Part I. Rulings — Internal Revenue Bulletin 1996-14

Section 42.—Low-Income Housing Credit

The adjusted applicable federal short-term, mid-term, and long-term rates are set forth for the month of April 1996. See Rev. Rul. 96–19, page 24.

Section 62.—Adjusted Gross Income Defined

26 CFR 1.62–2: Reimbursements and other expense allowance arrangements.

Rules are set forth under which a reimbursement or other expense allowance arrangement for the cost of lodging, meal, and/or incidental expenses incurred by an employee while traveling away from home will satisfy the requirements of § 62(c) of the Code as to substantiation of the amount of expenses. See Rev. Proc. 96– 28, 1996–14 I.R.B. page 31.

Section 162.—Trade or Business Expense

26 CFR 1.162–17: Reporting and substantia- tion of certain business expenses of employees.

The rules for substantiating the amount of a deduction or expense for lodging, meal, and/or incidental expenses incurred while traveling away from home that most nearly represents current costs are set forth. See Rev. Proc. 96–28, 1996–14 I.R.B. page 31.

Section 267.—Losses, Expenses, and Interest With Respect to Transactions Between Related Taxpayers

26 CFR 1.267(a)–1: Deductions disallowed.

When a payor provides a per diem allowance to an employee who is a related party, the rules set forth for the deemed substantiation to the payor of the amount of the employee’s ordinary and necessary business expenses for lodging, meal, and/or incidental expenses incurred while traveling away from home do not apply. See Rev. Proc. 96–28, 1996–14 I.R.B. page 31.

Section 274.—Disallowance of Certain Entertainment, etc., Expenses

26 CFR 1.274(d)–1(a): Substantiation requirements.

expenses. See Rev. Proc. 96–28, 1996–14 I.R.B. page 31.

26 CFR 1.274–5T: Substantiation requirements (temporary).

Rules are set forth for substantiating the amount of ordinary and necessary business expense of an employee for lodging, meal, and/ or incidental expenses incurred while traveling away from home when a payor provides a per diem allowance under a reimbursement or other expense allowance arrangement to pay for such expenses. Rules are also set forth for an optional method for employees and self-employed individuals to use in computing the deductible costs of business meal and incidental expenses paid or incurred while traveling away from home. See Rev. Proc. 96–28, 1996–14 I.R.B. page 31.

Section 280G.—Golden Parachute Payments

Federal short-term, mid-term, and long-term rates are set forth for the month of April 1996. See Rev. Rul. 96–19, page 24.

Section 382.—Limitation on Net Operating Loss Carryforwards and Certain Built-In Losses Following Ownership Change

The adjusted federal long-term rate is set forth for the month of April 1996. See Rev. Rul. 96– 19, page 24.

Section 412.—Minimum Funding Standards

The adjusted applicable federal short-term, mid-term, and long-term rates are set forth for the month of April 1996. See Rev. Rul. 96–19, page 24.

Section 467.—Certain Payments for the Use of Property or Services

The adjusted applicable federal short-term, mid-term, and long-term rates are set forth for the month of April 1996. See Rev. Rul. 96–19, page 24.

Section 468.—Special Rules for Mining and Solid Waste Reclamation and Closing Costs

The adjusted applicable federal short-term, mid-term, and long-term rates are set forth for the month of April 1996. See Rev. Rul. 96–19, page 24.

Section 483.—Interest on Certain Deferred Payments

The adjusted applicable federal short-term, mid-term, and long-term rates are set forth for the month of April 1996. See Rev. Rul. 96–19, page 24.

Section 807.—Rules for Certain Reserves

The adjusted applicable federal short-term, mid-term, and long-term rates are set forth for the month of April 1996. See Rev. Rul. 96–19, page 24.

Section 846.—Discounted Unpaid Losses Defined

The adjusted applicable federal short-term, mid-term, and long-term rates are set forth for the month of April 1996. See Rev. Rul. 96–19, page 24.

Section 864.—Definitions and Special Rules

26 CFR 1.864–4: U.S. source income effectively connected with U.S. business.

T.D. 8657

DEPARTMENT OF THE TREASURY Internal Revenue Service 26 CFR Parts 1 and 602

Regulations on Effectively Connected Income and the Branch Profits Tax

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final and temporary regulations.

SUMMARY: This document contains final Income Tax Regulations relating to the determination of effectively connected income under section 864 and final and temporary Income Tax Regulations relating to the branch profits tax and branch-level interest tax under section 884 of the Internal Revenue Code of 1986 (Code). Section 884 was added to the Code by section 1241 of the Tax Reform Act of 1986. This document also contains conforming changes to sections 861, 871 and 897.

EFFECTIVE DATE: June 6, 1996.

FOR FURTHER INFORMATION CONTACT: Gwendolyn A. Stanley, (202) 622-3860 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collections of information contained in these final regulations have been reviewed and approved by the Office of Management and Budget in accordance with the Paperwork Reduction Act (44 U.S.C. 3507) under control number 1545–1070.

An agency may not conduct or sponsor, and a person is not required to respond to, a collection of information unless the collection of information displays a valid control number.

The estimated annual burden per respondent is .25 hours.

Comments concerning the accuracy of this burden estimate and suggestions for reducing this burden should be sent to the Internal Revenue Service, Attn: IRS Reports Clearance Officer, T:FP, Washington, DC 20224, and to the Office of Management and Budget, Attn: Desk Officer for the Department of the Treasury, Office of Information and Regulatory Affairs, Washington, DC 20503.

Books or records relating to this collection of information must be retained as long as their contents may be material in the administration of any internal revenue law. Generally, tax returns and tax information are confidential, as required by 26 U.S.C. 6103.

Background

On September 2, 1988, proposed and temporary regulations (TD 8223 and INTL–934–86 [1988–2 C.B. 825]) under section 884 were published in the Federal Register (53 FR 34045). Written comments were received on the proposed amendments. On September 11, 1992, temporary regulations under § 1.884–2T were amended and final regulations (1992 final regulations) (TD 8432 [1992–2 C.B. 157]) under section 884 of the Code were published in the Federal Register (57 FR 41644). Proposed amendments (1992 proposed regulations) (INTL–0003–92 [1992–2 C.B.

752]) to the Income Tax Regulations (26 CFR part 1) under sections 864 and 884 of the Internal Revenue Code were published in the Federal Register (57 FR 41707) on the same day. Written comments were received on the proposed amendments. After consideration of all the comments, § 1.884–2(a)(2)(ii) and § 1.884–2(c)(2)(iii) of the 1988 proposed regulations and the 1992 proposed regulations are adopted as final regulations as amended by this Treasury decision. The revisions and conforming changes are discussed below.

Explanation of the Provisions

I. Section 864 stock rule .

The proposed regulations under section 864 provided that stock of a corporation shall not be treated as an asset used in, or held for use in, the conduct of a U.S. trade or business. Accordingly, the regulations proposed to delete the example of stock acquired and held to assure a constant source of supply as an asset that satisfies the asset-use test under § 1.864–4(c)(2). Commenters criticized this rule and cited to the legislative history to the Foreign Investors Tax Act of 1966 as contemplating that stock may satisfy the asset-use test. The IRS and Treasury continue to believe, however, that stock does not satisfy the asset-use test. Therefore § 1.864–4(c)(2)(iii) adopts the rule contained in the proposed regulations.

