incentive for U.S.-based multinational groups to restructure their debt arrangements so that group members assume proportionate shares of the global group debt.

This provision represents constructive tax policy, and debt structures that are accordingly modified should yield greater tax and financial statement certainty. However, the currently proposed legislation to provide additional economic relief in wake of the pandemic would repeal this provision under the stated intent of raising tax revenue. This would be unfortunate as this provision is not ideological in nature, but rather would promote the laudable outcome of increased focus on economic substance by aligning global income and expenses by source.

Election Mechanics

Although initially enacted in 2004 to apply to tax years beginning after 2008, the effective date of this provision was extended multiple times until “the first taxable year beginning after Dec. 31, 2020.” For calendar year taxpayers this would be 2021, with the election to adopt the worldwide interest expense apportionment methodology apparently needing to be made in 2022 pursuant to filing the 2021 income tax return. If the eligible taxpayer does not make the election for 2021, the election is forgone and cannot be made for a later taxable year.

The election is binding “for such taxable year and all subsequent years unless revoked with the consent of the Secretary.” This restriction, however, might not be as harsh as it appears because the election generally should be helpful, and is unlikely to be harmful, to most groups.

Consequences of Election

The election would require a multinational group, defined as consisting of a U.S. corporate parent and all of its 80% or greater owned corporate subsidiaries (inclusive of foreign subsidiaries and corporations owned indirectly through certain non-corporate entities) to perform six steps:

1. Regard itself as a single corporation, and then aggregate all interest expense. This presumably would eliminate intercompany interest expense, although back-to-back debt arrangements involving unrelated creditors presumably should be traced to the ultimate debtor entity within the group.
2. The inside bases of all assets owned by such hypothetical corporation would be aggregated, and the ratio of the foreign asset bases expressed as a percentage of the total asset bases.
3. The percentage of foreign assets would be multiplied by the global group interest expense.
4. The interest expense amounts of the group’s 80% or greater-owned foreign corporate subsidiaries would be aggregated as if those foreign corporations were a hypothetical single corporation.
5. Subtract the amount computed in Step 4 from that computed in Step 3.
6. The amount from Step 5, if positive, is allocated by the group’s domestic members to the domestic members’ foreign-source income.

If the foreign corporations were to carry at least their proportionate share of the global debt, then the result of the Step 5 subtraction should be zero or negative. In such case none of the U.S. group’s interest expense should be allocated against the domestic members’ foreign source income for purposes of computing the U.S. group’s foreign tax credit limitation. Alternatively, if a net amount were to remain, it would be apportionable against foreign source income. A U.S.-based multinational group therefore could incrementally reduce the extent to which its interest expense is allocable against foreign source income by elevating the proportion of global debt owed by its foreign corporate subsidiaries.

Implications Relative to GILTI Foreign Tax Credits

The significance of an optimized debt posture, with foreign corporate subsidiaries bearing their proportionate shares of the global debt load, cannot be overstated. In particular, the Section 951A provisions pertaining to global intangible low taxed income (GILTI) have caused extensive instances of double taxation (i.e., both foreign and U.S.) of foreign subsidiaries’ income to their U.S. shareholders for two main reasons:

(1) The allocation and apportionment of U.S.-based expenses (including interest expense) against the non-exempt portion (at least half) of income in the GILTI category of foreign source income. While this was not addressed by the relevant Congressional committee report, the U.S. Treasury and IRS have confirmed that the statutory language leaves no room for an alternative interpretation.

(2) The inability for any excess GILTI foreign tax credits, unlike as with other types of foreign tax credits, to be carried back one year and then forward for up to 10 years. This causes GILTI foreign tax credits to be permanently lost, and double taxation of income to result with respect to each year in which the group’s foreign corporate subsidiaries are (as is often the case) subject to a blended foreign tax rate in excess of 13.125%. A GILTI high-tax exception election is available with respect to certain foreign businesses that are subject to foreign tax at a rate in excess of 18.9% (i.e., 90% of the prevailing U.S. corporate tax rate). The election, however, is complex to use, has tradeoffs, and may be less relevant if the U.S. corporate income tax rate were to increase.

This dynamic has led to the GILTI imposing much more of a tax cost than likely was anticipated by its drafters, while causing endless complications and uncertainty. If, however, U.S.-based multinational groups restructured their debt arrangements so that foreign corporate subsidiaries bore their proportionate shares of the aggregate global debt burden, then none of the U.S. group’s interest expense would be apportionable against foreign source income (including GILTI), and the level of allowed foreign tax credits for each income category as limited by operation of Section 904 should be considerably higher. Each dollar of increased Section 904 limitation should enable utilization of an equivalent dollar of GILTI foreign tax credits that would otherwise be wasted, thereby reducing the extent of double taxation as currently often results by operation of the GILTI foreign tax credit limitation.

