Final Regs Revise Rules on Branch Profits Tax

 [4830-01]

 ACTION: Final and temporary regulations.

 SUMMARY: This document contains final Income Tax Regulations relating to the branch profits tax, branch-level interest tax and qualified resident rules issued under section 884 of the Internal Revenue Code of 1986 (the "Code"). Section 884 was added to the Code by section 1241 of the Tax Reform Act of 1986. These regulations provide guidance needed to comply with this section and generally affect foreign corporations engaged in trade or business in the United States. These regulations also provide guidance relating to the application of section 884 to foreign governments in light of the changes made by the Technical and Miscellaneous Revenue Act of 1988 under section 892(a)(3) of the Code.

 EFFECTIVE DATES: Except as otherwise provided, both the final and temporary regulations are effective for taxable years beginning on or after October 13, 1992. The fourth sentence of section 1.884-0(a) is effective for taxable years ending on or after September 11, 1992, subject to the conditions provided in section 1.884-0. The amendments to sections 1.884-2T(a)(2)(ii) and 1.884-2T(c)(2)(iii) are effective with respect to taxable years beginning after December 31, 1986.

 FOR FURTHER INFORMATION CONTACT: Elizabeth U. Karzon of the Office of Associate Chief Counsel (International), within the Office of Chief Counsel, Internal Revenue Service, 1111 Constitution Avenue, N.W., Washington, D.C. 20224 (202-622-3860, not a toll-free call).

SUPPLEMENTARY INFORMATION:

PAPERWORK REDUCTION ACT

The collection of information contained in these regulations has been reviewed and approved by the Office of Management and Budget in accordance with the Paperwork Reduction Act of 1980 (44 U.S.C. 3504(h)) under control number 1545-1070. The estimated average annual burden per respondent recordkeeper varies from .1 hours to 8.0 hours depending on individual circumstances, with an estimated average of .3 hours.

 These estimates are an approximation of the average time expected to be necessary for a collection of information. They are based on such information as is available to the Internal Revenue Service. Individual respondents/recordkeepers may require greater or less time, depending on their particular circumstances.

 Comments concerning the accuracy of this burden estimate and suggestions for reducing this burden should be directed to the Internal Revenue Service, Attention: IRS Reports Clearance Officer T:FP, Washington, DC 20224, and to the Office of Management and Budget, Attention: Desk Officer for the Department of the Treasury, Office of Information and Regulatory Affairs, Washington, DC 20503.

BACKGROUND

 On September 2, 1988, proposed and temporary regulations sections 1.884-0T, 1.884-1T, 1.884-2T, 1.884-4T and 1.884-5T were adopted (as part of T.D. 8223) and published in the Federal Register at 53 FR 34045 (September 2, 1988). Written comments were received and a public hearing was held on February 19, 1989. Subsequently, several notices were issued by the Internal Revenue Service that set forth changes that would be made to the temporary regulations. Notice 88-133 (1988-2 C.B. 559) provided for transitional relief with respect to certain procedural requirements relating to the qualified resident rules; Notice 89-14 (1989-1 C.B. 633) provided for transitional relief with respect to compliance with the branch-level interest tax rules; Notice 89-73 (1989-1 C.B. 739) announced the branch profits tax rate for foreign corporations that are qualified residents of France; and Notice 89-80 (1989-2 C.B. 394) clarified the branch-level interest tax rules, announced certain changes to those rules for taxable years beginning on or after January 1, 1990, and modified certain of the qualified resident rules.

 After consideration of all the comments relating to sections 1.884-0T, 1.884-1T, 1.884-4T, and 1.884-5T, these sections of the temporary regulations are adopted by this Treasury Decision as final regulations. The comments and revisions relating to these sections are discussed below. Section 1.884-2T is also amended by these regulations.

EXPLANATION OF THE PROVISIONS

I BRANCH PROFITS TAX

A. FOREIGN GOVERNMENTS

Under section 892(a)(3)(added to the Code by the Technical and Miscellaneous Revenue Act of 1988), a foreign government is treated as a corporate resident of its country for all purposes of the Internal Revenue Code. The final regulations under section 1.884-0 provide that a foreign government is treated as a foreign corporation for purposes of section 884 and is subject to the branch profits tax and the branch-level interest tax. This amendment to the regulations will be effective for taxable years of a foreign government ending on or after September 11, 1992. However, for the first taxable year ending on or after September 11, 1992, no branch profits tax shall be imposed with respect to effectively connected earnings and profits ("ECEP") of a foreign government earned prior to such date or with respect to decreases in U.S. net equity of a foreign government attributable to the portion of the taxable year prior to such date. Nor shall the tax on branch interest or excess interest apply to interest apportioned to the effectively connected income of the foreign government that has been paid or accrued by its U.S. trade or business prior to such date. Pending issuance of final regulations under section 1.882-5, a foreign government may apply the rules in the proposed regulations under section 1.882-5, issued at 57 FR 15038 (April 24, 1992), to determine the amount of its U.S. liabilities for purposes of section 1.884-1 and for purposes of determining its interest expense apportioned to its income that is (or is treated as) effectively connected with its U.S. trade or business for purposes of applying section 1.884-4 of the regulations.

B. U.S. ASSETS

The rules regarding the definition of U.S. assets have been reorganized for purposes of clarity and revised as discussed below.

 1. UNITED STATES REAL PROPERTY INTERESTS. A United States real property interest that does not meet the general definition of a U.S. asset under section 1.884-1(d)(1) is no longer treated as a U.S. asset under the special rules of section 1.884-1(d)(2). For example, if a foreign corporation owns non-income producing real property in the United States, such as raw land or a condominium not used in the foreign corporation's trade or business, the property shall not be treated as a U.S. asset of the foreign corporation. The elimination of real property not used in a trade or business as a U.S. asset allows a foreign corporation to make a passive investment in real property in the United States without incurring a branch profits tax on the amount of its initial investment in the United States. Only subsequent appreciation recognized on a disposition of the investment will be subject to the tax. The rule is also consistent generally with the proposed regulations under section 1.882-5 that exclude United States real property interests not used in a trade or business from the definition of U.S. assets for purposes of computing a foreign corporation's interest expense, other than in the year of disposition.

 2. INSTALLMENT OBLIGATIONS. Taxpayers commented that the rule in section 1.884-1T(d)(7) (relating to the amount of an installment obligation treated as a U.S. asset) inappropriately treats installment obligations arising in taxable years beginning prior to the effective date of the branch profits tax in the same manner as those arising after such date. The final regulations in section 1.884-1(d)(6)(ii)(B) provide that an installment obligation arising from a sale of a U.S. asset occurring in a taxable year prior to January 1, 1987, will have a zero basis (for purposes of computing earnings and profits) ("E&P basis").

 The final regulations in section 1.884-1(d)(2)(iii) provide also that if interest or original issue discount received by a foreign corporation on an installment obligation is not effectively connected with the conduct of a U.S. trade or business, the obligation will not be treated as a U.S. asset. Thus, a decrease in U.S. assets, and a dividend equivalent amount could arise in the year of an installment sale if the interest on the obligation does not give rise to effectively connected income. However, a foreign corporation may elect to treat the interest or original issue discount as effectively connected with the conduct of a trade or business in the United States if the interest or original issue discount would not otherwise be so considered. The U.S. asset rule for installment obligations now conforms more closely to the treatment of U.S. assets generally: an asset is a U.S. asset only if all the income and gain from the asset is (or is treated as) income effectively connected with the conduct of a trade or business in the United States. The rule also parallels the treatment of interest received on installment obligations held by domestic subsidiaries of foreign corporations. Since an installment obligation is generally no longer treated as a U.S. asset, a foreign corporation may completely terminate its U.S. trade or business, within the meaning of section 1.884-2T(a), while holding an installment obligation provided all other requirements of that section have been met.

 3. MARKETABLE SECURITIES. The rules of section 1.884-1T(d)(8) describing when marketable securities will be treated as U.S. assets have been replaced by three separate rules in section 1.884-1(d)(2)(v) through (vii): one for bank deposits and credit balances, whether or not interest-bearing; a second for debt instruments; and a third for certain stock or securities owned by foreign corporations engaged in the active conduct of a banking, financing, or similar business in the United States, to the extent that such stock or securities do not otherwise qualify as U.S. assets under the general rule. The rules of section 1.884-1T(d)(8) that are relevant for an election by a foreign corporation to remain engaged in a U.S. trade or business under section 1.884-2T(a) have been moved to that section.

 4. EXPANSION CAPITAL. The expansion capital election provided in section 1.884-1T(d)(11) was intended to permit a foreign corporation to treat cash in excess of working capital as a U.S. asset so that it could accumulate earnings for later capital investment. The election was also intended to provide relief to a foreign corporation that sold a major U.S. asset shortly before the close of the year and was unable to purchase a substitute U.S. asset before the end of the year. Taxpayers commented that the election as drafted in the temporary regulations does not provide the intended relief because an expansion capital asset is treated as a U.S. asset for all purposes of section 884. Thus, a foreign corporation's U.S. liabilities increase proportionately with the amount of expansion capital elected and the foreign corporation cannot in fact increase its U.S. net equity on a dollar-for-dollar basis. Taxpayers also criticized the rule because it does not permit a foreign corporation to convert expansion capital into "real" U.S. assets during the course of the taxable year.

 In response to the comments, the expansion capital election has been replaced with an election to reduce liabilities (discussed below). The election to reduce liabilities will accomplish many of the same objectives of the expansion capital election, but without the complexity of a properly drafted expansion capital rule.

 5. INTEREST IN A TRUST OR ESTATE. Section 1.884-1(d)(4) of the final regulations (relating to an interest in a trust or estate) has been reserved. Proposed regulations relating to this paragraph are being issued simultaneously with these final regulations.

 6. U.S. ASSETS OF INSURANCE COMPANIES. Section 1.884-1T(g) provides a special rule for the computation of U.S. assets of an insurance company that includes in taxable income effectively connected net investment income computed under section 842(b). Taxpayers have commented that the rule produces significant fluctuations in the amount of U.S. assets of an insurance company from year to year, because an insurance company may or may not be subject to the special rule in a given year, and the amount of U.S. assets produced by the formula each year will vary depending on the profitability of the U.S. branch of the insurance company vis-a-vis the profitability of the company worldwide.

 A number of alternative rules were considered that would have imputed an amount of U.S. assets to correspond to the additional net investment income computed under section 842(b). Because of the complexity of the other options and the problems inherent in section 1.884-1T(g), the special rule was deleted and the final regulations provide that foreign insurance companies will be subject to the same U.S. asset rules as all other foreign corporations.

C. U.S. LIABILITIES

1. U.S. LIABILITIES OF AN INSURANCE COMPANY. The final regulations add a rule to clarify that an insurance company's U.S. liabilities include the amount of its total insurance liabilities on United States business within the meaning of section 842(b)(2)(B), as well as any other U.S.-connected liabilities determined under section 1.882-5.

 2. ELECTION TO REDUCE U.S. LIABILITIES. Under section 1.884-1T(e), a foreign corporation is required to compute its U.S. liabilities by multiplying its U.S. assets by the ratio of its worldwide liabilities to worldwide assets, or, if the foreign corporation computes the amount of its interest expense under section 1.882-5 using a fixed ratio of liabilities to assets, then by such fixed ratio. The use of this formulary approach to determine U.S. liabilities is retained in section 1.884-1(e) of the final regulations, with some minor adjustments. Taxpayers commented, however, that the formulary approach creates a hardship in certain circumstances, because a foreign corporation may reinvest all of its effectively connected earnings and profits in its U.S. trade or business and still have a dividend equivalent amount.

 In response to this concern and as a replacement for expansion capital, the final regulations under section 1.884-1(e)(3) allow a foreign corporation to elect annually to reduce the amount of its U.S. liabilities for purposes of both sections 1.884-1 and 1.884-4 down to the amount of liabilities actually shown on the books of the U.S. trade or business for purposes of section 1.882-5(b)(3) as of the last day of the taxable year. In return, a taxpayer must permanently forego the interest deduction attributable to the reduction in liabilities.

 The election to reduce liabilities is similar to the expansion capital election because it would permit a foreign corporation to accumulate earnings to expand its U.S. trade or business. For example, if a foreign corporation has $50 of ECEP, it can retain $50 for expansion of its U.S. trade or business without triggering a $50 dividend equivalent amount if it elects to reduce its U.S. liabilities by $50, thereby increasing its U.S. net equity by $50.

 If, however, a foreign corporation does not ultimately reinvest the retained earnings created by the election in additional U.S. assets, it will be required to recapture that amount in a year of complete termination, notwithstanding the complete termination rules in section 1.884-2T(a).

 The election was also suggested by foreign corporations whose U.S. trades or businesses produce effectively connected losses. Although a foreign corporation with an effectively connected loss for a taxable year would generally not have a branch tax liability in that year, the interest apportioned to its effectively connected income would still be treated as U.S. source interest under section 884. Such a corporation may prefer to forego the interest deduction rather than be treated as paying U.S. source interest.

D. TREATY-RELATED ISSUES

The final regulations under section 1.884-1(g)(4)(iii) clarify the branch profits tax consequences for a foreign corporation with ECEP attributable to both a permanent establishment and a non- permanent establishment. The regulations in section 1.884-1(g)(1) also clarify that if a foreign corporation has more than one trade or business in the United States, and meets the requirements of the active trade or business test described in section 1.884-5(e) with respect to only one of the trades or businesses, the branch profits tax treaty benefits only apply to the ECEP related to the one trade or business. See, however, the new de minimis rule described in the active trade or business test (below).

II BRANCH-LEVEL INTEREST TAX

 The final regulations under section 1.884-4 were revised to incorporate the rules announced in Notices 89-14 and 89-80. In response to taxpayers' comments, other technical changes were made in this section relating to the special rules for interest paid and excess interest. For purposes of the final regulations, interest paid by a U.S. trade or business is referred to as "branch interest".

A. BRANCH INTEREST OF BANKS

Notice 89-80 sets forth a new definition of branch interest of banks for taxable years beginning after January 1, 1990. Under this definition, branch interest of a bank includes interest paid with respect to certain liabilities of offshore "shell" branches of foreign banks. A liability of a shell branch does not give rise to branch interest, however, unless the bank notifies its depositors within two months following the close of the calendar year that the interest they have received from the shell branch is U.S. source.

 Taxpayers criticized the notification requirement, however, because they believed it placed foreign banks in a competitive disadvantage vis-a-vis domestic banks that were not required to notify their shell branch depositors of the source of their interest payments. In response, the final regulations delete the notification requirements for banks. No inference should be drawn from this regulation regarding the source of interest received or paid with respect to shell branch liabilities. The Service is studying the circumstances under which a foreign branch of a domestic bank should be treated as a shell branch and not engaged in commercial banking business for purposes of section 861(a)(1)(B)(i). Comments are invited on this issue.

B. NONDEDUCTIBLE INTEREST

Section 1.884-4T(a)(2) of the temporary regulations defines excess interest as the excess of the amount of interest allowable as a deduction to the foreign corporation in computing its effectively connected taxable income under section 1.882-5 over the amount of interest paid by the U.S. trade or business, not including nondeductible amounts of branch interest. The final regulations define excess interest generally as the excess of the amount of interest apportioned to the effectively connected income of a foreign corporation under section 1.882-5, after application of section 1.884-1(e)(3) (relating to the election to reduce liabilities), over the foreign corporation's branch interest. The reference to nondeductible interest was deleted because the amount of interest expense apportioned to effectively connected income under section 1.882-5 includes both deductible and nondeductible interest. Provisions that permanently disallow or defer a deduction or result in the capitalization of interest expense apply after interest expense is apportioned to effectively connected income under section 1.882-5.

C. EXCESS INTEREST

The Treasury Department has concluded that the tax on excess interest is not prohibited by the nondiscrimination provision or any other provision in any income tax treaty to which the United States is a party.

III QUALIFIED RESIDENT RULES

 A majority of the comments with respect to this section related to clarifying and liberalizing the three "qualified resident" tests: the stock ownership and base erosion test, the publicly-traded test, and the active trade or business test.

A. STOCK OWNERSHIP AND BASE EROSION TEST

In the final regulations under section 1.884-5(b), a foreign corporation will satisfy the stock ownership test if more than 50 percent of its stock is beneficially owned by qualifying shareholders (individuals, governments, publicly-traded corporations, not-for- profit organizations and beneficiaries of certain pension trusts resident in the United States or the country of residence of the foreign corporation). As under the temporary regulations, a foreign corporation is required to obtain ownership statements from its qualifying shareholders showing the ownership of its stock by the due date of the corporation's return (including extensions). In addition, each individual shareholder (other than a U.S. citizen or resident) must obtain a certificate of residency from his or her Competent Authority or other relevant authority annually and submit it with the stock ownership statement. If a qualifying shareholder does not directly own stock in the foreign corporation seeking qualified resident status, both the qualifying shareholder and the intermediary in which it does have an interest must submit the appropriate documentation to the foreign corporation. Each intermediary must also submit sufficient information for the foreign corporation to determine the amount of stock (by value) that the qualifying shareholder (or other intermediary) beneficially owns in that intermediary for the requisite time period. The amount of information required has been streamlined where possible. The rules permitting intermediary verification statements as substitutes for certain documentation have been retained.

 1. FORM OF DOCUMENTATION. Commentators criticized as burdensome the documentation requirements, suggesting that documentation be required only once every three years, or that a resident tax return be provided in lieu of a certificate of residency. In response to these comments, the final regulations under section 1.884-5(b)(3)(iii) ease the documentation requirements for certain widely- held corporations, including mutual savings banks and insurance companies. If such a foreign corporation has at least 250 individual owners, it need not obtain ownership statements and certificates of residency from those of its owners that own less than one percent of the equity of the corporation and may generally rely instead on such individual owners' addresses of record.

 2. SPECIAL ATTRIBUTION RULES. Special attribution rules for stock owned by pension trusts were issued in Notice 89-80. Those rules have been incorporated into the regulations in section 1.884-5(b)(8) and expanded to cover pension funds and other entities that provide pension benefits. The regulations under section 1.884-5(b)(2) also provide attribution rules for determining the ownership of mutual insurance companies, savings banks, and other similar non- stock entities, and revise the attribution rules for corporations and partnerships generally.

 3. DOCUMENTATION RECEIVED AFTER FILING OF RETURN. The final regulations will continue to require that the documentation be received by the due date of the return (including extensions). However, section 1.884-5(b)(3)(v) provides that, on a showing of good cause in a petition (prior to examination) to the District Director or Assistant Commissioner (International), as appropriate, a foreign corporation may be granted the right to perfect its documentation after the due date of the return (including extensions).

 4. BASE EROSION. Taxpayers commented that the base erosion test in section 1.884-5T(c) is too broad because the test treats as base eroding payments all deductible payments, including bona fide payments at arms' length to unrelated persons. The test has been retained in large part, however, because of the difficulty in administering a rule that would exclude such payments. It should be noted that payments by a foreign corporation included in its cost of goods sold are not considered base eroding payments since such payments are excluded from gross income.

B. PUBLICLY-TRADED TEST

A foreign corporation can be a qualified resident of its country of residence if its stock is both primarily and regularly traded on an established securities market in its country of residence. With respect to the regularly traded portion of the test, taxpayers commented that the minimum turnover requirement for a class of stock in the temporary regulations was too high for many corporations listed on established securities exchanges. Consistent with Notice 89-80, the final regulations lower the turnover requirement for all corporations from 30 percent to 10 percent and the 10 percent rate is adopted in the final regulations in section 1.884-5(d)(4)(i)(B)(2).

 The final regulations also liberalize the closely-held exception to the regularly traded test. Under section 1.884-5T(d)(4)(ii), a class of stock that is otherwise regularly traded will not meet the test if 100 or fewer persons own 50 percent or more of the stock. The final regulations under section 1.884-5(d)(4)(iii) treat a class of stock as closely held if 50 percent or more of the stock is beneficially owned by one or more five percent shareholders who are not qualifying shareholders. The test applies to both domestic and foreign corporations. The regulations under section 1.884-5(d)(5) clarify that corporations with registered shareholders can sustain the burden of proof with respect to the closely-held test if they maintain a list of their registered shareholders and have no knowledge and no reason to know that their stock is closely held. Corporations with bearer shares can meet the burden of proof with respect to this test as long as they have no knowledge and no reason to know that their stock is closely held. No inference should be drawn from this regulation regarding the definition of "property where there is public trading" for purposes of section 1273(b)(3).

