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Bulletin No. 1996–14

April 1, 1996

HIGHLIGHTS

OF THIS ISSUE

These synopses are intended only as aids to the reader in

identifying the subject matter covered. They may not be

relied upon as authoritative interpretations.

INCOME TAX

Rev. Rul. 96–19, page 24.

Federal rates; adjusted federal rates; adjusted federal

long-term rate, and the long-term exempt rate. For

purposes of sections 1274, 1288, 382, and other

sections of the Code, tables set forth the rates for April

1996.

separated taxpayers. This study was initially described

in Announcement 96–5, 1996–4 I.R.B. 99 (Jan. 22,

1996).

Notice 96–20, page 30.

Rev. Proc. 96–11, 1996–2 I.R.B. 18 relating to

Specifications for Filing Form 1042–S, Foreign Person’s U.S. Source Income Subject to Withholding,

Magnetically or Electronically, is corrected.

T.D. 8657, page 4.

INTL–0054–95, page 39.

Final, temporary, and proposed regulations under

sections 864 and 884 of the Code relating to the

determination of effectively connected income and the

branch profits tax. A public hearing on the proposed

regulations will be held on June 6, 1996.

Notice 96–21, page 30.

T.D. 8636, 1996–4 I.R.B. 64, relating to the time for

furnishing wage statements to employees and for filing

wage statements with the Social Security Administration on termination of an employer’s operations, is

corrected.

T.D. 8658, page 13.

INTL–0054–95, page 39.

Final and proposed regulations under section 882 of

the Code relating to the determination of the interest

expense deduction of foreign corporations engaged in a

trade or business within the United States.

Notice 96–22, page 30.

T.D. 8630, 1996–3 I.R.B. 19, relating to income,

estate, and gift tax regulations regarding exceptions to

the use of valuation tables, is corrected.

ADMINISTRATIVE

Rev. Proc. 96–28, page 31.

Per diem allowances. This procedure provides rules

under which the amount of ordinary and necessary

business expenses of an employee for lodging, meals,

and/or incidental expenses incurred while away from

home will be deemed substantiated when a payor

provides a reimbursement or other expense allowance to

pay for such expenses. It also provides an optional

method for employees and self-employed individuals to

use in computing the deductible costs of business meal

and incidental expenses paid or incurred while traveling

away from home. Rev. Proc. 94–77 is superseded.

Notice 96–18, page 27.

Interest netting study. This notice invites public comment in connection with the Internal Revenue Service

and Treasury study of interest netting. This study was

initially described in Announcement 96–5, 1996–4

I.R.B. 99 (Jan. 22, 1996).

Notice 96–19, page 28.

Joint return study. This notice invites public comment in

connection with the Internal Revenue Service and

Treasury study of certain joint return and community

property issues, particularly as they affect divorced or

Finding Lists begins on page 46.

Announcement of Disbarments and Suspensions begins on page 43.

Quarterly Index for January, February and March begins on page 48.

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Mission of the Service

The purpose of the Internal Revenue Service is to

collect the proper amount of tax revenue at the least

cost; serve the public by continually improving the

quality of our products and services; and perform in a

manner warranting the highest degree of public

confidence in our integrity, efficiency and fairness.

Statement of Principles

of Internal Revenue

Tax Administration

The function of the Internal Revenue Service is to

administer the Internal Revenue Code. Tax policy

for raising revenue is determined by Congress.

With this in mind, it is the duty of the Service to

carry out that policy by correctly applying the laws

enacted by Congress; to determine the reasonable

meaning of various Code provisions in light of the

Congressional purpose in enacting them; and to

perform this work in a fair and impartial manner,

with neither a government nor a taxpayer point of

view.

At the heart of administration is interpretation of the

Code. It is the responsibility of each person in the

Service, charged with the duty of interpreting the

law, to try to find the true meaning of the statutory

provision and not to adopt a strained construction in

the belief that he or she is ‘‘protecting the revenue.’’

The revenue is properly protected only when we ascertain and apply the true meaning of the statute.

The Service also has the responsibility of applying

and administering the law in a reasonable,

practical manner. Issues should only be raised by

examining officers when they have merit, never

arbitrarily or for trading purposes. At the same

time, the examining officer should never hesitate

to raise a meritorious issue. It is also important

that care be exercised not to raise an issue or to

ask a court to adopt a position inconsistent with

an established Service position.

Administration should be both reasonable and

vigorous. It should be conducted with as little

delay as possible and with great courtesy and

considerateness. It should never try to overreach,

and should be reasonable within the bounds of law

and sound administration. It should, however, be

vigorous in requiring compliance with law and it

should be relentless in its attack on unreal tax

devices and fraud.

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Introduction

The Internal Revenue Bulletin is the authoritative

instrument of the Commissioner of Internal Revenue for

announcing official rulings and procedures of the

Internal Revenue Service and for publishing Treasury

Decisions, Executive Orders, Tax Conventions, legislation, court decisions, and other items of general

interest. It is published weekly and may be obtained

from the Superintendent of Documents on a subscription basis. Bulletin contents of a permanent nature are

consolidated semiannually into Cumulative Bulletins,

which are sold on a single-copy basis.

It is the policy of the Service to publish in the Bulletin

all substantive rulings necessary to promote a uniform

application of the tax laws, including all rulings that

supersede, revoke, modify, or amend any of those

previously published in the Bulletin. All published

rulings apply retroactively unless otherwise indicated.

Procedures relating solely to matters of internal

management are not published; however, statements of

internal practices and procedures that affect the rights

and duties of taxpayers are published.

Revenue rulings represent the conclusions of the

Service on the application of the law to the pivotal facts

stated in the revenue ruling. In those based on

positions taken in rulings to taxpayers or technical

advice to Service field offices, identifying details and

information of a confidential nature are deleted to

prevent unwarranted invasions of privacy and to comply

with statutory requirements.

Rulings and procedures reported in the Bulletin do not

have the force and effect of Treasury Department

Regulations, but they may be used as precedents.

Unpublished rulings will not be relied on, used, or cited

as precedents by Service personnel in the disposition of

other cases. In applying published rulings and procedures, the effect of subsequent legislation, regulations,

court decisions, rulings, and procedures must be

considered, and Service personnel and others concerned are cautioned against reaching the same

conclusions in other cases unless the facts and

circumstances are substantially the same.

The Bulletin is divided into four parts as follows:

Part I.—1986 Code.

This part includes rulings and decisions based on

provisions of the Internal Revenue Code of 1986.

Part II.—Treaties and Tax Legislation.

This part is divided into two subparts as follows:

Subpart A, Tax Conventions, and Subpart B, Legislation

and Related Committee Reports.

Part III.—Administrative, Procedural, and Miscellaneous.

To the extent practicable, pertinent cross references to

these subjects are contained in the other Parts and

Subparts. Also included in this part are Bank Secrecy

Act Administrative Rulings. Bank Secrecy Act Administrative Rulings are issued by the Department of the

Treasury’s Office of the Assistant Secretary

(Enforcement).

Part IV.—Items of General Interest.

With the exception of the Notice of Proposed Rulemaking and the disbarment and suspension list included in

this part, none of these announcements are consolidated in the Cumulative Bulletins.

The first Bulletin for each month includes an index for

the matters published during the preceding month.

These monthly indexes are cumulated on a quarterly

and semiannual basis, and are published in the first

Bulletin of the succeeding quarterly and semi-annual

period, respectively.

The Bulletin Index-Digest System, a research and

reference service supplementing the Bulletin, may be

obtained from the Superintendent of Documents on a

subscription basis. It consists of four Services: Service

No. 1, Income Tax; Service No. 2, Estate and Gift

Taxes; Service No. 3, Employment Taxes; Service No.

4, Excise Taxes. Each Service consists of a basic

volume and a cumulative supplement that provides (1)

finding lists of items published in the Bulletin, (2)

digests of revenue rulings, revenue procedures, and

other published items, and (3) indexes of Public Laws,

Treasury Decisions, and Tax Conventions.

The contents of this publication are not copyrighted and may be reprinted freely. A citation of the Internal Revenue Bulletin as the source would be appropriate.

For sale by the Superintendent of Documents U.S. Government Printing Office, Washington, D.C. 20402.

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Part I. Rulings and Decisions Under the Internal Revenue Code of 1986

Section 42.—Low-Income Housing

Credit

expenses. See Rev. Proc. 96–28, 1996–14 I.R.B.

page 31.

Section 483.—Interest on Certain

Deferred Payments

The adjusted applicable federal short-term,

mid-term, and long-term rates are set forth for

the month of April 1996. See Rev. Rul. 96–19,

page 24.

26 CFR 1.274–5T: Substantiation requirements

(temporary).

The adjusted applicable federal short-term,

mid-term, and long-term rates are set forth for

the month of April 1996. See Rev. Rul. 96–19,

page 24.

Section 62.—Adjusted Gross Income

Defined

26 CFR 1.62–2: Reimbursements and other

expense allowance arrangements.

Rules are set forth under which a reimbursement or other expense allowance arrangement for

the cost of lodging, meal, and/or incidental

expenses incurred by an employee while traveling away from home will satisfy the requirements of § 62(c) of the Code as to substantiation

of the amount of expenses. See Rev. Proc. 96–

28, 1996–14 I.R.B. page 31.

Section 162.—Trade or Business

Expense

26 CFR 1.162–17: Reporting and substantiation of certain business expenses of employees.

The rules for substantiating the amount of a

deduction or expense for lodging, meal, and/or

incidental expenses incurred while traveling

away from home that most nearly represents

current costs are set forth. See Rev. Proc. 96–28,

1996–14 I.R.B. page 31.

