U.S. Tax Alert - 9 October 2009

By Paul Epstein, Harrison Cohen and Kelly Kogan

On September 25, 2009, the Treasury Department and the Internal Revenue Service (IRS) released T.D. 9465,¹ finalizing amendments to Reg. §1.882-5 (the “interest allocation regulations”) and subsection (e)(3) and (5) of Reg. §1.884-1 (the “branch profits tax regulations”) relating to the computation of interest deductions in determining a foreign corporation’s taxable income effectively connected with the conduct of a trade or business within the United States (“effectively connected income,” or “ECI”) and the election to reduce U.S. liabilities for the purpose of computing a foreign corporation’s branch profits tax.

August 2006 temporary regulations (the “temporary regulations”) that modified the 1996 versions of the interest allocation and branch profits tax regulations (the “1996 regulations”) expired on August 15, 2009.² T.D. 9465 (the “2009 amendments”) finalizes the changes to the 1996 regulations that were set forth in the temporary regulations without substantive change. However, the 2009 amendments do change the procedures for effecting timely elections applicable to the “3-step” allocation methods under the interest allocation regulations and to the U.S. liabilities reduction election under the branch profits tax regulations.

As of the effective date of the 2009 amendments, the interest allocation and branch profits tax liability reduction elections generally must be effected on Schedule I (Form 1120-F), attached to the foreign corporation’s timely filed U.S. federal income tax return. The preamble to the 2009 amendments also provides that taxpayers that file “protective returns” to preserve the right to claim deductions under Reg. §1.882-4 may also make protective Reg. §1.882-5 elections on Schedule I (Form 1120-F). (The instructions to Schedule I provided for this protective election procedure for years beginning on or after January 1, 2007.) In addition to the disclosure required for the cumulative amount of elective liability reductions on Schedule I (Form 1120-F), the liability reduction election for a tax year must also be identified on a separate statement that must be attached to a timely filed return for that year.

The 2009 amendments are detailed below. Also addressed is a new issue discussed in the preamble for which the Treasury and IRS are considering changes and the status of issues on which comments were received in response to the temporary regulations. This discussion is followed by an overview of the 3-step interest allocation methods as background and a brief summary of the temporary 2006 amendments to the 1996 regulations that the 2009 amendments adopted without substantive change.

Effective date

Interest allocation regulations: The 2009 amendments to the interest allocation regulations are effective for tax years ending on or after August 15, 2009. (The temporary regulations expired on that date.) For taxable years beginning on or after August 16, 2008, but before August 15, 2009, a taxpayer may continue to apply the temporary regulations. Accordingly, tax returns for the calendar year 2009 are subject to the 2009 amendments, but a taxpayer filing such a return may choose to apply the temporary regulations for that year, instead of complying with the 2009 amendments.³ Taxpayers that do use the temporary regulations during the transition period must still attach a properly completed Schedule I (Form 1120-F) to a timely filed Form 1120-F in accordance with the Form 1120-F filing requirements that apply independently of the 2009 amendments.

Branch profits tax regulations: There is no effective date provided in the 2009 amendments to the branch profits tax regulations. Accordingly, unless a technical correction is made to the regulations, the liability reduction election in Reg. §1.884-1(e)(3) does not have a limitation on either the eligibility to make the election or the amount of the reduction, or a time, place and manner rule for effecting the election after August 15, 2009, and before September 28, 2009. Presumably the 2009 amendments to the branch profits tax regulations are effective on the latter date because that was the date they were published in the Federal Register.

Changes made by the 2009 amendments

The 2009 amendments change the procedure for adopting or changing the elections available under the 3-step allocation method provided under Reg. §1.882-5. (The mechanics of the elections are discussed in the final sections of this alert under “Overview of 3-step allocation method.”)

