Determination of Interest Expense Deduction of Foreign Corporations, 49315-49320 [E9-22867]

Agencies

• Internal Revenue Service
• DEPARTMENT OF THE TREASURY

[Federal Register Volume 74, Number 186 (Monday, September 28, 2009)]
[Rules and Regulations]
[Pages 49315-49320]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: E9-22867]


=======================================================================
-----------------------------------------------------------------------

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 1 and 602

[TD 9465]
RIN 1545-BF71


Determination of Interest Expense Deduction of Foreign 
Corporations

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations and removal of temporary regulations.

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

SUMMARY: This document contains final regulations under section 882(c) 
of the Internal Revenue Code (Code) concerning the determination of the 
interest expense deduction of foreign corporations engaged in a trade 
or business within the United States. These final regulations conform 
the interest expense rules to recent U.S. Income Tax Treaty agreements 
and adopt other changes to improve compliance.

DATES: These final regulations are effective September 28, 2009.

FOR FURTHER INFORMATION CONTACT: Anthony J. Marra, (202) 622-3870 (not 
a toll-free number).

SUPPLEMENTARY INFORMATION: 

Paperwork Reduction Act

    The collection of information contained in these final regulations 
has been reviewed and approved by the Office of Management and Budget 
in accordance with the Paperwork Reduction Act of 1995 (44 U.S.C. 
3507(d)) under control number 1545-2030. Responses to this collection 
of information are mandatory. The collection of information in these 
final regulations is in Sec.  1.884-1(e)(3)(iv). This information is 
required by the IRS to allow a taxpayer to reduce U.S. liabilities to 
the extent necessary to prevent the recognition of a dividend 
equivalent amount.
    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.
    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.

[[Page 49316]]

