Determination of Interest Expense Deduction of Foreign Corporations, 47443-47452 [E6-13402]

Agencies

• Internal Revenue Service
• DEPARTMENT OF THE TREASURY

[Federal Register Volume 71, Number 159 (Thursday, August 17, 2006)]
[Rules and Regulations]
[Pages 47443-47452]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: E6-13402]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 1 and 602

[TD 9281]
RIN 1545-BF70


Determination of Interest Expense Deduction of Foreign 
Corporations

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final and temporary regulations.

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SUMMARY: This document contains revised 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 to conform 
the rules to subsequent U.S. Income Tax Treaty agreements and to adopt 
changes to facilitate improved administrability for taxpayers and the 
IRS.

DATES: Effective Date: These regulations are effective starting the tax 
year end for which the original tax return due date (including 
extensions) is after August 17, 2006.
    Applicability Date: These regulations are applicable starting the 
tax year end for which the original tax return due date (including 
extensions) is after August 17, 2006.

FOR FURTHER INFORMATION CONTACT: Gregory Spring or Paul Epstein, (202) 
622-3870 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

    These temporary regulations are being issued without prior notice 
and public procedure pursuant to the Administrative Procedure Act (5 
U.S.C. 553). For this reason, the collection of information contained 
in these regulations has been reviewed and pending receipt and 
evaluation of public comments, approved by the Office of Management and 
Budget under control number 1545-2030. Responses to this collection of 
information are mandatory.
    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.
    For further information concerning these collections of 
information, and where to submit comments on the collection of 
information and the accuracy of the estimated burden, and suggestions 
for reducing this burden, please refer to the preamble of the cross-
referencing notice of proposed rulemaking published in this issue of 
the Federal Register.
    Books and records relating to a collection of information must be 
retained as long as their contents may become material in the 
administration of any internal revenue law. Generally, tax returns and 
tax return information are confidential, as required by 26 U.S.C. 6103.

Background

    On December 30, 1980, the Treasury Department and the IRS published 
final regulations TD 7749 [46 FR 16100 (1981-1 CB 390) (see Sec.  
601.601(d)(2) of this chapter)] under section 882(c) of the Internal 
Revenue Code (Code) regarding the determination of a foreign 
corporation's interest expense allocable to income effectively 
connected with the conduct of a trade or business within the United 
States. On March 8, 1996, the Treasury Department and the IRS published 
final regulations TD 8658 [61 FR 15891 (1996-1 CB 161) (see Sec.  
601.601(d)(2) of this chapter)], and new proposed amendments INTL-0054-
95 [61 FR 28118 (1996-1 CB 844) (see Sec.  601.601(d)(2) of this 
chapter)]. The 1996 amendments implemented certain statutory changes 
enacted in the Tax Reform Act of 1986, Public Law 99-514 (100 Stat. 
2085), and took account of developments in international financial 
markets. Comments were received on both the final and proposed 1996 
regulations. Since then, two new U.S. income tax treaties have entered 
into force that follow a different approach for determining the limit 
on profits attributable to a permanent establishment in a contracting 
state and for determining interest expense allowed in computing such 
profits. On July 14, 2005, the Treasury Department and the IRS 
published Notice 2005-53 (2005-32 IRB 32, see Sec.  601.601(d)(2)), 
which described those new treaties and announced the intention to 
update the final Sec.  1.882-5 regulations to take account of changes 
in the international banking sector and to promote both ease of 
administration and certainty of application.
    These temporary regulations in this document implement Notice 2005-
53, make effective one part of the 1996 proposed regulations, make 
miscellaneous clarifications to the 1996 final regulations, and modify 
the branch profits tax liability reduction regulations under Sec.  
1.884-1(e)(3).

Explanation of Provisions

    The following discussion is divided into several parts. Section 1 
of the following discussion summarizes Notice 2005-53. Section 2 
addresses the coordination of Sec.  1.882-5 with U.S. tax treaties and 
discusses other modifications made by these temporary regulations to 
the three-step calculation of interest expense under Sec.  1.882-5. 
Section 3 addresses changes made to the branch profits tax regulations 
under section 884. Section 4 then addresses miscellaneous technical 
modifications made by these temporary regulations that clarify 
application of the existing final regulations. Section 5 describes the 
effective date of these regulations.

1. Notice 2005-53

    Notice 2005-53 provided guidance regarding the interaction of Sec.  
1.882-5 and U.S. income tax treaties and explained that since the 
recent treaties with the United Kingdom and Japan entered into force, 
Sec.  1.882-5 no longer provides the exclusive rules for determining 
the interest expense attributable to the business profits of a U.S. 
permanent establishment. The Notice also provided guidance and 
requested comments regarding certain potential modifications to certain 
elements of the three-step calculation of interest expense under Sec.  
1.882-5. More specifically, the Notice requested information regarding 
a possible increase to the existing 93-percent fixed ratio in Step 2 of 
the calculation and announced the intention to allow the use of a safe-
harbor interest rate for determining excess interest under the 
``adjusted U.S.-booked liabilities'' method in Step 3. The Notice also 
requested comments regarding the effect of intangibles on the Step-1 
determination of U.S. assets under the elective fair market value 
method and the Step-2 determination of U.S. liabilities using the fixed 
or actual ratio.

2. Modifications to Three-Step Calculation Under Sec.  1.882-5

a. Introduction/Background
    Section 1.882-5 generally requires a foreign corporation to use a 
three-step calculation to determine the amount of interest expense that 
is allocable under section 882(c) to income effectively connected (or 
treated as effectively connected) with the foreign corporation's 
conduct of a trade or business within the United States.

[[Page 47444]]

