[Code of Federal Regulations]
[Title 26, Volume 9]
[Revised as of April 1, 2008]
From the U.S. Government Printing Office via GPO Access
[CITE: 26CFR1.861-8]

[Page 146-170]
 
                       TITLE 26--INTERNAL REVENUE
 
    CHAPTER I--INTERNAL REVENUE SERVICE, DEPARTMENT OF THE TREASURY 
                               (CONTINUED)
 
PART 1_INCOME TAXES--Table of Contents
 
Sec. 1.861-8  Computation of taxable income from sources within the
United States and from other sources and activities.

    (a) In general--(1) Scope. Sections 861(b) and 863(a) state in 
general terms how to determine taxable income of a taxpayer from sources 
within the United States after gross income from sources within the 
United States has been determined. Sections 862(b) and 863(a) state in 
general terms how to determine taxable income of a taxpayer from sources 
without the United States

[[Page 147]]

after gross income from sources without the United States has been 
determined. This section provides specific guidance for applying the 
cited Code sections by prescribing rules for the allocation and 
apportionment of expenses, losses, and other deductions (referred to 
collectively in this section as ``deductions'') of the taxpayer. The 
rules contained in this section apply in determining taxable income of 
the taxpayer from specific sources and activities under other sections 
of the Code, referred to in this section as operative sections. See 
paragraph (f)(1) of this section for a list and description of operative 
sections. The operative sections include, among others, sections 871(b) 
and 882 (relating to taxable income of a nonresident alien individual or 
a foreign corporation which is effectively connected with the conduct of 
a trade or business in the United States), section 904(a)(1) (as in 
effect before enactment of the Tax Reform Act of 1976, relating to 
taxable income from sources within specific foreign countries), and 
section 904(a)(2) (as in effect before enactment of the Tax Reform Act 
of 1976, or section 904(a) after such enactment, relating to taxable 
income from all sources without the United States).
    (2) Allocation and apportionment of deductions in general. A 
taxpayer to which this section applies is required to allocate 
deductions to a class of gross income and, then, if necessary to make 
the determination required by the operative section of the Code, to 
apportion deductions within the class of gross income between the 
statutory grouping of gross income (or among the statutory groupings) 
and the residual grouping of gross income. Except for deductions, if 
any, which are not definitely related to gross income (see paragraphs 
(c)(3) and (e)(9) of this section) and which, therefore, are ratably 
apportioned to all gross income, all deductions of the taxpayer (except 
the deductions for personal exemptions enumerated in paragraph (e)(11) 
of this section) must be so allocated and apportioned. As further 
detailed below, allocations and apportionments are made on the basis of 
the factual relationship of deductions to gross income.
    (3) Class of gross income. For purposes of this section, the gross 
income to which a specific deduction is definitely related is referred 
to as a ``class of gross income'' and may consist of one or more items 
(or subdivisions of these items) of gross income enumerated in section 
61, namely:
    (i) Compensation for services, including fees, commissions, and 
similar items;
    (ii) Gross income derived from business;
    (iii) Gains derived from dealings in property;
    (iv) Interest;
    (v) Rents;
    (vi) Royalties;
    (vii) Dividends;
    (viii) Alimony and separate maintenance payments;
    (ix) Annuities;
    (x) Income from life insurance and endowment contracts;
    (xi) Pensions;
    (xii) Income from discharge of indebtedness;
    (xiii) Distributive share of partnership gross income;
    (xiv) Income in respect of a decedent;
    (xv) Income from an interest in an estate or trust.
    (4) Statutory grouping of gross income and residual grouping of 
gross income. For purposes of this section, the term ``statutory 
grouping of gross income'' or ``statutory grouping'' means the gross 
income from a specific source or activity which must first be determined 
in order to arrive at ``taxable income'' from which specific source or 
activity under an operative section. (See paragraph (f)(1) of this 
section.) Gross income from other sources or activities is referred to 
as the ``residual grouping of gross income'' or ``residual grouping.'' 
For example, for purposes of determining taxable income from sources 
within specific foreign countries and possessions of the United States, 
in order to apply the per-country limitation to the foreign tax credit 
(as in effect before enactment of the Tax Reform Act of 1976), the 
statutory groupings are the separate gross incomes from sources within 
each country and possession. Moreover, if the taxpayer has income 
subject to section 904(d) (as in effect after enactment of the Tax 
Reform Act of 1976), such income constitutes one or more separate

[[Page 148]]

statutory groupings. In the case of the per-country limitation, the 
residual grouping is the aggregate of gross income from sources within 
the United States. In some instances, where the operative section so 
requires, the statutory grouping or the residual grouping may include, 
or consist entirely of, excluded income. See paragraph (d)(2) of this 
section with respect to the allocation and apportionment of deductions 
to excluded income.
    (5) Effective date--(i) Taxable years beginning after December 31, 
1976. The provisions of this section apply to taxable years beginning 
after December 31, 1976.
    (ii) [Reserved]. For further guidance, see Sec. 1.861-8T(a)(5) 
(ii).
    (iii) Taxable years beginning before January 1, 1977. For taxable 
years beginning before January 1, 1977, Sec. 1.861-8 applies as in 
effect on October 23, 1957 (T.D. 6258), as amended on August 22, 1966 
(T.D. 6892) and on September 29, 1975 (T.D. 7378). The specific rules 
for allocation and apportionment of deductions set forth in this section 
may, at the option of the taxpayer, apply to those taxable years on a 
deduction-by-deduction basis if the rules are applied consistently to 
all taxable years with respect to which action by the Internal Revenue 
Service is not barred by any statute of limitations. Thus, for example, 
a calendar year taxpayer may choose to have the rules of paragraph 
(e)(2) of this section apply for the allocation and apportionment of all 
interest expenses for the two taxable years ending December 31, 1975 and 
1976, which are open years under examination, and may justify the 
allocation and apportionment of all research and development expenses 
for those years on a basis supportable under Sec. 1.861-8 as in effect 
for 1975 and 1976 without regard to the rules of paragraph (e)(3) of 
this section.
    (b) Allocation--(1) In general. For purposes of this section, the 
gross income to which a specific deduction is definitely related is 
referred to as a ``class of gross income'' and may consist of one or 
more items of gross income. The rules emphasize the factual relationship 
between the deduction and a class of gross income. See paragraph (d)(1) 
of this section which provides that in a taxable year there may be no 
item of gross income in a class or less gross income than deductions 
allocated to the class, and paragraph (d)(2) of this section which 
provides that a class of gross income may include excluded income. 
Allocation is accomplished by determining, with respect to each 
deduction, the class of gross income to which the deduction is 
definitely related and then allocating the deduction to such class of 
gross income (without regard to the taxpayable year in which such gross 
income is received or accrued or is expected to be received or accrued). 
The classes of gross income are not predetermined but must be determined 
on the basis of the deductions to be allocated. Although most deductions 
will be definitely related to some class of a taxpayer's total gross 
income, some deductions are related to all gross income. In addition, 
some deductions are treated as not definitely related to any gross 
income and are ratably apportioned to all gross income. (See paragraph 
(e)(9) of this section.) In allocating deductions it is not necessary to 
differentiate between deductions related to one item of gross income and 
deductions related to another item of gross income where both items of 
gross income are exclusively within the same statutory grouping or 
exclusively within the residual grouping.
    (2) Relationship to activity or property. A deduction shall be 
considered definitely related to a class of gross income and therefore 
allocable to such class if it is incurred as a result of, or incident 
to, an activity or in connection with property from which such class of 
gross income is derived. Where a deduction is incurred as a result of, 
or incident to, an activity or in connection with property, which 
activity or property generates, has generated, or could reasonably have 
been expected to generate gross income, such deduction shall be 
considered definitely related to such gross income as a class whether or 
not there is any item of gross income in such class which is received or 
accrued during the taxable year and whether or not the amount of 
deductions exceeds the amount of the gross income in such class. See 
paragraph (d)(1) of this section and example 17 of

[[Page 149]]

paragraph (g) of this section with respect to cases in which there is an 
excess of deductions. In some cases, it will be found that this 
subparagraph can most readily be applied by determining, with respect to 
a deduction, the categories of gross income to which it is not related 
and concluding that it is definitely related to a class consisting of 
all other gross income.
    (3) Supportive functions. [Reserved]. For guidance, see Sec. 1.861-
8T(b)(3).
    (4) Deductions related to a class of gross income. See paragraph (e) 
of this section for rules relating to the allocation and apportionment 
of certain specific deductions definitely related to a class of gross 
income. See paragraph (c)(1) of this section for rules relating to the 
apportionment of deductions.
    (5) Deductions related to all gross income. If a deduction does not 
bear a definite relationship to a class of gross income constituting 
less than all of gross income, it shall ordinarily be treated as 
definitely related and allocable to all of the taxpayer's gross income 
except where provided to the contrary under paragraph (e) of this 
section. Paragraph (e)(9) of this section lists various deductions which 
generally are not definitely related to any gross income and are ratably 
apportioned to all gross income.
    (c) Apportionment of deductions--(1) Deductions definitely related 
to a class of gross income. [Reserved]. For guidance, see Sec. 1.861-
8T(c)(1).
    (2) Apportionment based on assets. [Reserved]. For guidance, see 
Sec. 1.861-8T(c)(2).
    (3) Deductions not definitely related to any gross income. If a 
deduction is not definitely related to any gross income (see paragraph 
(e)(9) of this section), the deduction must be apportioned ratably 
between the statutory grouping (or among the statutory groupings) of 
gross income and the residual grouping. Thus, the amount apportioned to 
each statutory grouping shall be equal to the same proportion of the 
deduction which the amount of gross income in the statutory grouping 
bears to the total amount of gross income. The amount apportioned to the 
residual grouping shall be equal to the same proportion of the deduction 
which the amount of the gross income in the residual grouping bears to 
the total amount of gross income.
    (d) Excess of deductions and excluded and eliminated income--(1) 
Excess of deductions. Each deduction which bears a definite relationship 
to a class of gross income shall be allocated to that class in 
accordance with paragraph (b)(1) of this section even though, for the 
taxable year, no gross income in such class is received or accrued or 
the amount of the deduction exceeds the amount of such class of gross 
income. In apportioning deductions, it may be that, for the taxable 
year, there is no gross income in the statutory grouping (or residual 
grouping), or that deductions exceed the amount of gross income in the 
statutory grouping (or residual grouping). If there is no gross income 
in a statutory grouping or the amount of deductions allocated and 
apportioned to a statutory grouping exceeds the amount of gross income 
in the statutory grouping, the effects are determined under the 
operative section. If the taxpayer is a member of a group filing a 
consolidated return, such excess of deductions allocated or apportioned 
to a statutory grouping of income of such member is taken into account 
in determining the consolidated taxable income from such statutory 
grouping, and such excess of deductions allocated or apportioned to the 
residual grouping of income is taken into account in determining the 
consolidated taxable income from the residual grouping. See Sec. 
1.1502-4(d)(1) and the last sentence of Sec. 1.1502-12. For an 
illustration of the principles of this paragraph (d)(1), see example 17 
of paragraph (g) of this section.
    (2) Allocation and apportionment to exempt, excluded, or eliminated 
income. [Reserved]. For guidance, see Sec. 1.861-8T(d)(2).
    (e) Allocation and apportionment of certain deductions--(1) In 
general. Paragraphs (e)(2) and (e)(3) of this section contain rules with 
respect to the allocation and apportionment of interest expense and 
research and development expenditures, respectively. Paragraphs (e)(4) 
through (e)(8) of this section contain rules with respect to the 
allocation of certain other deductions. Paragraph (e)(9) of this section 
lists those