Background

    On August 17, 2006, the Treasury Department and the IRS published 
TD 9281 (71 FR 47443-01, 2006-2 CB 517) (the temporary regulations) 
under section 882(c) of the Internal Revenue 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 the same day, a notice of proposed 
rulemaking (REG-120509-06, 71 FR 47459, 2006-2 CB 570) was published by 
cross-reference to the temporary regulations in the Federal Register. 
See Sec.  601.601(d)(2)(ii)(b).
    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. The notice of 
proposed rulemaking (the proposed regulations) provided for certain 
changes in the three-step calculation. First, the proposed regulations 
revised the election to use fair market value rather than adjusted 
basis in valuing U.S. assets in Step 1. That revision required the 
taxpayer to use fair market valuations for both Step 1 purposes and the 
entire determination of the actual ratio in Step 2. The proposed 
regulations also revised the Step 2 elective fixed ratio for foreign 
banks, allowing a 95 percent fixed ratio to be used in lieu of the 
actual ratio. In Step 3, the proposed regulations allowed a foreign 
bank with excess U.S.-connected liabilities over U.S.-booked 
liabilities under the adjusted U.S. booked liabilities (AUSBL) method 
to elect to use the 30-day London Interbank Offering Rate (LIBOR) to 
calculate interest on the excess U.S.-connected liabilities.
    In addition to the changes in the three-step calculation, the 
proposed regulations implemented guidance provided in Notice 2005-53 
(2005-32 IRB 263, 2005-2 CB 263) regarding the interaction of Sec.  
1.882-5 and U.S. income tax treaties in recognition that recent 
treaties expressly permit taxpayers to determine attribution of 
business profits to a permanent establishment by analogy to the 1995 
Organisation for Economic Co-operation and Development Transfer Pricing 
Guidelines (Authorized OECD Approach). For purposes of applying the 
branch profits tax, the proposed regulations expanded the election 
under Sec.  1.884-1 to allow a taxpayer to reduce U.S. liabilities to 
the extent necessary to prevent the recognition of a dividend 
equivalent amount, but not below zero. Finally, the proposed 
regulations clarified the application of the 1996 final regulations 
under Sec.  1.882-5 with respect to certain direct interest 
allocations, the definition of U.S.-booked liabilities, and the 
treatment of certain currency gain and loss for purposes of Sec.  
1.882-5. The preamble of TD 9281 includes background information with 
respect to the proposed regulations and a further explanation of these 
provisions. See Sec.  601.601(d)(2)(ii)(b).
    The IRS received written comments in response to the proposed 
regulations. No requests to speak at a public hearing were received and 
no hearing was held. After consideration of the comments received, the 
proposed regulations are adopted without substantive change by this 
Treasury decision, and the corresponding temporary regulations are 
removed. To relieve taxpayers of the burden of duplicative reporting, 
these final regulations coordinate the various elections provided in 
the three-step formula with the filing of taxpayer's Schedule I (Form 
1120-F). Taxpayers filing protective tax returns under Sec.  1.882-
4(a)(3)(vi) may make Sec.  1.882-5 protective elections by attaching 
Schedule I to a timely filed return (including extensions). Taxpayers 
must separately attach to the Form 1120-F, any election to reduce U.S. 
liabilities for branch profits tax purposes as permitted by Sec.  
1.884-1(e)(3). A taxpayer's Schedule I must reflect the cumulative 
amount of all U.S. liability reductions.
    Many of the comments received raised issues specific to certain 
financial transactions that require broader considerations than the 
interaction of Sec.  1.882-5 and those financial transactions. The 
Treasury Department and the IRS received a number of comments 
requesting that the 1996 proposed hedging regulations (INTL-0054-95, 
1996-1 CB 844) be finalized and expanded, in certain cases, to cover 
interbranch activities (including currency gains and losses). Since 
those regulations were proposed, the increase in interdesk and 
interbranch hedging (in both dealer and nondealer operations) has given 
rise to special considerations other than the familiar limitations 
associated with capital and ordinary income distinctions. In this 
regard, the proposed 1998 global dealing regulations, for example, 
require special considerations as to the appropriate treatment of risk 
transfer agreements in similar circumstances. In light of the need for 
a broader consideration of these issues, the Treasury Department and 
the IRS are not adopting the suggestions outlined in the comments 
received at this time. See Sec.  601.601(d)(2)(ii)(b).
    Commentators also suggested that the regulations adopt special 
rules that would govern the treatment of certain integrated financial 
transactions such as effectively connected sale-repurchase agreements 
and securities lending transactions. The commentators suggested the 
adoption of a direct tracing rule that would, in effect, give zero risk 
weighting to such assets, especially in defined dealer books consisting 
of sale-repurchase transactions and securities loans involving U.S. 
Treasuries and other government securities. The suggested rule would 
scale back the amount of capital that is imputed to such portfolios 
under either the actual ratio or the fixed ratio to reflect the 
economic reality that such assets are entirely debt-financed. 
Commentators also suggested that ``netting'' rules apply for offsetting 
notional principal contracts within discrete portfolios. Finally, 
commentators suggested revisions to the definition of U.S.-booked 
liabilities that would exclude certain conduit interbranch lending 
arrangements. The Treasury Department and the IRS are not adopting 
these suggestions at this time but continue to consider the issues 
raised in this context and intend to coordinate these issues, where 
appropriate, with similar issues in analogous contexts, such as global 
dealing operations and section 864(e). See Notice 2001-59 (2001-41 IRB 
315, 2001-2 CB 315). See Sec.  601.601(d)(2)(ii)(b).
    Section 861(a)(1)(C), as amended by the American Jobs Creation Act 
of 2004 provides a special source rule for interest on obligations of 
certain foreign partnerships and may require coordinating changes to 
the branch-level interest tax rules under Sec.  1.884-4. Specifically, 
a foreign corporate partner is not treated as paying branch interest 
under Sec.  1.884-4(b)(1)(i)(A) and therefore may be liable for tax on 
excess interest even if that foreign partner has U.S. book interest 
paid with respect to its distributive share of U.S. booked liabilities 
under Sec.  1.882-5. Accordingly, the Treasury Department and the IRS 
are currently considering how best to coordinate the U.S. booked 
liability rules with the determination of partnership branch interest 
so that foreign corporate partners of partnerships described in section 
861(a)(1)(C) are provided similar treatment under Sec.  1.884-4 with 
respect to their distributive shares of interest expense as foreign 
corporations directly

[[Page 49317]]

engaged in a trade or business within the United States.

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. It is hereby 
certified that the collection of information contained in these 
regulations will not have a significant economic impact on a 
substantial number of small entities. Accordingly, a regulatory 
flexibility analysis under the Regulatory Flexibility Act (5 U.S.C. 
chapter 6) is not required. The collection of information requirement 
in these regulations generally only affects large foreign banks. Thus, 
the number of affected small entities will not be substantial and any 
economic impacts on those entities in complying with the collection of 
information would be minimal. Pursuant to section 7805(f) of the Code, 
these regulations have 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 author of these regulations is Anthony J. Marra of 
the Office of Associate Chief Counsel (International). However, other 
persons from the Office of Associate Chief Counsel (International) and 
the Treasury Department have participated in their development.

List of Subjects

26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

26 CFR Part 602

    Reporting and recordkeeping requirements.