    Step 1 determines the total value of a foreign corporation's U.S. 
assets, which generally are the assets that produce (or would produce) 
income effectively connected with the foreign corporation's conduct of 
its U.S. trade or business. The value of the U.S. assets for this 
purpose is their adjusted basis, or, if the taxpayer makes an election, 
their fair market value.
    Step 2 determines the ``U.S.-connected liabilities'' of a foreign 
corporation as the product of the foreign corporation's U.S. assets 
multiplied either by the actual ratio of the foreign corporation's 
worldwide liabilities to worldwide assets, or by a fixed ratio. In the 
case of a bank, the fixed ratio is 93 percent. If a taxpayer elects to 
value its assets at fair market value for purposes of Step 1, then the 
taxpayer must value worldwide assets at fair market value for purposes 
of Step 2, as well.
    Step 3 determines the allocable amount of interest expense under 
either the adjusted U.S.-booked liabilities (AUSBL) method or the 
separate currency pools method. Under the AUSBL method, a foreign 
bank's interest expense allocable to effectively connected income is 
determined by comparing ``U.S.-booked liabilities'' with U.S.-connected 
liabilities and making appropriate adjustments as necessary. For this 
purpose, U.S.-booked liabilities generally include liabilities that are 
both entered on books relating to an activity that produces effectively 
connected income before the close of the day on which the liability is 
incurred and are directly connected to that activity. In consequence, 
U.S.-booked liabilities are not limited to liabilities reflected on 
books within the United States. If a taxpayer's U.S.-booked liabilities 
exceed its U.S.-connected liabilities, then its U.S-booked interest 
expense is proportionately disallowed under a ``scale down'' ratio. If 
a taxpayer's U.S.-connected liabilities exceed its U.S.-booked 
liabilities, then interest expense in addition to the U.S.-booked 
interest expense is allocated in an amount equal to the product of the 
excess U.S.-connected liabilities multiplied by the borrowing rate on 
U.S.-dollar liabilities that are not U.S.-booked liabilities.
    Under the separate currency pools method, a foreign corporation's 
interest expense allocable to income effectively connected with the 
conduct of a trade or business within the United States 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 generally are determined using a three-step calculation that 
multiplies the worldwide borrowing rate by the U.S.-connected 
liabilities relevant to U.S. assets denominated in each foreign 
currency.
    Elections under Sec.  1.882-5T, as under the 1996 final 
regulations, generally are binding for a minimum of five years unless 
specifically provided otherwise. For example, consistent with the 
binding nature of a domestic corporation's fair market value election 
under section 861, a fair market value election under Sec.  1.882-5T 
may be changed only with consent of the Commissioner.
b. Treaty Coordination--Modification of Sec.  1.882-5 Exclusivity Rule
    The preamble to the 1996 final regulations states that Sec.  1.882-
5 was fully consistent with all of the United States' then-existing 
treaty obligations, including Business Profits articles, and the 1996 
final regulations state that Sec.  1.882-5 provides the exclusive rules 
for determining the interest expense attributable to the business 
profits of a U.S. permanent establishment under a U.S. income tax 
treaty. However, the Treasury Department Technical Explanation to 
Article 7 of the United States-United Kingdom income tax treaty which 
entered into force on March 31, 2003, and the Treasury Department 
Technical Explanation to Article 7 of the United States-Japan income 
tax treaty which entered into force on March 30, 2004, note that Sec.  
1.882-5 may produce an inappropriate result in some cases. As a result, 
the implementing documentation of these treaties provides that the 1995 
Organisation for Economic Co-Operation and Development (OECD) Transfer 
Pricing Guidelines will apply by analogy for the purpose of determining 
the business profits attributable to a permanent establishment. Thus, 
as noted in Notice 2005-53, the exclusivity provision in the 1996 final 
regulations is no longer accurate.
    These temporary regulations modify the exclusivity provision by 
recognizing that express provision may be made by or pursuant to an 
income tax treaty or accompanying documents (such as exchange of notes) 
that alternative principles will apply by analogy to determine the 
business profits attributable to a permanent establishment. Such treaty 
provisions may be used to determine the limit on the business profits 
attributable to a U.S. permanent establishment, but taxpayers remain 
eligible to use Sec.  1.882-5, as explained in the Treasury Department 
Technical Explanations to Article 7(3) of the United States-United 
Kingdom and United States-Japan income tax treaties. The Treasury 
Department and the IRS believe that these treaties and agreements 
provide that a taxpayer must apply either the domestic law or the 
alternative rules expressly provided in the treaty in their entirety, 
in accordance with the consistency principle articulated in Rev. Rul. 
84-17 [(1984-1 CB 308) (see Sec.  601.601(d)(2) of this chapter)] and 
described in the Treasury Department Technical Explanation to Article 
1(2) of the United States-United Kingdom and United States-Japan income 
tax treaties. The Treasury Department and the IRS are continuing to 
consider the specific application of this consistency principle 
including the application of Sec.  1.882-5, the interaction of Sec.  
1.882-5 with other U.S. income tax treaties (particularly those being 
renegotiated in whole or in part), and the application of the branch 
profits tax under alternative rules for determining interest expense 
attributable to business profits.
c. Modifications to Step One
Consistency Requirement for Fair Market Value Election
    Under the 1996 final regulations, a taxpayer that uses the fair 
market value method for Step 1 must also use the fair market value 
method for Step 2. Notice 2005-53 clarified that this consistency rule 
applies only when the taxpayer has elected to use the actual ratio in 
Step 2, because assets are not valued when the fixed ratio is used. 
Accordingly, under the final regulations, electing the fair market 
value method under Step 1 does not obligate a taxpayer to elect the 
actual ratio under Step 2.
    Notice 2005-53 also stated that the prevalence and significance of 
intangibles in the banking industry warrants reevaluating the right to 
elect both the fair market value method in Step 1 and the fixed ratio 
in Step 2. The Treasury Department and the IRS are concerned that 
applying the fixed ratio to intangibles when a Step 1 fair market value 
election is in place would have the effect of treating existing 
intangibles as highly leveraged assets when in fact such items often 
are more properly reflected in the taxpayer's equity accounts under 
U.S. tax principles. Comments were requested.
    The single comment received in response to this request stated that 
distortions could result either by failing to take the value of 
intangibles into account when revising the fixed ratio for banks or by 
applying the fixed ratio to directly purchased intangibles that are 
valued at tax basis.

[[Page 47445]]