[[Page 150]]

deductions which are ordinarily considered as not being definitely 
related to any class of gross income. Paragraph (e)(10) of this section 
lists special deductions of corporations which must be allocated and 
apportioned. Paragraph (e)(11) of this section lists personal exemptions 
which are neither allocated nor apportioned. Paragraph (e)(12) of this 
section contains rules with respect to the allocation and apportionment 
of deductions for charitable contributions. Examples of allocation and 
apportionment are contained in paragraph (g) of this section.
    (2) Interest. [Reserved]. For guidance, see Sec. 1.861-8T(e)(2).
    (3) Research and experimental expenditures. For rules regarding the 
allocation and apportionment of research and experimental expenditures, 
see Sec. 1.861-17.
    (4) [Reserved]. For further guidance, see Sec. 1.861-8T(e)(4).
    (5) Legal and accounting fees and expenses. Fees and other expenses 
for legal and accounting services are ordinarily definitely related and 
allocable to specific classes of gross income or to all the taxpayer's 
gross income, depending on the nature of the services rendered (and are 
apportioned as provided in paragraph (c)(1) of this section). For 
example, accounting fees for the preparation of a study of the costs 
involved in manufacturing a specific product will ordinarily be 
definitely related to the class of gross income derived from (or which 
could reasonably have been expected to be derived from) that specific 
product. The taxpayer is not relieved from his responsibility to make a 
proper allocation and apportionment of fees on the grounds that the 
statement of services rendered does not identify the services performed 
beyond a generalized designation such as ``professional,'' or does not 
provide any type of allocation, or does not properly allocate the fees 
involved.
    (6) Income taxes--(i) In general. The deduction for state, local, 
and foreign income, war profits and excess profits taxes (``state income 
taxes'') allowed by section 164 shall be considered definitely related 
and allocable to the gross income with respect to which such state 
income taxes are imposed. For example, if a domestic corporation is 
subject to state income taxation and the state income tax is imposed in 
part on an amount of foreign source income, then that part of the 
taxpayer's deduction for state income tax that is attributable to 
foreign source income is definitely related and allocable to foreign 
source income. In allocating and apportioning the deduction for state 
income tax for purposes including (but not limited to) the computation 
of the foreign tax credit limitation under section 904 of the Code and 
the consolidated foreign tax credit under Sec. 1.1502-4 of the 
regulations, the income upon which the state income tax is imposed is 
determined by reference to the law of the jurisdiction imposing the tax. 
Thus, if a state attributes taxable income to a corporate taxpayer by 
applying an apportionment formula that takes into consideration the 
income and factors of one or more corporations related by ownership to 
the corporate taxpayer and engaging in activities related to the 
business of the corporate taxpayer, then the income so attributed is the 
income upon which the state income tax is imposed. If the income so 
attributed to the corporate taxpayer includes foreign source income, 
then, in computing the taxpayer's foreign tax credit limitation under 
section 904, for example, the taxpayer's deduction for state income tax 
will be considered definitely related and allocable to a class of gross 
income that includes the statutory grouping of foreign source income. 
When the law of the state includes dividends that are treated under 
section 862(a)(2) as income from sources without the United States in 
taxable income apportionable to the state, but does not include factors 
of the corporation paying such dividends in the apportionment formula 
used to determine state taxable income, an appropriate portion of the 
deduction for state income tax will be considered definitely related and 
allocable to a class of gross income consisting solely of foreign source 
dividend income. A deduction for state income tax will not be considered 
definitely related to a hypothetical amount of income calculated under 
federal tax principles when the jurisdiction imposing the tax computes

[[Page 151]]

taxable income under different principles. A corporate taxpayer's 
deduction for a state franchise tax that is computed on the basis of 
income attributable to business activities conducted within the state 
must be allocated and apportioned in the same manner as the deduction 
for state income taxes. In determining, for example, both the foreign 
tax credit under section 904 of the Code and the consolidated foreign 
tax credit limitation under Sec. 1.1502-4 of the regulations, the 
deduction for state income tax may be allocable and apportionable to 
foreign source income in a statutory grouping described in section 
904(d) in a taxable year in which the taxpayer has no foreign source 
income in such statutory grouping. Alternatively, such an allocation or 
apportionment may be appropriate if a taxpayer corporation has no 
foreign source income in a statutory grouping, but its deduction is 
attributable to foreign source income in such grouping that is 
attributed to the taxpayer corporation under the law of a state which 
attributes taxable income to a corporation by applying an apportionment 
formula that takes into consideration the income and factors of one or 
more corporations related by ownership to the taxpayer corporation and 
engaging in activities related to the business of the taxpayer 
corporation. Example 30 of paragraph (g) of this section illustrates the 
application of this last rule.
    (ii) Methods of allocation and apportionment--(A) In general. A 
taxpayer's deduction for a state income tax is to be allocated (and then 
apportioned, if necessary, subject to the rules of Sec. 1.861-8(d)) by 
reference to the taxable income that the law of the taxing jurisdiction 
attributes to the taxpayer (``state taxable income'').
    (B) Effect of subsequent recomputations of state income tax. 
[Reserved]
    (C) Illustrations--(1) In general. Examples 25 through 32 of 
paragraph (g) of Sec. 1.861-8 illustrate, in the given factual 
situations, the application of this paragraph (e)(6) and the general 
rule of paragraph (b)(1) of this section that a deduction must be 
allocated to the class of gross income to which the deduction is 
factually related. In general, these examples employ a presumption that 
state income taxes are allocable to a class of gross income that 
includes the statutory grouping of income from sources without the 
United States when the total amount of taxable income determined under 
state law exceeds the amount of taxable income determined under the Code 
(without taking into account the deduction for state income taxes) in 
the residual grouping of income from sources within the United States. A 
taxpayer that allocates and apportions the deduction for state income 
tax in accordance with the methodology of Example 25 of paragraph (g) of 
this section must also apply the modifications illustrated in Examples 
26 and 27 of paragraph (g) of this section, when applicable. The 
modification illustrated in Example 26 is applicable when the deduction 
for state income tax is attributable in part to taxes imposed by a state 
which factually excludes foreign source income (as determined for 
federal income tax purposes) from state taxable income. The modification 
illustrated in Example 27 is applicable when the taxpayer has income-
producing activities in a state which does not impose a corporate income 
tax. The specific allocation of state income tax illustrated in Example 
28 follows the rule in paragraph (e)(6)(i) of this section, and must be 
applied whenever a taxpayer's state taxable income includes dividends 
apportioned to the state under a formula that does not take into account 
the factors of the corporations paying those dividends, regardless of 
whether the taxpayer uses the methodology of Example 25 with respect to 
the remainder of the deduction for state income taxes.
    (2) Modifications. Before applying a method of allocation and 
apportionment illustrated in the examples, the computation of state 
taxable income under state law may be modified, subject to the approval 
of the District Director, to reflect more accurately the income with 
respect to which the state income tax is imposed. Any modification to 
the state law computation of state taxable income must yield an 
allocation and apportionment of the deduction for state income taxes 
that is consistent with the rules contained in

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this paragraph (e)(6), and that accurately reflects the factual 
relationship between the state income tax and the income on which that 
tax is imposed. For example, a modification to the computation of 
taxable income under state law might be appropriate to compensate for 
differences between the state law definition of taxable income and the 
federal definition of taxable income, due to a difference in the rate of 
allowable depreciation or the amount of another deduction that is 
allowable under both systems. This rule is illustrated in Example 31 of 
paragraph (g) of this section. However, a modification to the 
computation of taxable income under state law will not be appropriate, 
and will not more accurately reflect the factual relationship between 
the state tax and the income on which the tax is imposed, to the extent 
such modification reflects the fact that the state does not follow 
federal tax principles in attributing income to the taxpayer's 
activities in the state. This rule is illustrated in Example 32 of 
paragraph (g) of this section. A taxpayer may not modify the methods 
illustrated in the examples, or use an alternative method of allocation 
and apportionment of the deduction for state income taxes, if the 
modification or alternative method would be inconsistent with the rules 
of paragraph (e)(6)(i) of this section. A taxpayer that uses a method of 
allocation and apportionment other than one illustrated in Example 25 
(as modified by Examples 26 and 27), or 29 with respect to a factual 
situation similar to those of the examples, must describe the 
alternative method on an attachment to its federal income tax return and 
establish to the satisfaction of the District Director, upon 
examination, that the result of the alternative method more accurately 
reflects the factual relationship between the state income tax and the 
income on which the tax is imposed.
    (D) Elective safe harbor methods--(1) In general. In lieu of 
applying the rules set forth in paragraphs (e)(6)(ii) (A) through (C) of 
this section, a taxpayer may elect to allocate and apportion the 
deduction for state income tax in accordance with one of the two safe 
harbor methods described in paragraph (e)(6)(ii)(D) (2) and (3) of this 
section. A taxpayer shall make this election for a taxable year by 
filing a timely tax return for that year that reflects an allocation and 
apportionment of the deduction for state income tax under one of the 
safe harbor methods and attaching to such return a statement that the 
taxpayer has elected to use the safe harbor method provided in either 
paragraph (e)(6)(ii)(D) (2) or (3) of this section, as appropriate. Once 
made, this election is effective for the taxable year for which made and 
all subsequent taxable years, and may be revoked only with the consent 
of the Commissioner. Example 33 of paragraph (g) of this section 
illustrates the application of these safe harbor methods.
    (2) Method One--(i) Step One--Specific allocation to foreign source 
portfolio dividends and other income. If any portion of the deduction 
for state income tax is attributable to tax imposed by a state which 
includes in a corporate taxpayer's taxable income apportionable to the 
state, portfolio dividends (as defined in paragraph (i) of Example 28 of 
paragraph (g) of this section) that are treated under section 862(a)(2) 
as income from sources without the United States, but does not include 
factors of the corporations paying the portfolio dividends in the 
apportionment formula used to determine state taxable income, the 
taxpayer shall allocate an appropriate portion of the deduction to a 
class of gross income consisting solely of foreign source portfolio 
dividends. The portion of the deduction so allocated, and the amount of 
foreign source portfolio dividends included in such class, shall be 
determined in accordance with the methodology illustrated in paragraph 
(ii) of Example 28 of paragraph (g). If a state income tax is determined 
based upon formulary apportionment of the total taxable income 
attributable to the taxpayer's unitary business, the taxpayer must also 
apply the methodology illustrated in paragraph (ii) (C) through (G) of 
Example 29 of paragraph (g) of this section to make specific allocations 
of appropriate portions of the deduction for state income tax on the 
basis of income that, under separate accounting, would have been 
attributed to other members of the unitary group. The taxpayer

[[Page 153]]

shall reduce its aggregate state taxable income by the amount of foreign 
source portfolio dividends and other income to which a specific 
allocation is made (the reduced amount being referred to hereinafter as 
``adjusted state taxable income'').
    (ii) Step Two--Adjustment of U.S. source federal taxable income. If 
the taxpayer has significant income-producing activities in a state 
which does not impose a corporate income tax or other state tax measured 
by income derived from business activities in the state, the taxpayer 
shall reduce its U.S. source federal taxable income (solely for purposes 
of this safe harbor method) by the amount of federal taxable income 
attributable to its activities in such state. This amount shall be 
determined in accordance with the methodology illustrated in paragraph 
(ii) of Example 27 of paragraph (g) of this section, provided that the 
taxpayer shall be required to use the rules of the Uniform Division of 
Income for Tax Purposes Act to attribute income to the relevant state. 
The taxpayer's U.S. source federal taxable income, as so reduced, is 
referred to hereinafter as ``adjusted U.S. source federal taxable 
income.''
    (iii) Step Three--Allocation. The taxpayer shall allocate the 
remainder of the deduction for state income tax (after reduction by the 
portion allocated to foreign source portfolio dividends and other income 
under Step One) in accordance with the methodology illustrated in 
paragraph (ii) of Example 25 of paragraph (g) of this section. However, 
the taxpayer shall substitute for the comparison of aggregate state 
taxable income to U.S. source federal taxable income, illustrated in 
paragraph (ii) of Example 25 of paragraph (g) of this section, a 
comparison of its adjusted state taxable income to an amount equal to 
110% of its adjusted U.S. source federal taxable income.
    (iv) Step Four--Apportionment. In the event that apportionment of 
the remainder of the deduction for state income tax is required, the 
taxpayer shall apportion that remaining deduction to U.S. source income 
in accordance with the methodology illustrated in paragraph (iii) of 
Example 25 of paragraph (g) of this section, substituting for domestic 
source income in that paragraph an amount equal to 110% of the 
taxpayer's adjusted U.S. source federal taxable income. The remaining 
portion of the deduction shall be apportioned to the statutory groupings 
of foreign source income described in section 904(d) of the Code in 
accordance with the proportion of the income in each statutory grouping 
of foreign source income described in section 904(d) to the taxpayer's 
total foreign source federal taxable income (after reduction by the 
amount of foreign source portfolio dividends to which tax has been 
specifically allocated under Step One, above).
    (3) Method Two--(i) Step One--Specific allocation to foreign source 
portfolio dividends and other income. Step One of this method is the 
same as Step One of Method One (as described in paragraph 
(e)(6)(ii)(D)(2)(i) of this section).
    (ii) Step Two--Adjustment of U.S. source federal taxable income. 
Step Two of this method is the same as Step Two of Method One (as 
described in paragraph (e)(6)(ii)(D)(2)(ii) of this section).
    (iii) Step Three--Allocation. The taxpayer shall allocate the 
remainder of the deduction for state income tax (after reduction by the 
portion allocated to foreign source portfolio dividends and other income 
under Step One) in accordance with the methodology illustrated in 
paragraph (ii) of Example 25 of paragraph (g) of this section. However, 
the taxpayer shall substitute for the comparison of aggregate state 
taxable income to U.S. source federal taxable income, illustrated in 
paragraph (ii) of Example 25 of paragraph (g) of this section, a 
comparison of its adjusted state taxable income to its adjusted U.S. 
source federal taxable income.
    (iv) Step Four--Apportionment. In the event that apportionment of 
the deduction is required, the taxpayer shall apportion to U.S. source 
income that portion of the deduction that is attributable to state 
income taxes imposed upon an amount of state taxable income equal to 
adjusted U.S. source federal taxable income. The taxpayer shall 
apportion the remaining amount of the deduction to U.S. and foreign 
source income in the same proportions

