[Federal Register Volume 61, Number 47 (Friday, March 8, 1996)]
[Rules and Regulations]
[Pages 9325-9336]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 96-5262]
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DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Part 1
[TD 8658]
RIN 1545-AL84
Determination of Interest Expense Deduction of Foreign
Corporations
AGENCY: Internal Revenue Service (IRS), Treasury.
ACTION: Final regulations.
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SUMMARY: This document contains Income Tax Regulations relating to the
determination of the interest expense deduction of foreign corporations
and applies to foreign corporations engaged in a trade or business
within the United States. This action is necessary because of changes
to the applicable tax law made by the Tax Reform Act of 1986, and
because of changes in international financial markets.
EFFECTIVE DATE: June 6, 1996.
FOR FURTHER INFORMATION CONTACT: Ahmad Pirasteh or Richard Hoge, (202)
622-3870 (not a toll-free number).
SUPPLEMENTARY INFORMATION:
Background
On April 24, 1992, the IRS published proposed amendments (INTL-309-
88, 1992-1 C.B. 1157) to the Income Tax Regulations (26 CFR parts 1)
under section 882 of the Internal Revenue Code in the Federal Register
(57 FR 15308). A public hearing was held on October 30, 1992. Numerous
written comments were received. After consideration of all of the
comments, the regulations proposed by INTL-309-88 are adopted as
amended by this Treasury decision, and the prior regulations are
withdrawn. The revisions are discussed below.
Discussion of Major Comments and Changes to the Regulations
1. Introduction
Section 882(c) of the Internal Revenue Code provides that a foreign
corporation is allowed a deduction only to the extent that the expense
is connected with income that is effectively connected with the conduct
of a U.S. trade or business within the United States (ECI), and that
the proper allocation is to be determined as provided in regulations.
The proposed Sec. 1.882-5 regulations that were issued in 1992
generally followed the approach adopted in the 1981 final regulations,
with various changes intended to clarify and update the regulations.
The proposed regulations attracted a substantial number of
comments, addressing both general and specific aspects of the
regulations. In response to these comments, the Treasury Department and
the IRS simplified the regulations, coordinated them more closely with
other regulations, and generally responded to the concerns of foreign
corporations doing business in the United States. For example, U.S.
assets are defined in the first step of the three-step formula to
coincide closely with the definition of a U.S. asset used for purposes
of section 884. The computation of the actual ratio in Step 2 has been
simplified considerably, minimizing both the number and the frequency
of required computations. In Step 3, consistent with the emphasis in
the regulations on the use of actual ratios and rates rather than
prescribed ones whenever possible, the final regulations allow
taxpayers to use either their actual interest rate on U.S. dollar
liabilities, or, if they elect, to use their actual rates on
liabilities denominated in each of the currencies in which their U.S.
assets are denominated. The Treasury and the IRS believe that the final
regulations strike a reasonable balance between the concerns of foreign
corporate taxpayers and the interests of the United States Government.
2. Section 1.882-5(a): Rules of General Application
Section 1.882-5(a) provides general rules for determining a foreign
corporation's interest expense allocable to ECI. The final regulations
specify that the provisions of Sec. 1.882-5 constitute the exclusive
rules for allocating interest expense to the income from the U.S. trade
or business of all foreign corporations, including foreign corporations
that are residents of countries with which the United States has an
income tax treaty. In general, this requires all foreign corporations
to use the three-step methodology described in the final regulations.
In response to commenters' questions, however, Sec. 1.882-5(a)(1)(ii)
now provides that a foreign corporation that is engaged in a U.S. trade
or business, either directly or through a partnership, and that
satisfies certain requirements may allocate interest expense directly
to income generated by a particular asset to the same extent that a
U.S. corporation is permitted to directly allocate interest expense
under the rules of Sec. 1.861-10T. When a foreign corporation directly
allocates interest expense under this rule, the final regulations
require adjustments to all three steps of the calculation to avoid
double counting of assets and liabilities.
Numerous commenters questioned whether a taxpayer that is entitled
to the benefits of a U.S. income tax treaty should be required to use
the rules of Sec. 1.882-5 for purposes of determining the amount of
interest expense allocable to the foreign corporation's income
attributable to its U.S. permanent establishment. The IRS and the
Treasury Department believe that the methodology provided in these
regulations is fully consistent with all of the United States's treaty
obligations, including the Business Profits article of our tax
treaties. Generally, the Business Profits article requires that, in
determining the business profits of a permanent establishment, there
shall be allowed as deductions expenses that are incurred for the
purposes of the permanent establishment, including interest expense.
Section 1.882-5(a)(2) of the final regulations is a reasonable method
of implementing that general directive, as our treaties do not compel
the use of any particular method.
Most of the other changes to the general rules of Sec. 1.882-5(a)
are clarifications in response to commenters' questions. For example,
the final regulations clarify certain aspects of the rules that limit a
foreign corporation's allocable interest expense to the amount actually
paid or accrued by the corporation in a taxable year, and the rules
that coordinate the provisions of Sec. 1.882-5 with any other section
that disallows, defers, or capitalizes interest expense, and include
examples that illustrate how Sec. 1.882-5 applies to an asset that
produces income exempt from U.S. taxation.
Many commenters requested that the regulations clarify how and when
to make the various elections allowed under Sec. 1.882-5. The final
regulations provide uniform rules for changing any election prescribed
under Sec. 1.882-5, and give all taxpayers an opportunity to make new
elections, if desired, for the first taxable year beginning after the
effective date of these regulations. The regulations provide that, once
a method is elected, a taxpayer must use the method for five years,
unless the Commissioner or her delegate consents to an earlier change
based on extenuating circumstances. The final regulations reflect the
current practice of the IRS by providing that if the taxpayer fails to
make a timely election, the district director or the Assistant
Commissioner (International) may make any and all elections on the
taxpayer's behalf.
Several commenters asked that the final regulations allow taxpayers
to make correlative adjustments to their Sec. 1.882-5 calculations in
cases where,
[[Page 9327]]
under the authority of Sec. 1.881-3, the district director has
determined that a taxpayer has acted as a conduit entity in a conduit
financing arrangement. The IRS and Treasury do not believe that it is
appropriate in this regulation to alleviate the consequences of
Sec. 1.881-3 if a taxpayer has engaged in a transaction one of the
principal purposes of which is to avoid U.S. withholding tax. Allowing
such correlative adjustments in this regulation would prevent
Sec. 1.881-3 from serving its function as an anti-abuse rule.
3. Section 1.882-5(b): Determination of Total Amount of U.S. Assets for
the Taxable Year (Step 1)
As in the proposed regulations, the final regulations provide that
the classification of an item as a U.S. asset under Sec. 1.884-1(d)
generally governs its classification as a U.S. asset for purposes of
Sec. 1.882-5. Under the rules of Sec. 1.884-1(d), an item generally is
treated as a U.S. asset if all of the income it generates (or would
generate) and all of the gains that it would generate (if sold at a
gain) are ECI. Since the proposed Sec. 1.882-5 regulations were issued
in 1992, the regulations under Sec. 1.884-1 were amended and released
in final form. In light of those new regulations, the inclusions and
exclusions enumerated in the proposed regulations were largely
eliminated, so that the final Sec. 1.882-5 regulations now closely
conform to the Sec. 1.884-1(d) definition of a U.S. asset.
Section 1.882-5(b)(3) of the final regulations continues the
requirement that a foreign corporation must value its U.S. assets at
the most frequent, regular intervals for which data are reasonably
available. However, the rule is applied separately with respect to each
U.S. asset. Paragraph (b)(3) specifies that the value of a U.S. asset
must be computed at least monthly by a large bank and at least semi-
annually by other taxpayers.
Many questions have been raised about how Sec. 1.882-5 applies to
partnership interests held by foreign corporations. With the
elimination of Sec. 1.861-9T(e)(7)(i) by these regulations, Sec. 1.884-
1(d)(3) and Sec. 1.882-5 now provide the exclusive rules for
determining a foreign corporation's interest expense allocable to an
interest in a partnership. The new regulations under Sec. 1.884-1(d)(3)
provide that a foreign corporation determines its U.S. assets by
reference to its basis in the partnership, and expand the methods
available for determining the portion of its partnership basis that is
a U.S. asset.
Numerous commenters were concerned that the provisions of the
proposed regulations relating to real estate would treat international
banks unfairly, since banks frequently acquire real estate through
foreclosure, or own the buildings in which their offices are located.
