Proposed Amendments to the Regulations on the Determination of Interest Expense Deduction of Foreign Corporations and Branch Profits Tax

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[INTL-0054-95]

RIN 1545-AT96

Proposed Amendments to the Regulations on the Determination of

Interest Expense Deduction of Foreign Corporations and Branch Profits

Tax

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

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SUMMARY: This document contains proposed Income Tax Regulations

relating to the determination of the interest expense deduction of

foreign corporations under section 882 and the branch profits tax under

section 884 of the Internal Revenue Code of 1986. These proposed

regulations are necessary to provide guidance that coordinates with

guidance provided in final regulations under sections 882 and 884

published elsewhere in this issue of the Federal Register. These

regulations will affect foreign corporations engaged in a U.S. trade or

business. This document also provides notice of a public hearing on

these proposed regulations.

[[Page 9378]]

DATES: Written comments must be received by June 6, 1996. Outlines of

topics to be discussed at the public hearing scheduled for Thursday,

June 6, 1996, at 10 a.m. must be received by May 23, 1996.

ADDRESSES: Send submissions to: CC:DOM:CORP:R (INTL-0054-95), room

5228, Internal Revenue Service, POB 7604, Ben Franklin Station,

Washington DC 20044. In the alternative, submissions may be hand

delivered between the hours of 8 a.m. and 5 p.m. to CC:DOM:CORP:R

(INTL-0054-95), Courier's Desk, Internal Revenue Service, 1111

Constitution Avenue NW., Washington DC. The public hearing will be held

in the Auditorium, Internal Revenue Building, 1111 Constitution Avenue

NW., Washington DC.

FOR FURTHER INFORMATION CONTACT: Concerning the regulations, Ahmad

Pirasteh or Richard Hoge, (202) 622-3870; and the hearing, Michael

Slaughter (202) 622-7190 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background

This document contains proposed regulations amending the Income Tax

Regulations (26 CFR Part 1) under sections 882 and 884 of the Internal

Revenue Code. In final regulations under sections 882 and 884,

published elsewhere in this issue of the Federal Register, various

sections were reserved. These proposed regulations would provide

guidance under those reserved sections, as well as amend other

sections, to coordinate with the final regulations.

Explanation of the Provisions

I. Financial Products

The proposed regulations include several provisions that take into

account recent developments in the tax treatment of financial

instruments, such as the enactment of section 475, the development of

hedging rules and the introduction of profit split methodologies in

global trading Advance Pricing Agreements. The IRS and Treasury intend

to issue regulations under section 864 that will address these recent

developments as they affect the determination of a foreign

corporation's effectively connected income. Comments are solicited on

these proposed regulations as they relate to financial products and on

their interaction with the determination of effectively connected

income.

A. ``Split asset'' rule for section 475 securities and section 1256

contracts. Currently Sec. 1.884-1(d)(2)(vii) provides a ``split asset''

rule for certain securities described in Sec. 1.864-4(c)(5)(ii)(b)(3)

that produce income only a portion of which is treated as effectively

connected with the conduct of a U.S. trade or business. Since other

securities may also produce income split between effectively connected

and non-effectively connected income, the rule has been broadened to

cover all financial instruments that meet the definition of a security

under section 475(c)(2), as well as section 1256 contracts, that may

produce such split income. Accordingly, a foreign corporation that,

under an Advance Pricing Agreement, is permitted to apply a ``profit

split'' methodology to determine the portion of its income from a

portfolio of securities that is effectively connected with the conduct

of a U.S. trade or business would apply this rule. This rule will also

apply to determine the portion of a foreign corporation's portfolio of

securities that is a U.S. asset for purposes of Sec. 1.882-5.

B. Hedging transactions. Proposed Sec. 1.884-1(c)(2)(ii) introduces

a new rule for hedging transactions for purposes of section 884. The

new rule requires that a taxpayer increase or decrease, as the case may

be, the amount of their U.S. assets by the amount of any gain or loss

on any transaction that hedges the U.S. assets. If the hedging

transaction is undertaken outside the United States, perhaps as part of

a global hedging strategy of the foreign corporation, then the hedging

transaction is only taken into account to the extent that income from

the transaction would be treated as income effectively connected with

the U.S. trade or business of the taxpayer. If, however, the hedging

transaction is entered into by the U.S. branch, it will only affect the

amount of U.S. assets if it is contemporaneously identified as a

hedging transaction in accordance with the provisions of Sec. 1.1221-2.