    As further discussed in this section in connection with 
modifications to Step 2, these temporary regulations adopt a fixed 
ratio that is believed to represent an approximation of current average 
banking-industry balance-sheet ratios estimated under U.S. tax 
principles. Following due consideration of the comment, these temporary 
regulations require that the fair market value method may be elected in 
Step 1 only if a taxpayer is eligible to elect and in fact uses the 
actual ratio in Step 2. The consistency rule continues to require that 
the fair market value method, once elected, must be used in both Step 1 
and Step 2. This consistency rule applies to all foreign corporations 
that are subject to Sec.  1.882-5.
Conforming-Election Requirement
    A taxpayer that has both a valid fair market value method election 
for Step 1 and a valid fixed ratio method election for Step 2 in effect 
on the date these temporary regulations are effective must conform 
those elections to the new rules. Accordingly, such a taxpayer either 
may maintain the fixed ratio method for Step 2 and elect the adjusted 
basis method for Step 1, or may maintain the fair market value method 
for Step 1 and elect the actual ratio method for Step 2. Such 
conforming elections must be made for the first year these temporary 
regulations are effective, on either an original timely filed return 
(including extensions) or an amended return within 180 days after the 
extended due date. If a conforming election is not made by the extended 
due date for filing the amended return, the Director of Field 
Operations may make a binding conforming election on the taxpayer's 
behalf. Conforming elections are subject to the minimum five-year 
period applicable to the adjusted basis method, fixed ratio and actual 
ratio method elections. Elections with respect to Step 1 and Step 2, 
whether made by the taxpayer (either under the terms of the regulations 
or pursuant to the Commissioner's grant of consent within what would 
otherwise be a five-year minimum period) or imposed by the 
Commissioner, are separate. Thus, for example, the Commissioner may 
consent to a taxpayer's request to move from the fair market value 
method to the adjusted basis method for Step 1 without granting consent 
to move from the actual ratio method to the fixed ratio method for Step 
2.
Average Value of Securities Subject to Section 475 or Section 1256
    The 1996 proposed regulations provide that financial instruments 
that are subject to mark-to-market valuation under section 475 or 
section 1256 must be valued for purposes of Sec.  1.882-5 on each 
``determination date'' (as defined) within the taxable year. Taxpayers 
generally assess funding needs throughout the year, and this rule is 
intended to reflect such assessments more accurately than a single 
year-end valuation would do.
    These temporary regulations adopt this rule from the 1996 proposed 
regulations. The rule applies solely to determine the average values of 
relevant assets for purposes of computing the average valuation of U.S. 
assets in Step 1 of the formula. The rule does not determine the actual 
tax basis of an asset for any other purpose. ``Determination dates'' 
for purposes of the rule are defined as the most frequent regular 
intervals for which data are reasonably available. These temporary 
regulations provide that a taxpayer that has elected the actual ratio 
in Step 2 must also take interim mark-to-market values into account 
using the most frequently available data but in no event less 
frequently than actual-ratio taxpayers are required to do.
d. Modifications to Step Two
New Fixed Ratio
    The 1996 final regulations revised the fixed ratio for banks 
downward to 93 percent. Since then, foreign bank taxpayers have 
commented that 93 percent is not representative of regulated banking 
industry capital structures. Foreign bank taxpayers also have commented 
that use of the actual ratio in Step 2 presents the potential for 
significant tax risk and uncertainty of results, particularly when 
adjusting their books to conform to U.S. tax principles. It appears 
that many foreign banks have adopted the 93-percent fixed ratio despite 
indications that many operate on a smaller equity capital structure.
    Notice 2005-53 indicated that the Treasury Department and the IRS 
were considering increasing the fixed ratio. In order to improve 
administration by aligning the fixed ratio more closely with an 
approximation of current average banking industry balance sheet ratios 
estimated under U.S. tax principles, these temporary regulations revise 
the fixed ratio for foreign banks upward to 95 percent. The new fixed 
ratio may be adopted by foreign banks for the first year in which the 
original tax return due date (including extensions) is after August 17, 
2006, or for any subsequent year. The ratio may be adopted, for 
example, for the 2005 calendar year even if the original return was 
filed before these regulations were published. Taxpayers that want to 
try to support any further revision to the fixed ratio would have to 
submit detailed, specific, compelling evidence to that effect.
Branch Profits Tax Consequences of Fixed-Ratio Election
    Use of the new 95-percent fixed ratio in Step 2 conceivably could 
give rise to branch profits tax consequences. For example, a taxpayer 
that elects the new fixed ratio and that had been using either the 93-
percent fixed ratio or an actual ratio that is less than 95 percent 
could be viewed under the branch profits tax rules as having 
experienced a decrease in net equity, thus giving rise to a dividend 
equivalent amount. One comment received in response to Notice 2005-53 
requested that regulations implementing the notice provide special 
immunity from branch profits tax consequences except to the extent that 
a taxpayer benefited from the 1996 reduction of the fixed ratio from 95 
percent to 93 percent.
    Such consequences under the branch profits tax rules should arise 
only to the extent a taxpayer uses a 95-percent ratio that is 
substantially higher than the ratio used in the prior year, and the 
taxpayer's asset base has not increased sufficiently in the ordinary 
course of business to cause current and accumulated effectively 
connected earnings and profits to be treated as reinvested. The 1996 
final regulations identify the actual ratio as the preferred method, 
and taxpayers have always been entitled to elect their actual ratio. 
Accordingly, the Treasury Department and the IRS believe that granting 
the commenter's request is unnecessary and in some cases could produce 
an inappropriate windfall. In addition, considerable administrative 
difficulties would complicate efforts to identify and recapture prior 
tax benefits that may have resulted from the increase in net equity 
when the fixed ratio was reduced in the 1996 final regulations and to 
track the deferred component of the computation through the intervening 
years up to and including the effective date of the new fixed ratio. 
Further, a special rule of the type requested is inconsistent with the 
expectation of reduced effectively connected income through increased 
interest expense allocations that result from the higher ratio. 
Finally, any branch profits tax consequences of a new fixed-ratio 
election may be mitigated by applicable tax treaties and by the 
expanded availability of the liability-reduction election under section 
884, as further

[[Page 47446]]