Subsequent to the promulgation of the temporary regulations, Schedule I (Form 1120-F) was adopted as a required filing with Form 1120-F for tax years beginning on or after January 1, 2007. Thus, the temporary regulations did not refer to Schedule I in providing for the time and manner for making elections under the interest allocation and branch profits tax regulations.

While under the temporary regulations a taxpayer made these elections by using the elected method in its interest expense computation, under the 2009 amendments these elections are given effect only through the contemporaneous disclosure of the formula and methods used on a Schedule I (Form 1120-F) attached to the corporation’s timely filed U.S. federal income tax return. If an election is not disclosed on a Schedule I (Form 1120-F) attached to the taxpayer’s timely filed U.S. federal income tax return, the IRS may make the election on the taxpayer’s behalf in the first year the taxpayer is subject to the requirements of Reg. §1.882-5, and such election shall be binding as if made by the taxpayer.

The 2009 amendments continue to prohibit elections on an amended return (regardless of whether a Schedule I (Form 1120-F) is attached to the amended return), and they continue to deny eligibility for relief for late elections by administrative ruling under Reg. §301.9100-1.

Finally, in the case of banks that make the election to use 30-day LIBOR (London Interbank Offered Rate) to compute interest on excess liabilities, Schedule I (Form 1120-F) requires that such taxpayers identify only the rate used and not the source of the rate (e.g. International Monetary Statistics). Taxpayers that choose to use the temporary regulations for their 2009 tax return filings must file a separate attachment to their Form 1120-F. As a practical matter, the need to identify the source of the LIBOR rate used would seem to only apply if a taxpayer inadvertently did not file Schedule I (Form 1120-F) with its return but calculated excess interest using 30-day LIBOR. Taxpayers that correctly complete and file Schedule I (Form 1120-F) with their timely filed tax returns for tax years ending on or after August 15, 2009, are technically in compliance with the election procedures under the 2009 amendments. Taxpayers that make protective elections with protective returns filed in accordance with Reg. §1.882-4 need not complete the computational steps on Schedule I, but need only check the appropriate “filter boxes” indicating the elections protectively made. However, the instructions to the most recent Schedule I (Form 1120-F) also provide that the 30-day LIBOR rate protectively adopted must be identified.

Branch profits tax liability reduction election

The 2009 amendments adopt the relaxed limitation that was introduced in the temporary regulations on elective U.S. liability reductions, but, unlike the temporary regulations, the 2009 amendments refer to the requirement on line 7b of Schedule I (Form 1120-F) to report the total of all liability reduction election amounts. (The 2009 amendments refer to the amount on line 7b as “[t]he cumulative amount of all U.S. liability reductions.”) As under the temporary regulations, the limit on the reduction is the lesser of the amount of U.S. liabilities that a taxpayer has as of the determination date or the amount needed to reduce a dividend equivalent amount (DEA) to zero.

A reduction in U.S. liabilities to reduce a DEA has collateral effects besides the effect on branch profits tax liability. It may cause a reduction in the “excess interest” expense that a foreign corporation would otherwise have, and thus may reduce the corporation’s tax under §884(f)(1)(B) on excess interest. Additionally, a reduction in U.S. liabilities may decrease a current year tax loss or may accelerate the year in which a net operating loss carryover gives rise to a deduction under §172. However, if a corporation’s DEA would be zero without a further elective U.S. liability reduction, no such further reduction can be made by election, and thus no such collateral effects can be electively achieved.

Election procedure: Under the 2009 amendments, a separate statement must be attached to an original timely filed return showing the amount of the liability reductions made. The temporary regulations also require the liability reductions to be reported on a separate statement, but do not require the aggregate amounts to be reported on Schedule I (Form 1120-F) as the Schedule I requirement was adopted after the temporary regulations and was not applicable to taxable years beginning before January 1, 2007. The 2009 amendments now conform the Reg. §1.882-5 election procedures with Schedule I (Form 1120-F) filing requirements.

