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.