On March 16, 2022, the Tax Court issued the full opinion in Aptargroup Inc. v. Commissioner (158 T.C. No. 4). The primary issue presented in Aptargroup Inc. v. Commissioner was whether the taxpayer was required to characterize stock in controlled foreign corporation using gross income method.

Held: Yes, indeed it was.

Aptargroup Inc. v. Commissioner in a Nutshell

Aptargroup Inc. owns stock in a controlled foreign corporation (CFC). The CFC apportioned interest expenses under the modified gross income method. Aptargroup claimed a foreign tax credit under IRC § 904 as to the tax imposed on the income from the CFC. Aptargroup characterized its stock in the CFC (in order to determine the amount of the foreign tax credit) using the asset method.

This, dear readers is the crux of the issue: Aptargroup did not use the same method that the CFC used for interest expense apportionment.

The IRS issued a notice of deficiency denying the foreign tax credit. The parties disagree that Aptargroup must use the modified gross income method to characterize the stock of its CFC to compute the foreign tax credit because the CFC used this method to apportion interest expense.

In short, the Tax Court held that Aptargroup’s position was inconsistent with the proper application of Temp. Treas. Reg. § 1.861-9T(f)(3)(iv), which requires a U.S. shareholder of a CFC to characterize the stock of the CFC using the same method that the CFC used to apportion its interest expense.

Background to Aptargroup v. Commissioner

The petitioner owned, directly or indirectly, 42 CFCs and owned stock in other non-CFCs described in IRC § 902. The petitioner transferred ownership of most foreign subsidiaries to a Luxembourg holding company, AptarGroup Global. After restructuring, the petitioner wholly owned AptarGroup Global, which, itself, wholly owned 32 CFCs. The CFCs generated foreign source income. Some also held assets that generated U.S. source income. The petitioner remained the direct owner of five CFCs.

On its 2014 return the petitioner claimed a foreign tax credit of $3.5 million. In February 2020, the IRS issued a notice of deficiency, disallowing the foreign tax credit in its entirety, determining a deficiency of $3.5 million, and determining an IRC § 6662(a) accuracy-related penalty.

The Foreign Tax Credit

The United States taxes its citizens and domestic corporations on worldwide income.^[1] Because this policy creates the potential for double taxation, the Code allows U.S. citizens and domestic corporations a credit for income tax paid to a foreign country.^[2]

A domestic corporation may also claim a credit for tax that it is deemed to have paid or accrued.^[3] The extent to which a taxpayer is entitled to a foreign tax credit is determined by applying U.S. tax law; thus, the source of income depends on how U.S. tax law categorizes such income.^[4]

The Code limits the amount of a foreign tax credit to prevent taxpayers from using foreign tax to reduce U.S. tax on their U.S. source income.^[5] The allowable foreign tax credit for a taxable year is the lesser of foreign tax paid or accrued (or so deemed) or the foreign tax credit limitation (FTC limitation).^[6]

The foreign tax credit is limited to “the same proportion of the tax against which such credit is taken which the taxpayer’s taxable income from sources without the United States…bears to his entire taxable income for the same taxable year,” and the FTC limitation is computed by multiplying total U.S. tax on worldwide income by a fraction with a numerator of foreign source taxable income and a denominator of worldwide taxable income.^[7] Generally, in the case of an affiliated group of corporations, the foreign tax credit is determined on a consolidated basis.^[8]

Where a taxpayer has more than one category of income as listed in IRC § 904(d), the FTC limitation is computed separately for each category.^[9] The FTC limitation is computed for the affiliated group.^[10] Although the petitioner earns income in more than one category, AptarGroup Global stock generates income from only one limitation category.

Sourcing Rules

To compute the FTC limitation, the taxpayer must determine the source for its gross income. The sourcing rules are in the regulations under IRC § 861, which are used in conjunction with sections such as IRC § 904 that require the taxpayer to determine taxable income from specific sources or activities. After determining the source of the gross income, the taxpayer must allocate each loss, expense, and other deduction to a class of gross income and then, if necessary, apportion the expense within the class of gross income between (or among) a statutory grouping and a residual grouping.^[11]

A statutory grouping is gross income from the specific source or activity that is relevant for purposes of the operative section at issue, and the residual grouping is gross income from all other sources or activities.^[12] For purposes of the foreign tax credit, each limitation category is a statutory grouping, and a taxpayer claiming the credit must determine the foreign source taxable income in each limitation category in which it has income.

In general, expenses are allocated and apportioned on the basis of the factual relationship of the expense to gross income.^[13] Expenses are allocated to the class of gross income to which they “definitely relate.”^[14] Next, if necessary, expenses are apportioned between the statutory and residual groupings.^[15]

Special Rules for Interest Expense

Special rules exist for allocation and apportionment of interest expense in Temp. Treas. Reg. § 1.861-9T. In general, interest expense is treated as related to all income-producing activities.^[16] Thus, interest expense must be ratably allocated to all gross income. Allocation is not at issue. The petitioner must allocate its interest expense to all its income-producing assets and activities. The parties disagree over the apportionment of the interest expense.