discussed in Section 3. Accordingly, the comment is not adopted.
Elections
    Taxpayers that currently have elected the fixed ratio for Step 2 
may use the revised 95-percent ratio for the first tax year for which 
the original tax return due date (including extensions) is after August 
17, 2006. Remaining on the fixed ratio does not constitute the election 
of a new five-year minimum period. For example, a taxpayer that used 
the 93-percent fixed ratio for three years preceding the publication of 
these regulations and used the 95-percent fixed ratio for three more 
years would be entitled to elect the actual ratio method in the 
following year.
    Foreign bank taxpayers that currently use the actual ratio for Step 
2 may make a binding five-year election to use the new 95-percent fixed 
ratio for the first year this amendment is effective, on either an 
original return or on an amended return filed within 180 days of the 
extended due date. An amended return election may not be made for any 
year where the extended due date for a timely filing is after December 
31, 2006. If a fixed-ratio election is not made for the first year 
these regulations are effective, a taxpayer using the actual ratio may 
make the fixed-ratio election in any subsequent year, but only on a 
timely filed return.
Eligibility
    Under the 1996 final regulations, the 93-percent fixed ratio is 
available to foreign banks, which are defined for this purpose as banks 
within the meaning of section 585(a)(2)(B), without regard to the 
second sentence thereof. This definition excludes foreign banking 
corporations that are not engaged in a banking business within the 
United States. This has the effect of excluding a foreign corporation 
that is engaged in the banking business outside the United States but 
terminates its U.S. banking licenses and continues to engage in a 
nonregulated trade or business within the United States.
    The Treasury Department and the IRS intend that a taxpayer that 
meets the requirements of section 581 when considered on a worldwide 
basis should be eligible to elect the fixed ratio applicable to banks 
under Sec.  1.882-5 without regard to whether it remains engaged in a 
banking business within the United States. Therefore, a taxpayer that 
is regulated as a bank in its home country, takes deposits, and makes 
loans as a substantial part of its business outside the United States 
will be eligible to elect the 95-percent fixed ratio.
e. Modifications to Step Three
Excess Interest
    A foreign bank that uses the AUSBL method to determine its 
allocable interest expense may be required to allocate interest expense 
in addition to its U.S.-booked interest expense if U.S.-connected 
liabilities exceed U.S.-booked liabilities. The 1996 final regulations 
provide that the interest rate required to be applied to excess U.S.-
connected liabilities is generally the foreign bank's average U.S.-
dollar borrowing rate outside the United States. This rule was a change 
from the 1981 regulations, which had allowed taxpayers to use published 
rates under certain conditions. Taxpayers have commented informally 
that using actual non-U.S. dollar borrowing costs in all circumstances 
imposes significant administrative burdens.
    The Treasury Department and the IRS agree that the use of published 
data rather than the actual borrowing rate requirement would simplify 
administration of the excess-interest computation both for taxpayers 
and for the IRS. Notice 2005-53 announced the intention to permit the 
use of the published 30-day average London Interbank Offering Rate 
(LIBOR) for tax years beginning after the date the Notice was 
published.
    In response to Notice 2005-53, two comments were received. One 
comment stated that the proposal to use published 30-day LIBOR rates 
would make sense if it has been difficult for banks to calculate their 
actual rate of interest and that consideration might be given to making 
such a rule available for prior years. The other comment stated that a 
small sample of available information suggested that the 90-day LIBOR 
rate rather than the 30-day rate may be more representative of the 
sampled banks and suggested that the IRS review tax returns with excess 
interest.
    IRS experience in actual cases involving excess interest supports 
the adoption of a 30-day LIBOR rate rather than a 90-day LIBOR rate. In 
view of IRS experience and the absence of contrary data, these 
temporary regulations allow an annual binding election to use a 
published 30-day average LIBOR rate beginning with the first tax year 
in which an original tax return is due (including extensions) after 
August 17, 2006. Taxpayers may continue to use their actual U.S.-dollar 
borrowing rate in lieu of the 30-day LIBOR rate.
Relevant Excess U.S.-connected Liabilities
    These temporary and proposed regulations provide that the 
determination of the actual U.S.-dollar borrowing rate applicable to 
excess U.S.-connected liabilities is made with regard only to U.S.-
dollar liabilities that are booked outside the United States and that 
do not constitute U.S.-booked liabilities as defined. The rate 
applicable to excess U.S.-connected liabilities is intended to reflect 
the rate applicable to relevant borrowings and book interest expense 
that has not otherwise been allocated. Because interest with respect to 
U.S.-booked liabilities is allocable under Step 3 of the AUSBL method, 
including such interest expense in the determination of the rate 
applicable to excess U.S.-connected liabilities could distort the 
calculation.
Elections
    The 30-day LIBOR election may be adopted on a year-to-year basis. 
For the first tax year in which the original tax-return due date 
(including extensions) is after August 17, 2006 and not later than 
December 31, 2006, taxpayers may make the 30-day LIBOR election on an 
original return, or on an amended return within 180 days of the 
original extended due date. For subsequent years, the election must be 
made on an original tax return timely filed (including extensions). The 
election is made by attaching a statement to the return identifying the 
three-steps of the AUSBL calculation and the published rate used. An 
election to use a 30-day LIBOR rate is binding for such taxable year 
and may not be changed on an amended return for any year. Accordingly, 
a taxpayer is bound by the published rate used on its original return. 
If a taxpayer does not timely file an income tax return, then the 
opportunity to make a timely 30-day LIBOR election will be forfeited 
for the tax year. Consistent with the general rules for untimely 
elections, in such circumstances, the Director of Field Operations may 
require a taxpayer to use the actual U.S.-dollar borrowing rate or 
apply a published 30-day LIBOR rate for the year.

3. Liability Reduction Election Under Branch Profits Tax

    In general, the branch profits tax is imposed under section 884(a) 
in addition to the corporate income tax under section 882 and applies 
only to amounts that are treated as repatriated from the branch. These 
amounts are determined by reference to a foreign corporation's 
effectively connected earnings and profits for a year and accumulated 
effectively connected earnings and profits, adjusted upward to reflect 
decreases in U.S. net equity and adjusted downward to reflect increases

[[Page 47447]]

in U.S. net equity. Adjustments to net equity generally are made by 
comparing U.S. net equity at the end of a taxable year to U.S. net 
equity at the beginning of a taxable year.
    The branch profits tax rules impute equity capital to a branch 
according to a formula that treats a portion of reinvested amounts as 
having been funded by indebtedness. This generally reduces U.S. net 
equity and so gives rise to a dividend equivalent amount. Regulations 
provide that a taxpayer may elect to treat reinvested earnings as 
equity capital (rather than as debt-funded capital) by reducing U.S. 
liabilities as of the determination date. The amount of liabilities 
eligible for reduction under this election is limited to the excess of 
U.S. liabilities (which is generally based on U.S.-connected 
liabilities, as defined under Sec.  1.882-5) over U.S.-booked 
liabilities (as defined under Sec.  1.882-5) as of the determination 
date. An election to reduce liabilities under Sec.  1.884-1 also 
reduces the interest deduction available under Sec.  1.882-5.
    Taxpayers have expressed uncertainty regarding the policy served by 
setting U.S.-booked liabilities as a floor for liability reduction and 
have requested greater latitude to treat earnings as reinvested. For 
example, taxpayers have noted that the amount of U.S.-booked 
liabilities is not relevant to the Sec.  1.882-5 allocation under the 
separate currency pools method. They have noted also that the amount of 
U.S.-booked liabilities taken into account under the AUSBL method is an 
average balance for the year that may differ significantly from a year-
end balance.
    The Treasury Department and the IRS believe that it is desirable to 
more nearly align the branch profits tax treatment of distributed 
earnings with the tax treatment of a subsidiary's distributed earnings 
while retaining integration with the interest allocation rules provided 
in Sec.  1.882-5. In view of taxpayer comments, these temporary 
regulations permit a taxpayer to reduce U.S. liabilities to the extent 
necessary to prevent recognition of a dividend equivalent amount. 
However, this election may not reduce U.S. liabilities below zero. The 
other liability-reduction rules of Sec.  1.884-1(e)(3) continue to 
apply in their entirety. An example in the final regulations is amended 
in the temporary regulations to reflect the new limitation rule. The 
new liability reduction election is effective for the first year for 
which the original tax return due date (including extensions) is after 
August 17, 2006. For tax years for which the first original tax return 
due date (including extensions) is not later than December 31, 2006, a 
liability reduction election may be made on an amended return within 
180 days after the original extended due date for filing the original 
return.

