Recently issued legal advice by the Internal Revenue Service (IRS)’s Office of Chief Counsel discusses how to allocate and apportion certain deferred compensation expenses (DCE) relating to services provided before the effective date of the Foreign-Derived Intangible Income (FDII) provisions. Below are the highlights.
Allocation and Apportionment
When determining FDII, taxpayers must first determine the factual relationship between a deduction and a class of gross income. Then, it must be determined how to apportion that deduction to a statutory and residual income grouping within that gross income class. The taxpayer’s apportionment method must closely reflect the factual relationship between the deduction and gross income grouping.
Details on DCE
Although a DCE may relate to gross income derived by the taxpayer in a previous tax year, it must be allocated to a class of gross income. From there, it must be apportioned based on the relevant grouping(s) within the class that exists in the tax year deductions are taken.
Under general federal income tax principles, the law in effect for the tax year in which deductions are taken is applied when determining how deductions relate to a class of gross income. This includes determining which statutory groupings are relevant to apportionment of expenses within such class and the manner of apportionment.
Facts of a Case
The example given in the Legal Advice states if Corporation X is an accrual basis taxpayer with a calendar tax year, the sole class of gross income is sales of Product A. Beginning in 2018, Corporation X claimed the Sec. 250 FDII deduction.
For purposes of the FDII deduction, most of the corporation’s gross income in 2018 and later is deduction-eligible income (DEI). The corporation claims a sizable portion of that DEI income as foreign-derived deduction-eligible income (FDDEI).
Since 2014, Corporation X has compensated employees with stock-settled restricted stock units (RSUs). Corporation RSUs are designed to reward and retain employees over several years and vest after four years of continuous service. The terms of the RSU provide that delivery of substantially vested shares will occur on the date that the vesting condition is satisfied.
Corporation X claims some portion of the deductible RSU expenses for 2018 and later factually relate to a tax year before Sec. 250’s effective date and, therefore, may be allocated to residual income.
Chief Counsel’s Conclusion
Based on the above facts, the Office of Chief Counsel determined that Corporation X’s DCE deductions must be apportioned between DEI and FDDEI because those are the classes of gross income to which the 2018 DCE deduction relates. Any other approach would violate the requirements in the temporary regulations.
By claiming its DCE expense may be allocated solely against residual income, rather than apportioned, Corporation X is attempting to apply the federal income tax law of an earlier period to such expense, which distorts the amount of FDDEI.
Where To Go from Here
If you have a deferred compensation and FDII issue, consider discussing the ramifications of the legal advice with a Moore Doeren Mayhew advisor to determine whether and how it might affect your tax situation. Contact us today.