Global Tax Alert | 11 September 2013

US Chief Counsel Advice issued on interest expense allocation and apportionment for foreign tax credit purposes under Code Section 864(e)

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Executive summary

On 9 September 2013, the Office of Chief Counsel of the Internal Revenue Service (IRS) released an advice memorandum dated 14 May 2013, (CCA 201336018) concluding that, for interest expense allocation and apportionment purposes, the adjusted basis of the shares of a related foreign corporation should not be reduced under Temp. Reg. Section 1.861-12T(f) by the principal amount of a loan payable, the interest on which the taxpayer could pay with shares of such foreign corporation. Notwithstanding the taxpayer's position that the literal language of the regulation did not require the loan proceeds to have been used to fund the adjusted basis in the associated property (in this case, the shares of the foreign corporation), the IRS concluded Temp. Reg. Section 1.861-12T(f) should be read narrowly, as illustrated by the example in the regulations, and applied consistent with its underlying intent.


In the facts of the CCA, one member of a consolidated group (US Corp 2) was indebted to another member of the same consolidated group (US Corp 1). Under the terms of the loan, interest was payable on an annual basis either in cash or, at the discretion of US Corp 2, in shares of its wholly owned foreign subsidiary (F Corp 1). In relevant part, the common parent of the consolidated group (Taxpayer) determined that interest expense deductions were disallowed on the loan under Section 163(l) because US Corp 2 had the option to pay interest with shares of F Corp 1 and, more importantly, US Corp 2's adjusted basis in its shares of F Corp 1 was reduced by the principal amount of the loan payable under Treas. Reg. Section 1.861-12T(f), because interest expense deductions on the loan were disallowed “in connection with” shares of F Corp 1 under Section 163(l).

CCA position

The CCA disagrees with the Taxpayer's application of Treas. Reg. Section 1.861-12T(f) to reduce the adjusted basis of the shares of F Corp 1 for interest expense apportionment purposes. The IRS considered the Taxpayer's position as an overbroad interpretation of the language of Treas. Reg. Section 1.861-12T(f). The CCA further states that the regulation requires more of a connection between the principal amount of the loan on which the interest is disallowed and the asset whose basis is being reduced, in this case the shares of F Corp 1.

Treas. Reg. Section 1.861-12T(f) provides that, in the case of “any asset in connection with which interest expense accruing at the end of the taxable year is capitalized, deferred, or disallowed under any provision in the Code,” the adjusted basis (or fair market value, depending on the taxpayer's choice of apportionment methods) of such asset is reduced by the principal amount of indebtedness, the interest on which is capitalized, deferred or disallowed.

Under the IRS's view, the principle purpose of the regulation is to reduce the basis in property to the extent a portion of interest and underlying indebtedness has been specifically tied to such property (or portion thereof), noting that otherwise it would be inappropriate to further allocate and apportion other interest to such property (or portion thereof). As stated in the CCA, the IRS believes this principle is illustrated through the example provided within the regulation involving the capitalization of interest under Section 263A. The capitalization rules of Section 263A require, among other things, the capitalization of interest costs on debt that are related to the production of an asset. The IRS states that capitalizing interest under Section 263A is done by methods required under such section to connect the loan principal with the production costs of a specific asset, thus directly tying such obligation and interest to the specific asset.

The IRS stated it did not believe the principles of Treas. Reg. Section 1.861-12T(f) applied to the Taxpayer's facts. The only connection the IRS thought existed between the shares of F Corp 1 and the disallowed interest under Section 163(l) resulted from a provision within the Loan Agreement, which the IRS noted could have been drafted to allow interest to be paid in the form of shares of US Corp 2 or another related party. Such interest would be disallowed regardless of whether the proceeds were contributed to or invested in F Corp 1. Moreover, the Service reasoned, the amount of indebtedness on which the interest is disallowed under Section 163(I) is not tied in any way to the basis in F Corp 1.

Finally, the IRS stated that the Taxpayer's interpretation of “in connection with” was overly broad and therefore, not in keeping with the general policies of the interest allocation and apportionment rules of Section 864(e), which requires, based on Treas. Reg. Section 1.861-9T(a), the allocation and apportionment of interest to be based on an approach that money is fungible and interest is attributable to all activities, regardless of any specific purpose for incurring an obligation on which the interest is paid. The IRS further argued that Congress endorsed such a fungibility principle when it stated in the 1986 House Ways and Means Committee Report that, “[w]ith limited exceptions, the committee believes that it is appropriate for taxpayers to allocate and apportion interest expense on the basis that money is fungible.”1

The IRS noted that Treas. Reg. Section 1.861-10T provides exceptions to the general policy, but argued such exceptions are limited and should be applied narrowly, as each of these exceptions are drafted with numerous requirements and exceptions. As a result, the IRS states that these exceptions apply in very limited situations and, in its view, establish the intent that any exception to the general policy of fungibility should be applied in limited circumstances. Following this line of thinking, the IRS concluded that Temp. Treas. Reg. Section 1.861- 12T(f) should similarly be read to provide only a narrow exception to the general policy. Therefore the IRS disagreed with Taxpayer's interpretation of Temp. Treas. Reg. Section 1.861-12T(f), finding that it was an inappropriately broad exception to fungibility.


The CCA provides some guidance to taxpayers by demonstrating how the IRS interprets an exception to the general interest expense and apportionment rules, which it believes should be construed narrowly, focusing on the intent of the regulations rather than the literal language of the rules.

More importantly, the CCA highlights what appears to be the IRS's heightened focus on whether transactions undertaken by taxpayers are in keeping with the purpose and intent of the Code and regulations. It is another in a series of recent positions articulated by the IRS in the international tax area.2


1. H.R. Rep. No. 99-426, at 374 (1986). See also S. Rep. No. 99-313, at 348 (1986) (mentioning qualified nonrecourse indebtedness exception); H.R. Conf. Rep. No. 99-841, at II-606 (1986) (mentioning integrated financial transactions exception).

2. See ILM 201320014, released May 13, 2013, in which the IRS applied both the substance-over-form and step transaction doctrines to deny a US corporate taxpayer the use of the dividends received deduction.

For additional information with respect to this Alert, please contact the following:

Ernst & Young LLP, International Tax Services
  • Jose Murillo, Washington, DC
    +1 202 327 6044
  • Donna Siemaszko, New York
    +1 212 773 1908
  • Preya Patel, Washington, DC
    +1 202 327 7476
  • Maria Martinez, Washington, DC
    +1 202 327 8055

EYG no. CM3798