Section 267.—Losses, Expenses, and

Interest With Respect to Transactions

Between Related Taxpayers

26 CFR 1.267(a)–1: Deductions disallowed.

When a payor provides a per diem allowance

to an employee who is a related party, the rules

set forth for the deemed substantiation to the

payor of the amount of the employee’s ordinary

and necessary business expenses for lodging,

meal, and/or incidental expenses incurred while

traveling away from home do not apply. See

Rev. Proc. 96–28, 1996–14 I.R.B. page 31.

Section 274.—Disallowance of

Certain Entertainment, etc., Expenses

Rules are set forth for substantiating the

amount of ordinary and necessary business

expense of an employee for lodging, meal, and/

or incidental expenses incurred while traveling

away from home when a payor provides a per

diem allowance under a reimbursement or other

expense allowance arrangement to pay for such

expenses. Rules are also set forth for an optional

method for employees and self-employed individuals to use in computing the deductible costs

of business meal and incidental expenses paid or

incurred while traveling away from home. See

Rev. Proc. 96–28, 1996–14 I.R.B. page 31.

Section 280G.—Golden Parachute

Payments

Federal short-term, mid-term, and long-term

rates are set forth for the month of April 1996.

See Rev. Rul. 96–19, page 24.

Section 382.—Limitation on Net

Operating Loss Carryforwards and

Certain Built-In Losses Following

Ownership Change

Section 807.—Rules for Certain

Reserves

The adjusted applicable federal short-term,

mid-term, and long-term rates are set forth for

the month of April 1996. See Rev. Rul. 96–19,

page 24.

Section 846.—Discounted Unpaid

Losses Defined

The adjusted applicable federal short-term,

mid-term, and long-term rates are set forth for

the month of April 1996. See Rev. Rul. 96–19,

page 24.

Section 864.—Definitions and

Special Rules

26 CFR 1.864–4: U.S. source income

effectively connected with U.S. business.

T.D. 8657

The adjusted federal long-term rate is set forth

for the month of April 1996. See Rev. Rul. 96–

19, page 24.

Section 412.—Minimum Funding

Standards

The adjusted applicable federal short-term,

mid-term, and long-term rates are set forth for

the month of April 1996. See Rev. Rul. 96–19,

page 24.

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 1 and 602

Regulations on Effectively Connected

Income and the Branch Profits Tax

AGENCY: Internal Revenue Service

(IRS), Treasury.

Section 467.—Certain Payments

for the Use of Property or Services

ACTION: Final

regulations.

The adjusted applicable federal short-term,

mid-term, and long-term rates are set forth for

the month of April 1996. See Rev. Rul. 96–19,

page 24.

SUMMARY: This document contains

final Income Tax Regulations relating

to the determination of effectively

connected income under section 864

and final and temporary Income Tax

Regulations relating to the branch

profits tax and branch-level interest tax

under section 884 of the Internal

Revenue Code of 1986 (Code). Section

884 was added to the Code by section

1241 of the Tax Reform Act of 1986.

This document also contains conforming changes to sections 861, 871 and

897.

26 CFR 1.274(d)–1(a): Substantiation

requirements.

Section 468.—Special Rules

for Mining and Solid Waste

Reclamation and Closing Costs

Rules are set forth for substantiating the

amount of ordinary and necessary business

expense of an employee for lodging, meal, and/

or incidental expenses incurred while traveling

away from home when a payor provides a per

diem allowance under a reimbursement or other

expense allowance arrangement to pay for such

The adjusted applicable federal short-term,

mid-term, and long-term rates are set forth for

the month of April 1996. See Rev. Rul. 96–19,

page 24.

and

temporary

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EFFECTIVE DATE: June 6, 1996.

FOR FURTHER INFORMATION

CONTACT: Gwendolyn A. Stanley,

(202) 622-3860 (not a toll-free

number).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collections of information contained in these final regulations have

been reviewed and approved by the

Office of Management and Budget in

accordance with the Paperwork Reduction Act (44 U.S.C. 3507) under

control number 1545–1070.

An agency may not conduct or

sponsor, and a person is not required to

respond to, a collection of information

unless the collection of information

displays a valid control number.

The estimated annual burden per

respondent is .25 hours.

Comments concerning the accuracy

of this burden estimate and suggestions

for reducing this burden should be sent

to the Internal Revenue Service, Attn:

IRS Reports Clearance Officer, T:FP,

Washington, DC 20224, and to the

Office of Management and Budget,

Attn: Desk Officer for the Department

of the Treasury, Office of Information

and Regulatory Affairs, Washington,

DC 20503.

Books or records relating to this

collection of information must be retained as long as their contents may be

material in the administration of any

internal revenue law. Generally, tax

returns and tax information are confidential, as required by 26 U.S.C.

6103.

Background

On September 2, 1988, proposed and

temporary regulations (TD 8223 and

INTL–934–86 [1988–2 C.B. 825]) under section 884 were published in the

Federal Register (53 FR 34045). Written comments were received on the

proposed amendments. On September

11, 1992, temporary regulations under

§ 1.884–2T were amended and final

regulations (1992 final regulations) (TD

8432 [1992–2 C.B. 157]) under section

884 of the Code were published in the

Federal Register (57 FR 41644). Proposed amendments (1992 proposed regulations) (INTL–0003–92 [1992–2 C.B.

752]) to the Income Tax Regulations

(26 CFR part 1) under sections 864 and

884 of the Internal Revenue Code were

published in the Federal Register (57

FR 41707) on the same day. Written

comments were received on the proposed amendments. After consideration

of all the comments, § 1.884–2(a)(2)(ii)

and § 1.884–2(c)(2)(iii) of the 1988

proposed regulations and the 1992

proposed regulations are adopted as

final regulations as amended by this

Treasury decision. The revisions and

conforming changes are discussed

below.

Explanation of the Provisions

Section 864 stock rule.

The proposed regulations under section 864 provided that stock of a

corporation shall not be treated as an

asset used in, or held for use in, the

conduct of a U.S. trade or business.

Accordingly, the regulations proposed

to delete the example of stock acquired

and held to assure a constant source of

supply as an asset that satisfies the

asset-use test under § 1.864–4(c)(2).

Commenters criticized this rule and

cited to the legislative history to the

Foreign Investors Tax Act of 1966 as

contemplating that stock may satisfy

the asset-use test. The IRS and Treasury continue to believe, however, that

stock does not satisfy the asset-use test.

Therefore § 1.864–4(c)(2)(iii) adopts

the rule contained in the proposed

regulations.

In response to our request for comments on whether insurance companies

require an exception to the stock rule

for their portfolio stock, one commenter suggested that foreign life insurance

companies be permitted to refer to the

National Association of Insurance

Commissioners (NAIC) Annual Statement to determine whether their assets

are used in, or held for use in, the

conduct of a U.S. trade or business.

The IRS and Treasury will continue to

consider whether modifications to the

regulations under section 864 are appropriate for foreign insurance companies and reserve on the treatment of

stock held by a foreign insurance

company.

Conforming changes have been made

to regulations under section 864, as

well as regulations under sections 871

and 897 to reflect the clarification of

§ 1.864–4(c)(2). The effective date of

the changes to sections 871 and 897

corresponds to the effective date of the

changes to section 864.

II. Branch profits tax.

A. Interest in a partnership. Currently,

a foreign corporation engaged in a U.S.

trade or business through a partnership

applies different rules to determine its

U.S. assets depending on whether the

determination is for purposes of section

884 or § 1.882–5. For purposes of

computing its interest expense under

§ 1.882–5, the rules of § 1.861–

9T(e)(7) apply. Therefore a foreign

corporation takes into account either its

pro rata share of partnership assets and

liabilities or applies the rules of

§ 1.882–5 as if the partnership were a

foreign corporation, depending on the

nature of its interest in the partnership.

In contrast, for purposes of section 884,

a foreign corporation generally takes

into account its adjusted basis in its

partnership interest as a starting point

for determining its U.S. assets.

Final regulations under section 882

published elsewhere in this issue of the

Federal Register remove the temporary

regulations under § 1.861–9T(e)(7)(i).

These final regulations provide a new

U.S. asset rule for partnership interests

for purposes of determining the U.S.

assets of a foreign corporate partner

under sections 882 and 884. The final

regulations under § 1.882–5 contain a

corresponding rule to determine the

value of a partnership interest held by a

foreign corporation for purposes of

computing its worldwide assets.

In the event that a partnership

derives any income that is not effectively connected with a U.S. trade or

business, or otherwise holds non-U.S.

assets, the rules in § 1.884–1(d)(3)

continue to provide a rule that allocates

the basis in the partnership interest

between U.S. and non-U.S. assets.

However, the allocation rule is more

flexible than the rule contained in

either the 1992 final regulations or the

proposed regulations under section 884.

The rule allows a foreign corporation

to use either an income method or an

asset method to determine the proportionate share of its partnership interest

that is a U.S. asset, regardless of its

ownership interest in the partnership.

This is a change from the previous

1992 final regulations, which required

all foreign corporate partners to use an

income method, and from the 1992

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proposed regulations, which required

more than 10% partners to use the asset

method.

Based on commenters’ suggestions,

other clarifying changes have been

made to the asset method. For example,

the final regulations clarify that the

adjusted bases of partnership assets

reflect any adjustment under section

754 with respect to a foreign corporate

partner.

B. Interest in a trust or estate. The

rules applicable to interests in a trust or

estate in § 1.884–1(d)(4) are finalized

as proposed.

C. Nonrecourse indebtedness and integrated financial transactions. Because

the final regulations under § 1.882–5

incorporate the special allocation rules

of § 1.861–10T, certain changes to the

final regulations under § 1.884–1(e) are

needed to maintain the proper U.S. net

equity of a foreign corporation that

elects to directly allocate any portion of

its interest expense. These regulations

include a conforming change that

provides that liabilities giving rise to

such interest will be considered U.S.

liabilities for purposes of section 884,

notwithstanding that such liabilities are

not taken into account in Step 2 of

§ 1.882–5.

