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March 1992

Worthless stock loss is allocable to foreign source income.

by Pollack, Lawrence A.

    Abstract- The Tax Court has ruled that a foreign subsidiary's worthless stock loss be completely appropriated against foreign source income in order to assess limitations for foreign tax credit. This ruling is illustrated in the Tax Court's decision of the Black & Decker Corp vs Community case in 1991. The decision to allocate worthless stock loss was based on Regulations Section 1.861-8, and has resulted in increased restrictions on foreign tax credit usage for power tool manufacturer Black & Decker Corp.

In Black & Decker Corp. v. Corem. (T.C. Memo 1991-557, 11/7/91), the Tax Court held Black & Decker's worthless stock loss in a foreign subsidiary, claimed in a pre-TRA 86 taxable year, to be allocable entirely against its foreign source income for purposes of determining its foreign tax credit limitation. Prior to this decision, there was little guidance on allocating a foreign subsidiary worthless stock deduction to an income source.

Black & Decker, a U.S. manufacturer and seller of power tools and other products, formed a Japanese subsidiary called Nippon Black & Decker ("NBD") in 1972. Black & Decker's purpose in forming NBD was to compete against its two major Japanese competitors, thereby protecting its market share in the U.S. and worldwide. Black & Decker initially acquired all of the stock of NBD for $249,838 and made further investments in NBD increasing its basis therein to $7.9 million as of 1981. NBD, whose assets and operations were located exclusively within Japan sustained an operating loss for all but two years of its existence and never declared or paid a dividend. Because of NBD's continuing substantial losses, in 1981 Black & Decker abandoned the NBD operations and claimed a worthless stock loss pursuant to IRC Sec. 165(g)(3), which was allowed by the IRS. The sole issue in the case was the source of the deduction for purposes of the foreign tax credit limitation under Sec. 904.

Black & Decker contended the worthless stock loss to be allocable entirely against its U.S. source income since its purpose for investing in NBD was not to receive dividends but rather to protect and promote income from sales of its products in the U.S. The IRS disagreed since the taxpayer hoped to compete effectively against Japanese manufacturers and eventually to derive Japanese dividends.

Black & Decker argued alternatively that pursuant to the factual relationship test of Reg. Sec. 1.861-8, its worthless stock loss should be allocated and apportioned against the classes of gross income received from NBD. Although no dividends were received from NBD, in 1981 Black & Decker derived U.S. source income on sales to NBD, and received foreign source interest and royalty income from NBD. Of the total income received from NBD in 1981, 77% was U.S. source and 23% was foreign source. Thus, the taxpayer argued, only 23% of the loss deduction should be treated as foreign source.

The court disagreed, noting that Reg. Sec. 1.861-8(b)(2) allocates a deduction to a class of gross income if the deduction is incurred "... in connection with property from which such class of gross income is derived." In this case, the income received by Black & Decker from its transactions with NBD was not income generated by the stock, and it was not the ownership of the stock in NBD that gave rise to the income from sales, royalties, and interest. Rather, these kinds of income resulted from transactions between the taxpayer and another entity and did not depend on the taxpayer's stock ownership in NBD.

In supporting the IRS, the Tax Court held the worthless stock deduction allocable entirely against Black & Decker's foreign source income, resulting in a substantial restriction on the utilization of its foreign tax credits. The court based its decision primarily on Reg. Sec. 1.8618(e)(7)(i), which allocates losses recognized on the sale, exchange, or other disposition of property against the class of gross income to which such property "ordinarily" gives rise in the hands of the taxpayer. According to the court, although dividends had never been received from NBD, an investment in stock in a wholly owned foreign subsidiary ordinarily gives rise to foreign source dividends. Thus, the court held the worthless stock deduction to be allocable entirely against Black & Decker's foreign source dividend income even though no dividends were ever received from NBD.

The Black & Decker decision addressed a pre-TRA 86 taxable year. For taxable years subject to TRA 86, Sec. 865 governs the source rules for gains from the disposition of personal property. Sec. 865(a) provides the general rule that gains from the disposition of personal property are U.S. source if realized by a U.S. resident, which includes domestic corporations. An exception applies under Sec. 865(f) for gain from the sale of stock in a foreign affiliate, which is treated as foreign source if title to the shares passes in a foreign country and certain other requirements are satisfied. Regulations governing the source of losses have not yet been issued as directed by Sec. 865(j)(1). However, the "bluebook" to TRA 86 anticipates that regulations will provide that losses from sales of personal property generally will be allocated consistently with the source of income that gains would generate (Bluebook, page 923). Based on this, it appears that a foreign subsidiary worthless stock deduction realized in a postTRA 86 taxable year by a domestic corporation should be allocable against U.S. source income. Until regulations under Sec. 865 are issued, this will remain an uncertain area.

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