Adoption of 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 continues to read in 
part as follows:

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


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. Adding entries for Sec.  1.882-5(a)(7)(iii), (b)(3)(i), (b)(3)(ii), 
(d)(5)(ii)(A), and (d)(5)(ii)(B).
0
3. Removing the 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) Overview.
    (i) In general.
    (ii) Direct allocations.
    (A) In general.
    (B) Partnership interests.
    (2) Coordination with tax treaties.
* * * * *
    (7) Elections under Sec.  1.882-5.
    (i) In general.
    (ii) Failure to make the proper election.
    (iii) Step 2 special election for banks.
* * * * *
    (b) * * *
    (2) * * *
    (ii) * * *
    (A) In general.
* * * * *
    (3) Computation of total value of U.S. assets.
    (i) General rule.
    (ii) Adjustment to basis of financial instruments.
* * * * *
    (c)(2)(iv) Determination of value of worldwide assets.
* * * * *
    (4) Elective fixed ratio method of determining U.S. liabilities.
* * * * *
    (d) * * *
    (2) * * *
    (iii) * * *
    (A) In general.
* * * * *
    (5) * * *
    (ii) Interest rate on excess U.S.-connected liabilities.
    (A) General rule.
    (B) Annual published rate election.
* * * * *

0
Par. 3. Section 1.882-5 is amended by revising paragraphs (a)(1), 
(a)(2), (a)(7), (a)(7)(i), (a)(7)(ii), (a)(7)(iii), (b)(2)(ii)(A), 
(b)(3), (c)(2)(iv), (c)(4), (d)(2)(ii)(B)(2), (d)(2)(ii)(B)(3), 
(d)(2)(iii)(A), (d)(5)(ii), (d)(6) Example 5 and (f)(1) to read as 
follows:


Sec.  1.882-5  Determination of interest deduction.

    (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.

[[Page 49318]]

    (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.
* * * * *
    (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 indicating the method 
used on Schedule I (Form 1120-F) attached to the corporation's timely 
filed return. An elected method (other than the fair market value 
method under paragraph (b)(2)(ii) of this section, 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 taxable year 
for which an original income tax return is due (including extensions) 
after August 17, 2006, in which a taxpayer that is a bank as described 
in paragraph (c)(4) of this section is subject to the requirements of 
this section, a taxpayer may make a new election to use the fixed ratio 
on an original timely filed return. A new fixed ratio election may be 
made in any subsequent year subject to the timely filing and five-year 
minimum 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 paragraph (b) of this section. 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.
* * * * *
    (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 paragraph (c)(2) of this section 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 paragraphs (b) 
and (c) of this section, 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 
paragraph (b) of this section 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 paragraph (b) of this 
section purposes while continuing the fixed ratio for Step 2, or by 
making an actual ratio election under paragraph (c)(2) of this section 
while remaining on the fair market value method under paragraph (b) of 
this section. 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 taxable year for which an original income tax return is 
due (including extensions) after August 17, 2006, taxpayers that are 
required to make a conforming election under this paragraph 
(b)(2)(ii)(A)(2), may do so on an original timely filed return. 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.
* * * * *
    (3) Computation of total value of U.S. assets--(i) General rule. 
The total value

[[Page 49319]]

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 shall 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) * * *
    (2) * * *
    (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 
paragraph (b)(3) of this section 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 paragraph 
(c)(2)(i) of this section.
* * * * *
    (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.
* * * * *
    (d) * * *
    (2) * * *
    (ii) * * *
    (B) * * *
    (2) The foreign corporation enters the liability on a set of books 
reasonably contemporaneously 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.
* * * * *
    (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 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 paragraph (d)(2)(v) of 
this section.
* * * * *
    (5) * * *
    (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 paragraph (d)(2) of this 
section) 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 
indicating the rate used on Schedule I (Form 1120-F) attached to the 
timely filed return. Once selected, 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 paragraph 
(d)(4) of this section 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.
    (6) * * *

    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

[[Page 49320]]

paragraph (b) of this section. 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 paragraph 
(d)(2)(iii)(A)(1) of this section. Such set of books as a whole has 
a direct relationship to an ECI activity under paragraph 
(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 overall 
activity of bank lending and interbank placements which gives rise 
to substantial ECI. The facts show that the liabilities were not 
acquired to increase artificially the interest expense of Bank A's 
U.S. booked liabilities as a whole under paragraph (d)(2)(v) of this 
section. The third-party liabilities also constitute U.S. booked 
liabilities for purposes of determining Bank A's branch interest 
under Sec.  1.884-4(b)(1)(i)(A) regardless of whether Bank A uses 
the Adjusted U.S. booked liability method, or the Separate Currency 
Pool method to allocate its interest expense under paragraph 5(e) of 
this section.
* * * * *
    (f)(1) Effective/applicability date--(1) General rule. This section 
is applicable for taxable years ending on or after August 15, 2009. A 
taxpayer, however, may choose to apply Sec.  1.882-5T, rather than 
applying the final regulations, for any taxable year beginning on or 
after August 16, 2008 but before August 15, 2009.
* * * * *


Sec.  1.882-5T  [Removed]

0
Par. 4. Section 1.882-5T is removed.

0
Par. 5. Section 1.884-1 is amended by revising paragraphs (e)(3)(ii), 
(e)(3)(iv) and (e)(5) Example 2.


Sec.  1.884-1  Branch profits tax.

