[Federal Register Volume 61, Number 47 (Friday, March 8, 1996)]
[Rules and Regulations]
[Pages 9336-9343]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 96-5261]



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DEPARTMENT OF THE TREASURY
26 CFR Parts 1 and 602

[TD 8657]
RIN 1545-AQ58


Regulations on Effectively Connected Income and the Branch 
Profits Tax

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final and temporary regulations.

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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 Sec. 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, 
Sec. 1.884-2(a)(2)(ii) and Sec. 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 Sec. 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 Sec. 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 Sec. 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 Sec. 1.882-5. For 
purposes of computing its interest expense under Sec. 1.882-5, the 
rules of Sec. 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 Sec. 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 
Sec. 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 Sec. 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 Sec. 1.884-1(d)(3) continue to provide a 
rule that allocates the basis in 

[[Page 9337]]
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 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 Sec. 1.884-1(d)(4) are finalized as proposed.
    C. Nonrecourse indebtedness and integrated financial transactions. 
Because the final regulations under Sec. 1.882-5 incorporate the 
special allocation rules of Sec. 1.861-10T, certain changes to the 
final regulations under Sec. 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 Sec. 1.882-5.
    In addition, a new provision has been added in Sec. 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 Sec. 1.882-5 calculation.
    D. Structural changes to conform branch interest rules to final 
regulations under Sec. 1.882-5. These regulations adopt the changes 
made by the 1992 proposed regulations under Sec. 1.884-4(b), and thus 
incorporate the rules in Sec. 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 Sec. 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, Sec. 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 Sec. 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 Sec. 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.

List of Subjects

26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

26 CFR Part 602

    Reporting and recordkeeping requirements.

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:
    1. The third sentence in paragraph (c)(2)(i) is revised.
    2. Paragraph (c)(2)(ii) is revised.
    3. Paragraphs (c)(2)(iii) and (c)(2)(iv) are redesignated as 
(c)(2)(iv) and (c)(2)(v) respectively.
    4. New paragraph (c)(2)(iii) is added.
    5. 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 Example (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.
    6. The last sentence of paragraph (c)(6)(i) is removed.
    7. Paragraph (c)(7) is added.
    The additions and revisions read as follows:


Sec. 1.864-4  U.S. source income effectively connected with U.S. 
business.

* * * * *
    (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 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 

[[Page 9338]]
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:
* * * * *
    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. * * *
* * * * *
    (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.
* * * * *
    Par. 3. In Sec. 1.871-12, paragraph (d) is amended by:
    1. Revising the paragraph heading and introductory text.
    2. Removing Example 1.
    3. Removing the designation ``(2)'' in Example (2).
    The revision reads as follows:


Sec. 1.871-12  Determination of tax on treaty income.

* * * * *
    (d) Illustration. The application of this section may be 
illustrated by the following example:
* * * * *
    Par. 4. Section 1.884-0(b) is amended by revising the entries for 
Secs. 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 Secs. 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:


Sec. 1.884-0  Overview of regulation provisions for section 884.

* * * * *
    (b) * * *

Sec. 1.884-1  Branch profits tax.

* * * * *
    (d) * * *
    (4) Interest in a trust or estate.
* * * * *
    (i) * * *
    (4) Special rule for certain U.S. assets and liabilities.

Sec. 1.884-2T  Special Rules for termination or incorporation of a 
U.S. trade or business or liquidation or reorganization 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.
* * * * *

Sec. 1.884-4  Branch-level interest tax.