In response to comments, hedging rules also have been added to the

interest allocation rules of Sec. 1.882-5. These rules provide that a

transaction that hedges a U.S. booked liability will be taken into

account in determining the amount, currency denomination, and interest

rate associated with that liability for purposes of performing the

second and third steps of the interest expense calculation.

C. Securities marked-to-market. Section 1.884-1(d)(6), which

provides ``E&P basis'' rules for specific types of U.S. assets, has

been clarified to provide rules for securities subject to mark-to-

market accounting. The new provision in Sec. 1.884-1(d)(6)(v) specifies

that securities subject to section 475, as well as section 1256

contracts, have an E&P basis equal to their mark-to-market value as of

the determination date. Proposed Sec. 1.882-5(b)(2)(iv) provides a

basis adjustment rule under which such assets are treated as having

been marked-to-market on each determination date. Examples are

contained in the proposed regulations that illustrate the effect of

these rules on the calculation of worldwide assets and liabilities.

II. Transactions Between Partners and Partnerships

Example 4 in proposed Sec. 1.882-5(c)(5) would clarify that an

obligation of a partnership to make payments to its partner for the use

of capital, which gives rise to guaranteed payments under section

707(c), is not a liability for purposes of Sec. 1.882-5. The Service

and Treasury solicit comments on the treatment of loans between

partners and partnerships as part of Treasury's review of the

international tax aspects of pass-through entities.

Special Analyses

It has been determined that this notice of proposed rulemaking is

not a significant regulatory action as defined in EO 12866. Therefore,

a regulatory assessment is not required. It has also been determined

that section 553(b) of the Administrative Procedures Act (5 U.S.C.

chapter 5) and the Regulatory Flexibility Act (5 U.S.C. chapter 6) do

not apply to these regulations, and, therefore, a Regulatory

Flexibility Analysis is not required. Pursuant to section 7805(f) of

the Internal Revenue Code, this notice of proposed rulemaking will be

submitted to the Chief Counsel for Advocacy of the Small Business

Administration for comment on its impact on small business.

Comments and Request for a Public Hearing

Before these proposed regulations are adopted as final regulations,

consideration will be given to any written comments (signed original

and eight (8) copies) that are timely submitted to the IRS. All

comments will be available for public inspection and copying.

A public hearing has been scheduled for Thursday, June 6, 1996, at

10 a.m. in the Auditorium, Internal Revenue Building, 1111 Constitution

Avenue NW., Washington DC. Because of access restrictions, visitors

will not be admitted beyond the building lobby more than 15 minutes

before the hearing starts.

The rules of 26 CFR 601.601(a)(3) apply to the hearing. Persons

that wish to present oral comments at the hearing

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must submit written comments by June 6, 1996, and submit an outline of

topics to be discussed and time to be devoted to each topic (signed

original and eight (8) copies) by May 23, 1996.

A period of 10 minutes will be allotted to each person for making

comments.

An agenda showing the scheduling of the speakers will be prepared

after the deadline for receiving outlines has passed. Copies of the

agenda will be available free of charge at the hearing.

Drafting Information

Several persons from the Office of Chief Counsel and the Treasury

Department participated in drafting these regulations.

List of Subjects in 26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1--INCOME TAXES

Paragraph 1. The authority citation for part 1 continues to read in

part as follows:

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

Par. 2. Section 1.882-5 is amended as follows:

1. The text of paragraph (b)(2)(iv) is added.

2. The text of paragraph (c)(2)(v) is added.

3. In paragraph (c)(5), Example 4, Example 6, and Example 7 are

added.

4. The text of paragraph (d)(2)(vi) is added.

5. In paragraph (d)(6), Example 4 is added.

6. The text of paragraph (e)(3) is added.

7. In paragraph (e)(5), Example 2 is added.

8. The text of paragraph (f)(2) is added.

The added provisions read as follows:

Sec. 1.882-5 Determination of interest deduction.