C. ACTIVE TRADE OR BUSINESS TEST

The active trade or business test generally requires that a foreign corporation have both an active and substantial business in its home country and that the trade or business that gives rise to the income for which a treaty benefit is claimed is an integral part of the home country business. The temporary regulations generally require that a minimum percentage of the foreign corporation's assets, income, and payroll be in the treaty country to meet the substantial presence portion of the test.

 Commentators raised a number of issues regarding the regulation's standards for determining whether a foreign corporation has a substantial presence in its home country. In particular, it was argued that certain types of businesses, particularly trading companies, will frequently be unable to meet the minimum percentage of assets and income in the treaty country, although they may meet the payroll test. The suggestions made by commentators would have placed excessive weight on the payroll test, however, and thus were not adopted. While the final regulations retain the minimum asset and income ratios, they do provide an alternative to the income ratio for certain corporations. A foreign corporation engaged in selling tangible property or in manufacturing, producing, growing or extracting tangible property may use the ratio of its direct material costs attributable to tangible property manufactured, produced, grown or extracted in its country of residence to its total cost of goods sold rather than the ratio of its income derived from its country of residence to total income in computing whether it has a substantial presence in the treaty country.

 Through the private letter ruling process, it was determined that the active trade or business test should also be available to foreign groups that form a wholly-owned subsidiary in their country of residence to conduct the U.S. operations of the group. In such a case, the subsidiary corporation could not have a substantial presence in its country of residence, nor could its U.S. business be integrated with a foreign trade or business, although its affiliated group as a whole might have a substantial presence in the subsidiary's country of residence and the U.S. business might be an integral part of the business conducted by one or more of the other corporations included in that group. In response to this situation, a rule has been added to the active trade or business test that would allow a foreign corporation to apply the active trade or business test to its entire affiliated group within the meaning of section 1504(a), but without regard to the exclusions under section 1504(b)(2) and (3), rather than just to the foreign corporation alone.

 With respect to the integral part requirement of the active trade or business test, the temporary regulations provide that the U.S. and foreign business must be "complementary and mutually interdependent steps . . . in the production and sale or lease of goods or in the provision of services". The temporary regulations also provide a presumption that a U.S. branch of a foreign bank will be treated as an integral part of the foreign bank's activities if more than 50 percent of its loans to the public are to residents in the home country. The final regulations modify the presumption with regard to a bank so that a bank can meet the integral part test provided a substantial part of its business in its country of residence consists of receiving deposits and making loans and discounts. The final regulations also provide a rule that allows a foreign corporation with more than one trade or business in the United States to meet the integral part test with respect to all such trades or businesses provided that at least 80 percent of the foreign corporation's ECEP for a three-year period is attributable to one or more of such trades or businesses that would meet the test.

D. RULING PROCESS

The ruling process was designed to assist the Service in determining the extent to which the stock ownership test, publicly- traded test and active trade or business test did not adequately deal with the range of corporations seeking qualified resident status. Many of the issues raised by the rulings have been addressed by changes in the final regulations. The Service recognizes that there are still cases that have to be handled individually, and the regulations retain a ruling request procedure for situations in which corporations do not meet any of the other tests, provided that the ruling request is filed by the due date (including extensions) of the return for the taxable year. The final regulations also indicate with greater specificity some of the factors that will be considered in issuing a ruling.

IV COMPLETE TERMINATION, LIQUIDATION OR REORGANIZATION OF A FOREIGN CORPORATION

 Section 1.884-2T(a)(2)(ii) provides that a foreign corporation must extend the period for assessment of the branch profits tax for the year of complete termination to a date not earlier than the sixth taxable year following that taxable year. Section 1.884-2T(c)(2)(iii) provides that a foreign corporation must also extend the period for assessment of the branch profits tax if it liquidates or reorganizes as part of a section 381(a) transaction and the transferee is a domestic corporation. These regulations provide guidance concerning compliance with this waiver requirement until such time as forms are published.

V EFFECTIVE DATES

 Except as otherwise provided, the final regulations are effective for taxable years beginning on or after [30 DAYS AFTER THESE REGULATIONS ARE PUBLISHED IN THE FEDERAL REGISTER]. Taxpayers may elect, however, to apply section 1.884-1 together with section 1.884-4 to taxable years beginning after December 31, 1986 and before the effective date of these regulations, provided certain conditions are met. Taxpayers may also separately elect to apply section 1.884-5 retroactively to such date, provided certain conditions are met.

SPECIAL ANALYSIS

 It has been determined that these rules are not major rules as defined in Executive Order 12291. Therefore, a Regulatory Impact Analysis is not required. It has also been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) and the Regulatory Flexibility Act (5 U.S.C. chapter 6) do not apply to these regulations, and, therefore, a final Regulatory Flexibility Analysis is not required. Pursuant to section 7805(f) of the Internal Revenue Code, the notice of proposed rulemaking for the regulations was submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on their impact on small business.

DRAFTING INFORMATION

 The principal authors of these regulations are Elizabeth U. Karzon, of the Office of Associate Chief Counsel (International), within the Office of Chief Counsel, Internal Revenue Service and Richard M. Elliott, formerly of the Office of Associate Chief Counsel (International), within the Office of Chief Counsel, Internal Revenue Service. Other personnel from that office and other offices of the Internal Revenue Service and the Treasury Department participated in developing the regulations on matters of both substance and style.

LIST OF SUBJECTS IN 26 CFR SECTIONS 1.881-1 THROUGH 1.884-5

Foreign investments in United States, Income taxes.

Treasury Decision 8432

ADOPTION OF AMENDMENTS TO THE REGULATIONS

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

PART 1 -- INCOME TAX; TAXABLE YEARS BEGINNING AFTER DECEMBER 31, 1953

Paragraph 1. The authority citation for part 1 is amended by removing the entries for "Sections 1.884-0T through 1.884-5T", "Section 1.884-1T(d)", "Section 1.884-1T(e)" and "Section 1.884-5T(e) and (f)" and adding the following citations to read as follows:

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

 Section 1.884-0 also issued under 26 U.S.C. 884(g).

Par. 3. Sections 1.884-0 and 1.884-1 are added to read as follows:

SECTION 1.884-0 OVERVIEW OF REGULATION PROVISIONS FOR SECTION 884.

(a) INTRODUCTION. Section 884 consists of three main parts: a branch profits tax on certain earnings of a foreign corporation's U.S. trade or business; a branch-level interest tax on interest paid, or deemed paid, by a foreign corporation's U.S. trade or business; and an anti-treaty shopping rule. A foreign corporation is subject to section 884 by virtue of owning an interest in a partnership, trust, or estate that is engaged in a U.S. trade or business or has income treated as effectively connected with the conduct of a trade or business in the United States. An international organization (as defined in section 7701(a)(18)) is not subject to the branch profits tax by reason of section 884(e)(5). A foreign government treated as a corporate resident of its country of residence under section 892(a)(3) shall be treated as a corporation for purposes of section 884. The preceding sentence shall be effective for taxable years ending on or after [THE DATE THESE REGULATIONS ARE PUBLISHED IN THE FEDERAL REGISTER], except that, for the first taxable year ending on or after that date, the branch profits tax shall not apply to effectively connected earnings and profits of the foreign government earned prior to that date nor to decreases in the U.S. net equity of a foreign government occurring after the close of the preceding taxable year and before that date. Similarly, section 1.884-4 shall apply, in the case of branch interest, only with respect to amounts of interest accrued and paid by a foreign government on or after that date, or, in the case of excess interest, only with respect to amounts attributable to interest accrued by a foreign government on or after that date and apportioned to ECI, as defined in section 1.884-1(d)(1)(iii). Except as otherwise provided, for purposes of the regulations under section 884, the term "U.S. trade or business" includes all the U.S. trades or businesses of a foreign corporation.

(1) THE BRANCH PROFITS TAX. Section 1.884-1 provides rules for computing the branch profits tax and defines various terms that affect the computation of the tax. In general, section 884(a) imposes a 30-percent branch profits tax on the after-tax earnings of a foreign corporation's U.S. trade or business that are not reinvested in a U.S. trade or business by the close of the taxable year, or are disinvested in a later taxable year. Changes in the value of the equity of the foreign corporation's U.S. trade or business are used as the measure of whether earnings have been reinvested in, or disinvested from, a U.S. trade or business. An increase in the equity during the taxable year is generally treated as a reinvestment of the earnings for the current taxable year; a decrease in the equity during the taxable year is generally treated as a disinvestment of prior years' earnings that have not previously been subject to the branch profits tax. The amount subject to the branch profits tax for the taxable year is the dividend equivalent amount. Section 1.884-2T contains special rules relating to the effect on the branch profits tax of the termination or incorporation of a U.S. trade or business or the liquidation or reorganization of a foreign corporation or its domestic subsidiary.

(2) THE BRANCH-LEVEL INTEREST TAX. Section 1.884-4 provides rules for computing the branch-level interest tax. In general, interest paid by a U.S. trade or business of a foreign corporation ("branch interest", as defined in section 1.884-4(b)) is treated as if it were paid by a domestic corporation and may be subject to tax under section 871(a) or 881, and to withholding under section 1441 or 1442. In addition, if the interest apportioned to ECI exceeds branch interest, the excess is treated as interest paid to the foreign corporation by a wholly-owned domestic corporation and is subject to tax under section 881(a).

(3) QUALIFIED RESIDENT. Section 1.884-5 provides rules for determining whether a foreign corporation is a qualified resident of a foreign country. In general, a foreign corporation must be a qualified resident of a foreign country with which the United States has an income tax treaty in order to claim an exemption or rate reduction with respect to the branch profits tax, the branch-level interest tax, and the tax on dividends paid by the foreign corporation.

(b) Outline of major topics in section 1.884-1 through 1.884-5.

 SECTION 1.884-1 BRANCH PROFITS TAX.

(a) GENERAL RULE. A foreign corporation shall be liable for a branch profits tax in an amount equal to 30 percent of the foreign corporation's dividend equivalent amount for the taxable year. The branch profits tax shall be in addition to the tax imposed by section 882 and shall be reported on a foreign corporation's income tax return for the taxable year. The tax shall be due and payable as provided in section 6151 and such other provisions of Subtitle F of the Internal Revenue Code as apply to the income tax liability of corporations. However, no estimated tax payments shall be due with respect to a foreign corporation's liability for the branch profits tax. See paragraph (g) of this section for the application of the branch profits tax to corporations that are residents of countries with which the United States has an income tax treaty, and section 1.884-2T for the effect on the branch profits tax of the termination or incorporation of a U.S. trade or business, or the liquidation or reorganization of a foreign corporation or its domestic subsidiary.

(b) DIVIDEND EQUIVALENT AMOUNT -- (1) DEFINITION. The term "dividend equivalent amount" means a foreign corporation's effectively connected earnings and profits ("ECEP", as defined in paragraph (f)(1) of this section) for the taxable year, adjusted pursuant to paragraph (b)(2) or (3) of this section, as applicable. The dividend equivalent amount cannot be less than zero.

(2) ADJUSTMENT FOR INCREASE IN U.S. NET EQUITY. If a foreign corporation's U.S. net equity (as defined in paragraph (c) of this section) as of the close of the taxable year exceeds the foreign corporation's U.S. net equity as of the close of the preceding taxable year, then, for purposes of computing the foreign corporation's dividend equivalent amount for the taxable year, the foreign corporation's ECEP for the taxable year shall be reduced (but not below zero) by the amount of such excess.

(3) ADJUSTMENT FOR DECREASE IN U.S. NET EQUITY -- (i) IN GENERAL. Except as provided in paragraph (b)(3)(ii) of this section, if a foreign corporation's U.S. net equity as of the close of the taxable year is less than the foreign corporation's U.S. net equity as of the close of the preceding taxable year, then, for purposes of computing the foreign corporation's dividend equivalent amount for the taxable year, the foreign corporation's ECEP for the taxable year shall be increased by the amount of such difference.

(ii) LIMITATION BASED ON ACCUMULATED ECEP. The increase of a foreign corporation's ECEP under paragraph (b)(3)(i) of this section shall not exceed the accumulated ECEP of the foreign corporation as of the beginning of the taxable year. The term "accumulated ECEP" means the aggregate amount of ECEP of a foreign corporation for preceding taxable years beginning after December 31, 1986, minus the aggregate dividend equivalent amounts for such preceding taxable years. Accumulated ECEP may be less than zero.

(4) EXAMPLES. The principles of paragraph (b)(2) and (3) of this section are illustrated by the following examples.

EXAMPLE 1. REINVESTMENT OF ALL ECEP. Foreign corporation A, a calendar year taxpayer, had $1,000 U.S. net equity as of the close of 1986 and $100 of ECEP for 1987. A acquires $100 of additional U.S. assets during 1987 and its U.S. net equity as of the close of 1987 is $1,100. In computing A's dividend equivalent amount for 1987, A's ECEP of $100 is reduced under paragraph (b)(2) of this section by the $100 increase in U.S. net equity between the close of 1986 and the close of 1987. A has no dividend equivalent amount for 1987.

EXAMPLE 2. PARTIAL REINVESTMENT OF ECEP. Assume the same facts as in Example 1 except that A acquires $40 (rather than $100) of U.S. assets during 1987 and its U.S. net equity as of the close of 1987 is $1,040. In computing A's dividend equivalent amount for 1987, A's ECEP of $100 is reduced under paragraph (b)(2) of this section by the $40 increase in U.S. net equity between the close of 1986 and the close of 1987. A has a dividend equivalent amount of $60 for 1987.

EXAMPLE 3. DISINVESTMENT OF PRIOR YEAR'S ECEP. Assume the same facts as in Example 1 for 1987. A has no ECEP for 1988. A's U.S. net equity decreases by $40 (to $1,060) as of the close of 1988. A has a dividend equivalent amount of $40 for 1988, even though it has no ECEP for 1988. A's ECEP of $0 for 1988 is increased under paragraph (b)(3)(i) of this section by the $40 reduction in U.S. net equity (subject to the limitation in paragraph (b)(3)(ii) of this section of $100 of accumulated ECEP).

EXAMPLE 4. ACCUMULATED ECEP LIMITATION. Assume the same facts as in Example 2 for 1987. For 1988, A has $125 of ECEP and its U.S. net equity decreases by $50. A's U.S. net equity as of the close of 1988 is $990 ($1,040-$50). In computing A's dividend equivalent amount for 1988, the $125 of ECEP for 1988 is not increased under paragraph (b)(3)(i) of this section by the full amount of the $50 decrease in U.S. net equity during 1988. Rather, the increase in ECEP resulting from the decrease in U.S. net equity is limited to A's accumulated ECEP as of the beginning of 1988. A had $100 of ECEP for 1987 and a dividend equivalent amount of $60 for that year, so A had $40 of accumulated ECEP as of the beginning of 1988. The increase in ECEP resulting from a decrease in U.S. net equity is thus limited to $40, and the dividend equivalent amount for 1988 is $165 ($125 ECEP + $40 decrease in U.S. net equity).

EXAMPLE 5. EFFECT OF DEFICITS IN ECEP. Foreign corporation A, a calendar year taxpayer, has $150 of accumulated ECEP as of the beginning of 1991 ($200 aggregate ECEP less $50 aggregate dividend equivalent amounts for years preceding 1991). A has U.S. net equity of $450 as of the close of 1990, U.S. net equity of $350 as of the close of 1991 (i.e., a $100 decrease in U.S. net equity) and a $90 deficit in ECEP for 1991. A's dividend equivalent amount is $10 for 1991, i.e., A's deficit of $90 in ECEP for 1991 increased by $100, the decrease in A's U.S. net equity during 1991. A portion of the reduction in U.S. net equity in 1991 ($90) is attributable to A's deficit in ECEP for that year. The reduction in U.S. net equity in 1991 ($100) triggers a dividend equivalent amount only to the extent it exceeds the $90 current year deficit in ECEP for 1991. As of the beginning of 1992, A has $50 of accumulated ECEP (i.e., 110 aggregate ECEP less $60 aggregate dividend equivalent amounts for years preceding 1992).

EXAMPLE 6. NIMBLE DIVIDEND EQUIVALENT AMOUNT. Foreign corporation A, a calendar year taxpayer, had a deficit in ECEP of $100 for 1987 and $100 for 1988, and has $90 of ECEP for 1989. A had $2,000 U.S. net equity as of the close of 1988 and has $2,000 U.S. net equity as of the close of 1989. A has a dividend equivalent amount of $90 for 1989, its ECEP for the year, even though it has a net deficit of $110 in ECEP for the period 1987-1989.

(c) U.S. NET EQUITY -- (1) DEFINITION. The term "U.S. net equity" means the aggregate amount of the U.S. assets (as defined in paragraphs (c)(2) and (d)(1) of this section) of a foreign corporation as of the determination date (as defined in paragraph (c)(3) of this section), reduced (including below zero) by the U.S. liabilities (as defined in paragraph (e) of this section) of the foreign corporation as of the determination date.

(2) DEFINITION OF THE AMOUNT OF A U.S. ASSET. For purposes of this section, the term "amount of a U.S. asset" means the U.S. asset's adjusted basis for purposes of computing earnings and profits ("E&P basis") multiplied by the proportion of the asset that is treated as a U.S. asset under paragraphs (d)(1) through (4) of this section. The amount of a U.S. asset that is money shall be its face value. See paragraph (d)(6) of this section for rules concerning the computation of the E&P basis of a U.S. asset.

(3) DEFINITION OF DETERMINATION DATE. For purposes of this section, the term "determination date" means the close of the day on which the amount of U.S. net equity is required to be determined. Unless otherwise provided, the U.S. net equity of a foreign corporation is required to be determined as of the close of the foreign corporation's taxable year.

(d) U.S. ASSETS -- (1) DEFINITION OF A U.S. ASSET -- (i) GENERAL RULE. Except as provided in paragraph (d)(5) of this section, the term "U.S. asset" means an asset of a foreign corporation (other than an interest in a partnership, trust, or estate) that is held by the corporation as of the determination date if --

(A) All income produced by the asset on the determination date is ECI (as defined in paragraph (d)(1)(iii) of this section)(or would be ECI if the asset produced income on that date); and

(B) All gain from the disposition of the asset would be ECI if the asset were disposed of on that date and the disposition produced gain.

For purposes of determining whether income or gain from an asset would be ECI under this paragraph (d)(1)(i), it is immaterial whether the asset is of a type that is unlikely to, or cannot, produce income or gain. For example, money may be a U.S. asset although it does not produce income or gain. In the case of an asset that does not produce income, however, the determination of whether income from the asset would be ECI shall be made under the principles of section 864 and the regulations thereunder, but without regard to section 1.864-4(c)(2)(iii)(b). For purposes of determining whether an asset is a U.S. asset under this paragraph (d)(1), a foreign corporation may presume, unless it has reason to know otherwise, that gain from the sale of personal property (including inventory property) would be U.S. source if gain from the sale of that type of property would ordinarily be attributable to an office or other fixed place of business of the foreign corporation within the United States (within the meaning of section 865(e)(2)).

(ii) SPECIAL RULES FOR ASSETS NOT DESCRIBED IN PARAGRAPH (d)(1)(i) OF THIS SECTION. An asset of a foreign corporation that is held by the corporation as of the determination date and is not described in paragraph (d)(1)(i) of this section shall be treated as a U.S. asset to the extent provided in paragraph (d)(2) of this section (relating to special rules for certain assets, including assets that produce income or gain at least a portion of which is ECI), and in paragraphs (d)(3) and (4) of this section (relating to special rules for interests in a partnership, trust, and estate).

(iii) DEFINITION OF ECI. For purposes of the regulations under section 884, the term "ECI" means income that is effectively connected with the conduct of a trade or business in the United States and income that is treated as effectively connected with the conduct of a trade or business in the United States under any provision of the Code. The term "ECI" also includes all income that is or is treated as effectively connected with the conduct of a U.S. trade or business whether or not the income is included in gross income (for example, interest income earned with respect to tax- exempt bonds).

