- 45 -
With netting Total U.S. source Foreign source
Gross income
Operating income $1,300,000 $800,000 $500,000
Interest income -0- -0- -0-
Total 1,300,000 800,000 500,000
Gross income ratio 100% 61.54% 38.46%
Expenses
Operating expenses 500,000 300,000 200,000
Interest expense 175,000 107,692 67,308
Total 675,000 407,692 267,308
Taxable income 625,000 392,308 232,692
Sec. 904(a) ratio 100% 62.7692% 37.2308%
Thus, in this example, the netting of interest expense and
interest income has the effect of increasing, from 28
percent to 37.23 percent, the proportion of the taxpayer's
taxable income, $625,000, that is attributable to foreign
sources.
There are several consequences of netting that should
be noted. First, in order for the netting computation to
arrive at the taxpayer's correct taxable income, i.e.,
$625,000 in the above example, the taxpayer's total gross
income must be reduced by the amount of interest income
that is offset against interest expense. This adjustment
is necessary because only net interest expense is allocated
and apportioned to the statutory grouping (i.e., foreign
source) and the residual grouping (i.e., United States
source) under section 1.861-8(e)(2), Income Tax Regs.
Accordingly, the aggregate deductions used in the netting
computation are less than actual aggregate deductions.
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