IRS ISSUES FINAL REGS ON ALLOCATING DEDUCTIONS FOR STATE INCOME TAXES.

SUMMARY: The Service has issued final regulations under section 861 (TD 8337) on the allocation and apportionment of deductions for state income taxes in computing taxable income from sources inside and outside the United States. The regulations continue to be grounded in the principle that a deduction is to be allocated and, if necessary, apportioned, based on the factual relationship of the deduction to gross income. In response to comments, the rules have been revised to state more clearly that certain examples contained in the regulations do not provide exclusive methods of allocating and apportioning the deduction for state income taxes. In addition, new examples have been added. The regulations also contain two safe harbor methods that can be elected for allocating and apportioning state income tax deductions. The regulations are generally effective for tax years beginning after 1976; however, some examples contained in the rules are effective for tax years beginning on or after January 1, 1988, and the new elective safe harbors are effective for tax years ending after March 12, 1991.

The Service reports that several commentators argued that the deduction for state franchise taxes computed by referring to state taxable income should be allocated to a class of gross income consisting only of income from sources within the United States. But the Service says that it rejected this approach in the final rules. The Service also rejected assertions that the deduction for state income taxes must be allocated solely to income from sources within the United States because the states are not constitutionally permitted to tax income from sources outside the United States. The Service says that this argument reflects a misinterpretation of U.S. Supreme Court cases. The final regulations also reject the position of taxpayers who argued that a state income tax should be considered an additional cost of doing business and should be allocated by reference to income that is considered under federal tax principles to be derived from that business, without regard to whether the state imposes its tax on income using federal tax principles.

The Service has noted that it received several comments on the application of the regulations to deductions for income taxes imposed by states that have adopted a unitary business theory of income taxation. Commentators have suggested that the regulations improperly allocate and apportion the deduction to income other than that of the taxpayer corporation in the case of a deduction for income tax imposed by a state that uses the unitary business theory. The Service says that it rejected this argument because it does not recognize that the unitary business theory takes into account the income, assets, and other factors of a group of affiliated corporations solely for purposes of determining the amount of taxable income that is properly attributable to the corporations over which the state has taxing jurisdiction. The Service says that the application of formulary apportionment under a unitary business theory is simply one method of allocating the income of multinational enterprises among their component parts.

The final regulations reserve an area for possible simplified methods for dealing with the effect of redeterminations of state income tax liability following an allocation of the state income tax deduction. The Service says that a taxpayer is generally required to recompute its allocation and apportionment when state income tax liability is redetermined. But it is considering an approach that would permit a taxpayer to perform this recomputation on the basis of a method other than the one used for the initial allocation. The Service says that it is also considering a rule that would allow the deduction for state income tax in the tax year of redetermination to be allocated under the final regulations using information for the year of redetermination. The Service requests comments on these approaches and alternative approaches. The comments should be sent to Commissioner of Internal Revenue, Attention CC:CORP:T:R (INTL- 0009-91), Washington, DC 20224.

For further information on the final regulations, contact David F. Chan of the Office of Associate Chief Counsel (International), Internal Revenue Service, Attention CC:CORP:T:R (INTL-112-88), 1111 Constitution Ave., NW, Washington DC 20224 or telephone 202-566- 6645.

ACTION: Final Regulations.

SUMMARY: This document contains final Income Tax Regulations relating to the allocation and apportionment of deductions for state income taxes in computing taxable income from sources inside and outside the United States. These regulations are issued under the authority contained in section 7805 (26 U.S.C. 7805) of the Internal Revenue Code of 1986.

EFFECTIVE DATES: These regulations are effective for taxable years beginning after December 31, 1976, except as follows:

Section 1.861-8(e)(6)(ii) (other than

SUPPLEMENTARY INFORMATION:

PAPERWORK REDUCTION ACT

These regulations are being issued without prior notice and public comment pursuant to the Administrative Procedure Act (5 U.S.C. section 553). For this reason, the collections of information contained in these regulations have been reviewed and, pending receipt and evaluation of public comments, approved by the Office of Management and Budget under control number 1545-1224.

Comments concerning the collections of information and the accuracy of estimated average annual burden, and suggestions for reducing this burden should be directed to the Office of Management and Budget, Attention Desk Officer for the Department of the Treasury, Office of Information and Regulatory Affairs, Washington, D.C. 20503, with copies to the Internal Revenue Service, Attention: IRS Reports Clearance Officer, T:FP, Washington, D.C. 20224.

The collections of information in these regulations are in sections 1.861-8(e)(6)(ii)(C)(2), and 1.861-8(e)(6)(ii)(D). The information in section 1.861-8(e)(6)(ii)(C)(2) is required by the Service to serve as disclosure of the relevant facts affecting the treatment of the allocation and apportionment of the deduction for state income taxes. This information will be used to monitor compliance with the regulations. The information in section 1.861- 8(e)(6)(ii)(D) is required by the Internal Revenue Service to enable taxpayers to make an election to use safe harbor methods of allocating and apportioning the deduction for state income taxes. This information will be used to monitor compliance with the terms of the safe harbor methods. The likely respondents are businesses or other for profit institutions.

These estimates are an approximation of the average time expected to be necessary for a collection of income. They are based on such information as is available to the Internal Revenue Service. Individual respondents may require greater or less time, depending on their particular circumstances.

Estimated total annual reporting burden: 1000 hours.

The estimated annual burden per respondent varies from thirty minutes to one hour and thirty minutes, with an estimated average of one hour.

Estimated number of respondents: 1000.

Estimated annual frequency of responses: Annually.

BACKGROUND

On December 12, 1988, the Federal Register published a notice of proposed rulemaking by cross-reference to temporary regulations (53 F.R. 49893 [INTL-41-88, 1989-1 C.B. 1025]) and temporary regulations (53 F.R. 49873 [T.D. 8236, 1989-1 C.B. 228]) amending the Income Tax Regulations (26 CFR Part 1) under sections 861(b), 862(b), and 863(a) of the Internal Revenue Code of 1986. The notice restated and clarified the general principles applicable to the allocation and apportionment of the deduction for state, local and foreign income, war profits and excess profits taxes (herein "state income taxes"), and provided five specific examples of an appropriate method for the allocation and apportionment of the deduction for state income taxes.

Written comments responding to the notice were received. A public hearing was held on May 18, 1989. After consideration of all comments regarding the notice, that notice is adopted by this Treasury Decision. The significant points raised by the comments and the revisions are discussed below.

EXPLANATION OF PROVISIONS

SECTION 1.861-8

SECTION 1.861-8(e)(6)(i):

As adopted by this document, paragraph (e)(6)(i) of section 1.861-8 retains the rule of paragraph (e)(6)(i) of the prior final regulation that the deduction for state income taxes is definitely related, and thus allocable, to the gross income with respect to which those taxes are imposed. This rule is based upon the basic principle, stated in paragraph (a)(2) of section 1.861-8, that a deduction is to be allocated and, if necessary, apportioned based upon the factual relationship of the deduction to gross income.

In response to comments, the regulations have been revised to state more clearly that certain examples in the regulations do not provide exclusive methods of allocating and apportioning the deduction for state income taxes. In addition, the regulations provide two safe harbor methods that taxpayers may elect to use for purposes of allocating and apportioning the deduction for state income taxes.

Several commentators have argued that the deduction for state franchise taxes computed by reference to state taxable income should be allocated to a class of gross income consisting solely of income from sources within the United States. These commentators reason that, because a state franchise tax is technically a tax imposed upon a corporation's activity in that state, the tax is necessarily an expense related to income from sources within the United States.

This argument was rejected for two reasons. First, as discussed below, activities in a state may generate income from sources within or without the United States, or from both sources. Second, state franchise taxes measured by taxable income and state income taxes bear the same factual relationship to income. For example, one state imposes a franchise tax measured by the state's definition of taxable income on corporations doing business in that state, and an income tax imposed at the same rate on the same definition of taxable income on corporations that are not doing business in the state, but that derive income from sources within the state. A state franchise tax should not be allocated and apportioned differently than an income tax computed in an identical manner by the same state. The final regulations continue to reflect the view that a state franchise tax measured by state taxable income, like a state income tax, has a definite factual relationship to the income on which it is imposed, and continue to apply the general rule of paragraph (e)(6)(i) of section 1.861-8 to the deduction for such state franchise taxes.

Other commentators have asserted that the states are not constitutionally permitted to tax income from sources outside the state, and thus have reasoned that the deduction for state income taxes must be allocated solely to income from sources within the United States. The argument of these commentators was rejected because it reflects a misinterpretation of the decisions of the U.S. Supreme Court. The Court has explained that income apportioned by a state to business activities in that state under the unitary business theory of taxation may have more than one geographical source, and is not to be equated with the income sourced in that state in the geographical sense. Moreover, the Court has indicated that states may tax income that is considered to be from foreign sources under the principles of the Internal Revenue Code, provided the income has the appropriate nexus to activities performed in the state. Mobil Oil Corp. v. Commissioner of Taxes, 445 U.S. 425, 437-440 (1980).

