[Federal Register Volume 61, Number 47 (Friday, March 8, 1996)]
[Proposed Rules]
[Pages 9377-9380]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 96-5264]
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DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Part 1
[INTL-0054-95]
RIN 1545-AT96
Proposed Amendments to the Regulations on the Determination of
Interest Expense Deduction of Foreign Corporations and Branch Profits
Tax
AGENCY: Internal Revenue Service (IRS), Treasury.
ACTION: Notice of proposed rulemaking and notice of public hearing.
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SUMMARY: This document contains proposed Income Tax Regulations
relating to the determination of the interest expense deduction of
foreign corporations under section 882 and the branch profits tax under
section 884 of the Internal Revenue Code of 1986. These proposed
regulations are necessary to provide guidance that coordinates with
guidance provided in final regulations under sections 882 and 884
published elsewhere in this issue of the Federal Register. These
regulations will affect foreign corporations engaged in a U.S. trade or
business. This document also provides notice of a public hearing on
these proposed regulations.
[[Page 9378]]
DATES: Written comments must be received by June 6, 1996. Outlines of
topics to be discussed at the public hearing scheduled for Thursday,
June 6, 1996, at 10 a.m. must be received by May 23, 1996.
ADDRESSES: Send submissions to: CC:DOM:CORP:R (INTL-0054-95), room
5228, Internal Revenue Service, POB 7604, Ben Franklin Station,
Washington DC 20044. In the alternative, submissions may be hand
delivered between the hours of 8 a.m. and 5 p.m. to CC:DOM:CORP:R
(INTL-0054-95), Courier's Desk, Internal Revenue Service, 1111
Constitution Avenue NW., Washington DC. The public hearing will be held
in the Auditorium, Internal Revenue Building, 1111 Constitution Avenue
NW., Washington DC.
FOR FURTHER INFORMATION CONTACT: Concerning the regulations, Ahmad
Pirasteh or Richard Hoge, (202) 622-3870; and the hearing, Michael
Slaughter (202) 622-7190 (not toll-free numbers).
SUPPLEMENTARY INFORMATION:
Background
This document contains proposed regulations amending the Income Tax
Regulations (26 CFR Part 1) under sections 882 and 884 of the Internal
Revenue Code. In final regulations under sections 882 and 884,
published elsewhere in this issue of the Federal Register, various
sections were reserved. These proposed regulations would provide
guidance under those reserved sections, as well as amend other
sections, to coordinate with the final regulations.
Explanation of the Provisions
I. Financial Products
The proposed regulations include several provisions that take into
account recent developments in the tax treatment of financial
instruments, such as the enactment of section 475, the development of
hedging rules and the introduction of profit split methodologies in
global trading Advance Pricing Agreements. The IRS and Treasury intend
to issue regulations under section 864 that will address these recent
developments as they affect the determination of a foreign
corporation's effectively connected income. Comments are solicited on
these proposed regulations as they relate to financial products and on
their interaction with the determination of effectively connected
income.
A. ``Split asset'' rule for section 475 securities and section 1256
contracts. Currently Sec. 1.884-1(d)(2)(vii) provides a ``split asset''
rule for certain securities described in Sec. 1.864-4(c)(5)(ii)(b)(3)
that produce income only a portion of which is treated as effectively
connected with the conduct of a U.S. trade or business. Since other
securities may also produce income split between effectively connected
and non-effectively connected income, the rule has been broadened to
cover all financial instruments that meet the definition of a security
under section 475(c)(2), as well as section 1256 contracts, that may
produce such split income. Accordingly, a foreign corporation that,
under an Advance Pricing Agreement, is permitted to apply a ``profit
split'' methodology to determine the portion of its income from a
portfolio of securities that is effectively connected with the conduct
of a U.S. trade or business would apply this rule. This rule will also
apply to determine the portion of a foreign corporation's portfolio of
securities that is a U.S. asset for purposes of Sec. 1.882-5.
