[Federal Register Volume 61, Number 47 (Friday, March 8, 1996)]
[Rules and Regulations]
[Pages 9325-9336]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 96-5262]



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[[Page 9326]]


DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 8658]
RIN 1545-AL84


Determination of Interest Expense Deduction of Foreign 
Corporations

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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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 1) 
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withdrawn.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

1. 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 Sec. 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 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.

2. Section 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 Sec. 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 three-step methodology described in the final regulations. 
In response to commenters' questions, however, Sec. 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 Sec. 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 Sec. 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 Sec. 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 Sec. 1.882-5 with any other section 
that disallows, defers, or capitalizes interest expense, and include 
examples that illustrate how Sec. 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 Sec. 1.882-5. The final 
regulations provide uniform rules for changing any election prescribed 
under Sec. 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 Sec. 1.882-5 calculations in 
cases where, 

[[Page 9327]]
under the authority of Sec. 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 
Sec. 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 
Sec. 1.881-3 from serving its function as an anti-abuse rule.

3. Section 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 Sec. 1.884-1(d) 
generally governs its classification as a U.S. asset for purposes of 
Sec. 1.882-5. Under the rules of Sec. 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 Sec. 1.882-5 regulations were issued 
in 1992, the regulations under Sec. 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 Sec. 1.882-5 regulations now closely 
conform to the Sec. 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 Sec. 1.882-5 applies to 
partnership interests held by foreign corporations. With the 
elimination of Sec. 1.861-9T(e)(7)(i) by these regulations, Sec. 1.884-
1(d)(3) and Sec. 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 under Sec. 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 
Sec. 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 
Sec. 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 Sec. 1.864-
4(c)(2). In addition, the final regulations specify that a taxpayer may 
achieve the same result under Sec. 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 Sec. 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 debt-financed under the principles of section 
246A. This stock cut-back rule is eliminated from the final Sec. 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 Sec. 1.864-4(c). 
This is because the final regulations under Sec. 1.864-4, which are 
being issued contemporaneously with these regulations elsewhere in this 
issue of the Federal Register, generally eliminate any inference that 
stock can produce effectively connected income under the asset-use test 
of Sec. 1.864-4(c)(2).
    The final regulations add an anti-abuse rule similar to the rule in 
Sec. 1.884-1(d)(5)(ii) to prevent taxpayers from artificially 
increasing the amount of their U.S. assets.

4. Section 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 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 

[[Page 9328]]
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 Sec. 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.

5. Section 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 (excess 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 
Sec. 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 Sec. 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.

6. Section 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 
Sec. 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 Sec. 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 Sec. 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. 

[[Page 9329]]


Drafting Information

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

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

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). * * *


Sec. 1.861-9T  [Amended]

    Par. 2. Section 1.861-9T, paragraph (e)(7) is amended as follows:
    1. Paragraph (e)(7)(i) is removed.
    2. The heading in paragraph (e)(7)(ii) is removed.
    3. Paragraph (e)(7)(ii) is redesignated as the text of paragraph 
(e)(7).
    Par. 3. Section 1.882-0 is added to read as follows:


Sec. 1.882-0  Table of contents.

    This section lists captions contained in Secs. 1.882-1, 1.882-2, 
1.882-3, 1.882-4 and 1.882-5.
    Sec. 1.882-1  Taxation of foreign corporations engaged in U.S. 
business or of foreign corporations treated as having effectively 
connected income.
(a)  Segregation of income.
(b)  Imposition of tax.
(1)  Income not effectively connected with the conduct of a trade or 
business in the United States.
(2)  Income effectively connected 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 status.
(d)  Credits against tax.
(e)  Payment of estimated tax.
(f)  Effective date.

Sec. 1.882-2  Income of foreign corporation treated as effectively 
connected with U.S. business.

(a)  Election as to real property income.
(b)  Interest on U.S. obligations received by banks organized in 
possessions.
(c)  Treatment of income.
(d)  Effective date.

Sec. 1.882-3  Gross income of a foreign corporation.

(a)  In general.
(1)  Inclusions.
(2)  Exchange transactions.
(3)  Exclusions.
(b)  Foreign corporations not engaged in U.S. business.
(c)  Foreign corporations engaged in U.S. business.
(d)  Effective date.

Sec. 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 Service.
(b)  Allowed deductions and credits.
(1)  In general.
(2)  Verification.

Sec. 1.882-5  Determination of interest deduction.

