IRS releases guidance on deferred compensation expense for FDII: PwC

In brief

The IRS Office of Chief Counsel on May 6 released Generic Legal Advice Memorandum (GLAM) 2022-001 [AM 2022-001] dealing with the allocation and apportionment of deferred compensation expense for purposes of calculating the Section 250 deduction for foreign-derived intangible income (FDII). GLAM 2022-001 concludes that deferred compensation expense that relates to services provided in years prior to enactment of Section 250, but that is deductible post-enactment, may be allocated to deduction eligible income (DEI) and foreign-derived deduction eligible income (FDDEI) if the class of gross income to which the deduction relates includes DEI or FDDEI.

GLAM 2022-001 reasons that deductions for deferred compensation expense are to be allocated to a class of gross income, and apportioned based upon the relevant grouping or groupings within the class, that exists in the tax year in which the deductions are taken into account, even if the deductions may relate to gross income derived by the taxpayer in a prior tax year. The GLAM states that the law in effect for the tax year in which deductions are taken into account is applied in determining how deductions relate to a class of gross income, including which residual and statutory groupings are relevant to apportionment of expenses within such class and the manner of apportionment, rather than the law in effect for the tax year in which the services giving rise to the deduction were provided.

The GLAM also notes that the new memorandum reflects “reconsidered advice” and that a previous GLAM (GLAM 2009-001) – dealing with the allocation and apportionment of deferred compensation expense for purposes of computing a taxpayer’s qualified production activity income and the Section 199 deduction – is obsolete. The obsoleted GLAM allocated deferred compensation expense deductible in a post-enactment year to domestic production gross receipts only if the expense related to sales of products that generated domestic production gross receipts in a post-enactment year.

Actions to consider: While Advice Memoranda are not binding on taxpayers and cannot be used or cited as precedent, companies should revisit the allocation and apportionment of deferred compensation expense for purposes of their FDII computation, as well as similar types of expenses (e.g., pension payments, retiree medical payments, post-retirement benefits, stock options, warranty expenses, and other types of accruals) that may relate to a period that is earlier than the tax year in which a deduction is allowed. Taxpayers should note that this does not include the carryforward portion of certain expenses (e.g., interest expense limited under Section 163(j)), which are directly addressed in the final Section 250 regulations.

Observation: Taxpayers should consider the GLAM’s potential application to any open years in which Section 199 deductions were taken given the footnote stating that GLAM 2009-001 does not represent the position of the Office of the Associated Chief Counsel International (ACCI) and is obsolete. Taxpayers also should consider the potential applicability of the GLAM to contexts beyond FDII and Section 199.

Background

GLAM 2022-001 sets forth the fact pattern of a corporation that is an accrual-basis taxpayer with a calendar tax year. The corporation grants employees stock-settled restricted stock units (RSU) with a vesting date after four years of continuous service. For example, for RSUs granted on January 1, 2014, if the employee satisfies the vesting condition and the corporation initiates delivery of the shares of stock, then the employee would receive the stock on January 1, 2018, and the corporation would claim a deduction for the related expense in 2018. Beginning in 2018, the corporation claims a Section 250 deduction for FDII where the majority of the corporation’s gross income is DEI, and a significant portion of that is FDDEI.

The corporation takes the position that a deduction for an expense, such as deferred compensation expense, deducted in a year in which Section 250 is effective, but that factually relates to a class of gross income recognized in an earlier tax year (i.e., prior to the effective date of the Section 250 deduction for FDII), should only reduce gross income in the residual grouping (i.e., non-DEI) where Section 250 is the operative section and not reduce gross income in a statutory grouping (i.e., RDEI or FDDEI).

While GLAM 2022-001 focuses on stock-settled RSUs, it notes that the compensation element of deferred compensation expense may consist of other items such as pension payments, retiree medical payments, stock options, and other forms or types of compensation that may relate to an earlier period. GLAM 2022-001 states that the included analysis may apply to deductions other than compensation that may be seen as relating to an earlier period, such as a warranty payment.