B. Hedging transactions. Proposed Sec. 1.884-1(c)(2)(ii) introduces
a new rule for hedging transactions for purposes of section 884. The
new rule requires that a taxpayer increase or decrease, as the case may
be, the amount of their U.S. assets by the amount of any gain or loss
on any transaction that hedges the U.S. assets. If the hedging
transaction is undertaken outside the United States, perhaps as part of
a global hedging strategy of the foreign corporation, then the hedging
transaction is only taken into account to the extent that income from
the transaction would be treated as income effectively connected with
the U.S. trade or business of the taxpayer. If, however, the hedging
transaction is entered into by the U.S. branch, it will only affect the
amount of U.S. assets if it is contemporaneously identified as a
hedging transaction in accordance with the provisions of Sec. 1.1221-2.
In response to comments, hedging rules also have been added to the
interest allocation rules of Sec. 1.882-5. These rules provide that a
transaction that hedges a U.S. booked liability will be taken into
account in determining the amount, currency denomination, and interest
rate associated with that liability for purposes of performing the
second and third steps of the interest expense calculation.
C. Securities marked-to-market. Section 1.884-1(d)(6), which
provides ``E&P basis'' rules for specific types of U.S. assets, has
been clarified to provide rules for securities subject to mark-to-
market accounting. The new provision in Sec. 1.884-1(d)(6)(v) specifies
that securities subject to section 475, as well as section 1256
contracts, have an E&P basis equal to their mark-to-market value as of
the determination date. Proposed Sec. 1.882-5(b)(2)(iv) provides a
basis adjustment rule under which such assets are treated as having
been marked-to-market on each determination date. Examples are
contained in the proposed regulations that illustrate the effect of
these rules on the calculation of worldwide assets and liabilities.
II. Transactions Between Partners and Partnerships
Example 4 in proposed Sec. 1.882-5(c)(5) would clarify that an
obligation of a partnership to make payments to its partner for the use
of capital, which gives rise to guaranteed payments under section
707(c), is not a liability for purposes of Sec. 1.882-5. The Service
and Treasury solicit comments on the treatment of loans between
partners and partnerships as part of Treasury's review of the
international tax aspects of pass-through entities.
Special Analyses
It has been determined that this notice of proposed rulemaking 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 Procedures 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, this notice of proposed rulemaking will be
submitted to the Chief Counsel for Advocacy of the Small Business
Administration for comment on its impact on small business.
Comments and Request for a Public Hearing
Before these proposed regulations are adopted as final regulations,
consideration will be given to any written comments (signed original
and eight (8) copies) that are timely submitted to the IRS. All
comments will be available for public inspection and copying.
A public hearing has been scheduled for Thursday, June 6, 1996, at
10 a.m. in the Auditorium, Internal Revenue Building, 1111 Constitution
Avenue NW., Washington DC. Because of access restrictions, visitors
will not be admitted beyond the building lobby more than 15 minutes
before the hearing starts.
The rules of 26 CFR 601.601(a)(3) apply to the hearing. Persons
that wish to present oral comments at the hearing
[[Page 9379]]
must submit written comments by June 6, 1996, and submit an outline of
topics to be discussed and time to be devoted to each topic (signed
original and eight (8) copies) by May 23, 1996.
A period of 10 minutes will be allotted to each person for making
comments.
An agenda showing the scheduling of the speakers will be prepared
after the deadline for receiving outlines has passed. Copies of the
agenda will be available free of charge at the hearing.
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.
Proposed Amendments to the Regulations
Accordingly, 26 CFR part 1 is proposed to be amended as follows:
PART 1--INCOME TAXES
Paragraph 1. The authority citation for part 1 continues to read in
part as follows:
Authority: 26 U.S.C. 7805. * * *
Par. 2. Section 1.882-5 is amended as follows:
1. The text of paragraph (b)(2)(iv) is added.
2. The text of paragraph (c)(2)(v) is added.
3. In paragraph (c)(5), Example 4, Example 6, and Example 7 are
added.
4. The text of paragraph (d)(2)(vi) is added.
5. In paragraph (d)(6), Example 4 is added.
6. The text of paragraph (e)(3) is added.
7. In paragraph (e)(5), Example 2 is added.
8. The text of paragraph (f)(2) is added.
The added provisions read as follows:
Sec. 1.882-5 Determination of interest deduction.