In addition, a new provision has

been added in § 1.884–4(b) so that

branch interest continues to include

interest paid with respect to liabilities

that are subject to the special allocation

rules, notwithstanding that such liabilities are not considered U.S. booked

liabilities for purposes of Step 3 of the

§ 1.882–5 calculation.

D. Structural changes to conform

branch interest rules to final regulations under § 1.882–5. These regulations adopt the changes made by the

1992 proposed regulations under

§ 1.884–4(b), and thus incorporate the

rules in § 1.882–5(d)(2) (relating to

U.S. booked liabilities) in defining the

term branch interest of a foreign

corporation. Although certain changes

were made to the definition of U.S.

booked liabilities in the final regulations under § 1.882–5, the manner in

which a foreign corporation computes

its branch interest and excess interest

remains substantially unchanged.

E. Excess interest—definition of a

foreign bank. A foreign corporation

that is a foreign bank may treat a

minimum of 85% of its excess interest

as interest on deposits, regardless of its

actual ratio of deposits to interest

bearing liabilities. The IRS and Treasury believe this rule should be applicable only to a foreign bank engaging in

substantial deposit-taking activities,

taking into account its activities in the

United States as well as other countries

in which it operates. The definition

used in the 1992 final regulations did

not clearly convey this limitation. Thus,

§ 1.884–4(a)(2)(iii) now defines a foreign bank by reference to section

585(a)(2)(B) of the Code, but also

requires that a substantial part of its

business consists of receiving deposits

and making loans and discounts.

III. Complete termination rules.

The rules in § 1.884–2T(a)(5), applicable to a foreign corporation whose

beneficial interest in a trust terminates,

are finalized as proposed by the 1992

regulations. In addition the waiver

provisions contained in § 1.884–2 of

the 1988 proposed regulations are

finalized as amended by this Treasury

decision.

Special Analyses

It has been determined that this

Treasury decision is not a significant

regulatory action as defined in EO

12866. Therefore, a regulatory assessment is not required. It has also been

determined that section 553(b) of the

Administrative Procedure Act (5 U.S.C.

chapter 5) and the Regulatory Flexibility Act (5 U.S.C. chapter 6) do not

apply to these regulations, and, therefore, a Regulatory Flexibility Analysis

is not required. Pursuant to section

7805(f) of the Internal Revenue Code,

the notice of proposed rulemaking

preceding these regulations was submitted to the Chief Counsel for Advocacy

of the Small Business Administration

for comment on its impact on small

business.

Drafting Information

The principal author of these regulations is Gwendolyn A. Stanley, Office

of Associate Chief Counsel (International), within the Office of Chief

Counsel, IRS. However, other personnel from the IRS and Treasury Department participated in their development.

Adoption of

Regulations

amendments

the

Accordingly, 26 CFR parts 1 and

602 are amended as follows:

PART 1—INCOME TAXES.

Paragraph 1. The authority citation

for part 1 is amended by adding an

entry in numerical order to read as

follows:

Authority: 26 U.S.C. 7805.

Section 1.884–2 also issued under 26

U.S.C. 884(g)

Par. 2. Section 1.864–4 is amended

as follows:

1. The third sentence in paragraph

(c)(2)(i) is revised.

2. Paragraph (c)(2)(ii) is revised.

3. Paragraphs (c)(2)(iii) and

(c)(2)(iv) are redesignated as (c)(2)(iv)

and (c)(2)(v) respectively.

4. New paragraph (c)(2)(iii) is added.

5. Newly designated paragraph

(c)(2)(v) is amended by:

a. Revising the introductory text.

b. Removing Example (2) through

Example (4).

c. Redesignating ‘‘Example (5)’’ as

‘‘Example (2)’’.

d. Amending newly designated Example (2) by:

i. Revising the fifth and sixth

sentences.

ii. Removing the date ‘‘1968’’ and

adding the date ‘‘1997’’ where it

appears in the second, third, and eighth

sentences.

6. The last sentence of paragraph

(c)(6)(i) is removed.

7. Paragraph (c)(7) is added.

The additions and revisions read as

follows:

§ 1.864–4 U.S. source income effectively connected with U.S. business.

(2) * * *

(i) * * * The asset-use test is of

primary significance where, for example, interest income is derived from

sources within the United States by a

nonresident alien individual or foreign

corporation that is engaged in the

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business of manufacturing or selling

goods in the United States. * * *

(ii) Cases where applicable. Ordinarily, an asset shall be treated as

used in, or held for use in, the conduct

of a trade or business in the United

States if the asset is—

(a) Held for the principal purpose of

promoting the present conduct of the

trade or business in the United States;

(b) Acquired and held in the ordinary

course of the trade or business conducted in the United States, as, for

example, in the case of an account or

note receivable arising from that trade

or business; or

(c) Otherwise held in a direct relationship to the trade or business conducted in the United States, as determined under paragraph (c)(2)(iv) of

this section.

(iii) Application of asset-use test to

stock—(a) In general. Except as

provided in paragraph (c)(2)(iii)(b) of

this section, stock of a corporation

(whether domestic or foreign) shall not

be treated as an asset used in, or held

for use in, the conduct of a trade or

business in the United States.

(b) Stock held by foreign insurance

companies. [Reserved] * * * * *

(v) Illustration. The application of

paragraph (iv) may be illustrated by the

following examples:

Example (2). * * * During 1997, the branch

office derives from sources within the United

States interest on these securities, and gains and

losses resulting from the sale or exchange of

such securities. Since the securities were acquired with amounts generated by the business

conducted in the United States, the interest is

retained in that business, and the portfolio is

managed by personnel actively involved in the

conduct of that business, the securities are

presumed under paragraph (c)(2)(iv)(b) of this

section to be held in a direct relationship to that

business. * * *

(7) Effective date. Paragraphs (c)(2)

and (c)(6)(i) of this section are effective for taxable years beginning on or

after June 6, 1996.

2. Removing Example 1.

3. Removing the designation ‘‘(2)’’

in Example (2).

The revision reads as follows:

§ 1.871–12 Determination of tax on

treaty income.

(d) Illustration. The application of

this section may be illustrated by the

following example:

Par. 4. Section 1.884–0(b) is

amended by revising the entries for

§§ 1.884–1(d)(4), 1.884–2T(a)(5),

1.884–4(b)(1), and 1.884–4(b)(2) and

adding entries for §§ 1.884–1(i)(4),

1.884–2T(a)(6), 1.884–4(e)(1) and

1.884–4(e)(2) to read as follows:

§ 1.884–0 Overview of regulation

provisions for section 884.

(b) * * *

§ 1.884–1 Branch profits tax.

(d) * * *

(4) Interest in a trust or estate.

(i) * * *

(4) Special rule for certain U.S.

assets and liabilities.

§ 1.884–2T Special Rules for termination or incorporation of a U.S. trade or

business or liquidation or reorganization of a foreign corporation or its

domestic subsidiary (temporary).

(a) * * *

(5) Special rule if a foreign corporation terminates an interest in a trust.

[Reserved]

(6) Coordination with second-level

withholding tax.

Par. 3. In § 1.871–12, paragraph (d)

is amended by:

1. Revising the paragraph heading

and introductory text.

§ 1.884–4 Branch-level interest tax.

(b) * * *

(1) Definition of branch interest.

(2) [Reserved]

(3) * * *

(4) [Reserved]

(e) * * *

(1) General rule.

(2) Special rule.

Par. 5. Section 1.884–1 is amended

as follows:

1. Paragraph (c)(2) is amended as

follows:

a. The text of paragraph (c)(2) is

redesignated as paragraph (c)(2)(i) and

a paragraph heading for (c)(2)(i) is

added.

b. New paragraph (c)(2)(ii) is added.

2. In paragraph (d)(2)(xi), Example 2

through Example 4 are redesignated

Example 3 through Example 5, respectively, and new Example 2 is added.

3. Paragraph (d)(3) is revised.

4. The text of paragraph (d)(4) is

added.

5. Paragraph (d)(5)(iii) is revised.

6. In Paragraph (d)(6)(iii) the reference to ‘‘(d)(3)(iv)’’ is removed and

‘‘(d)(3)(vi)’’ is added in its place.

7. Paragraph (d)(6)(v) is redesignated

as paragraph (d)(6)(vi).

8. New paragraph (d)(6)(v) is added

and reserved.

9. Paragraph (e)(2) is amended as

follows:

a. The paragraph heading and text of

paragraph (e)(2) are redesignated as

paragraph (e)(2)(i).

b. In newly designated paragraph

(e)(2)(i) the language ‘‘(e)(2)’’ is removed and ‘‘(e)(2)(i)’’ is added in its

place.

c. A new paragraph heading for

paragraph (e)(2) is added.

d. Paragraph (e)(2)(ii) is added.

10. Paragraph (e)(3)(ii) is revised.

11. Paragraph (e)(5) is amended as

follows:

a. The second sentence in Example 1

is revised.

b. In the list below, for each

sentence in Example 1 indicated in the

left column, remove the language in the

middle column and add the language in

the right column:

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sentence

first and third sentence

Remove

1993

Add

1997

first sentence

§ 1.882–5(b)

§ 1.882–5(c)

fourth and fifth sentence

§ 1.882–5(b)(2)

§ 1.882–5(c)(2)

seventh sentence

amount

value

seventh sentence

§ 1.882–5(b)(1)

§ 1.882–5(b)(2)

c. The second sentence in paragraph (i) of Example 2 is revised.

d. In the list below, for each paragraph in Example 2 indicated in the left column, remove the language in the middle

column and add the language in the right column:

Paragraph

Remove

Add

(i) first sentence

(i) third and fifth sentence

(ii) first, second, and third sentence

(ii) second sentence

(iii) first sentence

(iii) last sentence

1993

1994

1995

1994

1995

1994

1997

1998

1999

1998

1999

1998

12. Paragraph (i)(4) is added.

The additions and revisions read as

follows:

§ 1.884–1 Branch profits tax.