[[Page 154]]

that the taxpayer's adjusted U.S. source federal taxable income and 
foreign source federal taxable income (after reduction by the amount of 
foreign source portfolio dividends to which tax has been specifically 
allocated under Step One, above) bear to its total federal taxable 
income (taking into account the adjustment of U.S. source federal 
taxable income under Step Two and after reduction by the amount of 
foreign source portfolio dividends to which tax has been specifically 
allocated under Step One). The portion of the deduction apportioned to 
foreign source income shall be apportioned among the statutory groupings 
described in section 904(d) of the Code in accordance with the 
proportions of the taxpayer's total foreign source federal taxable 
income (after reduction by the amount of foreign source portfolio 
dividends to which tax has been specifically allocated under Step One, 
above) in each grouping.
    (iii) Effective dates. The rules of Sec. 1.861-8(e)(6)(i) and the 
language preceding the examples in Sec. 1.861-8(g) are effective for 
taxable years beginning after December 31, 1976. The rules of Sec. 
1.861-8(e)(6)(ii) (other than Sec. 1.861-8(e)(6)(ii)(D)) and Examples 
25 through 32 of Sec. 1.861-8(g) are effective for taxable years 
beginning on or after January 1, 1988. The rules of Sec. 1.861-
8(e)(6)(ii)(D) and Example 33 of Sec. 1.861-8(g) are effective for 
taxable years ending after March 12, 1991. At the option of the 
taxpayer, however, the rules of Sec. 1.861-8(e)(6)(ii) (other than 
Sec. 1.861-8(e)(6)(ii)(D)) and Examples 25 through 32 of Sec. 1.861-
8(g) may be applied with respect to deductions for state taxes incurred 
in taxable years beginning before January 1, 1988.
    (7) Losses on the sale, exchange, or other disposition of property--
(i) Allocation. The deduction allowed for loss recognized on the sale, 
exchange, or other disposition of a capital asset or property described 
in section 1231(b) shall be considered a deduction which is definitely 
related and allocable to the class of gross income to which such asset 
or property ordinarily gives rise in the hands of the taxpayer. Where 
the nature of gross income generated from the asset or property has 
varied significantly over several taxable years of the taxpayer, such 
class of gross income shall generally be determined by reference to 
gross income generated from the asset or property during the taxable 
year or years immediately preceding the sale, exchange, or other 
dispostion of such asset or property. Thus, for example, where an asset 
generates primarily sales income from domestic sources in the early 
years of its operation and then is leased by the taxpayer to a foreign 
subsidiary in later years, the class of gross income to which the asset 
gives rise will be considered to be the rental income derived from the 
lease and will not include sales income from domestic sources.
    (ii) Apportionment of losses. Where in the unusual circumstances 
that an apportionment of a deduction for losses on the sale, exchange, 
or other disposition of a capital asset or property described in section 
1231(b) is necessary, the amount of such deduction shall be apportioned 
between the statutory grouping (or among the statutory groupings) of 
gross income (within the class of gross income) and the residual 
grouping (within the class of gross income) in the same proportion that 
the amount of gross income within such statutory grouping (or statutory 
groupings) and such residual grouping bear, respectively, to the total 
amount of gross income within the class of gross income. Apportionment 
will be necessary where, for example, the class of gross income to which 
the deduction is allocated consists of gross income (such as royalties) 
attributable to an intangible asset used both within and without the 
United States, or gross income (such as from sales or services) 
attributable to a tangible asset used both within and without the United 
States.
    (iii) Allocation of loss recognized in taxable years after 1986. See 
Sec. Sec. 1.865-1 and 1.865-2 for rules regarding the allocation of 
certain loss recognized in taxable years beginning after December 31, 
1986.
    (8) Net operating loss deduction. A net operating loss deduction 
allowed under section 172 shall be allocated and apportioned in the same 
manner as the deductions giving rise to the net operating loss 
deduction.

[[Page 155]]

    (9) Deductions which are not definitely related. Deductions which 
shall generally be considered as not definitely related to any gross 
income, and therefore are ratably apportioned as provided in paragraph 
(c)(3) of this section, are--
    (i) The deduction allowed by section 163 for interest described in 
subparagraph (2)(iii) of this paragraph (e);
    (ii) The deduction allowed by section 164 for real estate taxes on a 
personal residence or for sales tax on the purchase of items for 
personal use;
    (iii) The deduction for medical expenses allowed by section 213; and
    (iv) The deduction for alimony payments allowed by section 215.
    (10) Special deductions. The special deductions allowed in the case 
of a corporation by section 241 (relating to the deductions for 
partially tax exempt interest, dividends received, etc.), section 922 
(relating to Western Hemisphere trade corporations), and section 941 
(relating to China Trade Act corporations) shall be allocated and 
apportioned consistent with the principles of this section.
    (11) Personal exemptions. The deductions for the personal exemptions 
allowed by section 151, 642(b), or 873(b)(3) shall not be taken into 
account for purpose of allocation and apportionment under this section.
    (12) Deductions for certain charitable contributions--(i) In 
general. The deduction for charitable contributions that is allowed 
under sections 170, 873(b)(2), and 882(c)(1)(B) is definitely related 
and allocable to all of the taxpayer's gross income. The deduction 
allocated under this paragraph (e)(12)(i) shall be apportioned between 
the statutory grouping (or among the statutory groupings) of gross 
income and the residual grouping on the basis of the relative amounts of 
gross income from sources in the United States in each grouping.
    (ii) Treaty provisions. If a deduction for charitable contributions 
not otherwise permitted by sections 170, 873(b)(2), and 882(c)(1)(B) is 
allowed under a U.S. income tax treaty, and such treaty limits the 
amount of the deduction based on a percentage of income arising from 
sources within the treaty partner, the deduction is definitely related 
and allocable to all of the taxpayer's gross income. The deduction 
allocated under this paragraph (e)(12)(ii) shall be apportioned between 
the statutory grouping (or among the statutory groupings) of gross 
income and the residual grouping on the basis of the relative amounts of 
gross income from sources within the treaty partner within each 
grouping.
    (iii) Coordination with Sec. Sec. 1.861-14 and 1.861-14T. A 
deduction for a charitable contribution by a member of an affiliated 
group shall be allocated and apportioned under the rules of this 
section, Sec. 1.861-14(e)(6), and Sec. 1.861-14T(c)(1).
    (iv) Effective date. (A) The rules of paragraphs (e)(12)(i) and 
(iii) of this section shall apply to charitable contributions made on or 
after July 28, 2004. Taxpayers may apply the provisions of paragraphs 
(e)(12)(i) and (iii) of this section to charitable contributions made 
before July 28, 2004, but during the taxable year ending on or after 
July 28, 2004.
    (B) The rules of paragraphs (e)(12)(ii) of this section shall apply 
to charitable contributions made on or after July 14, 2005. Taxpayers 
may apply the provisions of paragraph (e)(12)(ii) of this section to 
charitable contributions made before July 14, 2005, but during the 
taxable year ending on or after July 14, 2005.
    (f) Miscellaneous matters--(1) Operative sections. The operative 
sections of the Code which require the determination of taxable income 
of the taxpayer from specific sources or activities and which give rise 
to statutory groupings to which this section is applicable include the 
sections described below.
    (i) Overall limitation to the foreign tax credit. Under the overall 
limitation to the foreign tax credit, as provided in section 904(a)(2) 
(as in effect before enactment of the Tax Reform Act of 1976, or section 
904(a) after such enactment) the amount of the foreign tax credit may 
not exceed the tentative U.S. tax (i.e., the U.S. tax before application 
of the foreign tax credit) multiplied by a fraction, the numerator of 
which is the taxable income from sources without the United States and 
the denominator of which is the entire taxable income. Accordingly, in 
this case, the statutory

[[Page 156]]

grouping is foreign source income (including, for example, interest 
received from a domestic corporation which meets the tests of section 
861(a)(1)(B), dividends received from a domestic corporation which has 
an election in effect under section 936, and other types of income 
specified in section 862). Pursuant to sections 862(b) and 863(a) and 
Sec. Sec. 1.862-1 and 1.863-1, this section provides rules for 
identifying the deductions to be taken into account in determining 
taxable income from sources without the United States. See section 
904(d) (as in effect after enactment of the Tax Reform Act of 1976) and 
the regulations thereunder which require separate treatment of certain 
types of income. See example 3 of paragraph (g) of this section for one 
example of the application of this section to the overall limitation.
    (ii) [Reserved]
    (iii) DISC and FSC taxable income. Sections 925 and 994 provide 
rules for determining the taxable income of a FSC and DISC, 
respectively, with respect to qualified sales and leases of export 
property and qualified services. The combined taxable income method 
available for determining a DISC's taxable income provides, without 
consideration of export promotion expenses, that the taxable income of 
the DISC shall be 50 percent of the combined taxable income of the DISC 
and the related supplier derived from sales and leases of export 
property and from services. In the FSC context, the taxable income of 
the FSC equals 23 percent of the combined taxable income of the FSC and 
the related supplier. Pursuant to regulations under section 925 and 994, 
this section provides rules for determining the deductions to be taken 
into account in determining combined taxable income, except to the 
extent modified by the marginal costing rules set forth in the 
regulations under sections 925(b)(2) and 994(b)(2) if used by the 
taxpayer. See Examples (22) and (23) of paragraph (g) of this section. 
In addition, the computation of combined taxable income is necessary to 
determine the applicability of the section 925(d) limitation and the 
``no loss'' rules of the regulations under sections 925 and 994.
    (iv) Effectively connected taxable income. Nonresident alien 
individuals and foreign corporations engaged in trade or business within 
the United States, under sections 871(b)(1) and 882(a)(1), on taxable 
income which is effectively connected with the conduct of a trade or 
business within the United States. Such taxable income is determined in 
most instances by initially determining, under section 864(c), the 
amount of gross income which is effectively connected with the conduct 
of a trade or business within the United States. Pursuant to sections 
873 and 882(c), this section is applicable for purposes of determining 
the deductions from such gross income (other than the deduction for 
interest expense allowed to foreign corporations (see Sec. 1.882-5)) 
which are to be taken into account in determining taxable income. See 
example 21 of paragraph (g) of this section.
    (v) Foreign base company income. Section 954 defines the term 
``foreign base company income'' with respect to controlled foreign 
corporations. Section 954(b)(5) provides that in determining foreign 
base company income the gross income shall be reduced by the deductions 
of the controlled foreign corporation ``properly allocable to such 
income''. This section provides rules for identifying which deductions 
are properly allocable to foreign base company income.
    (vi) Other operative sections. The rules provided in this section 
also apply in determining--
    (A) The amount of foreign source items of tax preference under 
section 58(g) determined for purposes of the minimum tax;
    (B) The amount of foreign mineral income under section 901(e);
    (C) [Reserved]
    (D) The amount of foreign oil and gas extraction income and the 
amount of foreign oil related income under section 907;
    (E) [Reserved]
    (F) [Reserved]
    (G) The limitation under section 934 on the maximum reduction in 
income tax liability incurred to the Virgin Islands;
    (H) [Reserved]

