SECTION 3. COORDINATION OF THE

DETERMINATION OF THE INTEREST EXPENSE DEDUCTION FOR FOREIGN BANKS AND TREATIES

Section 1.882–5(a)(2) currently states that “[t]he 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.” This statement is no longer accurate in light of the income tax treaties entered into with the United Kingdom and Japan, ¹ and, therefore, will be eliminated by the amendments to the regulations.

The Exchange of Notes to the current United States-United Kingdom and United States-Japan income tax treaties adopt the principles of Article 9(1) for determining the profits attributable to a permanent establishment. ² Both Notes address the allocation of the capital of financial institutions to their permanent establishments, stating in pertinent part that the Contracting States may treat the permanent establishment

as having the same amount of capital that it would need to support its activities if it were a distinct and separate enterprise engaged in the same or similar activities. With respect to financial institutions other than insurance companies, a Contracting State may determine the amount of capital to be attributed to a permanent establishment by allocating the institution’s total equity between its various offices on the basis of the proportion of the financial institu

1 See United States-United Kingdom Income Tax Treaty, Article 7 (July 24, 2001); United States-Japan Income Tax Treaty, Article 7 (November 6, 2003) and accompanying Exchange of Notes.

2 Exchange of Notes, United States-Japan Income Tax Treaty, para. 2 (July 24, 2001) and United States-United Kingdom Income Tax Treaty (July 24, 2001).

2005–32 I.R.B. 263 August 8, 2005

U.S.-connected liabilities exceed the taxpayer’s U.S. booked liabilities (as defined for banks in section 1.882–5(d)(2)(iii)), the excess U.S.-connected liabilities are multiplied by the taxpayer’s average U.S. dollar borrowing rate with respect to interest expense and liabilities shown on the books of the taxpayer’s offices or branches outside the United States. This portion of the Step 3 allocation is referred to as the “excess interest.”

In prior regulations (“the 1980 regulations”), section 1.882–5 provided that where information necessary to compute the actual foreign U.S. dollar borrowing rate could not “be reasonably obtained,” then “any method that reasonably approximates the actual rate” could be substituted so long as it was consistently applied from year to year. ⁵ The 1980 regulations provided that the 30-day LIBOR rate may constitute an appropriate proxy for an actual foreign borrowing rate but did not specify that the use of the published LIBOR rate could be used outright if the actual foreign borrowing rate was capable of being proved. Where the total foreign U.S. dollar borrowings were de min- imis, the prior regulations substituted the actual average borrowing rate of the foreign corporation’s trade or business within the United States.

Where a foreign corporation elects both the fixed ratio under Step 2 and the AUSBL method under Step 3, it is possible for the taxpayer’s entire interest expense allocation to be determined by reference to the books and records of its trade or business within the United States. This may be true under the current regulations if the allocation for the taxpayer does not result in excess interest but, instead, is subject to the scale-down rule under section 1.882–5(d)(4). Otherwise, when these elections are made together, resort may still be necessary to information typically maintained outside the United States. In many cases, the information would be collected only for purposes of computing the taxpayer’s excess interest.

To facilitate administrability both for foreign bank taxpayers and the IRS, the amendments to the regulations will provide that such taxpayers who are already

tion’s risk-weighted assets attributable to each of them. ³

The Treasury Technical Explanations of the United Kingdom and Japan treaties acknowledge that the allocation method provided by section 1.882–5 does not take into account the relative riskiness of assets that are attributable to a permanent establishment and that equal weighting of risk, in some cases, “may require a taxpayer to allocate more capital to the United States (and therefore would reduce the taxpayer’s interest expense deduction) than is appropriate.” ⁴

Accordingly, the two treaties permit United Kingdom and Japanese resident financial institutions the use of an alternative approach to the determination of their taxable income, without the section 1.882–5 determination of interest expense, for purposes of establishing the upper limit with respect to the amount of tax that may be imposed on a U.S. permanent establishment of a foreign bank. Such an alternative approach under the treaties would incorporate risk-weighting of the foreign bank’s assets as well as other consequential deviations from the rules of section 1.882–5 in line with the arm’s length principles of Articles 7 and 9(1) of those treaties. As reflected in the Notes and Technical Explanations, the two treaties require an allocation of sufficient equity capital in determining the profits attributable to a permanent establishment. The amount of equity capital shown on a taxpayer’s book’s is not determinative. Therefore, it will be acceptable only to the extent such allotment is sufficient to support the assets and risks attributable to the permanent establishment.

The Treasury Department and IRS continue to believe that application of section 1.882–5 also results in a sufficient allocation of equity capital to a permanent establishment, and is simpler to apply than an alternative approach under the treaties. As stated in both Technical Explanations, taxpayers are not required to use the risk-weighted approach for allocating equity capital provided by the treaties. Rather, taxpayers may continue to use sec

3 Id .

tion 1.882–5 in lieu of an alternative approach under the treaties.