* * * * *

(b) * * *

(2) * * *

(iv) Adjustment to basis of financial instruments. The basis of a

security or contract that is marked to market pursuant to section 475

or section 1256 will be determined as if each determination date were

the last business day of the taxpayer's taxable year. A financial

instrument with a fair market value of less than zero is a liability,

not an asset, for purposes of this section.

* * * * *

(c) * * *

(2) * * *

(v) Hedging transactions. A transaction (or transactions) that

hedges an asset or liability, or a pool of assets or a pool of

liabilities, will be taken into account in determining the value,

amount and currency denomination of the asset or liability that it

hedges. A transaction will be considered to hedge an asset or liability

only if the transaction meets the requirements of Sec. 1.1221-2.

* * * * *

(5) * * *

Example 4. Partnership liabilities. X and Y are each foreign

corporations engaged in the active conduct of a trade or business

within the United States through a partnership, P. Under the

partnership agreement, X and Y each have a 50% interest in the

capital and profits of P, and X is also entitled to a return of 6%

per annum on its capital account that is a guaranteed payment under

section 707(c). In addition, P has incurred a liability of $100x to

an unrelated bank, B. Under paragraph (c)(2)(vi) of this section, X

and Y each share equally in P's liability to B. In accordance with

U.S. tax principles, P's obligation to make guaranteed payments to X

does not constitute a liability of P, and therefore neither X nor Y

take into account that obligation of the partnership in computing

their actual ratio.

* * * * *

Example 6. Securities in ratio as assets. FC is a foreign

corporation engaged in a trade or business in the United States

through a U.S. branch. FC is a dealer in securities within the

meaning of section 475(c)(1)(B) because it regularly offers to enter

into positions in currency spot and forward contracts with customers

in the ordinary course of its trade or business. FC has not elected

to use the fixed ratio. On December 31, 1996, the end of FC's

taxable year, the mark-to-market value of the spot and forward

contracts entered into by FC worldwide is 1000x, which includes a

mark- to-market gain of 500x with respect to the spot and forward

contracts that are shown on the books of its U.S. branch and that

produce effectively connected income. On its December 31, 1996,

determination date, FC includes 500x in its U.S. assets, and 1000x

in its worldwide assets.

Example 7. Securities in ratio as assets and liabilities. The

facts are the same as in Example 4, except that on December 31,

1996, the mark-to-market value of the spot and forward contracts

entered into by FC worldwide is 1000x, and FC has a mark-to-market

loss of 500x with respect to the spot and forward contracts that are

shown on the books of its U.S. branch and that would produce

effectively connected income. On its December 31, 1996,

determination date, FC includes the 1000x in its worldwide assets

for purposes of determining its ratio of worldwide liabilities to

worldwide assets. For purposes of Step 3, however, FC has U.S-booked

liabilities in the United States equal to the 500x U.S. loss

position.

(d) * * *

(2) * * *

(vi) Hedging transactions. A transaction (or transactions) that

hedges a U.S. booked liability, or a pool of U.S. booked liabilities,

will be taken into account in determining the currency denomination,

amount of, and interest rate associated with, that liability. A

transaction will be considered to hedge a U.S. booked liability only if

the transaction meets the requirements of Sec. 1.1221-2(a), (b), and

(c), and is identified in accordance with the requirements of

Sec. 1.1221-2(e).

* * * * *

(6) * * *

Example 4. Liability hedge--(i) Facts. FC is a foreign

corporation that meets the definition of a bank, as defined in

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

thereof), and that is engaged in a banking business in the United

States through its branch, B. FC's corporate policy is to match the

currency denomination of its assets and liabilities, thereby

minimizing potential gains and losses from currency fluctuations.