Commenters stated that it is unclear whether such real estate would
qualify as a U.S. asset. Commenters also objected to the rule in the
proposed regulations that provides that an interest in a U.S. real
property holding company, which is not treated as a U.S. asset under
Sec. 1.884-1(d), would be treated as a U.S. asset only in the year of
disposition. Commenters argued that banks frequently hold property
acquired by foreclosure in special purpose subsidiaries in order to
limit their exposure to environmental or other liabilities. However,
such banks must service the debt they incurred to acquire the real
property throughout the period they hold the stock, not merely upon
disposition.
In response to these comments, an example is added under
Sec. 1.884-1(d)(2) to clarify that U.S. real estate acquired as a
result of foreclosure by a bank acting in the ordinary course of its
business is generally a U.S. asset, because the property would produce
ECI to the bank under section 864(c)(2). Similarly, the building in
which a bank's offices are located generally qualifies as a U.S. asset,
because gain from the sale of the building generally would constitute
effectively connected income under the asset-use test of Sec. 1.864-
4(c)(2). In addition, the final regulations specify that a taxpayer may
achieve the same result under Sec. 1.882-5 whether it holds foreclosure
property or the office building it occupies directly or indirectly
through a corporation. Section 1.882-5(b)(1)(iii)(A) provides a look-
through rule that treats such real property as a U.S. asset for
purposes of Sec. 1.882-5 to the extent that it would have qualified as
a U.S. asset if held directly by the taxpayer.
Commenters noted that the rule in the proposed regulations that
reduces the value of shares of stock claimed as a U.S. asset by a
percentage of the dividends received deduction had the effect of
treating all stock as debt-financed under the principles of section
246A. This stock cut-back rule is eliminated from the final Sec. 1.882-
5 regulations. The elimination of the rule, however, will affect only
those taxpayers whose stock satisfies the business-activities test or
the banking, financing or similar-business test of Sec. 1.864-4(c).
This is because the final regulations under Sec. 1.864-4, which are
being issued contemporaneously with these regulations elsewhere in this
issue of the Federal Register, generally eliminate any inference that
stock can produce effectively connected income under the asset-use test
of Sec. 1.864-4(c)(2).
The final regulations add an anti-abuse rule similar to the rule in
Sec. 1.884-1(d)(5)(ii) to prevent taxpayers from artificially
increasing the amount of their U.S. assets.
4. Section 1.882-5(c): Determination of Total Amount of U.S.
Liabilities for the Taxable Year (Step 2)
Commenters objected to many of the requirements in Step 2 of the
proposed regulations on the grounds that the rules effectively
prevented foreign banks from using their actual ratio of liabilities to
assets by imposing excessive administrative burdens and capping the
actual ratio at 96%. Because the IRS and Treasury believe that a
taxpayer's interest deduction should be based on the taxpayer's actual
ratio of liabilities to assets whenever possible, the final regulations
adopt rules that are intended to encourage taxpayers to use their
actual ratio. Accordingly, the final regulations drop the 96% cap on
the actual ratio that was in the proposed regulations. The final
regulations also substantially ease the administrative burden
associated with computing the actual ratio.
Many commenters objected to the requirement in the proposed
regulations that a taxpayer's worldwide liabilities to assets ratio be
computed strictly in accordance with U.S. tax principles, citing the
substantial burden that such a calculation would entail. In light of
these comments, the final regulations require that only the
classification of assets and liabilities must be strictly in accordance
with U.S. tax principles. The value of worldwide assets and the amount
of worldwide liabilities need only be substantially in accordance with
U.S. tax principles. Examples of how these requirements apply are
provided. With regard to material items, however, the final regulations
specify that a foreign corporation must compute the value of U.S.
assets and the amount of worldwide liabilities in Steps 1 and 2 in a
consistent manner.
The proposed regulations would have required that a foreign bank
compute its actual ratio monthly. Commenters were concerned that the
burden of this rule would be excessive. In response, the final
regulations decrease the required frequency of the computations of the
actual ratio to semi-annually for large banks, and to annually for
other taxpayers.
Commenters also were concerned that the rules in the proposed
regulation
[[Page 9328]]
requiring basis adjustments for 20% owned subsidiaries would be too
burdensome. These rules, which serve a somewhat different purpose in
section 864(e)(4), have been removed from the final regulations.
Commenters pointed out that the election provided by the proposed
regulations to compute the actual ratio of a bank on the basis of a
hypothetical tax year ending six months prior to the beginning of the
actual year does not serve its intended purpose. The six month lagging
ratio election has therefore been eliminated.
Section 1.882-5(c)(3) of the final regulations provides that the
district director or the Assistant Commissioner (International) may
make appropriate adjustments to prevent the artificial increase of a
corporation's actual ratio. This rule, in conjunction with more
specific anti-abuse rules in Steps 1 and 3, replaces the general anti-
abuse rule in Sec. 1.882-5(e) of the proposed regulations.
Commenters criticized the 93% fixed ratio for banks as too low, and
disagreed with the reasons provided in the preamble to the proposed
regulations supporting the 93% ratio. The final regulations, however,
retain the elective fixed ratio at 93%. In conjunction with the more
relaxed rules regarding the computation of a foreign corporation's
actual ratio, Treasury believes that a 93% fixed ratio, which remains
purely elective, represents an appropriate safe harbor for banks.
Section 1.882-5(c)(4) also modifies the definition of a bank for
these purposes to clarify the previous definition and to limit the 93%
fixed ratio to the intended class of businesses.
5. Section 1.882-5(d): Determination of Amount of Interest Expense
Allocable to ECI (Step 3)
Commenters were concerned that Step 3 of the proposed regulations
failed to reflect business realities, increased administrative costs
and created uncertainty. In particular, they objected to the rules that
eliminated certain high interest rate liabilities and certain
liabilities denominated in a non-functional currency from the
definition of booked liabilities, and the rules that prescribed an
interest rate applicable to the extent that a taxpayer's U.S.-connected
liabilities exceed booked liabilities (excess liabilities).
As noted above, the IRS and Treasury believe that the calculation
of a taxpayer's interest deduction should reflect, to the greatest
extent possible, the taxpayer's economic interest expense. Accordingly,
these comments have been largely accepted.
The final regulations eliminate the fixed interest rates assigned
to excess liabilities, and instead require that taxpayers compute their
actual interest rate outside the United States. The IRS anticipates
issuing regulations under section 6038C describing the records needed
to verify the taxpayer's actual interest rate, among other things.
The final regulations also respond to commenters' requests for
simplification and clarification in the Step 3 calculation. Under
Sec. 1.882-5(d)(2), a liability is a U.S. booked liability if the
liability is properly reflected on the books of the U.S. trade or
business. The final regulations set out two standards, one for non-
banks and another for banks, to determine whether a liability is
properly reflected on the foreign corporation's U.S. books. In general,
the final regulations use a facts and circumstances test to determine
whether a liability is properly booked in the United States. In
response to requests from commenters for additional guidance on the
requirement that the booking of a liability be ``reasonably
contemporaneous'' with the time that the liability is incurred, the
regulations specify that a bank is generally required to book a
liability before the end of the day in which the liability is incurred.
Section 1.882-5(d)(2)(iii)(B) provides a relief rule, however, for a
situation where, due to inadvertent error, a bank fails to book a
liability that otherwise would meet the criteria for a booked
liability. The special rules for banks in the proposed regulations have
otherwise been eliminated.
In response to comments, the computation of the scaling ratio that
applies to taxpayers with excess liabilities has also been simplified,
and its application has been reduced in scope. Under the final
regulations, the scaling ratio is computed by simply dividing U.S.-
connected liabilities by U.S. booked liabilities, and multiplying that
fraction by the interest paid or accrued by the foreign corporation.
The final regulations also delete the provision in the proposed
regulations that applied the scaling ratio to section 988 exchange gain
or loss from an unhedged liability. The amount and source of exchange
gain or loss from a section 988 transaction will therefore continue to
be determined under section 988, without any reduction as a result of
the scaling ratio in Sec. 1.882-5.
The rules in the proposed regulations relating to high interest
rate liabilities and nonfunctional currency liabilities have been
replaced in the final regulations by a simpler anti-abuse rule that
provides that U.S. booked liabilities will not include a liability if
one of the principal purposes of incurring or holding the liability is
to increase artificially the interest expense on U.S. booked
liabilities. Factors relevant to that determination are whether the
interest rate on a liability is excessive and whether, from an economic
standpoint, the currency denomination of U.S. booked liabilities
matches the currency denomination of U.S. assets.