In response to our request for comments on whether insurance companies require an exception to the stock rule for their portfolio stock, one commenter suggested that foreign life insurance companies be permitted to refer to the National Association of Insurance Commissioners (NAIC) Annual Statement to determine whether their assets are used in, or held for use in, the conduct of a U.S. trade or business. The IRS and Treasury will continue to consider whether modifications to the regulations under section 864 are appropriate for foreign insurance companies and reserve on the treatment of stock held by a foreign insurance company.

Conforming changes have been made to regulations under section 864, as well as regulations under sections 871 and 897 to reflect the clarification of § 1.864–4(c)(2). The effective date of

the changes to sections 871 and 897 corresponds to the effective date of the changes to section 864.

II. Branch profits tax .

A. Interest in a partnership . Currently, a foreign corporation engaged in a U.S. trade or business through a partnership applies different rules to determine its U.S. assets depending on whether the determination is for purposes of section 884 or § 1.882–5. For purposes of computing its interest expense under § 1.882–5, the rules of § 1.861– 9T(e)(7) apply. Therefore a foreign corporation takes into account either its pro rata share of partnership assets and liabilities or applies the rules of § 1.882–5 as if the partnership were a foreign corporation, depending on the nature of its interest in the partnership. In contrast, for purposes of section 884, a foreign corporation generally takes into account its adjusted basis in its partnership interest as a starting point for determining its U.S. assets.

Final regulations under section 882 published elsewhere in this issue of the Federal Register remove the temporary regulations under § 1.861–9T(e)(7)(i). These final regulations provide a new U.S. asset rule for partnership interests for purposes of determining the U.S. assets of a foreign corporate partner under sections 882 and 884. The final regulations under § 1.882–5 contain a corresponding rule to determine the value of a partnership interest held by a foreign corporation for purposes of computing its worldwide assets.

In the event that a partnership derives any income that is not effectively connected with a U.S. trade or business, or otherwise holds non-U.S. assets, the rules in § 1.884–1(d)(3) continue to provide a rule that allocates the basis in the partnership interest between U.S. and non-U.S. assets. However, the allocation rule is more flexible than the rule contained in either the 1992 final regulations or the proposed regulations under section 884. The rule allows a foreign corporation to use either an income method or an asset method to determine the proportionate share of its partnership interest that is a U.S. asset, regardless of its ownership interest in the partnership. This is a change from the previous 1992 final regulations, which required all foreign corporate partners to use an income method, and from the 1992

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Adoption of amendments to the Regulations

Accordingly, 26 CFR parts 1 and 602 are 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 1.884–2 also issued under 26 U.S.C. 884(g)

Par. 2. Section 1.864–4 is amended as follows:

The third sentence in paragraph (c)(2)(i) is revised.
Paragraph (c)(2)(ii) is revised.
Paragraphs (c)(2)(iii) and (c)(2)(iv) are redesignated as (c)(2)(iv) and (c)(2)(v) respectively.
New paragraph (c)(2)(iii) is added.
Newly designated paragraph (c)(2)(v) is amended by:

a. Revising the introductory text. b. Removing Example (2) through Example (4) .

c. Redesignating ‘‘ Example (5) ’’ as ‘‘ Example (2) ’’.

d. Amending newly designated Ex- ample (2) by:

i. Revising the fifth and sixth sentences.

ii. Removing the date ‘‘1968’’ and adding the date ‘‘1997’’ where it appears in the second, third, and eighth sentences.

The last sentence of paragraph (c)(6)(i) is removed.
Paragraph (c)(7) is added. The additions and revisions read as follows:

§ 1.864–4 U.S. source income effec- tively connected with U.S. business .

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(c) * * * (2) * * * (i) * * * The asset-use test is of primary significance where, for example, interest income is derived from sources within the United States by a nonresident alien individual or foreign corporation that is engaged in the

proposed regulations, which required more than 10% partners to use the asset method.

Based on commenters’ suggestions, other clarifying changes have been made to the asset method. For example, the final regulations clarify that the adjusted bases of partnership assets reflect any adjustment under section 754 with respect to a foreign corporate partner.

B. Interest in a trust or estate . The rules applicable to interests in a trust or estate in § 1.884–1(d)(4) are finalized as proposed.

C. Nonrecourse indebtedness and inte- grated financial transactions . Because the final regulations under § 1.882–5 incorporate the special allocation rules of § 1.861–10T, certain changes to the final regulations under § 1.884–1(e) are needed to maintain the proper U.S. net equity of a foreign corporation that elects to directly allocate any portion of its interest expense. These regulations include a conforming change that provides that liabilities giving rise to such interest will be considered U.S. liabilities for purposes of section 884, notwithstanding that such liabilities are not taken into account in Step 2 of § 1.882–5.

In addition, a new provision has been added in § 1.884–4(b) so that branch interest continues to include interest paid with respect to liabilities that are subject to the special allocation rules, notwithstanding that such liabilities are not considered U.S. booked liabilities for purposes of Step 3 of the § 1.882–5 calculation.

D. Structural changes to conform branch interest rules to final regula- tions under § 1.882–5 . These regulations adopt the changes made by the 1992 proposed regulations under § 1.884–4(b), and thus incorporate the rules in § 1.882–5(d)(2) (relating to U.S. booked liabilities) in defining the term branch interest of a foreign corporation. Although certain changes were made to the definition of U.S. booked liabilities in the final regulations under § 1.882–5, the manner in which a foreign corporation computes its branch interest and excess interest remains substantially unchanged.

E. Excess interest—definition of a foreign bank . A foreign corporation

that is a foreign bank may treat a minimum of 85% of its excess interest as interest on deposits, regardless of its actual ratio of deposits to interest bearing liabilities. The IRS and Treasury believe this rule should be applicable only to a foreign bank engaging in substantial deposit-taking activities, taking into account its activities in the United States as well as other countries in which it operates. The definition used in the 1992 final regulations did not clearly convey this limitation. Thus, § 1.884–4(a)(2)(iii) now defines a foreign bank by reference to section 585(a)(2)(B) of the Code, but also requires that a substantial part of its business consists of receiving deposits and making loans and discounts.

III. Complete termination rules .

The rules in § 1.884–2T(a)(5), applicable to a foreign corporation whose beneficial interest in a trust terminates, are finalized as proposed by the 1992 regulations. In addition the waiver provisions contained in § 1.884–2 of the 1988 proposed regulations are finalized as amended by this Treasury decision.

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 has also 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 Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small business.

Drafting Information

The principal author of these regulations is Gwendolyn A. Stanley, Office of Associate Chief Counsel (International), within the Office of Chief Counsel, IRS. However, other personnel from the IRS and Treasury Department participated in their development.

business of manufacturing or selling goods in the United States. * * *

(ii) Cases where applicable . Ordinarily, an asset shall be treated as used in, or held for use in, the conduct of a trade or business in the United States if the asset is—

( a ) Held for the principal purpose of promoting the present conduct of the trade or business in the United States; or

( b ) Acquired and held in the ordinary course of the trade or business conducted in the United States, as, for example, in the case of an account or note receivable arising from that trade or business; or

( c ) Otherwise held in a direct relationship to the trade or business conducted in the United States, as determined under paragraph (c)(2)(iv) of this section.

(iii) Application of asset-use test to stock —( a ) In general . Except as provided in paragraph (c)(2)(iii)( b ) of this section, stock of a corporation (whether domestic or foreign) shall not be treated as an asset used in, or held for use in, the conduct of a trade or business in the United States.