[[Page 157]]

    (I) The special deduction granted to China Trade Act corporations 
under section 941;
    (J) The amount of certain U.S. source income excluded from the 
subpart F income of a controlled foreign corporation under section 
952(b);
    (K) The amount of income from the insurance of U.S. risks under 
section 953(b)(5);
    (L) The international boycott factor and the specifically 
attributable taxes and income under section 999; and
    (M) The taxable income attributable to the operation of an agreement 
vessel under section 607 of the Merchant Marine Act of 1936, as amended, 
and the Capital Construction Fund Regulations thereunder (26 CFR, part 
3). See 26 CFR 3.2(b)(3).
    (2) Application to more than one operative section. (i) Where more 
than one operative section applies, it may be necessary for the taxpayer 
to apply this section separately for each applicable operative section. 
In such a case, the taxpayer is required to use the same method of 
allocation and the same principles of apportionment for all operative 
sections.
    (ii) When expenses, losses, and other deductions that have been 
properly allocated and apportioned between combined gross income of a 
related supplier and a DISC or former DISC and residual gross income, 
regardless of which of the administrative pricing methods of section 994 
has been applied, such deductions are not also allocated and apportioned 
to gross income consisting of distributions from the DISC or former DISC 
attributable to income of the DISC or former DISC as determined under 
the administrative pricing methods with respect to DISC or former DISC 
taxable years beginning after December 31, 1986. Accordingly, Example 
(22) of paragraph (g) of this section does not apply to distributions 
from a DISC or former DISC with respect to DISC or former DISC taxable 
years beginning after December 31, 1986. This rule does not apply to the 
extent that the taxable income of the DISC or former DISC is determined 
under the section 994(a)(3) transfer pricing method. In addition, for 
taxable years beginning after December 31, 1986, in the case of 
expenses, losses, and other deductions that have been properly allocated 
and apportioned between combined gross income of a related supplier and 
a FSC and residual gross income, regardless of which of the 
administrative pricing methods of section 925 has been applied, such 
deductions are not also allocated and apportioned to gross income 
consisting of distributions from the FSC or former FSC which are 
attributable to the foreign trade income of the FSC or former FSC as 
determined under the administrative pricing methods. This rule does not 
apply to the extent that the foreign trade income of the FSC or former 
FSC is determined under the section 925(a)(3) transfer pricing method. 
See Example (23) of paragraph (g) of this section.
    (3) Special rules of section 863(b)--(i) In general. Special rules 
under section 863(b) provide for the application of rules of general 
apportionment provided in Sec. Sec. 1.863-3 to 1.863-5, to worldwide 
taxable income in order to attribute part of such worldwide taxable 
income to U.S. sources and the remainder of such worldwide taxable 
income to foreign sources. The activities specified in section 863(b) 
are--
    (A) Transportation or other services rendered partly within and 
partly without the United States,
    (B) Sales of personal property produced by the taxpayer within and 
sold without the United States, or produced by the taxpayer without and 
sold within the United States, and
    (C) Sales within the United States of personal property purchased 
within a possession of the United States.

In the instances provided in Sec. Sec. 1.863-3 and 1.863-4 with respect 
to the activities described in (A), (B), and (C) of this subdivision, 
this section is applicable only in determining worldwide taxable income 
attributable to these activities.
    (ii) Relationship of sections 861, 862, 863(a), and 863(b). Sections 
861, 862, 863(a), and 863(b) are the four provisions applicable in 
determining taxable income from specific sources. Each of these four 
provisions applies independently. Where a deduction has been allocated 
and apportioned to income under one of these four provisions, the 
deduction shall not again be allocated and apportioned to gross income 
under any

[[Page 158]]

of the other three provisions. However, two or more of these provisions 
may have to be applied at the same time to determine the proper 
allocation and apportionment of a deduction. The special rules under 
section 863(b) take precedence over the general rules of Code sections 
861, 862 and 863(a). For example, where a deduction is allocable in 
whole or in part to gross income to which section 863(b) applies, such 
deduction or part thereof shall not otherwise be allocated under section 
861, 862, or 863(a). However, where the gross income to which the 
deduction is allocable includes both gross income to which section 
863(b) applies and gross income to which section 861, 862, or 863(a) 
applies, more than one section must be applied at the same time in order 
to determine the proper allocation and apportionment of the deduction.
    (4) Adjustments made under other provisions of the Code--(i) 
[Reserved]. For further guidance, see Sec. 1.861-8T(f)(4)(i).
    (ii) Example. X, a domestic corporation, purchases and sells 
consumer items in the United States and foreign markets. Its sales in 
foreign markets are made to related foreign subsidiaries. X reported 
$1,500,000 as sales during the taxable year of which $1,000,000 was 
domestic sales and $500,000 was foreign sales. X took a deduction for 
expenses incurred by its marketing department during the taxable year in 
the amount of $150,000. These expenses were determined to be allocable 
to both domestic and foreign sales and are apportionable between such 
sales. Thus, X allocated and apportioned the marketing department 
deduction as follows:

To gross income from domestic sales: $150,000x($1,000,000/      $100,000
 $1,500,000).................................................
To gross income from foreign sales: $150,000x($500,000/           50,000
 $1,500,000).................................................
                                                              ----------
 Total.......................................................    150,000


    On audit of X's return for the taxable year, the District Director 
adjusted, under section 482, X's sales to related foreign subsidiaries 
by increasing the sales price by a total of $100,000, thereby increasing 
X's foreign sales and total sales by the same amount. As a result of the 
section 482 adjustment, the apportionment of the deduction for the 
marketing department expenses is redetermined as follows:

To gross income from domestic sales: $150,000x($1,000,000/       $93,750
 $1,600,000)..................................................
To gross income from foreign sales: $150,000x($600,000/           56,250
 $1,600,000)
                                                               ---------
 Total........................................................   150,000


    (5) Verification of allocations and apportionments. Since, under 
this section, allocations and apportionments are made on the basis of 
the factual relationship between deductions and gross income, the 
taxpayer is required to furnish, at the request of the District 
Director, information from which such factual relationships can be 
determined. In reviewing the overall limitation to the foreign tax 
credit of a domestic corporation, for example, the District Director 
should consider information which would enable him to determine the 
extent to which deductions attributable to functions performed in the 
United States are related to earning foreign source income, United 
States source income, or income from both sources. In addition to 
functions with a specific international purpose, consideration should be 
given to the functions of management, the direction and results of an 
acquisition program, the functions of operating units and personnel 
located at the head office, the functions of support units (including 
but not limited to engineering, legal, budget, accounting, and 
industrial relations), the functions of selling and advertising units 
and personnel, the direction and uses of research and development and 
the direction and uses of services furnished by independent contractors. 
Thus, for example when requested by the District Director, the taxpayer 
shall make available any of its organization charts, manuals, and other 
writings which relate to the manner in which its gross income arises and 
to the functions of organizational units, employees, and assets of the 
taxpayer and arrange for the interview of such of its employees as the 
District Director deems desirable in order to determine the gross income 
to which deductions relate. See section 7602 and the regulations 
thereunder which generally provide for the examination of books and 
witnesses. See also section 905(b) and the regulations thereunder which 
require proof of foreign tax credits to the satisfaction of the 
Secretary or his delegate.

[[Page 159]]

    (g) General examples. The following examples illustrate the 
principles of this section. In each example, unless otherwise specified, 
the operative section which is applied and gives rise to the statutory 
grouping of gross income is the overall limitation to the foreign tax 
credit under section 904(a). In addition, in each example, where a 
method of allocation or apportionment is illustrated as an acceptable 
method, it is assumed that such method is used by the taxpayer on a 
consistent basis from year to year (except in the case of the optional 
method for apportioning research and development expense under paragraph 
(e)(3)(iii) of Sec. 1.861-8). Further, it is assumed that each party 
named in each example operates on a calendar year accounting basis and, 
where the party is a U.S. taxpayer, files returns on a calendar year 
basis.

    Examples 1-16 [Reserved]
    Example 17. [Reserved]. For further guidance, see Sec. 1.861-8T(g), 
Example 17.
    Example 18. [Reserved]. For further guidance, see Sec. 1.861-8T(g), 
Example 18.
    Example 19. Supportive Expense--(i) Facts. X, a domestic 
corporation, purchases and sells products both in the United States and 
in foreign countries. X has no foreign subsidiary and no international 
department. During the taxable year, X incurs the following expenses 
with respect to its worldwide activities:

Personnel department expenses...............................     $50,000
Training department expenses................................      35,000
General and administrative expenses.........................      55,000
President's salary..........................................      40,000
Sales manager's salary......................................      20,000
                                                             -----------
   Total....................................................     200,000
                                                             ===========



X has domestic gross receipts from sales of $750,000 and foreign gross 
receipts from sales of $500,000 and has gross income from such sales in 
the same ratio, namely $300,000 from domestic sources and $200,000 from 
foreign sources.
    (ii) Allocation. The above expenses are definitely related and 
allocable to all of X's gross income derived from both domestic and 
foreign markets.
    (iii) Apportionment. For purposes of applying the overall 
limitation, the statutory grouping is gross income from sources outside 
the United States and the residual grouping is gross income from sources 
within the United States. X's deductions for its worldwide sales 
activities must be apportioned between these groupings. Company X in 
this example (unlike Company X in example 18) does not have a separate 
international division which performs essentially all of the functions 
required to manage and oversee its foreign activities. The president and 
sales manager do not maintain time records. The division of their time 
between domestic and foreign activities varies from day to day and 
cannot be estimated on an annual basis with any reasonable degree of 
accuracy. Similarly, there are no facts which would justify a method of 
apportionment of their salaries or of one of the other listed deductions 
based on more specific factors than gross receipts or gross income. An 
acceptable method of apportionment would be on the basis of gross 
receipts. The apportionment of the $200,000 deduction is as follows:

Apportionment of the $200,000 expense to the statutory           $80,000
 grouping of gross income: $200,000x[$500,000/
 ($500,000+$750,000)].......................................
Apportionment of the $200,000 expense to the residual            120,000
 grouping of gross income: $200,000x[$750,000/
 ($500,000+$750,000)].......................................
                                                             -----------
  Total apportioned supportive expense......................     200,000


    Example 20. Supportive Expense. (i) Facts. Assume the same facts as 
above except that X's president devotes only 5 percent of his time to 
the foreign operations and 95 percent of his time to the domestic 
operations and that X's sales manager devotes approximately 10 percent 
of his time to foreign sales and 90 percent of his time to domestic 
sales.
    (ii) Allocation. The expenses incurred by X with respect to its 
worldwide activities are definitely related, and therefore allocable to 
X's gross income from both its foreign and domestic markets.
    (iii) Apportionment. On the basis of the additional facts it is not 
acceptable to apportion the salaries of the president and the sales 
manager on the basis of gross receipts. It is acceptable to apportion 
such salaries between the statutory grouping (gross income from sources 
without the United States) and residual grouping (gross income from 
sources within the United States) on the basis of time devoted to each 
sales activity. Remaining expenses may still be apportioned on the basis 
of gross receipts. The apportionment is as follows:

Apportionment of the $200,000 expense to the statutory
 grouping of gross income:
  President's salary: $40,000x5 pct.........................      $2,000
  Sales manager's salary: $20,000x10 pct....................       2,000
  Remaining expenses: $140,000x[$500,000/                         56,000
   ($500,000+$750,000)].....................................
                                                             -----------
    Subtotal: Apportionment of expense to statutory grouping      60,000
                                                             ===========
Apportionment of the $200,000 expense to the residual
 grouping of gross income:
  President's salary: $40,000x95 pct........................      38,000
  Sales manager's salary: $20,000x90 pct....................      18,000
  Remaining expenses: $140,000x[$750,000/                         84,000
   ($500,000+$750,000)].....................................
                                                             -----------
    Subtotal: Apportionment of expense to residual grouping.     140,000
                                                             ===========