Other commentators assert that a state income tax should be considered an additional cost of doing business, and should be allocated by reference to the income that is considered under federal income tax principles to be derived from that business, without regard to whether the state imposes its income tax on income determined using federal income tax principles. This argument was rejected because an allocation and apportionment of state income tax on this basis would ignore the direct factual relationship between a state income tax and the income upon which the state actually imposes the tax. The factual relationship of a state income tax to income computed under state law concepts is demonstrated by the fact that the amount of a state income tax increases or decreases in direct relation to the amount of income taxable by the state. A state income tax that is not based upon income determined under federal income tax principles has no such factual relationship to income based upon federal income tax principles.

Other commentators similarly argue that the determination of the income upon which a state income tax is imposed, for purposes of applying paragraph (e)(6)(i) of this section, should be made by reference to federal income tax principles, rather than by reference to state law. These commentators argue that the use of federal income tax principles in determining the income upon which state income taxes are imposed would yield consistency by ignoring differing state definitions of taxable income. These commentators would allocate and apportion state income tax to foreign source income under section 1.861-8 only when the taxpayer's activities in the state are considered to have generated income that is foreign source income under federal income tax principles.

This argument was rejected for several reasons. First, as discussed above, this argument ignores the direct factual relationship between a state income tax and the income upon which the state actually imposes that tax. As discussed above, this factual relationship is demonstrated by the fact that the amount of state income tax changes in direct relation to the amount of income taxable by the state. A state income tax has no such factual relationship to a hypothetical amount of state taxable income calculated on the basis of federal income tax principles which the commentators suggest as the alternative. The U.S. Supreme Court, in Container Corp. v. Franchise Tax Board, 463 U.S. 159, 184-197 (1983), ruled that a state is not constitutionally required to use federal income tax principles in determining the amount of income attributable to activities in the state.

The methodology suggested by these commentators was also rejected because, contrary to the assertion of those commentators, it would not necessarily be simpler than the approach taken in the proposed regulations. For example, the suggested methodology would require a taxpayer doing business through branches in several states to make a hypothetical determination under federal income tax principles of the amount of income earned from activities in each individual state, without regard to operations in any other state. The proposed regulations, under which each state's determination of taxable income attributable to activities in that state may be presumed valid, would be much simpler to apply in this case.

Numerous comments have been received regarding the application of the proposed regulations to deductions for income taxes imposed by states which have adopted a unitary business theory of income taxation. A state which has adopted a unitary business theory first determines the scope of the unitary business of which a taxpayer corporation's activities in the state form a part. The total income of that unitary business is then apportioned between the taxing state and the rest of the world by means of a formula which takes into account objective measures ("factors") of the taxpayer corporation's activities within and without the taxing state. The most widely used apportionment formula gives equal weight to the proportions of total payroll, property, and sales which are located in the taxing state.

The unitary business theory of state income taxation contrasts with the "arm's length" approach of federal income tax law (and the income tax laws of several states), under which an individual corporation is treated for most purposes as an independent entity dealing at arm's length with affiliated corporations. Under an arm's length approach, a corporation is subject to taxation only with respect to the income reflected on its own books, assuming that such income has been determined on the basis of arm's length principles. (Formulary apportionment may also be used in the context of an arm's length approach by applying an apportionment formula to the total taxable income of a single corporation and considering factors attributable solely to that corporation.)

Commentators have argued that, in the case of a deduction for an income tax imposed by a state which has adopted the unitary business theory, the proposed regulations improperly allocate and apportion the deduction to income other than that of the taxpayer corporation. These commentators appear to reason that the unitary business theory results in the imposition of state tax in part upon the taxable income of corporations other than the corporation paying the tax and, therefore, that the proposed regulations' reliance on a state's definition of taxable income will result in such cases in the allocation of a deduction for state income tax paid by one corporation in part to income attributable to other corporations.

This argument was rejected because it fails to recognize that the unitary business theory takes into account the income, assets, and other factors of a group of affiliated corporations (i.e., those comprising a unitary business) solely for purposes of determining the amount of taxable income that is properly attributable to the corporation or corporations over which a state has taxing jurisdiction. The application of formulary apportionment under a unitary business theory is simply one method of allocating the income of a multinational enterprise among its component parts (the "arm's length" approach being another such method). Container Corp. v. Franchise Tax Board, supra, at 188. A state which employs a unitary business theory imposes tax only upon taxable income which is attributed to a corporation over which it has taxing jurisdiction. It is, therefore, appropriate to allocate and apportion a deduction for state income taxes paid by such corporations on the basis of their state taxable income.

Finally, two commentators have argued that the proposed regulations are inconsistent with the pre-existing regulations under section 1502 of the Code relating to the computation of the consolidated foreign tax credit. These commentators assert that sections 1.1502-4 and 1.1502-12 of the regulations require a corporation to allocate and apportion its deductions based upon income as determined under federal income tax principles. They argue that the proposed regulations are inconsistent because the proposed regulations can require the deduction for a state income tax to be allocated and apportioned based upon an amount of state taxable income determined under the unitary business theory of taxation. Implicit in this argument is the notion that the unitary business theory may result in the taxation of the income of corporations other than the taxpayer.

This argument was rejected because section 1.1502-12 of the regulations, which defines separate taxable income for purposes of determining the limitation on the consolidated foreign tax credit under section 1.1502-4, merely states that, subject to enumerated modifications not relevant here, the taxable income of a corporation filing a consolidated income tax return as part of an affiliated group of corporations is to be computed using the same Code rules that would apply to a corporation filing a separate income tax return. Section 1.1502-12 does not alter the principle of section 1.861-8 that deductions are to be allocated and apportioned based on the factual relationship between the deduction and a class of gross income. Moreover, as noted above, the unitary business theory of taxation is merely a method of determining the amount of taxable income that can be properly attributed to the taxpayer corporation.

One commentator further argues that the proposed regulations are inconsistent with sections 1.1502-4 and 1.1502-12 because they could require state income tax imposed under the unitary business theory of taxation to be apportioned to foreign source income, thereby creating a negative amount of foreign source taxable income when a corporation has no foreign source gross income for federal tax purposes. This commentator asserts that sections 1.1502-4 and 1.1502-12 of the regulations, which refer to a company's "separate taxable income," do not permit an allocation and apportionment of a deduction to nonexistent foreign source gross income. This argument was rejected because it is contrary to the language of section 1.1502-12, which states that the term "separate taxable income" shall include an excess of deductions over gross income. It is also contrary to Example 17 of paragraph (g) of section 1.861-8, which illustrates that a deduction can be allocated and apportioned in part to foreign source income when computing the consolidated foreign tax credit in a year in which the taxpayer has no foreign source gross income. Example 17, which was promulgated in 1977, indicates that a deduction can be factually related and thus allocable to a class of gross income which includes foreign source income in a year in which the taxpayer actually derives no foreign source income. Thus, the allocation and apportionment of a deduction can create a foreign source loss for purposes of computing the consolidated foreign tax credit. This rule is restated in the final regulation and illustrated in new Example 30 of paragraph (g) of this section.

SECTION 1.861-8(e)(6)(ii):

One commentator asked that an allocation of state income tax based upon a methodology illustrated in the examples be presumed reasonable, and thus binding upon the Service, except at the election of the taxpayer. This proposal is adopted with respect to Example 33. However, this proposal was rejected with respect to the remaining examples because it could bind the Service to an allocation based upon an example, even if the taxpayer's facts bore no resemblance to the facts upon which those examples were based. Such a result would violate the fundamental principle of these regulations -- that deductions be allocated based upon the factual relationship of the deduction to a class of gross income.

The final regulations revise the proposed regulations to indicate that a taxpayer that chooses to apply the methodology of Example 25 of paragraph (g) of this section must also apply the modifications of Example 25 illustrated in Examples 26 and 27 of paragraph (g), and that a taxpayer must always apply the rule illustrated in Example 28, with respect to foreign source dividends taxed by a state without regard to factors of the corporations paying those dividends, without regard to whether the particular methodology of Example 25 is applied with respect to the remaining deduction. The modification illustrated in Example 26 must be applied if the taxpayer's deduction for state income taxes is attributable in part to taxes paid to a state which exempts foreign source income from taxation. The modification illustrated in Example 27 must be applied if the taxpayer has income-producing activities in a state which does not impose a corporate income tax or other tax computed by reference to income. The final regulations also revise the proposed regulations to clarify that a methodology illustrated in Example 25 (as modified by Examples 26 and 27), 29, or 31 will not be appropriate with respect to an actual taxpayer if the facts of the example are so dissimilar from the taxpayer's factual situation that the application of the example to the actual facts does not result in a reasonable allocation, under all of the facts and circumstances, of a deduction to the gross income to which it relates.

A deduction may be allocated and apportioned under a method other than those illustrated in Example 25 (as modified by Examples 26 and 27) or 29 if it is established to the satisfaction of the District Director upon examination that a different method yields a more accurate allocation and apportionment of state income taxes based on the factual relationship of the state income tax to the income on which the tax is imposed.