(2) SPECIAL RULES FOR CERTAIN ASSETS -- (i) DEPRECIABLE AND AMORTIZABLE PROPERTY. An item of depreciable personal property or an item of amortizable intangible property shall be treated as a U.S. asset of a foreign corporation in the same proportion that the amount of the depreciation or amortization with respect to the item of property that is allowable as a deduction, or is includible in cost of goods sold, for the taxable year in computing the effectively connected taxable income of the foreign corporation bears to the total amount of depreciation or amortization computed for the taxable year with respect to the item of property.

(ii) INVENTORY. An item or pool of inventory property (as defined in section 865(i)(1)) shall be treated as a U.S. asset in the same proportion as the amount of gross receipts from the sale or exchange of such property for the three preceding taxable years (or for such part of the three-year period as the corporation has been in existence) that is effectively connected with the conduct of a U.S. trade or business bears to the total amount of gross receipts from the sale or exchange of such property during such period (or part thereof). If a foreign corporation has not sold or exchanged such property during such three-year period (or part thereof), then the property shall be treated as a U.S. asset in the same proportion that the anticipated amount of gross receipts from the sale or exchange of the property that is reasonably anticipated to be ECI bears to the anticipated total amount of gross receipts from the sale or exchange of the property.

(iii) INSTALLMENT OBLIGATIONS. An installment obligation received in connection with an installment sale (as defined in section 453(b)) for which an election under section 453(d) has not been made shall be treated as a U.S. asset to the extent that it is received in connection with the sale of a U.S. asset. If an obligation is received in connection with the sale of an asset that is wholly a U.S. asset, it shall be treated as a U.S. asset in its entirety. If a single obligation is received in connection with the sale of an asset that is in part a U.S. asset under the rules of paragraphs (d)(2) through (4) of this section, or in connection with the sale of several assets including one or more non-U.S. assets, the obligation shall be treated as U.S. asset in the same proportion as--

(A) The sum of the amount of gain from the installment sale that would be ECI if the obligation were satisfied in full on the determination date and the adjusted basis of the obligation on such date (as determined under section 453B) attributable to the amount of gain that would be ECI bears to

(B) The sum of the total amount of gain from the sale if the obligation were satisfied in full and the adjusted basis of the obligation on such date (as determined under section 453B).

However, the obligation will only be treated as a U.S. asset if the interest income or original issue discount with respect to the obligation is ECI or the foreign corporation elects to treat the interest or original issue discount as ECI in the same proportion that the obligation is treated as a U.S. asset. A foreign corporation may elect to treat interest income or original issue discount as ECI by reporting such interest income or original issue discount as ECI on its income tax return or an amended return for the taxable year. See paragraph (d)(6)(ii) of this section to determine the E&P basis of an installment obligation for purposes of this paragraph (d)(2)(iii).

(iv) RECEIVABLES -- (A) RECEIVABLES ARISING FROM THE SALE OR EXCHANGE OF INVENTORY PROPERTY. An account or note receivable (whether or not bearing stated interest) with a maturity not exceeding six months that arises from the sale or exchange of inventory property (as defined in section 865(i)(1)) shall be treated as a U.S. asset in the proportion determined under paragraph (d)(2)(iii) of this section as if the receivable were an installment obligation.

(B) RECEIVABLES ARISING FROM THE PERFORMANCE OF SERVICES OR LEASING OF PROPERTY. An account or note receivable (whether or not bearing stated interest) with a maturity not exceeding six months that arises from the performance of services or the leasing of property in the ordinary course of a foreign corporation's trade or business shall be treated as a U.S. asset in the same proportion that the amount of gross income represented by the receivable that is ECI bears to the total amount of gross income represented by the receivable. For purposes of this paragraph (d)(2)(iv)(B), the amount of income represented by a receivable shall not include interest income or original issue discount.

(v) BANK AND OTHER DEPOSITS. A deposit or credit balance with a person described in section 871(i)(3) or a Federal Reserve Bank that is interest-bearing shall be treated as a U.S. asset if all income derived by the foreign corporation with respect to the deposit or credit balance during the taxable year is ECI. Any other deposit or credit balance shall only be treated as a U.S. asset if the deposit or credit balance is needed in a U.S. trade or business within the meaning of section 1.864-4(c)(2)(iii)(a).

(vi) DEBT INSTRUMENTS. A debt instrument, as defined in section 1275(a)(1) (other than an asset treated as a U.S. asset under any other subdivision of this paragraph (d)) shall be treated as a U.S. asset, notwithstanding the fact that gain from the sale or exchange of the obligation on the determination date would not be ECI, if--

(A) All income derived by the foreign corporation from such obligation during the taxable year is ECI; and

(B) The yield for the period that the instrument was held during the taxable year equals or exceeds the Applicable Federal Rate for instruments of similar type and maturity.

Shares in a regulated investment company that purchases solely instruments that, under this paragraph (d)(2)(vi), would be U.S. assets if held directly by the foreign corporation shall also be treated as a U.S. asset.

(vii) STOCKS OR SECURITIES HELD BY A FOREIGN CORPORATION ENGAGED IN A BANKING FINANCING OR SIMILAR BUSINESS. Stocks or securities described in section 1.864-4(c)(5)(ii)(b)(3) held by a foreign corporation engaged in the active conduct of a banking, financing, or similar business in the United States during the taxable year shall be treated as U.S. assets in the same proportion that income, gain, or loss from such stocks or securities is ECI for the taxable year under section 1.864-4(c)(5)(ii).

(viii) FEDERAL INCOME TAXES. An overpayment of Federal income taxes shall be treated as a U.S. asset to the extent that the tax would reduce a foreign corporation's ECEP for the taxable year but for the fact that the tax does not accrue during the taxable year.

(ix) LOSSES INVOLVING U.S. ASSETS. A foreign corporation that sustains, with respect to a U.S. asset, a loss for which a deduction is not allowed under section 165 (in whole or in part) because there exists a reasonable prospect of recovering compensation for the loss shall be treated as having a U.S. asset ("loss property") from the date of the loss in the same proportion that the asset was treated as a U.S. asset immediately before the loss. See paragraph (d)(6)(iv) of this section to determine the E&P basis of the loss property.

(x) RULING FOR INVOLUNTARY CONVERSION. If property that is a U.S. asset of a foreign corporation is compulsorily or involuntarily converted into property not similar or related in service or use (within the meaning of section 1033), the foreign corporation may apply to the Commissioner for a ruling to determine its U.S. assets for the taxable year of the involuntary conversion.

(xi) EXAMPLES. The principles of paragraphs (c) and (d)(1) and (2) of this section are illustrated by the following examples.

EXAMPLE 1. DEPRECIABLE PROPERTY. Foreign corporation A, a calendar year taxpayer, is engaged in a trade or business in the United States. A owns equipment that is used in its manufacturing business in country X and in the United States. Under section 1.861-8, A's depreciation deduction with respect to the equipment is allocated to sales income and is apportioned 70 percent to ECI and 30 percent to income that is not ECI. Under paragraph (d)(2)(ii) of this section, the equipment is 70 percent a U.S. asset. The equipment has an E&P basis of $100 at the beginning of 1993. A's depreciation deduction (for purposes of computing earnings and profits) with respect to the equipment is $10 for 1993. To determine the amount of A's U.S. asset at the close of 1993, the equipment's $90 E&P basis at the close of 1993 is multiplied by 70 percent (the proportion of the asset that is a U.S. asset). The amount of the U.S. asset as of the close of 1993 is $63.

EXAMPLE 2. U.S. REAL PROPERTY INTEREST NOT CONNECTED TO A U.S. BUSINESS. Foreign corporation A owns a condominium apartment in the United States. Assume that holding the apartment does not constitute a U.S. trade or business and the foreign corporation has not made an election under section 882(d) to treat income with respect to the property as ECI. The condominium apartment is not a U.S. asset of A because the income, if any, from the asset would not be ECI. However, the disposition by A of the condominium apartment at a gain will give rise to ECEP.

EXAMPLE 3. STOCK IN A DOMESTICALLY-CONTROLLED REIT. As an investment, foreign corporation A owns stock in a domestically- controlled REIT, within the meaning of section 897(h)(4)(B). Under section 897(h)(2), gain on disposition of stock in the REIT is not treated as ECI. For this reason the stock does not qualify as a U.S. asset under paragraph (d)(1) of this section even if dividend distributions from the REIT are treated as ECI. Thus, A will have a dividend equivalent amount based on the ECEP attributable to a distribution of ECI from the REIT, even if A invests the proceeds from the dividend in additional stock of the REIT. (Stock in a REIT that is not a domestically-controlled REIT is also not a U.S. asset. See section 1.884-1(d)(5)).

EXAMPLE 4. SECTION 864(c)(7) PROPERTY. Foreign corporation A is engaged in the equipment leasing business in the United States and Canada. A transfers the equipment leased by its U.S. trade or business to its Canadian business after the equipment is fully depreciated in the United States. The Canadian business sells the equipment two years later. Section 864(c)(7) would treat the gain on the disposition of the equipment by A as taxable under section 882 as if the sale occurred immediately before the equipment was transferred to the Canadian business. The equipment would not be treated as a U.S. asset even if the gain was ECI because the income from the equipment in the year of the sale in Canada would not be ECI.

(3) INTEREST IN A PARTNERSHIP -- (i) GENERAL RULE. Except as provided in paragraph (d)(3)(ii) of this section, a foreign corporation's interest in a partnership shall be treated as a U.S. asset in the same proportion as its distributive share of partnership gross income for the partnership's taxable year that ends with or within its taxable year that is ECI bears to its distributive share of all partnership gross income for that taxable year.

(ii) PARTNERSHIP OPERATED TO INCREASE A FOREIGN CORPORATION'S U.S. ASSETS ARTIFICIALLY. If the District Director determines that one of the principal purposes of the acquisition of a partnership interest or the acquisition or ownership of certain properties by a partnership is to increase the U.S. assets of a foreign corporation artificially, the District Director may compute the portion of the foreign corporation's interest in the partnership that is a U.S. asset using a method that more accurately reflects the foreign corporation's interest in the partnership property that would be U.S. assets if held directly by the foreign corporation. Whether a partnership interest is acquired, or partnership property is acquired or owned, for such purpose will depend on all the facts and circumstances of each case. Factors to be considered include whether the partnership conducts unrelated businesses or whether the partnership accumulates investment property unrelated to its trade or business or liquid assets in excess of the reasonable needs of its business. For purposes of this paragraph (d)(3)(ii), to be one of the principal purposes, a purpose must be important, but it is not necessary that it be the primary purpose.

(iii) EXAMPLE. The application of paragraph (d)(3)(ii) of this section is illustrated by the following example.

EXAMPLE. Foreign corporation A is a partner in partnership X and is entitled to 50 percent of the income of X and 50 percent of the value of all property of X upon X's liquidation. X is engaged in an active U.S. real estate business which, during the taxable year, produces $100 of gross income that is ECI. In the same taxable year, X acquires securities (from funds that are either generated by its business, borrowed or contributed) that produce $50 of gross income that is not ECI. The securities are unrelated to the real estate business and substantially exceed the reasonable needs of the business. The real estate securities each have an adjusted basis of $1000. Under paragraph (d)(3)(i) of this section, two-thirds (50/75) of A's distributive share of partnership gross income is ECI, and two-thirds of A's basis in its partnership interest is therefore treated as a U.S. asset. However, because the securities acquired by X are unrelated to X's real estate business and exceed the reasonable needs of the business, the District Director may determine that a principle purpose of X's acquisition of the securities is to increase artificially the U.S. assets of A. The District Director may, therefore, compute the portion of A's interest in X that is treated as a U.S. asset by, for example, using the ratio of A's pro rata share of the adjusted basis of the property of X that produces income that is ECI ($500) to A's pro rata share of all property of X ($1000). As a result, 50 percent of A's partnership interest would be treated as a U.S. asset rather than 75 percent.

(iv) SPECIAL RULE FOR DETERMINING A PARTNER'S ADJUSTED BASIS IN A PARTNERSHIP INTEREST. For purposes of this paragraph (d)(3) and paragraph (d)(6) of this section, a partner's adjusted basis in a partnership interest shall be the partner's basis in such interest (as determined under section 705) --

(A) Reduced by the partner's share of the liabilities of the partnership (as determined under section 752); and

(B) Increased by a proportionate share of each liability of the partnership equal to the partner's proportionate share, for income tax purposes, of the interest expense attributable to such liability for the taxable year.

(v) E&P BASIS OF A PARTNERSHIP INTEREST. See paragraph (d)(6)(iii) of this section for special rules governing the calculation of a foreign corporation's E&P basis in a partnership interest.

(4) INTEREST IN A TRUST OR ESTATE. [Reserved]

(5) PROPERTY THAT IS NOT A U.S. ASSET -- (i) PROPERTY THAT DOES NOT GIVE RISE TO ECEP. Property described in paragraphs (d)(1) through (4) of this section shall not be treated as a U.S. asset of a foreign corporation if, on the determination date, income from the use of the property, or gain or loss from the disposition of the property, would be described in paragraph (f)(2) of this section (relating to certain income that does not produce ECEP).

(ii) ASSETS ACQUIRED TO INCREASE U.S. NET EQUITY ARTIFICIALLY. U.S. assets shall not include assets acquired or used by a foreign corporation if one of the principal purposes of such acquisition or use is to increase artificially the U.S. assets of a foreign corporation on the determination date. Whether assets are acquired or used for such purpose will depend upon all the facts and circumstances of each case. Factors to be considered in determining whether one of the principal purposes in acquiring or using an asset is to increase artificially the U.S. assets of a foreign corporation include the length of time during which the asset was used in a U.S. trade or business, whether the asset was acquired from, or disposed of to, a related person, and whether the aggregate value of the U.S. assets of the foreign corporation increased temporarily on the determination date. For purposes of this paragraph (d)(5)(ii), to be one of the principal purposes, a purpose must be important, but it is not necessary that it be the primary purpose.

(iii) INTERBRANCH TRANSACTIONS DISREGARDED. All assets that arise from interbranch transactions will be disregarded.

(6) E&P BASIS OF A U.S. ASSET -- (i) GENERAL RULE. The E&P basis of a U.S. asset for purposes of this section is its adjusted basis for purposes of computing the foreign corporation's earnings and profits. In determining the E&P basis of a U.S. asset, the adjusted basis of the asset (for purposes of computing taxable income) must be increased or decreased to take into account inclusions of income or gain, and deductions or similar charges, that affect the basis of the asset where such items are taken into account in a different manner for purposes of computing earnings and profits than for purposes of computing taxable income. For example, if section 312(k) requires that depreciation with respect to a U.S. asset be determined using the straight line method for purposes of computing earnings and profits, but depreciation with respect to the asset is determined using a different method for purposes of computing taxable income, the E&P basis of the property for purposes of this section must be computed using the straight line method of depreciation.

(ii) INSTALLMENT OBLIGATIONS -- (A) SALES IN TAXABLE YEAR BEGINNING ON OR AFTER JANUARY 1, 1987. For purposes of this section, the E&P basis of an installment obligation described in paragraph (d)(2)(iii) of this section that arises in connection with an installment sale occurring in a taxable year beginning on or after January 1, 1987, shall equal the sum of the total amount of gain from the sale if the obligation were satisfied in full and the adjusted basis of the property sold as of the date of sale, reduced by payments received with respect to the obligation that are not interest or original issue discount. See paragraph (j)(2)(ii) of this section, however, for a special E&P basis rule for an installment obligation arising in connection with a sale of a U.S. asset by a foreign corporation described in section 312(k)(4), where such sale occurs in a taxable year beginning in 1987.

(B) SALES IN TAXABLE YEAR PRIOR TO JANUARY 1, 1987. For purposes of this section, the E&P basis of an installment obligation described in paragraph (d)(2)(iii) of this section that arises in connection with an installment sale occurring in a taxable year beginning before January 1, 1987, shall equal zero.

(iii) COMPUTATION OF E&P BASIS IN A PARTNERSHIP. For purposes of this section, a foreign corporation's E&P basis in a partnership interest shall be the foreign corporation's adjusted basis in such interest (as determined under paragraph (d)(3)(iv) of this section), further adjusted to take into account any differences between the foreign corporation's distributive share of items of partnership income, gain, loss, and deduction for purposes of computing the taxable income of the foreign corporation and the foreign corporation's distributive share of items of partnership income, gain, loss, and deduction for purposes of computing the earnings and profits of the foreign corporation.

(iv) COMPUTATION OF E&P BASIS OF A LOSS PROPERTY. The E&P basis of a loss property (as defined in paragraph (d)(2)(ix) of this section) shall equal the E&P basis, immediately before the loss, of the U.S. asset with respect to which the loss was sustained, reduced (but not below zero) by --

(A) The amount of any deduction claimed under section 165 by the foreign corporation with respect to the loss for earnings and profits purposes; and

(B) Any compensation received with respect to the loss.

(v) EXAMPLE. The application of paragraph (d)(6)(ii) of this section is illustrated by the following example.

EXAMPLE. SALE IN TAXABLE YEAR BEGINNING ON OR AFTER JANUARY 1, 1987. Foreign corporation A, a calendar year taxpayer, sells a U.S. asset on the installment method in 1993. Under the terms of the sale, A is to receive $100, payable in ten annual installments of $10 beginning in 1994, plus an arm's-length rate of interest on the unpaid balance of the sales price. A's adjusted basis in the property sold is $70. The obligation received in connection with the installment sale is treated as a U.S. asset with an E&P basis of $100 ($30 (the amount of gain from the sale if the obligation were satisfied in full) + $70 (the adjusted basis of the property sold)). If A receives a payment of $10 (not including interest) in 1994 with respect to the obligation, the obligation is treated as a U.S. asset with an E&P basis of $90 ($100 - $10) as of the close of 1994.

(e) U.S. LIABILITIES. The term "U.S. liabilities" means the amount of liabilities determined under paragraph (e)(1) of this section decreased by the amount of liabilities determined under paragraph (e)(3) of this section, and increased by the amount of liabilities determined under paragraph (e)(2) of this section.

(1) LIABILITIES BASED ON SECTION 1.882-5. The amount of liabilities determined under this paragraph (e)(1) is the amount of U.S.-connected liabilities of a foreign corporation under section 1.882-5 if the U.S.-connected liabilities were computed using the assets and liabilities of the foreign corporation as of the determination date (rather than the average of such assets and liabilities for the taxable year) and without regard to paragraph (e)(3) of this section.

(2) INSURANCE RESERVES. The amount of liabilities determined under this paragraph (e)(2) is the amount (as of the determination date) of the total insurance liabilities on United States business (within the meaning of section 842(b)(2)(B)) of a foreign corporation described in section 842(a) (relating to foreign corporations carrying on an insurance business in the United States) to the extent that such liabilities are not otherwise treated as U.S. liabilities by reason of paragraph (e)(1) of this section.

(3) ELECTION TO REDUCE LIABILITIES -- (i) GENERAL RULE. The amount of liabilities determined under this paragraph (e)(3) is the amount by which a foreign corporation elects to reduce its liabilities under paragraph (e)(1) of this section.

(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 excess, if any, of the amount of liabilities in paragraph (e)(1) of this section over the amount of liabilities shown on the books of the U.S. trade or business (determined under either section 1.882-5(b)(3)(i) or (ii)) as of the determination date.

(iii) EFFECT OF ELECTION ON INTEREST DEDUCTION AND BRANCH-LEVEL INTEREST TAX. A foreign corporation that elects to reduce its liabilities under this paragraph (e)(3) must, for purposes of computing the amount of its interest apportioned to ECI under section 1.882-5, reduce its U.S.-connected liabilities for the taxable year of the election by the amount of the reduction in liabilities under this paragraph (e)(3). The reduction of its U.S.-connected liabilities will also require a corresponding decrease in the amount of its interest apportioned to ECI under section 1.882-5 for purposes of section 1.884-4(a) and for all other Code sections for which the amount of interest apportioned under section 1.882-5 is relevant.

(iv) METHOD OF ELECTION. A foreign corporation that elects the benefits of this paragraph (e)(3) for a taxable year shall state on its return for the taxable year (or on a statement attached to the return) 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 the return or attachment. 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.