( b ) Stock held by foreign insurance companies . [Reserved] * - - - (v) Illustration . The application of paragraph (iv) may be illustrated by the following examples:

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Example (2) . * * * During 1997, the branch office derives from sources within the United States interest on these securities, and gains and losses resulting from the sale or exchange of such securities. Since the securities were acquired with amounts generated by the business conducted in the United States, the interest is retained in that business, and the portfolio is managed by personnel actively involved in the conduct of that business, the securities are presumed under paragraph (c)(2)(iv)( b ) of this section to be held in a direct relationship to that business. * * *

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(7) Effective date . Paragraphs (c)(2) and (c)(6)(i) of this section are effective for taxable years beginning on or after June 6, 1996.

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Par. 3. In § 1.871–12, paragraph (d) is amended by:

Revising the paragraph heading and introductory text.
Removing Example 1 .
Removing the designation ‘‘ (2) ’’ in Example (2) .

The revision reads as follows:

§ 1.871–12 Determination of tax on treaty income .

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(d) Illustration . The application of this section may be illustrated by the following example:

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Par. 4. Section 1.884–0(b) is amended by revising the entries for §§ 1.884–1(d)(4), 1.884–2T(a)(5), 1.884–4(b)(1), and 1.884–4(b)(2) and adding entries for §§ 1.884–1(i)(4), 1.884–2T(a)(6), 1.884–4(e)(1) and 1.884–4(e)(2) to read as follows:

§ 1.884–0 Overview of regulation provisions for section 884 .

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(b) * -

§ 1.884–1 Branch profits tax .

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(d) * * * (4) Interest in a trust or estate.

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(i) * * * (4) Special rule for certain U.S. assets and liabilities.

§ 1.884–2T Special Rules for termina- tion or incorporation of a U.S. trade or business or liquidation or reorganiza- tion of a foreign corporation or its domestic subsidiary (temporary) .

(a) * * * (5) Special rule if a foreign corporation terminates an interest in a trust.

[Reserved]

(6) Coordination with second-level withholding tax.

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§ 1.884–4 Branch-level interest tax .

(b) * * *

(1) Definition of branch interest. (2) [Reserved] (3) * * * (4) [Reserved]

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(e) * * * (1) General rule. (2) Special rule.

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Par. 5. Section 1.884–1 is amended as follows:

Paragraph (c)(2) is amended as follows:

a. The text of paragraph (c)(2) is redesignated as paragraph (c)(2)(i) and a paragraph heading for (c)(2)(i) is added.

b. New paragraph (c)(2)(ii) is added. 2. In paragraph (d)(2)(xi), Example 2 through Example 4 are redesignated Example 3 through Example 5, respectively, and new Example 2 is added.

Paragraph (d)(3) is revised.
The text of paragraph (d)(4) is added.
Paragraph (d)(5)(iii) is revised.
In Paragraph (d)(6)(iii) the reference to ‘‘(d)(3)(iv)’’ is removed and ‘‘(d)(3)(vi)’’ is added in its place.
Paragraph (d)(6)(v) is redesignated as paragraph (d)(6)(vi).
New paragraph (d)(6)(v) is added and reserved.
Paragraph (e)(2) is amended as follows:

a. The paragraph heading and text of paragraph (e)(2) are redesignated as paragraph (e)(2)(i).

b. In newly designated paragraph (e)(2)(i) the language ‘‘(e)(2)’’ is removed and ‘‘(e)(2)(i)’’ is added in its place.

c. A new paragraph heading for paragraph (e)(2) is added.

d. Paragraph (e)(2)(ii) is added. 10. Paragraph (e)(3)(ii) is revised. 11. Paragraph (e)(5) is amended as follows:

a. The second sentence in Example 1 is revised.

b. In the list below, for each sentence in Example 1 indicated in the left column, remove the language in the middle column and add the language in the right column:

sentence Remove Add first and third sentence 1993 1997

first sentence § 1.882–5(b) § 1.882–5(c)

fourth and fifth sentence § 1.882–5(b)(2) § 1.882–5(c)(2)

seventh sentence amount value

seventh sentence § 1.882–5(b)(1) § 1.882–5(b)(2)

c. The second sentence in paragraph (i) of Example 2 is revised. d. In the list below, for each paragraph in Example 2 indicated in the left column, remove the language in the middle column and add the language in the right column:

Paragraph Remove Add

(i) first sentence 1993 1997 (i) third and fifth sentence 1994 1998 (ii) first, second, and third sentence 1995 1999 (ii) second sentence 1994 1998 (iii) first sentence 1995 1999 (iii) last sentence 1994 1998

Paragraph (i)(4) is added. The additions and revisions read as follows:

§ 1.884–1 Branch profits tax .

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(c) * * * (2) * * * (i) In general . * * * (ii) Bad debt reserves . A bank described in section 585(a)(2)(B) (without regard to the second sentence thereof) that uses the reserve method of accounting for bad debts for U.S. federal income tax purposes shall decrease the amount of loans that qualify as U.S. assets by any reserve that is permitted under section 585.

(d) * * * (2) * * * (xi) * * * Example 2 . U.S. real property interest con- nected to a U.S. business . FC is a foreign corporation that is a bank, within the meaning of section 585(a)(2)(B) (without regard to the second sentence thereof), and is engaged in the business of taking deposits and making loans through its branch in the United States. In 1996, FC makes a loan in the ordinary course of its lending business in the United States, securing the loan with a mortgage on the U.S. real property being financed by the borrower. In 1997, after the borrower has defaulted on the loan, FC takes title to the real property that secures the loan. On December 31, 1997, FC continues to hold the property, classifying it on its financial statement as Other Real Estate Owned . Because all income and gain from the property would be ECI to FC under the principles of section 864(c)(2), the U.S. real property constitutes a U.S. asset within the meaning of paragraph (d) of this section.

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(3) Interest in a partnership —(i) In general. A foreign corporation that is a partner in a partnership must take into account its interest in the partnership (and not the partnership assets) in determining its U.S. assets. For purposes of determining the proportion of the partnership interest that is a U.S. asset, a foreign corporation may elect to use either the asset method described in paragraph (d)(3)(ii) of this section or the income method described in paragraph (d)(3)(iii) of this section.

(ii) Asset method —(A) In general . A partner’s interest in a partnership shall be treated as a U.S. asset in the same proportion that the sum of the partner’s proportionate share of the adjusted bases of all partnership assets as of the determination date, to the extent that the assets would be treated as U.S. assets if the partnership were a foreign corporation, bears to the sum of the partner’s proportionate share of the adjusted bases of all partnership assets as of the determination date. Generally a partner’s proportionate share of a partnership asset is the same as its proportionate share of all items of income, gain, loss, and deduction that may be generated by the asset.

(B) Non-uniform proportionate shares . If a partner’s proportionate share of all items of income, gain, loss, and deduction that may be generated by a single asset of the partnership throughout the period that includes the taxable year of the partner is not uniform, then, for purposes of determining the partner’s proportionate

share of the adjusted basis of that asset, a partner must take into account the portion of the adjusted basis of the asset that reflects the partner’s economic interest in that asset. A partner’s economic interest in an asset of the partnership must be determined by applying the following presumptions. These presumptions may, however, be rebutted if the partner or the Internal Revenue Service shows that the presumption is inconsistent with the partner’s true economic interest in the asset during the corporation’s taxable year.

