[Federal Register Volume 77, Number 10 (Tuesday, January 17, 2012)]
[Rules and Regulations]
[Pages 2225-2228]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2012-597]



 ========================================================================
 Rules and Regulations
                                                 Federal Register
 ________________________________________________________________________
 
 This section of the FEDERAL REGISTER contains regulatory documents 
 having general applicability and legal effect, most of which are keyed 
 to and codified in the Code of Federal Regulations, which is published 
 under 50 titles pursuant to 44 U.S.C. 1510.
 
 The Code of Federal Regulations is sold by the Superintendent of Documents. 
 Prices of new books are listed in the first FEDERAL REGISTER issue of each 
 week.
 
 ========================================================================
 

  Federal Register / Vol. 77, No. 10 / Tuesday, January 17, 2012 / 
Rules and Regulations  

[[Page 2225]]



DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 9571]
RIN 1545- BJ84


Allocation and Apportionment of Interest Expense

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Temporary regulations.

-----------------------------------------------------------------------

SUMMARY: This document contains temporary regulations that provide 
guidance regarding the allocation and apportionment of interest 
expense. These temporary regulations provide guidance concerning the 
allocation and apportionment of interest expense by corporations owning 
a 10 percent or greater interest in a partnership, as well as the 
allocation and apportionment of interest expense using the fair market 
value method. These temporary regulations also update the interest 
allocation regulations to conform to the statutory changes made by 
section 216 of the legislation commonly referred to as the Education 
Jobs and Medicaid Assistance Act (EJMAA), enacted on August 10, 2010, 
affecting the affiliation of certain foreign corporations for purposes 
of section 864(e). These regulations affect taxpayers that allocate and 
apportion interest expense. The text of these temporary regulations 
also serves as the text of the proposed regulations (REG-113903-10) set 
forth in the notice of proposed rulemaking on this subject published 
elsewhere in this issue of the Federal Register.

DATES: Effective Date: These regulations are effective on January 17, 
2012.
    Applicability Dates: For dates of applicability, see Sec. Sec.  
1.861-9T(k) and 1.861-11T(h).

FOR FURTHER INFORMATION CONTACT: Jeffrey L. Parry, (202) 622-3850 (not 
a toll-free call).

SUPPLEMENTARY INFORMATION: 

Background and Explanation of Provisions

I. Interest Expense Allocation by Partners

    Section 1.861-9T(e) provides rules governing the apportionment of 
interest expense by a partner in a partnership. In general, Sec.  
1.861-9T(e) adopts an aggregate, or look-through, approach to 
apportioning a partner's distributive share of interest expense 
incurred by the partnership. Section 1.861-9T(e)(1) provides the 
general rule that a partner's distributive share of the interest 
expense of a partnership is considered related to all income-producing 
activities and assets of the partner. Similarly, Sec.  1.861-9T(e)(2) 
requires that a corporate partner whose direct or indirect interest in 
the partnership is 10 percent or more apportion its distributive share 
of partnership interest expense by reference to the partner's assets, 
including the partner's pro rata share of the partnership's assets.
    By contrast, limited partners (whether individual or corporate) and 
corporate general partners with a less-than-10-percent partnership 
interest are excepted from aggregate treatment. Under Sec.  1.861-
9T(e)(4)(i), such partners must directly allocate their distributive 
share of partnership interest expense to their distributive share of 
partnership gross income. In addition, for purposes of allocating other 
interest expense incurred directly by such a partner, Sec.  1.861-
9T(e)(4)(ii) provides that the relevant asset is the partner's interest 
in the partnership, and not the partner's share of the partnership 
assets. This approach for such minority partners avoids the potential 
administrative burden that an aggregate approach would impose on such 
minority partners.
    These temporary regulations revise Sec.  1.861-9T(e)(2) to clarify 
that a corporate partner with a 10 percent or greater interest in a 
partnership must allocate its direct interest expense to all of its 
assets, including its proportionate share of partnership assets. The 
IRS and the Treasury Department believe that an aggregate approach for 
corporate partners with a 10 percent or greater interest in the 
partnership is appropriate and consistent with the aggregate approach 
applicable to apportioning such partner's distributive share of 
interest expense incurred by the partnership.
    These temporary regulations also revise Sec.  1.861-9T(e)(2) to 
provide that when a corporate partner with a 10 percent or greater 
interest in a partnership uses the tax book value or alternative tax 
book value method, and therefore must use the partnership's inside 
basis in its assets when allocating interest expense, the partnership's 
inside basis includes any section 734(b) adjustments and any section 
743(b) adjustments of the corporate partner for this purpose. Section 
1.861-9T(e)(3) is also revised to provide a similar rule for individual 
partners who are general partners or limited partners with a 10 percent 
or greater interest in the partnership.