* * * * *
(b) * * *
(2) * * *
(iv) Adjustment to basis of financial instruments. The basis of a
security or contract that is marked to market pursuant to section 475
or section 1256 will be determined as if each determination date were
the last business day of the taxpayer's taxable year. A financial
instrument with a fair market value of less than zero is a liability,
not an asset, for purposes of this section.
* * * * *
(c) * * *
(2) * * *
(v) Hedging transactions. A transaction (or transactions) that
hedges an asset or liability, or a pool of assets or a pool of
liabilities, will be taken into account in determining the value,
amount and currency denomination of the asset or liability that it
hedges. A transaction will be considered to hedge an asset or liability
only if the transaction meets the requirements of Sec. 1.1221-2.
* * * * *
(5) * * *
Example 4. Partnership liabilities. X and Y are each foreign
corporations engaged in the active conduct of a trade or business
within the United States through a partnership, P. Under the
partnership agreement, X and Y each have a 50% interest in the
capital and profits of P, and X is also entitled to a return of 6%
per annum on its capital account that is a guaranteed payment under
section 707(c). In addition, P has incurred a liability of $100x to
an unrelated bank, B. Under paragraph (c)(2)(vi) of this section, X
and Y each share equally in P's liability to B. In accordance with
U.S. tax principles, P's obligation to make guaranteed payments to X
does not constitute a liability of P, and therefore neither X nor Y
take into account that obligation of the partnership in computing
their actual ratio.
* * * * *
Example 6. Securities in ratio as assets. FC is a foreign
corporation engaged in a trade or business in the United States
through a U.S. branch. FC is a dealer in securities within the
meaning of section 475(c)(1)(B) because it regularly offers to enter
into positions in currency spot and forward contracts with customers
in the ordinary course of its trade or business. FC has not elected
to use the fixed ratio. On December 31, 1996, the end of FC's
taxable year, the mark-to-market value of the spot and forward
contracts entered into by FC worldwide is 1000x, which includes a
mark- to-market gain of 500x with respect to the spot and forward
contracts that are shown on the books of its U.S. branch and that
produce effectively connected income. On its December 31, 1996,
determination date, FC includes 500x in its U.S. assets, and 1000x
in its worldwide assets.
Example 7. Securities in ratio as assets and liabilities. The
facts are the same as in Example 4, except that on December 31,
1996, the mark-to-market value of the spot and forward contracts
entered into by FC worldwide is 1000x, and FC has a mark-to-market
loss of 500x with respect to the spot and forward contracts that are
shown on the books of its U.S. branch and that would produce
effectively connected income. On its December 31, 1996,
determination date, FC includes the 1000x in its worldwide assets
for purposes of determining its ratio of worldwide liabilities to
worldwide assets. For purposes of Step 3, however, FC has U.S-booked
liabilities in the United States equal to the 500x U.S. loss
position.
(d) * * *
(2) * * *
(vi) Hedging transactions. A transaction (or transactions) that
hedges a U.S. booked liability, or a pool of U.S. booked liabilities,
will be taken into account in determining the currency denomination,
amount of, and interest rate associated with, that liability. A
transaction will be considered to hedge a U.S. booked liability only if
the transaction meets the requirements of Sec. 1.1221-2(a), (b), and
(c), and is identified in accordance with the requirements of
Sec. 1.1221-2(e).
* * * * *
(6) * * *
Example 4. Liability hedge--(i) Facts. FC is a foreign
corporation that meets the definition of a bank, as defined in
section 585(a)(2)(B) (without regard to the second sentence
thereof), and that is engaged in a banking business in the United
States through its branch, B. FC's corporate policy is to match the
currency denomination of its assets and liabilities, thereby
minimizing potential gains and losses from currency fluctuations.
Thus, at the close of each business day, FC enters into one or more
hedging transactions as needed to maintain a balanced currency
position, and instructs each branch to do the same. At the close of
business on December 31, 1998, B has 100x of U.S. dollar assets, and
U.S. booked liabilities of 90x U.S. dollars and 1000 x Japanese yen
(exchange rate: $1 = 100). To eliminate the currency mismatch
in this situation, B enters into a forward contract with an
unrelated third party that requires FC to pay 10x dollars in return
for 1000x yen. Through this hedging transaction, FC has effectively
converted its 1000x Japanese yen liability into a U.S. dollar
liability. FC uses its actual ratio of 90% in 1998 for Step 2, the
adjusted U.S. booked liabilities method for purposes of Step 3, and
is a calendar year taxpayer.
