International Telephone & Telegraph Corp. v. Commissioner, 77 T. C. 67 (1981)

Foreign source operating losses of affiliated corporations must be included in the calculation of consolidated foreign source taxable income for foreign tax credit limitations.

Summary

In International Telephone & Telegraph Corp. v. Commissioner, the Tax Court addressed how to calculate the foreign tax credit limitation for a consolidated group, specifically whether to include foreign source operating losses in the numerator of the pertinent fraction. The court held that such losses must be included, aligning the numerator’s calculation with the denominator’s. This ruling clarified the treatment of intercompany transactions and the allocation of expenses in consolidated returns, emphasizing the group’s treatment as a single entity for tax purposes. The decision also addressed the nonrecognition of losses from convertible debentures, reinforcing the principles governing consolidated returns and foreign tax credit calculations.

Facts

International Telephone & Telegraph Corp. (ITT) and its affiliated group (ITT Group) filed a consolidated federal income tax return for 1965. The group elected to claim a foreign tax credit, subject to the overall limitation under section 904(a). Several ITT Group members incurred foreign source operating losses, which ITT excluded from the numerator of the pertinent fraction used to calculate the foreign tax credit limitation. Additionally, ITT subsidiaries acquired convertible debentures of other companies in reorganizations and later exchanged and retired them, seeking to recognize losses.

Procedural History

The IRS determined a deficiency in ITT’s income tax, leading ITT to petition the Tax Court. The case was submitted fully stipulated, focusing on the calculation of the foreign tax credit and the treatment of convertible debentures.

Issue(s)

1. Whether foreign source operating losses of certain ITT Group members must be included in the numerator of the pertinent fraction for calculating the consolidated foreign tax credit limitation.
2. Whether service fees and interest payments between ITT Group members should be allocated to domestic source income or apportioned to foreign source income in determining the consolidated foreign tax credit limitation.
3. Whether the exchanges and subsequent retirement of convertible debentures by ITT subsidiaries were integral parts of the reorganization plans, thus nonrecognizable transactions.
4. If not, whether ITT or its subsidiaries recognized any loss from the debenture transactions.

Holding

1. Yes, because the numerator and denominator of the pertinent fraction must be calculated on the same basis, including foreign source operating losses ensures consistency.
2. No, because these expenses must be apportioned to foreign source income as they are not definitely allocable to domestic source income.
3. No, because the exchanges and retirements were not essential to the reorganization plans and were independent transactions.
4. No, because the transactions were governed by the consolidated return regulations, which do not allow recognition of the losses claimed.

Court’s Reasoning

The court emphasized that the foreign tax credit limitation requires consistent calculation of the numerator and denominator of the pertinent fraction. It rejected ITT’s reliance on Rev. Rul. 72-281, clarifying that the ruling did not support excluding members with foreign source operating losses from the numerator. The court applied section 1. 1502-43A, Income Tax Regs. , which mirrors general provisions for nonaffiliated corporations, requiring inclusion of these losses. For the allocation of intercompany payments, the court applied section 862(b), determining that these expenses must be apportioned to foreign source income as they were not definitely allocable to domestic income. Regarding the convertible debentures, the court found that the exchanges and retirements were separate from the reorganization plans, thus not qualifying for nonrecognition under section 361. The court applied section 1. 1502-41A(b), Income Tax Regs. , to disallow recognition of any loss, as the debentures’ retirement was treated as a transaction within the consolidated group.

Practical Implications

This decision clarifies the calculation of foreign tax credit limitations for consolidated groups, requiring the inclusion of foreign source operating losses in the numerator. It impacts how intercompany transactions are treated, ensuring consistency in the allocation of expenses between domestic and foreign source income. The ruling also affects the treatment of convertible debentures in reorganizations, disallowing loss recognition when transactions are not integral to the reorganization plan. Legal practitioners must carefully consider these principles when advising clients on consolidated returns and foreign tax credit calculations. Subsequent cases like International Telephone & Telegraph Corp. v. United States have reinforced these principles, though distinguishing between separate and aggregate calculations.