The final regulation reserves on simplified methods for dealing with the effect of redeterminations of state income tax liability, subsequent to an allocation and apportionment of the deduction for state income tax. A taxpayer is generally required to recompute its allocation and apportionment of the deduction for state income taxes in the event of a redetermination of any state income tax liability. The Service is considering adoption of an approach in which the taxpayer would be permitted to perform this recomputation on the basis of a methodology other than that used for the initial allocation and apportionment, provided that the new methodology was consistent with these final regulations. If a taxpayer had performed an initial allocation and apportionment of the deduction on the basis of a methodology which utilized ratios of foreign source federal taxable income and U.S. source federal taxable income to total federal taxable income, the taxpayer generally would not be required to recompute these ratios for purposes of reapplying the same methodology to the redetermined deduction. In view of the fact that some taxpayers may not have retained all of the records that might be required to recompute an allocation and apportionment for an early taxable year, the Service is also considering adoption of a rule analogous to that of the regulations under section 905(c) with respect to redeterminations relating to taxable years beginning before January 1, 1988. Under such a rule, the deduction for state income tax in the taxable year of redetermination (whether a pre-1988 or post-1987 taxable year) would then be allocated and apportioned under this final regulation using the information for the year of the redetermination. The Service hereby requests taxpayer comments with respect to the approaches described above and alternative approaches. Comments should be directed to Commissioner of Internal Revenue, Attention: CC:CORP:T:R (INTL-0009-91), Washington, DC 20224.

SECTION 1.861-8(e)(6)(iii):

Paragraph (e)(6)(iii) of section 1.861-8 provides that the regulations in paragraph (e)(6)(i) are effective for taxable years beginning after December 31, 1976, and that the regulations in paragraph (e)(6)(ii) (other than paragraph (e)(6)(ii)(D)) and Examples 25 through 32 of section 1.861-8(g) are effective for taxable years beginning on or after January 1, 1988. Paragraph (e)(6)(ii)(D) and Example 33 of paragraph (g) of section 1.861-8 are effective for taxable years ending after March 12, 1991. This paragraph also provides taxpayers with the option to apply the regulations in (e)(6)(ii) (other than paragraph (e)(6)(ii)(D)) and Examples 25 through 32 of paragraph (g) to deductions for state income tax incurred in taxable years beginning before January 1, 1988.

SECTION 1.861-8(g)

Paragraph (g) of section 1.861-8 as promulgated herein restates the previously promulgated language that precedes the examples in section 1.861-8(g). Language on the effect of examples contained in this paragraph of the proposed regulations was moved to paragraph (e)(6)(ii) to clarify the effect of Examples 25 through 33. Several linguistic and clarifying changes also have been made to the language of Examples 25 through 29.

EXAMPLE 27

The final regulations revise Example 27 to state more clearly that any reasonable method may be used to determine the amount of taxable income attributable to a corporate taxpayer's activities in a state that does not impose a corporate income tax.

EXAMPLE 29

The language of Example 29 has been revised to indicate more clearly that a deduction for income tax imposed by a state that applies a unitary business theory to determine state taxable income is allocated and apportioned under section 1.861-8 based solely upon the taxable income which the state considers to be attributable to the taxpayer's activities in that state.

EXAMPLES 30 THROUGH 33

In response to comments concerning the allocation and apportionment of the deduction for state income taxes in computing the consolidated foreign tax credit limitation under section 1.1502- 4, the final regulations add new Example 30. Example 30 illustrates the general rule (stated in paragraph (e)(6)(i) of this section) that the principles of Example 17 of paragraph (g) of this section apply in the case of a deduction for state income tax, and that a deduction for state income tax may be apportionable to foreign source income even if the taxpayer has a foreign source loss in the taxable year as a result of the allocation and apportionment of deductions. Example 30 also demonstrates that a deduction for income tax imposed by a state which applies a unitary business theory of taxation may be apportionable to foreign source income, even if the taxpayer corporation has no foreign activities of its own, if the taxpayer's unitary business group includes one or more corporations whose activities produce foreign source income that is attributed to the taxpayer corporation.

In response to comments requesting clarification of acceptable alternatives to, and modifications of, the examples contained in the proposed regulations, the final regulations add new Examples 31 and 32 to paragraph (g) of section 1.861-8. Example 31 illustrates a situation in which an alternative method of allocating and apportioning a deduction does reasonably reflect the factual relationship of the deduction to gross income. Example 32 illustrates a situation in which an alternative method of allocating and apportioning a deduction does not reasonably reflect the factual relationship of the deduction to gross income.

Example 33 illustrates the operation of the elective safe harbor methods.

SPECIAL ANALYSES

It has been determined that this final rule is not a major legislative regulation subject to Executive Order 12291. Therefore, a Regulatory Impact Analysis is not required. It has also been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. Chapter 5) and the Regulatory Flexibility Act (5 U.S.C. Chapter 6) do not apply to these regulations, and, therefore, a final Regulatory Flexibility Analysis is not required. Pursuant to section 7805(f) of the Internal Revenue Code, the notice of proposed rulemaking for the regulations was submitted to the Chief Counsel of Advocacy of the Small Business Administration for comment on their impact on small business.

DRAFTING INFORMATION

The principal author of these regulations is David F. Chan of the Office of Associate Chief Counsel (International), within the Office of Chief Counsel, Internal Revenue Service. Other personnel from the Internal Revenue Service and Treasury Department participated in developing the regulations.

LIST OF SUBJECTS

26 CFR SECTIONS 1.861-1 THROUGH 1.997-1

Income taxes, Corporate deductions, Aliens, Exports, DISC, Foreign investment in United States, Foreign tax credit, FSC, Source of income, United States investments abroad.

26 CFR PART 602

Reporting and Recordkeeping requirements.

ADOPTION OF AMENDMENTS TO THE REGULATIONS

Accordingly, 26 CFR parts 1 and 602 are amended as follows:

PART 1 -- INCOME TAX; TAXABLE YEARS BEGINNING AFTER DECEMBER 31, 1953

Paragraph 1. The authority for part 1 continues to read in part:

Authority: 26 U.S.C 7805 * * *

1.861-8T [Amended]

Par. 2. Section 1.861-8T is amended as follows:

1. Section 1.861-8T(e)(6) is removed and reserved.

2. Section 1.861-8T(g) introductory text and Examples (25) through (29) are removed.

Par. 3. Section 1.861-8 is amended as follows:

1. Section 1.861-8(e)(6) is revised to read as set forth below.

2. In section 1.861-8(g), "[Reserved]" is removed, the introductory text and Examples 25 and 26 are revised and Examples 27 through 33 are added to read as set forth below. The amendments to section 1.861-8 read as follows:

SECTION 1.861-8. COMPUTATION OF TAXABLE INCOME FROM SOURCES WITHIN THE UNITED STATES AND FROM OTHER SOURCES AND ACTIVITIES.

* * * * *

(e) ALLOCATION AND APPORTIONMENT OF CERTAIN DEDUCTIONS * * *

(6) INCOME TAXES -- (i) IN GENERAL. The deduction for state, local, and foreign income, war profits and excess profits taxes ("state income taxes") allowed by section 164 shall be considered definitely related and allocable to the gross income with respect to which such state income taxes are imposed. For example, if a domestic corporation is subject to state income taxation and the state income tax is imposed in part on an amount of foreign source income, then that part of the taxpayer's deduction for state income tax that is attributable to foreign source income is definitely related and allocable to foreign source income. In allocating and apportioning the deduction for state income tax for purposes including (but not limited to) the computation of the foreign tax credit limitation under section 904 of the Code and the consolidated foreign tax credit under section 1.1502-4 of the regulations, the income upon which the state income tax is imposed is determined by reference to the law of the jurisdiction imposing the tax. Thus, if a state attributes taxable income to a corporate taxpayer by applying an apportionment formula that takes into consideration the income and factors of one or more corporations related by ownership to the corporate taxpayer and engaging in activities related to the business of the corporate taxpayer, then the income so attributed is the income upon which the state income tax is imposed. If the income so attributed to the corporate taxpayer includes foreign source income, then, in computing the taxpayer's foreign tax credit limitation under section 904, for example, the taxpayer's deduction for state income tax will be considered definitely related and allocable to a class of gross income that includes the statutory grouping of foreign source income. When the law of the state includes dividends that are treated under section 862(a)(2) as income from sources without the United States in taxable income apportionable to the state, but does not include factors of the corporation paying such dividends in the apportionment formula used to determine state taxable income, an appropriate portion of the deduction for state income tax will be considered definitely related and allocable to a class of gross income consisting solely of foreign source dividend income. A deduction for state income tax will not be considered definitely related to a hypothetical amount of income calculated under federal tax principles when the jurisdiction imposing the tax computes taxable income under different principles. A corporate taxpayer's deduction for a state franchise tax that is computed on the basis of income attributable to business activities conducted within the state must be allocated and apportioned in the same manner as the deduction for state income taxes. In determining, for example, both the foreign tax credit under section 904 of the Code and the consolidated foreign tax credit limitation under section 1.1502-4 of the regulations, the deduction for state income tax may be allocable and apportionable to foreign source income in a statutory grouping described in section 904(d) in a taxable year in which the taxpayer has no foreign source income in such statutory grouping. Alternatively, such an allocation or apportionment may be appropriate if a taxpayer corporation has no foreign source income in a statutory grouping, but its deduction is attributable to foreign source income in such grouping that is attributed to the taxpayer corporation under the law of a state which attributes taxable income to a corporation by applying an apportionment formula that takes into consideration the income and factors of one or more corporations related by ownership to the taxpayer corporation and engaging in activities related to the business of the taxpayer corporation. Example 30 of paragraph (g) of this section illustrates the application of this last rule.