( 1 ) If a partnership asset ordinarily generates directly identifiable income, a partner’s economic interest in the asset is determined by reference to its proportionate share of income that may be generated by the asset for the partnership’s taxable year ending with or within the partner’s taxable year.

( 2 ) If a partnership asset ordinarily generates current deductions and ordinarily generates no directly identifiable income, for example because the asset contributes equally to the generation of all the income of the partnership (such as an asset used in general and administrative functions), a partner’s economic interest in the asset is determined by reference to its proportionate share of the total deductions that may be generated by the asset for the partnership’s taxable year ending with or within the partner’s taxable year.

( 3 ) For other partnership assets not described in paragraph (d)(3)(ii)(B)( 1 ) or ( 2 ) of this section, a partner’s economic interest in the asset is deter

mined by reference to its proportionate share of the total gain or loss to which it would be entitled if the asset were sold at a gain or loss in the partnership’s taxable year ending with or within the partner’s taxable year.

(C) Partnership election under sec- tion 754 . If a partnership files an election in accordance with section 754, then for purposes of this paragraph (d)(3)(ii), the basis of partnership property shall reflect adjustments made pursuant to sections 734 (relating to distributions of property to a partner) and 743 (relating to the transfer of an interest in a partnership). However, adjustments made pursuant to section 743 may be made with respect to a transferee partner only.

(iii) Income method . Under the income method, a partner’s interest in a partnership shall be treated as a U.S. asset in the same proportion that its distributive share of partnership ECI for the partnership’s taxable year that ends with or within the partner’s taxable year bears to its distributive share of all partnership income for that taxable year.

(iv) Manner of election —(A) In general . In determining the proportion of a foreign corporation’s interest in a partnership that is a U.S. asset, a foreign corporation must elect one of the methods described in paragraph (d)(3) of this section on a timely filed 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 § 301.9100–1 of this chapter and any guidance promulgated thereunder apply. An election shall be made by the foreign corporation calculating its U.S. assets in accordance with the method elected. An elected method must be used for a minimum period of five years before the foreign corporation may elect a different method. To change an election before the end of the requisite five-year period, a foreign corporation must obtain the consent of the Commissioner or her delegate. The Commissioner or her delegate will generally consent to a foreign corporation’s request to change its election only in rare and unusual circumstances. A foreign corporation that is a partner in more than one partnership is not required to elect to use the same method for each partnership interest.

(B) Elections with tiered partner- ships . If a foreign corporation elects to

use the asset method with respect to an interest in a partnership, and that partnership is a partner in a lower-tier partnership, the foreign corporation may apply either the asset method or the income method to determine the proportion of the upper-tier partnership’s interest in the lower-tier partnership that is a U.S. asset.

(v) Failure to make proper election . If a foreign corporation, for any reason, fails to make an election to use one of the methods required by paragraph (d)(3) of this section in a timely fashion, the district director or the Assistant Commissioner (International) may make the election on behalf of the foreign corporation and such election shall be binding as if made by that corporation.

(vi) Special rule for determining a partner’s adjusted basis in a part- nership interest . For purposes of paragraphs (d)(3) and (6) of this section, a partner’s adjusted basis in a partnership interest shall be the partner’s basis in such interest (determined under section 705) reduced by the partner’s share of the liabilities of the partnership determined under section 752 and increased by a proportionate share of each liability of the partnership equal to the partner’s proportionate share of the expense, for income tax purposes, attributable to such liability for the taxable year. A partner’s adjusted basis in a partnership interest cannot be less than zero.

(vii) E&P basis of a partnership interest . See paragraph (d)(6)(iii) of this section for special rules governing the calculation of a foreign corporation’s E&P basis in a partnership interest.

(viii) The application of this paragraph (d)(3) is illustrated by the following examples:

Example 1 . General rule —(i) Facts . Foreign corporation, FC, is a partner in partnership ABC, which is engaged in a trade or business within the United States. FC and ABC are both calendar year taxpayers. ABC owns and manages two office buildings located in the United States, each with an adjusted basis of $50. ABC also owns a non-U.S. asset with an adjusted basis of $100. ABC has no liabilities. Under the partnership agreement, FC has a 50 percent interest in the capital of ABC and a 50 percent interest in all items of income, gain, loss, and deduction that may be generated by the partnership’s assets. FC’s adjusted basis in ABC is $100. In determining the proportion of its interest in ABC that is a U.S. asset, FC elects to use the asset method described in paragraph (d)(3)(ii) of this section.

(ii) Analysis . FC’s interest in ABC is treated as a U.S. asset in the same proportion that the

sum of FC’s proportionate share of the adjusted bases of all ABC’s U.S. assets (50% of $100), bears to the sum of FC’s proportionate share of the adjusted bases of all of ABC’s assets (50% of $200). Under the asset method, the amount of FC’s interest in ABC that is a U.S. asset is $50 ($100 - $50/$100).

Example 2 . Special allocation of gain with respect to real property —(i) Facts . The facts are the same as in Example 1, except that under the partnership agreement, FC is allocated 20 percent of the income from the partnership property but 80 percent of the gain on disposition of the partnership property.

(ii) Analysis . Assuming that the buildings ordinarily generate directly identifiable income, there is a rebuttable presumption under paragraph (d)(3)(ii)(B)( 1 ) of this section that FC’s proportionate share of the adjusted basis of the buildings is FC’s proportionate share of the income generated by the buildings (20%) rather than the total gain that it would be entitled to under the partnership agreement (80%) if the buildings were sold at a gain on the determination date. Thus, the sum of FC’s proportionate share of the adjusted bases in ABC’s U.S. assets (the buildings) is presumed to be $20 [(20% of $50) + (20% of $50)]. Assuming that the nonU.S. asset is not income-producing and does not generate current deductions, there is a rebuttable presumption under paragraph (d)(3)(ii)(B)( 3 ) of this section that FC’s proportionate share of the adjusted basis of that asset is FC’s interest in the gain on the disposition of the asset (80%) rather than its proportionate share of the income that may be generated by the asset (20%). Thus, FC’s proportionate share of the adjusted basis of ABC’s non-U.S. asset is presumed to be $80 (80% of $100). FC’s proportionate share of the adjusted bases of all of the assets of ABC is $100 ($20 + $80). The amount of FC’s interest in ABC that is a U.S. asset is $20 ($100 $20/$100).

Example 3 . Tiered partnerships (asset method) —(i) Facts . The facts are the same as in Example 1, except that FC’s adjusted basis in ABC is $175 and ABC also has a 50 percent interest in the capital of partnership DEF. DEF owns and operates a commercial shopping center in the United States with an adjusted basis of $200 and also owns non-U.S. assets with an adjusted basis of $100. DEF has no liabilities. ABC’s adjusted basis in its interest in DEF is $150 and ABC has a 50 percent interest in all the items of income, gain, loss and deduction that may be generated by the assets of DEF.

