In FDII Advice Memorandum, IRS Reverses Course in the Treatment of Deferred Compensation Expense
In a recently issued Chief Counsel Advice Memorandum, Generic Legal Advice Memorandum (GLAM) 2022-001, the IRS concluded that deferred compensation expense that is deductible in years subsequent to the enactment of the section 250 deduction for foreign-derived intangible income (FDII) but which relates to services provided in pre-FDII years should be allocated to FDII, even though FDII did not exist in the prior years to which the compensation relates. This position stands opposite to previous informal guidance issued by the IRS in the context of prior section 199, with the new GLAM stating that it "reflects the reconsidered advice" of the IRS and that prior guidance from 2009 is obsolete.
The fact pattern laid out in the GLAM envisions a corporation that compensates employees with certain restricted stock units (RSUs) that vest after four years of service. RSUs are generally treated as a deduction to the corporation and income to the service provider in the year they vest and are delivered. The GLAM observes that its analysis is not limited to deferred compensation; it may also apply to other payments that may relate to a period that is earlier than the period in which a deduction is allowed, such as warranty payments.
Under FDII regulations effective for tax years beginning after December 31, 2020, expenses are allocated and apportioned to gross deduction eligible income (DEI) and foreign-derived DEI (FDDEI) under the section 861 regulations. The GLAM addresses the position that because certain deferred expenses relate to gross income recognized in an earlier taxable year in which FDII did not exist, the current year's deduction for that expense should not be allocated to FDDEI.
The GLAM rejects this position in full. Noting that while the section 861 regulations "envision that a deduction may be factually related to a class of gross income even though no gross income is recognized in the current taxable year," the IRS finds that there is no authority for allocating a deduction to a particular grouping based on law applicable in a prior period or apportioned taking into account such prior period law. Instead, the IRS concludes that a deduction for deferred compensation expense must be allocated and apportioned to DEI and FDDEI in the year of the deduction. Even though the compensation may relate to services provided prior to the effective date of section 250, the IRS states that a taxpayer is not permitted to "depart from the normal rule that the deduction for such expense must be allocated to (and apportioned to groupings within) the class of gross income for the taxable year in which the deduction may be claimed."
The GLAM also takes the position that the same analysis applies even for tax years prior to the effective date of the FDII regulations. With respect to such tax years, the statutory language requires that DEI be reduced by deductions "properly allocable to such gross income," but the section 861 regulations do not expressly apply. According to the GLAM, the allocation and apportionment of a deduction is based on the factual relationship of the deduction to a class of gross income in the year of the deduction. Furthermore, the IRS states that no guidance or authority modifies the operation of income tax accounting provisions that require the computation of income and deductions for the current taxable year.
This result stands in contrast to guidance issued in 2009, which this GLAM explicitly disavows. In GLAM 2009-001, the IRS held that for purposes of the prior law section 199 deduction, currently deductible expenses that related to a tax year prior to the enactment of section 199 should be allocated based on whether the previous services ultimately generated receipts eligible for the section 199 deduction in the current taxable year. In the context of former section 199, the IRS had also issued a 2009 industry directive providing a safe harbor to taxpayers, allowing them to treat 90 percent of pre-period expenses (i.e., deductions related to services performed prior to the enactment of 199) as not allocable to domestic production gross receipts if certain conditions are met.
As evidenced by its reference to warranty expense, the GLAM has potential implications beyond the context of deferred compensation. In support of its conclusion, the GLAM points to an example in the 2020 section 861 regulations involving the allocation and apportionment of expenses stemming from the payment of legal damages from a warehouse disaster that occurred in a prior year. These section 861 regulations also address the allocation and apportionment of deductions for product liability claims and other claims for damages. The IRS had previously concluded in 2017 that legal fees related to product liability claims from sales that arose prior to the enactment of prior section 199 were not allocable to domestic production gross receipts. Expenses such as these that straddle the effective date of a change in law should be reviewed in light of the recent GLAM.
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