(v) EFFECT OF ELECTION ON COMPLETE TERMINATION. If a foreign corporation completely terminates its U.S. trade or business (within the meaning of section 1.884-2T(a)(2)), notwithstanding section 1.884-2T(a), the foreign corporation will be subject to tax on a dividend equivalent amount that equals the lesser of --

(A) The foreign corporation's accumulated ECEP that is attributable to an election to reduce liabilities; or

(B) The amount by which the corporation elected to reduce liabilities at the end of the taxable year preceding the year of complete termination.

For purposes of the preceding sentence, accumulated ECEP is attributable to an election to reduce liabilities to the extent that the ECEP was accumulated because of such an election rather than because of an increase in U.S. assets. For example, if a foreign corporation did not have positive ECEP in any year for which an election was made, it would not be required to include an amount as a dividend equivalent amount under this paragraph (e)(3)(v) because any accumulated ECEP that it may have is not attributable to an election to reduce liabilities.

(4) ARTIFICIAL DECREASE IN U.S. LIABILITIES. If a foreign corporation repays or otherwise decreases its U.S. liabilities and one of the principal purposes of such decrease is to decrease artificially its U.S. liabilities on the determination date, then such decrease shall not be taken into account for purposes of computing the foreign corporation's U.S. net equity. Whether the U.S. liabilities of a foreign corporation are artificially decreased will depend on all the facts and circumstances of each case. Factors to be considered in determining whether one of the principal purposes for the repayment or decrease of the liabilities is to decrease artificially the U.S. liabilities of a foreign corporation shall include whether the aggregate liabilities are temporarily decreased on or before the determination date by, for example, the repayment of liabilities, or U.S. liabilities are temporarily decreased on or before the determination date by the acquisition with contributed funds of passive-type assets that are not U.S. assets. For purposes of this paragraph (e)(4), to be one of the principal purposes, a purpose must be important, but it is not necessary that it be the primary purpose.

(5) EXAMPLES. The application of this paragraph (e) is illustrated by the following examples.

EXAMPLE 1. GENERAL RULE FOR COMPUTATION OF U.S. LIABILITIES. As of the close of 1993, foreign corporation A, a calendar year taxpayer computes its U.S.-connected liabilities under section 1.882-5(b) using its actual ratio of liabilities to assets. For purposes of computing its U.S.-connected liabilities under section 1.882-5(b), A must determine, the average total value of its assets that generate, have generated, or could reasonably have been or be expected to generate ECI. Assume that the average value of such assets is $100, while the amount of such assets as of the close of 1993 is $125. For purposes of section 1.882-5(b)(2), A must determine the ratio of the average of its worldwide liabilities for the year to the average total value of worldwide assets for the taxable year. Assume that A's average liabilities-to-assets ratio under section 1.882-5(b)(2) is 55 percent, while its liabilities-to- assets ratio at the close of 1993 is only 50 percent. Thus, assuming no further adjustments under paragraph (e)(3) of this section, A's U.S.-connected liabilities for purposes of section 1.882-5 are $55 ($100 x 55%). However, A's U.S. liabilities are $62.50 for purposes of this section, the amount of its assets determined under section 1.882-5(b)(1) as of the close of December ($125) multiplied by the liabilities-to-assets ratio (50%) as of such date.

EXAMPLE 2. ELECTION MADE TO REDUCE LIABILITIES. (i) As of the close of 1993, 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 and $300 of liabilities shown on the books and records of its U.S. trade or business under section 1.882-5(b)(3). A has accumulated ECEP of $500 and in 1994, 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 by the election.

(ii) In 1995, 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 1995 and to continue to retain for expansion (without the payment of the branch profits tax) the $60 of ECEP earned in 1994. Without an election to reduce liabilities, A's dividend equivalent amount for 1995 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 $120 does not exceed the excess of $800 (the amount of A's liabilities under paragraph (e)(1) of this section) over $300 (the amount of liabilities on A's books).

(iii) If A terminates its U.S. trade or business in 1995 in accordance with the rules in section 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 1994 that became accumulated ECEP because of an election to reduce liabilities.

(f) EFFECTIVELY CONNECTED EARNINGS AND PROFITS -- (1) IN GENERAL. Except as provided in paragraph (f)(2) of this section and as modified by section 1.884-2T (relating to the incorporation or complete termination of a U.S. trade or business or the reorganization or liquidation of a foreign corporation or its domestic subsidiary), the term "effectively connected earnings and profits" ("ECEP") means the earnings and profits (or deficits therein) determined under section 312 and this paragraph (f) that are attributable to ECI (within the meaning of paragraph (d)(1)(iii) of this section). Because the term "ECI" includes income treated as effectively connected, income that is ECI under section 842(b) (relating to minimum net investment income of an insurance business) or 864(c)(7) (relating to gain from property formerly held for use in a U.S. trade or business) gives rise to ECEP. ECEP also includes earnings and profits attributable to ECI of a foreign corporation earned through a partnership, and through a trust or estate. For purposes of section 884, gain on the sale of a U.S. real property interest by a foreign corporation that has made an election to be treated as a domestic corporation under section 897(i) will also give rise to ECEP. ECEP is not reduced by distributions made by the foreign corporation during any taxable year or by the amount of branch profits tax or tax on excess interest (as defined in section 1.884-4(a)(2)) paid by the foreign corporation. Earnings and profits are treated as attributable to ECI even if the earnings and profits are taken into account under section 312 in an earlier or later taxable year than the taxable year in which the ECI is taken into account.

(2) INCOME THAT DOES NOT PRODUCE ECEP. The term "ECEP" does not include any earnings and profits attributable to --

(i) Income excluded from gross income under section 883(a)(1) or 883(a)(2) (relating to certain income derived from the operation of ships or aircraft);

(ii) Income that is ECI by reason of section 921(d) or 926(b) (relating to certain income of a FSC and certain dividends paid by a FSC to a foreign corporation or nonresident alien) that is not otherwise ECI;

(iii) Gain on the disposition of a U.S. real property interest described in section 897(c)(1)(A)(ii) (relating to certain interests in a domestic corporation);

(iv) Income that is ECI by reason of section 953(c)(3)(C) (relating to certain income of a captive insurance company that a corporation elects to treat as ECI) that is not otherwise ECI;

(v) Income that is exempt from tax under section 892 (relating to certain income of foreign governments) ; and

(vi) Income that is ECI by reason of section 882(e) (relating to certain interest income of banks organized under the laws of a possession of the United States) that is not otherwise ECI.

(3) ALLOCATION OF DEDUCTIONS ATTRIBUTABLE TO INCOME THAT DOES NOT PRODUCE ECEP. In determining the amount of a foreign corporation's ECEP for the taxable year, deductions and other adjustments shall be allocated and apportioned under the principles of section 1.861-8 between ECI that gives rise to ECEP and income described in paragraph (f)(2) of this section (relating to income that is ECI but does not give rise to ECEP).

(4) EXAMPLES. The principles of paragraph (f) of this section are illustrated by the following examples.

EXAMPLE 1. TAX-EXEMPT INCOME. Foreign corporation A owns a tax-exempt municipal bond that is a U.S. asset as of the close of its 1989 taxable year. The municipal bond gives rise in 1989 to ECI (even though the income is excluded from gross income under section 103(a) and is not gross income of a foreign corporation by reason of section 882(b)), and therefore gives rise to ECEP in 1989.

EXAMPLE 2. INCOME EXEMPT UNDER A TREATY. Foreign corporation A derives ECI that constitutes business profits that are not attributable to a permanent establishment maintained by A in the United States. The ECI is exempt from taxation under section 882(a) by reason of an income tax treaty and section 894(a). The income nevertheless gives rise to ECEP under this paragraph (f). However, a dividend equivalent amount attributable to such ECEP may be exempt from the branch profits tax by reason of paragraph (g) of this section (relating to the application of the branch profits tax to corporations that are residents of countries with which the United States has an income tax treaty).

(g) CORPORATIONS RESIDENT IN COUNTRIES WITH WHICH THE UNITED STATES HAS AN INCOME TAX TREATY -- (1) GENERAL RULE. Except as provided in paragraph (g)(2) of this section, a foreign corporation that is a resident of a country with which the United States has an income tax treaty in effect for a taxable year in which it has a dividend equivalent amount and that meets the requirements, if any, of the limitation on benefits provisions of such treaty with respect to the dividend equivalent amount shall not be subject to the branch profits tax on such amount (or will qualify for a reduction in the amount of tax with respect to such amount) only if --

(i) The foreign corporation is a qualified resident of such country for the taxable year, within the meaning of section 1.884-5(a); or

(ii) The limitation on benefits provision, or an amendment to that provision, entered into force after December 31, 1986.

If, after application of section 1.884-5(e)(4)(iv), a foreign corporation is a qualified resident under section 1.884-5(e) (relating to the active trade or business test) only with respect to one of its trades or businesses in the United States, i.e., the trade or business that is an integral part of its business conducted in its country of residence, and not with respect to another, the rules of this paragraph shall apply only to that portion of its dividend equivalent amount attributable to the trade or business for which the foreign corporation is a qualified resident.

(2) SPECIAL RULES FOR FOREIGN CORPORATIONS THAT ARE QUALIFIED RESIDENTS ON THE BASIS OF THEIR OWNERSHIP -- (i) GENERAL RULE. A foreign corporation that, in any taxable year, is a qualified resident of a country with which the United States has an income tax treaty in effect solely by reason of meeting the requirements of section 1.884-5(b) and (c) (relating, respectively, to stock ownership and base erosion) shall be exempt from the branch profits tax or subject to a reduced rate of branch profits tax under paragraph (g)(1) of this section with respect to the portion of its dividend equivalent amount for the taxable year attributable to accumulated ECEP only if the foreign corporation is a qualified resident of such country within the meaning of section 1.884-5(a) for the taxable years includible, in whole or in part, in a consecutive 36-month period that includes the taxable year of the dividend equivalent amount. A foreign corporation that fails the 36-month test described in the preceding sentence shall be exempt from the branch profits tax or subject to the branch profits tax at a reduced rate under paragraph (g)(1) of this section with respect to accumulated ECEP (determined on a last-in-first-out basis) accumulated only during prior years in which the foreign corporation was a qualified resident of such country within the meaning of section 1.884-5(a).

(ii) RULES OF APPLICATION. A foreign corporation that has not satisfied the 36-month test as of the close of the taxable year of the dividend equivalent amount but satisfies the test with respect to such dividend equivalent amount by meeting the 36-month test by the close of the second taxable year succeeding the taxable year of the dividend equivalent amount shall be subject to the branch profits tax for the year of the dividend equivalent amount without regard to paragraph (g)(1) of this section on the portion of the dividend equivalent amount attributable to accumulated ECEP derived in a taxable year in which the foreign corporation was not a qualified resident within the meaning of section 1.884-5(a). Upon meeting the 36-month test, the foreign corporation shall be entitled to claim by amended return a refund of the tax paid with respect to the dividend equivalent amount in excess of the branch profits tax calculated by taking into account paragraph (g)(2)(i) of this section, provided the foreign corporation establishes in the amended return for the taxable year that it has met the requirements of such paragraph. For purposes of section 6611 (dealing with interest on overpayments), any overpayment of branch profits tax by reason of this paragraph (g)(2)(ii) shall be deemed not to have been made before the filing date for the taxable year in which the foreign corporation establishes that it has met the 36-month test.

(iii) EXAMPLE. The application of this paragraph (g)(2) is illustrated by the following example.

EXAMPLE. (i) Foreign corporation A, a calendar year taxpayer, is a resident of the United Kingdom. A has a dividend equivalent amount for its taxable year 1991 of $300, of which $100 is attributable to 1991 ECEP and $200 to accumulated ECEP. A is a qualified resident for its taxable year 1991 because for that year it meets the requirements of section 1.884-5(b) and (c), relating, respectively, to stock ownership and base erosion. For 1991 A does not meet the requirements of section 1.884-5(d), (e), or (f) for qualified residence. A is not a qualified resident of the United Kingdom for any taxable year prior to 1990 but is a qualified resident for its taxable years 1990 and 1992.

(ii) Because A is a qualified resident for the 3-year period (1990, 1991, and 1992) that includes the taxable year of the dividend equivalent amount (1991), A satisfies the 36-month test of this paragraph (g)(2) and no branch profits tax is imposed on the total $300 dividend equivalent amount. However, since A was not a qualified resident for any taxable year prior to 1990 and therefore cannot establish that it has satisfied the 36-month test until the taxable year following the year of the dividend equivalent amount, A must pay the branch profits tax for its taxable year 1991 with respect to the portion of the dividend equivalent amount attributable to accumulated ECEP relating to years prior to 1990 without regard to paragraph (g)(1) of this section. A may file for a refund of the branch profits tax paid with respect to its 1991 taxable year at any time after it establishes that it is a qualified resident for its 1992 taxable year.

(3) EXEMPTIONS FOR FOREIGN CORPORATIONS RESIDENT IN CERTAIN COUNTRIES WITH INCOME TAX TREATIES IN EFFECT ON JANUARY 1, 1987. The branch profits tax shall not be imposed on the portion of the dividend equivalent amount with respect to which a foreign corporation satisfies the requirements of paragraphs (g)(1) and (2) of this section for a country listed below, so long as the income tax treaty between the United States and that country, as in effect on January 1, 1987, remains in effect, except to the extent the treaty is modified on or after January 1, 1987, to expressly provide for the imposition of the branch profits tax:

 Aruba               Germany             Malta

(B) CERTAIN TREATIES IN EFFECT ON JANUARY 1, 1987. The branch profits tax shall generally be imposed at the following rates on the portion of the dividend equivalent amount with respect to which a foreign corporation satisfies the requirements of paragraphs (g)(1) and (2) of this section for a country listed below, for as long as the relevant provisions of those income tax treaties remain in effect and are not modified or superseded by subsequent agreement:

 Australia (15%)          New Zealand (5%)    Trinidad & Tobago

(ii) LIMITATIONS OTHER THAN RATE OF TAX. If, under paragraphs (g)(1) and (2) of this section, a foreign corporation qualifies for a reduction in the amount of branch profits tax and paragraph (g)(3) of this section does not apply, then --

(A) The foreign corporation shall be entitled to the benefit of any limitations on imposition of a tax on branch profits (in addition to any limitations on the rate of tax) contained in the treaty; and

(B) No branch profits tax shall be imposed with respect to a dividend equivalent amount out of ECEP or accumulated ECEP of the foreign corporation unless the ECEP or accumulated ECEP is attributable to a permanent establishment in the United States or, if not otherwise prohibited under the treaty, to gain from the disposition of a U.S. real property interest described in section 897(c)(1)(A)(i), except to the extent the treaty specifically permits the imposition of the branch profits tax on such earnings and profits.

No article in such treaty shall be construed to provide any limitations on imposition of the branch profits tax other than as provided in this paragraph (g)(4).

(iii) COMPUTATION OF THE DIVIDEND EQUIVALENT AMOUNT IF A FOREIGN CORPORATION HAS BOTH ECEP ATTRIBUTABLE TO A PERMANENT ESTABLISHMENT AND NOT ATTRIBUTABLE TO A PERMANENT ESTABLISHMENT. To determine the dividend equivalent amount of a foreign corporation out of ECEP that is attributable to a permanent establishment, the foreign corporation may only take into account its U.S. assets, U.S. liabilities, U.S. net equity and ECEP attributable to its permanent establishment. Thus, a foreign corporation may not reduce the amount of its ECEP attributable to its permanent establishment by reinvesting all or a portion of that amount in U.S. assets not attributable to the permanent establishment.

(iv) LIMITATIONS UNDER THE CANADIAN TREATY. The limitations on the imposition of the branch profits tax under the Canadian treaty include, but are not limited to, those described in paragraphs (g)(4)(iv)(A) and (B).

(A) EFFECT OF DEFICITS IN EARNINGS AND PROFITS. In the case of a foreign corporation that is a qualified resident of Canada, the dividend equivalent amount for any taxable year shall not exceed the foreign corporation's accumulated ECEP as of the beginning of the taxable year plus the corporation's ECEP for the taxable year. Thus, for example, if a foreign corporation that is a qualified resident of Canada has a deficit in accumulated ECEP of $200 as of the beginning of the taxable year and ECEP of $100 for the taxable year, it will have no dividend equivalent amount for the taxable year because it would have a cumulative deficit in ECEP of $100 as of the close of the taxable year. For purposes of this paragraph (g)(4)(iii)(A), any net deficit in accumulated earnings and profits attributable to taxable years beginning before January 1, 1987, shall be includible in determining accumulated ECEP.

(B) ONE-TIME EXEMPTION OF CANADIAN $500,000 -- (1) GENERAL RULE. In the case of a foreign corporation that is a qualified resident of Canada, the branch profits tax shall be imposed only with respect to that portion of the dividend equivalent amount for the taxable year that, when translated into Canadian dollars and added to the dividend equivalent amounts for preceding taxable years translated into Canadian dollars, exceeds Canadian $500,000. The value of the dividend equivalent amount in Canadian currency shall be determined by translating the ECEP for each taxable year that is includible in the dividend equivalent amount (as determined in U.S. dollars under the currency translation method used in determining the foreign corporation's taxable income for U.S. tax purposes) by the weighted average exchange rate for the taxable year (determined under the rules of section 989(b)(3)) during which the earnings and profits were derived.

(2) REDUCTION IN AMOUNT OF EXEMPTION IN THE CASE OF RELATED CORPORATIONS. The amount of a foreign corporation's exemption under this paragraph (g)(4)(iii)(B) shall be reduced by the amount of any exemption that reduced the dividend equivalent amount of an associated foreign corporation with respect to the same or a similar business. For purposes of this paragraph (g)(4)(iii)(B), a foreign corporation is an associated foreign corporation if it is related to the foreign corporation for purposes of section 267(b) or it and the foreign corporation are stapled entities (within the meaning of section 269B(c)(2)) or are effectively stapled entities. A business is the same as or similar to another business if it involves the sale, lease, or manufacture of the same or a similar type of property or the provision of the same or a similar type of services. A U.S. real property interest described in section 897(c)(1)(A)(i) shall be treated as a business and all such U.S. real property interests shall be treated as businesses that are the same or similar.

(3) COORDINATION WITH SECOND-TIER WITHHOLDING TAX. The value of the dividend equivalent amount that is exempt from the branch profits tax by reason of paragraph (g)(4)(iii)(B)(i) of this section shall not be subject to tax under section 871(a) or 881, or to withholding under section 1441 or 1442, when distributed by the foreign corporation.

(5) BENEFITS UNDER TREATIES OTHER THAN INCOME TAX TREATIES. A treaty that is not an income tax treaty does not exempt a foreign corporation from the branch profits tax or reduce the amount of the tax.

(h) STAPLED ENTITIES. Any foreign corporation that is treated as a domestic corporation by reason of section 269B (relating to stapled entities) shall continue to be treated as a foreign corporation for purposes of section 884 and the regulations thereunder, notwithstanding section 269B or the regulations thereunder. Dividends paid by such foreign corporation shall be treated as paid by a domestic corporation and shall be subject to the tax imposed by section 871(a) or 881(a), and to withholding under section 1441 or 1442, as applicable, to the extent paid out of earnings and profits that are not subject to tax under section 884(a). Dividends paid by such foreign corporation out of earnings and profits subject to tax under section 884(a) shall be exempt from the tax imposed by sections 871(a) and 881(a) and shall not be subject to withholding under section 1441 or 1442. Whether dividends are paid out of earnings and profits that are subject to tax under section 884(a) shall be determined under section 884(e)(3)(A) and the regulations thereunder. The limitation on the application of treaty benefits in section 884(e)(3)(B) (relating to qualified residents) shall apply to a foreign corporation described in this paragraph (h).

(i) EFFECTIVE DATE -- (1) GENERAL RULE. This section is effective for taxable years beginning on or after October 13, 1992. With respect to a taxable year beginning before October 13, 1992 and after December 31, 1986, a foreign corporation may elect to apply this section in lieu of section 1.884-1T of the temporary regulations (as contained in the CFR edition revised as of April 1, 1992), but only if the foreign corporation also makes an election under section 1.884-4(e) to apply section 1.884-4 in lieu of section 1.884-4T (as contained in the CFR edition revised as of April 1, 1992) for that taxable year, and the statute of limitations for assessment of a deficiency has not expired for that taxable year. Once an election has been made, an election under this section shall apply to all subsequent taxable years. However, paragraph (f)(2)(vi) of this section (relating to certain interest income of Possessions banks) shall not apply for taxable years beginning before January 1, 1990.