6. Section 1.882-5(e): Separate Currency Pools Method
Most commenters argued for retaining the separate currency pools
method, which was deleted from Step 3 in the proposed regulations.
After considering the comments, the IRS and Treasury agree that
taxpayers should be permitted to use a methodology that looks to
worldwide interest rates in all relevant currencies. Because the
separate currency pools rate in the 1981 regulations ignored the
currency denomination of U.S. assets and was based instead on the
currency denomination of U.S. booked liabilities, however, it was
subject to manipulation. The new separate currency pools method in
Sec. 1.882-5(e) of the final regulations allows taxpayers to treat
their U.S. assets in each currency as funded by the worldwide
liabilities of the taxpayer in that same currency. This new separate
currency pools method, which is elective, is an alternative to the Step
3 approach based on U.S. booked liabilities in Sec. 1.882-5(d). To
prevent distortions, taxpayers that have more than 10% of their U.S.
assets denominated in a hyperinflationary currency are precluded from
using the separate currency pools method.
The anti-abuse rule of proposed regulation Sec. 1.882-5(e) has been
replaced by three separate rules that appear under each of the three
steps of this section.
Special Analyses
It has been determined that this Treasury decision is not a
significant regulatory action as defined in EO 12866. Therefore, a
regulatory assessment is not required. It also has been determined that
section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5)
and the Regulatory Flexibility Act (5 U.S.C. chapter 6) do not apply to
these regulations, and, therefore, a Regulatory Flexibility Analysis is
not required. Pursuant to section 7805(f) of the Internal Revenue Code,
the notice of proposed rulemaking preceding these regulations was
submitted to the Small Business Administration for comment on its
impact on small business.
[[Page 9329]]
Drafting Information
Several persons from the Office of Chief Counsel and the Treasury
Department participated in drafting these regulations.
List of Subjects in 26 CFR Part 1
Income taxes, Reporting and recordkeeping requirements.
Adoption of Amendments to the Regulations
Accordingly, 26 CFR part 1 is amended as follows:
PART 1--INCOME TAXES
Paragraph 1. The authority citation for part 1 is amended by adding
an entry in numerical order to read as follows:
Authority: 26 U.S.C. 7805 * * *
Section 1.882-5 also issued under 26 U.S.C. 882, 26 U.S.C. 864(e),
26 U.S.C. 988(d), and 26 U.S.C. 7701(l). * * *
Sec. 1.861-9T [Amended]
Par. 2. Section 1.861-9T, paragraph (e)(7) is amended as follows:
1. Paragraph (e)(7)(i) is removed.
2. The heading in paragraph (e)(7)(ii) is removed.
3. Paragraph (e)(7)(ii) is redesignated as the text of paragraph
(e)(7).
Par. 3. Section 1.882-0 is added to read as follows:
Sec. 1.882-0 Table of contents.
This section lists captions contained in Secs. 1.882-1, 1.882-2,
1.882-3, 1.882-4 and 1.882-5.
Sec. 1.882-1 Taxation of foreign corporations engaged in U.S.
business or of foreign corporations treated as having effectively
connected income.
(a) Segregation of income.
(b) Imposition of tax.
(1) Income not effectively connected with the conduct of a trade or
business in the United States.
(2) Income effectively connected with the conduct of a trade or
business in the United States.
(i) In general.
(ii) Determination of taxable income.
(iii) Cross references.
(c) Change in trade or business status.
(d) Credits against tax.
(e) Payment of estimated tax.
(f) Effective date.
Sec. 1.882-2 Income of foreign corporation treated as effectively
connected with U.S. business.
(a) Election as to real property income.
(b) Interest on U.S. obligations received by banks organized in
possessions.
(c) Treatment of income.
(d) Effective date.
Sec. 1.882-3 Gross income of a foreign corporation.
(a) In general.
(1) Inclusions.
(2) Exchange transactions.
(3) Exclusions.
(b) Foreign corporations not engaged in U.S. business.
(c) Foreign corporations engaged in U.S. business.
(d) Effective date.
Sec. 1.882-4 Allowance of deductions and credits to foreign
corporations.
(a) Foreign corporations.
(1) In general.
(2) Return necessary.
(3) Filing deadline for return.
(4) Return by Internal Revenue Service.
(b) Allowed deductions and credits.
(1) In general.
(2) Verification.
Sec. 1.882-5 Determination of interest deduction.
(a) Rules of general application.
(1) Overview.
(i) In general.
(ii) Direct allocations.
(A) In general.
(B) Partnership interest.
(2) Coordination with tax treaties.
(3) Limitation on interest expense.
(4) Translation convention for foreign currency.
(5) Coordination with other sections.
(6) Special rule for foreign governments.
(7) Elections under Sec. 1.882-5.
(i) In general.
(ii) Failure to make the proper election.
(8) Examples.
(b) Step 1: Determination of total value of U.S. assets for the
taxable year.
(1) Classification of an asset as a U.S. asset.
(i) General rule.
(ii) Items excluded from the definition of U.S. asset.
(iii) Items included in the definition of U.S. asset.
(iv) Interbranch transactions.
(v) Assets acquired to increase U.S. assets artificially.
(2) Determination of the value of a U.S. asset.
(i) General rule.
(ii) Fair-market value election.
(A) In general.
(B) Adjustment to partnership basis.
(iii) Reduction of total value of U.S. assets by amount of bad debt
reserves under section 585.
(A) In general.
(B) Example.
(iv) Adjustment to basis of financial instruments.
(3) Computation of total value of U.S. assets.
(c) Step 2: Determination of total amount of U.S.-connected
liabilities for the taxable year.
(1) General rule.
(2) Computation of the actual ratio.
(i) In general.
(ii) Classification of items.
(iii) Determination of amount of worldwide liabilities.
(iv) Determination of value of worldwide assets.
(v) Hedging transactions.
(vi) Treatment of partnership interests and liabilities.
(vii) Computation of actual ratio of insurance companies.
(viii) Interbranch transactions.
(ix) Amounts must be expressed in a single currency.
(3) Adjustments.
(4) Elective fixed ratio method of determining U.S. liabilities.
(5) Examples.
(d) Step 3: Determination of amount of interest expense allocable
to ECI under the adjusted U.S. booked liabilities method.
(1) General rule.
(2) U.S. booked liabilities.
(i) In general.
(ii) Properly reflected on the books of the U.S. trade or business
of a foreign corporation that is not a bank.
(A) In general.
(B) Identified liabilities not properly reflected.
(iii) Properly reflected on the books of the U.S. trade or business
of a foreign corporation that is a bank.
(A) In general.
(B) Inadvertent error.
(iv) Liabilities of insurance companies.
(v) Liabilities used to increase artificially interest expense on
U.S. booked liabilities.
(vi) Hedging transactions.
(vii) Amount of U.S. booked liabilities of a partner.
(viii) Interbranch transactions.
(3) Average total amount of U.S. booked liabilities.
(4) Interest expense where U.S. booked liabilities equal or exceed
U.S. liabilities.
(i) In general.
(ii) Scaling ratio.
(iii) Special rules for insurance companies.
(5) U.S.-connected interest rate where U.S. booked liabilities are
less than U.S.-connected liabilities.
(i) In general.
(ii) Interest rate on excess U.S.-connected liabilities.
(6) Examples.
(e) Separate currency pools method.
(1) General rule.
(i) Determine the value of U.S. assets in each currency pool.
(ii) Determine the U.S.-connected liabilities in each currency
pool.
(iii) Determine the interest expense attributable to each currency
pool.
(2) Prescribed interest rate.
(3) Hedging transactions.
(4) Election not available if excessive hyperinflationary assets.
(5) Examples.
(f) Effective date.
(1) General rule.
(2) Special rules for financial products.
Par. 4. Section 1.882-5 is revised to read as follows:
Sec. 1.882-5 Determination of interest deduction.
(a) Rules of general application--(1) Overview--(i) In general. The
amount of interest expense of a foreign corporation that is allocable
under section 882(c) to income which is (or is treated as)
[[Page 9330]]
effectively connected with the conduct of a trade or business within
the United States (ECI) is the sum of the interest paid or accrued by
the foreign corporation on its liabilities booked in the United States,
as adjusted under the three-step process set forth in paragraphs (b),
(c), and (d) of this section and the specially allocated interest
expense determined under section (a)(1)(ii) of this section. The
provisions of this section provide the exclusive rules for allocating
interest expense to the ECI of a foreign corporation. Under the three-
step process, the total value of the U.S. assets of a foreign
corporation is first determined under paragraph (b) of this section
(Step 1). Next, the amount of U.S.-connected liabilities is determined
under paragraph (c) of this section (Step 2). Finally, the amount of
interest paid or accrued on liabilities booked in the United States, as
determined under paragraph (d)(2) of this section, is adjusted for
interest expense attributable to the difference between U.S.-connected
liabilities and U.S.-booked liabilities (Step 3). Alternatively, a
foreign corporation may elect to determine its interest rate on U.S.-
connected liabilities by reference to its U.S. assets, using the
separate currency pools method described in paragraph (e) of this
section.
