Q:  How does the ETI regime treat expenses attributable to excluded income?

A:  Under Sec. 114(c), expenses attributable to excluded ETI cannot be claimed as a deduction for U.S. tax purposes.  Thus, the exclusion amount (QFTI) would be “grossed-up” to include ETI (net income) plus expenses. 

Presumably, this disallowance would apply to expenses incurred by a U.S. or foreign electing company or business reporting the QFTI (gross income).  In addition, for U.S. tax reporting purposes, a Schedule M or similar adjusting entry will be required to reconcile the amount of total deductions being claimed on the return and the total amount of deductions reflected in the books.  This rule can be supported under tax benefit principles.

In theory, expenses disallowed under this rule include direct expenses incurred on each transaction.  Many companies or businesses, however, have limited product line expense data.  As a result, taxpayers may be able to establish a favorable grouping of transactions to reduce expenses attributable to QFTI.  Corporate overhead and other indirect expenses properly apportioned to FTGR and QFTI under Reg. Sec. 861-8 also must be included.

Under Sec. 114(c)(2), disallowed expenses are computed on a  gross-to-gross or gross income basis, using the ratio of excluded ETI to total ETI.  As a practical matter, taxpayers will look to minimize the apportionment of expenses to ETI in order to reduce the amount of disallowed expenses