(ii) METHODS OF ALLOCATION AND APPORTIONMENT -- (A) IN GENERAL. A taxpayer's deduction for a state income tax is to be allocated (and then apportioned, if necessary, subject to the rules of section 1.861-8(d)) by reference to the taxable income that the law of the taxing jurisdiction attributes to the taxpayer ("state taxable income").

(B) EFFECT OF SUBSEQUENT RECOMPUTATIONS OF STATE INCOME TAX. [Reserved]

(C) ILLUSTRATIONS -- (1) IN GENERAL. Examples 25 through 32 of paragraph (g) of section 1.861-8 illustrate, in the given factual situations, the application of this paragraph (e)(6) and the general rule of paragraph (b)(1) of this section that a deduction must be allocated to the class of gross income to which the deduction is factually related. In general, these examples employ a presumption that state income taxes are allocable to a class of gross income that includes the statutory grouping of income from sources without the United States when the total amount of taxable income determined under state law exceeds the amount of taxable income determined under the Code (without taking into account the deduction for state income taxes) in the residual grouping of income from sources within the United States. A taxpayer that allocates and apportions the deduction for state income tax in accordance with the methodology of Example 25 of paragraph (g) of this section must also apply the modifications illustrated in Examples 26 and 27 of paragraph (g) of this section, when applicable. The modification illustrated in Example 26 is applicable when the deduction for state income tax is attributable in part to taxes imposed by a state which factually excludes foreign source income (as determined for federal income tax purposes) from state taxable income. The modification illustrated in Example 27 is applicable when the taxpayer has income-producing activities in a state which does not impose a corporate income tax. The specific allocation of state income tax illustrated in Example 28 follows the rule in paragraph (e)(6)(i) of this section, and must be applied whenever a taxpayer's state taxable income includes dividends apportioned to the state under a formula that does not take into account the factors of the corporations paying those dividends, regardless of whether the taxpayer uses the methodology of Example 25 with respect to the remainder of the deduction for state income taxes.

(2) MODIFICATIONS. Before applying a method of allocation and apportionment illustrated in the examples, the computation of state taxable income under state law may be modified, subject to the approval of the District Director, to reflect more accurately the income with respect to which the state income tax is imposed. Any modification to the state law computation of state taxable income must yield an allocation and apportionment of the deduction for state income taxes that is consistent with the rules contained in this paragraph (e)(6), and that accurately reflects the factual relationship between the state income tax and the income on which that tax is imposed. For example, a modification to the computation of taxable income under state law might be appropriate to compensate for differences between the state law definition of taxable income and the federal definition of taxable income, due to a difference in the rate of allowable depreciation or the amount of another deduction that is allowable under both systems. This rule is illustrated in Example 31 of paragraph (g) of this section. However, a modification to the computation of taxable income under state law will not be appropriate, and will not more accurately reflect the factual relationship between the state tax and the income on which the tax is imposed, to the extent such modification reflects the fact that the state does not follow federal tax principles in attributing income to the taxpayer's activities in the state. This rule is illustrated in Example 32 of paragraph (g) of this section. A taxpayer may not modify the methods illustrated in the examples, or use an alternative method of allocation and apportionment of the deduction for state income taxes, if the modification or alternative method would be inconsistent with the rules of paragraph (e)(6)(i) of this section. A taxpayer that uses a method of allocation and apportionment other than one illustrated in Example 25 (as modified by Examples 26 and 27), or 29 with respect to a factual situation similar to those of the examples, must describe the alternative method on an attachment to its federal income tax return and establish to the satisfaction of the District Director, upon examination, that the result of the alternative method more accurately reflects the factual relationship between the state income tax and the income on which the tax is imposed.

(D) ELECTIVE SAFE HARBOR METHODS. (1) IN GENERAL. In lieu of applying the rules set forth in paragraphs (e)(6)(ii)(A) through (C) of this section, a taxpayer may elect to allocate and apportion the deduction for state income tax in accordance with one of the two safe harbor methods described in paragraph (e)(6)(ii)(D)(2) and (3) of this section. A taxpayer shall make this election for a taxable year by filing a timely tax return for that year that reflects an allocation and apportionment of the deduction for state income tax under one of the safe harbor methods and attaching to such return a statement that the taxpayer has elected to use the safe harbor method provided in either paragraph (e)(6)(ii)(D)(2) or (3) of this section, as appropriate. Once made, this election is effective for the taxable year for which made and all subsequent taxable years, and may be revoked only with the consent of the Commissioner. Example 33 of paragraph (g) of this section illustrates the application of these safe harbor methods.

(2) METHOD ONE. (i) STEP ONE -- Specific allocation to foreign source portfolio dividends. If any portion of the deduction for state income tax is attributable to tax imposed by a state which includes in a corporate taxpayer's taxable income apportionable to the state, portfolio dividends (as defined in paragraph (i) of Example 28 of paragraph (g) of this section) that are treated under section 862(a)(2) as income from sources without the United States, but does not include factors of the corporations paying the portfolio dividends in the apportionment formula used to determine state taxable income, the taxpayer shall allocate an appropriate portion of the deduction to a class of gross income consisting solely of foreign source portfolio dividends. The portion of the deduction so allocated, and the amount of foreign source portfolio dividends included in such class, shall be determined in accordance with the methodology illustrated in paragraph (ii) of Example 28 of paragraph (g). The taxpayer shall reduce its aggregate state taxable income by the amount of foreign source portfolio dividends to which a specific allocation is made (the reduced amount being referred to hereinafter as "adjusted state taxable income").

(ii) STEP TWO -- ADJUSTMENT OF U.S. SOURCE FEDERAL TAXABLE INCOME. If the taxpayer has significant income-producing activities in a state which does not impose a corporate income tax or other state tax measured by income derived from business activities in the state, the taxpayer shall reduce its U.S. source federal taxable income (solely for purposes of this safe harbor method) by the amount of federal taxable income attributable to its activities in such state. This amount shall be determined in accordance with the methodology illustrated in paragraph (ii) of Example 27 of paragraph (g) of this section, provided that the taxpayer shall be required to use the rules of the Uniform Division of Income for Tax Purposes Act to attribute income to the relevant state. The taxpayer's U.S. source federal taxable income, as so reduced, is referred to hereinafter as "adjusted U.S. source federal taxable income."

(iii) STEP THREE -- ALLOCATION. The taxpayer shall allocate the remainder of the deduction for state income tax (after reduction by the portion allocated to foreign source portfolio dividends under Step One) in accordance with the methodology illustrated in paragraph (ii) of Example 25 of paragraph (g) of this section. However, the taxpayer shall substitute for the comparison of aggregate state taxable income to U.S. source federal taxable income, illustrated in paragraph (ii) of Example 25 of paragraph (g), a comparison of its adjusted state taxable income to an amount equal to 110% of its adjusted U.S. source federal taxable income.

(iv) STEP FOUR -- APPORTIONMENT. In the event that apportionment of the remainder of the deduction for state income tax is required, the taxpayer shall apportion that remaining deduction to U.S. source income in accordance with the methodology illustrated in paragraph (iii) of Example 25 of paragraph (g) of this section, substituting for domestic source income in that paragraph an amount equal to 110% of the taxpayer's adjusted U.S. source federal taxable income. The remaining portion of the deduction shall be apportioned to the statutory groupings of foreign source income described in section 904(d) of the Code in accordance with the proportion of the income in each statutory grouping of foreign source income described in section 904(d) to the taxpayer's total foreign source federal taxable income (after reduction by the amount of foreign source portfolio dividends to which tax has been specifically allocated under Step One, above).

(3) METHOD TWO. (i) STEP ONE -- SPECIFIC ALLOCATION TO FOREIGN SOURCE PORTFOLIO DIVIDENDS. Step One of this method is the same as Step One of Method One (as described in paragraph (e)(6)(ii)(D)(2)(i) of this section).

(ii) STEP TWO -- ADJUSTMENT OF U.S. SOURCE FEDERAL TAXABLE INCOME. Step Two of this method is the same as Step Two of Method One (as described in paragraph (e)(6)(ii)(D)(2)(ii) of this section).

(iii) STEP THREE -- ALLOCATION. The taxpayer shall allocate the remainder of the deduction for state income tax (after reduction by the portion allocated to foreign source portfolio dividends under Step One) in accordance with the methodology illustrated in paragraph (ii) of Example 25 of paragraph (g) of this section. However, the taxpayer shall substitute for the comparison of aggregate state taxable income to U.S. source federal taxable income, illustrated in paragraph (ii) of Example 25 of paragraph (g) of this section, a comparison of its adjusted state taxable income to its adjusted U.S. source federal taxable income.