(ii) Direct allocations--(A) In general. A foreign corporation that
has a U.S. asset and indebtedness that meet the requirements of
Sec. 1.861-10T (b) and (c), as limited by Sec. 1.861-10T(d)(1), may
directly allocate interest expense from such indebtedness to income
from such asset in the manner and to the extent provided in Sec. 1.861-
10T. For purposes of paragraph (b)(1) or (c)(2) of this section, a
foreign corporation that allocates its interest expense under the
direct allocation rule of this paragraph (a)(1)(ii)(A) shall reduce the
basis of the asset that meets the requirements of Sec. 1.861-10T (b)
and (c) by the principal amount of the indebtedness that meets the
requirements of Sec. 1.861- 10T (b) and (c). The foreign corporation
shall also disregard any indebtedness that meets the requirements of
Sec. 1.861-10T (b) and (c) in determining the amount of the foreign
corporation's liabilities under paragraphs (c)(2) and (d)(2) of this
section, and shall not take into account any interest expense paid or
accrued with respect to such a liability for purposes of paragraph (d)
or (e) of this section.
(B) Partnership interest. A foreign corporation that is a partner
in a partnership that has a U.S. asset and indebtedness that meet the
requirements of Sec. 1.861-10T (b) and (c), as limited by Sec. 1.861-
10T(d)(1), may directly allocate its distributive share of interest
expense from that indebtedness to its distributive share of income from
that asset in the manner and to the extent provided in Sec. 1.861-10T.
A foreign corporation that allocates its distributive share of interest
expense under the direct allocation rule of this paragraph
(a)(1)(ii)(B) shall disregard any partnership indebtedness that meets
the requirements of Sec. 1.861-10T (b) and (c) in determining the
amount of its distributive share of partnership liabilities for
purposes of paragraphs (b)(1), (c)(2)(vi), and (d)(2)(vii) or
(e)(1)(ii) of this section, and shall not take into account any
partnership interest expense paid or accrued with respect to such a
liability for purposes of paragraph (d) or (e) of this section. For
purposes of paragraph (b)(1) of this section, a foreign corporation
that directly allocates its distributive share of interest expense
under this paragraph (a)(1)(ii)(B) shall--
(1) Reduce the partnership's basis in such asset by the amount of
such indebtedness in allocating its basis in the partnership under
Sec. 1.884-1(d)(3)(ii); or
(2) Reduce the partnership's income from such asset by the
partnership's interest expense from such indebtedness under Sec. 1.884-
1(d)(3)(iii).
(2) Coordination with tax treaties. The provisions of this section
provide the exclusive rules for determining the interest expense
attributable to the business profits of a permanent establishment under
a U.S. income tax treaty.
(3) Limitation on interest expense. In no event may the amount of
interest expense computed under this section exceed the amount of
interest on indebtedness paid or accrued by the taxpayer within the
taxable year (translated into U.S. dollars at the weighted average
exchange rate for each currency prescribed by Sec. 1.989(b)-1 for the
taxable year).
(4) Translation convention for foreign currency. For each
computation required by this section, the taxpayer shall translate
values and amounts into the relevant currency at a spot rate or a
weighted average exchange rate consistent with the method such taxpayer
uses for financial reporting purposes, provided such method is applied
consistently from year to year. Interest expense paid or accrued,
however, shall be translated under the rules of Sec. 1.988-2. The
district director or the Assistant Commissioner (International) may
require that any or all computations required by this section be made
in U.S. dollars if the functional currency of the taxpayer's home
office is a hyperinflationary currency, as defined in Sec. 1.985-1, and
the computation in U.S. dollars is necessary to prevent distortions.
(5) Coordination with other sections. Any provision that disallows,
defers, or capitalizes interest expense applies after determining the
amount of interest expense allocated to ECI under this section. For
example, in determining the amount of interest expense that is
disallowed as a deduction under section 265 or 163(j), deferred under
section 163(e)(3) or 267(a)(3), or capitalized under section 263A with
respect to a United States trade or business, a taxpayer takes into
account only the amount of interest expense allocable to ECI under this
section.
(6) Special rule for foreign governments. The amount of interest
expense of a foreign government, as defined in Sec. 1.892-2T(a), that
is allocable to ECI is the total amount of interest paid or accrued
within the taxable year by the United States trade or business on U.S.-
booked liabilities (as defined in paragraph (d)(2) of this section).
Interest expense of a foreign government, however, is not allocable to
ECI to the extent that it is incurred with respect to U.S.-booked
liabilities that exceed 80 percent of the total value of U.S. assets
for the taxable year (determined under paragraph (b) of this section).
This paragraph (a)(6) does not apply to controlled commercial entities
within the meaning of Sec. 1.892-5T.
(7) Elections under Sec. 1.882-5--(i) In general. A corporation
must make each election provided in this section on the corporation's
Federal income tax return for the first taxable year beginning on or
after the effective date of this section. An amended return does not
qualify for this purpose, nor shall the provisions of Sec. 301.9100-1
of this chapter and any guidance promulgated thereunder apply. Each
election under this section, whether an election for the first taxable
year or a subsequent change of election, shall be made by the
corporation calculating its interest expense deduction in accordance
with the methods elected. An elected method must be used for a minimum
period of five years before the taxpayer may elect a different method.
To change an election before the end of the requisite five-year period,
a taxpayer must obtain the consent of the Commissioner or her delegate.
The Commissioner or her delegate will generally consent to a taxpayer's
request to change its election only in rare and unusual circumstances.
(ii) Failure to make the proper election. If a taxpayer, for any
reason, fails to make an election provided in
[[Page 9331]]
this section in a timely fashion, the district director or the
Assistant Commissioner (International) may make any or all of the
elections provided in this section on behalf of the taxpayer, and such
elections shall be binding as if made by the taxpayer.
(8) Examples. The following examples illustrate the application of
paragraph (a) of this section:
Example 1. Direct allocations. (i) Facts: FC is a foreign
corporation that conducts business through a branch, B, in the
United States. Among B's U.S. assets is an interest in a
partnership, P, that is engaged in airplane leasing solely in the
U.S. FC contributes 200 x to P in exchange for its partnership
interest. P incurs qualified nonrecourse indebtedness within the
meaning of Sec. 1.861-10T to purchase an airplane. FC's share of the
liability of P, as determined under section 752, is 800 x .
(ii) Analysis: Pursuant to paragraph (a)(1)(ii)(B) of this
section, FC is permitted to directly allocate its distributive share
of the interest incurred with respect to the qualified nonrecourse
indebtedness to FC's distributive share of the rental income
generated by the airplane. A liability the interest on which is
allocated directly to the income from a particular asset under
paragraph (a)(1)(ii)(B) of this section is disregarded for purposes
of paragraphs (b)(1), (c)(2)(vi), and (d)(2)(vii) or (e)(1)(ii) this
section. Consequently, for purposes of determining the value of FC's
assets under paragraphs (b)(1) and (c)(2)(vi) of this section, FC's
basis in P is reduced by the 800 x liability as determined under
section 752, but is not increased by the 800 x liability that is
directly allocated under paragraph (a)(1)(ii)(B) of this section.
Similarly, pursuant to paragraph (a)(1)(ii)(B) of this section, the
800 x liability is disregarded for purposes of determining FC's
liabilities under paragraphs (c)(2)(vi) and (d)(2)(vii) of this
section.
Example 2. Limitation on interest expense--(i) FC is a foreign
corporation that conducts a real estate business in the United
States. In its 1997 tax year, FC has no outstanding indebtedness,
and therefore incurs no interest expense. FC elects to use the 50%
fixed ratio under paragraph (c)(4) of this section.
(ii) Under paragraph (a)(3) of this section, FC is not allowed
to deduct any interest expense that exceeds the amount of interest
on indebtedness paid or accrued in that taxable year. Since FC
incurred no interest expense in taxable year 1997, FC will not be
entitled to any interest deduction for that year under Sec. 1.882-5,
notwithstanding the fact that FC has elected to use the 50% fixed
ratio.