(ii) Analysis . Because FC has elected to use the asset method described in paragraph (d)(3)(ii) of this section, it must determine what proportion of ABC’s partnership interest in DEF is a U.S. asset. As permitted by paragraph (d)(3)(iv)(B) of this section, FC also elects to use the asset method with respect to ABC’s interest in DEF. ABC’s interest in DEF is treated as a U.S. asset in the same proportion that the sum of ABC’s proportionate share of the adjusted bases of all DEF’s U.S. assets (50% of $200), bears to the sum of ABC’s proportionate share of the adjusted bases of all of DEF’s assets (50% of $300). Thus, the amount of ABC’s interest in DEF that is a U.S. asset is $100 ($150 $100/$150). FC must then apply the rules of paragraph (d)(3)(ii) of this section to all the assets of ABC, including ABC’s interest in DEF that is treated in part as a U.S. asset ($100) and in part as a non-U.S. asset ($50). FC’s interest in ABC is treated as a U.S. asset in the same

able year. This form shall include such information as is required by the form and accompanying instructions. The waiver must be signed by the person authorized to sign the income tax returns for the foreign corporation (including an agent authorized to do so under a general or specific power of attorney). The waiver must be filed on or before the date (including extensions) prescribed for filing the foreign corporation’s income tax return for the year of complete termination. With respect to a complete termination occurring in a taxable year ending prior to June 6, 1996, a foreign corporation may also satisfy the requirements of this paragraph (a)(2)(ii) by applying § 1.884–2T(a)(2)(ii) of the temporary regulations (as contained in the CFR edition revised as of April 1, 1995). A properly executed Form 8848, substitute form, or other form of waiver authorized by this paragraph (a)(2)(ii) shall be deemed to be consented to and signed by a Service Center Director or the Assistant Commissioner (International) for purposes of § 301.6501(c)– 1(d) of this chapter. (a)(3) through (a)(4) [Reserved] For further information, see § 1.884– 2T(a)(3) through (a)(4). (a)(5) Special rule if a foreign corporation terminates an interest in a trust . A foreign corporation whose beneficial interest in a trust terminates (by disposition or otherwise) in any taxable year shall be subject to the branch profits tax on ECEP attributable to amounts (including distributions of accumulated income or gain) treated as ECI to such beneficiary in such taxable year notwithstanding any other provision of § 1.884–2T(a).

(b) through (c)(2)(ii) [Reserved] For further information, see § 1.884–2T(b) through (c)(2)(ii).

(c)(2)(iii) Waiver of period of limita- tions and transferee agreement . In the case of a transferee that is a domestic corporation, the provisions of § 1.884– 2T(c)(2)(i) shall not apply unless, as part of the section 381(a) transaction, the transferee executes a Form 2045 (Transferee Agreement) and a waiver of period of limitations as described in this paragraph (c)(2)(iii), and files both documents with its timely filed (including extensions) income tax return for the taxable year in which the section 381(a) transaction occurs. The waiver shall be executed on Form 8848, or substitute form, and shall extend the

proportion that the sum of FC’s proportionate share of the adjusted bases of the U.S. assets of ABC (including ABC’s interest in DEF), bears to the sum of FC’s proportionate share of the adjusted bases of all ABC’s assets (including ABC’s interest in DEF). Thus, the amount of FC’s interest in ABC that is a U.S. asset is $100 (FC’s adjusted basis in ABC ($175) multiplied by FC’s proportionate share of the sum of the adjusted bases of ABC’s U.S. assets ($100)) over FC’s proportionate share of the sum of the adjusted bases of ABC’s assets ($175)).

Example 4 . Tiered partnerships (income method) —(i) Facts . The facts are the same as in Example 3, except that FC has elected to use the income method described in paragraph (d)(3)(iii) of this section to determine the proportion of its interest in ABC that is a U.S. asset. The two office buildings located in the United States generate $60 of income that is ECI for the taxable year. The non-U.S. asset is not-income producing. In addition ABC’s distributive share of income from DEF consists of $40 of income that is ECI and $140 of income that is not ECI.

(ii) Analysis . Because FC has elected to use the income method it does need to determine what proportion of ABC’s partnership interest in DEF is a U.S. asset. FC’s interest in ABC is treated as a U.S. asset in the same proportion that its distributive share of ABC’s income for the taxable year that is ECI ($50) ($30 earned directly by ABC + $20 distributive share from DEF) bears to its distributive share of all ABC’s income for the taxable year ($55) ($30 earned directly by ABC + $25 distributive share from DEF). Thus, FC’s interest in ABC that is a U.S. asset is $159 ($175 - $50/$55).

(4) Interest in a trust or estate —(i) Estates and non-grantor trusts . A foreign corporation that is a beneficiary of a trust or estate shall not be treated as having a U.S. asset by virtue of its interest in the trust or estate.

(ii) Grantor trusts . If, under sections 671 through 678, a foreign corporation is treated as owning a portion of a trust that includes all the income and gain that may be generated by a trust asset (or pro rata portion of a trust asset), the foreign corporation will be treated as owning the trust asset (or pro rata portion thereof) for purposes of determining its U.S. assets under this section.

(5) * * * (iii) Interbranch transactions . A transaction of any type between separate offices or branches of the same taxpayer does not create a U.S. asset.

(6) * * * (v) Computation of E&P basis of financial instruments . [Reserved]

- - - - -

(e) * * * (2) Additional liabilities —(i) * * * (ii) Liabilities described in § 1.882– 5(a)(1)(ii) . The amount of liabilities

determined under this paragraph (e)(2)(ii) is the amount (as of the determination date) of liabilities described in § 1.882–5(a)(1)(ii) (relating to liabilities giving rise to interest expense that is directly allocated to income from a U.S. asset).

(3) * * * (ii) Limitation . For any taxable year, a foreign corporation may elect to reduce the amount of its liabilities determined under paragraph (e)(1) of this section by an amount that does not exceed the excess, if any, of the amount of liabilities in paragraph (e)(1) of this section over the amount, as of the determination date, of U.S. booked liabilities (determined under § 1.882– 5(d)(2)) and liabilities described in paragraph (e)(2) of this section.

- - - - -

(5) * * * Example 1 . * * * For purposes of computing its U.S.- connected liabilities under § 1.882–5(c), A must determine the average total value of its assets that are U.S. assets. * * *

Example 2 . * * * A has $800 of liabilities under paragraph (e)(1) of this section and $300 of liabilities properly reflected on the books of its U.S. trade or business under § 1.882–5(d)(2).

(i) * * * (4) Special rules for certain U.S. assets and liabilities . Paragraphs (c)(2)(i) and (ii), (d)(3), (d)(4), (d)(5)(iii), (d)(6)(iii), (d)(6)(vi), (e)(2), and (e)(3)(ii), of this section are effective for taxable years beginning on or after June 6, 1996.

Par. 6. § 1.884–2 is added to read as follows:

§ 1.884–2 Special rules for termination or incorporation of a U.S. trade or business or liquidation or reorganiza- tion of a foreign corporation or its domestic subsidiary .

(a) through (a)(2)(i) [Reserved] For further information, see § 1.884–2T(a) through (a)(2)(ii).

(a)(2)(ii) Waiver of period of limita- tions . The waiver referred to in § 1.884–2T(a)(2)(i)(D) shall be executed on Form 8848, or substitute form, and shall extend the period for assessment of the branch profits tax for the year of complete termination to a date not earlier than the close of the sixth taxable year following that tax

period for assessment of any additional branch profits tax for the taxable year in which the section 381(a) transaction occurs to a date not earlier than the close of the sixth taxable year following the taxable year in which such transaction occurs. This form shall include such information as is required by the form and accompanying instructions. The waiver must be signed by the person authorized to sign Form 2045. With respect to a complete termination occurring in a taxable year ending prior to June 6, 1996, a foreign corporation may also satisfy the requirements of this paragraph (c)(2)(iii) by applying § 1.884–2T(c)(2)(iii) of the temporary regulations (as contained in the CFR edition revised as of April 1, 1995). A properly executed Form 8848, substitute form, or other form of waiver authorized by this paragraph (c)(2)(iii) shall be deemed to be consented to and signed by a Service Center Director or the Assistant Commissioner (International) for purposes of § 301.6501(c)– 1(d) of this chapter. (c)(3) through (f) [Reserved] For further information, see § 1.884– 2T(c)(3) through (f). (g) Effective dates . Paragraphs (a)(2)(ii) and (c)(2)(iii) of this section are effective for taxable years begin

ning after December 31, 1986. Paragraph (a)(5) of this section is effective for taxable years beginning on or after June 6, 1996.

