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In a new generic legal advice memorandum (new GLAM), the IRS Office of Chief Counsel (AM 2022-001) addressed how to properly allocate and apportion amounts it calls "deferred compensation expense" (DCE) under the IRC Section 861 regulations for calculating a taxpayer's deduction for foreign-derived intangible income (FDII). Reversing previous guidance, the IRS asserted that so-called DCE deductions should be allocated to FDII for the tax years in which the compensation becomes deductible under federal income tax accounting principles, even if the compensation is based on employees' service in years before FDII became effective.

Background

IRC Section 250

IRC Section 250, which creates FDII, was enacted by the Tax Cuts and Jobs Act (TCJA) and effective beginning in 2018. A domestic corporation calculates its FDII for a tax year under a complex formula. The corporation's deemed intangible income (DII) is multiplied by a fraction, the numerator of which is the corporation's foreign-derived deduction-eligible income (FDDEI) and the denominator of which is the corporation's deduction-eligible income (DEI). Generally, the corporation's DEI is the excess, if any, of its gross income (excluding certain amounts, such as its foreign branch income, and its subpart F and GILTI inclusions) over properly allocable deductions. FDDEI is the portion of DEI that derives from (1) property sold to any non-US person for foreign use; or (2) services provided to a person, or with respect to property, located outside the US.

The IRC Section 250 regulations allocate and apportion deductions to statutory categories of gross income under the IRC Section 861 regulations. For purposes of IRC Section 250, the statutory categories generally are (1) gross FDDEI, (2) gross RDEI (defined in the regulations as income that is DEI but not FDDEI), and (3) the residual category in non-DEI.

Prior guidance

In GLAM 2009-001 (2009 GLAM) and CCA 201714029 (2017 CCA), the IRS addressed the allocation of deductions that related to activities occurring before IRC Section 199's enactment but accrued following enactment (prior period expenses). The 2009 GLAM involved deductions for deferred compensation and the 2017 CCA involved deductions of certain litigation expenses.

To the extent the deductions factually related to gross income accruing before IRC Section 199's enactment, the IRS concluded the deductions would be allocated/apportioned under IRC Section 861 to statutory and residual groupings of gross income based on the statutory groupings that existed before IRC Section 199's enactment; they would not be based on the statutory groupings that existed in the year that the deductions accrued following enactment. As a consequence, to the extent the deductions factually related to gross income accruing before IRC Section 199's enactment, the deductions would not be allocated/apportioned to IRC Section 199 "domestic production gross receipts" because IRC Section 199 did not exist when the related gross income accrued.

Nothing in the GLAM or CCA suggested that the analysis was specific to IRC Section 199. Rather, the analysis in the GLAM and CCA interpreted Treas. Reg. Section 1.861-8.

In 2020, the Treasury Department issued regulations that included a new provision, Treas. Reg. Section 1.861-8(e)(5)(ii), which addresses the allocation/apportionment of deductions for litigation damages. The provision apportions deductions among statutory and residual groupings based on "the relative amounts of gross income in the relevant class in each grouping in the year in which the deductions are allowed." Example 17, which illustrates how to apply Treas. Reg. Section 1.861-8(e)(5)(ii), apportions a post-TCJA payment for litigation damages for events preceding the TCJA to the branch basket (the applicable statutory category post-TCJA), not the general basket (the applicable statutory category pre-TCJA), for purposes of the IRC Section 904 foreign tax credit limitation.

This apportionment method is consistent with the method in the new GLAM and is inconsistent with the method in the 2009 GLAM and 2017 CCA.

Fact pattern

In the new GLAM, Corporation X has compensated its employees since 2014 with stock-settled restricted stock units that cliff vest after four years of continuous service. On these facts, Corporation X's deduction for the related expense arises in the year the stock vests and is delivered. Consistent with the analysis in the 2009 GLAM, Corporation X allocates and apportions the deduction for restricted stock units relating to periods of employee services in tax years before the enactment of IRC Section 250 to non-DEI because IRC Section 250 did not exist in those years.

IRS conclusions

Even though DCE may relate to gross income from a previous tax year, the IRS concluded that "it must be allocated to a class of gross income, and apportioned based upon the relevant grouping or groupings within the class that exists in the taxable year the deductions are taken into account under generally applicable federal income tax accounting rules."

Because the DCE belongs to a class of gross income in 2018 consisting of FDDEI, RDEI and non-DEI, the IRS continued, Corporation X must apportion the deductions between those statutory and residual groupings of gross income in that year. "The fact that the service period to which compensation expense is relevant straddles the effective date of [IRC S]ection 250 does not permit a taxpayer to depart from the normal rule that the deduction for such expense must be allocated to (and apportioned to groupings within) the class of gross income for the taxable year in which the deduction may be claimed. By claiming the DCE expense may be allocated solely against residual income rather than apportioned, Corporation X is in effect attempting to apply the federal income tax law of an earlier period to such expense, with resulting distortion of the amount of FDDEI."

The IRS stated that the GLAM reflects "the reconsidered advice" of the Office of Associate Chief Counsel International and that GLAM 2009-001 is obsolete.

Implications

The new GLAM will likely surprise many taxpayers, as it reverses the 2009 GLAM's longstanding guidance on the treatment of prior period expenses related to DCE. Treas. Reg. Section 1.861-8(e)(5)(ii), issued in 2020, sets forth an allocation method consistent with the analysis in the new GLAM. This provision, however, applies only to litigation damages. The regulation does not expressly address the treatment of other types of prior period expenses.

The analysis in the new GLAM applies not only to restricted stock units, but also to other types of DCE, such as stock options and pensions. Moreover, the GLAM notes that the analysis "may apply to deductions other than compensation that may be seen as relating to an earlier period, such as a warranty payment resulting in a deduction allowable in 2018 that was incurred in respect of a product sold in an earlier year."

The GLAM's implications are not limited to FDII. Consistent with Treas. Reg. Section 1.861-8(e)(5)(ii), the analysis in the GLAM may apply to prior period expenses for purposes of the IRC Section 904 foreign credit limitation.

On the other hand, the new GLAM has no implications for what is treated as deferred compensation for purposes of federal income tax accounting rules. Despite the new GLAM's use of labels such as "deferred compensation," "deferred compensation expense" and "DCE," the form of compensation specifically addressed in the new GLAM generally would not be treated as deferred compensation under domestic tax rules, such as IRC Sections 404, 409A, or 3121(v)(2).

The new GLAM is not entitled to judicial deference, but merely reflects the position of IRS counsel. Taxpayers should, nevertheless, assess the implications of the new GLAM for IRC Section 861 allocation positions that they have taken, or are considering taking, for the treatment of prior period expenses.

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