Example 3. Coordination with other sections--(i) FC is a foreign
corporation that is a bank under section 585(a)(2) and a financial
institution under section 265(b)(5). FC is a calendar year taxpayer,
and operates a U.S. branch, B. Throughout its taxable year 1997, B
holds only two assets that are U.S. assets within the meaning of
paragraph (b)(1) of this section. FC does not make a fair-market
value election under paragraph (b)(2)(ii) of this section, and,
therefore, values its U.S. assets according to their bases under
paragraph (b)(2)(i) of this section. The first asset is a taxable
security with an adjusted basis of $100. The second asset is an
obligation the interest on which is exempt from federal taxation
under section 103, with an adjusted basis of $50. The tax-exempt
obligation is not a qualified tax-exempt obligation as defined by
section 265(b)(3)(B).
(ii) FC calculates its interest expense under Sec. 1.882-5 to be
$12. Under paragraph (a)(5) of this section, however, a portion of
the interest expense that is allocated to FC's effectively connected
income under Sec. 1.882-5 is disallowed in accordance with the
provisions of section 265(b). Using the methodology prescribed under
section 265, the amount of disallowed interest expense is $4,
calculated as follows:
[GRAPHIC] [TIFF OMITTED] TR08MR96.000
(iii) Therefore, FC deducts a total of $8 ($12-$4) of interest
expense attributable to its effectively connected income in 1997.
Example 4. Treaty exempt asset--(i) FC is a foreign corporation,
resident in Country X, that is actively engaged in the banking
business in the United States through a permanent establishment, B.
The income tax treaty in effect between Country X and the United
States provides that FC is not taxable on foreign source income
earned by its U.S. permanent establishment. In its 1997 tax year, B
earns $90 of U.S. source income from U.S. assets with an adjusted
tax basis of $900, and $12 of foreign source interest income from
U.S. assets with an adjusted tax basis of $100. FC's U.S. interest
expense deduction, computed in accordance with Sec. 1.882-5, is
$500.
(ii) Under paragraph (a)(5) of this section, FC is required to
apply any provision that disallows, defers, or capitalizes interest
expense after determining the interest expense allocated to ECI
under Sec. 1.882-5. Section 265(a)(2) disallows interest expense
that is allocable to one or more classes of income that are wholly
exempt from taxation under subtitle A of the Internal Revenue Code.
Section 1.265-1(b) provides that income wholly exempt from taxes
includes both income excluded from tax under any provision of
subtitle A and income wholly exempt from taxes under any other law.
Section 894 specifies that the provisions of subtitle A are applied
with due regard to any relevant treaty obligation of the United
States. Because the treaty between the United States and Country X
exempts foreign source income earned by B from U.S. tax, FC has
assets that produce income wholly exempt from taxes under subtitle
A, and must therefore allocate a portion of its Sec. 1.882-5
interest expense to its exempt income. Using the methodology
prescribed under section 265, the amount of disallowed interest
expense is $50, calculated as follows:
[GRAPHIC] [TIFF OMITTED] TR08MR96.001
(iii) Therefore, FC deducts a total of $450 ($500-$50) of
interest expense attributable to its effectively connected income in
1997.
(b) Step 1: Determination of total value of U.S. assets for the
taxable year--(1) Classification of an asset as a U.S. asset--(i)
General rule. Except as otherwise provided in this paragraph (b)(1), an
asset is a U.S. asset for purposes of this section to the extent that
it is a U.S. asset under Sec. 1.884-1(d). For purposes of this section,
the term determination date, as used in Sec. 1.884-1(d), means each day
for which the total value of U.S. assets is computed under paragraph
(b)(3) of this section.
(ii) Items excluded from the definition of U.S. asset. For purposes
of this section, the term U.S. asset excludes an asset to the extent it
produces income or gain described in sections 883 (a)(3) and (b).
(iii) Items included in the definition of U.S. asset. For purposes
of this section, the term U.S. asset includes--
(A) U.S. real property held in a wholly-owned domestic subsidiary
of a foreign corporation that qualifies as a bank under section
585(a)(2)(B) (without regard to the second sentence thereof), provided
that the real property would qualify as used in the foreign
corporation's trade or business within the meaning of Sec. 1.864-4(c)
(2) or (3) if held directly by the foreign corporation and either was
initially acquired through foreclosure or similar proceedings or is
U.S. real property occupied by the foreign corporation (the value of
which shall be adjusted by the amount of any indebtedness that is
reflected in the value of the property);
(B) An asset that produces income treated as ECI under section
921(d) or 926(b) (relating to certain income of a FSC and certain
dividends paid by a FSC to a foreign corporation);
(C) An asset that produces income treated as ECI under section
953(c)(3)(C) (relating to certain income of a captive insurance company
that a corporation elects to treat as ECI) that is not otherwise ECI;
and
(D) An asset that produces income treated as ECI under section
882(e) (relating to certain interest income of possessions banks).
(iv) Interbranch transactions. A transaction of any type between
separate offices or branches of the same taxpayer does not create a
U.S. asset.
(v) Assets acquired to increase U.S. assets artificially. An asset
shall not be treated as a U.S. asset if one of the principal purposes
for acquiring or using that asset is to increase artificially the U.S.
assets of a foreign corporation on the determination date. Whether an
asset is acquired or used for such
[[Page 9332]]
purpose will depend upon all the facts and circumstances of each case.
Factors to be considered in determining whether one of the principal
purposes in acquiring or using an asset is to increase artificially the
U.S. assets of a foreign corporation include the length of time during
which the asset was used in a U.S. trade or business, whether the asset
was acquired from a related person, and whether the aggregate value of
the U.S. assets of the foreign corporation increased temporarily on or
around the determination date. A purpose may be a principal purpose
even though it is outweighed by other purposes (taken together or
separately).
(2) Determination of the value of a U.S. asset--(i) General rule.
The value of a U.S. asset is the adjusted basis of the asset for
determining gain or loss from the sale or other disposition of that
item, further adjusted as provided in paragraph (b)(2)(iii) of this
section.
(ii) Fair-market value election--(A) In general. A taxpayer may
elect to value all of its U.S. assets on the basis of fair market
value, subject to the requirements of Sec. 1.861-9T(g)(1)(iii), and
provided the taxpayer uses the methodology prescribed in Sec. 1.861-
9T(h). Once elected, the fair market value must be used by the taxpayer
for both Step 1 and Step 2 described in paragraphs (b) and (c) of this
section, and must be used in all subsequent taxable years unless the
Commissioner or her delegate consents to a change.
(B) Adjustment to partnership basis. If a partner makes a fair
market value election under paragraph (b)(2)(ii) of this section, the
value of the partner's interest in a partnership that is treated as an
asset shall be the fair market value of his partnership interest,
increased by the fair market value of the partner's share of the
liabilities determined under paragraph (c)(2)(vi) of this section. See
Sec. 1.884-1(d)(3).
(iii) Reduction of total value of U.S. assets by amount of bad debt
reserves under section 585--(A) In general. The total value of loans
that qualify as U.S. assets shall be reduced by the amount of any
reserve for bad debts additions to which are allowed as deductions
under section 585.
(B) Example. The following example illustrates the provisions of
paragraph (b)(2)(iii)(A) of this section:
Example. Foreign banks; bad debt reserves. FC is a foreign
corporation that qualifies as a bank under section 585(a)(2)(B)
(without regard to the second sentence thereof), but is not a large
bank as defined in section 585(c)(2). FC conducts business through a
branch, B, in the United States. Among B's U.S. assets are a
portfolio of loans with an adjusted basis of $500. FC accounts for
its bad debts for U.S. federal income tax purposes under the reserve
method, and B maintains a deductible reserve for bad debts of $50.
Under paragraph (b)(2)(iii) of this section, the total value of FC's
portfolio of loans is $450 ($500-$50).
(iv) Adjustment to basis of financial instruments. [Reserved]
(3) Computation of total value of U.S. assets. The total value of
U.S. assets for the taxable year is the average of the sums of the
values (determined under paragraph (b)(2) of this section) of U.S.
assets. For each U.S. asset, value shall be computed at the most
frequent, regular intervals for which data are reasonably available. In
no event shall the value of any U.S. asset be computed less frequently
than monthly by a large bank (as defined in section 585(c)(2)) and
semi-annually by any other taxpayer.
(c) Step 2: Determination of total amount of U.S.-connected
liabilities for the taxable year--(1) General rule. The amount of U.S.-
connected liabilities for the taxable year equals the total value of
U.S. assets for the taxable year (as determined under paragraph (b)(3)
of this section) multiplied by the actual ratio for the taxable year
(as determined under paragraph (c)(2) of this section) or, if the
taxpayer has made an election in accordance with paragraph (c)(4) of
this section, by the fixed ratio.
