United States: Recent IRS Guidance clarifies the allocation and apportionment of deferred compensation expense in the context of FDII

August Tax News and Developments

In brief

On 3 May 2022, the IRS issued general legal advice memorandum (GLAM) 2022-001, which addresses the proper method of allocating and apportioning deferred compensation expense (DCE) in the context of the foreign derived intangible income (FDII) regime, where the DCE relates to activities that occurred prior to the effective date of the regime.


In more detail

Section 861 and the section 861 regulations provide that a taxpayer allocates a deduction to a class of gross income, and then, if necessary, apportions that deduction between the statutory and residual groupings of gross income within that class. The taxpayer must determine the factual relationship of the deduction to income for the taxpayer to properly allocate and apportion the deduction. The taxpayer must allocate the deduction to the relevant class, and must apportion the deduction between the relevant groupings, even if there is no gross income in the class/groupings in the taxable year in which the deduction arises.

As readers will recall, in the 2017 Tax Cuts and Jobs Act (TCJA), Congress enacted section 250, which allows a domestic corporation to deduct a fixed percentage of its FDII. Specifically, a taxpayer’s FDII deduction is equal to the product of this fixed percentage (currently 37.5%) and the portion of the taxpayer’s deduction eligible income (DEI) equal to the ratio of the taxpayer’s foreign-derived deduction eligible income (FDDEI) over its DEI. DEI is the excess of a domestic corporation’s gross income, determined without regard to certain excluded categories of income listed in section 250(b)(3)(A)(i), over the deductions properly allocable to such gross income. FDDEI is generally a subset of DEI that is derived from sales of property to a foreign person for a foreign use or services provided to a person, or with respect to property, located outside of the United States. Gross DEI that is not FDDEI is often referred to as gross residual deduction eligible income (RDEI). The FDII regime is effective for taxable years beginning after 31 December 2017.

Treas. Reg. section 1.861-8(f)(1)(vi)(N) establishes section 250(b) as an “operative section” for purposes of apportioning expenses to determine DEI and FDDEI. In other words, for FDII purposes, a taxpayer allocates expenses to a class of gross income and then apportions those expenses among RDEI and FDDEI as the statutory groupings under the section 861 regulations. To the extent expenses relate to income that is excluded from DEI under section 250(b)(3)(A)(i)(I) through (VI), the taxpayer apportions those expenses to the residual grouping(i.e., non-DEI), and those expenses do not offset gross DEI or FDDEI.

In GLAM 2022-001, a calendar-year taxpayer manufactured and sold Product A. Income from sales of Product A was the taxpayer’s sole class of gross income. Beginning in 2018, the taxpayer claimed the FDII deduction pursuant to section 250.

The taxpayer compensated its employees with restricted stock units (“RSUs”). Each stock-settled RSU represented a promise by the taxpayer to deliver one or more shares of stock to the relevant employee at a future date following a specified vesting condition.

The DCE in GLAM 2022-001 related to RSUs which vested on or after 1 January 2018, but were granted to the taxpayer’s employees before 1 January 2018. Thus, the DCE arising from the RSUs could accrue on or after 1 January 2018 (i.e., after the effective date of the FDII regime), although some or all services to which the RSUs related were performed before 1 January 2018.

The taxpayer took the position that DCE attributable to RSUs that vested post- 1 January 2018 but related to pre- 1 January 2018 services, and which was both allocable to the taxpayer’s sole class of gross income (income from sales of Product A) and not definitely related to non-DEI, should nevertheless still be apportioned to the residual grouping (non-DEI) and thus should not reduce RDEI or FDDEI for purposes of computing the taxpayer’s section 250 deduction. The taxpayer asserted that this DCE should not be treated as apportionable to income in a statutory grouping under an operative section that did not exist when the relevant employee activities occurred.

The IRS disagreed. The IRS instead concluded that DCE that has a factual relationship to income that falls in the RDEI and FDDEI groupings (i.e., the activities to which the DCE relates were in some way responsible for generating this income) must be apportioned between those groupings, regardless of the fact that the activities themselves occurred before the enactment of FDII. Simply put, from the IRS’s perspective, nothing in section 861 or the section 861 regulations changes the year in which an expense accrues. When the expense accrues, the expense must be allocated and apportioned pursuant to the law in force in the accrual year. If the expense has the requisite factual relationship to particular income, the expense effectively attaches to that income; the fact that the governing law categorizes that income in a way that is different from how the law might have categorized that income previously is irrelevant.

Contact Information

Copyright © 2023 Baker & McKenzie. All rights reserved. Ownership: This documentation and content (Content) is a proprietary resource owned exclusively by Baker McKenzie (meaning Baker & McKenzie International and its member firms). The Content is protected under international copyright conventions. Use of this Content does not of itself create a contractual relationship, nor any attorney/client relationship, between Baker McKenzie and any person. Non-reliance and exclusion: All Content is for informational purposes only and may not reflect the most current legal and regulatory developments. All summaries of the laws, regulations and practice are subject to change. The Content is not offered as legal or professional advice for any specific matter. It is not intended to be a substitute for reference to (and compliance with) the detailed provisions of applicable laws, rules, regulations or forms. Legal advice should always be sought before taking any action or refraining from taking any action based on any Content. Baker McKenzie and the editors and the contributing authors do not guarantee the accuracy of the Content and expressly disclaim any and all liability to any person in respect of the consequences of anything done or permitted to be done or omitted to be done wholly or partly in reliance upon the whole or any part of the Content. The Content may contain links to external websites and external websites may link to the Content. Baker McKenzie is not responsible for the content or operation of any such external sites and disclaims all liability, howsoever occurring, in respect of the content or operation of any such external websites. Attorney Advertising: This Content may qualify as “Attorney Advertising” requiring notice in some jurisdictions. To the extent that this Content may qualify as Attorney Advertising, PRIOR RESULTS DO NOT GUARANTEE A SIMILAR OUTCOME. Reproduction: Reproduction of reasonable portions of the Content is permitted provided that (i) such reproductions are made available free of charge and for non-commercial purposes, (ii) such reproductions are properly attributed to Baker McKenzie, (iii) the portion of the Content being reproduced is not altered or made available in a manner that modifies the Content or presents the Content being reproduced in a false light and (iv) notice is made to the disclaimers included on the Content. The permission to re-copy does not allow for incorporation of any substantial portion of the Content in any work or publication, whether in hard copy, electronic or any other form or for commercial purposes.