Thus, at the close of each business day, FC enters into one or more

hedging transactions as needed to maintain a balanced currency

position, and instructs each branch to do the same. At the close of

business on December 31, 1998, B has 100x of U.S. dollar assets, and

U.S. booked liabilities of 90x U.S. dollars and 1000 x Japanese yen

(exchange rate: $1 = 100). To eliminate the currency mismatch

in this situation, B enters into a forward contract with an

unrelated third party that requires FC to pay 10x dollars in return

for 1000x yen. Through this hedging transaction, FC has effectively

converted its 1000x Japanese yen liability into a U.S. dollar

liability. FC uses its actual ratio of 90% in 1998 for Step 2, the

adjusted U.S. booked liabilities method for purposes of Step 3, and

is a calendar year taxpayer.

(ii) Analysis. Under paragraph 1.882-5(d)(2)(vi), FC is required to

take into account hedges of U.S. booked liabilities in determining the

currency denomination, amount, and interest rate associated with those

liabilities. Accordingly, FC must treat the Japanese yen liabilities

booked in the United States on December 31, 1998, as U.S. dollar

liabilities to determine both the amount of the liabilities and the

interest paid or accrued on U.S. booked liabilities for purposes of

this section. Moreover, in applying the scaling ratio prescribed in

paragraph (d)(4)(i) of this section, FC must scale back both the U.S.

booked liabilities and the hedge(s) of those liabilities. Assuming that

FC's average U.S. booked liabilities for the year ending December 31,

1998, exceed its U.S.-connected liabilities determined

[[Page 9380]]

under paragraphs (a)(1) through (c)(5) of this section by 10%, FC must

scale back by 10% both its interest expense associated with U.S. booked

liabilities, and any income or loss from the forward contract to

purchase Japanese yen that hedges its U.S. booked liabilities.

(e) * * *

(3) Hedging transactions. A transaction (or transactions) that

hedges a liability, or a pool of liabilities, will be taken into

account in determining the amount of, or interest rate associated with,

that liability. A transaction will be considered to hedge a liability

only if the transaction meets the requirements of Sec. 1.1221-2(a),

(b), and (c).

* * * * *

(5) * * *

Example 2. Asset hedge--(i) Facts. FC is a foreign corporation

that meets the definition of a bank, as defined in section

585(a)(2)(B) (without regard to the second sentence thereof), and

that is engaged in the banking business in the United States through

its branch, B. FC's corporate policy is to match the currency

denomination of its assets and liabilities, thereby minimizing

potential gains and losses from currency fluctuations. Thus, at the

close of each business day, FC enters into one or more hedging

transactions as needed to maintain a balanced currency position, and

instructs each branch to do the same. At the close of business on

December 31, 1998, B has two U.S. assets, a loan of 90x U.S. dollars

and a loan of 1000x Japanese yen (exchange rate: $1 = 100). B

has U.S. booked liabilities, however, of 100x U.S. dollars. To

eliminate the currency mismatch, B enters into a forward contract

with an unrelated third party that requires FC to pay 1000x yen in

return for 10x dollars. Through this hedging transaction, FC has

effectively converted its 1000x Japanese yen asset into a U.S.

dollar asset. FC uses its actual ratio of 90% in 1998 for Step 2,

has elected the separate currency pools method in paragraph (e) of

this section, and is a calendar year taxpayer.

(ii) Analysis. Under paragraph (e)(1)(i) of this section, FC

must take into account any transaction that hedges a U.S. asset in

determining the currency denomination and value of that asset. FC's

Japanese yen asset will therefore be treated as a U.S. dollar asset

in determining its U.S. assets in each currency. Accordingly, FC

will be treated as having only U.S. dollar assets in making its

separate currency pools computation.

(f) * * *

(2) Special rules for financial products. Paragraphs (b)(2)(iv),

(c)(2)(v), (d)(2)(vi), and (e)(3) of this section will be effective for

taxable years beginning on or after the date these regulations are

published as final regulations in the Federal Register.

Par. 3. Section 1.884-1 is amended as follows:

1. Paragraph (c)(2)(iii) is added.

2. Paragraph (d)(2) is amended as follows:

a. Paragraph (d)(2)(vii) is revised.

b. In paragraph (d)(2)(xi), Example 6 through Example 8 are added.

3. The text of paragraph (d)(6)(v) is added.

4. In paragraph (i)(4), a sentence is added at the end of the

existing text.

The revised and added provisions read as follows:

Sec. 1.884-1 Branch profits tax.