(iv) STEP FOUR -- APPORTIONMENT. In the event that apportionment of the deduction is required, the taxpayer shall apportion to U.S. source income that portion of the deduction that is attributable to state income taxes imposed upon an amount of state taxable income equal to adjusted U.S. source federal taxable income. The taxpayer shall apportion the remaining amount of the deduction to U.S. and foreign source income in the same proportions that the taxpayer's adjusted U.S. source federal taxable income and foreign source federal taxable income (after reduction by the amount of foreign source portfolio dividends to which tax has been specifically allocated under Step One, above) bear to its total federal taxable income (taking into account the adjustment of U.S. source federal taxable income under Step Two and after reduction by the amount of foreign source portfolio dividends to which tax has been specifically allocated under Step One). The portion of the deduction apportioned to foreign source income shall be apportioned among the statutory groupings described in section 904(d) of the Code in accordance with the proportions of the taxpayer's total foreign source federal taxable income (after reduction by the amount of foreign source portfolio dividends to which tax has been specifically allocated under Step One, above) in each grouping.

(iii) EFFECTIVE DATES. The rules of section 1.861-8(e)(6)(i) and the language preceding the examples in section 1.861-8(g) are effective for taxable years beginning after December 31, 1976. The rules of section 1.861-8(e)(6)(ii) (other than section 1.861- (e)(6) (ii)(D)) and Examples 25 through 32 of section 1.861-8(g) are effective for taxable years beginning on or after January 1, 1988. The rules of section 1.861-8(e)(6)(ii)(D) and Example 33 of section 1.861-8(g) are effective for taxable years ending after [date of publication of this regulation in the Federal Register]. At the option of the taxpayer, however, the rules of section 1.861-8(e) (6)(ii) (other than section 1.861-8(e)(6)(ii)(D)) and Examples 25 through 32 of section 1.861-8(g) may be applied with respect to deductions for state taxes incurred in taxable years beginning before January 1, 1988.

* * * * *

(g) GENERAL EXAMPLES. The following examples illustrate the principles of this section. In each example, unless otherwise specified, the operative section which is applied and gives rise to the statutory grouping of gross income is the overall limitation to the foreign tax credit under section 904(a). In addition, in each example, where a method of allocation or apportionment is illustrated as an acceptable method, it is assumed that such method is used by the taxpayer on a consistent basis from year to year (except in the case of the optional method for apportioning research and development expense under paragraph (e)(3)(iii) of section 1.861-8). Further, it is assumed that each party named in each example operates on a calendar year accounting basis and, where the party is a U.S. taxpayer, files returns on a calendar year basis.

* * * * *

EXAMPLE 25 -- INCOME TAXES -- (i) FACTS. X, a domestic corporation, is a manufacturer and distributor of electronic equipment with operations in states A, B, and C. X also has a branch in country Y which manufactures and distributes the same type of electronic equipment. In 1988, X has taxable income from these activities, as determined under the Code (without taking into account the deduction for state income taxes), of $1,000,000, of which $200,000 is foreign source general limitation income subject to a separate limitation under section 904(d)(1)(I) ("general limitation income") and $800,000 is domestic source income. States A, B, and C each determine X's income subject to tax within their state by making adjustments to X's taxable income as determined under the Code, and then apportioning the adjusted taxable income on the basis of the relative amounts of X's payroll, property, and sales within each state as compared to X's worldwide payroll, property, and sales. The adjustments made by states A, B, and C all involve adding and subtracting enumerated items from taxable income as determined under the Code. However, in making these adjustments to taxable income, none of the states specifically exempts foreign source income as determined under the Code. On this basis, it is determined that X has taxable income of $550,000, $200,000, and $200,000 in states A, B, and C, respectively. The corporate tax rates in states A, B, and C are 10 percent, 5 percent, and 2 percent, respectively, and X has total state income tax liabilities of $69,000 ($55,000 + $10,000 + $4,000), which it deducts as an expense for federal income tax purposes.

(ii) ALLOCATION. X's deduction of $69,000 for state income taxes is definitely related and thus allocable to the gross income with respect to which the taxes are imposed. Since the statutes of states A, B, and C do not specifically exempt foreign source income (as determined under the Code) from taxation and since, in the aggregate, states A, B, and C tax $950,000 of X's income while only $800,000 is domestic source income under the Code, it is presumed that state income taxes are imposed on $150,000 of foreign source income. The deduction for state income taxes is therefore related and allocable to both X's foreign source and domestic source income.

(iii) APPORTIONMENT. For purposes of computing the foreign tax credit limitation, X's income is comprised of one statutory grouping, foreign source general limitation gross income, and one residual grouping, gross income from sources within the United States. The state income tax deduction of $69,000 must be apportioned between these two groupings. Corporation X calculates the apportionment on the basis of the relative amounts of foreign source general limitation taxable income and U.S. source taxable income subject to state taxation. In this case, state income taxes are presumed to be imposed on $800,000 of domestic source income and $150,000 of foreign source general limitation income.

     State income tax deduction apportioned

(ii) ALLOCATION. X's deduction of $69,000 for state income taxes is definitely related and thus allocable to the gross income with respect to which the taxes are imposed. Since state A exempts all foreign source income by statute, state A is presumed to impose tax on $550,000 of X's $800,000 of domestic source income. X's state A tax of $55,000 is allocable, therefore, solely to domestic source income. Since the statutes of states B and C do not specifically exclude all foreign source income as determined under the Code, and since states B and C impose tax on $400,000 ($200,000 + $200,000) of X's income of which only $250,000 ($800,000 - $550,000) is presumed to be domestic source, the deduction for the $14,000 of income taxes imposed by states B and C is related and allocable to both foreign source and domestic source income.

(iii) APPORTIONMENT. (A) For purposes of computing the foreign tax credit limitation, X's income is comprised of one statutory grouping, foreign source general limitation gross income, and one residual grouping, gross income from sources within the United States. The deduction of $14,000 for income taxes of states B and C must be apportioned between these two groupings.

(B) Corporation X calculates the apportionment on the basis of the relative amounts of foreign source general limitation income and U.S. source income subject to state taxation.

     States B and C income tax deduction

EXAMPLE 27 -- INCOME TAX -- (i) FACTS. Assume the same facts as in Example 25 except that state A, in which X has significant income-producing activities, does not impose a corporate income tax or other state tax computed on the basis of income derived from business activities conducted in state A. X therefore has a total state income tax liability in 1988 of $14,000 ($10,000 paid to state B plus $4,000 paid to state C), all of which is subject to allocation and apportionment under paragraph (b) of this section.

(ii) ALLOCATION. (A) X's deduction of $14,000 for state income taxes is definitely related and allocable to the gross income with respect to which the taxes are imposed. However, in these facts, an adjustment is necessary before the aggregate state taxable incomes can be compared with U.S. source income on the federal income tax return in the manner described in Examples 25 and 26. Unlike the facts in Examples 25 and 26, state A imposes no income tax and does not define taxable income attributable to activities in state A. The total amount of X's income subject to state taxation is, therefore, $400,000 ($200,000 in state B and $200,000 in state C). This total presumptively does not include any income attributable to activities performed in state A and therefore can not properly be compared to total U.S. source taxable income reported by X for federal income tax purposes, which does include income attributable to state A activities.

(B)(1) Accordingly, before applying the method used in Examples 25 and 26 to the facts of this example, it is necessary first to estimate the amount of taxable income that state A could reasonably attribute to X's activities in state A, and then to reduce federal taxable income by that amount.

(2) Any reasonable method may be used to attribute taxable income to X's activities in state A. For example, the rules of the Uniform Division of Income for Tax Purposes Act ("UDITPA") attribute income to a state on the basis of the average of three ratios that are based upon the taxpayer's facts -- property within the state over total property, payroll within the state over total payroll, and sales within the state over total sales -- and, with adjustments, provide a reasonable method for this purpose. When applying the rules of UDITPA to estimate U.S. source income derived from state A activities, the taxpayer's UDITPA factors must be adjusted to eliminate both taxable income and factors attributable to a foreign branch. Therefore, in this example all taxable income as well as UDITPA apportionment factors (property, payroll, and sales) attributable to X's country Y branch must be eliminated.

(C)(1) Since it is presumed that, if state A had had an income tax, state A would not attempt to tax the income derived by X's country Y branch, any reasonable estimate of the income that would be taxed by state A must exclude any foreign source income.

(2) When using the rules of UDITPA to estimate the income that would have been taxable by state A in these facts, foreign source income is excluded by starting with federally defined taxable income (before deduction for state income taxes) and subtracting any income derived by X's country Y branch. The hypothetical state A taxable income is then determined by multiplying the resulting difference by the average of X's state A property, payroll, and sales ratios, determined using the principles of UDITPA (after adjustment by eliminating the country Y branch factors). The resulting product is presumed to be exclusively U.S. source income, and the allocation and apportionment method described in Example 26 must then be applied.

(3) If, for example, state A taxable income were determined to equal $550,000, then $550,000 of U.S. source income for federal income tax purposes would be presumed to constitute state A taxable income. Under Example 26, the remaining $250,000 ($800,000 - $550,000) of U.S. source income for federal income tax purposes would be presumed to be subject to tax in states B and C. Since states B and C impose tax on $400,000, the application of Example 25 would result in a presumption that $150,000 is foreign source income and $250,000 is domestic source income. The deduction for the $14,000 of income taxes of states B and C would therefore be related and allocable to both foreign source and domestic source income and would be subject to apportionment.

