Foreign Tax Credit - Associating Deductions With Income

Associating Deductions With Income

Where a system limits the credit based on domestic tax generated by foreign source net income, it must provide a mechanism for determining net income subject to home country tax, including associating deductions or exclusions with income for such purpose. Such mechanisms tend to be complex or rely on local accounting rules or judgments. The process of associating deductions with income is referred to allocation and apportionment in some jurisdictions.

Most rules rely to some extent on factual relationships between deductions and income produced by incurring the deduction. Thus, all deductions related to producing a set of income would be allocated to that set of income. To the extent a particular set of income includes both foreign and domestic income, the deductions so allocated are then apportioned in some manner in some systems. Canadian rules require that deductions reasonably regarded as wholly allocable to income form a particular place be allocated thereto, as well as that portion of other deductions reasonably regarded as applicable to that income. Under U.S. rules, apportionment of most deductions may be done based on relative sales, gross income (sales less cost of goods sold), space used, headcount, or some other rational and systematic basis.

The U.S. has rules requiring that certain deductions be apportioned among all income on a formulary basis. These rules are quite complex. Interest expense must be apportioned based on relative adjusted tax basis of assets that produce or could produce the particular type of income. Research and experimentation expenses must be apportioned based on either relative sales or relative gross income. Taxpayers must elect which base to use, and such election applies for five years. State income taxes must be apportioned based on complex formulae. Stewardship and supportive expenses must each be allocated and apportioned under one of several methods. Note that few other countries have developed rules to this level of complexity and specificity.