(2) ELECTION TO REDUCE LIABILITIES. A foreign corporation may make an election to reduce its liabilities under paragraph (e)(3) of this section with respect to a taxable year for which an election under paragraph (i)(1) of this section is in effect by filing an amended return for the taxable year and recomputing its interest deduction and any other item affected by the election on an amended Form 1120F to take into account the reduction in liabilities for such year.

(3) SEPARATE ELECTION FOR INSTALLMENT OBLIGATIONS. A foreign corporation may make a separate election to apply paragraphs (d)(2)(iii) and (d)(6)(ii) of this section (relating to installment obligations treated as U.S. assets) to any prior taxable year without making an election under paragraph (i)(1) of this section, provided the statute of limitations for assessment of a deficiency has not expired for that taxable year and each succeeding taxable year. Once an election under this paragraph (i)(3) has been made, it shall apply to all subsequent taxable years.

(j) TRANSITION RULES -- (1) GENERAL RULE. Except as provided in paragraph (j)(2) of this section, in order to compute its dividend equivalent amount in the first taxable year to which this section applies (whether or not such year begins before October 13, 1992), a foreign corporation must recompute its U.S. net equity as of close of the preceding taxable year using the rules of this section and use such recomputed amount, rather than the amount computed under section 1.884-1T (as contained in the CFR edition revised as of April 1, 1992), to determine the amount of any increase or decrease in the U.S. net equity as of the close of that taxable year.

(2) INSTALLMENT OBLIGATIONS -- (i) INTEREST ELECTION. In recomputing its U.S. net equity as of the close of the preceding taxable year, a foreign corporation that holds an installment obligation treated as a U.S. asset under section 1.884-1T(d)(7) (as contained in the CFR edition revised as of April 1, 1992) as of such date may apply the rules of paragraph (d)(2)(iii) of this section without regard to the rule in that paragraph that requires interest or original issue discount on the obligation to be treated as ECI in order for such obligation to be treated as a U.S. asset.

(ii) 1987 SALES BY CERTAIN FOREIGN CORPORATIONS. The E&P basis of an installment obligation arising in connection with a sale of property by a foreign corporation described in section 312(k)(4), where such sale occurs in a taxable year beginning in 1987, shall equal the E&P basis of the property sold as of the determination date reduced by payments received with respect to the obligation that do not represent gain for earnings and profits purposes, interest or original issue discount.

Par. 4. Section 1.884-2T is amended as follows:

1. In paragraph (a)(2)(i), the first sentence of the concluding text, the reference to "section 1.884-1T" is removed and the language "section 1.884-1" is added in its place.

2. Paragraph (a)(2)(ii) is amended by adding three new sentences following the last sentence in that paragraph, which read as set forth below.

3. Paragraph (b) is revised to read as set forth below.

4. In paragraph (c)(2) introductory text, the reference to "section 1.884-1T" is removed and the language "section 1.884-1" is added in its place.

5. Paragraph (c)(2)(iii) is amended by adding three new sentences following the last sentence in that paragraph, which read as set forth below.

6. In paragraph (c)(3), the reference to "section 1.884-1T (b)(3)(ii)" is removed and the language "section 1.884-1(b)(3)(ii)" is added in its place.

7. In paragraph (c)(4)(iii), the reference to "section 1.884-1T(h)(1) and (2)(i)" is removed and the language "section 1.884-1(g)(1) and (2)(i)" is added in its place.

8. In paragraph (c)(5), the reference to "section 1.884-1T" is removed and the language "section 1.884-1" is added in its place.

9. In paragraph (c)(6), the concluding text, the reference to "section 1.884-1T" is removed and the language "section 1.884-1" is added in its place.

10. In paragraph (d)(3) introductory text, the reference to "section 1.884-1T" is removed and the language "section 1.884-1" is added in its place.

11. In paragraph (d)(3)(ii), the reference to "section 1.884-1T(b)(3)(ii)" is removed and the language "section 1.884-1(b)(3)(ii)" is added in its place.

12. In paragraph (d)(6), paragraph (iv) of the Example, the reference to "section 1.884-1T" is removed and the language "section 1.884-1" is added in its place.

SECTION 1.884-2T SPECIAL RULES FOR TERMINATION OR INCORPORATION OF A U.S. TRADE OR BUSINESS OR LIQUIDATION OR REORGANIZATION OF A FOREIGN CORPORATION OR ITS DOMESTIC SUBSIDIARY (TEMPORARY).

(a) * * *

(2) * * *

(ii) * * * . Until such time as forms are published, a foreign corporation may file Form 872 to extend the period for assessment of the branch profits tax for the year of complete termination. With respect to a complete termination occurring in a taxable year ending prior to [THE DATE OF PUBLICATION OF THIS REGULATION IN THE FEDERAL REGISTER], a foreign corporation may also satisfy the requirements of this paragraph (a)(2)(ii) by attaching a statement to its income tax return that the foreign corporation agrees to extend the period for assessment of the branch profits tax for the year of complete termination in accordance with the terms of this paragraph (a)(2)(ii). A properly executed Form 872 or a statement authorized under the preceding sentence shall be deemed to be consented to and signed by a Service Center Director or the Assistant Commissioner (International) for purposes of section 301.6501(c)-1(d).

(b) ELECTION TO REMAIN ENGAGED IN A U.S. TRADE OR BUSINESS -- (1) GENERAL RULE. A foreign corporation that would be considered to have completely terminated all of its U.S. trade or business for the taxable year under the provisions of paragraph (a)(2)(i) of this section, but for the provisions of paragraph (a)(2)(i)(B) of this section that prohibit reinvestment within a three-year period, may make an election under this paragraph (b) for the taxable year in which it completely terminates all its U.S. trade or business (as determined without regard to paragraph (a)(2)(i)(B) of this section) and, if it so chooses, for the following taxable year (but not for any succeeding taxable year). The election under this paragraph (b) is an election by the foreign corporation to designate an amount of marketable securities as U.S. assets for purposes of section 1.884-1. The marketable securities identified pursuant to the election under paragraph (b)(3) of this section shall be treated as being U.S. assets in an amount equal, in the aggregate, to the lesser of the adjusted basis of the U.S. assets that ceased to be U.S. assets during the taxable year in which the election is made (determined on the date or dates the U.S. assets ceased to be U.S. assets) or the adjusted basis of the marketable securities as of the end of the taxable year. The securities must be held from the date that they are identified until the end of the taxable year for which the election is made, or if disposed of during the taxable year, must be replaced on the date of disposition with other marketable securities that are acquired on or before that date and that have a fair market value as of the date of substitution is not less than their adjusted basis.

(2) MARKETABLE SECURITY. For purposes of this paragraph (b), the term "marketable security" means a security (including stock) that is part of an issue any portion of which is regularly traded on an established securities market (within the meaning of section 1.884-5(d)(2) and (4)) and a deposit described in section 871(i)(3)(A) or (B).

(3) IDENTIFICATION REQUIREMENTS. In order to qualify for this election --

(i) The marketable securities must be identified on the books and records of the U.S. trade or business within 30 days of the date an equivalent amount of U.S. assets ceases to be U.S. assets; and

(ii) On the date a marketable security is identified, its adjusted basis must not exceed its fair market value.

(4) TREATMENT OF INCOME FROM DEEMED U.S. ASSETS. The income or gain from the marketable securities (or replacement securities) subject to an election under this paragraph (b) that arises in a taxable year for which an election is made shall be treated as ECI (other than for purposes of section 864(c)(7)), and losses from the disposition of such marketable securities shall be allocated entirely to income that is ECI. In addition, all such securities shall be treated as if they had been sold for their fair market value on the earlier of the last business day of a taxable year for which an election is in effect or the day immediately prior to the date of substitution by the foreign corporation of a U.S. asset for the marketable security, and any gain (but not loss) and accrued interest on the securities shall also be treated as ECI. The adjusted basis of such property shall be increased by the amount of any gain recognized by reason of this paragraph (b).

(5) METHOD OF ELECTION. A foreign corporation may make an election under this paragraph (b) by attaching to its income tax return for the taxable year a statement --

(i) Identifying the marketable securities treated as U.S. assets under this paragraph (b);

(ii) Setting forth the E&P bases of such securities; and

(iii) Agreeing to treat any income, gain or loss as provided in paragraph (b)(4) of this section. Such statement must be filed on or before the due date (including extensions) of the foreign corporation's income tax return for the taxable year. A foreign corporation shall not be permitted to make an election under this paragraph (b) more than once.

(6) EFFECTIVE DATE. This paragraph (b) is effective for taxable years beginning on or after [THE DATE THAT IS 30 DAYS AFTER THESE REGULATIONS ARE PUBLISHED IN THE FEDERAL REGISTER]. However, if a foreign corporation has made a valid election under section 1.884-1 (i) to apply that section with respect to a taxable year beginning before [THE DATE THAT IS 30 DAYS AFTER THESE REGULATIONS ARE PUBLISHED IN THE FEDERAL REGISTER] and after December 31, 1986, this paragraph (b) shall be effective beginning with such taxable year.

(c) * * *

(2) * * *

(iii) * * *. Until such time as forms are published, a foreign corporation may file Form 872 to extend the period for assessment of any additional branch profits tax for the taxable year in which the section 381(a) transaction occurs. With respect to a section 381(a) transaction occurring in a taxable year ending prior to [THE DATE OF PUBLICATION OF THIS REGULATION IN THE FEDERAL REGISTER], a foreign corporation may also satisfy the requirements of this paragraph (c)(2)(iii) by attaching a statement to its income tax return that the foreign corporation agrees to extend the period for assessment of the branch profits tax in accordance with the terms of this paragraph (c)(2)(iii). A properly executed Form 872 or a statement authorized under the preceding sentence shall be deemed to be consented to and signed by a Service Center Director or the Assistant Commissioner (International) for purposes of section 301.6501(c)-1(d).

* * *

Par. 5. Sections 1.884-4 and 1.884-5 are added to read as follows:

SECTION 1.884-4 BRANCH-LEVEL INTEREST TAX.

(a) GENERAL RULE -- (1) TAX ON BRANCH INTEREST. In the case of a foreign corporation that, during the taxable year, is engaged in trade or business in the United States or has gross income that is ECI (as defined in section 1.884-1(d)(1)(iii)), any interest paid by such trade or business (hereinafter "branch interest," as defined in paragraph (b) of this section) shall, for purposes of subtitle A (Income Taxes), be treated as if it were paid by a domestic corporation (other than a corporation described in section 861(c)(1), relating to a domestic corporation that meets the 80 percent foreign business requirement). Thus, for example, whether such interest is treated as income from sources within the United States by the person who receives the interest shall be determined in the same manner as if such interest were paid by a domestic corporation (other than a corporation described in section 861(c)(1)). Such interest shall be subject to tax under section 871(a) or 881, and to withholding under section 1441 or 1442, in the same manner as interest paid by a domestic corporation (other than a corporation described in section 861(c)(1)) if received by a foreign person and not effectively connected with the conduct by the foreign person of a trade or business in the United States, unless the interest, if paid by a domestic corporation, would be exempt under section 871(h) or 881(c) (relating to exemption for certain portfolio interest received by a foreign person), section 871(i) or 881(d) (relating, in part, to exemption for certain bank deposit interest received by a foreign person), or another provision of the Code. Such interest shall also be treated as interest paid by a domestic corporation (other than a corporation described in section 861(c)(1)) for purposes of sections 864(c), 871(b) and 882(a) (relating to income that is effectively connected with the conduct of a trade or business within the United States) and section 904 (relating to the limitation on the foreign tax credit). For purposes of this section, a foreign corporation also shall be treated as engaged in trade or business in the United States if, at any time during the taxable year, it owns an asset taken into account under section 1.882-5(b)(1) (referring to assets that generate, or may generate, effectively connected income) for purposes of determining the amount of the foreign corporation's interest expense apportioned to ECI and the interest apportioned by reference to the value of such asset provides in any taxable year a tax benefit for U.S. tax purposes. See paragraph (b)(8) of this section for the effect of income tax treaties on branch interest.

(2) TAX ON EXCESS INTEREST -- (i) DEFINITION OF EXCESS INTEREST. For purposes of this section, the term "excess interest" means --

(A) The amount of interest apportioned to ECI of the foreign corporation under section 1.882-5 for the taxable year, after application of section 1.884-1(e)(3); minus

(B) The foreign corporation's branch interest (as defined in paragraph (b) of this section) for the taxable year, but not including interest accruing in a taxable year beginning before January 1, 1987; minus

(C) The amount of interest determined under paragraph (c)(2) of this section (relating to interest paid by a partnership).

(ii) IMPOSITION OF TAX. A foreign corporation shall be liable for tax on excess interest under section 881(a) in the same manner as if such excess interest were interest paid to the foreign corporation by a wholly-owned domestic corporation (other than a corporation described in section 861(c)(1)) on the last day of the foreign corporation's taxable year. Excess interest shall be exempt from tax under section 881(a) only as provided in paragraph (a)(2)(iii) of this section (relating to treatment of certain excess interest of banks as interest on deposits) or paragraph (c)(3) of this section (relating to income tax treaties).

(iii) TREATMENT OF A PORTION OF THE EXCESS INTEREST OF BANKS AS INTEREST ON DEPOSITS. A portion of the excess interest of a foreign corporation described in paragraph (b)(2) of this section (relating to foreign banks) shall be treated as interest on deposits (as described in section 871(i)(3)), and shall be exempt from the tax imposed by section 881(a) as provided in such section. The portion of the excess interest of the foreign corporation that is treated as interest on deposits shall equal the product of the foreign corporation's excess interest and the greater of --

(A) The ratio of the amount of interest-bearing deposits, within the meaning of section 871(i)(3)(A), of the foreign corporation as of the close of the taxable year to the amount of all interest-bearing liabilities of the foreign corporation on such date; or

(B) 85 percent.

(iv) REPORTING AND PAYMENT OF TAX ON EXCESS INTEREST. The amount of tax due under section 884(f) and this section with respect to excess interest of a foreign corporation shall be reported on the foreign corporation's income tax return for the taxable year in which the excess interest is treated as paid to the foreign corporation under section 884 (f)(1)(B) and paragraph (a)(2) of this section, and shall not be subject to withholding under section 1441 or 1442. The tax shall be due and payable as provided in section 6151 and such other sections of Subtitle F of the Internal Revenue Code as apply, and estimated tax payments shall be due with respect to a foreign corporation's liability for the tax on excess interest as provided in section 6655.

(3) ORIGINAL ISSUE DISCOUNT. For purposes of this section, the term "interest" includes original issue discount, as defined in section 1273(a)(1).

(4) EXAMPLES. The application of this paragraph (a) is illustrated by the following examples.

EXAMPLE 1. TAXATION OF BRANCH INTEREST AND EXCESS INTEREST. Foreign corporation A, a calendar year taxpayer that is not a corporation described in paragraph (b)(2) of this section (relating to banks), has $120 of interest apportioned to ECI under section 1.882-5 for 1993. A's branch interest (as defined in paragraph (b) of this section) for 1993 is as follows: $55 of portfolio interest (as defined in section 871(h)(2)) to B, a nonresident alien; $25 of interest to foreign corporation C, which owns 15 percent of the combined voting power of A's stock, with respect to bonds issued by A; and $20 to D, a domestic corporation. B and C are not engaged in the conduct of a trade or business in the United States. A, B and C are residents of countries with which the United States does not have an income tax treaty. The interest payments made to B and D are not subject to tax under section 871(a) or 881 and are not subject to withholding under section 1441 or 1442. The payment to C, which does not qualify as portfolio interest because C owns at least 10 percent of the combined voting power of A's stock, is subject to withholding of $7.50 ($25 X 30%). In addition, because A's interest apportioned to ECI under section 1.882-5 ($120) exceeds its branch interest ($100), A has excess interest of $20, which is subject to a tax of $6 ($20 X 30%) under section 881. The tax on A's excess interest must be reported on A's income tax return for 1993.

EXAMPLE 2. TAXATION OF EXCESS INTEREST OF A BANK. Foreign corporation A, a calendar year taxpayer, is a corporation described in paragraph (b)(2) of this section (relating to banks) and is a resident of a country with which the United States does not have an income tax treaty. A has excess interest of $100 for 1993. At the close of 1993, A has $10,000 of interest-bearing liabilities (including liabilities that give rise to branch interest), of which $8,700 are interest-bearing deposits. For purposes of computing the tax on A's excess interest, $87 of the excess interest ($100 excess interest x ($8,700 interest-bearing deposits/$10,000 interest-bearing liabilities)) is treated as interest on deposits. Thus, $87 of A's excess interest is exempt from tax under section 881(a) and the remaining $13 of excess interest is subject to a tax of $3.90 ($13 x 30%) under section 881(a).

(b) BRANCH INTEREST -- (1) DEFINITION OF BRANCH INTEREST OF A FOREIGN CORPORATION THAT IS NOT A BANK. For purposes of this section, the term "branch interest" means interest paid by a foreign corporation (other than a corporation described in paragraph (b)(2) of this section) with respect to a liability --

(i) Shown on the books of a U.S. trade or business of the foreign corporation for purposes of computing its interest apportioned to ECI under the branch book/dollar pool method of section 1.882-5(b)(3)(i) or the separate currency pool method of section 1.882-5(b)(3)(ii);

(ii) Secured (during at least half the days during the portion of the taxable year in which the interest accrues) predominantly by a U.S. asset (as defined in section 1.884-1(d)) of the foreign corporation unless such liability is secured by substantially all the property of the foreign corporation;

(iii) Taken into account by an insurance company described in section 842(a) on an annual statement approved by the National Association of Insurance Commissioners that is furnished to an insurance regulatory authority of a State or the District of Columbia;

(iv) Giving rise to interest for which no deduction is allowed and either --

(A) The liability is incurred or continued to purchase a U.S. asset (as defined in section 1.884-1(d)); or

(B) The basis of a U.S. asset is increased by the amount of the interest for which no deduction is allowed; or

(v) Specifically identified (as provided in paragraph (b)(3)(i) of this section) as a liability of a U.S. trade or business of the foreign corporation on or before the earlier of the date on which the first payment of interest is made (or deemed made under paragraph (c)(1) of this section) with respect to the liability or the due date (including extensions) of the foreign corporation's income tax return for the taxable year, provided that --

(A) The amount of interest attributable to specifically identified liabilities does not exceed 85 percent of the amount of interest of the foreign corporation that would be excess interest before taking into account interest treated as branch interest by reason of this paragraph (b)(1)(v);

(B) The requirements of paragraph (b)(3)(ii) of this section (relating to notification of recipient of interest) are satisfied; and

(C) The liability is not described in paragraph (b)(3)(iii) of this section (relating to liabilities incurred in the ordinary course of a foreign business or secured by foreign assets) or in paragraph (b)(1)(i) through (iv) of this section.

A foreign corporation may identify a liability under paragraph (b)(1)(v) of this section whether or not the foreign corporation is engaged in the conduct of a trade or business in the United States. See paragraph (b)(5) of this section for special rules relating to branch interest of a foreign corporation whose U.S. assets equal 80 percent or more of its worldwide assets. See paragraph (b)(6) of this section for a limitation on the amount of branch interest in certain situations in which branch interest exceeds the amount of interest apportioned to ECI under section 1.882-5 and paragraph (b)(7) of this section for the treatment of interest that is paid and accrued in different taxable years.

(2) DEFINITION OF BRANCH INTEREST OF A BANK. In the case of a foreign corporation that maintains and operates a Federal branch, Federal agency, State branch or State agency (as these terms are defined in section 1(b) of the International Banking Act of 1978) (hereinafter "U.S. branch or agency"), the term "branch interest" means, for purposes of this section --

(i) Interest paid by the foreign corporation with respect to a liability described in paragraph (b)(1)(ii) or (iv) of this section (concerning liabilities related to U.S. assets);

(ii) Interest paid with respect to a liability that is treated as a liability of a U.S. branch or agency of the foreign corporation for purposes of regulatory requirements of the Federal Reserve Board, Comptroller of the Currency, Federal Deposit Insurance Corporation, or an equivalent bank regulatory authority of a State or the District of Columbia (including a deposit with an international banking facility (as defined in 12 CFR 204.8(a)(1)) of the foreign corporation that is treated as a liability of such U.S. branch or agency for purposes of such regulatory requirements); and

(iii) Interest paid with respect to a liability properly reflected on the books of a foreign branch, agency, or office of the foreign corporation if personnel of the U.S. branch or agency perform substantially all of the material activities required to incur the liability.

