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Interest expense is allocated under the regulations to all
gross income that the property or activity "could reasonably have
been expected to generate." Sec. 1.861-8(e)(2)(ii), Income Tax
Regs. Even if not predictable with precision, exchange gains
were certainly a reasonable possibility. Furthermore, the
regulations specifically contemplate a situation where there will
be a deduction even with no corresponding income.7
Next, although exchange gain has traditionally been treated
separately from the underlying income from the transaction,
Philip Morris Inc. v. Commissioner, 104 T.C. 61, 66 (1995), affd.
71 F.3d 1040 (2d Cir. 1995), we do not see how such separate
treatment undermines the validity of respondent's approach. In
prorating the assets across two groupings of income, respondent
is not challenging the separateness of the income, but is merely
attempting a reasonable allocation of interest expense to that
income.
Furthermore, while the regulations are silent on this
particular point, they do provide a foundation for respondent's
approach. When a single item of deduction is attributable to two
different sources, it must be prorated between them. See supra
note 4. When a piece of property produces income attributable to
two different sources, the loss on the sale of that property can
7 "Each deduction * * * shall be allocated * * * even though,
for the taxable year, no gross income in such class is received
or accrued". Sec. 1.861-8(d)(1), Income Tax Regs.
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