Making sense of fair market value elections for foreign income

By Admin

January 16, 2018

U.S. multinational corporations should scrutinize how they report foreign source income.

A recognized foreign tax credit planning technique employed by U.S. multinational corporations is to elect to apportion interest expense by reference to fair market value rather than the tax book value of assets that generate U.S. and foreign source income (known as a “fair market value election”). A fair market value election is made under Treasury Regulations §1.861-9T(g) and prevents unintentional skewing of interest expense to foreign source income where the economic value of the U.S. income-producing assets is not fully reflected in the allocation and apportionment exercise.

These elections likely make sense for companies with foreign operations, a high level of interest expense that could potentially qualify for an excess foreign tax credit or could benefit from additional foreign source net taxable income. They make sense if the fair market value of U.S. tangible assets, as a percentage of total assets, is greater than the tax basis of those assets. Those with substantial intangible asset values may also benefit.

In cases where companies are expanding outside the U.S. and the expansion is reflected in newly created book and tax balance sheets, these newly created balance sheets would show higher values relative to the historical book and tax balance sheets reflecting U.S. business assets. The fair market value election is designed to adjust the relative values of the U.S. and foreign assets to reflect their real economic income producing value to the worldwide enterprise.

However, the allocation of interest expense to foreign source taxable income can be complex. These fair market value elections and the values that drive the apportionment of foreign source income must be supported and well documented to avoid IRS scrutiny. When making fair market value elections, keep in mind the following:

• To support the election, the assets must be measured at fair market value. This premise of value assumes the assets will continue in their present use as part of an ongoing business enterprise. Assets that must be valued consist of the tangible and non-tangible assets of the company. All other current and non-current assets and liabilities, as well as any investments, are valued at net book value.

• The valuation approaches used to determine the fair market value of assets include the cost, market and income approaches to value. Each approach is applied based on the nature of the underlying asset being valued.

• The fair market value of the tangible assets of the company—including current assets, real estate and machinery and equipment—is conducted in conformance with generally accepted valuation techniques. In performing the valuation, assets may be combined into reasonable groupings. Value conclusions are provided on a total foreign and total domestic basis only as to not conflict with any other more specific locational tax filings. The fair market value of other assets and liabilities is based upon discussions with management as to the reasonableness of their book amounts. Adjustments are made, as appropriate, based upon these discussions. Investments are treated similarly.

• Intangible asset values are calculated by applying the guidance of Treasury Regulation §1.862-9T. The aggregate value will be determined by estimating the company’s and subsidiaries’ business enterprise value. The total value of net tangible assets is subtracted from the aggregate value resulting in value for intangible assets.

Once all assets are valued, the apportionment percentages for foreign and domestic will be calculated in a manner consistent with the interest apportionment calculation with the guidance of Treasury Regulation §1.861-9T, which provides for the apportionment of interest expense to statutory groupings based on the average value of assets in each grouping for the year. The foreign interest apportionment percentage is calculated by dividing the average net foreign asset value by the average total worldwide asset value.

Completing fair market value elections requires a multi-disciplinary valuation approach and coordination between fixed assets, real estate and financial assets to create the schedule of assets. It is a recognized foreign tax planning technique that takes into account fair market value rather than the tax book value.