However, with respect to the interest described in paragraph (b)(2)(iii) of this section, if less than 80 percent of the gross income of such foreign branch, agency, or office for the taxable year is ECI, the total amount of interest paid or accrued with respect to liabilities of the branch, agency, or office that is treated as branch interest of the foreign corporation for the taxable year shall not exceed the amount of gross income of the branch, agency, or office that is ECI for the taxable year.

(3) REQUIREMENTS RELATING TO SPECIFICALLY IDENTIFIED LIABILITIES -- (i) METHOD OF IDENTIFICATION. A liability described in paragraph (b)(1)(v) of this section is identified as a liability of a U.S. trade or business only if the liability is shown on the records of the U.S. trade or business, or is identified as a liability of the U.S. trade or business on other records of the foreign corporation or on a schedule established for the purpose of identifying the liabilities of the U.S. trade or business. Each such liability must be identified with sufficient specificity so that the amount of branch interest attributable to the liability, and the name and address of the recipient, can be readily identified from such records or schedule. However, with respect to liabilities that give rise to portfolio interest (as defined in sections 871(h) and 881(c)) or that are payable 183 days or less from the date of original issue, and form part of a larger debt issue, such liabilities may be identified by reference to the issue and maturity date, principal amount and interest payable with respect to the entire debt issue. Records or schedules described in this paragraph that identify liabilities that give rise to branch interest must be maintained in the United States by the foreign corporation or an agent of the foreign corporation for the entire period commencing with the due date (including extensions) of the income tax return for the taxable year to which the records or schedules relate and ending with the expiration of the period of limitations for assessment of tax for such taxable year.

(ii) NOTIFICATION TO RECIPIENT. Interest with respect to a liability described in paragraph (b)(1)(v) of this section shall not be treated as branch interest unless the foreign corporation paying the interest either --

(A) Makes a return, pursuant to section 6049, with respect to the interest payment; or

(B) Sends a notice to the person who receives such interest in a confirmation of the transaction, a statement of account, or a separate notice, within two months of the end of the calendar year in which the interest was paid, stating that the interest paid with respect to the liability is from sources within the United States.

(iii) LIABILITIES THAT DO NOT GIVE RISE TO BRANCH INTEREST UNDER PARAGRAPH (b)(1)(v) OF THIS SECTION. A liability is described in this paragraph (b)(3)(iii) (and interest with respect to the liability may not be treated as branch interest of a foreign corporation by reason of paragraph (b)(1)(v) of this section) if --

(A) The liability is directly incurred in the ordinary course of the profit-making activities of a trade or business of the foreign corporation conducted outside the United States, as, for example, an account or note payable arising from the purchase of inventory or receipt of services by such trade or business; or

(B) The liability is secured (during more than half the days during the portion of the taxable year in which the interest accrues) predominantly by property that is not a U.S. asset (as defined in section 1.884-1(d)) unless such liability is secured by substantially all the property of the foreign corporation.

(4) INTERBRANCH INTEREST DISREGARDED. Interest with respect to liabilities to another office or branch of the same foreign corporation shall be disregarded for purposes of computing branch interest.

(5) INCREASE IN BRANCH INTEREST WHERE U.S. ASSETS CONSTITUTE 80 PERCENT OR MORE OF A FOREIGN CORPORATION'S ASSETS -- (i) GENERAL RULE. If a foreign corporation would have excess interest before application of this paragraph (b)(5) and the amount of the foreign corporation's U.S. assets as of the close of the taxable year equals or exceeds 80 percent of all money and the aggregate E&P basis of all property of the foreign corporation on such date, then all interest paid and accrued by the foreign corporation during the taxable year that was not treated as branch interest before application of this paragraph (b)(5) and that is not paid with respect to a liability described in paragraph (b)(3)(iii) of this section (relating to liabilities incurred in the ordinary course of a foreign business or secured by non-U.S. assets) shall be treated as branch interest. However, if application of the preceding sentence would cause the amount of the foreign corporation's branch interest to exceed the amount permitted by paragraph (b)(6)(i) of this section (relating to branch interest in excess of a foreign corporation's interest apportioned to ECI under section 1.882-5) the amount of branch interest arising by reason of this paragraph shall be reduced as provided in paragraphs (b)(6)(ii) and (iii) of this section, as applicable.

(ii) EXAMPLE. The application of this paragraph (b)(5) is illustrated by the following example.

EXAMPLE. APPLICATION OF 80 PERCENT TEST. Foreign corporation A, a calendar year taxpayer, has $90 of interest apportioned to ECI under section 1.882-5 for 1993. Before application of this paragraph (b)(5), A has $40 of branch interest in 1993. A pays $60 of other interest during 1993, none of which is attributable to a liability described in paragraph (b)(3)(iii) of this section (relating to liabilities incurred in the ordinary course of a foreign business and liabilities predominantly secured by foreign assets). As of the close of 1993, A has an amount of U.S. assets that exceeds 80 percent of the money and E&P bases of all A's property. Before application of this paragraph (b)(5), A would have $50 of excess interest (i.e., the $90 interest apportioned to its ECI under section 1.882-5 less $40 of branch interest). Under this paragraph (b)(5), the $60 of additional interest paid by A is also treated as branch interest. However, to the extent that treating the $60 of additional interest as branch interest would create an amount of branch interest that would exceed the amount of branch interest permitted under paragraph (b)(6) of this section (relating to branch interest that exceeds a foreign corporation's interest apportioned to ECI under section 1.882-5) the amount of the additional branch interest is reduced under paragraph (b)(6)(iii) of this section, which generally allows a foreign corporation to specify certain liabilities that do not give rise to branch interest or paragraph (b)(6)(ii) of this section, which generally specifies liabilities that do not give rise to branch interest beginning with the most-recently incurred liability.

(6) SPECIAL RULE WHERE BRANCH INTEREST EXCEEDS INTEREST APPORTIONED TO ECI OF A FOREIGN CORPORATION -- (i) GENERAL RULE. If the amount of branch interest that is both paid and accrued by a foreign corporation during the taxable year (including interest that the foreign corporation elects under paragraph (c)(1) of this section to treat as paid during the taxable year) exceeds the amount of interest apportioned to ECI of a foreign corporation under section 1.882-5 for the taxable year, then the amount of the foreign corporation's branch interest shall be reduced by the amount of such excess as provided in paragraphs (b)(6)(ii) and (iii) of this section, as applicable. The rules of paragraphs (b)(6)(ii) and (iii) of this section shall also apply where the amount of branch interest with respect to liabilities identified under paragraph (b)(1)(v) of this section exceeds the maximum amount that may be treated as branch interest under that paragraph. This paragraph (b)(6) shall apply whether or not a reduction in the amount of branch interest occurs as a result of adjustments made during the examination of the foreign corporation's income tax return, such as a reduction in the amount of interest apportioned to ECI of the foreign corporation under section 1.882-5.

(ii) REDUCTION OF BRANCH INTEREST BEGINNING WITH MOST-RECENTLY INCURRED LIABILITY. Except as provided in paragraph (b)(6)(iii) of this section (relating to an election to specify liabilities that do not give rise to branch interest), the amount of the excess in paragraph (b)(6)(i) of this section shall first reduce branch interest attributable to liabilities described in paragraph (b)(1)(v) of this section (relating to liabilities identified as giving rise to branch interest) and then, if such excess has not been reduced to zero, branch interest attributable to the group of liabilities described in paragraphs (b)(1)(i) through (iv) of this section. The reduction of branch interest attributable to each group of liabilities (i.e., liabilities described in paragraph (b)(1)(v) of this section and liabilities described in paragraphs (b)(1)(i) through (iv) of this section) shall be made beginning with interest attributable to the latest-incurred liability and continuing, in reverse chronological order, with branch interest attributable to the next-latest incurred liability. The branch interest attributable to a liability must be reduced to zero before a reduction is made with respect to branch interest attributable to the next-latest incurred liability. Where only a portion of the branch interest attributable to a liability is reduced by reason of this paragraph (b)(6)(ii), the reduction shall be made beginning with the last interest payment made with respect to the liability during the taxable year and continuing, in reverse chronological order, with the next latest payment until the amount of branch interest has been reduced by the amount specified in paragraph (b)(6)(i) of this section. The amount of interest that is not treated as branch interest by reason of this paragraph (b)(6)(ii) shall not be treated as paid by a domestic corporation and thus shall not be subject to tax under section 871(a) or 881(a).

(iii) ELECTION TO SPECIFY LIABILITIES THAT DO NOT GIVE RISE TO BRANCH INTEREST. For purposes of reducing the amount of branch interest under paragraph (b)(6)(i) of this section, a foreign corporation may, instead of using the method described in paragraph (b)(6)(ii) of this section, elect for any taxable year to specify which liabilities will not be treated as giving rise to branch interest or will be treated as giving rise only in part to branch interest. Branch interest paid during the taxable year with respect to a liability specified under this paragraph (b)(6)(iii) must be reduced to zero before a reduction is made with respect to branch interest attributable to the next-specified liability. If all interest payments with respect to a specified liability, when added to all interest payments with respect to other liabilities specified under this paragraph (b)(6)(iii), would exceed the amount of the reduction under paragraph (b)(6)(i) of this section, then only a portion of the branch interest attributable to that specified liability shall be reduced under this paragraph (b)(6)(iii), and the reduction shall be made beginning with the last interest payment made with respect to the liability during the taxable year and continuing, in reverse chronological order, with the next-latest payment until the amount of branch interest has been reduced by the amount of the reduction under paragraph (b)(6)(i) of this section. A foreign corporation that elects to have this paragraph (b)(6)(iii) apply shall note on its books and records maintained in the United States that the liability is not to be treated as giving rise to branch interest, or is to be treated as giving rise to branch interest only in part. Such notation must be made after the close of the taxable year in which the foreign corporation pays the interest and prior to the due date (with extensions) of the foreign corporation's income tax return for the taxable year. However, if the excess interest in paragraph (b)(6)(i) of this section occurs as a result of adjustments made during the examination of the foreign corporation's income tax return, the election and notation may be made at the time of examination. The amount of interest that is not treated as branch interest by reason of this paragraph (b)(6)(iii) shall not be treated as paid by a domestic corporation and thus shall not be subject to tax under section 871(a) or 881(a).

(iv) EXAMPLES. The application of this paragraph (b)(6) is illustrated by the following examples.

EXAMPLE 1. BRANCH INTEREST EXCEEDS INTEREST APPORTIONED TO ECI WITH NO ELECTION IN EFFECT. Foreign corporation A, a calendar year, accrual method taxpayer, has interest expense apportioned to ECI under section 1.882-5 of $230 for 1993. A's branch interest for 1993 is as follows:

(i) $130 paid to B, a domestic corporation, with respect to a note issued on March 10, 1993, and secured by real property located in the United States;

(ii) $60 paid to C, an individual resident of country X who is entitled to a 10 percent rate of withholding on interest payments under the income tax treaty between the United States and X, with respect to a note issued on October 15, 1992, which gives rise to interest subject to tax under section 871(a);

(iii) $80 paid to D, an individual resident of country Y who is entitled to a 15 percent rate of withholding on interest payments under the income tax treaty between the United States and Y, with respect to a note issued on February 15, 1993, which gives rise to interest subject to tax under section 871(a); and

(iv) $70 of portfolio interest (as defined in section 871(h)(2)) paid to E, a nonresident alien, with respect to a bond issued on March 1, 1993.

A's branch interest accrues during 1993 for purposes of calculating the amount of A's interest apportioned to ECI under section 1.882-5. A has identified under paragraph (b)(1)(v) of this section the liabilities described in paragraphs (ii), (iii) and (iv) of this example. A has not made an election under paragraph (b)(6)(iii) of this section to specify liabilities that do not give rise to branch interest. The amount of A's branch interest in 1993 is limited under paragraph (b)(6)(i) of this section to $230, the amount of the interest apportioned to A's ECI for 1993. The amount of A's branch interest must thus be reduced by $110 ($340-$230) under paragraph (b)(6)(ii) of this section. The reduction is first made with respect to interest attributable to liabilities described in paragraph (b)(1)(v) of this section (i.e., liabilities identified as giving rise to branch interest) and, within the group of liabilities described in paragraph (b)(1)(v) of this section, is first made with respect to the latest-incurred liability. Thus, the $70 of interest paid to E with respect to the bond issued on March 1, 1993, and $40 of the $80 of interest paid to D with respect to the note issued on February 15, 1993, are not treated as branch interest. The interest paid to D is no longer subject to tax under section 871(a), and D may claim a refund of amounts withheld with respect to the interest payments. There is no change in the tax consequences to E because the interest received by E was portfolio interest and was not subject to tax when it was treated as branch interest.

EXAMPLE 2. EFFECT OF ELECTION TO SPECIFY LIABILITIES. Assume the same facts as in Example 1 except that A makes an election under paragraph (b)(6)(iii) of this section to specify which liabilities are not to be treated as giving rise to branch interest. A specifies the liability to D, who would be taxable at a rate of 15 percent on interest paid with respect to the liability, as a liability that does not give rise to branch interest, and D is therefore not subject to tax under section 871(a) and is entitled to a refund of amounts withheld with respect to the interest payments. A also specifies the liability to C as a liability that gives rise to branch interest only in part. As a result, $30 of the $60 of interest paid to C is not treated as branch interest, and C is entitled to a refund with respect to the $30 of interest that is not treated as branch interest.

(7) EFFECT OF ELECTION UNDER PARAGRAPH (c)(1) OF THIS SECTION TO TREAT INTEREST AS IF PAID IN YEAR OF ACCRUAL. If a foreign corporation accrues an interest expense in a taxable year earlier than the taxable year of payment and elects under paragraph (c)(1) of this section to compute its excess interest as if the interest expense were branch interest paid in the year of accrual, the interest expense shall be treated as branch interest that is paid at the close of such year (and not in the actual year of payment) for all purposes of this section. Such interest shall thus be subject to tax under section 871(a) or 881(a) and withholding under section 1441 or section 1442, as if paid on the last day of the taxable year of accrual. Interest that is treated under paragraph (c)(1) of this section as paid in a later year for purposes of computing excess interest shall be treated as paid only in the actual year of payment for all purposes of this section other than paragraphs (a)(2) and (c)(1) of this section (relating to excess interest).

(8) EFFECT OF TREATIES -- (i) PAYOR'S TREATY. In the case of a foreign corporation's branch interest, relief shall be available under an article of an income tax treaty between the United States and the foreign corporation's country of residence relating to interest paid by the foreign corporation only if, for the taxable year in which the branch interest is paid (or if the branch interest is treated as paid in an earlier taxable year under paragraph (b)(7) of this section, for the earlier taxable year) --

(A) The foreign corporation meets the requirements of the limitation on benefits provision, if any, in the treaty, and either --

(1) The corporation is a qualified resident (as defined in section 1.884-5(a)) of that foreign country in such year; or

(2) The corporation meets the requirements of paragraph (b)(8)(iii) of this section in such year; or

(B) The limitation on benefits provision, or an amendment to that provision, entered into force after December 31, 1986.

(ii) RECIPIENT'S TREATY. A foreign person (other than a foreign corporation) that derives branch interest is entitled to claim benefits under provisions of an income tax treaty between the United States and its country of residence relating to interest derived by the foreign person. A foreign corporation may claim such benefits if it meets, with respect to the branch interest, the requirements of the limitation on benefits provision, if any, in the treaty and --

(A) The foreign corporation meets the requirements of paragraphs (b)(8)(i)(A) or (B) of this section; and

(B) In the case of interest paid in a taxable year beginning after December 31, 1988, with respect to an obligation with a maturity not exceeding one year, each foreign corporation that beneficially owned the obligation prior to maturity was a qualified resident (for the period specified in paragraph (b)(8)(i) of this section) of a foreign country with which the United States has an income tax treaty or met the requirements of the limitation on benefits provision in a treaty with respect to the interest payment and such provision entered into force after December 31, 1986.

(iii) PRESUMPTION THAT A FOREIGN CORPORATION CONTINUES TO BE A QUALIFIED RESIDENT. For purposes of this paragraph (b)(8), a foreign corporation that was a qualified resident for the prior taxable year because it fulfills the requirements of section 1.884-5 shall be considered a qualified resident with respect to branch interest that is paid or received during the current taxable year if --

(A) In the case of a foreign corporation that met the stock ownership and base erosion tests in section 1.884-5(b) and (c) for the preceding taxable year, the foreign corporation does not know, or have reason to know, that either 50 percent of its stock (by value) is not beneficially owned (or treated as beneficially owned by reason of section 1.884-5(b)(2)) by qualifying shareholders at any time during the portion of the taxable year that ends with the date on which the interest is paid, or that the base erosion test is not met during the portion of the taxable year that ends with the date on which the interest is paid;

(B) In the case of a foreign corporation that met the requirements of section 1.884-5(d) (relating to publicly-traded corporations) for the preceding taxable year, the foreign corporation is listed on an established securities exchange in the United States or its country of residence at all times during the portion of the taxable year that ends with the date on which the interest is paid and does not fail the requirements of section 1.884-5(d)(4)(iii) (relating to certain closely-held corporations) at any time during such period; or

(C) In the case of a foreign corporation that met the requirements of section 1.884-5(e) (relating to the active trade or business test) for the preceding taxable year, the foreign corporation continues to operate (other than in a nominal degree), at all times during the portion of the taxable year that ends with the date on which the interest is paid, the same business in the U.S. and its country of residence that caused it to meet such requirements for the preceding taxable year.

(iv) TREATIES OTHER THAN INCOME TAX TREATIES. A treaty that is not an income tax treaty does not provide any benefits with respect to branch interest.

(v) EFFECT OF INCOME TAX TREATIES ON INTEREST PAID BY A PARTNERSHIP. If a foreign corporation is a partner (directly or indirectly) in a partnership that is engaged in a trade or business in the United States and owns an interest of 10 percent or more (as determined under the attribution rules of section 318) in the capital, profits, or losses of the partnership at any time during the partner's taxable year, the relief that may be claimed under an income tax treaty with respect to the foreign corporation's distributive share of interest paid or treated as paid by the partnership shall not exceed the relief that would be available under paragraphs (b)(8)(i) and (ii) of this section if such interest were branch interest of the foreign corporation. See paragraph (c)(2) of this section for the effect on a foreign corporation's excess interest of interest paid by a partnership of which the foreign corporation is a partner.

(vi) EXAMPLES. The following examples illustrate the application of this paragraph (b)(8).

EXAMPLE 1. PAYOR'S TREATY. The income tax treaty between the United States and country X provides that the United States may not impose a tax on interest paid by a corporation that is a resident of that country (and that is not a domestic corporation) if the recipient of the interest is a nonresident alien or a foreign corporation. Corp A is a qualified resident of country X and meets the limitation on benefits provision in the treaty. A's branch interest is not subject to tax under section 871(a) or 881(a) regardless of whether the recipient is entitled to benefits under an income tax treaty.

EXAMPLE 2. RECIPIENT'S TREATY AND INTEREST RECEIVED FROM A PARTNERSHIP. A, a foreign corporation, and B, a nonresident alien, are partners in a partnership that owns and operates U.S. real estate and each has a distributive share of partnership interest deductions equal to 50 percent of the interest deductions of the partnership. There is no income tax treaty between the United States and the countries of residence of A and B. The partnership pays $1,000 of interest to a bank that is a resident of a foreign country, Y, and that qualifies under an income tax treaty in effect with the United States for a 5 percent rate of tax on U.S. source interest paid to a resident of country Y. However, the bank is not a qualified resident of country Y and the limitation on benefits provision of the treaty has not been amended since December 31, 1986. The partnership is required to withhold at a rate of 30 percent on $500 of the interest paid to the bank (i.e., A's 50 percent distributive share of interest paid by the partnership) because the bank cannot, under paragraph (b)(8)(iv) of this section, claim greater treaty benefits by lending money to the partnership than it could claim if it lent money to A directly and the $500 were branch interest of A.

