Chapter 10 Foreign Investment Interest Offset Contents: 10.1 In General 10.2 Form FTB 2424 10.3 Overview – Federal Law 10.4 PASS Schedules 10.5 Audit Tips 10.1 In General a. The Foreign Investment Interest Offset b. Computation on a Combined Basis c. Intercompany Adjustments d. Forms a. The Foreign Investment Interest Offset Revenue and Taxation Code (R&TC) §24344(c) provides that interest expense incurred for purposes of foreign investments may offset dividends deductible under R&TC §24411. The purpose of the foreign investment interest offset is to offset the water's-edge group's R&TC §24411 dividend deduction by interest expense attributable to foreign investments. The underlying theory being one of "matching" income and expense. In other words, interest expense incurred to carry an investment that generates income which is not included in the measure of tax should be "matched" with the nontaxable income, and should be excluded. Before computing the foreign investment interest offset, compute the R&TC §24411 dividend deduction. If the water's-edge group does not claim an R&TC §24411 dividend deduction, then there would be no foreign investment interest offset. It is important to note that the foreign investment interest offset is limited to the LESSER of: 1. Interest expense attributable to foreign investments. 2. The water's-edge group's R&TC §24411 dividend deduction. Total interest expense paid or incurred by the water's-edge group is specifically allocated or assigned by formula between foreign and domestic investments. The total interest expense attributable to foreign investment is subject to the foreign investment interest offset, which is a direct adjustment to net income after state adjustments. Interest expense, subject to the foreign investment interest offset, is equal to the sum of: • Interest expense allocated to specific foreign investment; plus • Unassigned interest expense allocated to foreign investment. The computation of the foreign investment interest offset is a two-step process: • First, the taxpayer determines if any interest is specifically assignable to either domestic or foreign investments. • Second, any remaining interest not specifically assignable is allocated between domestic and foreign investments based on a ratio. (CCR §24344(c) (5).) The ratio is the group's foreign investments to total assets: Unassigned Pool of Interest Expense Foreign Unassigned Assigned to x Investment = Interest Foreign Unassigned Expense Investment Total Assets The foreign investment interest offset is the sum of the amount of interest specifically assignable to foreign investments plus the amount allocated to foreign investment by formula. However, the amount of the offset may not exceed the R&TC §24411 dividend deduction. For taxable years beginning on or after January 1, 1997, the foreign investment interest offset as calculated above is multiplied by the same percentage that was used to determine the dividend deduction under R&TC §24411, usually 75 percent. (R&TC §24344(c)(2).) b. Computation on a Combined Basis The interest offset is computed on a combined basis, not a separate entity basis. Authority for computing the foreign investment interest offset on a combined basis can be found in the regulatory requirement to eliminate intercompany accounts of interest and assets from the offset computation. (CCR §24344(c)(2)(B)(3) and CCR §24344(c)(2)(C)(3).) The reason for the eliminations is to avoid double counting that would otherwise occur in a combined offset computation. The fact that the regulation requires these adjustments clearly indicates a requirement to compute the offset on a combined basis. If the offset were required to be computed on a separate entity basis, there would be no reason to make the intercompany account adjustments. Additional authority can be found in the California Supreme Court's decision in Pacific Telephone and Telegraph Co. v. Franchise Tax Board (1972) 102 Cal. Rptr. 782. In that case, the FTB computed the interest offset adjustment (R&TC §24344(b)) on a group basis. The taxpayer argued that the computation should be done on a separate entity basis. The court found that FTB's computation of the offset on a group basis was supported by the statute and rejected the single entity argument made by the taxpayer. The court's reasoning is equally applicable to the foreign investment interest offset provision of CCR §24344(c). c. Intercompany Adjustments In preparing a water's-edge combined report, intercompany accounts of assets, liabilities, equities, income, costs and expenses may be required to be eliminated in whole or in part, to properly reflect net income and apportionment factors in a combined report. For partially included entities, intercompany transactions are eliminated only to the extent of the amounts actually included in