(a)  Rules of general application.
(1)  Overview.
(i)  In general.
(ii)  Direct allocations.
(A)  In general.
(B)  Partnership interest.
(2)  Coordination with tax treaties.
(3)  Limitation on interest expense.
(4)  Translation convention for foreign currency.
(5)  Coordination with other sections.
(6)  Special rule for foreign governments.
(7)  Elections under Sec. 1.882-5.
(i)  In general.
(ii)  Failure to make the proper election.
(8)  Examples.
(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.
(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.
(2)  Determination of the value of a U.S. asset.
(i)  General rule.
(ii)  Fair-market value election.
(A)  In general.
(B)  Adjustment to 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 of U.S. assets.
(c)  Step 2: Determination of total amount of U.S.-connected 
liabilities for the taxable year.
(1)  General rule.
(2)  Computation of the actual 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 transactions.
(ix)  Amounts must be expressed in a single currency.
(3)  Adjustments.
(4)  Elective fixed ratio method of determining U.S. liabilities.
(5)  Examples.
(d)  Step 3: Determination of amount of interest expense allocable 
to ECI under the adjusted U.S. booked liabilities method.
(1)  General rule.
(2)  U.S. booked liabilities.
(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)  In general.
(B)  Identified liabilities 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 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.
(f)  Effective date.
(1)  General rule.
(2)  Special rules for financial products.

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


Sec. 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) 

[[Page 9330]]
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 general. A foreign corporation that 
has a U.S. asset and indebtedness that meet the requirements of 
Sec. 1.861-10T (b) and (c), as limited by Sec. 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 Sec. 1.861-
10T. For purposes of paragraph (b)(1) or (c)(2) of this section, a 
foreign corporation that allocates its interest expense under the 
direct allocation rule of this paragraph (a)(1)(ii)(A) shall reduce the 
basis of the asset that meets the requirements of Sec. 1.861-10T (b) 
and (c) by the principal amount of the indebtedness that meets the 
requirements of Sec. 1.861- 10T (b) and (c). The foreign corporation 
shall also disregard any indebtedness that meets the requirements of 
Sec. 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 paragraph (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 Sec. 1.861-10T (b) and (c), as limited by Sec. 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 Sec. 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 Sec. 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 
Sec. 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 Sec. 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.
    (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 Sec. 1.989(b)-1 for the 
taxable year).
    (4) Translation convention for foreign 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 Sec. 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 Sec. 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 governments. The amount of interest 
expense of a foreign government, as defined in Sec. 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 Sec. 1.892-5T.
    (7) Elections under Sec. 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 Sec. 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 

[[Page 9331]]
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 x  to P in exchange for its partnership 
interest. P incurs qualified nonrecourse indebtedness within the 
meaning of Sec. 1.861-10T to purchase an airplane. FC's share of the 
liability of P, as determined under section 752, is 800 x .
    (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 x  liability as determined under 
section 752, but is not increased by the 800 x  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 
800 x  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 Sec. 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 Sec. 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 Sec. 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:
[GRAPHIC] [TIFF OMITTED] TR08MR96.000

    (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 Sec. 1.882-5, is 
$500.
    (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 Sec. 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 Sec. 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:
[GRAPHIC] [TIFF OMITTED] TR08MR96.001

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

[[Page 9332]]
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 Sec. 1.861-9T(g)(1)(iii), and 
provided the taxpayer uses the methodology prescribed in Sec. 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 
Sec. 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.
    (c) Step 2: Determination of total amount of U.S.-connected 
liabilities for the taxable year--(1) General rule. 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 worldwide 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 interests 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 

[[Page 9333]]
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 
Sec. 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 corporation 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 liabilities 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 properly 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 Sec. 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 

[[Page 9334]]
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 companies. [Reserved]
    (v) Liabilities used to increase artificially 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).
    (vi) Hedging transactions. [Reserved]
    (vii) Amount of U.S. booked liabilities 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
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  x  40%). 

[[Page 9335]]

    (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  x  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  x  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 x 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 U500. 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 + 
(U500  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 Sec. 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 (U5,000).
    (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 x 95%), 
and U4750 (U5000 x 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 x 6%), the sum of the expense associated with its 
U.S. dollar liabilities, plus U570 (U4750 x 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]


[[Page 9336]]

    (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 products. [Reserved]
Margaret Milner Richardson,
Commissioner of Internal Revenue.

    Approved: February 28, 1996.
Leslie Samuels,
Assistant Secretary of the Treasury.
[FR Doc. 96-5262 Filed 3-5-96; 8:45 am]
BILLING CODE 4830-01-U