Treas. Reg. § 1.861-9T sets out two methods for apportioning interest: (i) the asset method,^[17] and (ii) the modified gross income method.^[18] Domestic corporations must use the asset method.^[19] CFCs are permitted to choose either method subject to certain consistency requirements.^[20]

As a domestic corporation, the petitioner apportioned its interest expense using the asset method. That method requires taxpayers to apportion interest expense to the various statutory groupings based on the average total value of assets assigned to each grouping for the year.^[21] To apply the asset method, therefore, the petitioner is required to divide the value of its assets among the relevant statutory groupings, a process the regulations define as “characterizing” the assets.^[22]

Asset Characterization

Treas. Reg. § 1.861-9T(g)(3) sets out general asset characterization rules for purposes of applying the asset method. However, the regulations also provide a special consistency rule regarding the characterization of CFC stock in the hands of any U.S. shareholder. Specifically, Treas. Reg. § 1.861-9T(f)(3)(iv) provides:

Pursuant to [Treas. Reg. 1.861-12T(c)(2)], the stock of a controlled foreign corporation shall be characterized in the hands of any United States shareholder using the same method that the controlled foreign corporation uses to apportion its interest expense.

Temp. Treas. Reg. § 1.861-12T(c)(3) describes two methods for characterizing CFC stock: (i) the asset method and (ii) the modified gross income method and imposes the same consistency rule. That rule provides that:

Stock in a controlled foreign corporation whose interest expense is apportioned on the basis of assets shall be characterized in the hands of its United States shareholders under the asset method described in paragraph (c)(3)(ii). Stock in a controlled foreign corporation whose interest expense is apportioned on the basis of gross income shall be characterized in the hands of its United States shareholders under the gross income method described in paragraph (c)(3)(iii).^[23]

AptarGroup Global elected to apportion interest expense using the gross income method, as it was entitled to do under Treas. Reg. § 1.861-9T(f)(3)(i). In characterizing its AptarGroup Global stock, the petitioner did not apply the special characterization rules of Treas. Reg. § 1.861-9T(f)(3)(iv) and Treas. Reg. § 1.861-12T(c)(3), both of which require consistency. Instead, the petitioner relied on the general characterization rules of Treas. Reg. § 1.861-9T(g)(3).

Why do this, you may ask… The petitioner made this choice so that it could reduce the amount of interest expense that it apportioned to foreign source income thereby increasing its foreign source taxable income and increasing its foreign tax credit.

The IRS argues that the petitioner is not permitted to use the general characterization rules because Treas. Reg. § 1.861-9T(f)(3)(iv) and Treas. Reg. § 1.861-12T(c)(3)(i) require consistency—which is to say, these regulations required the petitioner to characterize its stock in AptarGroup Global using the modified gross income method described in Treas. Reg. 1.861-12T(c)(3)(iii). The petitioner disagreed, arguing that Treas. Reg. § 1.861-9T(f)(3)(iv) and Treas. Reg. § 1.861-12T(c)(3)(i) do not apply, and therefore, it was free to characterize its AptarGroup Global stock howsoever it pleased, thank you very much.

Unfortunately for Aptargroup, the Tax Court heartily agreed with the IRS.

Interpretation of Regulations in the Tax Court

The Tax Court interprets regulations using canons of statutory construction, begin with the text of the regulation, and give effect to its plain meaning.^[24] To determine the plain meaning, the Tax Court looks to the text at issue as well as the text and design of the regulation.^[25] Stated differently, the Tax Court interprets regulations in toto rather than phrase by phrase.^[26]

A regulation should be interpreted to avoid conflict with the statute.^[27] If a regulation is ambiguous, the Tax Court must interpret the regulation in a manner that is “most harmonious with its scheme and with the general purposes.”^[28] The Tax Court begins by looking at the text of the relevant parts of the temporary regulations.

Treas. Reg. § 1.861-9T(f)(3) provides the CFC an election between the asset and the modified gross income methods, but it also imposes a consistency requirement. Treas. Reg. § 1.861-9T(g)(1) describes the asset method and refers to paragraph Treas. Reg. § 1.861-9T(g)(3)(i) and Treas. Reg. § 1.861-12T for asset characterization rules. Specifically, Treas. Reg. § 1.861-9T(g)(1) provides:

Under the asset method, the taxpayer apportions interest expense to the various statutory groupings based on the average total value of assets within each such grouping for the taxable year, as determined under the asset valuation rules of this paragraph (g)(1) and paragraph (g)(2) of this IRC § and the asset characterization rules of paragraph (g)(3) of this IRC § and [Treas. Reg. 1.861-12T].