the water's-edge combined report. In general, the elimination of intercompany accounts of expense, assets and equities for purposes of R&TC §24344(c) will not increase or decrease the net income that would otherwise be taken into account for any entity, except as provided under R&TC §24344(c), (CCR §25106.5-1.) The purpose of the elimination is to avoid taking into account the subject item more than once in a combined report. The following example shows that, while a CFC and US entity may have intercompany transactions, the intercompany elimination is limited by the CFC's partial inclusion ratio. Example 1 P and S are affiliated corporations included in the water's-edge combined report under R&TC §25110(a)(1)(C) and (a)(2)(A)(ii). P has net income of $500. S has net income of $300 and a ratio of Subpart F income to earnings and profits (E&P) for the taxable year of 1/3. P incurs $30 of interest expense paid to S, of which $10 ($30 x 1/3) is considered an intercompany account. It is determined that $10 of P's interest expense is an intercompany account to be eliminated for purposes of calculating the foreign investment interest offset. (See WEM 14 for a detailed discussion of the proper treatment of intercompany transactions in the water's-edge combined report.) The combined net income of P and S is determined as follows. Combined Net Income: Corp P & S Net income of P $500 Net income of S ($300 multiplied by 1/3) $100 Combined net income before offset $600 Combined Net Income With Intercompany Adjustment: Corp P Corp S Total Net income $500 $100 Intercompany interest adjustment + 10 - 10 Net income $510 $ 90 = $600 For purposes of determining the interest offset, $10 of P's interest expense is considered to be intercompany and $10 S's interest income is considered to be intercompany. These amounts are eliminated in the computation of interest offset. However, the combined net income is not increased or decreased by intercompany interest expense. d. Forms The water's-edge group's foreign investment interest offset appears in the following forms: • FTB 2424 Water’s-Edge Foreign Investment Interest Offset • Schedule R Line 1b, Water’s-edge foreign investment interest offset from Form FTB 2424, Lin 17 10.2 Form FTB 2424 a. Form FTB 2424, Line 1 - R&TC §24411 Dividend Deduction b. Form FTB 2424, Line 2 - Total Interest Expense c. Form FTB 2424, Lines 3 and 4, Specifically Assigned Interest d. Form FTB 2424, Line 5 - Unassigned Interest Expense e. Form FTB 2424, Line 11 - Unassigned Foreign Investment f. Form FTB 2424, Line 12 – Unassigned Total Assets g. Form FTB 2424, Lines 13, 14, 15, 16 and 17 a. Form FTB 2424, Line 1 – R&TC §24411 Dividend Deduction The R&TC §24411 dividend deduction is the amount determined on Schedule H (100W), which flows up to California Form 100W or Form 100S as a state adjustment. If there is no R&TC §24411 dividend deduction claimed or allowed, then there will be no foreign investment interest offset. The foreign investment interest offset is limited to the lesser of interest expense attributable to foreign investments, or the R&TC §24411 dividend deduction allowed. It may not exceed the total R&TC §24411 dividend deduction. (CCR §24344(c)(3)(A).) b. Form FTB 2424, Line 2 – Total Interest Expense Total interest expense includes all interest expense incurred or paid within the taxable year by any bank or corporation, to the extent the entity is included in the water's-edge combined report (CCR §24344(c)(2)(B).) Total interest expense should reconcile to the financial statements of the entities included in the combined report and to their books and records. The computation is done on an aggregate basis for the entire water's-edge group. Total interest includes: 1. All interest expense paid or incurred by entities included 100 percent in the water's-edge combined report, which includes the following entities: • US incorporated banks and corporations that are owned more than 50 percent by the same interests. • Domestic International Sales Corporations, Foreign Sales Corporation and Export Trade Corporations. • Any corporation, regardless of where incorporated, whose average property, payroll, and sales in the US are 20 percent or more. Interest expense can generally be found on California Form 100W, Schedule F, line 18, Federal Form 1120, page 1, line 18, and Federal Form 1118, Schedule H, Part II, Column (b), line 1a. 2. Interest expense included in the combined report that is paid or incurred by partially included entities. Partially included entities may include the following entities: • Controlled Foreign Corporations (CFCs) with Subpart F Income A CFC’s total interest expense will be included to the extent of the ratio of its Subpart F income to its current year E&P (CCR §24344(c)(2)(B)(2)(b).) CFCs report interest expense on Federal Form 5471, Sch.