Section 2. Interest Expense Apportionment

Factors

This information is relevant to a partner to allocate and apportion interest expense for foreign tax credit limitation purposes.

Complete this Section 2 only if the partnership or the partners have interest expense or stewardship expense.

Stewardship expenses. In the case of the partner’s stewardship expenses incurred to oversee the partnership, the partnership’s value is determined and characterized under the asset method in Regulations section 1.861-9 (taking into account any adjustments under sections 734(b) and 743(b)). See Regulations section 1.861-8(e)(4)(ii)(C). So, the reporting below for Part III, Section 2, for interest expense apportionment factors generally applies to the partner’s stewardship expense apportionment.

For corporate partners with an interest in the partnership of 10% or more, interest expense, including the partner’s distributive share of partnership interest expense, is apportioned

10 Inst. for Schedules K-2 and K-3 (Form 8865) (2025)

by reference to the partner’s assets, including the partner’s share of partnership assets. See Regulations section 1.861-9(e)(2). Interest expense is apportioned based on the average value of assets. See Regulations section 1.861-9(g)(2)(i)(A). A taxpayer can use either the tax book value or the alternative tax book value of its assets. See Regulations section 1.861-9(i). Under both methods, the partner uses the partnership’s inside basis in its assets, including adjustments required under sections 734(b) and 743(b). See Regulations sections 1.861-9(e)(2) and (3). When reporting the basis in an asset which is stock in nonaffiliated 10%-owned corporations, adjust such amount for earnings and profits (E&P). See Regulations section 1.861-12(c) (2)(i)(A).

Note: Attach to Form 1065 a second Part III, Section 2, if the filer reports both the tax book value and the alternative tax book value of its assets.

Column (b). Characterize the share of the partnership assets that give rise to foreign branch category income as assets in the foreign branch category. See Regulations section 1.861-9(e) (10).

Column (e). As of the date of these instructions, the only separate category that could be included in column (e) is the section 901(j) category of income. See the Instructions for Form 1118 for the potential countries to be listed with the section 901(j) category of income.

Line 1. On Schedule K-2, report the average of the beginning-of-year and end-of-year inside bases in the partnership’s total assets. See Regulations section 1.861-9(g)(2) (i)(A). On Schedule K-3, report the partner’s distributive share of the assets reported on Schedule K-2.

Line 2. On Schedule K-2, report the partnership’s average of the beginning-of-year and end-of-year inside bases adjustments under sections 734(b) and 743(b). On Schedule K-3, report the partner’s distributive share of the adjustments reported on Schedule K-2.

Lines 3 and 4. On Schedule K-2, report reductions in the partnership’s asset values to reflect the partnership’s directly allocable interest under Regulations section 1.861-10(e) and Temporary Regulations section 1.861-10T. See also Temporary Regulations section 1.861-9T(e)(1). On Schedule K-3, report the partner’s distributive share of the reduction in the partnership’s assets reported on Schedule K-2.

Line 5. On Schedule K-2, report the average value of partnership assets excluded from the apportionment formula. See section 864(e)(3). On Schedule K-3, report the partner’s distributive share of the excluded assets reported on Schedule K-2.

Line 6. Individual partners who are (a) general partners, (b) limited partners with an interest in the partnership of 10% or more, or (c) limited partners with an interest in the partnership of less than 10% but hold such interest in the ordinary course of the partner’s active trade or business follow the same rules as corporate partners whose interest in the partnership is 10% or more except that their interest expense must be apportioned according to the interest expense classifications under sections 163 and 469. See Temporary Regulations section 1.961-9T(d). This includes reporting the assets according to such classifications. If the partnership has no such partners, don’t complete Schedule K-2, Part III, Section 2; or Schedule K-3, Part III, Section 2.

Line 6a is the sum of lines 1 and 2 less the sum of lines 3, 4, and 5. Line 6a is divided into the types of assets on lines 6b, 6c, and 6d if the partnership has partners other than corporate partners. See the Partnership Instructions Schedules K-2 and K-3 (Form 1065) for an example.

Schedule K-3. If the partnership’s partners aren’t limited to corporate partners, when completing Schedule K-3, Part III, Section 2, for the corporate partners with an interest of 10% or more in the partnership, don’t complete lines 6b through 6d. Include the total distributive share on line 6a.

Lines 7 and 8. The amounts reported on lines 7 and 8 are subsets of the amounts reported on line 6 representing the value of stock held by the partnership in certain foreign corporations. In determining its foreign tax credit limitation, a partner should disregard interest expense that is “properly allocable’’ to stock of a 10%-owned foreign corporation that has been characterized as a section 245A asset. See section 904(b)(4) and Regulations section 1.904(b)-3(a)(1)(ii). The amount of properly allocable deductions is determined by treating the section 245A subgroup for each separate category as a statutory grouping for purposes of allocating and apportioning interest deductions on the basis of assets. Assets in a section 245A subgroup only include stock of a specified 10%-owned foreign corporation that has been characterized as a section 245A asset.

The stock is characterized as a section 245A asset to the extent it generates income that would generate a dividends received deduction under section 245A if distributed. This doesn’t include income that is included as GILTI, subpart F income, or a section 951(a)(1)(B) inclusion or income described in section 245(a)(5) (which gives rise to a dividends received deduction under section 245 instead of section 245A).

In the case of a specified 10%-owned foreign corporation that isn’t a CFC, all of the value of its stock is potentially in a section 245A subgroup because the stock generally generates dividends eligible for the section 245A deduction (and cannot generate an inclusion under section 951(a)(1) or 951A(a)) if the partner meets the requirements for eligibility. See Regulations section 1.904(b)-3(c)(2). However, because there may not be information to determine if a partner is eligible for a section 245A deduction (for example, due to tiered ownership), the partner must determine to what extent the stock is treated as an asset in a section 245A subgroup.

For a partnership-owned specified 10% foreign corporation that isn’t a CFC, report on line 7, columns (a) through (e), the total value of the stock in all such foreign corporations. The value of the stock is the partnership’s basis in the stock adjusted to take into account the E&P of the foreign corporations as explained in Regulations section 1.861-12(c)(2). Attach to the Schedules K-2 and K-3 a statement with the following information for each foreign corporation for which adjusted basis is reported on line 7.

If the specified 10%-owned foreign corporation is a CFC, a portion of the value of stock in each separate category and in the residual grouping for U.S. source income is subdivided between a section 245A and non-section 245A subgroup under the rules described in Regulations section 1.861-13(a)(5). However, because there will generally not be information to apply the stock characterization rules described in Regulations section 1.861-13(a)(5), the partner must apply those rules to characterize the stock.

For partnership-owned CFCs, report on line 8, column (f), the total value of its stock in all such foreign corporations. The value of the stock is the partnership’s inside basis in the stock adjusted to take into account the E&P of the foreign corporations as explained in Regulations section 1.861-12(c)(2). Attach to the

• Name of foreign corporation.

• EIN or reference ID number. Don’t enter “FOREIGNUS” or “APPLIED FOR.”

• Percentage of voting and value of stock owned by the partnership in such foreign corporation.

• Value of the stock in such corporation included in each of the groupings on lines 6b through 6d (identify separately each of those groupings).

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Schedules K-2 and K-3 a statement with the following information for each foreign corporation for which basis is reported on line 8.

• Name of foreign corporation.

• EIN or reference ID number. Don’t enter “FOREIGNUS” or “APPLIED FOR.”

• Percentage of voting and value of stock owned by the partnership in such foreign corporation.

• Value of the stock in such corporation included in each of the groupings on lines 6b through 6d (identify separately each of those groupings).