(c) RULES RELATING TO EXCESS INTEREST -- (1) ELECTION TO COMPUTE EXCESS INTEREST BY TREATING BRANCH INTEREST THAT IS PAID AND ACCRUED IN DIFFERENT YEARS AS IF PAID IN YEAR OF ACCRUAL -- (i) GENERAL RULE. If branch interest is paid in one or more taxable years before or after the year in which the interest accrues, a foreign corporation may elect to compute its excess interest as if such branch interest were paid on the last day of the taxable year in which it accrues, and not in the taxable year in which it is actually paid. The interest expense will thus reduce the amount of the foreign corporation's excess interest in the year of accrual rather than in the year of actual payment. Except as provided in paragraph (c)(1)(ii) of this section, if an election is made for a taxable year, this paragraph (c)(1)(i) shall apply to all branch interest that is paid or accrued during that year. See paragraph (b)(7) of this section for the effect of an election under this paragraph (c)(1) on branch interest that accrues in a taxable year after the year of payment.

(ii) ELECTION NOT TO APPLY IN CERTAIN CASES. An election under this paragraph (c)(1) shall not apply to an interest expense that accrued in a taxable year beginning before January 1, 1987, and shall not apply to an interest expense that was paid in a taxable year beginning before such date unless the interest was income from sources within the United States. An election under this paragraph (c)(1) shall not apply to branch interest that accrues during the taxable year and is paid in an earlier taxable year if the branch interest reduced excess interest in such earlier year. However, a foreign corporation may amend its income tax return for such earlier taxable year so that the branch interest does not reduce excess interest in such year.

(iii) REQUIREMENTS FOR ELECTION. A foreign corporation that elects to apply this paragraph (c)(1) shall attach to its income tax return (or to an amended income tax return) a statement that it elects to have the provisions of this paragraph (c)(1) apply, or shall provide written notice to the Commissioner during an examination that it elects to apply this paragraph (c)(1). The election shall be effective for the taxable year to which the return relates and for all subsequent taxable years unless the Commissioner consents to revocation of the election.

(iv) EXAMPLES. The following examples illustrate the application of this paragraph (c)(1).

EXAMPLE 1. INTEREST ACCRUED BEFORE PAID. Foreign corporation A, a calendar year, accrual method taxpayer, has $100 of interest apportioned to ECI under section 1.882-5 for 1993. A has $60 of branch interest in 1993 before application of this paragraph (c)(1). A has an interest expense of $20 that properly accrues for tax purposes in 1993 but is not paid until 1994. When the interest is paid in 1994 it will meet the requirements for branch interest under paragraph (b)(1) of this section. A makes a timely election under this paragraph (c)(1) to treat the accrued interest as if it were paid in 1993. A will be treated as having branch interest of $80 for 1993 and excess interest of $20 in 1993. The $20 of interest treated as branch interest of A in 1993 will not again be treated as branch interest in 1994.

EXAMPLE 2. INTEREST PAID BEFORE ACCRUED. Foreign corporation A, a calendar year, accrual method taxpayer, has $60 of branch interest in 1993. The interest expense does not accrue until 1994 and the amount of interest apportioned to A's ECI under section 1.882-5 is zero for 1993 and $60 for 1994. A makes an election under this paragraph (c)(1) with respect to 1993. As a result of the election, A's $60 of branch interest in 1993 reduces the amount of A's excess interest for 1994 rather than in 1993.

(2) INTEREST PAID BY A PARTNERSHIP -- (i) GENERAL RULE. Except as otherwise provided in paragraphs (c)(2)(i) and (ii) of this section, if a foreign corporation is a partner in a partnership that is engaged in trade or business in the United States, the amount of the foreign corporation's distributive share of interest paid or accrued by the partnership shall reduce (but not below zero) the amount of the foreign corporation's excess interest for the year to the extent such interest is taken into account by the foreign corporation in that year for purposes of calculating the interest apportioned to the ECI of the foreign corporation under section 1.882-5. A foreign corporation's excess interest shall not be reduced by its distributive share of partnership interest that is attributable to a liability described in paragraph (b)(3)(iii) of this section (relating to interest on liabilities incurred in the ordinary course of a foreign business or secured predominantly by assets that are not U.S. assets) or would be described in paragraph (b)(3)(iii) of this section if entered on the partner's books. See paragraph (b)(8)(v) of this section for the effect of income tax treaties on interest paid by a partnership.

(ii) SPECIAL RULE FOR INTEREST THAT IS PAID AND ACCRUED IN DIFFERENT YEARS. Paragraph (c)(2)(i) of this section shall not apply to any portion of a foreign corporation's distributive share of partnership interest that is paid and accrued in different taxable years unless the foreign corporation has an election in effect under paragraph (c)(1) of this section that is effective with respect to such interest and any tax due under section 871(a) or 881(a) with respect to such interest has been deducted and withheld at source in the earlier of the taxable year of payment or accrual.

(3) EFFECT OF TREATIES -- (i) GENERAL RULE. The rate of tax imposed on the excess interest of a foreign corporation that is a resident of a country with which the United States has an income tax treaty shall not exceed the rate provided under such treaty that would apply with respect to interest paid by a domestic corporation to that foreign corporation if the foreign corporation meets, with respect to the excess interest, the requirements of the limitation on benefits provision, if any, in the treaty and either --

(A) The corporation is a qualified resident (as defined in section 1.884-5(a)) of that foreign country for the taxable year in which the excess interest is subject to tax; or

(B) The limitation on benefits provision, or an amendment to that provision, entered into force after December 31, 1986.

(ii) PROVISIONS RELATING TO INTEREST PAID BY A FOREIGN CORPORATION. Any provision in an income tax treaty that exempts or reduces the rate of tax on interest paid by a foreign corporation does not prevent imposition of the tax on excess interest or reduce the rate of such tax.

(4) EXAMPLE. The application of paragraphs (c)(2) and (3) of this section is illustrated by the following example.

EXAMPLE. INTEREST PAID BY A PARTNERSHIP. Foreign corporation A, a calendar year taxpayer, is not a resident of a foreign country with which the United States has an income tax treaty. A is engaged in the conduct of a trade or business both in the United States and in foreign countries, and owns a 50 percent interest in X, a calendar year partnership engaged in the conduct of a trade or business in the United States. For 1993, all of X's liabilities are of a type described in paragraph (b)(1) of this section (relating to liabilities on U.S. books) and none are described in paragraph (b)(3)(iii) of this section (relating to liabilities that may not give rise to branch interest). A's distributive share of interest paid by X in 1993 is $20. For 1993, A has $150 of interest apportioned to its ECI under section 1.882-5, $120 of which is attributable to branch interest. Thus, the amount of A's excess interest for 1993, before application of paragraph (c)(2)(i) of this section, is $30. Under paragraph (c)(2)(i) of this section, A's $30 of excess interest is reduced by $20, representing A's share of interest paid by X. Thus, the amount of A's excess interest for 1993 is reduced to $10. A is subject to a tax of 30 percent on its $10 of excess interest.

(d) STAPLED ENTITIES. A foreign corporation that is treated as a domestic corporation by reason of section 269B (relating to stapled entities) shall continue to be treated as a foreign corporation for purposes of section 884(f) and this section, notwithstanding section 269B and the regulations thereunder. Interest paid by such foreign corporation shall be treated as paid by a domestic corporation and shall be subject to the tax imposed by section 871(a) or 881(a), and to withholding under section 1441 and 1442, as applicable, to the extent such interest is not subject to tax by reason of section 884(f) and this section.

(e) EFFECTIVE DATES. This section is effective for taxable years beginning [THE DATE THAT IS 30 DAYS AFTER THESE REGULATIONS ARE PUBLISHED IN THE FEDERAL REGISTER], and for payments of interest described in section 884(f)(1)(A) made (or treated as made under paragraph (b)(7) of this section) during taxable years of the payor beginning after such date. With respect to taxable years beginning before [THE DATE THAT IS 30 DAYS AFTER THESE REGULATIONS ARE PUBLISHED IN THE FEDERAL REGISTER] and after December 31, 1986, a foreign corporation may elect to apply this section in lieu of section 1.884-4T of the temporary regulations (as contained in the CFR edition revised as of April 1, 1992) as they applied to the foreign corporation after issuance of Notice 89-80, 1989-2 C.B. 394, but only if the foreign corporation has made an election under section 1.884-1(i) to apply S 1.884-1 in lieu of section 1.884-1T (as contained in the CFR edition revised as of April 1, 1992) for that year, and the statute of limitations for assessment of a deficiency has not expired for that taxable year. Once an election has been made, an election under this section shall apply to all subsequent taxable years.

(f) TRANSITION RULES -- (1) ELECTION UNDER PARAGRAPH (c)(1) OF THIS SECTION. If a foreign corporation has made an election described in section 1.884-4T(b)(7) (as contained in the CFR edition revised as of April 1, 1992) with respect to interest that has accrued and been paid in different taxable years, such election shall be effective for purposes of paragraph (c)(1) of this section as if the corporation had made the election under paragraph (c)(1) of this section of these regulations.

(2) WAIVER OF NOTIFICATION REQUIREMENT FOR NON-BANKS UNDER NOTICE 89-80. If a foreign corporation that is not a bank has made an election under Notice 89-80 to apply the rules in Part 2 of Section I of the Notice in lieu of the rules in section 1.884-4T(b) (as contained in the CFR edition revised as of April 1, 1992) to determine the amount of its interest paid and excess interest in taxable years beginning prior to 1990, the requirement that the foreign corporation satisfy the notification requirements described in paragraph (b)(3)(ii) of this section is waived with respect to interest paid in taxable years ending on or before the date the Notice was issued.

(3) WAIVER OF LEGENDING REQUIREMENT FOR CERTAIN DEBT ISSUED PRIOR TO JANUARY 3, 1989. For purposes of sections 871(h), 881(c), and this section, branch interest of a foreign corporation that would be treated as portfolio interest under section 871(h) or 881(c) but for the fact that it fails to meet the requirements of section 163(f)(2)(B)(ii)(II) (relating to the legend requirement), shall nevertheless be treated as portfolio interest provided the interest arises with respect to a liability incurred by the foreign corporation before January 3, 1989, and interest with respect to the liability was treated as branch interest in a taxable year beginning before January 1, 1990.

SECTION 1.884-5 QUALIFIED RESIDENT.

(a) DEFINITION OF QUALIFIED RESIDENT. A foreign corporation is a qualified resident of a foreign country with which the United States has an income tax treaty in effect if, for the taxable year, the foreign corporation is a resident of that country (within the meaning of such treaty) and either --

(1) Meets the requirements of paragraphs (b) and (c) of this section (relating to stock ownership and base erosion);

(2) Meets the requirements of paragraph (d) of this section (relating to publicly-traded corporations);

(3) Meets the requirements of paragraph (e) of this section (relating to the conduct of an active trade or business); or

(4) Obtains a ruling as provided in paragraph (f) of this section that it shall be treated as a qualified resident of its country of residence.

(b) STOCK OWNERSHIP REQUIREMENT -- (1) GENERAL RULE -- (i) OWNERSHIP BY QUALIFYING SHAREHOLDERS. A foreign corporation satisfies the stock ownership requirement of this paragraph (b) for the taxable year if more than 50 percent of its stock (by value) is beneficially owned (or is treated as beneficially owned by reason of paragraph (b)(2) of this section) during at least half of the number of days in the foreign corporation's taxable year by one or more qualifying shareholders. A person shall be treated as a qualifying shareholder only if such person meets the requirements of paragraph (b)(3) of this section and is either --

(A) An individual who is either a resident of the foreign country of which the foreign corporation is a resident or a citizen or resident of the United States;

(B) The government of the country of which the foreign corporation is a resident (or a political subdivision or local authority of such country), or the United States, a State, the District of Columbia, or a political subdivision or local authority of a State;

(C) A corporation that is a resident of the foreign country of which the foreign corporation is a resident and whose stock is primarily and regularly traded on an established securities market (within the meaning of paragraph (d) of this section) in that country or the United States or a domestic corporation whose stock is primarily and regularly traded on an established securities market (within the meaning of paragraph (d) of this section) in the United States;

(D) A not-for profit organization described in paragraph (b)(1)(iv) of this section that is not a pension fund as defined in paragraph (b)(8)(i)(A) of this section and that is organized under the laws of the foreign country of which the foreign corporation is a resident or the United States; or

(E) A beneficiary of certain pension funds (as defined in paragraph (b)(8)(i)(A) of this section) administered in or by the country in which the foreign corporation is a resident to the extent provided in paragraph (b)(8) of this section.

Beneficial owners of an association taxable as a corporation shall be treated as shareholders of such association for purposes of this paragraph (b)(1). If stock of a foreign corporation is owned by a corporation that is treated as a qualifying shareholder under paragraph (b)(1)(i)(C) of this section, such stock shall not also be treated as owned, directly or indirectly, by any qualifying shareholders of such corporation for purposes of this paragraph (b). Notwithstanding the above, a foreign corporation will not be treated as a qualified resident unless it obtains the documentation described in paragraph (b)(3) of this section to show that the requirements of this paragraph (b)(1)(i) have been met and maintains the documentation as provided in paragraph (b)(9) of this section. See also paragraph (b)(1)(iii) of this section, which treats certain publicly-traded classes of stock as owned by qualifying shareholders.

(ii) SPECIAL RULES RELATING TO QUALIFYING SHAREHOLDERS. For purposes of applying paragraph (b)(1)(i) of this section --

(A) Stock owned on any day shall be taken into account only if the beneficial owner is a qualifying shareholder on that day or, in the case of a corporation or not-for-profit organization that is a qualifying shareholder under paragraph (b)(1)(i)(C) or (D) of this section, for a one-year period that includes such day; and

(B) An individual, corporation or not-for-profit organization is a resident of a foreign country if it is a resident of that country for purposes of the income tax treaty between the United States and that country.

(iii) PUBLICLY-TRADED CLASS OF STOCK TREATED AS OWNED BY QUALIFYING SHAREHOLDERS. A class of stock of a foreign corporation shall be treated as owned by qualifying shareholders if --

(A) The class of stock is listed on an established securities market in the United States or in the country of residence of the foreign corporation seeking qualified resident status; and

(B) The class of stock is primarily and regularly traded on such market (within the meaning of paragraphs (d)(3) and (4) of this section, applied as if the class of stock were the sole class of stock relied on to meet the requirements of paragraph (d)(4)(i)(A)).

For purposes of this paragraph (b), stock in such class shall not also be treated as owned by any qualifying shareholders who own such stock, either directly or indirectly.

(iv) SPECIAL RULE FOR NOT-FOR-PROFIT ORGANIZATIONS. A not-for- profit organization is described in paragraph (b)(1)(iv) of this section if it meets the following requirements --

(A) It is a corporation, association taxable as a corporation, trust, fund, foundation, league or other entity operated exclusively for religious, charitable, educational, or recreational purposes, and it is not organized for profit;

(B) It is generally exempt from tax in its country of organization by virtue of its not-for-profit status;

(C) Either --

(1) More than 50 percent of its annual support is expended on behalf of persons described in paragraphs (b)(1)(i)(A) through (E) of this section or on qualified residents of the country in which the organization is organized; or

(2) More than 50 percent of its annual support is derived from persons described in paragraphs (b)(1)(i)(A) through (E) of this section or from persons who are qualified residents of the country in which the organization is organized.

For purposes of meeting the requirements of paragraph (b)(1)(iv)(C) of this section, a not-for-profit organization may rely on the addresses of record of its individual beneficiaries and supporters to determine if such persons are resident in the country in which the not-for-profit organization is organized, provided that the addresses of record are not nonresidential addresses such as a post office box or in care of a financial intermediary, and the officers, directors or administrators of the organization do not know or have reason to know that the individual beneficiaries or supporters do not reside at that address.

(2) RULES FOR DETERMINING CONSTRUCTIVE OWNERSHIP -- (i) GENERAL RULES FOR ATTRIBUTION. For purposes of this section, stock owned by a corporation, partnership, trust, estate, or mutual insurance company or similar entity shall be treated as owned proportionately by its shareholders, partners, beneficiaries, grantors or other interest holders as provided in paragraph (b)(2)(ii) through (v) of this section. The proportionate interest rules of this paragraph (b)(2) shall apply successively upward through a chain of ownership, and a person's proportionate interest shall be computed for the relevant days or period that is taken into account in determining whether a foreign corporation is a qualified resident. Except as otherwise provided, stock treated as owned by a person by reason of this paragraph (b)(2) shall, for purposes of applying this paragraph (b)(2), be treated as actually owned by such person.

(ii) PARTNERSHIPS. A partner shall be treated as having an interest in stock of a foreign corporation owned by a partnership in proportion to the least of --

(A) The partner's percentage distributive share of the partnership's dividend income from the stock;

(B) The partner's percentage distributive share of gain from disposition of the stock by the partnership;

(C) The partner's percentage distributive share of the stock (or proceeds from the disposition of the stock) upon liquidation of the partnership.

For purposes of this paragraph (b)(2)(ii), however, all qualifying shareholders that are partners of a partnership shall be treated as one partner. Thus, the percentage distributive shares of dividend income, gain and liquidation rights of all qualifying shareholders that are partners in a partnership are aggregated prior to determining the least of the three percentages.

(iii) TRUSTS AND ESTATES -- (A) BENEFICIARIES. In general, a person shall be treated as having an interest in stock of a foreign corporation owned by a trust or estate in proportion to the person's actuarial interest in the trust or estate, as provided in section 318(a)(2)(B)(i), except that an income beneficiary's actuarial interest in the trust will be determined as if the trust's only asset were the stock. The interest of a remainder beneficiary in stock will be equal to 100 percent minus the sum of the percentages of any interest in the stock held by income beneficiaries. The ownership of an interest in stock owned by a trust shall not be attributed to any beneficiary whose interest cannot be determined under the preceding sentence, and any such interest, to the extent not attributed by reason of this paragraph (b)(2)(iii)(A), shall not be considered owned by a beneficiary unless all potential beneficiaries with respect to the stock are qualifying shareholders. In addition, a beneficiary's actuarial interest will be treated as zero to the extent that a grantor is treated as owning the stock under paragraph (b) (2)(iii)(B) of this section. A substantially separate and independent share of a trust, within the meaning of section 663(c), shall be treated as a separate trust for purposes of this paragraph (b)(2)(iii)(A), provided that payment of income, accumulated income or corpus of a share of one beneficiary (or group of beneficiaries) cannot affect the proportionate share of income, accumulated income or corpus of another beneficiary (or group of beneficiaries).

(B) GRANTOR TRUSTS. A person is treated as the owner of stock of a foreign corporation owned by a trust to the extent that the stock is included in the portion of the trust that is treated as owned by the person under sections 671 to 679 (relating to grantors and others treated as substantial owners).

(iv) CORPORATIONS THAT ISSUE STOCK. A shareholder of a corporation that issues stock shall be treated as owning stock of a foreign corporation that is owned by such corporation on any day in a proportion that equals the value of the stock owned by such shareholder to the value of all stock of such corporation. If there is an agreement, express or implied, that a shareholder of a corporation will not receive distributions from the earnings of stock owned by the corporation, the shareholder will not be treated as owning that stock owned by the corporation.

(v) MUTUAL INSURANCE COMPANIES AND SIMILAR ENTITIES. Stock held by a mutual insurance company, mutual savings bank, or similar entity (including an association taxable as a corporation that does not issue stock interests) shall be considered owned proportionately by the policy holders, depositors, or other owners in the same proportion that such persons share in the surplus of such entity upon liquidation or dissolution.

(vi) PENSION FUNDS. See paragraphs (b)(8)(ii) and (iii) of this section for the attribution of stock owned by a pension fund (as defined in paragraph (b)(8)(i)(A)) to beneficiaries of the fund.

(vii) EXAMPLES. The rules of paragraph (b)(2)(ii) of this section are illustrated by the following examples.

