Rev. Rul. 87-64

1987-2 C.B. 166, 1987-29 I.R.B. 1987.

FOREIGN CORPORATIONS; CORPORATE FRANCHISE TAX

Published:  1987

Section 882 - Tax on income of foreign corporations connected with United States business, 26 CFR 1.882-1: Taxation of foreign corporations engaged in U.S.  business or of foreign corporations treated as having effectively connected income

(Also Section 861; 1.861-8.)

  Foreign corporations; corporate franchise tax. A state corporate franchise tax must be allocated to a class of gross income consisting of the income attributable under state law to the corporations activities in the state and then apportioned between effectively connected income and the noneffectively connected income in that class of gross income in order to determine the amount deductible under section 882(c) of the Code. Rev. Rul. 79-186 revoked.

ISSUE

  In determining the deductions allowed in computing the taxable income of a foreign corporation under section 882(c)(1)(A) of the Internal Revenue Code, to what extent is a state-imposed corporate franchise tax considered to be connected with income which is effectively connected with the conduct of a trade or business in the United States, and thus deductible?

FACTS

  Taxpayer is a foreign corporation engaged in a trade or business in the United States through a branch located in State A. It operates a unitary (integrated) business in a number of foreign countries, either directly or through wholly owned subsidiaries.

  State A imposes one of two alternative taxes on corporations (including foreign corporations deriving income from State A). One of the taxes is a franchise tax imposed on a corporation for the privilege of doing business or exercising a corporate franchise in the state. The other tax is an income tax imposed on corporations deriving income from activities in the state which do not rise to the level of doing business or exercising a corporate franchise.

  The State A corporate franchise tax is equal to a stated tax rate applied to the amount of Taxpayer's entire net income that is attributed to State A activities. The State A corporate income tax in all cases is imposed on the amount of Taxpayer's entire net income attributed to State A activities. The amount of the entire net income attributed to Taxpayer's activities in State A for purposes of computing both the franchise tax and the income tax is the sum of the allocable net business income and the allocable net investment income. Allocable net business income and allocable net investment income are determined by dividing Taxpayer's worldwide income (which is Federal taxable income as adjusted under state law) between business and investment income, and

then multiplying separate business and investment allocation fractions against those respective amounts of income.

  The business allocation fraction is the average of three fractions which are determined by comparing (1) the average value of Taxpayer's real and personal property within State A with the average value of all of Taxpayer's real and personal property, (2) sales within the state with worldwide sales, and (3) payroll within the state with worldwide payroll. Taxpayer's net business income is multiplied by the business allocation fraction to determine the amount of Taxpayer's net business income deemed to be derived from State A.

  State A includes in its definition of worldwide business income foreign source portfolio dividends that are not effectively connected with a U.S. trade or business for Federal purposes. These dividends are subject to the business allocation fraction determined on the basis of state factors. The state business allocation fraction does not include, however, any factors relating to the foreign corporations paying those dividends. Consequently, the state's inclusion of foreign source portfolio dividends in worldwide business income (without including the associated factors) increases Taxpayer's net income subject to tax beyond the amount that would be subject to tax if State A excluded from income all income not effectively connected with a U.S. trade or business.

LAW AND ANALYSIS

  A foreign corporation engaged in a U.S. trade or business is taxed on income which is effectively connected with the conduct of a U.S. trade or business in the same manner as a U.S. corporation. Section 882(a)(1) of the Code. In computing its effectively connected taxable income, a foreign corporation is allowed deductions only to the extent that they are connected with income which is effectively connected with a U.S. trade or business. Section 882(c)(1). The amount of a state corporate franchise tax that is deductible by a foreign corporation depends, therefore, on the amount of the tax that is allocated and apportioned to income which is effectively connected with the conduct of a trade or business within the United States. Section 882(c)(1)(A). Deductible expenses (other than charitable contributions and interest expense) are allocated and apportioned between effectively connected income and non- effectively connected income in accordance with the rules of section 1.861-8 of the Income Tax Regulations. Sections 1.882-4(c)(1) and 1.861-8(f)(l)(iv).

  Under the general expense allocation and apportionment rules of section 1.861-8(a)(2) of the regulations, expenses must be allocated and apportioned on the basis of the factual relationship of expenses to gross income. Expenses must be allocated and apportioned in certain circumstances even to gross income that is exempt from U.S. taxation (such as the non-effectively connected income of a foreign corporation or nonresident alien). Section 1.861-8(d)(2). Section 1.861-8(e) provides for the application of this general principle in the context of specific types of deductible expenses. Section 1.861-8(e)(6) governs the allocation and apportionment of the deduction for state, local, and foreign income, war profits, and excess profits taxes allowed under section 164 of the Code. Section 1.861-8(e)(6) states that such taxes are considered to be definitely related and allocable to the gross income with respect to which the taxes are imposed.