(2) * * * (i) In general. * * *

(ii) Bad debt reserves. A bank

described in section 585(a)(2)(B) (without regard to the second sentence

thereof) that uses the reserve method of

accounting for bad debts for U.S.

federal income tax purposes shall decrease the amount of loans that qualify

as U.S. assets by any reserve that is

permitted under section 585.

(d) * * *

(2) * * *

(xi) * * *

Example 2. U.S. real property interest connected to a U.S. business. FC is a foreign

corporation that is a bank, within the meaning of

section 585(a)(2)(B) (without regard to the

second sentence thereof), and is engaged in the

business of taking deposits and making loans

through its branch in the United States. In 1996,

FC makes a loan in the ordinary course of its

lending business in the United States, securing

the loan with a mortgage on the U.S. real

property being financed by the borrower. In

1997, after the borrower has defaulted on the

loan, FC takes title to the real property that

secures the loan. On December 31, 1997, FC

continues to hold the property, classifying it on

its financial statement as Other Real Estate

Owned. Because all income and gain from the

property would be ECI to FC under the

principles of section 864(c)(2), the U.S. real

property constitutes a U.S. asset within the

meaning of paragraph (d) of this section.

(3) Interest in a partnership—(i) In

general. A foreign corporation that is a

partner in a partnership must take into

account its interest in the partnership

(and not the partnership assets) in

determining its U.S. assets. For purposes of determining the proportion of

the partnership interest that is a U.S.

asset, a foreign corporation may elect

to use either the asset method described

in paragraph (d)(3)(ii) of this section or

the income method described in paragraph (d)(3)(iii) of this section.

(ii) Asset method—(A) In general. A

partner’s interest in a partnership shall

be treated as a U.S. asset in the same

proportion that the sum of the partner’s

proportionate share of the adjusted

bases of all partnership assets as of the

determination date, to the extent that

the assets would be treated as U.S.

assets if the partnership were a foreign

corporation, bears to the sum of the

partner’s proportionate share of the

adjusted bases of all partnership assets

as of the determination date. Generally

a partner’s proportionate share of a

partnership asset is the same as its

proportionate share of all items of

income, gain, loss, and deduction that

may be generated by the asset.

(B) Non-uniform proportionate

shares. If a partner’s proportionate

share of all items of income, gain, loss,

and deduction that may be generated by

a single asset of the partnership

throughout the period that includes the

taxable year of the partner is not

uniform, then, for purposes of determining the partner’s proportionate

share of the adjusted basis of that asset,

a partner must take into account the

portion of the adjusted basis of the

asset that reflects the partner’s

economic interest in that asset. A

partner’s economic interest in an asset

of the partnership must be determined

by applying the following presumptions. These presumptions may, however, be rebutted if the partner or the

Internal Revenue Service shows that

the presumption is inconsistent with the

partner’s true economic interest in the

asset during the corporation’s taxable

year.

(1) If a partnership asset ordinarily

generates directly identifiable income, a

partner’s economic interest in the asset

is determined by reference to its

proportionate share of income that may

be generated by the asset for the

partnership’s taxable year ending with

or within the partner’s taxable year.

(2) If a partnership asset ordinarily

generates current deductions and ordinarily generates no directly identifiable income, for example because the

asset contributes equally to the generation of all the income of the partnership (such as an asset used in

general and administrative functions), a

partner’s economic interest in the asset

is determined by reference to its

proportionate share of the total deductions that may be generated by the

asset for the partnership’s taxable year

ending with or within the partner’s

taxable year.

(3) For other partnership assets not

described in paragraph (d)(3)(ii)(B)(1)

or (2) of this section, a partner’s

economic interest in the asset is deter-

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mined by reference to its proportionate

share of the total gain or loss to which

it would be entitled if the asset were

sold at a gain or loss in the partnership’s taxable year ending with or

within the partner’s taxable year.

election in accordance with section

754, then for purposes of this paragraph (d)(3)(ii), the basis of partnership

property shall reflect adjustments made

pursuant to sections 734 (relating to

distributions of property to a partner)

and 743 (relating to the transfer of an

interest in a partnership). However,

adjustments made pursuant to section

743 may be made with respect to a

transferee partner only.

(iii) Income method. Under the income method, a partner’s interest in a

partnership shall be treated as a U.S.

asset in the same proportion that its

distributive share of partnership ECI

for the partnership’s taxable year that

ends with or within the partner’s

taxable year bears to its distributive

share of all partnership income for that

taxable year.

(iv) Manner of election—(A) In

general. In determining the proportion

of a foreign corporation’s interest in a

partnership that is a U.S. asset, a

foreign corporation must elect one of

the methods described in paragraph

(d)(3) of this section on a timely filed

return for the first taxable year beginning on or after the effective date of

this section. An amended return does

not qualify for this purpose, nor shall

the provisions of § 301.9100–1 of this

chapter and any guidance promulgated

thereunder apply. An election shall be

made by the foreign corporation calculating its U.S. assets in accordance

with the method elected. An elected

method must be used for a minimum

period of five years before the foreign

corporation may elect a different

method. To change an election before

the end of the requisite five-year

period, a foreign corporation must

obtain the consent of the Commissioner

or her delegate. The Commissioner or

her delegate will generally consent to a

foreign corporation’s request to change

its election only in rare and unusual

circumstances. A foreign corporation

that is a partner in more than one

partnership is not required to elect to

use the same method for each partnership interest.

(B) Elections with tiered partnerships. If a foreign corporation elects to

use the asset method with respect to an

interest in a partnership, and that

partnership is a partner in a lower-tier

partnership, the foreign corporation

may apply either the asset method or

the income method to determine the

proportion of the upper-tier partnership’s interest in the lower-tier

partnership that is a U.S. asset.

(v) Failure to make proper election.

If a foreign corporation, for any reason,

fails to make an election to use one of

the methods required by paragraph

(d)(3) of this section in a timely

fashion, the district director or the

Assistant Commissioner (International)

may make the election on behalf of the

foreign corporation and such election

shall be binding as if made by that

corporation.

(vi) Special rule for determining a

partner’s adjusted basis in a partnership interest. For purposes of paragraphs (d)(3) and (6) of this section, a

partner’s adjusted basis in a partnership

interest shall be the partner’s basis in

such interest (determined under section

705) reduced by the partner’s share of

the liabilities of the partnership determined under section 752 and increased

by a proportionate share of each

liability of the partnership equal to the

partner’s proportionate share of the

expense, for income tax purposes,

attributable to such liability for the

taxable year. A partner’s adjusted basis

in a partnership interest cannot be less

than zero.

(vii) E&P basis of a partnership

interest. See paragraph (d)(6)(iii) of

this section for special rules governing

the calculation of a foreign corporation’s E&P basis in a partnership

interest.

(viii) The application of this paragraph (d)(3) is illustrated by the

following examples:

Example 1. General rule—(i) Facts. Foreign

corporation, FC, is a partner in partnership ABC,

which is engaged in a trade or business within

the United States. FC and ABC are both calendar

year taxpayers. ABC owns and manages two

office buildings located in the United States,

each with an adjusted basis of $50. ABC also

owns a non-U.S. asset with an adjusted basis of

$100. ABC has no liabilities. Under the partnership agreement, FC has a 50 percent interest

in the capital of ABC and a 50 percent interest in

all items of income, gain, loss, and deduction

that may be generated by the partnership’s

assets. FC’s adjusted basis in ABC is $100. In

determining the proportion of its interest in ABC

that is a U.S. asset, FC elects to use the asset

method described in paragraph (d)(3)(ii) of this

section.

(ii) Analysis. FC’s interest in ABC is treated

as a U.S. asset in the same proportion that the

sum of FC’s proportionate share of the adjusted

bases of all ABC’s U.S. assets (50% of $100),

bears to the sum of FC’s proportionate share of

the adjusted bases of all of ABC’s assets (50%

of $200). Under the asset method, the amount of

FC’s interest in ABC that is a U.S. asset is $50

($100 2 $50/$100).

Example 2. Special allocation of gain with

respect to real property—(i) Facts. The facts are

the same as in Example 1, except that under the

partnership agreement, FC is allocated 20 percent

of the income from the partnership property but

80 percent of the gain on disposition of the

partnership property.

(ii) Analysis. Assuming that the buildings

ordinarily generate directly identifiable income,

there is a rebuttable presumption under paragraph

(d)(3)(ii)(B)(1) of this section that FC’s proportionate share of the adjusted basis of the

buildings is FC’s proportionate share of the

income generated by the buildings (20%) rather

than the total gain that it would be entitled to

under the partnership agreement (80%) if the

buildings were sold at a gain on the determination date. Thus, the sum of FC’s proportionate

share of the adjusted bases in ABC’s U.S. assets

(the buildings) is presumed to be $20 [(20% of

$50) + (20% of $50)]. Assuming that the nonU.S. asset is not income-producing and does not

generate current deductions, there is a rebuttable

presumption under paragraph (d)(3)(ii)(B)(3) of

this section that FC’s proportionate share of the

adjusted basis of that asset is FC’s interest in the

gain on the disposition of the asset (80%) rather

than its proportionate share of the income that

may be generated by the asset (20%). Thus, FC’s

proportionate share of the adjusted basis of

ABC’s non-U.S. asset is presumed to be $80

(80% of $100). FC’s proportionate share of the

adjusted bases of all of the assets of ABC is

$100 ($20 + $80). The amount of FC’s interest

in ABC that is a U.S. asset is $20 ($100 2

$20/$100).

