FOREIGN CORPORATION'S ACTIONS CONSTITUTE PARTIAL CHARGE-OFF.

UIL Number(s) 0166.00-00

                                             Date: June 30, 1993

This letter is in response to the Taxpayer's letter dated June 18, 1991, as supplemented, requesting a ruling as to whether certain actions constitute a charge-off for purposes of section 166 of the Internal Revenue Code of 1986. The pertinent facts submitted for our consideration are set forth below.

The Taxpayer is a Country Y banking corporation operating a commercial banking business with branches in the United States. Its year end for both financial accounting and United States income tax purposes is March 31. The Taxpayer files a single form 1120F to report income earned by its branches. Each branch is treated as a separate division with a separate set of books and records maintained in accordance with Country Y accounting principles. At year end, the financial information of all of the U.S. branches is consolidated by the home office in Country Y with the rest of the bank's worldwide operations.

The Taxpayer, via its State X branch, entered into two separate loan transactions (Loan A and Loan B) with two separate State X general partnerships. The Taxpayer materially participated in soliciting, negotiating and servicing the loans and treats them both as effective1y connected with its United States banking business. The debtor in each transaction filed a voluntary petition commencing a case under chapter 11 of the Bankruptcy Reform Act of 1978 and filed a plan of reorganization. With respect to Loan A, the Bankruptcy court signed the Order Confirming the Debtor's Plan of Reorganization on March 28, 1991. A similar order was signed with respect to Loan B on May 30, 1991. The effective dates of the orders were April 17, 1991 and June 20, 1991, respectively.

For Country Y accounting purposes, the charge-off process is a two-step process. The Taxpayer must obtain prior approval from the Country Y Ministry of Finance both to establish a reserve for a specific debt and to subsequently charge off the debt. On March 29, 1991, the Ministry of Finance approved a reserve against Loan A for the Taxpayer's fiscal year ended March 31, 1991. On March 31, 1991, the Taxpayer established this reserve as a debt write-off special reserve account (specific reserve) on the Country Y books and records in the home office. The physical charge-off, reflecting the difference between the basis of Loan A and its fair market value did not occur until September 30, 1991.

Notwithstanding the fact that the Taxpayer could not physically charge-off Loan A under Country Y accounting principles for its fiscal year ended March 31, 1991, the Taxpayer treated the debt as partially worthless for that year under United States generally accepted accounting principles. In accordance with these accounting principles, the Taxpayer (1) treated Loan A as a foreclosure in substance on its U.S. books and records and reflected the loan as having been partially charged off on its U.S. Call Report filed with the Board of Governors of the Federal Reserve for the quarter ended March 31, 1991; (2) made manual adjustments to its State X branch books and records, that were prepared under Country Y accounting principles, treating Loan A as having been partially charged off as of March 28, 1991; and (3) recorded a loss via a partial charge-off of Loan A on its U.S. profit and loss statement for the fiscal year ended March 31, 1991. In addition, the Taxpayer was consistent in its treatment of Loan A for U.S. federal income tax purposes by reflecting the loan as partially charged off for purposes of sections 1.166-2(a), 1.166-3 and 1.882-5 of the Income Tax Regulations.

The Taxpayer treated Loan B similarly to Loan A. On September 30, 1991, the Ministry of Finance approved a reserve against Loan B, and the Taxpayer set up a debt write-off special reserve account on its Country Y books and records in the home office. In connection with its June 30, 1991 quarterly U.S. Call Report, the Taxpayer made manual adjustments to its State X branch books and records treating Loan B as having been partially charged off as of June 20, 1991. The Taxpayer also treated the debt as partial1y charged off for federal income tax purposes for the quarter ended June 30, 1991. The Ministry of Finance had not approved the physical charge-off of Loan B as of May 1993, but the Taxpayer expects to receive approval before the close of its fiscal year ending March 31, 1994.

LAW & ANALYSIS

Section 166(a)(1) of the Code provides that there shall be allowed as a deduction any debt which becomes worthless within the taxable year.

Section 166(a)(2) of the Code provides that when satisfied that a debt is recoverable only in part, the Secretary may allow such debt, in an amount not in excess of the part charged off within the taxable year, as a deduction.

Rules for establishing worthlessness are found in section 1.166- 2 of the regulations. Pursuant to section 1.166-2(a), in determining whether a debt is worthless in whole or in part, the district director will consider all pertinent evidence, including the value of the collateral, if any, securing the debt and the financial condition of the debtor. Section 1.166-2(c) provides that bankruptcy is generally an indication of the worthlessness of at least a part of an unsecured and unpreferred debt. Section 1.166-2(d) provides rules for establishing a conclusive presumption of worthlessness of a debt under certain circumstances, none of which is present in this instance.