Law and analysis

Under the Section 250 regulations, for tax years beginning after December 31, 2020, deductions are allocated to gross RDEI and gross FDDEI under the Section 861 regulations. For tax years beginning before January 1, 2021, taxpayers may, for purposes of determining RDEI and FDDEI, allocate and apportion deductions in accordance with the principles of the Section 861 regulations (consistent with the Section 250 regulations) or apply the Section 250 statutory language, which includes a “properly allocable” standard. GLAM 2022-001 emphasizes that while case law does not offer guidance helpful in determining how the “properly allocable” standard should be applied in the context of Section 250, Treasury and the IRS have frequently used the Section 861 regulations, which rely on a factual linkage of income and expense.

Under Section 861 and the associated regulations, a deduction is allocated to a class of gross income, and then, if necessary, apportioned between the statutory and residual groupings of gross income within that class. For this purpose, the classes of gross income are not predetermined, but must be determined on the basis of the deductions to be allocated.

The allocation and apportionment of a deduction is based on the factual relationship of the deduction to a class of gross income. Expenses allocated and apportioned to gross DEI then are further allocated and apportioned between gross FDDEI and RDEI (non-FDDEI). For purposes of applying Section 250(b) as an operative section, gross RDEI and gross FDDEI are treated as separate statutory groupings. Income that is not included in DEI is treated as the residual grouping. The Section 861 regulations provide that a deduction may be allocated to a class of gross income even if no gross income in such class is received or accrued for the tax year.

IRS position in GLAM

GLAM 2022-001 cites other Code provisions, including Sections 162(a)(1), 83(a), 83(h), 441(a), and 461(a), to support the position that under Section 861 and the associated regulations, expenses must be allocated and apportioned within the tax year the deductions are taken into account. The GLAM notes that no judicial guidance or other authority has suggested that the statutory “properly allocable” standard affects the meaning or operation of those income tax accounting provisions.

The GLAM rejects the position that a deduction for an expense which factually relates to a class of gross income recognized in an earlier tax year should only reduce gross income in the residual grouping and not reduce gross income in the statutory grouping (e.g., RDEI or FDDEI). The IRS notes that under Section 461(a), a corporation’s deductions are taken in the proper tax year under the method of accounting used in computing the corporation’s tax income. Also, while the Section 861 regulations envision that a deduction may be factually related to a class of gross income even though no gross income is recognized in the current tax year, they do not (and cannot) change the tax year in which an expense accrues. The IRS concludes that how expenses deducted in a tax year relate to a class of gross income must be governed by the tax laws in effect in the year of the deduction, including which statutory groupings (e.g., RDEI or FDDEI) are relevant to apportionment of expenses within such class and the manner of apportionment.

The IRS notes that the fact that the service period to which compensation expense is relevant straddles the effective date of Section 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 tax year in which the deduction may be claimed.

Observation: While the GLAM departs from the IRS’s prior position, which had stood since 2009, the GLAM does not explain why the IRS changed its position or why the reasoning in GLAM 2009-001 would not be a more appropriate interpretation of the Section 861 regulations, which have not changed since 2009 in a manner materially relevant to this analysis. The GLAM also does not address reasoning adopted in a 2017 Chief Counsel Advice that was consistent with the 2009 GLAM (CCA 201714029, Apr. 7, 2017). The Section 861 regulations and these authorities (specifically, the 2017 CCA or GLAM 2009-001) look to the class of gross income that resulted from the activities to apportion the expense which would not have included RDEI or FDDEI. When taxpayers consider their positions in respect of the issues addressed by the GLAM, they should consider the applicable regulations, the reasoning of all relevant IRS guidance, and the legal status of a GLAM as a position of the IRS rather than binding authority.

The takeaway

GLAM 2022-001 renders GLAM 2009-001 obsolete. While Advice Memoranda are not binding on taxpayers and cannot be used or cited as precedent, companies should revisit the allocation and apportionment of deferred compensation expense for purposes of their FDII deductions, as well as similar types of expenses (e.g., pension payments, retiree medical payments, post-retirement benefits, stock options, warranty expense, and other types of accruals) that may relate to a period that is earlier than the period a deduction is allowed. Taxpayers should note that this does not include the carryforward portion of certain expenses (e.g., interest expense limited under Section 163(j)) that are directly addressed in the final Section 250 regulations. Taxpayers also should consider the potential application of the GLAM to contexts other than FDII.