Par. 7. Section 1.884–2T is amended as follows:

Paragraph (a)(2)(ii) is revised.
Paragraph (a)(5) is redesignated as (a)(6).
New paragraph (a)(5) is added.
Paragraph (c)(2)(iii) is revised. The additions and revisions read as follows:

§ 1.884–2T Special rules for termina- tion or incorporation of a U.S. trade or business or liquidation or reorganiza- tion of a foreign corporation or its domestic subsidiary (Temporary) .

(a) * * * (2) - * * (ii) Waiver of period of limitations .

[Reserved] See § 1.884–2(a)(2)(ii) for rules relating to this paragraph.

- - - - -

(5) Special rule if a foreign corpora- tion terminates an interest in a trust .

[Reserved] See § 1.884–2(a)(5) for

rules relating to this paragraph.

- - - - -

(c) * * * (2) * * * (iii) Waiver of period of limitations and transferee agreement . [Reserved] See § 1.884–2(c)(2)(iii) for rules relating to this paragraph.

Par. 8. Section 1.884–4 is amended as follows:

In paragraph (a)(1), the fifth sentence is revised.
Paragraph (a)(2)(iii) is revised.
Paragraph (b)(1) is revised and paragraph (b)(2) is removed and reserved.
Paragraph (b)(3) is amended by: a. Removing the reference ‘‘(b)(1)(v)’’ and adding the language ‘‘(b)(1)(ii)’’ in the following:

i. Paragraph (b)(3)(i), first sentence. ii. Paragraph (b)(3)(ii), introductory text.

iii. Paragraph (b)(3)(iii), heading and introductory text.

b. Adding a sentence at the end of paragraph (b)(3)(i).

Paragraph (b)(4) is removed and reserved.
In the list below, for each paragraph indicated in the left column, remove the language in the middle column and add the language in the right column:

Paragraph Remove Add

(a)(2)(i)(A) apportioned allocated or apportioned

(a)(4) Example 1 first sentence (b)(2) (a)(2)(iii)

(a)(4) Example 1 first and seventh sentence apportioned allocated or apportioned

(a)(4) Example 1 first, second, and eighth sentence 1993 1997

(a)(4) Example 2 first sentence (b)(2) (a)(2)(iii)

(a)(4) Example 2 second and third sentence 1993 1997

(b)(5)(i) last sentence apportioned allocated or apportioned

(b)(5)(ii) Example first, fifth, and last sentence apportioned allocated or apportioned

(b)(6) paragraph heading apportioned allocated or apportioned

(b)(6)(i) first and last sentence apportioned allocated or apportioned

(b)(6)(i) second sentence (b)(1)(v) (b)(1)(ii)

(b)(6)(ii) first and second sentence (b)(1)(v) (b)(1)(ii)

(b)(6)(ii) first and second sentence paragraphs (b)(1)(i) through (b)(i)(iv)

paragraph (b)(1)(i)

Paragraph Remove Add

(b)(6)(iv) Example 1 introductory text, paragraphs (i), (iii), and (iv), flush language first, fourth, and seventh sentence

1993 1997

(b)(6)(iv) Example 1 paragraph (ii) 1992 1996

(b)(6)(iv) Example 1 flush language second, and sixth sentence

(b)(1)(v) (b)(1)(ii)

(c)(1)(iv) Example 1 first sentence apportioned allocated or apportioned

(c)(1)(iv) Example 1 first, second, third, fifth, sixth, and seventh sentence

(c)(1)(iv) Example 1 third, fourth, and seventh sentence

1993 1997

1994 1998

(c)(1)(iv) Example 2 second sentence apportioned allocated or apportioned

(c)(1)(iv) Example 2 first, second, third, and last sentence

(c)(1)(iv) Example 2 second and last sentence

1993 1997

1994 1998

(c)(2)(i) first sentence apportioned allocated or apportioned

(c)(4) Example third, fourth, fifth, sixth, and eighth sentence

1993 1997

(c)(4) Example fifth sentence allocated allocated or apportioned

Paragraph (e) is amended as follows:

a. The text of paragraph (e) is redesignated as paragraph (e)(1) and a paragraph heading for (e)(1) is added.

b. The first sentence of newly designated paragraph (e)(1) is revised.

Paragraph (e)(2) is added. The revisions and additions read as follows:

§ 1.884–4 Branch-level interest tax .

(a) * * * (1) * * * For purposes of this section, a foreign corporation also shall be treated as engaged in trade or business in the United States if, at any time during the taxable year, it owns an asset taken into account under § 1.882– 5(a)(1)(ii) or (b)(1) for purposes of determining the amount of the foreign corporation’s interest expense allocated or apportioned to ECI. * * *

(2) * * * (iii) Treatment of a portion of the excess interest of banks as interest on deposits . A portion of the excess interest of a foreign corporation that is a bank (as defined in section 585(a)(2)(B) without regard to the second sentence thereof) provided that a substantial part of its business in the United States, as well as all other countries in which it operates, consists of receiving deposits and making loans and discounts, shall be treated as interest on deposits (as described in

section 871(i)(3)), and shall be exempt from the tax imposed by section 881(a) as provided in such section. The portion of the excess interest of the foreign corporation that is treated as interest on deposits shall equal the product of the foreign corporation’s excess interest and the greater of—

(A) The ratio of the amount of interest bearing deposits, within the meaning of section 871(i)(3)(A), of the foreign corporation as of the close of the taxable year to the amount of all interest bearing liabilities of the foreign corporation on such date; or

(B) 85 percent.

- - - - -

(b) Branch interest —(1) Definition of branch interest . For purposes of this section, the term ‘‘branch interest’’ means interest that is —

(i) Paid by a foreign corporation with respect to a liability that is—

(A) A U.S. booked liability within the meaning of § 1.882–5(d)(2) (other than a U.S. booked liability of a partner within the meaning of § 1.882– 5(d)(2)(vii)); or (B) Described in § 1.884–1(e)(2) (relating to insurance liabilities on U.S. business and liabilities giving rise to interest expense that is directly allocated to income from a U.S. asset); or

(ii) In the case of a foreign corporation other than a corporation described

in paragraph (a)(2)(iii) of this section, a liability specifically identified (as provided in paragraph (b)(3)(i) of this section) as a liability of a U.S. trade or business of the foreign corporation on or before the earlier of the date on which the first payment of interest is made with respect to the liability or the due date (including extensions) of the foreign corporation’s income tax return for the taxable year, provided that—

(A) The amount of such interest does not exceed 85 percent of the amount of interest of the foreign corporation that would be excess interest before taking into account interest treated as branch interest by reason of this paragraph (b)(1)(ii);

(B) The requirements of paragraph (b)(3)(ii) of this section (relating to notification of recipient of interest) are satisfied; and

(C) The liability is not described in paragraph (b)(3)(iii) of this section (relating to liabilities incurred in the ordinary course of a foreign business or secured by foreign assets) or paragraph (b)(1)(i) of this section.

