Rev. Rul. 87-65,1987-2 C.B. 173.

Published: 1987

FOREIGN TAX CREDIT; LIMITATION; CORPORATE FRANCHISE TAX

SECTION 904--LIMITATION ON CREDIT, 26 CFR 1.904-1: Limitation on Credit for Foreign Taxes.

(Also Section 861; 1.861-8.)

  Foreign tax credit; limitation; corporate franchise tax. A state corporate franchise tax must be allocated and apportioned under section 1.861-8(e)(6) of the regulations between foreign source and U.S. source income includable in the state tax base for purposes of computing the foreign tax credit limitation under section 904 of the Code.

ISSUE

  How is the deduction for a state-imposed corporate franchise tax to be allocated and apportioned for purposes of computing a taxpayer's foreign source taxable income for purposes of the foreign tax credit limitation under section 904 of the Internal Revenue Code?

FACTS

  Taxpayer is a domestic corporation organized under the laws of State A. It operates a unitary (integrated) business in the United States (including State A) and in a number of foreign countries, either directly or through wholly owned subsidiaries.

  State A imposes a franchise tax on corporations for the privilege of doing business or exercising a corporate franchise in the state. 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 amount of the entire net income attributed to Taxpayer's activities in State A 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 fraction 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 foreign source dividends in the definition of worldwide business income that is subject to allocation, but does not include any factors relating to the foreign corporations paying those dividends when computing the state business allocation fraction. The state's inclusion of these portfolio dividends (without factors) increases Taxpayer's state taxable income, and the increased amount is entirely from foreign sources.

LAW AND ANALYSIS

  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. 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. Section 1.861-8(a)(2) and (b)(2). 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) 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) and is consequently subject to the allocation and apportionment rules of section 1.861-8(e)(6). See Rev. Rul. 87-64, this bulletin. Under section 1.861-8(e)(6), the deduction for the franchise tax is definitely related and allocated to the gross income on which the tax is imposed, and must be apportioned between the statutory and residual groupings of foreign source and U.S. source income contained therein for purposes of computing the foreign tax credit limitation under section 904.

  Rev. Rul. 79-186, 1979-1 C.B. 238, discusses the allocation and apportionment of state franchise taxes in determining the amount of a foreign corporation's deduction for the New York State 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 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.

  Rev. Rul. 79-186 does not address the allocation and apportionment of deductions for purposes of computing the section 904 foreign tax credit limitation of a U.S. corporation and thus has no relevance with respect to this issue.

HOLDING

  For purposes of computing the section 904 foreign tax credit limitation, a state-imposed corporate franchise tax must be allocated and apportioned between the foreign source and U.S. source income includable in the state tax base. Section 1.861-8(e)(6) of the regulations must be applied in making this allocation and apportionment.

Rev. Rul. 87-65, 1987-2 C.B. 173