(ii) Analysis. Under paragraph 1.882-5(d)(2)(vi), FC is required to
take into account hedges of U.S. booked liabilities in determining the
currency denomination, amount, and interest rate associated with those
liabilities. Accordingly, FC must treat the Japanese yen liabilities
booked in the United States on December 31, 1998, as U.S. dollar
liabilities to determine both the amount of the liabilities and the
interest paid or accrued on U.S. booked liabilities for purposes of
this section. Moreover, in applying the scaling ratio prescribed in
paragraph (d)(4)(i) of this section, FC must scale back both the U.S.
booked liabilities and the hedge(s) of those liabilities. Assuming that
FC's average U.S. booked liabilities for the year ending December 31,
1998, exceed its U.S.-connected liabilities determined
[[Page 9380]]
under paragraphs (a)(1) through (c)(5) of this section by 10%, FC must
scale back by 10% both its interest expense associated with U.S. booked
liabilities, and any income or loss from the forward contract to
purchase Japanese yen that hedges its U.S. booked liabilities.
(e) * * *
(3) Hedging transactions. A transaction (or transactions) that
hedges a liability, or a pool of liabilities, will be taken into
account in determining the amount of, or interest rate associated with,
that liability. A transaction will be considered to hedge a liability
only if the transaction meets the requirements of Sec. 1.1221-2(a),
(b), and (c).
* * * * *
(5) * * *
Example 2. Asset hedge--(i) Facts. FC is a foreign corporation
that meets the definition of a bank, as defined in section
585(a)(2)(B) (without regard to the second sentence thereof), and
that is engaged in the banking business in the United States through
its branch, B. FC's corporate policy is to match the currency
denomination of its assets and liabilities, thereby minimizing
potential gains and losses from currency fluctuations. Thus, at the
close of each business day, FC enters into one or more hedging
transactions as needed to maintain a balanced currency position, and
instructs each branch to do the same. At the close of business on
December 31, 1998, B has two U.S. assets, a loan of 90x U.S. dollars
and a loan of 1000x Japanese yen (exchange rate: $1 = 100). B
has U.S. booked liabilities, however, of 100x U.S. dollars. To
eliminate the currency mismatch, B enters into a forward contract
with an unrelated third party that requires FC to pay 1000x yen in
return for 10x dollars. Through this hedging transaction, FC has
effectively converted its 1000x Japanese yen asset into a U.S.
dollar asset. FC uses its actual ratio of 90% in 1998 for Step 2,
has elected the separate currency pools method in paragraph (e) of
this section, and is a calendar year taxpayer.
(ii) Analysis. Under paragraph (e)(1)(i) of this section, FC
must take into account any transaction that hedges a U.S. asset in
determining the currency denomination and value of that asset. FC's
Japanese yen asset will therefore be treated as a U.S. dollar asset
in determining its U.S. assets in each currency. Accordingly, FC
will be treated as having only U.S. dollar assets in making its
separate currency pools computation.
(f) * * *
(2) Special rules for financial products. Paragraphs (b)(2)(iv),
(c)(2)(v), (d)(2)(vi), and (e)(3) of this section will be effective for
taxable years beginning on or after the date these regulations are
published as final regulations in the Federal Register.
Par. 3. Section 1.884-1 is amended as follows:
1. Paragraph (c)(2)(iii) is added.
2. Paragraph (d)(2) is amended as follows:
a. Paragraph (d)(2)(vii) is revised.
b. In paragraph (d)(2)(xi), Example 6 through Example 8 are added.
3. The text of paragraph (d)(6)(v) is added.
4. In paragraph (i)(4), a sentence is added at the end of the
existing text.
The revised and added provisions read as follows:
Sec. 1.884-1 Branch profits tax.