[[Page 160]]


    Total: Apportioned general and administrative expense...     200,000


    Example 21. Supportive Expense. (i) Facts. X, a foreign corporation 
doing business in the United States, is a manufacturer of metal stamping 
machines. X has no United States subsidiaries and no separate division 
to manage and oversee its business in the United States. X manufactures 
and sells these machines in the United States and in foreign countries A 
and B and has a separate manufacturing facility in each country. Sales 
of these machines are X's only source of income. In 1977, X incurs 
general and administrative expenses related to both its U.S. and foreign 
operations of $100,000. It has machine sales of $500,000, $1,000,000 and 
$1,000,000 on which it earns gross income of $200,000, $400,000 and 
$400,000 in the United States, country A, and country B, respectively. 
The income from the manufacture and sale of the machines in countries A 
and B is not effectively connected with X's business in the United 
States.
    (ii) Allocation. The $100,000 of general and administrative expense 
is definitely related to the income to which it gives rise, namely a 
part of the gross income from sales of machines in the United States, in 
country A, and in country B. The expenses are allocable to this class of 
income, even though X's gross income from sources outside the United 
States is excluded income since it is not effectively connected with a 
U.S. trade or business.
    (iii) Apportionment Since X is a foreign corporation, the statutory 
grouping is gross income effectively connected with X's trade of 
business in the United States, namely gross income from sources within 
the United States, and the residual grouping is gross income not 
effectively connected with a trade or business in the United States, 
namely gross income from countries A and B. Since there are no facts 
which would require a method of apportionment other than on the basis of 
sales or gross income, the amount may be apportioned between the two 
groupings on the basis of amounts of gross income as follows:

Apportionment of general and administrative expense to the       $20,000
 statutory grouping, gross income from sources within the
 United States: $100,000x[$200,000/($200,000 + $400,000 +
 $400,000)].................................................
Apportionment of general and administrative expense to the        80,000
 residual grouping, gross income from sources without the
 United States: $100,000x[($400,000 + $400,000)/($200,000 +
 $400,000 + $400,000)]......................................
                                                             -----------
    Total apportioned general and administrative expense....     100,000


    Example 22. Domestic International Sales Corporations. (i) Facts. X, 
a domestic corporation, manufactures a line of kitchenware and sells it 
to retailers in the United States, France, and the United Kingdom. After 
the Domestic International Sales Corporation (DISC) legislation was 
passed in 1971, X established, as of January 1, 1972, a DISC and 
thereafter did all of its foreign marketing through sales by the DISC. 
In 1977 the DISC has total sales of $7,700,000 for which X's cost of 
goods sold is $6,000,000. Thus, the gross income attributable to exports 
through the DISC is $1,700,000 ($7,700,000-$6,000,000). Moreover, X has 
U.S. domestic sales of kitchenware of $12,000,000 on which it earned 
gross income of $900,000, and X receives royalty income from the foreign 
license of its kitchenware technology in the amount of $800,000. The 
DISC's expenses attributable to the resale of export property are 
$400,000 of which $300,000 qualify as export promotion expenses. X also 
incurs $125,000 of general and administrative expenses in connection 
with its domestic and foreign sales activities, and its foreign 
licensing activities. X and the DISC determine transfer prices charged 
on the basis of a single product grouping and the ``50-50'' combined 
taxable income method (without marginal costing) which permits the DISC 
to have a taxable income equal to 50 percent of the combined taxable 
income attributable to the production and sales of the export property, 
plus 10 percent of the DISC's export promotion expenses.
    (ii) Allocation. For purposes of determining combined taxable income 
of X and the DISC from export sales, general and administrative expenses 
of $125,000 must be allocated to and apportioned between gross income 
resulting from the production and sale of kitchenware for export, and 
from the production and sale of kitchenware for the domestic market. The 
deduction of $400,000 for expenses attributable to the resale of export 
property is allocated solely to gross income from the production and 
sale of kitchenware in foreign markets.
    (iii) Apportionment. Apportionment of expense takes place in two 
stages. In the first stage, for computing conbined taxable income from 
the production and sale of export property, the general and 
administrative expense should be apportioned between the statutory 
grouping of gross income from the export of kitchenware and the residual 
grouping of gross income from domestic sales and foreign licenses. In 
the second stage, since the limitation on the foreign tax credit 
requires the use of a separate limitation with respect to dividends from 
a DISC (section 904(d)), the general and administrative expense should 
be apportioned between two statutory groupings, DISC dividends and 
foreign royalty income (for which the overall limitation is used), and 
the residual grouping of gross income from sales within the United 
States. In the first stage, in the absence of more specific or contrary 
information, the general and administrative expense may be

[[Page 161]]

apportioned on the basis of gross income in the respective groupings, as 
follows:

Apportionment of general and administrative expense to the       $62,500
 statutory grouping, gross income from exports of
 kitchenware: $125,000x[$1,700,000/($1,700,000 + $900,000 +
 $800,000)].................................................
Apportionment of general and administrative expense to the        62,500
 residual grouping, gross income from domestic sales of
 kitchenware and foreign royalty income from licensing
 kitchenware technology: $125,000x[($900,000 + $800,000)/
 ($1,700,000 + $900,000 + $800,000)]........................
                                                             -----------
  Total apportionment of general and administrative expense.     125,000



On the basis of this apportionment, the combined taxable income, and the 
DISC portion of taxable income may be calculated as follows:

Gross income from exports....................   $1,700,000
Less:
  DISC expense for resale of export property.      400,000
  Apportioned general and administrative            62,500
   expense...................................
                                              -------------
                                                                $462,500
                                                           -------------
Combined taxable income from production and export of          1,237,500
 kitchenware..............................................
                                              ==============
DISC income:
  50 pct of combined taxable income.......................       618,750
  10 pct of export promotion expense of $300,000..........        30,000
                                              --------------
   Total DISC income......................................       648,750
DISC income as a percentage of combined taxable income....          52.4


In the second stage, in the absence of more specific or contrary 
information, the general and administrative expense may also be 
apportioned on the basis of gross income in the respective groupings. 
Since DISC taxable income is 52.4 percent of combined taxable income, 
DISC gross income is treated as 52.4 percent of the gross income from 
exports $1,700,000. The apportionment follows:

Apportionment of general and administrative expense to the       $32,750
 statutory grouping, DISC dividends:
 $125,000x[(0.524x$1,700,000)/($1,700,000 + $900,000 +
 $800,000)].................................................
Apportionment of general and administrative expense to the        29,412
 statutory grouping, foreign royalty income:
 $125,000x[$800,000/($1,700,000 + 900,000 + $800,000)]......
Apportionment of general and administrative expense to the        62,838
 residual grouping, gross income from sources within the
 United States: $125,000x[($900,000 + (0.476 x$1,700,000))/
 ($1,700,000 + $900,000 + $800,000)]........................
                                                             -----------
    Total apportioned general and administrative expense....     125,000


    (iv) This Example 22 applies only to DISC taxable years ending 
before January 1, 1987, and to distributions from a DISC or former DISC 
with respect to DISC or former DISC taxable years ending before January 
1, 1987.
    Example 23. [Reserved]
    Example 24. [Reserved]. For guidance, see Sec. 1.861-8T(g) Example 
24.
    Example 25. Income Taxes. (i) Facts. X, a domestic corporation, is a 
manufacturer and distributor of electronic equipment with operations in 
states A, B, and C. X also has a branch in country Y which manufactures 
and distributes the same type of electronic equipment. In 1988, X has 
taxable income from these activities, as described under the Code 
(without taking into account the deduction for state income taxes), of 
$1,000,000, of which $200,000 is foreign source general limitation 
income subject to a separate limitation under section 904(d)(1)(I) 
(``general limitation income'') and $800,000 is domestic source income. 
States A, B, and C each determine X's income subject to tax within their 
state by making adjustments to X's taxable income as determined under 
the Code, and then apportioning the adjusted taxable income on the basis 
of the relative amounts of X's payroll, property, and sales within each 
state as compared to X's worldwide payroll, property, and sales. The 
adjustments made by states A, B, and C all involve adding and 
subtracting enumerated items from taxable income as determined under the 
Code. However, in making these adjustments to taxable income, none of 
the states specifically exempts foreign source income as determined 
under the Code. On this basis, it is determined that X has taxable 
income of $550,000, $200,000, and $200,000 in states A, B, and C, 
respectively. The corporate tax rates in states A, B, and C are 10 
percent, 5 percent, and 2 percent, respectively, and X has total state 
income tax liabilities of $69,000 ($55,000 + $10,000 + $4,000), which it 
deducts as an expense for federal income tax purposes.
    (ii) Allocation. X's deduction of $69,000 for state income taxes is 
definitely related and thus allocable to the gross income with respect 
to which the taxes are imposed. Since the statutes of states A, B, and C 
do not specifically exempt foreign source income (as determined under 
the Code) from taxation and since, in the aggregate, states A, B, and C 
tax $950,000 of X's income while only $800,000 is domestic source income 
under the Code, it is presumed that state income taxes are imposed on 
$150,000 of foreign source income. The deduction for state income taxes 
is therefore related and allocable to both X's foreign source and 
domestic source income.
    (iii) Apportionment. For purposes of computing the foreign tax 
credit limitation, X's income is comprised of one statutory grouping, 
foreign source general limitation gross income, and one residual 
grouping, gross income from sources within the United States. The state 
income tax deduction of $69,000 must be apportioned between these two 
groupings. Corporation X calculates the apportionment on the basis of 
the relative

[[Page 162]]

amounts of foreign source general limitation taxable income and U.S. 
source taxable income subject to state taxation. In this case, state 
income taxes are presumed to be imposed on $800,000 of domestic source 
income and $150,000 of foreign source general limitation income.

State income tax deduction apportioned to foreign source         $10,895
 general limitation income (statutory grouping):
 $69,000x($150,000/$950,000)..................................
State income tax deduction apportioned to income from sources     58,105
 within the United States (residual grouping):
 $69,000x($800,000/$950,000)..................................
                                                               ---------
      Total apportioned state income tax deduction............   $69,000


    Example 26. Income Taxes. (i) Facts. Assume the same facts as in 
Example 25 except that the language of state A's statute and the 
statute's operation exempt from taxation all foreign source income, as 
determined under the Code, so that foreign source income is not included 
in adjusted taxable income subject to apportionment in state A (and 
factors relating to X's country Y branch are not taken into account in 
computing the state A apportionment fraction).
    (ii) Allocation. X's deduction of $69,000 for state income taxes is 
definitely related and thus allocable to the gross income with respect 
to which the taxes are imposed. Since state A exempts all foreign source 
income by statute, state A is presumed to impose tax on $550,000 of X's 
$800,000 of domestic source income. X's state A tax of $55,000 is 
allocable, therefore, solely to domestic source income. Since the 
statutes of states B and C do not specifically exclude all foreign 
source income as determined under the Code, and since states B and C 
impose tax on $400,000 ($200,000 + $200,000) of X's income of which only 
$250,000 ($800,000 - $550,000) is presumed to be domestic source, the 
deduction for the $14,000 of income taxes imposed by states B and C is 
related and allocable to both foreign source and domestic source income.
    (iii) Apportionment. (A) For purposes of computing the foreign tax 
credit limitation, X's income is comprised of one statutory grouping, 
foreign source general limitation gross income, and one residual 
grouping, gross income from sources within the United States. The 
deduction of $14,000 for income taxes of states B and C must be 
apportioned between these two groupings.
    (B) Corporation X calculates the apportionment on the basis of the 
relative amounts of foreign source general limitation income and U.S. 
source income subject to state taxation.