Caveat: Reporting the aggregate liability reduction amount from all elections on Schedule I (Form 1120-F) does not in itself constitute the timely filed election (even though a reduction for the year is embedded in the computation of the allocable interest for the year on Schedule I). The 2009 amendments have retained an additional separate statement requirement. This requirement does appear duplicative since the separate statement does not require separate disclosure of multiple liability reduction elections but only requires the aggregate amount of the liability reduction that is already disclosed on line 7b of Schedule I (Form 1120-F). A technical correction, if made, might eliminate this duplicative reporting, but, unless a change is made to the regulations, the separate statement will be required.

Solicitation of comments

New issue on which Treasury/IRS are considering changes

The preamble to the 2009 amendments describes a new issue as to how foreign corporate partners of partnerships described in §861(a)(1)(C) (foreign partnerships predominantly engaged in the active conduct of a trade or business outside the United States) should be treated for purposes of the branch-level interest tax with respect to their distributive shares of interest expense. The branch-level interest tax regulations (Reg. §1.884-4) were last amended in 1996; §861(a)(1)(C) was enacted in 2004, changed the source rule for interest paid by a foreign partnership, and made relevant to the sourcing question whether the interest is paid by the U.S. trade or business of a foreign partnership, and whether it is allocable to ECI (in the nomenclature of the branch-level interest tax rules, whether the interest paid by the foreign partnership is “branch interest”).

Interest paid by foreign corporations directly engaged in a trade or business in the United States with respect to “U.S. booked liabilities” is treated as “branch interest” under Reg. §1.884-4(b) (to the extent such interest expense paid does not exceed the interest expense allocation under Reg. §1.882-5). Branch interest reduces “excess interest.” (The United States imposes gross basis tax on branch interest by treating it as U.S. source interest income of the recipient. The United States imposes gross basis tax on excess interest as if it were U.S. source interest income of the payor). By contrast, interest on “U.S. booked liabilities” of partnerships engaged in trade or business within the United States may cause a foreign corporate partner to have a distributive share of interest on “U.S. booked liabilities” for Reg. §1.882-5 purposes, but, under the branch-level interest tax regulations (see Reg. §1.884-4(b)), such interest need not reduce the partner’s excess interest, potentially resulting in the treatment of excessive amounts of interest as U.S. source income for U.S. gross-basis tax purposes.

The preamble to the 2009 amendments states that the enactment of §861(a)(1)(C) may require coordinating changes to the branch-level interest tax regulations. In the preamble, Treasury and IRS announced that they are currently considering “how best” to coordinate the U.S. booked liability rules with the branch-level interest tax rules “so that foreign corporate partners of partnerships described in section 861(a)(1)(C) are provided similar treatment under §1.884-4 with respect to their distributive shares of interest expense as foreign corporations directly engaged in a trade or business within the United States.”

2006 temporary regulations – treatment of comments received

The 2009 amendments do not adopt any provisions to address the comments that were specifically solicited in the preamble to the temporary regulations, or the comments received in response, except with respect to the coordination of the elections with the filing of Schedule I (Form 1120-F). All other comments remain under consideration for additional guidance, which the preamble to the 2009 amendments indicates may be coordinated with guidance in analogous contexts, such as global dealing regulations and §864(e) (interest allocation rules applicable to domestic taxpayers). The issues discussed in the preamble that remain open and under Treasury and IRS evaluation include:

• The manner in which interbranch currency hedging should be coordinated with the interest allocation rules;
• How derivatives and matched-book repo transactions should be treated for dealers in securities, including whether direct interest allocation rules should be adopted to avoid excessive equity imputation and whether derivative mark to market values for similar contracts should be netted against each other in determining average assets and liabilities; and
• Whether the determination of U.S. booked liabilities should be subject to a conduit tracing rule in certain circumstances.