4. Clarifications of 1996 Final Regulations

    Questions have arisen regarding the application of certain rules 
contained in the 1996 final regulations. These temporary regulations 
clarify the application of the 1996 final regulations with respect to 
certain direct interest allocations, certain requirements applicable to 
elections generally under Sec.  1.882-5, the definition of U.S.-booked 
liability, and the treatment of certain currency gain and loss for 
purposes of Sec.  1.882-5.
a. Direct Interest Allocations
    The direct interest allocation rules under Sec.  1.882-5 provide 
generally that a foreign taxpayer with both a U.S. asset and 
indebtedness that meet the requirements of both Sec.  1.861-10T(b) and 
(c) may treat the asset and the indebtedness as an integrated financial 
transaction and so may allocate interest expense with respect to the 
indebtedness directly to income from the asset. In general, Sec.  
1.861-10T(b) provides rules for certain nonrecourse indebtedness, and 
Sec.  1.861-10T(c) provides rules for certain integrated financial 
transactions. Financial institutions may allocate interest directly 
only to the extent provided by the nonrecourse indebtedness rules. 
These temporary regulations clarify that a financial institution is not 
disqualified from direct allocation treatment by satisfying only the 
rules provided in Sec.  1.861-10T(b) with respect to particular 
nonrecourse indebtedness transactions. These temporary regulations also 
clarify that direct allocation is mandatory for eligible taxpayers if 
the requirements of either Sec.  1.861-10T(b) or (c) are satisfied.
b. General Election Requirements
    The 1996 final regulations specify the time, place, and manner for 
making elections under each step of the formula. These temporary 
regulations clarify that a taxpayer eligible to change an election as 
of right after the minimum five-year period may do so only on an 
original timely filed return. These temporary regulations also clarify 
that the election procedures prohibit relief under Sec.  301.9100 for 
future elections as well as the elections in the first year a taxpayer 
is subject to the rules. These temporary regulations also clarify that 
after the minimum five-year period, a taxpayer may change an election 
on a timely filed return for any subsequent year. For example, leaving 
an election in place in the sixth year after the election was made does 
not constitute a new election subject to a new 5-year minimum period. 
The general election provision is updated to provide expressly that the 
elections to use the fair market value method election and the 30-day 
LIBOR rate election are subject to their own specific period 
requirements instead of the five-year minimum period.
c. U.S.-Booked Liabilities
    The definition of U.S.-booked liability has changed over time. The 
1981 final regulations defined U.S.-booked liabilities to include only 
liabilities shown on the books and records of the U.S. trade or 
business. This definition excluded assets that produced effectively 
connected income but were booked and maintained in a foreign branch. 
The 1996 final regulations modified the definition to include 
generally, for non banks, liabilities that are recorded reasonably 
contemporaneously with their acquisition on a set of books that has a 
direct relationship to an activity that gives rise to effectively 
connected income. For banks, liabilities generally must be recorded 
contemporaneously with their acquisition. These rules do not require 
tracing of specific borrowings to specific effectively connected uses. 
Whether there is a direct connection between the liability and an 
activity that produces effectively connected income is determined under 
all the facts and circumstances.
    These temporary regulations amend the definition of U.S.-booked 
liability and provide an example to clarify that in the case of a bank, 
the liability must be recorded on a set of books before the end of the 
day on which it is incurred, and the liability relates to an activity 
that produces effectively connected income. The reasonably 
contemporaneous booking rule is retained for non banks and the language 
clarified to reassert that the liability must relate to an activity 
that produces effectively connected income.
d. Currency Gain and Loss
    A foreign bank's U.S. branch commonly books third-party liabilities 
denominated in non-dollar currencies and uses the proceeds to make 
interbranch loans. Because interbranch transactions generally are not 
recognized for U.S. tax purposes, the third-party liability is treated 
as unhedged. As noted in the preamble to the 1996 final regulations, 
foreign currency gain or loss from an unhedged liability remains 
subject to the rules of

[[Page 47448]]

section 988. As a result, the U.S. branch may have currency gain or 
loss with respect to the third-party borrowing but may not be entitled 
to recognize currency gain or loss with respect to the offsetting 
interbranch transaction. In addition, any scaling down of interest 
expense that might otherwise be required under the AUSBL method does 
not apply to foreign currency gain or loss.
    Some taxpayers have suggested informally that, despite the absence 
of a general tracing principle in the interest allocation rules, 
currency gain and loss from such third-party liabilities should be 
traceable to currency gains and losses with respect to specific 
interbranch and noneffectively connected assets. The Treasury 
Department and the IRS solicit comments regarding the allocation, 
sourcing, and apportionment of currency gain or loss from unhedged 
third-party borrowings between effectively connected and non-
effectively connected income. Comments are specifically requested 
regarding the viability of a tracing principle for this purpose and the 
extent to which current booking practices may provide an administrable 
basis for such rules in accordance with existing authority.

5. Effective Date

    The temporary regulations are applicable for the first tax year end 
for which the original tax return due date (including extensions) is 
after August 17, 2006. Accordingly, for calendar-year taxpayers, the 
applicability date is for the tax year ended December 31, 2005. The 
rules provide an additional 180 days to make certain one-time special 
elections on an amended return for tax years for which the original tax 
return due date is not later than December 31, 2006.

Special Analyses

    It has been determined that this Treasury decision is not a 
significant regulatory action as defined in Executive Order 12866. 
Therefore, a regulatory assessment is not required. It also has been 
determined that section 553(b) of the Administrative Procedure Act (5 
U.S.C. chapter 5) does not apply to these regulations. For 
applicability of the Regulatory Flexibility Act (5 U.S.C. chapter 6) 
please refer to the cross reference notice of proposed rulemaking 
published elsewhere in this issue of the Federal Register. Pursuant to 
section 7805(f) of the Code, this regulation has been submitted to the 
Chief Counsel for Advocacy of the Small Business Administration for 
comment on its impact on small business.

Drafting Information

    The principal authors of these regulations are Paul S. Epstein and 
Gregory A. Spring of the Office of Associate Chief Counsel 
(International).

List of Subjects

26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

26 CFR Part 602

    Reporting and recordkeeping requirements.

Amendments to the Regulations

0
Accordingly, 26 CFR parts 1 and 602 are amended as follows:

PART 1--INCOME TAXES

0
Paragraph 1. The authority citation for part 1 is amended by adding 
entries in numerical order to read in part as follows:

    Authority: 26 U.S.C. 7805 * * *.
    Section 1.882-5 also issued under 26 U.S.C. 882, 26 U.S.C. 
864(e), 26 U.S.C. 988(d), and 26 U.S.C. 7701(l). * * *
    Section 1.884-1 is also issued under 26 U.S.C. 884. * * *


0
Par. 2. Section 1.882-0 is amended by:
0
1. Revising the entries for Sec.  1.882-5(a)(1), (a)(1)(i), (a)(1)(ii), 
(a)(1)(ii)(A), (a)(1)(ii)(B), (a)(2), (a)(7), (a)(7)(i), (a)(7)(ii), 
(b)(2)(ii)(A), (b)(3), (c)(2)(iv), (c)(4), (d)(2)(iii)(A), and 
(d)(5)(ii).
0
2. Removing the entry for Sec.  1.882-5(b)(2)(iv).
0
3. Adding entries for Sec.  1.882-5T. The revisions and additions read 
as follows:


Sec.  1.882-0  Table of contents.