States B and C income tax deduction apportioned to foreign        $5,250
 source general limitation income (statutory grouping):
 $14,000x($150,000/$400,000)..................................
States B and C income tax deduction apportioned to income from     8,750
 sources within the United States (residual grouping):
 $14,000x($250,000/$400,000)..................................
                                                               ---------
      Total apportioned state income tax deduction............   $14,000


    (C) Of X's total income taxes of $69,000, the amount allocated and 
apportioned to foreign source general limitation income equals $5,250. 
The total amount of state income taxes allocated and apportioned to U.S. 
source income equals $63,750 ($55,000 + $8,750).
    Example 27. Income Tax. (i) Facts. Assume the same facts as in 
Example 25 except that state A, in which X has significant income-
producing activities, does not impose a corporate income tax or other 
state tax computed on the basis of income derived from business 
activities conducted in state A. X therefore has a total state income 
tax liability in 1988 of $14,000 ($10,000 paid to state B plus $4,000 
paid to state C), all of which is subject to allocation and 
apportionment under paragraph (b) of this section.
    (ii) Allocation. (A) X's deduction of $14,000 for state income taxes 
is definitely related and allocable to the gross income with respect to 
which the taxes are imposed. However, in these facts, an adjustment is 
necessary before the aggregate state taxable incomes can be compared 
with U.S. source income on the federal income tax return in the manner 
described in Examples 25 and 26. Unlike the facts in Examples 25 and 26, 
state A imposes no income tax and does not define taxable income 
attributable to activities in state A. The total amount of X's income 
subject to state taxation is, therefore, $400,000 ($200,000 in state B 
and $200,000 in state C). This total presumptively does not include any 
income attributable to activities performed in state A and therefore can 
not properly be compared to total U.S. source taxable income reported by 
X for federal income tax purposes, which does include income 
attributable to state A activities.
    (B)(1) Accordingly, before applying the method used in Examples 25 
and 26 to the facts of this example, it is necessary first to estimate 
the amount of taxable income that state A could reasonably attribute to 
X's activities in state A, and then to reduce federal taxable income by 
that amount.
    (2) Any reasonable method may be used to attribute taxable income to 
X's activities in state A. For example, the rules of the Uniform 
Division of Income for Tax Purposes Act (``UDITPA'') attribute income to 
a state on the basis of the average of three ratios

[[Page 163]]

that are based upon the taxpayer's facts--property within the state over 
total property, payroll within the state over total payroll, and sales 
within the state over total sales--and, with adjustments, provide a 
reasonable method for this purpose. When applying the rules of UDITPA to 
estimate U.S. source income derived from state A activities, the 
taxpayer's UDITPA factors must be adjusted to eliminate both taxable 
income and factors attributable to a foreign branch. Therefore, in this 
example all taxable income as well as UDITPA apportionment factors 
(property, payroll, and sales) attributable to X's country Y branch must 
be eliminated.
    (C)(1) Since it is presumed that, if state A had had an income tax, 
state A would not attempt to tax the income derived by X's country Y 
branch, any reasonable estimate of the income that would be taxed by 
state A must exclude any foreign source income.
    (2) When using the rules of UDITPA to estimate the income that would 
have been taxable by state A in these facts, foreign source income is 
excluded by starting with federally defined taxable income (before 
deduction for state income taxes) and subtracting any income derived by 
X's country Y branch. The hypothetical state A taxable income is then 
determined by multiplying the resulting difference by the average of X's 
state A property, payroll, and sales ratios, determined using the 
principles of UDITPA (after adjustment by eliminating the country Y 
branch factors). The resulting product is presumed to be exclusively 
U.S. source income, and the allocation and apportionment method 
described in Example 26 must then be applied.
    (3) If, for example, state A taxable income were determined to equal 
$550,000, then $550,000 of U.S. source income for federal income tax 
purposes would be presumed to constitute state A taxable income. Under 
Example 26, the remaining $250,000 ($800,000 - $550,000) of U.S. source 
income for federal income tax purposes would be presumed to be subject 
to tax in states B and C. Since states B and C impose tax on $400,000, 
the application of Example 25 would result in a presumption that 
$150,000 is foreign source income and $250,000 is domestic source 
income. The deduction for the $14,000 of income taxes of states B and C 
would therefore be related and allocable to both foreign source and 
domestic source income and would be subject to apportionment.
    (iii) Apportionment. The deduction of $14,000 for income taxes of 
states B and C is apportioned in the same manner as in Example 26. As a 
result, $5,250 of the $14,000 of state B and state C income taxes is 
apportioned to foreign source general limitation income 
($14,000x$150,000/$400,000), and $8,750 ($14,000x$250,000/$400,000) of 
the $14,000 of state B and state C income taxes is apportioned to U.S. 
source income.
    Example 28. Income Tax. (i) Facts. (A) Assume the same facts as in 
Example 25 (X has $1,000,000 of taxable income for federal income tax 
purposes, $800,000 of which is U.S. source income and $200,000 of which 
is foreign source general limitation income), except that $100,000 of 
X's $200,000 of foreign source general limitation income consists of 
dividends from first-tier controlled foreign corporations (``CFCs'') (as 
defined in section 957(a) of the Code) which derive exclusively foreign 
source general limitation income. X owns stock representing 10 to 50 
percent of the vote and value in such CFCs.
    (B) State A taxable income is computed by first making adjustments 
to X's federal taxable income. These adjustments result in X having a 
total of $1,100,000 of apportionable taxable income for state A tax 
purposes. None of the $100,000 of adjustments made by state A relate to 
the dividends paid by the CFCs. As in Example 25, the amount of 
apportionable taxable income attributable to business activities 
conducted in state A is determined by multiplying apportionable taxable 
income by a fraction (the ``state apportionment fraction'') that 
compares the relative amounts of X's payroll, property, and sales within 
state A with X's worldwide payroll, property and sales. An analysis of 
state A law indicates that state A law includes in its definition of the 
taxable business income of X which is apportionable to X's state A 
activities, dividends paid to X by its subsidiaries that are in the same 
business as X, but are less than 50 percent owned by X (``portfolio 
dividends''). The dividends received by X from the 10 to 50 percent 
owned first-tier CFCs, therefore, are considered to be portfolio 
dividends includable in apportionable business income for state A tax 
purposes. However, the factors of these CFCs are not included in the 
state A apportionment fraction for purposes of apportioning income to 
X's activities in the state. The comparison of X's state A factors with 
X's worldwide factors results in a state apportionment fraction of 50 
percent. Applying this fraction to apportionable taxable income of 
$1,100,000, as determined under state law, results in attributing 50 
percent of apportionable taxable income to state A, and produces total 
state A taxable income of $550,000. State A imposes an income tax at a 
rate of 10 percent on the amount of income that is attributed to state 
A, which results in $55,000 of tax imposed by state A.
    (ii) Allocation. (A) States A, B, and C impose income taxes of 
$69,000 which must be allocated to the classes of gross income upon 
which the taxes are imposed. A portion of X's federal income tax 
dedution of $55,000 for state A income tax is definitely related and 
thus allocable to the class of gross income consisting of foreign source 
portfolio dividends. A definite relationship exists between

[[Page 164]]

a deduction for state income tax and portfolio dividends when a state 
includes portfolio dividends in state taxable income apportionable to 
the state, but determines state taxable income by applying an 
apportionment fraction that excludes the factors of the corporations 
paying those dividends. By applying a state apportionment fraction that 
excludes factors of the corporations paying portfolio dividends to 
apportionable taxable income that includes the $100,000 of foreign 
source portfolio dividends, $50,000 (50 percent of the $100,000) of the 
portfolio dividends is attributed to X's activities in state A and 
subjected to state A income tax. Applying the state A income tax rate of 
10 percent to the $50,000 of foreign source portfolio dividends 
subjected to state A income tax, $5,000 of X's $55,000 total state A 
income tax liability is definitely related and allocable to a class of 
gross income consisting of the foreign source portfolio dividends. Since 
under the look-through rules of section 904(d)(3) the foreign source 
portfolio dividends from the first-tier CFCs are included within the 
general limitation described in section 904(d)(1)(I), the $5,000 of 
state A tax on foreign source portfolio dividends is allocated entirely 
to foreign source general limitation income and, therefore, is not 
apportioned. (If the total amount of state A tax imposed on foreign 
source portfolio dividends were to exceed the actual amount of X's state 
A income tax liability (for example, due to net operating losses), the 
actual amount of state A tax would be allocated entirely to those 
foreign source portfolio dividends.) After allocation of a portion of 
the state A tax to portfolio dividends, $50,000 ($55,000-$5,000) of 
state A tax remains to be allocated.
    (B) A total of $64,000 (the aggregate of the $50,000 remaining state 
A tax, and the $10,000 and $4,000 of taxes imposed by states B and C, 
respectively) is to be allocated (as provided in Example 25) by 
comparing U.S. source taxable income (as determined under the Code) with 
the aggregate of the state taxable incomes determined by states A, B, 
and C (after reducing state apportionable taxable incomes by the amount 
of any portfolio dividends included in apportionable taxable income to 
which tax has been specifically allocated). X's state A taxable income, 
after reduction by the $50,000 of portfolio dividends taxed by state A, 
equals $500,000. X also has taxable income of $200,000 and $200,000 in 
states B and C, respectively. In the aggregate, therefore, states A, B, 
and C tax $900,000 of X's income, after excluding state taxable income 
attributable to portfolio dividends. Since X has only $800,000 of U.S. 
source taxable income for federal income tax purposes, it is presumed 
that state income taxes are imposed on $100,000 of foreign source 
income. The remaining deduction of $64,000 for state income taxes is 
therefore related and allocable to both foreign source and domestic 
source income and is subject to apportionment.
    (iii) Apportionment. For purposes of computing the foreign tax 
credit limitation, X's income is comprised of one statutory grouping, 
foreign source general limitation income, and one residual grouping, 
gross income from sources within the United States. The remaining state 
income tax deduction of $64,000 must be apportioned between these two 
groupings on the basis of relative amounts of foreign source general 
limitation taxable income and U.S. source taxable income subject to 
state taxation. In this case, the $64,000 of state income taxes is 
considered to be imposed on $800,000 of domestic source income and 
$100,000 of foreign source general limitation income and is apportioned 
as follows:

State income tax deduction apportioned to foreign source          $7,111
 general limitation income (statutory grouping):
 $64,000x($100,000/$900,000)...............................
State income tax deduction apportioned to income from             56,889
 sources within the United States (residual grouping):
 $64,000x($800,000/$900,000)...............................
                                                            ------------
      Total apportioned state income tax deduction.........      $64,000


    Of the total state income taxes of $69,000, the amount allocated and 
apportioned to foreign source general limitation income equals $12,111 
($5,000 + $7,111). The total amount of state income taxes allocated and 
apportioned to U.S. source income equals $56,889.
    Example 29. Income Taxes. (i) Facts. (A) P, a domestic corporation, 
is a manufacturer and distributor of electronic equipment with 
operations in states F, G, and H. P also has a branch in country Y which 
manufactures and distributes the same type of electronic equipment. In 
addition, P has three wholly owned subsidiaries, US1, US2, and FS, the 
latter a controlled foreign corporation (``CFC'') as defined in section 
957(a) of the Code. P also owns stock representing 10 to 50 percent of 
the vote and value of various other first-tier CFCs that derive 
exclusively foreign source general limitation income.
    (B) In 1988, P derives $1,000,000 of federal taxable income (without 
taking into account the deduction for state income taxes), which 
consists of $250,000 of foreign source general limitation income and 
$750,000 of U.S. source income. The foreign source general limitation 
income consists of a $25,000 subpart F inclusion with respect to FS, 
$150,000 of dividends from the other first-tier CFCs deriving 
exclusively foreign source general limitation income, in which P owns 
stock representing 10 to 50 percent of the vote and value, and $75,000 
of manufacturing and sales income