* * * * *
    (e) * * *
    (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 
lesser of the amount of U.S. liabilities as of the determination date, 
or the amount of U.S. liability reduction needed to reduce a dividend 
equivalent amount as of the determination date to zero.
* * * * *
    (iv) Method of election. A foreign corporation that elects the 
benefits of this paragraph (e)(3) for a taxable year shall attach a 
statement to its return for the taxable year that it has elected to 
reduce its liabilities for the taxable year under this paragraph (e)(3) 
and that it has reduced the amount of its U.S.-connected liabilities as 
provided in paragraph (e)(3)(iii) of this section and shall indicate 
the amount of such reductions on such attachment. The cumulative amount 
of all U.S. liability reductions is shown on Schedule I (Form 1120-F) 
in addition to the separate elections attached to the timely filed 
return. An election under this paragraph (e)(3) must be made before the 
due date (including extensions) for the foreign corporation's income 
tax return for the taxable year.
* * * * *
    (5) * * *

    Example 2. Election made to reduce liabilities. (i) As of the 
close of 2007, foreign corporation A, a real estate company, owns 
U.S. assets with an E&P basis of $1000. A has $800 of liabilities 
under paragraph (e)(1) of this section. A has accumulated ECEP of 
$500 and in 2008, A has $60 of ECEP that it intends to retain for 
future expansion of its U.S. trade or business. A elects under 
paragraph (e)(3) of this section to reduce its liabilities by $60 
from $800 to $740. As a result of the election, assuming A's U.S. 
assets and U.S. liabilities would otherwise have remained constant, 
A's U.S. net equity as of the close of 1994 will increase by the 
amount of the decrease in liabilities ($60) from $200 to $260 and 
its ECEP will be reduced to zero. Under paragraph (e)(3)(iii) of 
this section, A's interest expense for the taxable year is reduced 
by the amount of interest attributable to $60 of liabilities and A's 
excess interest is reduced by the same amount. A's taxable income 
and ECEP are increased by the amount of the reduction in interest 
expense attributable to the liabilities, and A may make an election 
under paragraph (e)(3) of this section to further reduce its 
liabilities, thus increasing its U.S. net equity and reducing the 
amount of additional ECEP created for the election.
    (ii) In 2009, assuming A again has $60 of ECEP, A may again make 
the election under paragraph (e)(3) to reduce its liabilities. 
However, assuming A's U.S. assets and liabilities under paragraph 
(e)(1) of this section remain constant, A will need to make an 
election to reduce its liabilities by $120 to reduce to zero its 
ECEP in 2009 and to continue to retain for expansion (without the 
payment of the branch profits tax) the $60 of ECEP earned in 2008. 
Without an election to reduce liabilities, A's dividend equivalent 
amount for 2009 would be $120 ($60 of ECEP plus the $60 reduction in 
U.S. net equity from $260 to $200). If A makes the election to 
reduce liabilities by $120 (from $800 to $680), A's U.S. net equity 
will increase by $60 (from $260 at the end of the previous year to 
$320), the amount necessary to reduce its ECEP to $0. However, the 
reduction of liabilities will itself create additional ECEP subject 
to section 884 because of the reduction in interest expense 
attributable to the $120 of liabilities. A can make the election to 
reduce liabilities by $120 without exceeding the limitation on the 
election provided in paragraph (e)(3)(ii) of this section because 
the $120 reduction does not exceed the amount needed to treat the 
2009 and 2008 ECEP as reinvested in the net equity of the trade or 
business within the United States.
    (iii) If A terminates its U.S. trade or business in 2009 in 
accordance with the rules in Sec.  1.884-2T(a), A would not be 
subject to the branch profits tax on the $60 of ECEP earned in that 
year. Under paragraph (e)(3)(v) of this section, however, it would 
be subject to the branch profits tax on the portion of the $60 of 
ECEP that it earned in 2008 that became accumulated ECEP because of 
an election to reduce liabilities.
* * * * *


Sec.  1.884-1T  [Removed]

0
Par. 6. Section 1.884-1T is removed.

PART 602--OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT

0
Par. 7. The authority citation for part 602 continues to read as 
follows:


    Authority: 26 U.S.C. 7805.


0
Par. 8. In Sec.  602.101, paragraph (b) is amended by removing the 
entry for ``Sec.  1.882-5T'' from the table.

Linda E. Stiff,
Deputy Commissioner for Services and Enforcement.
    Approved: September 15, 2009.
Michael Mundaca,
(Acting) Assistant Secretary of the Treasury (Tax Policy).
[FR Doc. E9-22867 Filed 9-25-09; 8:45 am]
BILLING CODE 4830-01-P