Example 3. Tiered partnerships (asset

method)—(i) Facts. The facts are the same as in

Example 1, except that FC’s adjusted basis in

ABC is $175 and ABC also has a 50 percent

interest in the capital of partnership DEF. DEF

owns and operates a commercial shopping center

in the United States with an adjusted basis of

$200 and also owns non-U.S. assets with an

adjusted basis of $100. DEF has no liabilities.

ABC’s adjusted basis in its interest in DEF is

$150 and ABC has a 50 percent interest in all

the items of income, gain, loss and deduction

that may be generated by the assets of DEF.

(ii) Analysis. Because FC has elected to use

the asset method described in paragraph (d)(3)(ii)

of this section, it must determine what proportion

of ABC’s partnership interest in DEF is a U.S.

asset. As permitted by paragraph (d)(3)(iv)(B) of

this section, FC also elects to use the asset

method with respect to ABC’s interest in DEF.

ABC’s interest in DEF is treated as a U.S. asset

in the same proportion that the sum of ABC’s

proportionate share of the adjusted bases of all

DEF’s U.S. assets (50% of $200), bears to the

sum of ABC’s proportionate share of the

adjusted bases of all of DEF’s assets (50% of

$300). Thus, the amount of ABC’s interest in

DEF that is a U.S. asset is $100 ($150 2

$100/$150). FC must then apply the rules of

paragraph (d)(3)(ii) of this section to all the

assets of ABC, including ABC’s interest in DEF

that is treated in part as a U.S. asset ($100) and

in part as a non-U.S. asset ($50). FC’s interest in

ABC is treated as a U.S. asset in the same

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proportion that the sum of FC’s proportionate

share of the adjusted bases of the U.S. assets of

ABC (including ABC’s interest in DEF), bears to

the sum of FC’s proportionate share of the

adjusted bases of all ABC’s assets (including

ABC’s interest in DEF). Thus, the amount of

FC’s interest in ABC that is a U.S. asset is $100

(FC’s adjusted basis in ABC ($175) multiplied

by FC’s proportionate share of the sum of the

adjusted bases of ABC’s U.S. assets ($100)) over

FC’s proportionate share of the sum of the

adjusted bases of ABC’s assets ($175)).

Example 4. Tiered partnerships (income

method)—(i) Facts. The facts are the same as in

Example 3, except that FC has elected to use the

income method described in paragraph (d)(3)(iii)

of this section to determine the proportion of its

interest in ABC that is a U.S. asset. The two

office buildings located in the United States

generate $60 of income that is ECI for the

taxable year. The non-U.S. asset is not-income

producing. In addition ABC’s distributive share

of income from DEF consists of $40 of income

that is ECI and $140 of income that is not ECI.

(ii) Analysis. Because FC has elected to use

the income method it does need to determine

what proportion of ABC’s partnership interest in

DEF is a U.S. asset. FC’s interest in ABC is

treated as a U.S. asset in the same proportion

that its distributive share of ABC’s income for

the taxable year that is ECI ($50) ($30 earned

directly by ABC + $20 distributive share from

DEF) bears to its distributive share of all ABC’s

income for the taxable year ($55) ($30 earned

directly by ABC + $25 distributive share from

DEF). Thus, FC’s interest in ABC that is a U.S.

asset is $159 ($175 2 $50/$55).

determined under this paragraph

(e)(2)(ii) is the amount (as of the

determination date) of liabilities described in § 1.882–5(a)(1)(ii) (relating

to liabilities giving rise to interest

expense that is directly allocated to

income from a U.S. asset).

(3) * * *

(ii) Limitation. For any taxable year,

a foreign corporation may elect to

reduce the amount of its liabilities

determined under paragraph (e)(1) of

this section by an amount that does not

exceed the excess, if any, of the

amount of liabilities in paragraph (e)(1)

of this section over the amount, as of

the determination date, of U.S. booked

liabilities (determined under § 1.882–

5(d)(2)) and liabilities described in

paragraph (e)(2) of this section.

(5) * * *

Example 1. * * * For purposes of computing

its U.S.- connected liabilities under § 1.882–5(c),

A must determine the average total value of its

assets that are U.S. assets. * * *

Example 2. * * * A has $800 of liabilities

under paragraph (e)(1) of this section and $300

of liabilities properly reflected on the books of

its U.S. trade or business under § 1.882–5(d)(2).

* * *

(4) Interest in a trust or estate—(i)

Estates and non-grantor trusts. A foreign corporation that is a beneficiary of

a trust or estate shall not be treated as

having a U.S. asset by virtue of its

interest in the trust or estate.

(ii) Grantor trusts. If, under sections

671 through 678, a foreign corporation

is treated as owning a portion of a trust

that includes all the income and gain

that may be generated by a trust asset

(or pro rata portion of a trust asset), the

foreign corporation will be treated as

owning the trust asset (or pro rata

portion thereof) for purposes of determining its U.S. assets under this

section.

(5) * * *

(iii) Interbranch transactions. A

transaction of any type between separate offices or branches of the same

taxpayer does not create a U.S. asset.

(6) * * *

(v) Computation of E&P basis of

financial instruments. [Reserved]

(e) * * *

(2) Additional liabilities—(i) * * *

(ii) Liabilities described in § 1.882–

5(a)(1)(ii). The amount of liabilities

(i) * * *

(4) Special rules for certain U.S.

assets and liabilities. Paragraphs

(c)(2)(i) and (ii), (d)(3), (d)(4),

(d)(5)(iii), (d)(6)(iii), (d)(6)(vi), (e)(2),

and (e)(3)(ii), of this section are

effective for taxable years beginning on

or after June 6, 1996.

Par. 6. § 1.884–2 is added to read as

follows:

§ 1.884–2 Special rules for termination

or incorporation of a U.S. trade or

business or liquidation or reorganization of a foreign corporation or its

domestic subsidiary.

(a) through (a)(2)(i) [Reserved] For

further information, see § 1.884–2T(a)

through (a)(2)(ii).

(a)(2)(ii) Waiver of period of limitations. The waiver referred to in

§ 1.884–2T(a)(2)(i)(D) shall be executed on Form 8848, or substitute

form, and shall extend the period for

assessment of the branch profits tax for

the year of complete termination to a

date not earlier than the close of the

sixth taxable year following that tax-

able year. This form shall include such

information as is required by the form

and accompanying instructions. The

waiver must be signed by the person

authorized to sign the income tax

returns for the foreign corporation

(including an agent authorized to do so

under a general or specific power of

attorney). The waiver must be filed on

or before the date (including extensions) prescribed for filing the foreign

corporation’s income tax return for the

year of complete termination. With

respect to a complete termination occurring in a taxable year ending prior

to June 6, 1996, a foreign corporation

may also satisfy the requirements of

this paragraph (a)(2)(ii) by applying

§ 1.884–2T(a)(2)(ii) of the temporary

regulations (as contained in the CFR

edition revised as of April 1, 1995). A

properly executed Form 8848, substitute form, or other form of waiver

authorized by this paragraph (a)(2)(ii)

shall be deemed to be consented to and

signed by a Service Center Director or

the Assistant Commissioner (International) for purposes of § 301.6501(c)–

1(d) of this chapter.

(a)(3) through (a)(4) [Reserved] For

further information, see § 1.884–

2T(a)(3) through (a)(4).

(a)(5) Special rule if a foreign

corporation terminates an interest in a

trust. A foreign corporation whose

beneficial interest in a trust terminates

(by disposition or otherwise) in any

taxable year shall be subject to the

branch profits tax on ECEP attributable

to amounts (including distributions of

accumulated income or gain) treated as

ECI to such beneficiary in such taxable

year notwithstanding any other provision of § 1.884–2T(a).

(b) through (c)(2)(ii) [Reserved] For

further information, see § 1.884–2T(b)

through (c)(2)(ii).

(c)(2)(iii) Waiver of period of limitations and transferee agreement. In the

case of a transferee that is a domestic

corporation, the provisions of § 1.884–

2T(c)(2)(i) shall not apply unless, as

part of the section 381(a) transaction,

the transferee executes a Form 2045

(Transferee Agreement) and a waiver

of period of limitations as described in

this paragraph (c)(2)(iii), and files both

documents with its timely filed (including extensions) income tax return for

the taxable year in which the section

381(a) transaction occurs. The waiver

shall be executed on Form 8848, or

substitute form, and shall extend the

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period for assessment of any additional

branch profits tax for the taxable year

in which the section 381(a) transaction

occurs to a date not earlier than the

close of the sixth taxable year following the taxable year in which such

transaction occurs. This form shall

include such information as is required

by the form and accompanying instructions. The waiver must be signed by

the person authorized to sign Form

2045. With respect to a complete

termination occurring in a taxable year

ending prior to June 6, 1996, a foreign

corporation may also satisfy the requirements of this paragraph (c)(2)(iii)

by applying § 1.884–2T(c)(2)(iii) of the

temporary regulations (as contained in

the CFR edition revised as of April 1,

1995). A properly executed Form 8848,

substitute form, or other form of waiver

authorized by this paragraph (c)(2)(iii)

shall be deemed to be consented to and

signed by a Service Center Director or

the Assistant Commissioner (International) for purposes of § 301.6501(c)–

1(d) of this chapter.

(c)(3) through (f) [Reserved] For

further information, see § 1.884–

2T(c)(3) through (f).

(g) Effective dates. Paragraphs

(a)(2)(ii) and (c)(2)(iii) of this section

are effective for taxable years begin-

ning after December 31, 1986. Paragraph (a)(5) of this section is effective

for taxable years beginning on or after

June 6, 1996.

Par. 7. Section 1.884–2T is amended

as follows:

1. Paragraph (a)(2)(ii) is revised.

2. Paragraph (a)(5) is redesignated as

(a)(6).