Reg. §1.882-5: General principles

Overview of 3-step allocation method

Under Reg. §1.882-5 (before and after the 2009 amendments), a foreign corporation with ECI calculates its allowable interest deduction using a three-step formula. Under this formula, the amount of the foreign corporation’s allowable interest deduction may be more or less than the interest that is associated with the debt on its U.S. books. Each step has alternative elections that must be adopted on original timely filed returns. Generally, most elections must be maintained for a minimum five-year period unless consent of the Commissioner is obtained to switch methods beforehand. Certain other elections may be made annually. One election for asset valuation requires consent from the Commissioner to change methods.

Step 1: This step determines the average amount of “U.S. assets” (generally ECI-generating assets) for the year, measured by adjusted basis or, if elected by the taxpayer, fair market value (FMV). Under the regulations, a taxpayer may make the FMV election if it is eligible for and uses the “actual ratio” method in Step 2 (discussed below). In addition, a taxpayer that makes the FMV election to value its U.S. assets in Step 1 must also use the FMV method to value its worldwide assets in Step 2 and must also use the actual worldwide ratio election in Step 2.

Election requirements: The adjusted basis method, if used, must be used for a minimum period of five years and is the default method. The FMV method, if elected, must be followed until consent to change is obtained from the Commissioner, even if the method is in place more than five years. A taxpayer may not elect the FMV method until such time that it is eligible to make an actual ratio election under Step 2.

Step 2: This step determines “U.S.-connected liabilities” and thus the percentage of U.S. assets deemed to be funded with debt and with equity capital. The “U.S.-connected liabilities” are determined by multiplying U.S. assets in Step 1 by one of two alternative, elective ratios. The ratio may be either the ratio of the foreign corporation’s average worldwide liabilities for the year to its average worldwide assets for the year (the “actual ratio”) or, if the taxpayer elects, the “fixed ratio.” The fixed ratio for corporations that are not banks or insurance companies is 50%. For banks, the fixed ratio has been 95%, ever since the temporary regulations took effect. Insurance companies may not use a fixed ratio.

Election requirements: The fixed and actual ratio elections each must remain in place for a minimum of five years. If a taxpayer has a FMV election in place, it may not switch off the actual ratio until the Commissioner consents to a change to switch off the FMV method even if the actual ratio method is in place more than five years.

Step 3: This step determines the interest expense allocable to ECI. It varies significantly depending upon whether the corporation has elected to use the adjusted U.S. book liabilities (AUSBL) method or the separate currency pools (SCP) method.

Election requirements: The AUSBL and SCP methods are subject to the minimum five-year election period before a change may be made as of right.

AUSBL method—The AUSBL method compares U.S.-connected liabilities determined in Step 2 with average liabilities shown on books that produce ECI (“U.S. booked liabilities”). If U.S.-connected liabilities are equal to or less than U.S. booked liabilities, the interest expense on U.S. booked liabilities is allocable to ECI to the extent of the ratio of U.S.-connected liabilities to U.S. booked liabilities (the “scaling ratio”). If U.S.-connected liabilities exceed U.S. booked liabilities, the interest expense allocable to ECI equals 100% of the interest expense with respect to the U.S. booked liabilities, plus an imputed rate of interest times the excess U.S.-connected liabilities. This imputed interest rate equals the total interest expense on U.S.-dollar-denominated liabilities on the books of foreign offices and branches of the foreign corporation, divided by the average of such liabilities for the year. Alternatively, if the taxpayer is a bank, it may elect to compute this imputed interest rate by reference to a published average 30-day LIBOR for the year.

