United States

New regulations flexible on tax deduction limit calculation methods

TAX ALERT  | 

The Tax Code’s rules allow deductions for various amounts that are to be computed with reference to the taxpayer’s taxable income. Recently-issued final regulations permit taxpayers to use simultaneous equations, rather than a multi-step tentative and final sum procedure, to calculate certain of these deduction amounts. These recent regulations also broadly address foreign-derived intangible income (FDII) and global intangible low-taxed income (GILTI), and we discuss them in our Alert Treasury and IRS issue final rules on FDII and GILTI deductions. This Alert focuses on one aspect only – the permission provided to taxpayers to perform certain deduction calculations in any reasonable manner. 

Tax deduction amounts that vary based on taxable income computed in interdependent calculations 

The section 250 deduction is meant to reduce the effective tax rate imposed on FDII and GILTI for certain taxpayers, generally corporations. The section 250 deduction is subject to a taxable income limitation. The net operating loss (NOL) rules under section 172 and the business interest expense limitation of section 163(j) similarly limit deductions based on a corporation’s taxable income in certain circumstances. 

Where more than one of these sets of tax rules apply, they raise the issue of whether the allowed deduction amounts should be computed using simultaneous equations (a Simultaneous Equation Approach), or whether they should be computed instead in a sequence of steps following a particular order, with each earlier computation driving the latter (a Set Sequence Approach). Under the final regulations, either approach is permissible, provided that taxpayer’s implementation represents a reasonable method.  

Proposed regulations’ Set Sequence Approach

Treasury and the IRS previously issued proposed regulations that would have required a Set Sequence Approach, as discussed in our previous Alert Proposed ordering rules for GILTI, FDII, NOL, 163(j) deductions.1

Final regulations’ flexibility

In the preamble to the Final Regulations, Treasury and the IRS acknowledged public comments received regarding the proposed ordering rules requesting authorization of a Simultaneous Equation Approach, as well as some comments expressing concern with requiring a Simultaneous Equation Approach. Treasury and the IRS concluded that further study would be required to definitively determine how to appropriately calculate the section 250 deductions in coordination with other tax deduction amounts calculated in whole or in part with regard to taxable income. 

Treasury and the IRS therefore decided to permit taxpayers to apply any reasonable method, including the Set Sequence Approach set out in the proposed regulations or a Simultaneous Equations Approach, if such method is applied consistently for all taxable years beginning on or after Jan. 1, 2021. 

Takeaway

The final GILTI and FDII regulations provide some additional flexibility to taxpayers in calculating their section 250 deduction in conjunction with section 163(j) interest deduction limitation and net operating loss deduction rules under section 172. Given the general complexity of these rules, taxpayers should consult with their tax advisors when applying them. 

 

The proposed Set Sequence Approach was set out in the proposed regulations their preamble and in an example. It involved a five-step sequence of calculations: 

  1. Compute the tentative amount of the FDII and section 250 deduction (Tentative Section 250 Deduction) taking into account all deductions except (i) section 163(j) interest deduction carryforwards or disallowances and (ii) section 172 NOL deductions.
  2. Compute the section 163(j) interest deduction, taking into account the amount of the Tentative Section 250 Deduction, but without regard to any section 172 NOL deductions.
  3. Compute the section 172 NOL deduction, taking into account the section 163(j) interest deduction, but without regard to the section 250 deduction (or the Tentative Section 250 Deduction).
  4. Compute the FDII, taking into account the section 163(j) deduction and the section 172 NOL deduction (determined in previous steps).
  5. Compute the section 250 deduction, taking into account the section 163(j) deduction and the section 172 NOL deduction (determined in previous steps).

 Prop. Reg. section 1.250(a)-1(f)(2), Ex. 2.

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