* * * * *
(c) * * *
(2) * * *
(iii) Hedging transactions. A transaction that hedges a U.S. asset,
or a pool of U.S. assets, will be taken into account in determining the
amount of that asset (or pool of assets) to the extent that income or
loss from the hedging transaction produces ECI or reduces ECI. A
transaction that hedges a U.S. asset, or pool of U.S. assets, is also
taken into account in determining the currency denomination of the U.S.
asset (or pool of U.S. assets). A transaction will be considered to
hedge a U.S. asset only if the transaction meets the requirements of
Sec. 1.1221-2(a), (b), and (c), and is identified in accordance with
the requirements of Sec. 1.1221-2(e).
(d) * * *
(2) * * *
(vii) Financial instruments. A financial instrument, including a
security as defined in section 475 and a section 1256 contract, shall
be treated as a U.S. asset of a foreign corporation in the same
proportion that the income, gain, or loss from such security is ECI for
the taxable year.
* * * * *
(xi) * * *
Example 6. Hedging transactions--(i) Facts. FC is a foreign
corporation engaged in a trade or business in the United States
through a U.S. branch. The functional currency of FC's U.S. branch
is the U.S. dollar. On January 1, 1997, in the ordinary course of
its business, the U.S. branch of FC enters into a forward contract
with an unrelated party to purchase 100 German marks (DM) on March
31, 1997, for $50. To hedge the risk of currency fluctuation on this
transaction, the U.S. branch also enters into a forward contract
with another unrelated party to sell 100 DM on March 31, 1997, for
$52, identifying this contract as a hedging transaction in
accordance with the requirements of Sec. 1.1221-2(e). FC marks its
foreign currency transactions to market for U.S. tax purposes.
(ii) Net assets. At the end of FC's taxable year, the value of
the forward contract to purchase 100 DM is marked to market,
resulting in gain of $10 being realized and recognized as U.S.
source effectively connected income by FC. Similarly, FC marks to
market the contract to sell 100 DM, resulting in $8 of realized and
recognized loss by FC. Pursuant to paragraph (c)(2)(iii) of this
section, FC must increase or decrease the amount of its U.S. assets
to take into account any transaction that hedges the contract to
purchase 100 DM. Consequently, FC has a U.S. asset of $2 ($10 (the
adjusted basis of the contract to purchase 100 DM) -$8 (the loss on
the contract to sell 100 DM)).
Example 7. Split hedge. The facts are the same as in Example 5,
except that the contract to sell 100 DM is entered into with an
unrelated third party by the home office of FC. FC includes the
contract to sell 100 DM in a pool of assets treated as producing
income effectively connected with the U.S. trade or business of FC.
Therefore, under paragraph (c)(2)(iii) of this section, at its next
determination date FC will report a U.S. asset of $2, computed as in
Example 5.
Example 8. Securities. FC is a foreign corporation engaged in a
U.S. trade or business through a branch in the United States. During
the taxable year 1997, FC derives $100 of income from securities, of
which $60 is treated as U.S. source effectively connected income
under the terms of an Advance Pricing Agreement that uses a profit
split methodology. Accordingly, pursuant to paragraph (d)(2)(vii) of
this section, FC has a U.S. asset equal to 60% ($60 of ECI divided
by $100 of gross income from securities) of the value of the
securities.
* * * * *
(6) * * *
(v) Computation of E&P basis of financial instruments. For purposes
of this section, the E&P basis of a security that is marked to market
under section 475 and a section 1256 contract shall be adjusted to take
into account gains and losses recognized by reason of section 475 or
section 1256. The E&P basis must be further adjusted to take into
account a transaction that hedges a U.S. asset, as provided in
paragraph (c)(2)(ii) of this section.
* * * * * *
(i) * * *
(4) * * * Paragraphs (c)(2)(iii), (d)(2)(vii), and (d)(6)(v) of
this section will be effective for taxable years beginning on or after
the date these regulations are published as final regulations in the
Federal Register.
* * * * *
Margaret Milner Richardson,
Commissioner of Internal Revenue.
[FR Doc. 96-5264 Filed 3-5-96; 8:45 am]
BILLING CODE 4830-01-U