While the level of acquisition activity shows little sign of decreasing, the high price tags on many transactions are prompting companies to look to overseas markets for potential opportunities. These opportunities are not without a possible tax downside. An increase in foreign investment and debt levels is causing companies to review the interest expense allocation between their foreign and domestic operations.

Multinational companies must allocate interest expense to foreign and domestic units as provided under Internal Revenue Code §861. The allocation can be based upon either the tax basis or fair market value of the underlying assets. Some feel that the fair market value method has not been widely used because no company wants to be the first to put its "tax toe" in the water. An increase in foreign acquisitions may compel more companies to adopt this method.

Companies contemplating the fair market value method need only have interest expense along with foreign and domestic assets to be faced with this issue. Even with a modest component of debt, the simple passage of time changes the tax basis of a company's assets, which in turn can cause a dramatic shift in the allocation of interest expense. Additionally, if a company's foreign acquisitions are accounted for under IRC §338(g), which steps up foreign assets to fair market value, the interest allocated to foreign operations increases since there is no corresponding step up in U.S. assets. This allocation effectively decreases foreign source income, and can limit the ability of a U.S. company to credit foreign income taxes against its U.S. tax liability.

Before electing the fair market value method, a company should obviously seek competent tax counsel. Expert valuation guidance is also required to appropriately evaluate potential benefits. Preliminary valuation studies can be conducted to analyze the distribution of fair market value between domestic and foreign entities. These studies also provide valuable insight into the quality of financial and fixed asset information from foreign operations.

The information required to conduct a preliminary valuation for §861 purposes is relatively straightforward. The results provide an excellent basis for evaluating the benefits of the two allocation methods. An overview of the valuation process is outlined below:

1. Determine the value of the consolidated company based upon its share price without regard for control premiums. 

2. Value current assets and current liabilities. 

3. Value all tangible assets by major operating group.

4. Value intangible assets of the consolidated group on a residual basis and apportion based upon pretax income, before interest expense.

5. Compare value conclusions between foreign and domestic operations to determine distribution of interest expense.

With the above information, an initial interest expense allocation can be made for domestic and foreign operations based upon fair market value. These results can then be compared to the interest allocated under the tax basis method. It should be noted that the purpose of the analysis is to choose the method that allocates the least amount of interest expense to foreign source income.

An additional advantage to selecting the fair market value method is that less interest expense is allocated to any foreign operations that may be underperforming. This is due to the fact that economic penalties are applied to these assets to reflect their underutilization from an income standpoint. The amount of interest allocated to each unit will increase as performance improves.

Once a decision has been made to apply the fair market value method, a final assessment of the availability of information at foreign units should be completed. If inadequate financial statements, poor fixed asset records, poor land records or asset ownership issues exists, a plan can be developed to resolve any inadequacies. The focus of this step is to insure that the valuation of all underlying assets is supported by a strong foundation of information. This data is also needed to update and support the interest allocation on an annual basis.

The use of competent valuation professionals is key to evaluating a company's options under §861. A preliminary analysis can provide management with the tools necessary to choose between the net tax basis or fair market value method. 

Valuation Research has significant domestic and international experience and the resources to provide management with preliminary feasibility studies as well as ongoing valuation support. For more information, contact your Valuation Research representative or call Richard B. Nordberg at (414) 221-6220. VR