[[Page 165]]

derived by P's U.S. operations and country Y branch. The $750,000 of 
U.S. source income consists of manufacturing and sales income derived by 
P's U.S. operations.
    (C) For federal income tax purposes, US1 derives $75,000 of taxable 
income, before deduction for state income taxes, which consists entirely 
of U.S. source income. US2, a so-called ``80/20'' corporation described 
in section 861(c)(1), derives $250,000 of federal taxable income before 
deduction for state or foreign income taxes, all of which is derived 
from foreign operations and consists entirely of foreign source general 
limitation income. FS is not engaged in a U.S. trade or business and 
derives $550,000 of foreign source general limitation income before 
deduction for foreign income taxes.
    (D) State F imposes a corporate income tax of 10 percent of P's 
state F taxable income, which is determined by formulary apportionment 
of the total taxable income attributable to P's worldwide unitary 
business. State F determines P's taxable income for state F tax purposes 
by first making adjustments to the taxable income, as determined for 
federal income tax purposes, of the members of the unitary business 
group to determine the total taxable income of the group. State F then 
computes P's state taxable income by attributing a portion of that 
unitary business taxable income to activities of P that are conducted in 
state F. State F does this by multiplying the unitary business taxable 
income (federal taxable income with state adjustments) by a fraction 
(the ``state apportionment fraction'') that compares the relative 
amounts of the unitary business group's payroll, property, and sales 
(the ``factors'') in state F with the payroll, property, and sales of 
the unitary business group. P is the only member of its unitary business 
group that has state F factors and that is thereby subject to state F 
income tax and filing requirements. State F defines the unitary business 
group to include any corporation more than 50 percent of which is 
directly or indirectly owned by a state F taxpayer and is engaged in the 
same unitary business. P's unitary business group, therefore, includes 
P, US1, US2, and FS, but does not include the 10 to 50 percent owned 
CFCs. The income of the unitary business group excludes intercompany 
dividends between members of the unitary business group and subpart F 
inclusions with respect to a member of the unitary business group. 
Dividends paid from nonmembers of the unitary group (the 10 to 50 
percent owned CFCs) for state F tax purposes are referred to as 
``portfolio dividends'' and are included in taxable income of the 
unitary business. None of the factors (in state F or worldwide) of the 
corporations paying portfolio dividends are included in the state F 
apportionment fraction for purposes of apportioning total taxable income 
of the unitary business to P's state F activities.
    (E) After state adjustments to the taxable income of the unitary 
business group, as determined under federal tax principles, the total 
taxable income of P's unitary business group equals $2,000,000, 
consisting of $1,050,000 of P's income ($100,000 of foreign source 
manufacturing and sales income, $150,000 of foreign source portfolio 
dividends, and $800,000 of U.S. source manufacturing and sales income, 
but excluding the $25,000 subpart F inclusion attributable to FS since 
FS is a member of the unitary business group), $100,000 of US1's income 
(from sales made in the United States), $275,000 of US2's income (from 
an active business outside the United States), and $575,000 of FS's 
income. The differences between taxable income under federal tax 
principles and state F apportionable taxable income for P, US1, US2, and 
FS represent adjustments to taxable income under federal tax principles 
that are made pursuant to the tax laws of state F.
    (F) The taxable income for each member of the unitary business group 
under federal tax principles and state law principles is summarized in 
the following table. (The items of income listed in the ``Federal'' 
column of the table refer to taxable income before deduction for state 
income tax.)

------------------------------------------------------------------------
                                                    Federal     State F
------------------------------------------------------------------------
                        P

U.S. source income..............................    $750,000    $800,000
Foreign source general limitation income:
    Portfolio dividends.........................     150,000     150,000
    Subpart F income............................      25,000           0
    Manufacturing and sales income..............      75,000     100,000
                                                 -----------------------
      Total taxable income......................   1,000,000   1,050,000

                       US1

U.S. source income..............................      75,000     100,000

                       US2

Foreign source general limitation income........     250,000     275,000

                       FS

Foreign source general limitation income........     550,000     575,000
                                                 -----------------------
Taxable income of the unitary business group....  ..........   2,000,000
                                                 =======================
------------------------------------------------------------------------

    (G) State F deems P to have state F taxable income of $500,000, 
which is determined by multiplying the total taxable income of the 
unitary business group ($2,000,000) by the group's state F apportionment 
fraction, which is assumed to be 25 percent in these facts. P's state F 
taxable income is then multiplied by the state F tax rate of 10 percent, 
resulting in a state F tax liability of $50,000. State G and state H, 
unlike state F, do not tax portfolio dividends. Although

[[Page 166]]

state G and state H apportion taxable income, respectively, on the basis 
of an apportionment fraction that compares state factors to total 
factors, state G and state H, unlike state F, do not apply a unitary 
business theory and consider only P's taxable income and factors in 
computing P's taxable income. P's taxable income under state G law 
equals $300,000, which is subject to a 5 percent tax rate resulting in a 
state G tax liability of $15,000. P's taxable income under state H law 
is $300,000, which is subject to a tax rate of 2 percent resulting in a 
state H tax liability of $6,000. P has a total federal income tax 
deduction for state income taxes of $71,000 ($50,000 + 15,000 + 6,000).
    (ii) Allocation. (A) P's deduction of $71,000 for state income taxes 
is definitely related and allocable to the gross income with respect to 
which the taxes are imposed. Adjustments may be necessary, however, 
before aggregate state taxable incomes can be compared with U.S. source 
taxable income on the federal income tax return in the manner described 
in Examples 25 and 26. In allocating P's deduction for state income 
taxes, it is necessary first to determine the portion, if any, of the 
deduction that is definitely related and allocable to a particular class 
of gross income. A definite relationship exists between a deduction for 
state income tax and dividend income when a state includes portfolio 
dividends in state taxable income apportionable to the taxpayer's 
activities in the state, but determines state taxable income by applying 
an apportionment formula that excludes the factors of the corporations 
paying portfolio dividends.
    (B) In this case, $150,000 of foreign source portfolio dividends are 
subject to a state F apportionment fraction of 25 percent, which results 
in a total of $37,500 of state F taxable income attributable to such 
dividends. As illustrated in Example 28, $3,750 ($150,000x25 percent 
state F apportionment percentage x 10 percent state F tax rate) of P's 
state F income tax is definitely related and allocable to a class of 
gross income consisting entirely of the foreign source portfolio 
dividends. Since under the look-through rules of section 904(d)(3) the 
foreign source portfolio dividends paid by first-tier CFCs are included 
within the general limitation described in section 904(d)(1)(I), the 
$3,750 of state F tax on foreign source portfolio dividends is allocated 
entirely to foreign source general limitation income and, therefore, is 
not apportioned.
    (C) After reducing state F taxable income of the unitary business 
group by the taxable income attributable to portfolio dividends, P's 
remaining state F taxable income equals $462,500 ($500,000 - $37,500), 
the portion of the taxable income of the unitary business that state F 
attributes to P's activities in state F. Accordingly, in order to 
allocate and apportion the remaining $46,250 of state F tax ($50,000 of 
state F tax minus the $3,750 of state F tax allocated to foreign source 
portfolio dividends), it is necessary first to determine if state F is 
taxing only P's non-unitary taxable income (as defined below) or is 
imposing its tax partly on other unitary business income that is 
attributed under state F law to P's activities in state F. P's state F 
non-unitary taxable income is computed by applying the state F 
apportionment formula, solely on the basis of P's income (excluding 
portfolio dividends) and state F apportionment factors. If the state F 
taxable income (after reduction by the portfolio dividends attributed to 
state F) attributed to P under state F law exceeds P's non-unitary 
taxable income, a portion of the state F tax must be allocated and 
apportioned on the basis of the other unitary business income that is 
attributed to and taxable to P under state F law. If P's non-unitary 
taxable income equals or exceeds the $462,500 of remaining state F 
taxable income, it is presumed that state F is only taxing P's non-
unitary taxable income, so that the entire amount of the remaining state 
F tax should be allocated and apportioned in the manner described in 
Example 25.
    (D) If P's non-unitary taxable income is less than the $462,500 of 
remaining state F taxable income (after reduction for the $37,500 of 
state F taxable income attributable to portfolio dividends), it is 
presumed that state F is attributing to P, and taxing P upon, other 
unitary business income. In such a case, it is necessary to determine if 
state F is attributing to P, and imposing its income tax on, a part of 
the foreign source income that would be generally presumed under 
separate accounting to be the income of foreign affiliates and 80/20 
companies included in the unitary group, or whether state F is limiting 
the income it attributes to P, and its taxation of P, to the U.S. source 
income that would be generally presumed under separate accounting to be 
the income of domestic members of the unitary group.
    (E) Assume for purposes of this example that the non-unitary taxable 
income attributable to P equals $396,000, computed by multiplying P's 
state F taxable income of $900,000 (P's state F taxable income (before 
state F apportionment) of $1,050,000 less the $150,000 of foreign source 
portfolio dividends) by P's non-unitary state F apportionment fraction, 
which is assumed to be 44 percent. Because P's non-unitary taxable 
income of $396,000 is less than the $462,500 of remaining state F 
taxable income, state F is presumed to be attributing to P and taxing 
the income that would have been generally attributed under separate 
accounting to P's affiliates in the unitary group. To determine if state 
F tax is being imposed on members of the unitary group (other that P) 
that produce foreign source income, it is necessary to compute a 
hypothetical state F taxable income

[[Page 167]]

for all companies in the unitary group with significant U.S. operations. 
(For this purpose, the hypothetical group of companies with significant 
domestic operations is referred to as the ``water's edge group.'') State 
F is presumed to be attributing to P and taxing income that would have 
been generally attributable under separate accounting to foreign 
corporations and 80/20 companies to the extent that the remaining state 
F taxable income ($462,500) of P exceeds the hypothetical state F 
taxable income that would have been attributed under state F law to P if 
state F had defined the unitary group to be the water's edge group.
    (F) The members of the water's edge group would have been P and US1. 
The unitary business income of this water's edge group is $1,000,000, 
the sum of $900,000 (P's state F taxable income (before state F 
apportionment) of $1,050,000 less the $150,000 of foreign source 
portfolio dividends) and $100,000 (US1's state F taxable income). For 
purposes of this example, the state F apportionment fraction determined 
on a unitary basis for this water's edge group is assumed to equal 40 
percent, the average of P and US1's state F payroll, property, and sales 
factor ratios (the water's edge group's state F factors over its 
worldwide factors). Applying this apportionment fraction to the 
$1,000,000 of unitary business income of the water's edge group yields 
state F water's edge taxable income of $400,000. The excess of the 
remaining $462,500 of P's state F taxable income over the $400,000 of 
P's state F water's edge taxable income equals $62,500, and is 
attributable to the inclusion of US2 and FS in the unitary group. The 
state F tax attributable to the $62,500 of taxable income attributed to 
P under state F law, and that would have generally been attributed to 
US2 and FS under non-unitary accounting, equals $6,250 and is allocated 
entirely to a class of gross income consisting of foreign source general 
limitation income, because the income of FS and US2 consists entirely of 
such income. After the $6,250 of state F tax attributable to US2 and FS 
is subtracted from the remaining $46,250 of net state F tax, P has 
$40,000 of state F tax remaining to be allocated and apportioned.
    (G) To the extent that the remainder of P's state F taxable income 
($400,000) exceeds P's non-unitary state F taxable income ($396,000), it 
is presumed that state F is attributing to and imposing on P a tax on 
U.S. source income that would have been attributed under separate 
accounting to members of the water's edge group other than P. In these 
facts, the $4,000 difference in P's state F taxable income results from 
the inclusion of US1 in the unitary group. The $400 of P's state F tax 
attributable to this $4,000 is allocated entirely to P's U.S. source 
income. P's remaining $39,600 of state F tax ($40,000 of P's state F tax 
resulting from the attribution of P of income that would have been 
attributed under non-unitary accounting to other members of the water's 
edge group, minus $400 of state F tax attributable to US1 and allocated 
to P's U.S. source income) is the state F tax attributable to P's non-
unitary state F taxable income that is to be allocated and apportioned 
together with P's state G tax of $15,000 and state H tax of $6,000 as 
illustrated in Example 25.
    (H) In allocating the $60,600 of state tax liabilities ($39,600 
state F tax attributable to P's non-unitary state F income + $15,000 
state G tax + $6,000 state H tax) under Example 25, P's state taxable 
income in state G and state H ($300,000 + $300,000) must be added to P's 
non-unitary state F taxable income ($396,000). The resulting $996,000 of 
combined state taxable incomes is compared with $750,000 of U.S. source 
income on P's federal income tax return. Because P's combined state 
taxable incomes exceeds P's federal U.S. source taxable income, it is 
presumed that the remaining $60,600 of P's total state income taxes is 
imposed in part on foreign source income. Accordingly, P's remaining 
deduction of $60,600 ($39,600 + $15,000 + $6,000) for state income taxes 
is related and allocable to both P's foreign source and domestic source 
income and is subject to apportionment.
    (iii) Apportionment. The $60,600 of state taxes (the remaining 
$39,600 of state F tax + $15,000 of state G tax + $6,000 of state H tax) 
must be apportioned between foreign source general limitation income and 
U.S. source income for federal income tax purposes. This apportionment 
is based upon the relative amounts of foreign source general limitation 
taxable income and U.S. source taxable income comprising the $996,000 of 
income subject to tax by the states, after reducing the total amount of 
income subject to tax by the portfolio dividends and the income 
attributed to P under state F law that would have been attributed under 
arm's length principles to other members of P's state F unitary business 
group. The deduction for the $60,600 of state income taxes is 
apportioned as follows:

State income tax deduction apportioned to foreign source         $14,967
 general limitation income (statutory grouping):
 $60,600x($246,000/$996,000)..................................
State income tax deduction apportioned to income from sources     45,633
 within the United States (residual grouping):
 $60,600x($750,000/$996,000)..................................
                                                               ---------
    Total apportioned state income tax deduction..............    60,600




Of the total state income taxes of $71,000, the amount allocated and 
apportioned to foreign source general limitation income is $24,967--the 
sum of $14,967 of state F, state G, and state H taxes apportioned to 
foreign source general limitation income, $3,750 of state F tax 
allocated to foreign source apportionable

[[Page 168]]

dividend income, and the $6,250 of state F tax allocated to foreign 
source general limitation income as the result of state F's worldwide 
unitary business theory of taxation. The total amount of state income 
taxes allocated and apportioned to U.S. source income equals $46,033--
the sum of the $400 of state F tax attributable to the inclusion of US1 
in the state F unitary business group and $45,633 of combined state F, 
G, and H tax apportioned under the method provided in Example 25.
    Example 30. [Reserved]. For further guidance, see Sec. 1.861-8T(g), 
Example 30.
    Example 31. Income Taxes. (i) Facts. Assume that the facts are the 
same as in Example 29, except that state G requires P to adjust its 
federal taxable income by depreciating an asset at a different rate than 
is allowed P under the Internal Revenue Code for the same asset. Before 
using the methodology of Example 25 to determine whether a portion of 
its deduction for state income taxes is allocable to a class of gross 
income that includes foreign source income, P recomputes its taxable 
income under state G law by using the rate of depreciation that it is 
entitled to use under the Code, and uses this recomputed amount in 
applying the methodology of Example 25.
    (ii) Allocation. P's modification of its state G taxable income is 
permissible. Under the methdology of Example 25, this modification of 
state G taxable income will produce a reasonable determination of the 
portion (if any) of P's state income taxes that is allocable to a class 
of gross income that includes foreign sources income.
    Example 32. Income Taxes. (i) Facts. Assume the facts are the same 
as Example 29, except that P's state F taxable income differs from the 
amount of its U.S. source income under federal income tax principles 
solely because state F determines P's state taxable income under a 
worldwide unitary business theory instead of the arm's length principles 
applied in the Code. Before using the methodology of Example 25 to 
determine whether a portion of its deduction for state income taxes is 
allocable to a class of gross income that includes foreign source 
income, P recomputes state F taxable income under the arm's length 
principles applied in the Code. P substitutes that recomputed amount for 
the amount of taxable income actually determined under state F law in 
applying the methodology of Example 25.
    (ii) Allocation. P's modification of state F taxable income does not 
accurately reflect the factual relationship between the deduction for 
state F income tax and the income on which the tax is imposed, because 
there is no factual relationship between the state F income tax and the 
state F taxable income as recomputed under Code principles. State F does 
not impose its income tax upon P's income as it might have been defined 
under the Internal Revenue Code. Consequently, P's modification of state 
F taxable income is impermissible because it will not produce a 
reasonable determination of the portion (if any) of P's state income 
taxes that is allocable to a class of gross income that includes foreign 
source income.
    Example 33. Income Taxes. (i) Facts. Assume the same facts as in 
Example 29, except that state G does not impose an income tax on 
corporations, and P's non-unitary state F taxable income equals 
$462,500. Thus only $56,000 of state income taxes ($50,000 of state F 
income tax and $6,000 of state H income tax) are deductible and required 
to be allocated and (if necessary) apportioned. As in Example 29, P has 
$800,000 of aggregate state taxable income ($500,000 of state F taxable 
income and $300,000 of state H taxable income).
    (ii) Method One. Assume that P has elected to allocate and apportion 
its deduction for state income tax under the safe harbor method provided 
in Sec. 1.861-8 (e)(6)(ii)(D)(2) (``Method One'').
    (A) Step One--Specific allocation to foreign source portfolio 
dividends. P applies the methodology of paragraph (ii) of Example 28 to 
determine the portion of the deduction that must be allocated to a class 
of gross income consisting solely of foreign source portfolio dividends. 
As illustrated in paragraphs (ii) (A) and (B) of Example 29, $3,750 of 
the deduction for state F income tax is attributable to the $37,500 of 
foreign source portfolio dividends attributed under state F law to P's 
activities in state F. Thus $3,750 of P's deduction for state income tax 
must be specifically allocated to a class of gross income consisting 
solely of $37,500 of foreign source portfolio dividends. No 
apportionment of the $3,750 is necessary. P's adjusted state taxable 
income is $762,500 (aggregate state taxable income of $800,000 reduced 
by $37,500 of foreign source portfolio dividends). Because the remaining 
amount of state F taxable income ($462,500) equals P's non-unitary state 
F taxable income, no further specific allocation of state tax is 
required.
    (B) Step Two--Adjustment of U.S. source federal taxable income. P 
applies the methodology illustrated in paragraph (ii) of Example 27 
(including the rules of UDITPA described therein) to determine the 
amount of its federal taxable income attributable to its activities in 
state G. Assume that P determines under this methodology that $300,000 
of its federal taxable income is attributable to activities in state G. 
P's adjusted U.S. source federal taxable income equals $450,000 
($750,000 minus the $300,000 attributed to P's activities in state G).
    (C) Step Three--Allocation. The portion of P's deduction for state 
income tax remaining to be allocated equals $52,250 ($56,000 minus the 
$3,750 specifically allocated to foreign source portfolio dividends). P 
allocates this

[[Page 169]]

portion by applying the methodology illustrated in paragraph (ii) of 
Example 25, as modified by paragraph (e)(6)(ii)(D)(2)(iii) of this 
section. Thus, P compares its adjusted state taxable inocme (as 
determined under Step One in paragraph (A) above) with an amount equal 
to 110% of its adjusted U.S. source federal taxable income (as 
determined under Step Two in paragraph (B) above). Because P's adjusted 
state taxable income ($762,500) exceeds 110% of P's adjusted U.S. source 
federal taxable income ($495,000, or 110% of $450,000), the remaining 
portion of P's deduction for state income tax ($52,500) must be 
allocated to a class of gross income that includes both U.S. and foreign 
source income.
    (D) Step Four--Apportionment. P must apportion to U.S. source income 
the portion of the deduction that is attributable to state income tax 
imposed upon state taxable income in an amount equal to 110% of P's 
adjusted U.S. source federal taxable income. The remainder of the 
deduction must be apportioned to foreign source general limitation 
income.

Amount of deduction to be apportioned.....................    $52,250.00
Less portion of deduction to be apportioned to income from    $33,919.67
 sources within the United States (residual grouping):
 ($52,250x($495,000/$762,500).............................
                                                           -------------
Equals Portion of deduction to be apportioned to foreign      $18,330.33
 source general limitation income (statutory grouping):...


    (iii) Method Two. Assume that P has elected to allocate and 
apportion its deduction for state income tax under the safe harbor 
method provided in Sec. 1.861-8(e)(6)(ii)(D)(3) (``Method Two'').
    (A) Step One--Specific allocation. Step One of Method Two is the 
same as Step One of Method One. Therefore, as described in paragraph (A) 
of paragraph (ii) above, $3,750 of P's deduction for state income tax 
must be specifically allocated to a class of gross income consisting 
solely of $37,500 of foreign source portfolio dividends. No 
apportionment of the $3,750 is necessary. P's adjusted state taxable 
income is $762,500 (aggregate state taxable income of $800,000 reduced 
by $37,500 of foreign source portfolio dividends).
    (B) Step Two--Adjustment of U.S. source federal taxable income. Step 
Two of Method Two is the same as Step Two of Method One. Therefore, as 
described in paragraph (B) of paragraph (ii) above, assume that P 
determines that $300,000 of its federal taxable income is attributable 
to activities in state G. P's adjusted U.S. source federal taxable 
income equals $450,000 ($750,000 minus the $300,000 attributed to P's 
activities in state G).
    (C) Step Three--Allocation. The portion of P's deduction for state 
income tax remaining to be allocated equals $52,250 ($56,000 minus the 
$3,750 of state F income tax specifically allocated to foreign source 
portfolio dividends). P allocates this portion by applying the 
methodology illustrated in paragraph (ii) of Example 25, as modified by 
paragraph (e)(6)(ii)(D)(3)(iii) of this section. Thus, P compares its 
adjusted state taxable income (as determined under Step One in paragraph 
(A) above) with its adjusted U.S. source federal taxable income (as 
determined under Step Two in paragraph (B) above). Because P's adjusted 
state taxable income ($762,500) exceeds P's adjusted U.S. source federal 
taxable income ($450,000), the remaining portion of P's deduction for 
state income tax ($52,500) must be allocated to a class of gross income 
that includes both U.S. and foreign source income.
    (D) Step Four--Apportionment. P must apportion to U.S. source income 
the portion of the deduction that is attributable to state income tax 
imposed upon state taxable income in an amount equal to P's adjusted 
U.S. source federal taxable income.

Amount of deduction to be apportioned.....................    $52,250.00
Less portion of deduction initially apportioned to income      30,836.07
 from sources within the United States (residual
 grouping): $52,250x($450,000/$762,500)...................
                                                           -------------
Remainder requiring further apportionment:                     21,413.93
 $52,250x($312,500/$762,500)..............................



The remainder of $21,413.93 must be further apportioned between foreign 
source general limitation income and U.S. source federal taxable income 
in the same proportions that P's adjusted U.S. source federal taxable 
income and foreign source general limitation income bear to P's total 
federal taxable income (taking into account the adjustment of U.S. 
source federal taxable income and reduced by the amount of foreign 
source portfolio dividends to which the tax has been specifically 
allocated).

Portion of remainder apportioned to foreign source general     $6,868.62
 limitation income (statutory grouping): $21,413.93 X
 ($212,500/$662,500)......................................
Remaining state income tax deduction to be apportioned to     $14,545.31
 income from sources within the United States (residual
 grouping): $21,413.93 X ($450,000/$662,500)..............


    Of P's total deduction of $56,000 for state income tax, the portion 
allocated and apportioned to foreign source general limitation income 
equals $10,618.62--the sum of $6,868.62 apportioned under Step Four and 
the $3,750.00 specifically allocated to foreign source portfolio 
dividend income under Step One. The portion of the deduction allocated 
and apportioned to U.S. source income equals $45,381.38--the sum of the 
$30,836.07

[[Page 170]]

and the $14,545.31 apportioned under Step Four.

[T.D. 7456, 42 FR 1195, Jan. 6, 1977, as amended by T.D. 7749, 46 FR 
1683, Jan. 7, 1981; T.D. 7939, 49 FR 4207, Feb. 3, 1984; T.D. 8228, 53 
FR 35474, Sept. 14, 1988; T.D. 8286, 55 FR 3052, Jan. 30, 1990; T.D. 
8337, 56 FR 10369, Mar. 12, 1991; 56 FR 22760, May 16, 1991; 56 FR 
24001, May 28, 1991; T.D. 8228, 60 FR 36669, July 18, 1995; T.D. 8646, 
60 FR 66503, Dec. 22, 1995; T.D. 8805, 64 FR 1509, Jan 11, 1999; T.D. 
8973, 66 FR 67083, Dec. 28, 2001; T.D. 9143, 69 FR 44931, July 28, 2004; 
T.D. 9194, 70 FR 18928, Apr. 11, 2005; T.D. 9211, 70 FR 40662, July 14, 
2005; T.D. 9278, 71 FR 44514, Aug. 4, 2006]