An ideal state where more foreign corporate subsidiaries prospectively would be partially debt capitalized should reduce their amounts of foreign taxes paid, thereby also reducing the potential amounts of foreign tax credits that might accrue to their U.S. shareholders. Also, the interest expense should, in many instances, at the foreign entity level reduce U.S. shareholders’ accrual of both GILTI and subpart F income. The GILTI reduction would generally equate to the excess of foreign subsidiaries’ aggregate interest expense over their deemed tangible income return (DTIR), which is computed as 10% of the aggregate U.S. tax bases of the foreign subsidiaries’ depreciable tangible assets (also referred to as their qualified business asset investment or “QBAI”). (Note that President Biden has proposed eliminating the GILTI deduction for QBAI—a sensible policy objective because the current statutory language yields a U.S. tax benefit to U.S.-based multinational groups that make capital investments outside the U.S.) Such a deduction against both GILTI and subpart F income should reduce the amount of taxable income accruing to U.S. shareholders, and proportionately reduce the consequent extent to which indirect foreign tax credits accrue.

Example

A U.S. corporation (USCO) wholly-owns a foreign corporation (CFC), and each company has half of the aggregate global operating assets. Each company generates $100 of earnings before interest and taxes (EBIT) and USCO has $40 of unrelated interest expense. All of CFC’s income is tested income for purposes of the Section 951A GILTI provisions, and it has no tangible assets. CFC is assumed taxable by its local jurisdiction at 25%.

Considerations relative to Debt Restructuring

While the benefits of a worldwide interest expense apportionment election might appear quite favorable, it must be kept in mind that they come at the cost of the U.S. parent losing interest expense deductions that otherwise could have reduced U.S. taxable income. The interest expense deductions instead reduce the foreign taxable income of the foreign subsidiaries. Worldwide interest expense apportionment, and the ensuing restructuring of a global group’s debt arrangements, thus should cause a U.S. shareholder to attain an improved foreign tax credit posture at the cost of increased U.S. taxable income, and potentially also increased U.S. tax liability. The efficacy of a debt reallocation therefore depends on the ability of the ensuing foreign entity-level interest deductions to reduce foreign taxable income and consequent foreign tax liability. It also would be desirable for the relevant foreign tax rate to be proximate to that of the U.S. (which President Biden has proposed increasing from 21% to 28%), thereby to avoid significant negative tax rate arbitrage. Assuming such proximate parity in tax rates, the increased U.S. taxable income would be offset by the equivalently reduced foreign taxable income. This dynamic, whereby taxable income effectively shifts to the U.S. parent from its foreign subsidiaries, implicates an analysis of worldwide interest expense apportionment’s policy dynamics.

Tax Policy Rationale for Worldwide Interest Expense Apportionment

The historic U.S. tax treatment of interest expense deductions, together with the size and sophistication of the U.S. debt markets, have generally caused U.S.-based multinational groups to concentrate their external debt at the level of the U.S. parent corporation. As mentioned, this often leads to the U.S. parent having disproportionately low taxable income, with foreign subsidiaries having disproportionately high taxable income due to being funded with essentially “free” equity capital. This leads to excessive levels of foreign tax being paid by the group, which the U.S. parent and its domestic affiliates then seek to obtain recompense for by means of the U.S. foreign tax credit mechanism (though often in vain or only succeeding in part). The foreign tax credit mechanism, if divorced from a proportionate global sharing of the aggregate debt burden, thus often functions as an unintended subsidy from the U.S. government to those countries in which the various foreign subsidiary corporations operate. The worldwide interest expense apportionment provisions would, in contrast, function to allow each country to collect tax in proportion to the economic value created by their resident businesses, with the U.S. Treasury no longer being at a structural disadvantage.

From an accounting perspective it generally is preferable for foreign subsidiaries of multinational groups to be debt-capitalized in their particular functional currencies, thereby to stabilize cash flows at the entity level, and also balance sheets at the global consolidated group level. Finally, from a management perspective the presence of debt tends to create an awareness by each subsidiary’s leadership team that the capital invested in their business carries an economic cost, and should be compensated by superior earnings. Such a mindset typically enhances operating performance.

As noted, the proposed repeal of Section 864(f) is motivated by an intent to raise U.S. tax revenue. The above example, however, illustrates that retaining this provision could in fact increase U.S. tax revenue: This is because the tax savings to U.S. multinational groups would arise from outside the U.S., as foreign subsidiaries reduce their local tax by bearing their proportionate share of the global financing costs. The U.S. parent group then would have fewer interest expense deductions against taxable income, and fewer indirect foreign taxes that could invoke foreign tax credits.

Conclusion

The worldwide interest expense apportionment rules of Section 864(f) represent sound tax policy, and should ideally be retained so as to allow certain U.S.-based multinational groups to improve their capital structures and global tax profiles in a manner consistent with their economic substance.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Author Information

Ian Ross is the International Tax Planning Director of Illinois Tool Works, Inc. The thoughtful input provided by Libin Zhang, Tax Partner at Fried Frank, is much appreciated. The views expressed are solely those of the author, and are not necessarily those of either Illinois Tool Works, Inc. or Fried Frank.

Bloomberg Tax Insights articles are written by experienced practitioners, academics, and policy experts discussing developments and current issues in taxation. To contribute, please contact us at TaxInsights@bloombergindustry.com.