(2) Computation of the actual ratio--(i) In general. A taxpayer's
actual ratio for the taxable year is the total amount of its worldwide
liabilities for the taxable year divided by the total value of its
worldwide assets for the taxable year. The total amount of worldwide
liabilities and the total value of worldwide assets for the taxable
year is the average of the sums of the amounts of the taxpayer's
worldwide liabilities and the values of its worldwide assets
(determined under paragraphs (c)(2) (iii) and (iv) of this section). In
each case, the sums must be computed semi-annually by a large bank (as
defined in section 585(c)(2)) and annually by any other taxpayer.
(ii) Classification of items. The classification of an item as a
liability or an asset must be consistent from year to year and in
accordance with U.S. tax principles.
(iii) Determination of amount of worldwide liabilities. The amount
of a liability must be determined consistently from year to year and
must be substantially in accordance with U.S. tax principles. To be
substantially in accordance with U.S. tax principles, the principles
used to determine the amount of a liability must not differ from U.S.
tax principles to a degree that will materially affect the value of
taxpayer's worldwide liabilities or the taxpayer's actual ratio.
(iv) Determination of value of worldwide assets. The value of an
asset must be determined consistently from year to year and must be
substantially in accordance with U.S. tax principles. To be
substantially in accordance with U.S. tax principles, the principles
used to determine the value of an asset must not differ from U.S. tax
principles to a degree that will materially affect the value of the
taxpayer's worldwide assets or the taxpayer's actual ratio. The value
of an asset is the adjusted basis of that asset for determining the
gain or loss from the sale or other disposition of that asset, adjusted
in the same manner as the basis of U.S. assets are adjusted under
paragraphs (b)(2) (ii) through (iv) of this section.
(v) Hedging transactions. [Reserved]
(vi) Treatment of partnership interests and liabilities. For
purposes of computing the actual ratio, the value of a partner's
interest in a partnership that will be treated as an asset is the
partner's adjusted basis in its partnership interest, reduced by the
partner's share of liabilities of the partnership as determined under
section 752 and increased by the partner's share of liabilities
determined under this paragraph (c)(2)(vi). If the partner has made a
fair market value election under paragraph (b)(2)(ii) of this section,
the value of its interest in the partnership shall be increased by the
fair market value of the partner's share of the liabilities determined
under this paragraph (c)(2)(vi). For purposes of this section a partner
shares in any liability of a partnership in the same proportion that it
shares, for income tax purposes, in the expense attributable to that
liability for the taxable year. A partner's adjusted basis in a
partnership interest cannot be less than zero.
(vii) Computation of actual ratio of insurance companies.
[Reserved]
(viii) Interbranch transactions. A transaction of any type between
separate offices or branches of the same taxpayer does not create an
asset or a liability.
(ix) Amounts must be expressed in a single currency. The actual
ratio must be computed in either U.S. dollars or the functional
currency of the home office of the taxpayer, and that currency must be
used consistently from year to year. For example, a taxpayer that
determines the actual ratio annually using British pounds converted at
the spot rate for financial reporting purposes must translate the U.S.
dollar values of assets and amounts of liabilities of the U.S. trade or
business into pounds using the spot rate on the last day of its taxable
year. The district director or the
[[Page 9333]]
Assistant Commissioner (International) may require that the actual
ratio be computed in dollars if the functional currency of the
taxpayer's home office is a hyperinflationary currency, as defined in
Sec. 1.985-1, that materially distorts the actual ratio.
(3) Adjustments. The district director or the Assistant
Commissioner (International) may make appropriate adjustments to
prevent a foreign corporation from intentionally and artificially
increasing its actual ratio. For example, the district director or the
Assistant Commissioner (International) may offset a loan made from or
to one person with a loan made to or from another person if any of the
parties to the loans are related persons, within the meaning of section
267(b) or 707(b)(1), and one of the principal purposes for entering
into the loans was to increase artificially the actual ratio of a
foreign corporation. A purpose may be a principal purpose even though
it is outweighed by other purposes (taken together or separately).
(4) Elective fixed ratio method of determining U.S. liabilities. A
taxpayer that is a bank as defined in section 585(a)(2)(B)(without
regard to the second sentence thereof) may elect to use a fixed ratio
of 93 percent in lieu of the actual ratio. A taxpayer that is neither a
bank nor an insurance company may elect to use a fixed ratio of 50
percent in lieu of the actual ratio.
(5) Examples. The following examples illustrate the application of
paragraph (c) of this section:
Example 1. Classification of item not in accordance with U.S.
tax principles. Bank Z, a resident of country X, has a branch in the
United States through which it conducts its banking business. In
preparing its financial statements in country X, Z treats an
instrument documented as perpetual subordinated debt as a liability.
Under U.S. tax principles, however, this instrument is treated as
equity. Consequently, the classification of this instrument as a
liability for purposes of paragraph (c)(2)(iii) of this section is
not in accordance with U.S. tax principles.
Example 2. Valuation of item not substantially in accordance
with U.S. tax principles. Bank Z, a resident of country X, has a
branch in the United States through which it conducts its banking
business. Bank Z is a large bank as defined in section 585(c)(2).
The tax rules of country X allow Bank Z to take deductions for
additions to certain reserves. Bank Z decreases the value of the
assets on its financial statements by the amounts of the reserves.
The additions to the reserves under country X tax rules cause the
value of Bank Z's assets to differ from the value of those assets
determined under U.S. tax principles to a degree that materially
affects the value of taxpayer's worldwide assets. Consequently, the
valuation of Bank Z's worldwide assets under country X tax
principles is not substantially in accordance with U.S. tax
principles. Bank Z must increase the value of its worldwide assets
under paragraph (c)(2)(iii) of this section by the amount of its
country X reserves.
Example 3. Valuation of item substantially in accordance with
U.S. tax principles. Bank Z, a resident of country X, has a branch
in the United States through which it conducts its banking business.
In determining the value of its worldwide assets, Bank Z computes
the adjusted basis of certain non-U.S. assets according to the
depreciation methodology provided under country X tax laws, which is
different than the depreciation methodology provided under U.S. tax
law. If the depreciation methodology provided under country X tax
laws does not differ from U.S. tax principles to a degree that
materially affects the value of Bank Z's worldwide assets or Bank
Z's actual ratio as computed under paragraph (c)(2) of this section,
then the valuation of Bank Z's worldwide assets under paragraph
(c)(2)(iv) of this section is substantially in accordance with U.S.
tax principles.
Example 4. [Reserved]
Example 5. Adjustments. FC is a foreign corporation engaged in
the active conduct of a banking business through a branch, B, in the
United States. P, an unrelated foreign corporation, deposits
$100,000 in the home office of FC. Shortly thereafter, in a
transaction arranged by the home office of FC, B lends $80,000
bearing interest at an arm's length rate to S, a wholly owned U.S.
subsidiary of P. The district director or the Assistant Commissioner
(International) determines that one of the principal purposes for
making and incurring such loans is to increase FC's actual ratio.
For purposes of this section, therefore, P is treated as having
directly lent $80,000 to S. Thus, for purposes of paragraph (c) of
this section (Step 2), the district director or the Assistant
Commissioner (International) may offset FC's liability and asset
arising from this transaction, resulting in a net liability of
$20,000 that is not a booked liability of B. Because the loan to S
from B was initiated and arranged by the home office of FC, with no
material participation by B, the loan to S will not be treated as a
U.S. asset.
(d) Step 3: Determination of amount of interest expense allocable
to ECI under the adjusted U.S. booked liabilities method--(1) General
rule. The adjustment to the amount of interest expense paid or accrued
on U.S. booked liabilities is determined by comparing the amount of
U.S.-connected liabilities for the taxable year, as determined under
paragraph (c) of this section, with the average total amount of U.S.
booked liabilities, as determined under paragraphs (d)(2) and (3) of
this section. If the average total amount of U.S. booked liabilities
equals or exceeds the amount of U.S.-connected liabilities, the
adjustment to the interest expense on U.S. booked liabilities is
determined under paragraph (d)(4) of this section. If the amount of
U.S.-connected liabilities exceeds the average total amount of U.S.
booked liabilities, the adjustment to the amount of interest expense
paid or accrued on U.S. booked liabilities is determined under
paragraph (d)(5) of this section.