* * * * *


Sec.  1.882-5  Determination of interest deduction.

* * * * *
    (a)(1) through (a)(2) [Reserved].
* * * * *
    (a)(7) through (a)(7)(ii) [Reserved].
* * * * *
    (b)(2)(ii)(A) [Reserved].
* * * * *
    (b)(3) [Reserved].
* * * * *
    (c)(2)(iv) [Reserved].
* * * * *
    (c)(4) [Reserved].
* * * * *
    (d)(2)(iii)(A) [Reserved].
* * * * *
    (d)(5)(ii) [Reserved].
* * * * *


Sec.  1.882-5T  Determination of interest deduction (temporary).

    (a) [Reserved].
    (1) Overview.
    (i) In general.
    (ii) Direct allocations.
    (A) In general.
    (B) Partnership interests
    (2) Coordination with tax treaties.
    (3) through (6) [Reserved].
    (7) Elections under Sec.  1.882-5.
    (i) In general.
    (ii) Failure to make the proper election.
    (iii) Step 2 special election for banks.
    (8) through (b)(2)(ii) [Reserved].
    (A) In general.
    (b)(2)(ii)(B) through (b)(2)(iii)(B) [Reserved].
    (3) Computation of total value of U.S. assets.
    (i) General rule.
    (ii) Adjustment to basis of financial instruments.
    (c) through (c)(2)(iii) [Reserved].
    (iv) Determination of value of worldwide assets.
    (c)(2)(v) through (c)(3) [Reserved].
    (4) Elective fixed ratio method of determining U.S. liabilities.
    (c)(5) through (d)(2)(iii) [Reserved].
    (A) In general.
    (B) through (d)(5)(i) [Reserved].
    (ii) Interest rate on excess U.S.-connected liabilities.
    (A) General rule.
    (B) Annual published rate election.
    (6) through (f)(2) [Reserved].

0
Par. 3. Section 1.882-5 is amended by:
0
1. Revising paragraphs (a)(1) through (a)(2), (a)(7) through 
(a)(7)(ii), (b)(2)(ii)(A), (b)(3), (c)(2)(iv), (c)(4), 
(d)(2)(ii)(A)(2), (d)(2)(ii)(A)(3), (d)(2)(iii)(A), and (d)(5)(ii).
0
2. Removing paragraph (b)(2)(iv).
0
3. Adding paragraph (d)(6) Example 5.
    The revisions and additions read as follows:


Sec.  1.882-5  Determination of interest deduction.

* * * * *
    (a)(1) through (a)(2) [Reserved]. For further guidance, see entry 
in Sec.  1.882-5T(a)(1) through (a)(2).
* * * * *
    (a)(7) through (a)(7)(ii) [Reserved]. For further guidance, see 
Sec.  1.882-5T(a)(7) through (a)(7)(ii).
* * * * *
    (b)(2)(ii)(A) [Reserved]. For further guidance, see Sec.  1.882-
5T(b)(2)(ii)(A).
* * * * *
    (b)(3) [Reserved]. For further guidance, see Sec.  1.882-5T(b)(3).
* * * * *
    (c)(2)(iv) [Reserved]. For further guidance, see Sec.  1.882-
5T(c)(2)(iv).
* * * * *

[[Page 47449]]

    (c)(4) [Reserved]. For further guidance, see Sec.  1.882-5T(c)(4).
* * * * *
    (d)(2)(ii)(A)(2) through (3) [Reserved]. For further guidance, see 
Sec.  1.882-5T(d)(2)(ii)(A)(2) through (3).
* * * * *
    (d)(2)(iii)(A) [Reserved]. For further guidance, see Sec.  1.882-
5T(d)(2)(iii)(A).
* * * * *
    (d)(5)(ii) [Reserved]. For further guidance, see Sec.  1.882-
5T(d)(5)(ii).
* * * * *
    (d)(6) Example 5[Reserved]. For further guidance, see Sec.  1.882-
5T(d)(6) Example 5.

0
Par. 4. Section 1.882-5T is added to read as follows:


Sec.  1.882-5T  Determination of interest deduction (temporary).