II. Fair Market Value Method

    Section 864(e)(2) requires that the allocation and apportionment of 
interest expense be made on the basis of assets and not gross income 
(the asset method). Under the asset method, interest expense is 
apportioned between (or among) statutory and residual groupings of 
gross income in proportion to the average total values of assets within 
each such grouping for the taxable year. For this purpose, taxpayers 
may elect to value assets based on their fair market value (the FMV 
method), tax book value, or alternative tax book value. Sec. Sec.  
1.861-8T(c)(2) and 1.861-9(i).
    The temporary regulations set forth a multi-step methodology for 
determining the fair market value of a taxpayer's assets. Section 
1.861-9T(h)(1) provides rules for determining the fair market value of 
the taxpayer's intangible assets. First, the taxpayer determines the 
aggregate value of assets that it and its subsidiaries own (Step 1); 
second, the taxpayer values its tangible assets, excluding any stock or 
indebtedness in a related person (Step 2); and third, it subtracts the 
amount determined in Step 2 from the amount determined in Step 1 to 
arrive at total intangible asset value (Step 3). The intangible assets 
owned by the taxpayer are then apportioned among the taxpayer's 
affiliates under Sec.  1.861-9T(h)(2) on the basis of net income (Step 
4).
    Once a taxpayer has determined the fair market value of its 
intangible assets, those assets must be characterized as

[[Page 2226]]

provided in Sec.  1.861-9T(h)(3) (Step 5). Finally, the rules of Sec.  
1.861-9T(h)(4) apply to determine the value of stock in a related 
person held by the taxpayer (or by another person related to the 
taxpayer) (Step 6). Under those rules, Sec.  1.861-9T(h)(4) states that 
the value of such stock is equal to the sum of the following amounts, 
less the taxpayer's pro rata share of liabilities of such related 
person: (i) The intangible assets apportioned to the related person in 
Step 4, above; (ii) the tangible assets (as determined in Step 2) held 
by the related person; and (iii) the total value of stock held in all 
other related persons held by the related person.
    The IRS and the Treasury Department have become aware that certain 
taxpayers are taking the position that the language of Step 2 of the 
FMV method, which requires related party debt to be excluded as an 
asset as part of the process for determining total intangible asset 
value, means that such debt also is not treated as an asset in the 
hands of the taxpayer for the broader purpose of applying the asset 
method. In addition, for purposes of valuing the stock in related 
persons under Step 6, some taxpayers are taking the position that those 
rules exclude related party debt as an asset (because of the reference 
in Sec.  1.861-9T(h)(4) to Sec.  1.861-9T(h)(1)(ii)), but permit 
reduction of the value of the stock of the related person obligor by 
the amount of the related party debt as a liability (because the 
language of Sec.  1.861-9T(h)(4)(ii) does not limit the reduction for 
liabilities to unrelated party liabilities).
    The IRS and the Treasury Department believe that interpreting the 
regulations to require that the related party debt be taken into 
account as a liability for purposes of valuing stock in the related 
person without also treating the related party debt as an asset in the 
creditor's hands distorts the relative values of assets assigned to 
each statutory grouping. This result is contrary to the general 
principles of the Sec.  1.861-9 regulations, which are based on the 
concept that interest expense must be apportioned on the basis of the 
value of all assets. Accordingly, these temporary regulations amend 
Sec.  1.861-9T(h)(4) to reflect the fact that related party debt is an 
asset that must be taken into account whether held by the taxpayer or a 
related person.
    These temporary regulations first revise Sec.  1.861-9T(h)(4) by 
adding a new paragraph Sec.  1.861-9T(h)(4)(i) to provide for the 
valuation of related party debt. Prior to its revision by these 
temporary regulations, Sec.  1.861-9T(h)(4) provided for the valuation 
of the stock of a related person, but the regulations did not provide 
any explanation of how the related party debt is to be valued. As 
revised by these temporary regulations, Sec.  1.861-9T(h)(4)(i) 
provides that a related party debt obligation held by a taxpayer or 
another person related to the taxpayer has a value equal to the amount 
of the liability of the obligor related person. These temporary 
regulations also revise Sec.  1.861-9T(h)(4) by providing that the 
value of stock in a related person includes the taxpayer's pro rata 
share of related party debt held by the related person. Finally, these 
temporary regulations provide a new example illustrating the changes 
made to Sec.  1.861-9T(h)(4).
    These amendments make clear that related party debt is an asset in 
the hands of the creditor for purposes of applying the asset method and 
is included in the valuation of stock of a related person. Very 
broadly, these changes ensure that both the receivable and the payable 
sides of related party debt are included for valuation purposes under 
the FMV method, and that the value of each side is determined in a 
consistent manner. No inference is intended regarding the 
interpretation of prior regulations as a result of these modifications.