3. New paragraph (a)(5) is added.

4. Paragraph (c)(2)(iii) is revised.

The additions and revisions read as

follows:

§ 1.884–2T Special rules for termination or incorporation of a U.S. trade or

business or liquidation or reorganization of a foreign corporation or its

domestic subsidiary (Temporary).

(a) * * *

(2) * * *

(ii) Waiver of period of limitations.

[Reserved] See § 1.884–2(a)(2)(ii) for

rules relating to this paragraph.

(5) Special rule if a foreign corporation terminates an interest in a trust.

[Reserved] See § 1.884–2(a)(5) for

rules relating to this paragraph.

(2) * * *

(iii) Waiver of period of limitations

and transferee agreement. [Reserved]

See § 1.884–2(c)(2)(iii) for rules relating to this paragraph.

Par. 8. Section 1.884–4 is amended

as follows:

1. In paragraph (a)(1), the fifth

sentence is revised.

2. Paragraph (a)(2)(iii) is revised.

3. Paragraph (b)(1) is revised and

paragraph (b)(2) is removed and reserved.

4. Paragraph (b)(3) is amended by:

a. Removing the reference

‘‘(b)(1)(v)’’ and adding the language

‘‘(b)(1)(ii)’’ in the following:

i. Paragraph (b)(3)(i), first sentence.

ii. Paragraph (b)(3)(ii), introductory

text.

iii. Paragraph (b)(3)(iii), heading and

introductory text.

b. Adding a sentence at the end of

paragraph (b)(3)(i).

5. Paragraph (b)(4) is removed and

reserved.

6. In the list below, for each paragraph indicated in the left column, remove the language in the middle column and add

the language in the right column:

Paragraph

Remove

Add

(a)(2)(i)(A)

apportioned

allocated or apportioned

(a)(4) Example 1 first sentence

(b)(2)

(a)(2)(iii)

(a)(4) Example 1 first and seventh sentence

apportioned

allocated or apportioned

(a)(4) Example 1 first, second, and eighth sentence

1993

1997

(a)(4) Example 2 first sentence

(b)(2)

(a)(2)(iii)

(a)(4) Example 2 second and third sentence

1993

1997

(b)(5)(i) last sentence

apportioned

allocated or apportioned

(b)(5)(ii) Example first, fifth, and last sentence

apportioned

allocated or apportioned

(b)(6) paragraph heading

apportioned

allocated or apportioned

(b)(6)(i) first and last sentence

apportioned

allocated or apportioned

(b)(6)(i) second sentence

(b)(1)(v)

(b)(1)(ii)

(b)(6)(ii) first and second sentence

(b)(1)(v)

(b)(1)(ii)

(b)(6)(ii) first and second sentence

paragraphs (b)(1)(i)

through (b)(i)(iv)

paragraph (b)(1)(i)

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Paragraph

Remove

Add

(b)(6)(iv) Example 1 introductory text,

paragraphs (i), (iii), and (iv), flush language first, fourth, and seventh sentence

1993

1997

(b)(6)(iv) Example 1 paragraph (ii)

1992

1996

(b)(6)(iv) Example 1 flush language second, and sixth sentence

(b)(1)(v)

(b)(1)(ii)

(c)(1)(iv) Example 1 first sentence

apportioned

allocated or apportioned

(c)(1)(iv) Example 1 first, second, third,

fifth, sixth, and seventh sentence

1993

1997

(c)(1)(iv) Example 1 third, fourth, and

seventh sentence

1994

1998

(c)(1)(iv) Example 2 second sentence

apportioned

allocated or apportioned

(c)(1)(iv) Example 2 first, second, third,

and last sentence

1993

1997

(c)(1)(iv) Example 2 second and last sentence

1994

1998

(c)(2)(i) first sentence

apportioned

allocated or apportioned

(c)(4) Example third, fourth, fifth, sixth,

and eighth sentence

1993

1997

(c)(4) Example fifth sentence

allocated

allocated or apportioned

7. Paragraph (e) is amended as

follows:

a. The text of paragraph (e) is

redesignated as paragraph (e)(1) and a

paragraph heading for (e)(1) is added.

b. The first sentence of newly

designated paragraph (e)(1) is revised.

8. Paragraph (e)(2) is added.

The revisions and additions read as

follows:

§ 1.884–4 Branch-level interest tax.

(a) * * * (1) * * * For purposes of

this section, a foreign corporation also

shall be treated as engaged in trade or

business in the United States if, at any

time during the taxable year, it owns an

asset taken into account under § 1.882–

5(a)(1)(ii) or (b)(1) for purposes of

determining the amount of the foreign

corporation’s interest expense allocated

or apportioned to ECI. * * *

(2) * * *

(iii) Treatment of a portion of the

excess interest of banks as interest on

deposits. A portion of the excess

interest of a foreign corporation that is

a bank (as defined in section

585(a)(2)(B) without regard to the

second sentence thereof) provided that

a substantial part of its business in the

United States, as well as all other

countries in which it operates, consists

of receiving deposits and making loans

and discounts, shall be treated as

interest on deposits (as described in

section 871(i)(3)), and shall be exempt

from the tax imposed by section 881(a)

as provided in such section. The

portion of the excess interest of the

foreign corporation that is treated as

interest on deposits shall equal the

product of the foreign corporation’s

excess interest and the greater of—

(A) The ratio of the amount of

interest bearing deposits, within the

meaning of section 871(i)(3)(A), of the

foreign corporation as of the close of

the taxable year to the amount of all

interest bearing liabilities of the foreign

corporation on such date; or

(B) 85 percent.

(b) Branch interest—(1) Definition

of branch interest. For purposes of this

section, the term ‘‘branch interest’’

means interest that is —

(i) Paid by a foreign corporation with

respect to a liability that is—

(A) A U.S. booked liability within

the meaning of § 1.882–5(d)(2) (other

than a U.S. booked liability of a

partner within the meaning of § 1.882–

5(d)(2)(vii)); or

(B) Described in § 1.884–1(e)(2)

(relating to insurance liabilities on U.S.

business and liabilities giving rise to

interest expense that is directly allocated to income from a U.S. asset); or

(ii) In the case of a foreign corporation other than a corporation described

in paragraph (a)(2)(iii) of this section, a

liability specifically identified (as

provided in paragraph (b)(3)(i) of this

section) as a liability of a U.S. trade or

business of the foreign corporation on

or before the earlier of the date on

which the first payment of interest is

made with respect to the liability or the

due date (including extensions) of the

foreign corporation’s income tax return

for the taxable year, provided that—

(A) The amount of such interest does

not exceed 85 percent of the amount of

interest of the foreign corporation that

would be excess interest before taking

into account interest treated as branch

interest by reason of this paragraph

(b)(1)(ii);

(B) The requirements of paragraph

(b)(3)(ii) of this section (relating to

notification of recipient of interest) are

satisfied; and

paragraph (b)(3)(iii) of this section

(relating to liabilities incurred in the

ordinary course of a foreign business or

secured by foreign assets) or paragraph

(b)(1)(i) of this section.

(2) [Reserved]

(3)(i) * * * A foreign corporation

that is subject to this section may

identify a liability under paragraph

(b)(1)(ii) of this section whether or not

it is actually engaged in the conduct of

a trade or business in the United States.

* * *

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* * *

(4) [Reserved]

* * * * * *

(e) Effective dates—(1) General rule.

Except as provided in paragraph (e)(2)

of this section, this section is effective

for taxable years beginning October 13,

1992, and for payments of interest

described in section 884(f)(1)(A) made

(or treated as made under paragraph

(b)(7) of this section) during taxable

years of the payor beginning after such

date. * * *

(2) Special rule. Paragraphs (a)(1),

(a)(2)(i)(A), (a)(2)(iii), (b)(1), (b)(3),

(b)(5)(i), (b)(6)(i), (b)(6)(ii), and

(c)(2)(i) of this section are effective for

taxable years beginning on or after

June 6, 1996.

Par. 9. In section 1.884–5, paragraphs (e)(4)(ii) and (g) are revised to

read as follows:

§ 1.884–5 Qualified resident

(f) * * *

(2) * * *

(i) Held for the principal purpose of

promoting the present conduct of the

trade or business,

PART 602—OMB CONTROL

NUMBERS UNDER THE

PAPERWORK REDUCTION ACT

Par. 11. The authority for part 602

continues to read as follows:

Authority: 26 U.S.C. 7805.

Par. 12. In § 602.101, the table in

paragraph (c) is amended by adding in

numerical order ‘‘§ 1.884–2 . . . 1545–

1070’’.

Margaret Milner Richardson,

Commissioner of Internal Revenue.

Approved February 28, 1996.

(e) * * *

(4) * * *

(ii) Presumption for banks. A U.S.

trade or business of a foreign corporation that is described in § 1.884–

4(a)(2)(iii) shall be presumed to be an

integral part of an active banking

business conducted by the foreign

country in its country of residence

provided that a substantial part of the

business of the foreign corporation in

both its country of residence and the

United States consists of receiving

deposits and making loans and discounts. This paragraph shall be effective for taxable years beginning on or

after June 6, 1996.

* * * * * *

(g) * * * Except as provided in

paragraph (e)(4)(ii) of this section, this

section is effective for taxable years

beginning on or after October 13, 1992.

* * *

* * * * * *

Par. 10. Section 1.897–1 is amended

as follows:

1. In paragraph (f)(1)(iii) the language ‘‘stock,’’ is removed.

2. Paragraph (f)(2)(i) is revised to

read as follows:

§ 1.897–1 Taxation of foreign investments in United States real property

interests, definition of terms.

Leslie Samuels,

Assistant Secretary of the Treasury.