* * * * *
    (b) * * *
    (1) Definition of branch interest.
    (2) [Reserved]
    (3) * * *
    (4) [Reserved]
* * * * *
    (e) * * *
    (1) General rule.
    (2) Special rule.
* * * * *
    Par. 5. Section 1.884-1 is amended as follows:
    1. 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.
    3. Paragraph (d)(3) is revised.
    4. The text of paragraph (d)(4) is added.
    5. Paragraph (d)(5)(iii) is revised.
    6. In Paragraph (d)(6)(iii) the reference to ``(d)(3)(iv)'' is 
removed and ``(d)(3)(vi)'' is added in its place.
    7. Paragraph (d)(6)(v) is redesignated as paragraph (d)(6)(vi).
    8. New paragraph (d)(6)(v) is added and reserved.
    9. 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..................  Sec.  1.882-5(b)..  Sec.  1.882-5(c). 
Fourth and fifth sentence.......  Sec.  1.882-5(b)(2  Sec.  1.882-5(c)(2
                                   ).                  )                
Seventh sentence................  Amount............  Value.            
Seventh sentence................  Sec.  1.882-5(b)(1  Sec.  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
------------------------------------------------------------------------

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


Sec. 1.884-1  Branch profits tax.

* * * * *
    (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) * * * 
    
[[Page 9339]]

    (2) * * *
    (xi) * * *

    Example 2. U.S. real property interest connected 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.
* * * * *
    (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 determined 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 section 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 Sec. 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 partnerships. 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 
partnership 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 

[[Page 9340]]
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  x  $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 non-U.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  x  
$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 x $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 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 x $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 Sec. 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 Sec. 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 Sec. 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 Sec. 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 Sec. 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), 

[[Page 9341]]
of this section are effective for taxable years beginning on or after 
June 6, 1996.
    Par. 6. Sec. 1.884-2 is added to read as follows:


Sec. 1.884-2  Special rules for termination or incorporation of a U.S. 
trade or business or liquidation or reorganization of a foreign 
corporation or its domestic subsidiary.

    (a) through (a)(2)(i) [Reserved] For further information, see 
Sec. 1.884-2T(a) through (a)(2)(ii).
    (a)(2)(ii) Waiver of period of limitations. The waiver referred to 
in Sec. 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 taxable 
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 Sec. 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 Sec. 301.6501(c)-1(d) of this chapter.
    (a)(3) through (a)(4) [Reserved] For further information, see 
Sec. 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 Sec. 1.884-2T(a).
    (b) through (c)(2)(ii) [Reserved] For further information, see 
Sec. 1.884-2T (b) through (c)(2)(ii).
    (c)(2)(iii) Waiver of period of limitations and transferee 
agreement. In the case of a transferee that is a domestic corporation, 
the provisions of Sec. 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 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 
Sec. 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 Sec. 301.6501(c)-1(d) of this chapter.
    (c)(3) through (f) [Reserved] For further information, see 
Sec. 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 beginning 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:
    1. Paragraph (a)(2)(ii) is revised.
    2. Paragraph (a)(5) is redesignated as (a)(6).
    3. New paragraph (a)(5) is added.
    4. Paragraph (c)(2)(iii) is revised.
    The additions and revisions read as follows:


Sec. 1.884-2T  Special rules for termination or incorporation of a U.S. 
trade or business or liquidation or reorganization of a foreign 
corporation or its domestic subsidiary (Temporary).

    (a) * * *
    (2) * * *
    (ii) Waiver of period of limitations. [Reserved] See Sec. 1.884-
2(a)(2)(ii) for rules relating to this paragraph.
* * * * *
    (5) Special rule if a foreign corporation terminates an interest in 
a trust. [Reserved] See Sec. 1.884-2(a)(5) for rules relating to this 
paragraph.
* * * * *
    (c) * * *
    (2) * * *
    (iii) Waiver of period of limitations and transferee agreement. 
[Reserved] See Sec. 1.884-2(c)(2)(iii) for rules relating to this 
paragraph.
    Par. 8. Section 1.884-4 is amended as follows:
    1. In paragraph (a)(1), the fifth sentence is revised.
    2. Paragraph (a)(2)(iii) is revised.
    3. Paragraph (b)(1) is removed and paragraph (b)(2) is revised and 
reserved.
    4. 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).
    5. Paragraph (b)(4) is removed and reserved.
    6. 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        (b)(2)..............  (a)(2)(iii).        
 sentence.                                                              
(a)(4) Example 1 first and    Apportioned.........  Allocated or        
 seventh sentence.                                   apportioned.       
(a)(4) Example 1  first,      1993................  1997.               
 second, and eighth sentence.                                           
(a)(4) Example 2 first        (b)(2)..............  (a)(2)(iii).        
 sentence.                                                              

