IRS and Treasury Request Comments on Financial Services Income and Entities under Treas. Reg. § 1.904-4(e)

International Tax Alert

The IRS and Treasury released Notice 2007-58 requesting comments on whether the provisions of Treasury Regulation § 1.904-4(e) relating to the definitions of financial services income, active financing income, or financial services entities should be modified due to legal or economic developments since the regulation’s original publication in 1988. Specifically, comments are requested on whether any items currently listed as “active financing income” under Treasury Regulation § 1.904-4(e)(2)(i) are over-inclusive or underinclusive and whether any of the listed items should be clarified as applying only to transactions involving customers.
The scope of these regulations is critical to foreign tax creditability of taxpayers that engage in financial activities in addition to other active business operations. First, the regulations limit the scope of income and related credits that will roll into the “active” basket. Second, beginning in 2009 the regulations will be relevant to the appropriate allocation and apportionment of interest expense for purposes of the foreign tax credit, the manufacturing deduction under Code section 199, and other purposes.

Foreign Tax Credit Rules

The extent to which a taxpayer can credit foreign taxes depends on the foreign tax credit limitation, which is computed separately with respect to income in each limitation basket. The taxpayer’s ability to credit foreign taxes may be enhanced where high- and low-taxed foreign income are combined in the same limitation basket. The American Jobs Creation Act of 2004 (AJCA) generally reduced the number of limitation baskets under Code section 904(d) from eight to two. As a result, income that previously would have been assigned to the financial services income basket is now treated as general category income for members of a financial services group or other persons predominantly engaged in the active conduct of a financing business. A person is considered to be predominantly engaged in the active financing business for any year if at least 80 percent of its gross income for that year is “active financing income,” as defined in Treasury Regulation § 1.904-4(e)(2). As such, changes to the scope of the “active financing income” definition could broaden or limit the amount of such income that is treated as in the general category, as opposed to passive, income basket for purposes of the foreign tax credit, and therefore could affect the ability of taxpayers to credit foreign taxes on such income.

Interest Expense Allocation Rules

The AJCA also modified the interest expense allocation rules under Code section 864 to provide a one-time election in 2009 to allocate and apportion interest expense of the domestic members of a worldwide affiliated group on a worldwide-group basis. See Code section 864(f). Taxpayers may apply financial institution group rules to treat certain financial institutions as a separate affiliated group under this approach. Alternatively, the AJCA also provides a one-time election in 2009 to expand the financial institution group to include “financial corporations,” i.e., any corporation if at least 80 percent of its gross income is “financial services income” (as described in Code section 904(d)(2)(D)(ii) and the regulations thereunder) derived from transactions with persons who are not related to the corporation. See Code section 864(f)(5). Thus, changes to the definition of “financial services income” would affect the composition of the financial institution group, which in turn could affect interest expense allocation. In particular, the segregation of interest expense from financial services activities could lead to more appropriate foreign tax credit results and could increase the benefit of the section 199 manufacturing deduction.

Taxpayers, in particular those that conduct consumer financing in conjunction with a main, non-financial service business, should consider submitting comments in connection with Notice 2007-58 relating to the potential effect that a modification to “active financing income” could have on their foreign tax credit position, including ancillary consequences for their manufacturing deduction and other tax attributes. Comments are due by September 10, 2007.

For further information, please contact any of the following lawyers:

Rocco Femia,, 202-626-5823

Marc Gerson,, 202-626-1475

Kimberly Majure

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