III. Affiliated Groups

    The interest expense of each member of an affiliated group is 
allocated and apportioned as if all members of such group were a single 
corporation. Section 864(e)(1). Prior to its amendment by the EJMAA, 
section 864(e)(5)(A) defined the term ``affiliated group'' by reference 
to the rules under section 1504 for determining whether corporations 
are eligible to file consolidated returns. The section 1504 rules 
generally exclude foreign corporations from an affiliated group. 
Section 1.861-11T(d)(6)(ii) provides that certain foreign corporations 
are nevertheless treated as affiliated corporations for purposes of 
allocating and apportioning interest expense if (1) at least 80 percent 
of either the vote or value of the corporation's outstanding stock is 
owned directly or indirectly by members of an affiliated group, and (2) 
more than 50 percent of the corporation's gross income for the taxable 
year is effectively connected with the conduct of a trade or business 
in the United States (effectively connected income).
    In the case of a foreign corporation that is treated as an 
affiliated corporation for interest allocation and apportionment 
purposes, Sec.  1.861-11T(d)(6)(ii) provides that the percentage of 
assets and income that is taken into account for purposes of applying 
the affiliated group interest apportionment rules depends on the 
percentage of the corporation's gross income that is effectively 
connected income. If 80 percent or more of the foreign corporation's 
gross income is effectively connected income, then all of the 
corporation's assets and interest expense are taken into account. If, 
instead, between 50 percent and 80 percent of the foreign corporation's 
gross income is effectively connected income, then only the 
corporation's assets that generate effectively connected income and a 
percentage of its interest expense equal to the percentage of its 
assets that generate effectively connected income are taken into 
account.
    Section 864(e)(5)(A), as amended by the EJMAA, provides that a 
foreign corporation will be treated as a member of an affiliated group 
for interest allocation and apportionment purposes if (1) more than 50 
percent of the gross income of such foreign corporation for the taxable 
year is effectively connected income, and (2) at least 80 percent of 
either the vote or value of all outstanding stock of such foreign 
corporation is owned directly or indirectly by members of the 
affiliated group. In such event, all of the qualifying foreign 
corporation's assets and interest expense are taken into account for 
purposes of applying the affiliated group interest apportionment rules. 
These temporary regulations revise Sec.  1.861-11T(d)(6) to reflect 
these statutory changes.

Special Analyses

    It has been determined that this Treasury decision is not a 
significant regulatory action as defined in Executive Order 12866. 
Therefore, a regulatory assessment is not required. It has also been 
determined that section 553(b) of the Administrative Procedure Act (5 
U.S.C. chapter 5) does not apply to these regulations, and because the 
regulations do not impose a collection of information on small 
entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not 
apply. Pursuant to section 7805(f), these regulations have been 
submitted to the Chief Counsel for Advocacy of the Small Business 
Administration for comment on their impact on small business.