[[Page 9342]]
                                                                        
(a)(4) Example 2 second and   1993................  1997.               
 third sentence.                                                        
(b)(5)(i) last sentence.....  Apportioned.........  Allocated or        
                                                     apportioned.       
(b)(5)(ii) Example first,     Apportioned.........  Allocated or        
 fifth, and last sentence.                           apportioned.       
(b)(6) paragraph heading....  Apportioned.........  Allocated or        
                                                     apportioned.       
(b)(6)(i) first and last      Apportioned.........  Allocated or        
 sentence.                                           apportioned.       
(b)(6)(i) second sentence...  (b)(1)(v)...........  (b)(1)(ii).         
(b)(6)(ii) first and second   (b)(1)(v)...........  (b)(1)(ii).         
 sentence.                                                              
(b)(6)(ii) first and second   Paragraphs (b)(1)(i)  Paragraph (b)(1)(i).
 sentence.                     through (b)(i)(iv).                      
(b)(6)(iv) Example 1          1993................  1997.               
 introductory text,                                                     
 paragraphs (i), (iii), and                                             
 (iv), flush language first,                                            
 fourth, and seventh                                                    
 sentence.                                                              
(b)(6)(iv) Example 1          1992................  1996.               
 paragraph (ii).                                                        
(b)(6)(iv) Example 1 flush    (b)(1)(v)...........  (b)(1)(ii).         
 language second, and sixth                                             
 sentence.                                                              
(c)(1)(iv) Example 1 first    Apportioned.........  Allocated or        
 sentence.                                           apportioned.       
(c)(1)(iv) Example 1 first,   1993................  1997.               
 second, third, fifth,                                                  
 sixth, and seventh sentence.                                           
(c)(1)(iv) Example 1 third,   1994................  1998.               
 fourth, and seventh                                                    
 sentence.                                                              
(c)(1)(iv) Example 2 second   Apportioned.........  Allocated or        
 sentence.                                           apportioned.       
(c)(1)(iv) Example 2 first,   1993................  1997.               
 second, third, and last                                                
 sentence.                                                              
(c)(1)(iv) Example 2 second   1994................  1998.               
 and last sentence.                                                     
(c)(2)(i) first sentence....  Apportioned.........  Allocated or        
                                                     apportioned.       
(c)(4) Example third,         1993................  1997.               
 fourth, fifth, sixth, and                                              
 eighth sentence.                                                       
(c)(4) Example fifth          Allocated...........  Allocated or        
 sentence.                                           apportioned.       
------------------------------------------------------------------------


    7. 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.
    8. Paragraph (e)(2) is added.
    The revisions and additions read as follows:


Sec. 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 Sec. 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 Sec. 1.882-
5(d)(2) (other than a U.S. booked liability of a partner within the 
meaning of Sec. 1.882-5(d)(2)(vii)); or
    (B) Described in Sec. 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 

[[Page 9343]]
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 Sec. 1.884-5, paragraphs (e)(4)(ii) and (g) are revised 
to read as follows:


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


Sec. 1.897-1  Taxation of foreign investments 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.


Sec. 602.101  [Amended]

    Par. 12. In Sec. 602.101, the table in paragraph (c) is amended by 
adding in numerical order ``Sec. 1.884-2 * * * 1545-1070''.
Margaret Milner Richardson,
Commissioner of Internal Revenue.

    Approved: February 28, 1996.
Leslie Samuels,
Assistant Secretary of the Treasury.
[FR Doc. 96-5261 Filed 3-5-96; 8:45 am]
BILLING CODE 4830-01-U