Implications Of The Selection Of A Method To Allocate State Income Taxes In Order To Determine Net Foreign-Source Income

Abstract

Internal Revenue Code Sections 861-864 determine the source of income and Sections 861(a) and 862(a) specifically allocate certain items of gross income to sources within or without the United States.  Sections 861(b) and 862(b) state generally how to determine taxable income for a taxpayer with income sources within or without the United States after such source has been determined. Regulation § 1.861-8 provides more information on allocating state and local taxes to U.S. - and foreign-source income.  Regulation § 1.861-8 is based on the factual relationship of deductions to gross income test.  This Regulation provides a concise rule requiring that the deduction for state, local, and foreign income, war profits, and excess profits taxes under Section 164 are definitely related and allocable to the gross income with respect to which such taxes are imposed. Under Regulation § 1.861(e)(6) if foreign-source of a corporation related by ownership to a corporate taxpayer is attributed to the activities conducted by the taxpayer in a state and is subject to state income tax, as in a state unitary income tax, the state tax deduction is allocable to the foreign-source income of the related corporation for purposes of the foreign tax credit used § 904.  This paper first considers the most common methods for allocating state income taxes, the presumptive, analytic, and state-by-state methods.  In the Chevron case, the Tax Court was asked to consider whether any of the following methods comply with the regulations; these methods are the gross income, factor operations, statutory notice, the pro rata, and the example methods.  This paper will also consider the requirements and validity of related regulations.