Drafting Information

    The principal author of these regulations is Jeffrey L. Parry of 
the Office of Chief Counsel (International). However, other personnel 
from the IRS and the Treasury Department participated in their 
development.

[[Page 2227]]

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Amendments to the Regulations

    Accordingly, 26 CFR part 1 is amended as follows:

PART 1--INCOME TAXES

0
Paragraph 1. The authority citation for part 1 continues to read in 
part as follows:

    Authority:  26 U.S.C. 7805 * * *


0
Par. 2. Section 1.861-9T is amended by:
0
1. Revising the first two sentences of paragraph (e)(2), the fifth 
sentence of (e)(3), and paragraph (h)(4);
0
2. Adding four sentences before the last sentence of paragraph (k); and
0
3. Adding paragraph (l).
    The revisions and additions read as follows:


Sec.  1.861-9T  Allocation and apportionment of interest expense 
(temporary).

* * * * *
    (e) * * *
    (2) Corporate partners whose interest in the partnership is 10 
percent or more. A corporate partner shall apportion its interest 
expense (including the partner's distributive share of partnership 
interest expense) by reference to the partner's assets, including the 
partner's pro rata share of partnership assets, under the rules of 
paragraph (f) of this section if the corporate partner's direct and 
indirect interest in the partnership (as determined under the 
attribution rules of section 318) is 10 percent or more. A corporation 
using the tax book value method or alternative tax book value method of 
apportionment shall use the partnership's inside basis in its assets, 
including adjustments under sections 734(b) and 743(b), if any, and 
adjusted to the extent required under Sec.  1.861-10T(d)(2). * * *
    (3) Individual partners who are general partners or who are limited 
partners with an interest in the partnership of 10 percent or more. * * 
* An individual using the tax book value or alternative tax book value 
method of apportionment shall use the partnership's inside basis in its 
assets, including adjustments under sections 734(b) and 743(b), if any, 
and adjusted to the extent required under Sec.  1.861-10T(d)(2). * * *
* * * * *
    (h) * * *
    (4) Valuing related party debt and stock in related persons--(i) 
Related party debt. For purposes of this section, the value of a debt 
obligation of a related person held by the taxpayer or another person 
related to the taxpayer equals the amount of the liability of the 
obligor related person.
    (ii) Stock in related persons. The value of stock in a related 
person held by the taxpayer or by another person related to the 
taxpayer equals the sum of the following amounts reduced by the 
taxpayer's pro rata share of liabilities of such related person:
    (A) The portion of the value of intangible assets of the taxpayer 
and related persons that is apportioned to such related person under 
paragraph (h)(2) of this section;
    (B) The taxpayer's pro rata share of tangible assets held by the 
related person (as determined under paragraph (h)(1)(ii) of this 
section);
    (C) The taxpayer's pro rata share of debt obligations of any 
related person held by the related person (as valued under paragraph 
(h)(4)(i) of this section); and
    (D) The total value of stock in all related persons held by the 
related person as determined under this paragraph (h)(4).