(iii) APPORTIONMENT. The deduction of $14,000 for income taxes of states B and C is apportioned in the same manner as in Example 26. As a result, $5,250 of the $14,000 of state B and state C income taxes is apportioned to foreign source general limitation income ($14,000 x $150,000/$400,000), and $8,750 ($14,000 x $250,000/$400,000) of the $14,000 of state B and state C income taxes is apportioned to U.S. source income.

EXAMPLE 28 -- INCOME TAX -- (i) FACTS. (A) Assume the same facts as in Example 25 (X has $1,000,000 of taxable income for federal income tax purposes, $800,000 of which is U.S. source income and $200,000 of which is foreign source general limitation income), except that $100,000 of X's $200,000 of foreign source general limitation income consists of dividends from first-tier controlled foreign corporations ("CFCs") (as defined in section 957(a) of the Code) which derive exclusively foreign source general limitation income. X owns stock representing 10 to 50 percent of the vote and value in such CFCs.

(B) State A taxable income is computed by first making adjustments to X's federal taxable income. These adjustments result in X having a total of $1,100,000 of apportionable taxable income for state A tax purposes. None of the $100,000 of adjustments made by state A relate to the dividends paid by the CFCs. As in Example 25, the amount of apportionable taxable income attributable to business activities conducted in state A is determined by multiplying apportionable taxable income by a fraction (the "state apportionment fraction") that compares the relative amounts of X's payroll, property, and sales within state A with X's worldwide payroll, property and sales. An analysis of state A law indicates that state A law includes in its definition of the taxable business income of X which is apportionable to X's state A activities, dividends paid to X by its subsidiaries that are in the same business as X, but are less than 50 percent owned by X ("portfolio dividends"). The dividends received by X from the 10 to 50 percent owned first- tier CFCs, therefore, are considered to be portfolio dividends includable in apportionable business income for state A tax purposes. However, the factors of these CFCs are not included in the state A apportionment fraction for purposes of apportioning income to X's activities in the state. The comparison of X's state A factors with X's worldwide factors results in a state apportionment fraction of 50 percent. Applying this fraction to apportionable taxable income of $1,100,000, as determined under state law, results in attributing 50 percent of apportionable taxable income to state A, and produces total state A taxable income of $550,000. State A imposes an income tax at a rate of 10 percent on the amount of income that is attributed to state A, which results in $55,000 of tax imposed by state A.

(ii) ALLOCATION. (A) States A, B, and C impose income taxes of $69,000 which must be allocated to the classes of gross income upon which the taxes are imposed. A portion of X's federal income tax deduction of $55,000 for state A income tax is definitely related and thus allocable to the class of gross income consisting of foreign source portfolio dividends. A definite relationship exists between a deduction for state income tax and portfolio dividends when a state includes portfolio dividends in state taxable income apportionable to the state, but determines state taxable income by applying an apportionment fraction that excludes the factors of the corporations paying those dividends. By applying a state apportionment fraction that excludes factors of the corporations paying portfolio dividends to apportionable taxable income that includes the $100,000 of foreign source portfolio dividends, $50,000 (50 percent of the $100,000) of the portfolio dividends is attributed to X's activities in state A and subjected to state A income tax. Applying the state A income tax rate of 10 percent to the $50,000 of foreign source portfolio dividends subjected to state A income tax, $5,000 of X's $55,000 total state A income tax liability is definitely related and allocable to a class of gross income consisting of the foreign source portfolio dividends. Since under the look-through rules of section 904(d)(3) the foreign source portfolio dividends from the first-tier CFCs are included within the general limitation described in section 904(d)(1)(I), the $5,000 of state A tax on foreign source portfolio dividends is allocated entirely to foreign source general limitation income and, therefore, is not apportioned. (If the total amount of state A tax imposed on foreign source portfolio dividends were to exceed the actual amount of X's state A income tax liability (for example, due to net operating losses), the actual amount of state A tax would be allocated entirely to those foreign source portfolio dividends.) After allocation of a portion of the state A tax to portfolio dividends, $50,000 ($55,000 - $5,000) of state A tax remains to be allocated.

(B) A total of $64,000 (the aggregate of the $50,000 remaining state A tax, and the $10,000 and $4,000 of taxes imposed by states B and C, respectively) is to be allocated (as provided in Example 25) by comparing U.S. source taxable income (as determined under the Code) with the aggregate of the state taxable incomes determined by states A, B, and C (after reducing state apportionable taxable incomes by the amount of any portfolio dividends included in apportionable taxable income to which tax has been specifically allocated). X's state A taxable income, after reduction by the $50,000 of portfolio dividends taxed by state A, equals $500,000. X also has taxable income of $200,000 and $200,000 in states B and C, respectively. In the aggregate, therefore, states A, B, and C tax $900,000 of X's income, after excluding state taxable income attributable to portfolio dividends. Since X has only $800,000 of U.S. source taxable income for federal income tax purposes, it is presumed that state income taxes are imposed on $100,000 of foreign source income. The remaining deduction of $64,000 for state income taxes is therefore related and allocable to both foreign source and domestic source income and is subject to apportionment.

(iii) APPORTIONMENT. For purposes of computing the foreign tax credit limitation, X's income is comprised of one statutory grouping, foreign source general limitation income, and one residual grouping, gross income from sources within the United States. The remaining state income tax deduction of $64,000 must be apportioned between these two groupings on the basis of relative amounts of foreign source general limitation taxable income and U.S. source taxable income subject to state taxation. In this case, the $64,000 of state income taxes is considered to be imposed on $800,000 of domestic source income and $100,000 of foreign source general limitation income and is apportioned as follows:

     State income tax deduction

EXAMPLE 29 -- INCOME TAXES -- (i) FACTS. (A) P, a domestic corporation, is a manufacturer and distributor of electronic equipment with operations in states F, G, and H. P also has a branch in country Y which manufactures and distributes the same type of electronic equipment. In addition, P has three wholly owned subsidiaries, US1, US2, and FS, the latter a controlled foreign corporation ("CFC") as defined in section 957(a) of the Code. P also owns stock representing 10 to 50 percent of the vote and value of various other first-tier CFCs that derive exclusively foreign source general limitation income.

(B) In 1988, P derives $1,000,000 of federal taxable income (without taking into account the deduction for state income taxes), which consists of $250,000 of foreign source general limitation income and $750,000 of U.S. source income. The foreign source general limitation income consists of a $25,000 subpart F inclusion with respect to FS, $150,000 of dividends from the other first-tier CFCs deriving exclusively foreign source general limitation income, in which P owns stock representing 10 to 50 percent of the vote and value, and $75,000 of manufacturing and sales income derived by P's U.S. operations and country Y branch. The $750,000 of U.S. source income consists of manufacturing and sales income derived by P's U.S. operations.

(C) For federal income tax purposes, US1 derives $75,000 of taxable income, before deduction for state income taxes, which consists entirely of U.S. source income. US2, a so-called "80/20" corporation described in section 861(c)(1), derives $250,000 of federal taxable income before deduction for state or foreign income taxes, all of which is derived from foreign operations and consists entirely of foreign source general limitation income. FS is not engaged in a U.S. trade or business and derives $550,000 of foreign source general limitation income before deduction for foreign income taxes.

(D) State F imposes a corporate income tax of 10 percent on P's state F taxable income, which is determined by formulary apportionment of the total taxable income attributable to P's worldwide unitary business. State F determines P's taxable income for state F tax purposes by first making adjustments to the taxable income, as determined for federal income tax purposes, of the members of the unitary business group to determine the total taxable income of the group. State F then computes P's state taxable income by attributing a portion of that unitary business taxable income to activities of P that are conducted in state F. State F does this by multiplying the unitary business taxable income (federal taxable income with state adjustments) by a fraction (the "state apportionment fraction") that compares the relative amounts of the unitary business group's payroll, property, and sales (the "factors") in state F with the payroll, property, and sales of the unitary business group. P is the only member of its unitary business group that has state F factors and that is thereby subject to state F income tax and filing requirements. State F defines the unitary business group to include any corporation more than 50 percent of which is directly or indirectly owned by a state F taxpayer and is engaged in the same unitary business. P's unitary business group, therefore, includes P, US1, US2, and FS, but does not include the 10 to 50 percent owned CFCs. The income of the unitary business group excludes intercompany dividends between members of the unitary business group and subpart F inclusions with respect to a member of the unitary business group. Dividends paid from nonmembers of the unitary group (the 10 to 50 percent owned CFCs) for state F tax purposes are referred to as "portfolio dividends" and are included in taxable income of the unitary business. None of the factors (in state F or worldwide) of the corporations paying portfolio dividends are included in the state F apportionment fraction for purposes of apportioning total taxable income of the unitary business to P's state F activities.

(E) After state adjustments to the taxable income of the unitary business group, as determined under federal tax principles, the total taxable income of P's unitary business group equals $2,000,000, consisting of $1,050,000 of P's income ($100,000 of foreign source manufacturing and sales income, $150,000 of foreign source portfolio dividends, and $800,000 of U.S. source manufacturing and sales income, but excluding the $25,000 subpart F inclusion attributable to FS since FS is a member of the unitary business group), $100,000 of US1's income (from sales made in the United States), $275,000 of US2's income (from an active business outside the United States), and $575,000 of FS's income. The differences between taxable income under federal tax principles and state F apportionable taxable income for P, US1, US2, and FS represent adjustments to taxable income under federal tax principles that are made pursuant to the tax laws of state F.