    (a) [Reserved]. For further guidance, see Sec.  1.882-5(a).
    (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 allocable by the foreign corporation under the three-step 
process set forth in paragraphs (b), (c), and (d) of this section and 
the specially allocated interest expense determined under paragraph 
(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 section 882(c). 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 U.S.-booked liabilities, as determined under paragraph 
(d)(2) of this section, is adjusted for interest expense attributable 
to the difference between U.S.-connected liabilities and U.S.-booked 
liabilities (Step 3). Alternatively, a foreign corporation may elect to 
determine its interest rate on U.S.-connected liabilities by reference 
to its U.S. assets, using the separate currency pools method described 
in paragraph (e) of this section.
    (ii) Direct allocations--(A) In general. A foreign corporation that 
has a U.S. asset and indebtedness that meet the requirements of Sec.  
1.861-10T(b) or (c), as limited by Sec.  1.861-10T(d)(1), shall 
directly allocate interest expense from such indebtedness to income 
from such asset in the manner and to the extent provided in Sec.  
1.861-10T. For purposes of paragraph (b)(1) or (c)(2) of this section, 
a foreign corporation that allocates its interest expense under the 
direct allocation rule of this paragraph (a)(1)(ii)(A) shall reduce the 
basis of the asset that meets the requirements of Sec.  1.861-10T (b) 
or (c) by the principal amount of the indebtedness that meets the 
requirements of Sec.  1.861-10T(b) or (c). The foreign corporation 
shall also disregard any indebtedness that meets the requirements of 
Sec.  1.861-10T(b) or (c) in determining the amount of the foreign 
corporation's liabilities under paragraphs (c)(2) and (d)(2) of this 
section and shall not take into account any interest expense paid or 
accrued with respect to such a liability for purposes of paragraph (d) 
or (e) of this section.
    (B) Partnership interest. A foreign corporation that is a partner 
in a partnership that has a U.S. asset and indebtedness that meet the 
requirements of Sec.  1.861-10T(b) or (c), as limited by Sec.  1.861-
10T(d)(1), shall directly allocate its distributive share of interest 
expense from that indebtedness to its distributive share of income from 
that asset in the manner and to the extent provided in Sec.  1.861-10T. 
A foreign corporation that allocates its distributive share of interest 
expense under the direct allocation rule of this paragraph 
(a)(1)(ii)(B) shall disregard any partnership indebtedness that meets 
the requirements of Sec.  1.861-10T(b) or (c) in determining the amount 
of its distributive share of partnership liabilities for purposes of 
paragraphs (b)(1), (c)(2)(vi), and (d)(2)(vii) or (e)(1)(ii) of this 
section, and shall not take into account any partnership interest 
expense paid or accrued with respect to such a liability for purposes 
of paragraph (d) or (e) of this section. For purposes of paragraph 
(b)(1) of this section, a foreign corporation that directly allocates 
its distributive share of interest expense under this paragraph 
(a)(1)(ii)(B) shall--
    (1) Reduce the partnership's basis in such asset by the amount of 
such indebtedness in allocating its basis in the partnership under 
Sec.  1.884-1(d)(3)(ii); or
    (2) Reduce the partnership's income from such asset by the 
partnership's interest expense from such indebtedness under Sec.  
1.884-1(d)(3)(iii).
    (2) Coordination with tax treaties. Except as expressly provided by 
or pursuant to a U.S. income tax treaty or accompanying documents (such 
as an exchange of notes), the provisions of this section provide the 
exclusive rules for determining the interest expense attributable to 
the business profits of a permanent establishment under a U.S. income 
tax treaty.
    (3) through (a)(6) [Reserved]. For further guidance, see Sec.  
1.882-5(a)(3) through (a)(6).
    (7) Elections under Sec.  1.882-5--(i) In general. A corporation 
must make each election provided in this section on the corporation's 
original timely filed Federal income tax return for the first taxable 
year it is subject to the rules of this section. An amended return does 
not qualify for this purpose, nor shall the provisions of Sec.  
301.9100-1 of this chapter and any guidance promulgated thereunder 
apply. Except as provided elsewhere in this section, 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 (other than the fair market value 
method under Sec.  1.882-5(b)(2)(ii), or the annual 30-day London 
Interbank Offered Rate (LIBOR) election in paragraph (d)(5)(ii) of this 
section) 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 his delegate. The Commissioner or his 
delegate will generally consent to a taxpayer's request to change its 
election only in rare and unusual circumstances. After the five-year 
minimum period, an elected method may be changed for any subsequent 
year on the foreign corporation's original timely filed tax return for 
the first year to which the changed election applies.
    (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 Director of Field Operations 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.
    (iii) Step 2 special election for banks. For the first tax year for 
which an original income tax return is due (including extensions) after 
August 17, 2006 and not later than December 31, 2006, in which a 
taxpayer that is a bank as described in Sec.  1.882-5(c)(4) is subject 
to the requirements of this section, a taxpayer may make a new election 
to use the fixed ratio on either an original timely filed return, or on 
an amended return filed within 180 days after the original due date 
(including extensions). A new fixed ratio election may be made in any 
subsequent year subject to the timely filing and five-year minimum

[[Page 47450]]

period requirements of paragraph (a)(7)(i) of this section. A new fixed 
ratio election under this paragraph (a)(7)(iii) is subject to the 
adjusted basis or fair market value conforming election requirements of 
paragraph (b)(2)(ii)(A)(2) of this section and may not be made if a 
taxpayer elects or maintains a fair market value election for purposes 
of Sec.  1.882-5(b). Taxpayers that already use the fixed ratio method 
under an existing election may continue to use the new fixed ratio at 
the higher percentage without having to make a new five-year election 
in the first year that the higher percentage is effective.
    (8) through (b)(2)(ii) [Reserved]. For further guidance, see Sec.  
1.882-5(a)(8) through (b)(2)(ii) .
    (A) In general--(1) Fair market value conformity requirement. A 
taxpayer may elect to value all of its U.S. assets on the basis of fair 
market value, subject to the requirements of Sec.  1.861-9T(g)(1)(iii), 
and provided the taxpayer is eligible and uses the actual ratio method 
under Sec.  1.882-5(c)(2) and the methodology prescribed in Sec.  
1.861-9T(h). Once elected, the fair market value must be used by the 
taxpayer for both Step 1 and Step 2 described in Sec. Sec.  1.882-5(b) 
and (c), and must be used in all subsequent taxable years unless the 
Commissioner or his delegate consents to a change.
    (2) Conforming election requirement. Taxpayers that as of the 
effective date of this paragraph (b)(2)(ii)(A)(2) have elected and 
currently use both the fair market value method for purposes of Sec.  
1.882-5(b) and a fixed ratio for purposes of paragraph (c)(4) of this 
section must conform either the adjusted basis or fair market value 
methods in Step 1 and Step 2 of the allocation formula by making an 
adjusted basis election for Sec.  1.882-5(b) purposes while continuing 
the fixed ratio for Step 2, or by making an actual ratio election under 
Sec.  1.882-5(c)(2) while remaining on the fair market value method 
under Sec.  1.882-5(b). Taxpayers who elect to conform Step 1 and Step 
2 of the formula to the adjusted basis method must remain on both 
methods for the minimum five-year period in accordance with the 
provisions of paragraph (a)(7) of this section. Taxpayers that elect to 
conform Step 1 and Step 2 of the formula to the fair market value 
method must remain on the actual ratio method until the consent of the 
Commissioner or his delegate is obtained to switch to the adjusted 
basis method. If consent to use the adjusted basis method in Step 1 is 
granted in a later year, the taxpayer must remain on the actual ratio 
method for the minimum five-year period unless consent to use the fixed 
ratio is independently obtained under the requirements of paragraph 
(a)(7) of this section. For the first tax year for which an original 
income tax return is due (including extensions) after August 17, 2006 
and not later than December 31, 2006, taxpayers that are required to 
make a conforming election under this paragraph (b)(2)(ii)(A)(2), may 
do so either on a timely filed original return or on an amended return 
within 180 days after the original due date (including extensions). If 
a conforming election is not made within the timeframe provided in this 
paragraph, the Director of Field Operations or his delegate may make 
the conforming elections in accordance with the provisions of paragraph 
(a)(7)(ii) of this section.
    (B) through (b)(2)(iii)(B) [Reserved]. For further guidance, see 
Sec.  1.882-5(b)(2)(ii)(B) through (b)(2)(iii)(B).
    (3) Computation of total value of U.S. assets--(i) General rule. 
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 (beginning of taxable year and monthly 
thereafter) by a large bank (as defined in section 585(c)(2)) or a 
dealer in securities (within the meaning of section 475) and semi-
annually (beginning, middle and end of taxable year) by any other 
taxpayer.
    (ii) Adjustment to basis of financial instruments. For purposes of 
determining the total average value of U.S. assets in this paragraph 
(b)(3), the value 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 is the most frequent regular interval for which data 
are reasonably available that reflects the taxpayer's consistent 
business practices for reflecting mark-to-market valuations on its 
books and records.
    (c) through (c)(2)(iii) [Reserved]. For further guidance, see Sec.  
1.882-5(c) through (c)(2)(iii).
    (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. The rules of Sec.  
1.882-5(b)(3)(ii) apply in determining the total value of applicable 
worldwide assets for the taxable year, except that the minimum number 
of determination dates are those stated in Sec.  1.882-5(c)(2)(i).
    (c)(2)(v) through (c)(3) [Reserved]. For further guidance, see 
Sec.  1.882-5(c)(2)(v) through (c)(3).
    (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 or whether any such activities 
are effectively connected with a trade or business within the United 
States) may elect to use a fixed ratio of 95 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) through (d)(2)(ii)(A)(1) [Reserved]. For further guidance, see 
Sec.  1.882-5(c)(5) through (d)(2)(ii)(A)(1).
    (2) The foreign corporation enters the liability on a set of books 
reasonably contemporaneous with the time at which the liability is 
incurred and the liability relates to an activity that produces ECI.
    (3) The foreign corporation maintains a set of books and records 
relating to an activity that produces ECI and the Director of Field 
Operations 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.
    (d)(2)(ii)(B) through (d)(2)(iii) [Reserved]. For further guidance, 
see Sec.  1.882-5(d)(2)(ii)(B) through (d)(2)(iii).
    (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 before the 
close of the day on which the liability is incurred, and the liability 
relates to an activity that produces ECI; and
    (2) There is a direct connection or relationship between the 
liability and that activity. Whether there is a direct connection 
between the liability and an activity that produces ECI depends on