• • Additional AUSBL election requirements: The 30-day LIBOR election is an annual election that must be made with a timely filed return. If a taxpayer is subject to an excess interest calculation only as a result of an audit, the taxpayer may not make the election as of such time.
• SCP method—Under the SCP method, Steps 1 and 2 apply separately to each currency pool in which the taxpayer has U.S. assets. In determining its U.S. assets in Step 1 under the SCP method, the foreign corporation may make an additional election to convert into U.S. dollars any currency pool in which the foreign corporation holds less than 3% of its U.S. assets. Step 3 then determines the interest expense attributable to each currency pool by multiplying the foreign corporation’s average worldwide borrowing rate for the currency by the U.S.-connected liabilities in that currency. The interest allocable to ECI equals the sum of these products.
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  • Additional SCP election requirements: Use of the U.S. dollar rate for U.S. connected liabilities with respect to U.S. assets in a foreign currency that constitute less than 3% of the taxpayers total U.S. assets is arguably an annual “election” since the taxpayer may not be within the 3% threshold with respect to such assets for five consecutive years.⁴

Overview of retained changes from 2006 temporary regulations

The 2009 amendments finalize without change the treaty coordination, fixed ratio and 30-day LIBOR changes to Reg. §1.882-5 that were originally discussed in Notice 2005-53⁵ and implemented in 2006 in the temporary regulations, and also adopt other rules first adopted in the temporary regulations. Particularly significant changes to the 1996 regulations that were made by the temporary regulations (and retained in the 2009 amendments) include:

• An express statement that Reg. §1.882-5 is the exclusive method for allocating interest expense under treaties, except for treaties that expressly provide another approach in the treaty text or accompanying documents (e.g. an Exchange of Notes). Currently, the alternative provided by the “Authorized OECD Approach” (see the OECD’s 2008 “Report on the Attribution of Profits to Permanent Establishments”) has been adopted in U.S. treaties with the United Kingdom, Japan, Germany, Belgium, Iceland and Canada, and in the pending treaty with Bulgaria. These treaties provide that the attribution of business profits is determined by reference to the OECD Transfer Pricing Guidelines principles. Equity capital allocation is provided by reference to a risk-weighted asset approach, which is explained more fully in Part II of the 2008 OECD report.
• The 95% elective “fixed ratio” for banks, and the modification to the definition of a “bank” for this purpose. The “bank” definition is based on §585(a)(2)(B) without regard to whether the trade or business conducted within the United States is a banking trade or business. Section 585(a)(2)(B) incorporates the bank definition principles of §581 (applicable to domestic banks) requiring that the foreign bank be subject to bank regulatory supervision, that it also take deposits and that it make loans and discounts in the ordinary course of its business. These principles are applied at the worldwide level for this purpose.
• The asset valuation consistency requirement providing that a foreign corporation that elects the FMV method to value its U.S. assets must use the “actual ratio,” and not the “fixed ratio,” in Step 2.
• The annual election permitting a bank to use 30-day LIBOR to compute deductible interest on U.S.-connected liabilities in excess of U.S.-booked liabilities under the AUSBL method.
• A minimum frequency of asset valuation (which modifies and clarifies a similar provision in the 1996 proposed regulations) for determining the annual average asset value in Step 1, and in Step 2 for actual ratio taxpayers, in the case of the assets of a securities dealer or electing trader or commodities dealer that marks to market under §475, or a taxpayer that holds assets that are marked to market under §1256.
• The modified U.S. liability reduction election, for purposes of computing the branch profits tax, in an amount sufficient to eliminate the DEA.

Footnotes
¹T.D. 9465, 74 Fed. Reg. 49315 (9/28/09).
²Reg. §1.882-5T, T.D. 9281, 71 Fed. Reg. 47443 (8/17/06), and REG-120509-06, 71 Fed. Reg. 47459 (8/17/06). See U.S. International Tax Alert, “Temporary Regs Change Rules for Calculating U.S. Interest Deduction and Branch Profits Tax of a Foreign Corporation” (August 31, 2006) (attached below).
³Reg. §1.882-5(a)(7)(i) and (d)(5)(ii)(B).
⁴Under the SCP method, the final regulations do not refer to this U.S.-dollar conversion entitlement specifically as either an “election” or an annual right conditioned on factual qualification for the year. See Reg. §1.882-5(e)(1)(i).
⁵2005-2 CB 263.