SECTION 2. LEGAL BACKGROUND

Section 1.882–5 generally requires a foreign corporation to determine the amount of interest expense that is allocable under section 882(c) to income effectively connected (or treated as effectively connected) with the conduct of the foreign corporation’s trade or business in the United States by a three step calculation.

Step 1 determines the total value of the U.S. assets of the foreign corporation, generally the assets that produce (or would produce) income effectively connected with the conduct of the U.S. trade or business of the foreign corporation. The value of the U.S. assets is their adjusted basis, unless the taxpayer makes an election to value the assets on the basis of their fair market value.

Step 2 determines the U.S.-connected liabilities of the foreign corporation as the product of the U.S. assets multiplied either by the actual ratio of worldwide liabilities to worldwide assets or, if the taxpayer makes an election, by a fixed ratio, currently 93-percent. If the taxpayer has elected to value U.S. assets on the basis of fair market value for purposes of Step 1, then the taxpayer must value worldwide assets on a fair market value basis for purposes of Step 2.

Step 3 determines the allocable amount of interest expense under the adjusted U.S. booked liabilities (“AUSBL”) method, or, if the taxpayer makes an election, under the separate currency pools method. Under the AUSBL method, the foreign corporation’s interest expense is based on the interest expense on the foreign corporation’s U.S. books. If the U.S. booked liabilities exceed the U.S.-connected liabilities, then the foreign bank’s U.S. booked interest expense is scaled down. If the U.S.-connected liabilities exceed the U.S.-booked liabilities, interest expense in addition to the U.S. booked interest expense is allo

cated by reference to the foreign U.S. dollar borrowing rate multiplied by the excess U.S.-connected liabilities. Under the separate currency pools method, the worldwide interest expense is allocated to effectively connected income based on the U.S.-connected liabilities in each currency multiplied by the foreign bank’s worldwide rate for liabilities in such currency.

Rules on the time and manner of making and changing the various elections are provided in sections 1.882–5(a)(7) and 1.882–5(b)(2).