  Rev. Rul. 79-186, 1979-1 C.B. 238, discusses the allocation and apportionment of state franchise taxes for the purpose of determining the amount of a foreign corporation's deduction for the New York State corporate franchise tax under section 882(c)(1) of the Code. The facts of Rev. Rul. 79-186 involve a foreign corporation engaged in a U.S. trade or business through a branch located in New York State. The foreign corporation's franchise tax liability for the year is calculated by applying a stated tax rate to the portion of the foreign corporation's net worldwide income (as defined under New York law) that is allocated to activities in New York State. The ruling states that net income for purposes of the franchise tax may include income which is not includable in the foreign corporation's Federal taxable income, because New York State's definition of worldwide net income may include income that is not effectively connected with a U.S. trade or business.

  Rev. Rul. 79-186 states that the specific allocation rules of section 1.861-8(e)(6) of the regulations, relating to state income taxes, do not apply in allocating and apportioning the New York franchise tax, because the tax is imposed on the activity of doing business in New York State and is not an income tax within the meaning of section 1.861-8(e)(6). The ruling concludes that the New York franchise tax is solely attributable to the gross income generated by the corporation's activities in the state, and holds that the franchise tax is deductible in full against the foreign corporation's effectively connected income.

  Section 1.861-8(e)(6) of the regulations treats as an 'income tax,' subject to the allocation and apportionment rules of that section, state taxes imposed on state taxable income determined by apportioning adjusted taxable income on the basis of the ratio of a taxpayer's payroll, property, and sales within the state to all payroll, property, and sales, wherever located. Section 1.861- 8(g), Example (25). The franchise tax imposed by State A is generally computed in the same manner as the income tax which is described in Example (25) of section 1.861-8(g). The only difference between the state income tax subject to section 1.861-8(e)(6) and the franchise tax imposed by State A is that the income tax is a tax imposed on income while the franchise tax, although also measured by income, is nominally a tax imposed on the right to do business or exercise a corporate franchise in State A. Since the State A corporate franchise tax and the income tax subject to section 1.861-8(e)(6) have the same factual relationship to the same state law definition of taxable income, the basic principle of section 1.861-8 - that the allocation and apportionment of expenses must be made on the basis of the factual relationship of expenses to gross income - requires that both taxes be allocated and apportioned in a consistent fashion. The franchise tax, when based on entire net income, thus must be allocated and apportioned in accordance with the rules of section 1.861-8(e)(6).

  Under section 1.861-8(e)(6) of the regulations, which incorporates the principles of sections 1.861-8(a)(2) and (b)(2) of the regulations, the allocation of a deduction is to be made by first determining the activity from which the deduction resulted or to which the deduction was incident, or the property in connection with which the deduction was incurred. The deduction is then allocated to the class of gross income generated by that activity or that property. The State A franchise tax is incurred as the result of the activities that the state defines as taxable. The class of gross income generated by those activities is the income allocated to the state as a result of the state law definition of income and the application of the allocation percentages, even in situations in which that gross income includes income exempt or excluded from Federal income taxation. Section 1.861-8(d) of the regulations. This class of gross income is appropriate because there is (1) a direct factual relationship between the amount of income included in state taxable income and the activities taxable by the state and (2) a direct correlation between the amount of the tax and the amount of income in that class of gross income.

  Rev. Rul. 79-186 states that the New York franchise tax is determined by an allocation percentage that may result in deeming part of the taxpayer's net income to be derived from New York State for state tax purposes even though not connected with the conduct of a U.S. trade or business under Federal rules. Rev. Rul. 79-186 is incorrect to the extent that it holds that the entire amount of the New York franchise tax would be deductible even if imposed, in part, on non-effectively connected income. This result is contrary to the limitation on deductions contained in section 882(c)(1)(A) of the Code and section 1.882-4(c)(1) of the regulations and is inconsistent with section 1.861-8(d)(2) which explicitly requires the allocation of deductions to the class of gross income to which they relate - even to gross income not effectively connected to a U.S. trade or business. It is the prerogative of a state to consider foreign source portfolio dividends to be income generated in whole or in part from state business activities. However, when a state imposes a tax on an amount that exceeds the income that would be taxed if the state did not include non-effectively connected income in its computation, the tax imposed on such excess income is not a tax on effectively connected income and is not, therefore, deductible for Federal income tax purposes.

HOLDING

  The amount of the State A corporate franchise tax that is deductible by a foreign corporation under section 882(c)(1) of the Code is the amount allocated and apportioned to effectively connected income under section 1.861-8(e)(6) of the regulations. The total amount of the tax must be allocated to a class of gross income consisting of the income attributed under state law to the foreign corporation's activities in State A, and then apportioned between the effectively connected income and the non-effectively connected income in that class of gross income.

EFFECT ON OTHER RULINGS

  Rev. Rul. 79-186 is hereby revoked for taxable years ending on or after the date of publication of this ruling.

Rev. Rul. 87-64, 1987-2 C.B. 166, 1987-29 I.R.B. 1987