* * * * *

(c) * * *

(2) * * *

(iii) Hedging transactions. A transaction that hedges a U.S. asset,

or a pool of U.S. assets, will be taken into account in determining the

amount of that asset (or pool of assets) to the extent that income or

loss from the hedging transaction produces ECI or reduces ECI. A

transaction that hedges a U.S. asset, or pool of U.S. assets, is also

taken into account in determining the currency denomination of the U.S.

asset (or pool of U.S. assets). A transaction will be considered to

hedge a U.S. asset only if the transaction meets the requirements of

Sec. 1.1221-2(a), (b), and (c), and is identified in accordance with

the requirements of Sec. 1.1221-2(e).

(d) * * *

(2) * * *

(vii) Financial instruments. A financial instrument, including a

security as defined in section 475 and a section 1256 contract, shall

be treated as a U.S. asset of a foreign corporation in the same

proportion that the income, gain, or loss from such security is ECI for

the taxable year.

* * * * *

(xi) * * *

Example 6. Hedging transactions--(i) Facts. FC is a foreign

corporation engaged in a trade or business in the United States

through a U.S. branch. The functional currency of FC's U.S. branch

is the U.S. dollar. On January 1, 1997, in the ordinary course of

its business, the U.S. branch of FC enters into a forward contract

with an unrelated party to purchase 100 German marks (DM) on March

31, 1997, for $50. To hedge the risk of currency fluctuation on this

transaction, the U.S. branch also enters into a forward contract

with another unrelated party to sell 100 DM on March 31, 1997, for

$52, identifying this contract as a hedging transaction in

accordance with the requirements of Sec. 1.1221-2(e). FC marks its

foreign currency transactions to market for U.S. tax purposes.

(ii) Net assets. At the end of FC's taxable year, the value of

the forward contract to purchase 100 DM is marked to market,

resulting in gain of $10 being realized and recognized as U.S.

source effectively connected income by FC. Similarly, FC marks to

market the contract to sell 100 DM, resulting in $8 of realized and

recognized loss by FC. Pursuant to paragraph (c)(2)(iii) of this

section, FC must increase or decrease the amount of its U.S. assets

to take into account any transaction that hedges the contract to

purchase 100 DM. Consequently, FC has a U.S. asset of $2 ($10 (the

adjusted basis of the contract to purchase 100 DM) -$8 (the loss on

the contract to sell 100 DM)).

Example 7. Split hedge. The facts are the same as in Example 5,

except that the contract to sell 100 DM is entered into with an

unrelated third party by the home office of FC. FC includes the

contract to sell 100 DM in a pool of assets treated as producing

income effectively connected with the U.S. trade or business of FC.

Therefore, under paragraph (c)(2)(iii) of this section, at its next

determination date FC will report a U.S. asset of $2, computed as in

Example 5.

Example 8. Securities. FC is a foreign corporation engaged in a

U.S. trade or business through a branch in the United States. During

the taxable year 1997, FC derives $100 of income from securities, of

which $60 is treated as U.S. source effectively connected income

under the terms of an Advance Pricing Agreement that uses a profit

split methodology. Accordingly, pursuant to paragraph (d)(2)(vii) of

this section, FC has a U.S. asset equal to 60% ($60 of ECI divided

by $100 of gross income from securities) of the value of the

securities.

* * * * *

(6) * * *

(v) Computation of E&P basis of financial instruments. For purposes

of this section, the E&P basis of a security that is marked to market

under section 475 and a section 1256 contract shall be adjusted to take

into account gains and losses recognized by reason of section 475 or

section 1256. The E&P basis must be further adjusted to take into

account a transaction that hedges a U.S. asset, as provided in

paragraph (c)(2)(ii) of this section.

* * * * * *

(i) * * *

(4) * * * Paragraphs (c)(2)(iii), (d)(2)(vii), and (d)(6)(v) of

this section will be effective for taxable years beginning on or after

the date these regulations are published as final regulations in the

Federal Register.

* * * * *

Margaret Milner Richardson,

Commissioner of Internal Revenue.

[FR Doc. 96-5264 Filed 3-5-96; 8:45 am]

BILLING CODE 4830-01-U