    (iii) Example.  (A) Facts. USP, a domestic corporation, wholly 
owns CFC1 and owns 80% of CFC2, both foreign corporations. The 
aggregate trading value of USP's stock traded on established 
securities markets at the end of Year 1 is $700 and the amount of 
USP's liabilities to unrelated persons at the end of Year 1 is $400. 
Neither CFC1 nor CFC2 has liabilities to unrelated persons at the 
end of Year 1. USP owns plant and equipment valued at $500, CFC1 
owns plant and equipment valued at $400, and CFC2 owns plant and 
equipment valued at $250. The value of these assets has been 
determined using generally accepted valuation techniques, as 
required by Sec.  1.861-9T(h)(1)(ii). There is an outstanding loan 
from CFC2 to CFC1 in an amount of $100. There is also an outstanding 
loan from USP to CFC1 in an amount of $200.
    (B) Valuation of group assets. Pursuant to Sec.  1.861-
9T(h)(1)(i), the aggregate value of USP's assets is $1100 (the $700 
trading value of USP's stock increased by $400 of USP's liabilities 
to unrelated persons).
    (C) Valuation of tangible assets. Pursuant to Sec.  1.861-
9T(h)(1)(ii), the value of USP's tangible assets and pro rata share 
of assets held by CFC1 and CFC2 is $1100 (the plant and equipment 
held directly by USP, valued at $500, plus USP's 100% pro rata share 
of the plant and equipment held by CFC1 valued at $400 and USP's 80% 
pro rata share of the plant and equipment held by CFC 2 valued at 
$200 (80% of $250)).
    (D) Computation of intangible asset value. Pursuant to Sec.  
1.861-9T(h)(1)(iii), the value of the intangible assets of USP, 
CFC1, and CFC2 is $0 (total aggregate group asset value ($1100) 
determined in paragraph (B) less total tangible asset value ($1100) 
determined in paragraph (C)). Because the intangible asset value is 
zero, the provisions of Sec.  1.861-9T(h)(2) and (3) relating to the 
apportionment and characterization of intangible assets do not 
apply.
    (E) Valuing related party debt obligations. Pursuant to Sec.  
1.861-9T(h)(4)(i), the value of the debt obligation of CFC1 held by 
CFC2 is equal to the amount of the liability, $100. The value of the 
debt obligation of CFC1 held by USP is equal to the amount of the 
liability, $200.
    (F) Valuing the stock of CFC1 and CFC2. Pursuant to Sec.  1.861-
9T(h)(4)(ii), the value of the stock of CFC2 held by USP is $280 
(USP's 80% pro rata share of tangible assets of CFC2 included in 
paragraph (C) ($200) plus USP's 80% pro rata share of the debt 
obligation of CFC1 held by CFC2 valued in paragraph (E) ($80). The 
value of the stock of CFC1 held by USP is $100 (USP's 100% pro rata 
share of tangible assets of CFC1 included in paragraph (C) ($400) 
less USP's 100% pro rata share of the liabilities of CFC1 to USP and 
CFC2 ($300)).
* * * * *
    (k) * * * Paragraphs (e)(2) and (3) apply to taxable years 
beginning after January 17, 2012. See 26 CFR 1.861-9T(e)(2) and (3) 
(revised as of April 1, 2011) for rules applicable to taxable years 
beginning on or before January 17, 2012. Paragraph (h)(4) applies to 
taxable years ending on or after January 17, 2012. See 26 CFR 1.861-
9T(h)(4) (revised as of April 1, 2011) for rules applicable to taxable 
years ending before January 17, 2012. * * *
    (l) Expiration date. The applicability of paragraphs (e)(2), 
(h)(1)(iv), and (h)(4) expires on January 13, 2015.

0
Par. 4. Sec 1.861-11T is amended by revising paragraphs (d)(6)(ii) and 
(h) and adding paragraph (i) to read as follows:


Sec.  1.861-11T  Special rules for allocating and apportioning interest 
expense of an affiliated group of corporations (temporary).

* * * * *
    (6) * * *
    (ii) Any foreign corporation if more than 50 percent of the gross 
income of such foreign corporation for the taxable year is effectively 
connected with the conduct of a trade or business within the United 
States and at least 80 percent of either the vote or value of all 
outstanding stock of such foreign corporation is owned directly or 
indirectly by members of the affiliated group (determined with regard 
to this sentence).
* * * * *
    (h) Effective/applicability date. In general, the rules of this 
section apply for taxable years beginning after December 31, 1986. 
Paragraph (d)(6)(ii) applies to taxable years beginning after August 
10, 2010. See 26 CFR 1.861-11T(d)(6)(ii) (revised as of April 1, 2010) 
for rules applicable to taxable years beginning on or before August 10, 
2010.

[[Page 2228]]

    (i) Expiration date. The applicability of paragraphs (d)(1) and (6) 
expires on January 13, 2015.

Steven T. Miller,
Deputy Commissioner for Services and Enforcement.
    Approved: December 6, 2011.
Emily S. McMahon,
Acting Assistant Secretary of the Treasury (Tax Policy).
[FR Doc. 2012-597 Filed 1-13-12; 8:45 am]
BILLING CODE 4830-01-P