(Filed by the Office of the Federal Register on

March 5, 1996, 8:45 a.m., and published in the

issue of the Federal Register for March 8,

1996, 61 F.R. 9336)

Section 882.—Tax on Income of

Foreign Corporations Connected With

United States Business

26 CFR 1.882–5: Determination of interest

deduction.

T.D. 8658

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

Determination of Interest Expense Deduction of Foreign Corporations

AGENCY: Internal Revenue Service

(IRS), Treasury.

ACTION: Final regulations.

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

§ 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

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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. § 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 § 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 threestep methodology described in the final

regulations. In response to commenters’

questions, however, § 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 § 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

§ 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 § 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

§ 1.882–5 with any other section that

disallows, defers, or capitalizes interest

expense, and include examples that

illustrate how § 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 § 1.882–5. The final regulations

provide uniform rules for changing any

election prescribed under § 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

§ 1.882–5 calculations in cases where,

under the authority of § 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

§ 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 § 1.881–3 from serving

its function as an anti-abuse rule.

3. § 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 § 1.884–1(d) generally governs

its classification as a U.S. asset for

purposes of § 1.882–5. Under the rules

of § 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 § 1.882–5 regulations were issued in 1992, the regulations under § 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 § 1.882–5

regulations now closely conform to the

§ 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 § 1.882–5 applies to partnership interests held by foreign corporations. With the elimination of

§ 1.861–9T(e)(7)(i) by these regulations, § 1.884–1(d)(3) and § 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

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under § 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 § 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 § 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 § 1.864–4(c)(2). In

addition, the final regulations specify

that a taxpayer may achieve the same

result under § 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 § 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 debtfinanced under the principles of section

246A. This stock cut-back rule is

eliminated from the final § 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

§ 1.864–4(c). This is because the final

regulations under § 1.864–4, which are

being issued contemporaneously with

these regulations elsewhere in this issue

of the Bulletin, generally eliminate any

inference that stock can produce effectively connected income under the

asset-use test of § 1.864–4(c)(2).

The final regulations add an antiabuse rule similar to the rule in

§ 1.884–1(d)(5)(ii) to prevent taxpayers

from artificially increasing the amount

of their U.S. assets.

4. § 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

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 § 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.

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5. § 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 § 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 § 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. § 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 § 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 § 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 § 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.

Drafting Information

Several persons from the Office of

Chief Counsel and the Treasury Department participated in drafting these

regulations.

Adoption of

Regulations

Amendments

the

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

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U.S.C. 988(d), and 26 U.S.C. 7701(l). *

* *

§ 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. Sections 1.882–0 is added to

read as follows:

§ 1.882–0 Table of contents.

This section lists captions contained

in §§ 1.882–1, 1.882–2, 1.882–3,

1.882–4 and 1.882–5.

§ 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.

status.

(d) Credits against tax.

(e) Payment of estimated tax.

(f) Effective date.

§ 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.

(d) Effective date.

§ 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.

in U.S. business.

(d) Effective date.

§ 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.

§ 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 § 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.

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.

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(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:

§ 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) 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 § 1.861–10T(b) and

(c), as limited by § 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 § 1.861–10T. For

purposes of paragraphs (b)(1) or (c)(2)

of this section, a foreign corporation

that allocates its interest expense under

the direct allocation rule of this para-

graph (a)(1)(ii)(A) shall reduce the

basis of the asset that meets the

requirements of § 1.861–10T(b) and (c)

by the principal amount of the indebtedness that meets the requirements

of § 1.861–10T(b) and (c). The foreign

corporation shall also disregard any

indebtedness that meets the requirements of § 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 paragraphs (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 § 1.861–10T(b) and (c), as limited

by § 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 § 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 § 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 § 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 § 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.

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(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 § 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

§ 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 § 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

§ 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 § 1.892–5T.

(7) Elections under § 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 § 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

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 2002 to P in exchange for

its partnership interest. P incurs qualified nonrecourse indebtedness within the meaning of

§ 1.861–10T to purchase an airplane. FC’s share

of the liability of P, as determined under section

752, is 8002.

(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 8002 liability as determined

under section 752, but is not increased by the

800x 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 800x 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 § 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

§ 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 § 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:

$12 2

$50 Tax-exempt U.S. assets

= $4

$150 Total U.S. assets

(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

§ 1.882–5, is $500.

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(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 § 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 § 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:

$500 2

$100 Treaty-exempt U.S. assets

= $50

$1000 Total U.S. assets

(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 § 1.884–

1(d). For purposes of this section, the

term determination date, as used in

§ 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 § 1.864–4(c)(2) or (3)

if held directly by the foreign corporation and either was initially acquired

through foreclosure or similar proceed-

ings 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);

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 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 § 1.861–9T(g)(1)(iii),

and provided the taxpayer uses the

methodology prescribed in § 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 § 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.

amount of U.S.-connected liabilities for

the taxable year—(1) General rule.

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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 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 § 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 corpo-

ration 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

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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 § 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

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

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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

Asset 2

Asset 3

Liability 1

Liability 2

Capital

$2,000

$2,500

$5,500

Amount

Interest

Expense

$ 800

$3,200

$6,000

256

(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 2 40%).

(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 2 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 2 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 2 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 3 5)).

(ii) U.S.-connected liabilities. Because Z’s

U.S. booked liabilities of $400 exceed its U.S.-

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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 3 $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 § 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:

U.S. Dollar Assets

U Assets

Average Value

$20,000

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 2

95%), and U4750 (U5000 2 95%).

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 2 6%), the sum of the

expense associated with its U.S. dollar liabilities,

plus U570 (U4750 2 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]

(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.

(Filed by the Office of the Federal Register on

March 5, 1996, 8:45 a.m., and published in the

issue of the Federal Register for March 8,

1996, 61 F.R. 9326)

Section 1274.—Determination of

Issue Price in the Case of Certain

Debt Instruments Issued for Property

(Also Sections 42, 280G, 382, 412, 467, 468,

482, 483, 807, 846, 1288, 7520, 7872.)

Federal rates; adjusted federal rates;

adjusted federal long-term rate, and

the long-term exempt rate. For purposes of sections 1274, 1288, 382, and

other sections of the Code, tables set

forth the rates for April 1996.

Rev. Rul. 96–19

This revenue ruling provides various

prescribed rates for federal income tax

purposes for April 1996 (the current

month.) Table 1 contains the shortterm, mid-term, and long-term applicable federal rates (AFR) for the current

month for purposes of section 1274(d)

of the Internal Revenue Code. Table 2

contains the short-term, mid-term, and

long-term adjusted applicable federal

rates (adjusted AFR) for the current

month for purposes of section 1288(b).

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Table 3 sets forth the adjusted federal

long-term rate and the long-term taxexempt rate described in section 382(f).

Table 4 contains the appropriate percentages for determining the low-

income housing credit described in

section 42(b)(2) for buildings placed in

service during the current month. Finally, Table 5 contains the federal rate

for determining the present value of an

annuity, an interest for life or for a

term of years, or a remainder or a

reversionary interest for purposes of

section 7520.

REV. RUL. 96–19 TABLE 1

Applicable Federal Rates (AFR) for April 1996

Period for Compounding

Short-Term

AFR

110% AFR

120% AFR

130% AFR

Mid-Term

AFR

110% AFR

120% AFR

130% AFR

150% AFR

175% AFR

Long-Term

AFR

110% AFR

120% AFR

130% AFR

Annual

Semiannual

Quarterly

Monthly

5.33%

5.87%

6.41%

6.96%

5.26%

5.79%

6.31%

6.84%

5.23%

5.75%

6.26%

6.78%

5.20%

5.72%

6.23%

6.74%

5.88%

6.48%

7.08%

7.68%

8.89%

10.41%

5.80%

6.38%

6.96%

7.54%

8.70%

10.15%

5.76%

6.33%

6.90%

7.47%

8.61%

10.02%

5.73%

6.30%

6.86%

7.42%

8.55%

9.94%

6.51%

7.17%

7.84%

8.50%

6.41%

7.05%

7.69%

8.33%

6.36%

6.99%

7.62%

8.25%

6.33%

6.95%

7.57%

8.19%

REV. RUL. 96–19 TABLE 2

Adjusted AFR for April 1996

Period for Compounding

Short-Term

adjusted AFR

Mid-term

adjusted AFR

Long-term

adjusted AFR

Annual

3.40%

Semiannual

3.37%

Quarterly

3.36%

Monthly

3.35%

4.37%

4.32%

4.30%

4.28%

5.31%

5.24%

5.21%

5.18%

REV. RUL. 96–19 TABLE 3

Rates Under Section 382 for April 1996

Adjusted federal long-term rate for the current month

5.31%

Long-term tax-exempt rate for ownership changes during the current month (the highest of the

adjusted federal long-term rates for the current month and the prior two months.)

5.31%

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REV. RUL. 96–19 TABLE 4

Appropriate Percentages Under Section 42(b)(2)

for April 1996

Appropriate percentage for the 70% present value low-income housing credit

8.45%

Appropriate percentage for the 30% present value low-income housing credit

3.62%

REV. RUL. 96-19 TABLE 5

Rate Under Section 7520 for April 1996

Applicable federal rate for determining the present value of an annuity, an interest for life or a term

of years, or a remainder or reversionary interest

7.0%

Section 1288.—Treatment of Original

Issue Discount on Tax-Exempt

Obligations

The adjusted applicable federal short-term,

mid-term, and long-term rates are set forth for

the month of April 1996. See Rev. Rul. 96–19,

page 24.

Section 7520.—Valuation Tables

The adjusted applicable federal short-term,

mid-term, and long-term rates are set forth for

the month of April 1996. See Rev. Rul. 96–19,

page 24.