[[Page 47451]]

the facts and circumstances of each case. For example, a liability that 
is used to fund an interbranch or other asset that produces non-ECI may 
have a direct connection to an ECI producing activity and may 
constitute a U.S.-booked liability if both the interbranch or non-ECI 
activity is the same type of activity in which ECI assets are also 
reflected on the set of books (for example, lending or money market 
interbank placements), and such ECI activities are not de minimis. Such 
U.S. booked liabilities may still be subject to Sec.  1.882-5(d)(2)(v).
    (B) through (d)(5)(i) [Reserved]. For further guidance, see Sec.  
1.882-5(d)(2)(iii)(B) through (d)(5)(i).
    (ii) Interest rate on excess U.S.-connected liabilities--(A) 
General rule. 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 that are not 
U.S.-booked liabilities (as defined in Sec.  1.882-5(d)(2)) and that 
are 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) that are not 
U.S.-booked liabilities and that are shown on the books of the offices 
or branches of the foreign corporation outside the United States for 
the taxable year.
    (B) Annual published rate election. For each taxable year beginning 
with the first year end for which the original tax return due date 
(including extensions) is after August 17, 2006, in which a taxpayer is 
a bank within the meaning of section 585(a)(2)(B) (without regard to 
the second sentence thereof or whether any such activities are 
effectively connected with a trade or business within the United 
States), such taxpayer may elect to compute its excess interest by 
reference to a published average 30-day London Interbank Offering Rate 
(LIBOR) for the year. The election may be made for any eligible year by 
attaching a statement to a timely filed tax return (including 
extensions) that shows the 3-step components of the taxpayer's interest 
expense allocation under the adjusted U.S.-booked liabilities method 
and identifies the provider (for example, International Monetary Fund 
statistics) of the 30-day LIBOR rate selected. Once selected, the 
provider and the rate may not be changed by the taxpayer. If a taxpayer 
that is eligible to make the 30-day LIBOR election either does not file 
a timely return or files a calculation that allocates interest expense 
under the scaling ratio in Sec.  1.882-5(d)(4) and it is determined by 
the Director of Field Operations that the taxpayer's U.S.-connected 
liabilities exceed its U.S.-booked liabilities, then the Director of 
Field Operations, and not the taxpayer, may choose whether to determine 
the taxpayer's excess interest rate under paragraph (d)(5)(ii)(A) or 
(B) of this section and may select the published 30-day LIBOR rate. For 
the first taxable year for which an original tax return due date 
(including extensions) is after August 17, 2006 and not later than 
December 31, 2006, an eligible taxpayer may make the 30-day LIBOR 
election one time for the taxable year on an amended return within 180 
days after the original due date (including extensions).
    (d)(6) through (d)(6) Example 4 [Reserved]. For further guidance, 
see Sec.  1.882-5(d)(6) through (d)(6) Example 4.

    Example 5. U.S. booked liabilities--direct relationship. (i) 
Facts. Bank A, a resident of Country X, maintains a banking office 
in the U.S. that records transactions on three sets of books for 
State A, an International Banking Facility (IBF) for its bank 
regulatory approved international transactions, and a shell branch 
licensed operation in Country C. Bank A records substantial ECI 
assets from its bank lending and placement activities and a mix of 
interbranch and non-ECI producing assets from the same or similar 
activities on the books of State A branch and on its IBF. Bank A's 
Country C branch borrows substantially from third parties, as well 
as from its home office, and lends all of its funding to its State A 
branch and IBF to fund the mix of ECI, interbranch and non-ECI 
activities on those two books. The consolidated books of State A 
branch and IBF indicate that a substantial amount of the total book 
assets constitute U.S. assets under Sec.  1.882-5(b). Some of the 
third-party borrowings on the books of the State A branch are used 
to lend directly to Bank A's home office in Country X. These 
borrowings reflect the average borrowing rate of the State A branch, 
IBF and Country C branches as a whole. All third-party borrowings 
reflected on the books of State A branch, the IBF and Country C 
branch were recorded on such books before the close of business on 
the day the liabilities were acquired by Bank A.
    (ii) U.S. booked liabilities. The facts demonstrate that the 
separate State A branch, IBF and Country C branch books taken 
together, constitute a set of books within the meaning of 
(d)(2)(iii)(A)(1) of this section. Such set of books as a whole has 
a direct relationship to an ECI activity under (d)(2)(iii)(A)(2) of 
this section even though the Country C branch books standing alone 
would not. The third-party liabilities recorded on the books of 
Country C constitute U.S. booked liabilities because they were 
timely recorded and the overall set of books on which they were 
reflected has a direct relationship to a bank lending and interbank 
placement ECI producing activity. The third-party liabilities that 
were recorded on the books of State A branch that were used to lend 
funds to Bank A's home office also constitute U.S. booked 
liabilities because the interbranch activity the funds were used for 
is a lending activity of a type that also gives rise to a 
substantial amount of ECI that is properly reflected on the same set 
of books as the interbranch loans. Accordingly, the liabilities are 
not traced to their specific interbranch use but to the ove