(F) The taxable income for each member of the unitary business group under federal tax principles and state law principles is summarized in the following table. (The items of income listed in the "Federal" column of the table refer to taxable income before deduction for state income tax.)

                                        Federal        State F

(ii) ALLOCATION. (A) P's deduction of $71,000 for state income taxes is definitely related and allocable to the gross income with respect to which the taxes are imposed. Adjustments may be necessary, however, before aggregate state taxable incomes can be compared with U.S. source taxable income on the federal income tax return in the manner described in Examples 25 and 26. In allocating P's deduction for state income taxes, it is necessary first to determine the portion, if any, of the deduction that is definitely related and allocable to a particular class of gross income. A definite relationship exists between a deduction for state income tax and dividend income when a state includes portfolio dividends in state taxable income apportionable to the taxpayer's activities in the state, but determines state taxable income by applying an apportionment formula that excludes the factors of the corporations paying portfolio dividends.

(B) In this case, $150,000 of foreign source portfolio dividends are subject to a state F apportionment fraction of 25 percent, which results in a total of $37,500 of state F taxable income attributable to such dividends. As illustrated in Example 28, $3,750 ($150,000 x 25 percent state F apportionment percentage x 10 percent state F tax rate) of P's state F income tax is definitely related and allocable to a class of gross income consisting entirely of the foreign source portfolio dividends. Since under the look-through rules of section 904(d)(3) the foreign source portfolio dividends paid by first- tier CFCs are included within the general limitation described in section 904(d)(1)(I), the $3,750 of state F tax on foreign source portfolio dividends is allocated entirely to foreign source general limitation income and, therefore, is not apportioned.

(C) After reducing state F taxable income of the unitary business group by the taxable income attributable to portfolio dividends, P's remaining state F taxable income equals $462,500 ($500,000 - $37,500), the portion of the taxable income of the unitary business that state F attributes to P's activities in state F. Accordingly, in order to allocate and apportion the remaining $46,250 of state F tax ($50,000 of state F tax minus the $3,750 of state F tax allocated to foreign source portfolio dividends), it is necessary first to determine if state F is taxing only P's non-unitary taxable income (as defined below) or is imposing its tax partly on other unitary business income that is attributed under state F law to P's activities in state F. P's state F non-unitary taxable income is computed by applying the state F apportionment formula, solely on the basis of P's income (excluding portfolio dividends) and state F apportionment factors. If the state F taxable income (after reduction by the portfolio dividends attributed to state F) attributed to P under state F law exceeds P's non-unitary taxable income, a portion of the state F tax must be allocated and apportioned on the basis of the other unitary business income that is attributed to and taxable to P under state F law. If P's non-unitary taxable income equals or exceeds the $462,500 of remaining state F taxable income, it is presumed that state F is only taxing P's non-unitary taxable income, so that the entire amount of the remaining state F tax should be allocated and apportioned in the manner described in Example 25.

(D) If P's non-unitary taxable income is less than the $462,500 of remaining state F taxable income (after reduction for the $37,500 of state F taxable income attributable to portfolio dividends), it is presumed that state F is attributing to P, and taxing P upon, other unitary business income. In such a case, it is necessary to determine if state F is attributing to P, and imposing its income tax on, a part of the foreign source income that would be generally presumed under separate accounting to be the income of foreign affiliates and 80/20 companies included in the unitary group, or whether state F is limiting the income it attributes to P, and its taxation of P, to the U.S. source income that would be generally presumed under separate accounting to be the income of domestic members of the unitary group.

(E) Assume for purposes of this example that the non- unitary taxable income attributable to P equals $396,000, computed by multiplying P's state F taxable income of $900,000 (P's state F taxable income (before state F apportionment) of $1,050,000 less the $150,000 of foreign source portfolio dividends) by P's non-unitary state F apportionment fraction, which is assumed to be 44 percent. Because P's non-unitary taxable income of $396,000 is less than the $462,500 of remaining state F taxable income, state F is presumed to be attributing to P and taxing the income that would have been generally attributed under separate accounting to P's affiliates in the unitary group. To determine if state F tax is being imposed on members of the unitary group (other than P) that produce foreign source income, it is necessary to compute a hypothetical state F taxable income for all companies in the unitary group with significant U.S. operations. (For this purpose, the hypothetical group of companies with significant domestic operations is referred to as the "water's edge group.") State F is presumed to be attributing to P and taxing income that would have been generally attributable under separate accounting to foreign corporations and 80/20 companies to the extent that the remaining state F taxable income ($462,500) of P exceeds the hypothetical state F taxable income that would have been attributed under state F law to P if state F had defined the unitary group to be the water's edge group.

(F) The members of the water's edge group would have been P and US1. The unitary business income of this water's edge group is $1,000,000, the sum of $900,000 (P's state F taxable income (before state F apportionment) of $1,050,000 less the $150,000 of foreign source portfolio dividends) and $100,000 (US1's state F taxable income). For purposes of this example, the state F apportionment fraction determined on a unitary basis for this water's edge group is assumed to equal 40 percent, the average of P and US1's state F payroll, property, and sales factor ratios (the water's edge group's state F factors over its worldwide factors). Applying this apportionment fraction to the $1,000,000 of unitary business income of the water's edge group yields state F water's edge taxable income of $400,000. The excess of the remaining $462,500 of P's state F taxable income over the $400,000 of P's state F water's edge taxable income equals $62,500, and is attributable to the inclusion of US2 and FS in the unitary group. The state F tax attributable to the $62,500 of taxable income attributed to P under state F law, and that would have generally been attributed to US2 and FS under non-unitary accounting, equals $6,250 and is allocated entirely to a class of gross income consisting of foreign source general limitation income, because the income of FS and US2 consists entirely of such income. After the $6,250 of state F tax attributable to US2 and FS is subtracted from the remaining $46,250 of net state F tax, P has $40,000 of state F tax remaining to be allocated and apportioned.

(G) To the extent that the remainder of P's state F taxable income ($400,000) exceeds P's non-unitary state F taxable income ($396,000), it is presumed that state F is attributing to and imposing on P a tax on U.S. source income that would have been attributed under separate accounting to members of the water's edge group other than P. In these facts, the $4,000 difference in P's state F taxable income results from the inclusion of US1 in the unitary group. The $400 of P's state F tax attributable to this $4,000 is allocated entirely to P's U.S. source income. P's remaining $39,600 of state F tax ($40,000 of P's state F tax resulting from the attribution to P of income that would have been attributed under non-unitary accounting to other members of the water's edge group, minus $400 of state F tax attributable to US1 and allocated to P's U.S. source income) is the state F tax attributable to P's non-unitary state F taxable income that is to be allocated and apportioned together with P's state G tax of $15,000 and state H tax of $6,000 as illustrated in Example 25.

(H) In allocating the $60,600 of state tax liabilities ($39,600 state F tax attributable to P's non-unitary state F income + $15,000 state G tax + $6,000 state H tax) under Example 25, P's state taxable income in state G and state H ($300,000 + $300,000) must be added to P's non-unitary state F taxable income ($396,000). The resulting $996,000 of combined state taxable incomes is compared with $750,000 of U.S. source income on P's federal income tax return. Because P's combined state taxable incomes exceeds P's federal U.S. source taxable income, it is presumed that the remaining $60,600 of P's total state income taxes is imposed in part on foreign source income. Accordingly, P's remaining deduction of $60,600 ($39,600 + $15,000 + $6,000) for state income taxes is related and allocable to both P's foreign source and domestic source income and is subject to apportionment.

(iii) APPORTIONMENT. The $60,600 of state taxes (the remaining $39,600 of state F tax + $15,000 of state G tax + $6,000 of state H tax) must be apportioned between foreign source general limitation income and U.S. source income for federal income tax purposes. This apportionment is based upon the relative amounts of foreign source general limitation taxable income and U.S. source taxable income comprising the $996,000 of income subject to tax by the states, after reducing the total amount of income subject to tax by the portfolio dividends and the income attributed to P under state F law that would have been attributed under arm's length principles to other members of P's state F unitary business group. The deduction for the $60,600 of state income taxes is apportioned as follows:

     State income tax deduction

EXAMPLE 30 -- INCOME TAXES -- (i) FACTS. (A) As in Example 17 of section 1.861-8(g), X is a domestic corporation that wholly owns M, N, and O, also domestic corporations. X, M, N, and O file a consolidated income tax return. All the income of X and O is from sources within the United States, all of M's income is from sources within South America, and all of N's income is from sources within Africa. X receives no dividends from M, N, or O. During the taxable year, the consolidated group of corporations earned consolidated gross income of $550,000 and incurred total deductions of $370,000. X has gross income of $100,000 and deductions of $50,000, without regard to its deduction for state income tax. Of the $50,000 of deductions incurred by X, $15,000 relates to X's ownership of M; $10,000 relates to X's ownership of N; $5,000 relates to X's ownership of O; and the entire $30,000 constitutes stewardship expenses. The remainder of X's $20,000 of deductions (which is assumed not to include state income tax) relates to production of income from its plant in the United States. M has gross income of $250,000 and deductions of $100,000, which yield foreign source taxable income of $150,000. N has gross income of $150,000 and deductions of $200,000, which yield a foreign source loss of $50,000. O has gross income of $50,000 and deductions of $20,000, which yield U.S. source taxable income of $30,000.