(2) [Reserved] (3)(i) * * * A foreign corporation that is subject to this section may identify a liability under paragraph (b)(1)(ii) of this section whether or not it is actually engaged in the conduct of a trade or business in the United States.

- - - - - - (4) [Reserved]
- - - - (e) Effective dates —(1) General rule .

Except as provided in paragraph (e)(2) of this section, this section is effective for taxable years beginning October 13, 1992, and for payments of interest described in section 884(f)(1)(A) made (or treated as made under paragraph (b)(7) of this section) during taxable years of the payor beginning after such date. * * *

(2) Special rule . Paragraphs (a)(1), (a)(2)(i)(A), (a)(2)(iii), (b)(1), (b)(3), (b)(5)(i), (b)(6)(i), (b)(6)(ii), and (c)(2)(i) of this section are effective for taxable years beginning on or after June 6, 1996.

Par. 9. In section 1.884–5, paragraphs (e)(4)(ii) and (g) are revised to read as follows:

§ 1.884–5 Qualified resident

- - - - -

(e) * * * (4) * * * (ii) Presumption for banks . A U.S. trade or business of a foreign corporation that is described in § 1.884– 4(a)(2)(iii) shall be presumed to be an integral part of an active banking business conducted by the foreign country in its country of residence provided that a substantial part of the business of the foreign corporation in both its country of residence and the United States consists of receiving deposits and making loans and discounts. This paragraph shall be effective for taxable years beginning on or after June 6, 1996.

- - - - - (g) * * * Except as provided in

paragraph (e)(4)(ii) of this section, this section is effective for taxable years beginning on or after October 13, 1992.

- - - - - - Par. 10. Section 1.897–1 is amended
  as follows:

In paragraph (f)(1)(iii) the language ‘‘stock,’’ is removed.
Paragraph (f)(2)(i) is revised to read as follows:

§ 1.897–1 Taxation of foreign invest- ments in United States real property interests, definition of terms .

- - - - -

(f) * * * (2) * * * (i) Held for the principal purpose of promoting the present conduct of the trade or business,

- - - - -

PART 602—OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT

Par. 11. The authority for part 602 continues to read as follows:

Authority: 26 U.S.C. 7805. Par. 12. In § 602.101, the table in paragraph (c) is amended by adding in numerical order ‘‘§ 1.884–2 ... 1545– 1070’’.

Margaret Milner Richardson, Commissioner of Internal Revenue.

Approved February 28, 1996.

Leslie Samuels, Assistant Secretary of the Treasury.

(Filed by the Office of the Federal Register on

March 5, 1996, 8:45 a.m., and published in the issue of the Federal Register for March 8, 1996, 61 F.R. 9336)

Section 882.—Tax on Income of Foreign Corporations Connected With United States Business

26 CFR 1.882–5: Determination of interest deduction.

T.D. 8658

DEPARTMENT OF THE TREASURY Internal Revenue Service 26 CFR Part 1

Determination of Interest Expense De- duction of Foreign Corporations

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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

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 .

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 § 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

§ 1.882–5 calculations in cases where, under the authority of § 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 § 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 § 1.881–3 from serving its function as an anti-abuse rule.

§ 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 § 1.884–1(d) generally governs its classification as a U.S. asset for purposes of § 1.882–5. Under the rules of § 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 § 1.882–5 regulations were issued in 1992, the regulations under § 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 § 1.882–5 regulations now closely conform to the § 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 § 1.882–5 applies to partnership interests held by foreign corporations. With the elimination of § 1.861–9T(e)(7)(i) by these regulations, § 1.884–1(d)(3) and § 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

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.

§ 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 § 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 threestep methodology described in the final regulations. In response to commenters’ questions, however, § 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 § 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 § 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 § 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 § 1.882–5 with any other section that disallows, defers, or capitalizes interest expense, and include examples that illustrate how § 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 § 1.882–5. The final regulations provide uniform rules for changing any election prescribed under § 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

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 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 § 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.

under § 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 § 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 § 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 § 1.864–4(c)(2). In addition, the final regulations specify that a taxpayer may achieve the same result under § 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 § 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 debtfinanced under the principles of section 246A. This stock cut-back rule is eliminated from the final § 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 § 1.864–4(c). This is because the final regulations under § 1.864–4, which are being issued contemporaneously with these regulations elsewhere in this issue of the Bulletin, generally eliminate any inference that stock can produce effectively connected income under the asset-use test of § 1.864–4(c)(2).

The final regulations add an antiabuse rule similar to the rule in § 1.884–1(d)(5)(ii) to prevent taxpayers from artificially increasing the amount of their U.S. assets.

§ 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

§ 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 ( ex- cess 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 § 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 § 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.

§ 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 § 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 § 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 § 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.

Drafting Information

Several persons from the Office of Chief Counsel and the Treasury Department participated in drafting these regulations.

- - - - -

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). *

§ 1.861–9T [Amended]

Par. 2. Section 1.861–9T, paragraph (e)(7) is amended as follows:

Paragraph (e)(7)(i) is removed.
The heading in paragraph (e)(7)(ii) is removed.
Paragraph (e)(7)(ii) is redesignated as the text of paragraph (e)(7).

Par. 3. Sections 1.882–0 is added to read as follows:

§ 1.882–0 Table of contents .

This section lists captions contained in §§ 1.882–1, 1.882–2, 1.882–3, 1.882–4 and 1.882–5.

§ 1.882–1 Taxation of foreign corpora- tions engaged in U.S. business or of foreign corporations treated as having effectively connected income .

(1) Overview.

(1) Inclusions. (2) Exchange transactions. (3) Exclusions. (b) Foreign corporations not

(2) Determination of the value

engaged in U.S. business. (c) Foreign corporations engaged

of a U.S. asset. (i) General rule. (ii) Fair-market value election. (A) In general. (B) Adjustment to

in U.S. business. (d) Effective date.

§ 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

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

Service. (b) Allowed deductions and credits.

of U.S. assets. (c) Step 2: Determination of total

(1) In general. (2) Verification.

§ 1.882–5 Determination of interest deduction .

amount of U.S.-connected liabilities for the taxable year. (1) General rule. (2) Computation of the actual

(a) Rules of general application.

(a) Segregation of income. (b) Imposition of tax.

(1) Income not effectively con nected with the conduct of a trade or business in the United States. (2) Income effectively con

treaties. (3) Limitation on interest

expense. (4) Translation convention for

(i) In general. (ii) Direct allocations. (A) In general. (B) Partnership

interest. (2) Coordination with tax

nected 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

(i) In general. (ii) Failure to make the proper election. (8) Examples. (b) Step 1: Determination of total

governments. (7) Elections under § 1.882–5.

foreign currency. (5) Coordination with other

sections. (6) Special rule for foreign

transactions. (ix) Amounts must be expressed in a single currency. (3) Adjustments. (4) Elective fixed ratio method

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

status. (d) Credits against tax. (e) Payment of estimated tax. (f) Effective date.

§ 1.882–2 Income of foreign corpora- tion treated as effectively connected with U.S. business .

value of U.S. assets for the taxable year. (1) Classification of an asset

of determining U.S. liabilities. (5) Examples. (d) Step 3: Determination of

(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) Election as to real property

income. (b) Interest on U.S. obligations re

amount of interest expense allocable to ECI under the adjusted U.S. booked liabilities method. (1) General rule. (2) U.S. booked liabilities.

ceived by banks organized in possessions. (c) Treatment of income. (d) Effective date.