Section 7872.—Treatment of Loans

with Below-Market Interest Rates

The adjusted applicable federal short-term,

mid-term, and long-term rates are set forth for

the month of April 1996. See Rev. Rul. 96–19,

page 24.

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Part III. Administrative, Procedural, and Miscellaneous

Interest Netting Study

Notice 96–18

This Notice invites public comment

in connection with the Internal Revenue Service’s and Treasury’s study of

‘‘interest netting.’’ This study was

initially described in Announcement

96–5, ‘‘Administrative Initiatives to

Enhance Taxpayer Rights,’’ 1996–4

I.R.B. 99 at 101 (January 22, 1996).

BACKGROUND

The Internal Revenue Code provides

that taxpayers who underpay their taxes

generally must pay interest to the

government for the period of the

underpayment. Section 6601. The IRS

has limited authority to abate the

interest that is required by statute.

Section 6404.

The Code likewise generally requires

the government to pay interest to

taxpayers with respect to any overpayment of taxes. Section 6611. There are,

however, a number of limitations on

the government’s liability for interest,

including the rule that no interest is

payable with respect to a tax refund

claimed for a current year if the refund

is issued within 45 days of the last day

prescribed for filing a return claiming

the refund. Section 6611(e).

Prior to enactment of the Tax Reform Act of 1986, the same interest

rate applied to underpayments and

overpayments. The Tax Reform Act of

1986, however, provided for the interest rate charged on underpayments to

be one percentage point higher than the

interest rate paid on overpayments. See

§§ 6621(a)(1) and (2). The Omnibus

Budget Reconciliation Act of 1990

added that, under certain conditions,

the interest rate on large corporate

underpayments would be 3 percentage

points higher than the interest rate on

overpayments. The Uruguay Round

Agreements Act, enacted in 1994,

increased the differential between large

corporate underpayments and certain

corporate overpayments to 4.5 percentage points. See §§ 6621(a)(1) and (c).

If an overpayment is credited against

an underpayment, the effect of these

interest rate differences is reduced.

Section 6601(f) provides:

If any portion of a tax is satisfied by

credit of an overpayment, then no

interest shall be imposed . . . on the

portion of the tax so satisfied for any

period during which, if the credit had

not been made, interest would have

been allowable with respect to such

overpayment.

Section 6402(a) provides general

authority for the IRS to credit an

overpayment against an underpayment.

This section states:

In the case of any overpayment, the

Secretary, within the applicable period

of limitations, may credit the amount of

such overpayment, including any interest allowed thereon, against any liability in respect of an internal revenue

tax on the part of the person who made

the overpayment and shall . . . refund

any balance to such person.

Section 301.6402–1 of the Regulations on Procedure and Administration

provides that the Commissioner may

credit any overpayment of tax against

any ‘‘outstanding liability’’ for any tax.

Congress has recognized the potential burden that the interest rate differential places on taxpayers who have

both overpayments and underpayments.

Thus, each time Congress has increased

the interest rate differential, Congress

has stated in legislative history that the

Service should implement the most

comprehensive procedures ‘‘consistent

with sound administrative practice’’ to

allow overpayments to be credited

against underpayments. See H.R. Conf.

Rep. No. 841, 99th Cong., 2d. Sess.,

1986–3 C.B. (Vol. 4) 785 (accompanying the Tax Reform Act of 1986); H.R.

Conf. Rep. No. 964, 101st Cong., 2d

Sess., 1991–2 C.B. 591 (accompanying

the Omnibus Budget Reconciliation Act

of 1990); H.R. Rep. No. 826, 103d

Cong., 2d Sess., 1995–1 C.B. 254

(accompanying the Uruguay Round

Agreements Act).

The Service has developed substantial crediting procedures to implement

interest netting. For example:

(a) The Service will consider all

increases and decreases in a taxpayer’s

liabilities within a single tax year

before applying the statutory interest

rules to that year. Rev. Proc. 94–60,

1994–2 C.B. 774, provides that a

taxpayer will not be charged the

differential interest rate under

§ 6621(a) on an underpayment that is

satisfied by credit of an overpayment

arising in the same taxable year. This

interest netting procedure is referred to

as ‘‘annual interest netting.’’

(b) The Service permits crediting of

overpayments against underpayments

for the period of time when the

underpayments and overpayments are

both unpaid and outstanding, even if

they are from different tax years or for

different types of tax. This procedure

for interest netting is referred to as

‘‘offsetting.’’

The Service, however, generally does

not net interest where a taxpayer

realizes an overpayment in one tax year

that overlaps with a deficiency that a

taxpayer has already paid for a different tax year. Likewise, the Service

generally does not net interest where an

unpaid deficiency in one tax year

overlaps with an overpayment that the

Service has already paid for a different

tax year. This kind of interest netting is

referred to as ‘‘global interest netting.’’

The Eighth Circuit recently addressed whether the Service is required

to perform global interest netting calculations. Northern States Power Co.

v. United States, 73 F.3d 764 (8th Cir.

1996). Interpreting §§ 6402(a) and

301.6402–1, the Eighth Circuit held

that where the taxpayer’s liability was

fully paid, there was no ‘‘outstanding

liability’’ against which to net the

taxpayer’s subsequent overpayment.

The court further held that the Service,

in any event, has the discretion whether

to credit overpayments against underpayments.

REQUEST FOR PUBLIC COMMENT

Many taxpayers and practitioners

have suggested that the Service adopt

global interest netting procedures.

Global interest netting, however, raises

a number of legal, policy and administrative issues. Thus, Announcement

96–5 states that the Service will

conduct a study of these issues and

solicit public comments for the study.

Legal and Policy Issues of Global

Interest Netting

As described above, global interest

netting would allow the taxpayer or the

Service to recalculate interest for a

certain period of time whenever a

taxpayer has either a new overpayment

that overlaps with an underpayment

that the taxpayer has already paid to

the Service, or a new underpayment

that overlaps with an overpayment that

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the Service has already paid to the

taxpayer. The Service requests comments on the following issues:

1. In view of the policy generally

favoring the finality of tax determinations, should a rule concerning the

finality of global interest netting computations be adopted, and, if so, what

should that rule be? What effect, if

any, should the statute of limitations

have on global interest netting, particularly considering the language in

§ 6402(a) regarding the applicable

period of limitations? Should the statute of limitations be kept open longer

in light of global interest netting?

2. When would it be appropriate for

the Service to net interest globally for a

particular tax year or period? For

example, would it be appropriate to net

interest globally before the final decision of an appeal or court decision for a

tax period overlapping with the period

at issue that might affect the interest

calculation for such period? Would it be

appropriate to net interest globally before the final decision of an appeal or

court decision for a tax period that does

not overlap with the period at issue, if

such decision could produce an adjustment, such as a net operating loss or

credit, that might affect the interest

calculation for such period?

3. What would be the effect of

carrybacks and carryforwards (e.g., net

operating losses, various credits, etc.)

on the global interest netting calculation for a certain period? Would

carrybacks and carryforwards always

require a recalculation of interest for

such period? Or should global interest

netting calculations only be made after

carryforwards and carrybacks that

might affect the period at issue are

finally determined? How would the

analysis be affected by the restricted

interest provisions of §§ 6601(d) and

6611(f)?

4. Does global interest netting present any unique implications for taxpayers filing consolidated returns?

5. How would global interest netting

affect § 861 allocations or interact with

other U.S. international tax provisions?

system but must instead retrieve the

data on paid deficiencies and paid

refunds from its computer storage files

and then manually make the interest

calculations. This procedure could entail a significant additional commitment

of IRS resources, primarily because of

the need to verify the accuracy and

completeness of the data necessary to

make a global interest netting calculation and ensure an accurate calculation.

Accordingly, the Service requests the

following comments:

1. To the extent that taxpayers or

practitioners currently make global interest netting calculations for themselves or their clients, the Service

would like to receive a detailed description of how those calculations are

performed, the cost of performing those

calculations, and the reasons why the

method used by particular taxpayers or

practitioners would be appropriate for

the Service to apply to large numbers

of taxpayers without requiring significant additional Service resources.

2. How should the Service fulfill its

obligation to verify the accuracy and

completeness of all taxpayer data relevant to make a global interest netting

calculation for a particular period,

given the Service’s computer data

storage limitations?

Time and Address for Comments

The Service and Treasury would

appreciate written comments on the

above issues. Comments should be

submitted by June 30, 1996, to:

Internal Revenue Service

P.O. Box 7604

Ben Franklin Station

Attn: CC:DOM:CORP:T:R:IT&A

(Branch 1) Room 5228

Washington, DC 20044

The comments you submit will be

available for public inspection and

copying.

DRAFTING INFORMATION

For further information regarding

this notice, contact Joel Rutstein on

(202) 622-4530 (not a toll-free call).

Administrative Issues

The Service’s computer system does

not have the data storage capacity to

keep information concerning paid deficiencies and paid refunds on line. The

Service thus cannot make global interest netting calculations on its computer

Study of Certain Joint Return and

Community Property Issues For

Divorced and Separated Taxpayers

Notice 96–19

This Notice invites public comments

for a study being conducted by the

Service and Treasury on certain joint

return and community property issues,

particularly as they affect divorced and

separated taxpayers. This study was

initially described in Announcement

96–5, ‘‘Administrative Initiatives to

Enhance Taxpayer Rights,’’ 1996–4

I.R.B. 99 at 101 (Jan. 22, 1996).

BACKGROUND

Section 6013(a) of the Internal Revenue Code generally provides that

spouses may file a joint return even

though one of the spouses has neither

gross income nor deductions. Section

6013(d)(3) states that spouses are

jointly and severally liable for the taxes

on a joint return.

For married taxpayers who filed

jointly but then divorce or separate,

joint and several liability means that a

former spouse remains liable for all

taxes, additions to tax, penalties a

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