(B) Unlike Example 17 of section 1.861-8(g), however, X also has a deduction of $1,800 for state A income taxes. X's state A taxable income is computed by first making adjustments to the federal taxable income of X to derive apportionable taxable income for state A tax purposes. An analysis of state A law indicates that state A law also includes in its definition of the taxable business income of X which is apportionable to X's state A activities, the taxable income of M, N, and O, which is related to X's business. As in Example 25, the amount of apportionable taxable income attributable to business activities conducted in state A is determined by multiplying apportionable taxable income by a fraction (the "state apportionment fraction") that compares the relative amounts of payroll, property, and sales within state A with worldwide payroll, property and sales. Assuming that X's apportionable taxable income equals $180,000, $100,000 of which is from sources without the United States, and $80,000 is from sources within the United States, and that the state apportionment fraction is equal to 10 percent, X has state A taxable income of $18,000. The state A income tax of $1,800 is then derived by applying the state A income tax rate of 10 percent to the $18,000 of state A taxable income.

(ii) ALLOCATION AND APPORTIONMENT. In accordance with section 1.1502-4, each corporation must first compute its separate taxable income for purposes of computing the consolidated limitation on the foreign tax credit. Assume that under Example 29, it is determined that X's deduction for state A income tax is definitely related to a class of gross income consisting of income from sources both within and without the United States, and that the state A tax is apportioned $1,000 to sources without the United States, and $800 to sources within the United States. Under Example 17, without regard to the deduction for X's state A income tax, X has a separate loss of ($25,000) from sources without the United States. After taking into account the deduction for state A income tax, X's separate loss from sources without the United States is increased by the $1,000 state A tax apportioned to sources without the United States, and equals a loss of ($26,000), for purposes of computing the numerator of the consolidated foreign tax credit limitation.

EXAMPLE 31 -- INCOME TAXES -- (i) FACTS. Assume that the facts are the same as in Example 29, except that state G requires P to adjust its federal taxable income by depreciating an asset at a different rate than is allowed P under the Internal Revenue Code for the same asset. Before using the methodology of Example 25 to determine whether a portion of its deduction for state income taxes is allocable to a class of gross income that includes foreign source income, P recomputes its taxable income under state G law by using the rate of depreciation that it is entitled to use under the Code, and uses this recomputed amount in applying the methodology of Example 25.

(ii) ALLOCATION. P's modification of its state G taxable income is permissible. Under the methodology of Example 25, this modification of state G taxable income will produce a reasonable determination of the portion (if any) of P's state income taxes that is allocable to a class of gross income that includes foreign source income.

EXAMPLE 32 -- INCOME TAXES -- (i) FACTS. Assume the facts are the same as Example 29, except that P's state F taxable income differs from the amount of its U.S. source income under federal income tax principles solely because state F determines P's state taxable income under a worldwide unitary business theory instead of the arm's length principles applied in the Code. Before using the methodology of Example 25 to determine whether a portion of its deduction for state income taxes is allocable to a class of gross income that includes foreign source income, P recomputes state F taxable income under the arm's length principles applied in the Code. P substitutes that recomputed amount for the amount of taxable income actually determined under state F law in applying the methodology of Example 25.

(ii) ALLOCATION. P's modification of state F taxable income does not accurately reflect the factual relationship between the deduction for state F income tax and the income on which the tax is imposed, because there is no factual relationship between the state F income tax and the state F taxable income as recomputed under Code principles. State F does not impose its income tax upon P's income as it might have been defined under the Internal Revenue Code. Consequently, P's modification of state F taxable income is impermissible because it will not produce a reasonable determination of the portion (if any) of P's state income taxes that is allocable to a class of gross income that includes foreign source income.

EXAMPLE 33 -- INCOME TAXES -- (i) FACTS. Assume the same facts as in Example 29, except that state G does not impose an income tax on corporations. Thus only $56,000 of state income taxes ($50,000 of state F income tax and $6,000 of state H income tax) are deductible and required to be allocated and (if necessary) apportioned. As in Example 29, P has $800,000 of aggregate state taxable income ($500,000 of state F taxable income and $300,000 of state H taxable income).

(ii) METHOD ONE. Assume that P has elected to allocate and apportion its deduction for state income tax under the safe harbor method provided in section 1.861-8(e)(6)(ii)(D)(2) ("Method One").

(A) STEP ONE -- SPECIFIC ALLOCATION TO FOREIGN SOURCE PORTFOLIO DIVIDENDS. P applies the methodology of paragraph (ii) of Example 28 to determine the portion of the deduction that must be allocated to a class of gross income consisting solely of foreign source portfolio dividends. As illustrated in paragraphs (ii)(A) and (B) of Example 29, $3,750 of the deduction for state F income tax is attributable to the $37,500 of foreign source portfolio dividends attributed under state F law to P's activities in state F. Thus $3,750 of P's deduction for state income tax must be specifically allocated to a class of gross income consisting solely of $37,500 of foreign source portfolio dividends. No apportionment of the $3,750 is necessary. P's adjusted state taxable income is $762,500 (aggregate state taxable income of $800,000 reduced by $37,500 of foreign source portfolio dividends).

(B) STEP TWO -- ADJUSTMENT OF U.S. SOURCE FEDERAL TAXABLE INCOME. P applies the methodology illustrated in paragraph (ii) of Example 27 (including the rules of UDITPA described therein) to determine the amount of its federal taxable income attributable to its activities in state G. Assume that P determines under this methodology that $300,000 of its federal taxable income is attributable to activities in state G. P's adjusted U.S. source federal taxable income equals $450,000 ($750,000 minus the $300,000 attributed to P's activities in state G).

(C) STEP THREE -- ALLOCATION. The portion of P's deduction for state income tax remaining to be allocated equals $52,250 ($56,000 minus the $3,750 specifically allocated to foreign source portfolio dividends). P allocates this portion by applying the methodology illustrated in paragraph (ii) of Example 25, as modified by paragraph (e)(6)(ii)(D)(2)(iii) of this section. Thus, P compares its adjusted state taxable income (as determined under Step One in paragraph (A) above) with an amount equal to 110% of its adjusted U.S. source federal taxable income (as determined under Step Two in paragraph (B) above). Because P's adjusted state taxable income ($762,500) exceeds 110% of P's adjusted U.S. source federal taxable income ($495,000, or 110% of $450,000), the remaining portion of P's deduction for state income tax ($52,500) must be allocated to a class of gross income that includes both U.S. and foreign source income.

(D) STEP FOUR -- APPORTIONMENT. P must apportion to U.S. source income the portion of the deduction that is attributable to state income tax imposed upon state taxable income in an amount equal to 110% of P's adjusted U.S. source federal taxable income. The remainder of the deduction must be apportioned to foreign source general limitation income.

     Amount of deduction to

(A) STEP ONE -- SPECIFIC ALLOCATION. Step One of Method Two is the same as Step One of Method One. Therefore, as described in paragraph (A) of paragraph (ii) above, $3,750 of P's deduction for state income tax must be specifically allocated to a class of gross income consisting solely of $37,500 of foreign source portfolio dividends. No apportionment of the $3,750 is necessary. P's adjusted state taxable income is $762,500 (aggregate state taxable income of $800,000 reduced by $37,500 of foreign source portfolio dividends).

(B) STEP TWO -- ADJUSTMENT OF U.S. SOURCE FEDERAL TAXABLE INCOME. Step Two of Method Two is the same as Step Two of Method One. Therefore, as described in paragraph (B) of paragraph (ii) above, assume that P determines that $300,000 of its federal taxable income is attributable to activities in state G. P's adjusted U.S. source federal taxable income equals $450,000 ($750,000 minus the $300,000 attributed to P's activities in state G).

(C) STEP THREE -- ALLOCATION. The portion of P's deduction for state income tax remaining to be allocated equals $52,250 ($56,000 minus the $3,750 of state F income tax specifically allocated to foreign source portfolio dividends). P allocates this portion by applying the methodology illustrated in paragraph (ii) of Example 25, as modified by paragraph (e)(6)(ii)(D)(3)(iii) of this section. Thus, P compares its adjusted state taxable income (as determined under Step One in paragraph (A) above) with its adjusted U.S. source federal taxable income (as determined under Step Two in paragraph (B) above). Because P's adjusted state taxable income ($762,500) exceeds P's adjusted U.S. source federal taxable income ($450,000), the remaining portion of P's deduction for state income tax ($52,500) must be allocated to a class of gross income that includes both U.S. and foreign source income.

(D) STEP FOUR -- APPORTIONMENT. P must apportion to U.S. source income the portion of the deduction that is attributable to state income tax imposed upon state taxable income in an amount equal to P's adjusted U.S. source federal taxable income.

     Amount of deduction to

     Portion of remainder

PART 602 -- OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT

Par. 4. The authority for part 602 continues to read as follows:

Authority: 26 U.S.C. 7805.

Par. 5. Section 602.101(c) is amended by adding in the appropriate place in the table: "1.861-8(e)(6) and (g) 1545-1224."

Fred T. Goldberg, Jr.