Section 1.166-3(a) of the regulations provides that if, from all the surrounding and attending circumstances, the district director is satisfied that a debt is partially worthless, the amount which has become worthless shall be allowed as a deduction under section 166(a)(2) of the Code but only to the extent charged off during the taxable year. A taxpayer may only deduct a debt in part, upon demonstrating to the satisfaction of the district director the amount thereof which is worthless and the part thereof which has been charged off.

Although section 166 of the Code and the regulations thereunder do not define the term "charge-off," authority exists that a "charge-off" is not limited to a taxpayer's physical act of charging off a debt. Rather, a taxpayer must take some action to remove the worthless portion of an asset from its books as an indication that the debt is actually worthless. See, Fairless v. Commissioner, 67 F.2d 475 at 478 (6th Cir. 1933), (affirming decision of United States Board of Tax Appeals and disallowing deductions for bad debts where taxpayer had not made a charge-off on its books.) There the court stated: "It was c1early the purpose of the Congress to condition allowance of deduction for bad debts upon the perpetuation of evidence that they were ascertained to be worthless within the taxable year, and upon some specific act of the taxpayer clearly indicating their abandonment as assets." See also, Brandtjen & Kluge v. Commissioner, 34 T.C. 416 at 441 (1960) acq. 1960-2 C.B. 4, where the court stated: "But, generally speaking, an effective charge-off has been made if the entries relied upon have effectually eliminated the amount of the debt, or that part which is worthless, from the book assets of the taxpayer."

The court in Brandtjen, while finding it difficult to determine that a charge-off had been made where the taxpayer credited an entry to a reserve (a fund designed to absorb anticipated losses) rather than eliminating any amount from the asset account itself, nevertheless held that the entries made satisfied the statutory requirement of a charge-off. The court arrived at this conclusion because (1) the book entries were limited to one specific indebtedness (a specific reserve) and (2) the entries were intended to accomplish a charge-off and were described in terms indicating a sustained loss, rather than an anticipated loss, in the one specific account.

Section 882(a) of the Code provides that a foreign corporation engaged in trade or business within the United States during the taxable year shall be taxable as provided in section 11, 55, 59A, or 1201(a) on its taxable income which is effectively connected with the conduct of a trade or business within the United States.

Section 882(c) of the Code provides that deductions shall be allowed for purposes of section 882(a) only if and to the extent that they are connected with income which is effectively connected with the conduct of a trade or business within the United States. The proper allocation and apportionment of the deductions are determined as provided in regulations prescribed by the Secretary.

Section 1.882-5(a) of the regulations sets forth rules a foreign corporation must follow to determine its interest deduction al1owed under section 882(c) of the Code. One of the components necessary for computing the interest deduction is the average total value of all assets of the corporation that generate, have generated, or could reasonably have been or be expected to generate income, gain, or loss effectively connected with the conduct of a trade or business in the United States for the taxable year. See section 1.882-5(b)(1). With respect to the assets of a corporation, section 1.882-5(a) provides that the classification of items as assets or liabilities must be on a consistent basis from year to year and substantially in accordance with U.S. tax principles. Further, all assets must be valued on the basis of either U.S. tax book value (adjusted basis for determining gain or loss from sale or other disposition of the asset (see section 1011 of the Code)) or fair market value.

Therefore, a foreign corporation doing business in the United States that charges off an asset for purposes of section 166 of the Code, must likewise treat the asset as charged off for purposes of section 882.

Based on the information submitted, we conclude that the combination of the actions taken by the Taxpayer, with respect to Loan A and Loan B, indicates an abandonment, and removal from the Taxpayer's books, of a portion of each of the two loans. Therefore, for purposes of section 166 of the Code, the Taxpayer has partially charged off Loan A and Loan B.

No opinion is expressed concerning the appropriateness of either the amount or the timing of the charge-off. Those determinations, pursuant to sections 1.166-2(a) and 1.166-3 of the regulations, remain under the jurisdiction of the district director. Thus, for example, no opinion is expressed regarding whether any of the actions taken by the Taxpayer were accelerated or delayed primarily to influence the timing of the charge-off for federal income tax purposes.

No opinion is expressed concerning the tax treatment of the transaction under any other provision of the Code. In particular, no opinion is expressed concerning the tax consequences under section 882 of the Code.

This ruling is directed only to the taxpayer who requested it. Section 6110(j)(3) of the Code provides that it may not be used or cited as precedent.

A copy of this letter should be attached to (or, if already filed, associated with) the federal income tax return for the taxable year in which the deduction is claimed.

Pursuant to the power of attorney on file in this office, we are sending this letter to the Taxpayer's authorized representative with a copy to the Taxpayer.

                                   Sincerely yours,