(2) U.S. booked liabilities--(i) In general. A liability is a U.S.
booked liability if it is properly reflected on the books of the U.S.
trade or business, within the meaning of paragraph (d)(2)(ii) or (iii)
of this section.
(ii) Properly reflected on the books of the U.S. trade or business
of a foreign corporation that is not a bank--(A) In general. A
liability, whether interest bearing or non-interest bearing, is
properly reflected on the books of the U.S. trade or business of a
foreign corporation that is not a bank as described in section
585(a)(2)(B) (without regard to the second sentence thereof) if--
(1) The liability is secured predominantly by a U.S. asset of the
foreign corporation;
(2) The foreign corporation enters the liability on a set of books
relating to an activity that produces ECI at a time reasonably
contemporaneous with the time at which the liability is incurred; or
(3) The foreign corporation maintains a set of books and records
relating to an activity that produces ECI and the District Director or
Assistant Commissioner (International) determines that there is a
direct connection or relationship between the liability and that
activity. Whether there is a direct connection between the liability
and an activity that produces ECI depends on the facts and
circumstances of each case.
(B) Identified liabilities not properly reflected. A liability is
not properly reflected on the books of the U.S. trade or business
merely because a foreign corporation identifies the liability pursuant
to Sec. 1.884-4(b)(1)(ii) and (b)(3).
(iii) Properly reflected on the books of the U.S. trade or business
of a foreign corporation that is a bank--(A) In general. A liability,
whether interest bearing or non-interest bearing, is properly reflected
on the books of the U.S. trade or business of a foreign corporation
that is a bank as described in section 585(a)(2)(B) (without regard to
the second sentence thereof) if--
(1) The bank enters the liability on a set of books relating to an
activity that produces ECI before the close of the day on which the
liability is incurred; and
(2) There is a direct connection or relationship between the
liability and that activity. Whether there is a direct connection
between the liability and an activity that produces ECI depends on
[[Page 9334]]
the facts and circumstances of each case.
(B) Inadvertent error. If a bank fails to enter a liability in the
books of the activity that produces ECI before the close of the day on
which the liability was incurred, the liability may be treated as a
U.S. booked liability only if, under the facts and circumstances, the
taxpayer demonstrates a direct connection or relationship between the
liability and the activity that produces ECI and the failure to enter
the liability in those books was due to inadvertent error.
(iv) Liabilities of insurance companies. [Reserved]
(v) Liabilities used to increase artificially interest expense on
U.S. booked liabilities. U.S. booked liabilities shall not include a
liability if one of the principal purposes for incurring or holding the
liability is to increase artificially the interest expense on the U.S.
booked liabilities of a foreign corporation. Whether a liability is
incurred or held for the purpose of artificially increasing interest
expense will depend upon all the facts and circumstances of each case.
Factors to be considered in determining whether one of the principal
purposes for incurring or holding a liability is to increase
artificially the interest expense on U.S. booked liabilities of a
foreign corporation include whether the interest expense on the
liability is excessive when compared to other liabilities of the
foreign corporation denominated in the same currency and whether the
currency denomination of the liabilities of the U.S. branch
substantially matches the currency denomination of the U.S. branch's
assets. A purpose may be a principal purpose even though it is
outweighed by other purposes (taken together or separately).
(vi) Hedging transactions. [Reserved]
(vii) Amount of U.S. booked liabilities of a partner. A partner's
share of liabilities of a partnership is considered a booked liability
of the partner provided that it is properly reflected on the books
(within the meaning of paragraph (d)(2)(ii) of this section) of the
U.S. trade or business of the partnership.
(viii) Interbranch transactions. A transaction of any type between
separate offices or branches of the same taxpayer does not result in
the creation of a liability.
(3) Average total amount of U.S. booked liabilities. The average
total amount of U.S. booked liabilities for the taxable year is the
average of the sums of the amounts (determined under paragraph (d)(2)
of this section) of U.S. booked liabilities. The amount of U.S. booked
liabilities shall be computed at the most frequent, regular intervals
for which data are reasonably available. In no event shall the amount
of U.S. booked liabilities be computed less frequently than monthly by
a large bank (as defined in section 585(c)(2)) and semi-annually by any
other taxpayer.
(4) Interest expense where U.S. booked liabilities equal or exceed
U.S. liabilities--(i) In general. If the average total amount of U.S.
booked liabilities (as determined in paragraphs (d)(2) and (3) of this
section) exceeds the amount of U.S.-connected liabilities (as
determined under paragraph (c) of this section (Step 2)), the interest
expense allocable to ECI is the product of the total amount of interest
paid or accrued within the taxable year by the U.S. trade or business
on U.S. booked liabilities and the scaling ratio set out in paragraph
(d)(4)(ii) of this section. For purposes of this section, the reduction
resulting from the application of the scaling ratio is applied pro-rata
to all interest expense paid or accrued by the foreign corporation. A
similar reduction in income, expense, gain, or loss from a hedging
transaction (as described in paragraph (d)(2)(vi) of this section) must
also be determined by multiplying such income, expense, gain, or loss
by the scaling ratio. If the average total amount of U.S. booked
liabilities (as determined in paragraph (d)(3) of this section) equals
the amount of U.S.-connected liabilities (as determined under Step 2),
the interest expense allocable to ECI is the total amount of interest
paid or accrued within the taxable year by the U.S. trade or business
on U.S. booked liabilities.
(ii) Scaling ratio. For purposes of this section, the scaling ratio
is a fraction the numerator of which is the amount of U.S.-connected
liabilities and the denominator of which is the average total amount of
U.S. booked liabilities.
(iii) Special rules for insurance companies. [Reserved]
(5) U.S.-connected interest rate where U.S. booked liabilities are
less than U.S.-connected liabilities--(i) In general. If the amount of
U.S.-connected liabilities (as determined under paragraph (c) of this
section (Step 2)) exceeds the average total amount of U.S. booked
liabilities, the interest expense allocable to ECI is the total amount
of interest paid or accrued within the taxable year by the U.S. trade
or business on U.S. booked liabilities, plus the excess of the amount
of U.S.-connected liabilities over the average total amount of U.S.
booked liabilities multiplied by the interest rate determined under
paragraph (d)(5)(ii) of this section.
(ii) Interest rate on excess U.S.-connected liabilities. The
applicable interest rate on excess U.S.-connected liabilities is
determined by dividing the total interest expense paid or accrued for
the taxable year on U.S.-dollar liabilities shown on the books of the
offices or branches of the foreign corporation outside the United
States by the average U.S.-dollar denominated liabilities (whether
interest-bearing or not) shown on the books of the offices or branches
of the foreign corporation outside the United States for the taxable
year.
(6) Examples. The following examples illustrate the rules of this
section:
Example 1. Computation of interest expense; actual ratio--(i)
Facts. (A) FC is a foreign corporation that is not a bank and that
actively conducts a real estate business through a branch, B, in the
United States. For the taxable year, FC's balance sheet and income
statement is as follows (assume amounts are in U.S. dollars and
computed in accordance with paragraphs (b)(2) and (b)(3) of this
section):
------------------------------------------------------------------------
Value
------------------------------------------------------------------------
Asset 1............................................. $2,000
Asset 2............................................. 2,500
Asset 3............................................. 5,500
Amount Interest
Liability 1......................................... $800 56
Liability 2......................................... 3,200 256
Capital............................................. 6,000 0
------------------------------------------------------------------------
(B) Asset 1 is the stock of FC's wholly-owned domestic
subsidiary that is also actively engaged in the real estate
business. Asset 2 is a building in the United States producing
rental income that is entirely ECI to FC. Asset 3 is a building in
the home country of FC that produces rental income. Liabilities 1
and 2 are loans that bear interest at the rates of 7% and 8%,
respectively. Liability 1 is a booked liability of B, and Liability
2 is booked in FC's home country. Assume that FC has not elected to
use the fixed ratio in Step 2.
(ii) Step 1. Under paragraph (b)(1) of this section, Assets 1
and 3 are not U.S. assets, while Asset 2 qualifies as a U.S. asset.
Thus, under paragraph (b)(3) of this section, the total value of
U.S. assets for the taxable year is $2,500, the value of Asset 2.
(iii) Step 2. Under paragraph (c)(1) of this section, the amount
of FC's U.S.-connected liabilities for the taxable year is
determined by multiplying $2,500 (the value of U.S. assets
determined under Step 1) by the actual ratio for the taxable year.
