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New guidance for foreign tax credit allocation and apportionment of deductions

In May of 2021, the IRS released a practice unit for foreign tax credit allocation and apportionment of deductions. Practice units are training materials for IRS employees that provide specific guidance on certain tax issues. These practice units are not to be relied on as official regulations but are used more to assist IRS employees working through certain tax topics alongside other IRS materials and regulations. This new practice unit (found here https://www.irs.gov/pub/irs-utl/allocation_apportionment_deduct.pdf ) goes over the steps to determine the allocation and apportionment of deductions to the foreign tax credit claimed by individuals.

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The focus of this practice unit is how to figure the deductions on lines 2-4 of Form 1116, which offset the foreign source gross income to determine the foreign tax credit limitation. The limitation is calculated by taking the ratio of foreign source taxable income over worldwide taxable income and multiplying that by the U.S. income tax. Allocating and apportioning deductions to your foreign source income reduces the amount of foreign tax credit allowed (the foreign tax credit limitation).

Step One discusses the allocation of deductions to gross income. First, review the deduction to determine which category it belongs to. The practice unit defines these three categories:

  1. Definitely Related to a Class of Gross Income – Refers to whether a deduction is incurred as a result of, or incident to, an activity or in connection with property from which that income is derived. Treas. Reg. 1.861-8(b)(4).
  2. Definitely Related to All Gross Income – Refers to those deductions definitely related and allocable to all gross income. Treas. Reg. 1.861-8(b)(5).
  3. Not Definitely Related to Any Gross Income – Refers to deductions that are not definitely related to any gross income and, therefore, are ratably apportioned. Treas. Reg. 1.861-8(e)(9).

Step two is to apportion the deductions. If a deduction cannot be directly allocated to any gross income, it is apportioned based on a specific method. The method may be based on units sold, gross receipts, cost of goods sold, time spent, etc., and must be a reasonable method when comparing the relationship between the income and deduction. Specific methods are outlined in the regulations.

The practice unit then goes on to provide guidance on allocating and apportioning specific types of deductions, such as interest expense, state income taxes, charitable deductions and the standard deduction. Helpful examples are included for each category.

Lastly, the practice unit offers additional considerations and resources for the IRS employee to take in mind.

Please note this information is general in nature and should not be relied on.  Please contact a qualified tax advisor if you have any questions.

Jill A. Helm, CPA

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