§ 1.882–3 Gross income of a foreign corporation .

(a) In general.

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.

graph (a)(1)(ii)(A) shall reduce the basis of the asset that meets the requirements of § 1.861–10T(b) and (c) by the principal amount of the indebtedness that meets the requirements of § 1.861–10T(b) and (c). The foreign corporation shall also disregard any indebtedness that meets the requirements of § 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 paragraphs (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 § 1.861–10T(b) and (c), as limited by § 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 § 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 § 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 § 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 § 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.

(A) In general. (B) Identified lia

bilities 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

(f) Effective date. (1) General rule. (2) Special rules for financial

products.

Par. 4. Section 1.882–5 is revised to read as follows:

§ 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) 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 gen- eral . A foreign corporation that has a U.S. asset and indebtedness that meet the requirements of § 1.861–10T(b) and (c), as limited by § 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 § 1.861–10T. For purposes of paragraphs (b)(1) or (c)(2) of this section, a foreign corporation that allocates its interest expense under the direct allocation rule of this para

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.

(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 § 1.989(b)–1 for the taxable year).

(4) Translation convention for for- eign 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 § 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 § 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 govern- ments . The amount of interest expense of a foreign government, as defined in § 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 § 1.892–5T.

(7) Elections under § 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 § 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 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� to P in exchange for its partnership interest. P incurs qualified nonrecourse indebtedness within the meaning of § 1.861–10T to purchase an airplane. FC ’s share of the liability of P, as determined under section 752, is 800�. (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� liability as determined under section 752, but is not increased by the 800x 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 800x 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 § 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 § 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 § 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:

^Tax-exempt ^U.S. ^assets $12 - ^$50 = $4 $150 Total U.S. assets

(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 § 1.882–5, is $500.

methodology prescribed in § 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 § 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.

(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 § 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 § 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:

^U.S. ^assets $500 - ^{$100 Treaty-exempt} = $50 $1000 Total U.S. assets

(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 § 1.884– 1(d). For purposes of this section, the term determination date, as used in § 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 defini- tion 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 § 1.864–4(c)(2) or (3) if held directly by the foreign corporation and either was initially acquired through foreclosure or similar proceed

ings 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 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 § 1.861–9T(g)(1)(iii), and provided the taxpayer uses the

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 world- wide 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 inter- ests 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 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 § 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 corpo

ration 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 lia- bilities 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 prop- erly 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 § 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 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 com- panies . [Reserved]

(v) Liabilities used to increase ar- tificially 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).

( v i ) H e d g i n g t r a n s a c t i o n s .

[Reserved]

(vii) Amount of U.S. booked lia- bilities 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 Expense

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 - 40%).

(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 - 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 - 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 - 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 U 500. 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 + ( U 500 - 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 § 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 ( U 5,000).

(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 95%), and U 4750 ( U 5000 - 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 - 6%), the sum of the expense associated with its U.S. dollar liabilities, plus U 570 ( U 4750 - 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]

(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 prod- ucts . [Reserved]

Margaret Milner Richardson, Commissioner of Internal Revenue.

Approved February 28, 1996.

Leslie Samuels, Assistant Secretary of the Treasury.

(Filed by the Office of the Federal Register on

March 5, 1996, 8:45 a.m., and published in the issue of the Federal Register for March 8, 1996, 61 F.R. 9326)

Section 1274.—Determination of Issue Price in the Case of Certain Debt Instruments Issued for Property

(Also Sections 42, 280G, 382, 412, 467, 468, 482, 483, 807, 846, 1288, 7520, 7872.)

Federal rates; adjusted federal rates; adjusted federal long-term rate, and the long-term exempt rate. For purposes of sections 1274, 1288, 382, and other sections of the Code, tables set forth the rates for April 1996.

Rev. Rul. 96–19

This revenue ruling provides various prescribed rates for federal income tax purposes for April 1996 (the current month.) Table 1 contains the shortterm, mid-term, and long-term applicable federal rates (AFR) for the current month for purposes of section 1274(d) of the Internal Revenue Code. Table 2 contains the short-term, mid-term, and long-term adjusted applicable federal rates (adjusted AFR) for the current month for purposes of section 1288(b).

Table 3 sets forth the adjusted federal long-term rate and the long-term taxexempt rate described in section 382(f). Table 4 contains the appropriate percentages for determining the low

income housing credit described in section 42(b)(2) for buildings placed in service during the current month. Finally, Table 5 contains the federal rate for determining the present value of an annuity, an interest for life or for a term of years, or a remainder or a reversionary interest for purposes of section 7520.

Applicable Federal Rates (AFR) for April 1996

Period for Compounding

Annual Semiannual Quarterly Monthly Short-Term

AFR 5.33% 5.26% 5.23% 5.20% 110% AFR 5.87% 5.79% 5.75% 5.72% 120% AFR 6.41% 6.31% 6.26% 6.23% 130% AFR 6.96% 6.84% 6.78% 6.74% Mid-Term

AFR 5.88% 5.80% 5.76% 5.73% 110% AFR 6.48% 6.38% 6.33% 6.30% 120% AFR 7.08% 6.96% 6.90% 6.86% 130% AFR 7.68% 7.54% 7.47% 7.42% 150% AFR 8.89% 8.70% 8.61% 8.55% 175% AFR 10.41% 10.15% 10.02% 9.94% Long-Term

AFR 6.51% 6.41% 6.36% 6.33% 110% AFR 7.17% 7.05% 6.99% 6.95% 120% AFR 7.84% 7.69% 7.62% 7.57% 130% AFR 8.50% 8.33% 8.25% 8.19%

REV. RUL. 96–19 TABLE 2

Adjusted AFR for April 1996

Period for Compounding

Annual Semiannual Quarterly Monthly Short-Term 3.40% 3.37% 3.36% 3.35% adjusted AFR

Mid-term adjusted AFR

Long-term adjusted AFR

4.37% 4.32% 4.30% 4.28%

5.31% 5.24% 5.21% 5.18%

REV. RUL. 96–19 TABLE 3

Rates Under Section 382 for April 1996

Adjusted federal long-term rate for the current month 5.31%

Long-term tax-exempt rate for ownership changes during the current month (the highest of the adjusted federal long-term rates for the current month and the prior two months.) 5.31%

REV. RUL. 96–19 TABLE 4

Appropriate Percentages Under Section 42(b)(2)

for April 1996

Appropriate percentage for the 70% present value low-income housing credit 8.45%

Appropriate percentage for the 30% present value low-income housing credit 3.62%

REV. RUL. 96-19 TABLE 5

Rate Under Section 7520 for April 1996

Applicable federal rate for determining the present value of an annuity, an interest for life or a term of years, or a remainder or reversionary interest 7.0%

Section 1288.—Treatment of Original Issue Discount on Tax-Exempt Obligations

The adjusted applicable federal short-term, mid-term, and long-term rates are set forth for the month of April 1996. See Rev. Rul. 96–19, page 24.

Section 7520.—Valuation Tables

The adjusted applicable federal short-term, mid-term, and long-term rates are set forth for the month of April 1996. See Rev. Rul. 96–19, page 24.

Section 7872.—Treatment of Loans with Below-Market Interest Rates

The adjusted applicable federal short-term, mid-term, and long-term rates are set forth for the month of April 1996. See Rev. Rul. 96–19, page 24.