The actual ratio is the average amount of FC's worldwide liabilities
divided by the average value of FC's worldwide assets. The amount of
Liability 1 is $800, and the amount of Liability 2 is $3,200. Thus,
the numerator of the actual ratio is $4,000. The average value of
worldwide assets is $10,000 (Asset 1 + Asset 2 + Asset 3). The
actual ratio, therefore, is 40% ($4,000/$10,000), and the amount of
U.S.-connected liabilities for the taxable year is $1,000 ($2,500
U.S. assets x 40%).
[[Page 9335]]
(iv) Step 3. Because the amount of FC's U.S.-connected
liabilities ($1,000) exceeds the average total amount of U.S. booked
liabilities of B ($800), FC determines its interest expense in
accordance with paragraph (d)(5) of this section by adding the
interest paid or accrued on U.S. booked liabilities, and the
interest expense associated with the excess of its U.S.-connected
liabilities over its average total amount of U.S. booked
liabilities. Under paragraph (d)(5)(ii) of this section, FC
determines the interest rate attributable to its excess U.S.-
connected liabilities by dividing the interest expense paid or
accrued by the average amount of U.S.-dollar denominated
liabilities, which produces an interest rate of 8% ($256/$3200).
Therefore, FC's allocable interest expense is $72 ($56 of interest
expense from U.S. booked liabilities plus $16 ($200 x 8%) of
interest expense attributable to its excess U.S.-connected
liabilities).
Example 2. Computation of interest expense; fixed ratio--(i) The
facts are the same as in Example 1, except that FC makes a fixed
ratio election under paragraph (c)(4) of this section. The
conclusions under Step 1 are the same as in Example 1.
(ii) Step 2. Under paragraph (c)(1) of this section, the amount
of U.S.-connected liabilities for the taxable year is determined by
multiplying $2,500 (the value of U.S. assets determined under Step
1) by the fixed ratio for the taxable year, which, under paragraph
(c)(4) of this section is 50 percent. Thus, the amount of U.S.-
connected liabilities for the taxable year is $1,250 ($2,500 U.S.
assets x 50%).
(iii) Step 3. As in Example 1, the amount of FC's U.S.-connected
liabilities exceed the average total amount of U.S. booked
liabilities of B, requiring FC to determine its interest expense
under paragraph (d)(5) of this section. In this case, however, FC
has excess U.S.-connected liabilities of $450 ($1,250 of U.S.-
connected liabilities--$800 U.S. booked liabilities). FC therefore
has allocable interest expense of $92 ($56 of interest expense from
U.S. booked liabilities plus $36 ($450 x 8%) of interest expense
attributable to its excess U.S.-connected liabilities).
Example 3. Scaling ratio.--(i) Facts. Bank Z, a resident of
country X, has a branch in the United States through which it
conducts its banking business. For the taxable year, Z has U.S.-
connected liabilities, determined under paragraph (c) of this
section, equal to $300. Z, however, has U.S. booked liabilities of
$300 and U500. Therefore, assuming an exchange rate of the U to the
U.S. dollar of 5:1, Z has U.S. booked liabilities of $400 ($300 +
(U500 5)).
(ii) U.S.-connected liabilities. Because Z's U.S. booked
liabilities of $400 exceed its U.S.-connected liabilities by $100,
all of Z's interest expense allocable to its U.S. trade or business
must be scaled back pro-rata. To determine the scaling ratio, Z
divides its U.S.-connected liabilities by its U.S. booked
liabilities, as required by paragraph (d)(4) of this section. Z's
interest expense is scaled back pro rata by the resulting ratio of
\3/4\ ($300 $400). Z's income, expense, gain or loss from
hedging transactions described in paragraph (d)(2)(vi) of this
section must be similarly reduced.
Example 4. [Reserved]
(e) Separate currency pools method--(1) General rule. If a foreign
corporation elects to use the method in this paragraph, its total
interest expense allocable to ECI is the sum of the separate interest
deductions for each of the currencies in which the foreign corporation
has U.S. assets. The separate interest deductions are determined under
the following three-step process.
(i) Determine the value of U.S. assets in each currency pool.
First, the foreign corporation must determine the amount of its U.S.
assets, using the methodology in paragraph (b) of this section, in each
currency pool. The foreign corporation may convert into U.S. dollars
any currency pool in which the foreign corporation holds less than 3%
of its U.S. assets. A transaction (or transactions) that hedges a U.S.
asset shall be taken into account for purposes of determining the
currency denomination and the value of the U.S. asset.
(ii) Determine the U.S.-connected liabilities in each currency
pool. Second, the foreign corporation must determine the amount of its
U.S.-connected liabilities in each currency pool by multiplying the
amount of U.S. assets (as determined under paragraph (b)(3) of this
section) in the currency pool by the foreign corporation's actual ratio
(as determined under paragraph (c)(2) of this section) for the taxable
year or, if the taxpayer has made an election in accordance with
paragraph (c)(4) of this section, by the fixed ratio.
(iii) Determine the interest expense attributable to each currency
pool. Third, the foreign corporation must determine the interest
expense attributable to each currency pool by multiplying the U.S.-
connected liabilities in each currency pool by the prescribed interest
rate as defined in paragraph (e)(2) of this section.
(2) Prescribed interest rate. For each currency pool, the
prescribed interest rate is determined by dividing the total interest
expense that is paid or accrued for the taxable year with respect to
the foreign corporation's worldwide liabilities denominated in that
currency, by the foreign corporation's average worldwide liabilities
(whether interest bearing or not) denominated in that currency. The
interest expense and liabilities are to be stated in that currency.
(3) Hedging transactions. [Reserved]
(4) Election not available if excessive hyperinflationary assets.
The election to use the separate currency pools method of this
paragraph (e) is not available if the value of the foreign
corporation's U.S. assets denominated in a hyperinflationary currency,
as defined in Sec. 1.985-1, exceeds ten percent of the value of the
foreign corporation's total U.S. assets. If a foreign corporation made
a valid election to use the separate currency pools method in a prior
year but no longer qualifies to use such method pursuant to this
paragraph (e)(4), the taxpayer must use the method provided by
paragraphs (b) through (d) of this section.
(5) Examples. The separate currency pools method of this paragraph
(e) is illustrated by the following examples:
Example 1. Separate currency pools method--(i) Facts. (A) Bank
Z, a resident of country X, has a branch in the United States
through which it conducts its banking business. For its 1997 taxable
year, Z has U.S. assets, as defined in paragraph (b) of this
section, that are denominated in U.S. dollars and in U, the country
X currency. Accordingly, Z's U.S. assets are as follows:
------------------------------------------------------------------------
Average
value
------------------------------------------------------------------------
U.S. Dollar Assets........................................... $20,000
U Assets..................................................... U 5,000
------------------------------------------------------------------------
(B) Z's worldwide liabilities are also denominated in U.S.
Dollars and in U. The average interest rates on Z's worldwide
liabilities, including those in the United States, are 6% on its
U.S. dollar liabilities, and 12% on its liabilities denominated in
U. Assume that Z has properly elected to use its actual ratio of 95%
to determine its U.S.-connected liabilities in Step 2, and has also
properly elected to use the separate currency pools method provided
in paragraph (e) of this section.
(ii) Determination of interest expense. Z determines the
interest expense attributable to its U.S.-connected liabilities
according to the steps described below.
(A) First, Z separates its U.S. assets into two currency pools,
one denominated in U.S. dollars ($20,000) and the other denominated
in U (U5,000).
(B) Second, Z multiplies each pool of assets by the applicable
ratio of worldwide liabilities to assets, which in this case is 95%.
Thus, Z has U.S.-connected liabilities of $19,000 ($20,000 x 95%),
and U4750 (U5000 x 95%).
(C) Third, Z calculates its interest expense by multiplying each
pool of its U.S.-connected liabilities by the relevant interest
rates. Accordingly, Z's allocable interest expense for the year is
$1140 ($19,000 x 6%), the sum of the expense associated with its
U.S. dollar liabilities, plus U570 (U4750 x 12%), the interest
expense associated with its liabilities denominated in U. Z must
translate its interest expense denominated in U in accordance with
the rules provided in section 988, and then must determine whether
it is subject to any other provision of the Code that would disallow
or defer any portion of its interest expense so determined.
Example 2. [Reserved]
[[Page 9336]]
(f) Effective date--(1) General rule. This section is effective for
taxable years beginning on or after June 6, 1996.
(2) Special rules for financial products. [Reserved]
Margaret Milner Richardson,
Commissioner of Internal Revenue.
Approved: February 28, 1996.
Leslie Samuels,
Assistant Secretary of the Treasury.
[FR Doc. 96-5262 Filed 3-5-96; 8:45 am]
BILLING CODE 4830-01-U