Treas. Reg. § 1.861-9T(f) also allows a CFC to elect to use the modified gross income method. However, it cautions that the U.S. shareholder of a CFC must characterize the CFC stock using the same method that the CFC used to apportion interest expense. Thus, under Treas. Reg. § 1.861-9T(f), the CFC’s election of the modified gross income method binds the U.S. shareholder to that method.

The petitioner argued that the modified gross income method is an exception to the consistency requirement. It is not. The consistency requirement is a condition of the election.

Moreover, Treas. Reg. § 1.861-12T is not determinative as to whether consistency is required on the facts here. Treas. Reg. § 1.861-9T(f)(3)(iv) imposes the consistency requirement. It provides the rule, and Treas. Reg. § 1.861-12T is intended to supplement “the rule,” including its consistency requirement. The reference to Treas. Reg. § 1.861-12T in Treas. Reg. § 1.861-9T(f)(3)(iv) does not limit the application of the consistency requirement

Aptargroup Inc. v. Commissioner in Sum

First and most significant, the consistency requirement of Treas. Reg. § 1.861-9T(f)(3)(iv) does not depend on whether Treas. Reg. § 1.861-12T applies. It imposes an independent consistency requirement for the interest expense apportionment by a CFC, if that CFC elected the modified gross income method. Treas. Reg. § 1.861-12T is intended to supplement other rules including the Treas. Reg. § 1.861-9T provisions at issue here.

Therefore, the petitioner’s position is inconsistent with the proper application of Treas. Reg. § 1.861-9T. Because the petitioner’s CFC, AptarGroup Global, elected to use the modified gross income method to apportion interest expense, the petitioner must also characterize its AptarGroup Global stock using the modified gross income method.

(158 T.C. No. 4) Aptargroup Inc. v. Commissioner

Footnotes:

1. See, e.g., Cook v. Tait, 265 U.S. 47, 56 (1924); Huff v. Commissioner, 135 T.C. 222, 230 (2010). ↑
2. IRC § 901(a); Am. Chicle Co. v. United States, 316 U.S. 450 (1942); Vento v. Commissioner, 147 T.C. 198, 203-04 (2016), supplemented by 152 T.C. 1 (2019), aff’d, 836 F. App’x 607 (9th Cir. 2021). ↑
3. IRC § 960. ↑
4. United States v. Goodyear Tire & Rubber Co., 493 U.S. 132 (1989); Phillips Petroleum Co. v. Commissioner, 104 T.C. 256, 295 (1995). ↑
5. Theo. H. Davies & Co. v. Commissioner, 75 T.C. 443, 446 n.9 (1980), aff’d per curiam, 678 F.2d 1367 (9th Cir. 1982). ↑
6. IRC § 904(a). ↑
7. Id. ↑
8. Treas. Reg. § 1.1502-4(c). ↑
9. IRC § 904(d)(1). ↑
10. Treas. Reg. § 1.1502-4(d). ↑
11. See Treas. Reg. § 1.861-8(a)(2). ↑
12. See Treas. Reg. § 1.861-8(a)(4). ↑
13. See Treas. Reg. § 1.861-8(a)(2). ↑
14. See Treas. Reg. § 1.861-8(b)(1), (2) (defining “definitely related”). ↑
15. See Treas. Reg. § 1.861-8(a)(3). ↑
16. Temp. Treas. Reg. § 1.861-9T(a). ↑
17. Temp. Treas. Reg. § 1.861-9T(g). ↑
18. Temp. Treas. Reg. § 1.861-9T(j). ↑
19. Temp. Treas. Reg. § 1.861-9T(f)(1)(i). ↑
20. Temp. Treas. Reg. § 1.861-9T(f)(3). ↑
21. Temp. Treas. Reg. § 1.861-9T(g)(1). ↑
22. Temp. Treas. Reg. § 1.861-9T(g)(1), (3). ↑
23. Treas. Reg. 1.861-12T(c)(3)(i) (flush text). ↑
24. See Austin v. Commissioner, 141 T.C. 551, 563 (2013). ↑
25. K Mart Corp. v. Cartier, Inc., 486 U.S. 281, 291 (1988). ↑
26. Microsoft Corp. v. Commissioner, 115 T.C. 228, 248-49 (2000) (citing Norfolk Energy, Inc. v. Hodel, 898 F.2d 1435, 1442 (9th Cir. 1990)), rev’d and remanded, 311 F.3d 1178 (9th Cir. 2002). ↑
27. Phillips Petroleum Co. v. Commissioner, 97 T.C. 30, 35 (1991), aff’d without published opinion, 70 F.3d 1282 (10th Cir. 1995). ↑
28. NLRB v. Lion Oil Co., 352 U.S. 282, 297 (1957) (Frankfurter, J., concurring in part). ↑

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