EXAMPLE 1. STOCK HELD SOLELY BY QUALIFYING SHAREHOLDERS THROUGH A PARTNERSHIP. A and B, residents of country X, are qualifying shareholders, within the meaning of paragraphs (b)(1)(i)(A) through (E) of this section, and the sole partners of partnership P. P's only asset is the stock of foreign corporation Z, a country X corporation seeking qualified resident status under this section. A's distributive share of P's income and gain on the disposition of P's assets is 80 percent, but A's distributive share of P's assets (or the proceeds therefrom) on P's liquidation is 20 percent. B's distributive share of P's income and gain is 20 percent and B is entitled to 80 percent of the assets (or proceeds therefrom) on P's liquidation. Under the attribution rules of paragraph (b)(2)(ii) of this section, A and B will be treated as a single partner owning in the aggregate 100 percent of the stock of Z owned by P.

EXAMPLE 2. STOCK HELD BY BOTH QUALIFYING AND NON-QUALIFYING SHAREHOLDERS THROUGH A PARTNERSHIP. Assume the same facts as in EXAMPLE 1 except that C, an individual who is not a qualifying shareholder, is also a partner in P and that C's distributive share of P's income is 60 percent. The distributive shares of A and B are the same as in EXAMPLE 1 except that A's distributive share of income is 20 percent. Under the attribution rules of paragraph (b)(2)(ii) of this section, A and B will be treated as a single partner owning in the aggregate 40 percent of the stock of Z owned by P (i.e., the least of A and B's aggregate distributive shares of dividend income (40 percent), gain (100 percent), and liquidation rights (100 percent) with respect to the Z stock).

EXAMPLE 3. STOCK HELD THROUGH TIERED PARTNERSHIPS. Assume the same facts as in EXAMPLE 1, except that P does not own the stock of Z directly, but rather is a partner in partnership P1, which owns the stock of Z. Assume that P's distributive share of the dividend income, gain and liquidation rights with respect to the Z stock held by P1 is 40 percent. Assume that of the remaining partners of P1 only D is a qualifying shareholder. D's distributive share of P1's dividend income and gain is 15 percent; D's distributive share of P1's assets on liquidation is 25 percent. Under the attribution rules of paragraph (b)(2)(ii) of this section, A and B, treated as a single partner, will own 40 percent of the Z stock owned by P1 (100 percent X 40 percent) and D will be treated as owning 15 percent of the Z stock owned by P1 (the least of D's dividend income (15 percent), gain (15 percent), and liquidation rights (25 percent) with respect to the Z stock). Thus, 55 percent of the Z stock owned by P1 is treated as owned by qualifying shareholders under paragraph (b)(2)(ii) of this section.

(3) REQUIRED DOCUMENTATION -- (i) OWNERSHIP STATEMENTS, CERTIFICATES OF RESIDENCY AND INTERMEDIARY OWNERSHIP STATEMENTS. Except as provided in paragraphs (b)(3)(ii), (iii) and (iv) and paragraph (b)(8) of this section, a person shall only be treated as a qualifying shareholder of a foreign corporation if --

(A) For the relevant period, the person completes an ownership statement described in paragraph (b)(4) of this section and, in the case of an individual who is not a U.S. citizen or resident, also obtains a certificate of residency described in paragraph (b)(5) of this section;

(B) In the case of a person owning stock in the foreign corporation indirectly through one or more intermediaries (including mere legal owners or recordholders acting as nominees), each intermediary completes an intermediary ownership statement described in paragraph (b)(6) of this section; and

(C) Such ownership statements and certificates of residency are received by the foreign corporation on or before the earlier of the date it files its income tax return for the taxable year to which the statements relate or the due date (including extensions) for filing such return or, in the case of a foreign corporation claiming treaty benefits under section 1.884-4(b)(8)(i) or (ii) (relating to branch interest) on or before the date on which such interest is paid.

(ii) SUBSTITUTION OF INTERMEDIARY VERIFICATION STATEMENT FOR OWNERSHIP STATEMENTS AND CERTIFICATES OF RESIDENCY. If a qualifying shareholder owns stock through an intermediary that is either a domestic corporation, a resident of the United States, or a resident (for treaty purposes) of a country with which the United States has an income tax treaty in effect, the intermediary may provide an intermediary verification statement (as described in paragraph (b)(7) of this section) in place of any relevant ownership statements and certificates of residency from qualifying shareholders, and in place of intermediary ownership statements (or, where applicable, intermediary verification statements) from all intermediaries standing in the chain of ownership between the qualifying shareholders and the intermediary issuing the intermediary verification statement. An intermediary verification statement generally certifies that the verifying intermediary holds the documentation described in the preceding sentence and agrees to make it available to the District Director on request. Such intermediary verification statements, along with an intermediary ownership statement from the verifying intermediary, must be received by the foreign corporation on or before the earlier of the date it files its income tax return for the taxable year to which the statements relate or the due date (including extensions) for filing such return. An indirect owner of a foreign corporation is thus treated as a qualifying shareholder of a foreign corporation if the foreign corporation receives, on or before the time specified above, an intermediary verification statement and an intermediary ownership statement from the verifying intermediary and an intermediary ownership statement from all intermediaries standing in the chain of the verifying intermediary's ownership of its interest in the foreign corporation.

(iii) SPECIAL RULE FOR REGISTERED SHAREHOLDERS OF WIDELY-HELD CORPORATIONS. An ownership statement and a certificate of residency shall not be required in the case of an individual who is a shareholder of record of a corporation that has at least 250 shareholders if --

(A) The individual owns less than one percent of the stock (by value) (applying the attribution rules of section 318) of the corporation at all times during the taxable year;

(B) The individual's address of record is in the corporation's country of residence and is not a nonresidential address such as a post office box or in care of a financial intermediary or stock transfer agent; and

(C) The officers and directors of the corporation do not know or have reason to know that the individual does not reside at that address.

The rule in this paragraph (b)(3)(iii) may also be applied with respect to individual owners of mutual insurance companies, mutual savings banks or similar entities, provided that the same conditions set forth in this paragraph are met with respect to such individuals.

(iv) SPECIAL RULE FOR PENSION FUNDS. See paragraphs (b)(8)(ii) through (v) of this section for special documentation rules applicable to pension funds (as defined in paragraph (b)(8)(i)(A) of this section).

(v) REASONABLE CAUSE EXCEPTION. If a foreign corporation does not obtain the documentation described in this paragraph (b)(3) or (b)(8) of this section in a timely manner but is able to show prior to notification of an examination of the return for the taxable year that the failure was due to reasonable cause and not willful neglect, the foreign corporation may perfect the documentation after the deadlines specified in paragraph (b)(3) or (b)(8) of this section. It may make such a showing by providing a written statement to the District Director having jurisdiction over the taxpayer's return or the Office of the Assistant Commissioner (International), as applicable, setting forth the reasons for the failure to obtain the documentation in a timely manner and a describing the documentation that was received after the deadline had passed. Whether a failure to obtain the documentation in a timely manner was due to reasonable cause shall be determined by the District Director or the Office of the Assistant Commissioner (International), as applicable, under all the facts and circumstances.

(4) OWNERSHIP STATEMENTS FROM QUALIFYING SHAREHOLDERS -- (i) OWNERSHIP STATEMENTS FROM INDIVIDUALS. An ownership statement from an individual is a written statement signed by the individual under penalties of perjury stating --

(A) The name, permanent address, and country of residence of the individual and, if the individual was not a resident of the country for the entire taxable year of the foreign corporation seeking qualified resident status, the period during which it was a resident of the foreign corporation's country of residence;

(B) If the individual is a direct beneficial owner of stock in the foreign corporation, the name of the corporation, the number of shares in each class of stock of the corporation that are so owned, and the period of time during the taxable year of the foreign corporation during which the individual owned the stock (or, in the case of an association taxable as a corporation, the amount and nature of the owner's interest in such association);

(C) If the individual directly owns an interest in a corporation, partnership, trust, estate or other intermediary that owns (directly or indirectly) stock in the foreign corporation, the name of the intermediary, the number and class of shares or amount and nature of the interest of the individual in such intermediary (that is relevant for purposes of attributing ownership in paragraph (b)(2) of this section), and the period of time during the taxable year of the foreign corporation during which the individual held such interest; and

(D) To the extent known by the individual, a description of the chain of ownership through which the individual owns stock in the foreign corporation, including the name and address of each intermediary standing between the intermediary described in paragraph (b)(4)(i)(C) of this section and the foreign corporation.

(ii) OWNERSHIP STATEMENTS FROM GOVERNMENTS. An ownership statement from a government that is a qualifying shareholder is a written statement signed by either --

(A) An official of the governmental authority, agency or office that has supervisory authority with respect to the government's ownership interest who is authorized to sign such a statement on behalf of the authority, agency or office; or

(B) The competent authority of the foreign country (as defined in the income tax treaty between the United States and the foreign country).

Such statement shall provide the title of the official signing the statement and the name and address of the government agency, and shall provide the information described in paragraphs (b)(4)(i)(B) through (D) of this section (substituting "government" for "individual") with respect to the government's direct or indirect ownership of stock in the foreign corporation seeking qualified resident status.

(iii) OWNERSHIP STATEMENTS FROM PUBLICLY-TRADED CORPORATIONS. An ownership statement from a corporation that is a qualifying shareholder under paragraph (b)(1)(i)(C) of this section is a written statement signed by a person authorized to sign a tax return on behalf of the corporation under penalties of perjury stating --

(A) The name, permanent address, and principal place of business of the corporation (if different from its permanent address);

(B) The information described in paragraphs (b)(4)(i)(B) through (D) of this section (substituting "corporation" for "individual"); and

(C) That the corporation's stock is primarily and regularly traded on an established securities exchange (within the meaning of paragraph (d) of this section) in the United States or its country of residence.

(iv) OWNERSHIP STATEMENTS FROM NOT-FOR-PROFIT ORGANIZATIONS. An ownership statement from a not-for-profit organization (other than a pension fund as defined in paragraph (b)(8)(i)(A) of this section) is a written statement signed by a person authorized to sign a tax return on behalf of the organization under penalties of perjury stating --

(A) The name, permanent address, and principal location of the activities of the organization (if different from its permanent address);

(B) The information described in paragraphs (b)(4)(i)(B) through (D) of this section (substituting "not-for-profit organization" for "individual") with respect to the not-for profit organization's direct or indirect ownership of stock in the foreign corporation seeking qualified resident status; and

(C) That the not-for-profit organization satisfies the requirements of paragraph (b)(1)(iv) of this section.

(v) OWNERSHIP THROUGH A NOMINEE. For purposes of this paragraph (b)(4) and paragraph (b)(6) of this section, a person who owns either stock in a foreign corporation seeking qualified resident status or an interest in an intermediary described in paragraph (b)(4)(i)(C) of this section through a nominee shall be treated as owning such stock or interest directly and must, therefore, provide the information described in paragraphs (b)(4)(i) through (iv) of this section, as applicable. Such person must also provide the name and address of the nominee.

(5) CERTIFICATE OF RESIDENCY. A certificate of residency must be signed by the relevant authorities (as described below) of the country of residence of the individual shareholder and must state that the individual is a resident of that country for purposes of its income tax laws or, if the authorities do not customarily make such a determination, that the individual has filed a tax return claiming resident status and subjecting the individual's income to tax on a resident basis for the taxable year or period that ends with or within the taxable year for which the corporation is seeking qualified resident status. In the case of an individual who is not legally required to file a tax return in his or her country of residence or in any other country, a certificate of residency of a parent or guardian residing at such individual's address shall be considered sufficient to meet that individual's obligation under this paragraph (b)(5). The relevant authorities shall be the competent authority of the foreign country of which the foreign corporation is a resident, as defined in the income tax treaty between the foreign country and the United States, or such other governmental office of the foreign country (or political subdivision thereof) that customarily provides statements of residence. Notwithstanding the foregoing, the Commissioner may consult with the competent authority of a country regarding the procedures set forth in this paragraph (b)(5) and if necessary agree on additional or alternative procedures under which these certificates may be issued.

(6) INTERMEDIARY OWNERSHIP STATEMENT. An intermediary ownership statement is a written statement signed under penalties of perjury by the intermediary (if the intermediary is an individual) or a person that would be authorized to sign a tax return on behalf of the intermediary (if the intermediary is not an individual) containing the following information:

(i) The name, address, country of residence, and principal place of business (in the case of a corporation or partnership) of the intermediary and, if the intermediary is a trust or estate, the name and permanent address of all trustees or executors (or equivalent under foreign law);

(ii) The information described in paragraphs (b)(4) (i)(B) through (D) (substituting "intermediary making the ownership statement" for "individual") with respect to the intermediary's direct or indirect ownership in the stock in the foreign corporation seeking qualified resident status;

(iii) If the intermediary is a nominee for a qualifying shareholder or another intermediary, the name and permanent address of the qualifying shareholder, or the name and principal place of business of such other intermediary;

(iv) If the intermediary is not a nominee for a qualifying shareholder or another intermediary, the proportionate interest in the intermediary of each direct shareholder, partner, beneficiary, grantor, or other interest holder (or if the direct holder is a nominee, of its beneficial shareholder, partner, beneficiary, grantor, or other interest holder) from which the intermediary received an ownership statement and the period of time during the taxable year for which the interest in the intermediary was owned by such shareholder, partner, beneficiary, grantor or other interest holder. For purposes of this paragraph (b)(6)(iv), the proportionate interest of a person in an intermediary is the percentage interest (by value) held by such person, determined using the principles for attributing ownership in paragraph (b)(2) of this section. If an intermediary is not required to receive an ownership statement from its individual registered shareholders or other interest holders by reason of paragraph (b)(3)(iii) of this section, then it must provide a list of the names and addresses of such registered shareholders or other interest holders and the aggregate proportionate interest in the intermediary of such registered shareholders or other interest holders.

(7) INTERMEDIARY VERIFICATION STATEMENT. An intermediary verification statement that may be substituted for certain documentation under paragraph (b)(3)(ii) of this section is a written statement signed under penalties of perjury by the intermediary (if the intermediary is an individual) or by a person that would be authorized to sign a tax return on behalf of the intermediary (if the verifying intermediary is not an individual) containing the following information --

(i) The name, principal place of business, and country of residence of the verifying intermediary;

(ii) A statement that the verifying intermediary has obtained either --

(A) An ownership statement and, if applicable, a certificate of residency from a qualifying shareholder with respect to the foreign corporation seeking qualified resident status, and an intermediary ownership statement from each intermediary standing in the chain of ownership between the verifying intermediary and the qualifying shareholder; or

(B) An intermediary verification statement substituting for the documentation described in paragraph (b)(7)(ii)(A) and an intermediary ownership statement from such intermediary and each intermediary standing in the chain of ownership between such intermediary and the verifying intermediary;

(iii) The proportionate interest (as computed using the documentation described in paragraph (b)(7)(ii) of this section) in the intermediary owned directly or indirectly by qualifying shareholders;

(iv) An agreement to make available to the Commissioner at such time and place as the Commissioner may request the underlying documentation described in paragraph (b)(7)(ii) of this section; and

(v) A specific and valid waiver of any right to bank secrecy or other secrecy under the laws of the country in which the verifying intermediary is located, with respect to any qualifying shareholder ownership statements, certificates of residency, intermediary ownership statements or intermediary verification statements that the verifying intermediary has obtained pursuant to paragraph (b)(7)(ii) of this section.

A foreign corporation may combine, in a single statement, the information in an intermediary ownership statement and the information in an intermediary verification statement.

(8) SPECIAL RULES FOR PENSION FUNDS -- (i) DEFINITIONS --

(A) PENSION FUND. For purposes of this section, the term "pension fund" shall mean a trust, fund, foundation, or other entity that is established exclusively for the benefit of employees or former employees of one or more employers, the principal purpose of which is to provide retirement, disability, and death benefits to beneficiaries of such entity and persons designated by such beneficiaries in consideration for prior services rendered.

(B) BENEFICIARY. For purposes of this section, the term "beneficiary" of a pension fund shall mean any person who has made contributions to the pension fund, or on whose behalf contributions have been made, and who is currently receiving retirement, disability, or death benefits from the pension fund or can reasonably be expected to receive such benefits in the future, whether or not the person's right to receive benefits from the fund has vested.

(ii) GOVERNMENT PENSION FUNDS. An individual who is a beneficiary of a pension fund that would be a controlled entity of a foreign sovereign within the principles of section 1.892-2T(c)(1) of the regulations (relating to pension funds established for the benefit of employees or former employees of a foreign government) shall be treated as a qualifying shareholder of a foreign corporation in which the pension fund owns a direct or indirect interest without having to meet the documentation requirements under paragraph (b)(3)(i)(A) of this section, if the foreign corporation is resident in the country of the foreign sovereign and the trustees, directors, or other administrators of the pension fund provide, with the pension funds's intermediary ownership statement described in paragraph (b)(6) of this section, a written statement that the fund is a controlled entity described in this paragraph (b)(8)(ii). See paragraph (b)(4)(ii) of this section regarding an ownership statement from a pension fund that is an integral part of a foreign government.

(iii) NON-GOVERNMENT PENSION FUNDS. For purposes of this section, an individual who is a beneficiary of a pension fund not described in paragraph (b)(8)(ii) of this section shall be treated as a qualifying shareholder of a foreign corporation owned directly or indirectly by such pension fund without having to meet the documentation requirements under paragraph (b)(3)(i)(A) of this section, if --

(A) The pension fund is administered in the foreign corporation's country of residence and is subject to supervision or regulation by a governmental authority (or other authority delegated to perform such supervision or regulation by a governmental authority) in such country;

(B) The pension fund is generally exempt from income taxation in its country of administration;

(C) The pension fund has 100 or more beneficiaries;

(D) The beneficiary's address, as it appears on the records of the fund, is in the foreign corporation's country of residence or the United States and is not a nonresidential address, such as a post office box or in care of a financial intermediary, and none of the trustees, directors or other administrators of the pension fund know, or have reason to know, that the beneficiary is not an individual resident of such foreign country or the United States;

(E) In the case of a pension fund that has fewer than 500 beneficiaries, the beneficiary's employer provides (if the beneficiary is currently contributing to the fund) to the trustees, directors or other administrators a written statement that the beneficiary is currently employed in the country in which the fund is administered or is usually employed in such country but is temporarily employed by the company outside of the country; and

(F) The trustees, directors or other administrators of the pension fund provide, with the pension fund's intermediary ownership statement described in paragraph (b)(6) of this section, a written statement signed under penalties of perjury declaring that the pension fund meets the requirements in paragraphs (b)(8)(iii)(A), (B) and (C) of this section and giving the number of beneficiaries who meet the requirements of paragraph (b)(8)(iii)(D) of this section, and, if applicable, paragraph (b)(8)(iii)(E) of this section.

(iv) COMPUTATION OF BENEFICIAL INTERESTS IN NON-GOVERNMENT PENSION FUNDS. The number of shares in a foreign corporation that are held indirectly by beneficiaries of a pension fund who are qualifying shareholders may be computed based on the ratio of the number of such beneficiaries to all beneficiaries of the pension fund (rather than on the basis of the rules in paragraph (b)(2) of this section) if --

(A) The pension fund meets the requirements of paragraphs (b)(8)(iii)(A), (B) and (C) of this section;

(B) The trustees, directors or other administrators of the pension fund have no knowledge, and no reason to know, that the ratio of the pension fund's beneficiaries who are residents of either the country in which the pension fund is administered or of the United States to all beneficiaries of the pension fund would differ significantly from the ratio of the sum of the actuarial interests of such residents in the pension fund to the actuarial interests of all beneficiaries in the pension fund (or, if the beneficiaries, actuarial interest in the stock held directly or indirectly by the pension fund differs from the beneficiaries's actuarial interest in the pension fund, the ratio of actuarial interests computed by reference to the beneficiaries' actuarial interest in the stock);

(C) Either --

(1) Any overfunding of the pension fund would be payable, pursuant to the governing instrument or the laws of the foreign country in which the pension fund is administered, only to, or for the benefit of, one or more corporations that are qualified residents of the country in which the pension fund is administered, individual beneficiaries of the pension fund or their designated beneficiaries, or social or charitable causes (the reduction of the obligation of the sponsoring company or companies to make future contributions to the pension fund by reason of overfunding shall not itself result in such overfunding being deemed to be payable to or for the benefit of such company or companies); or

(2) The foreign country in which the pension fund is administered has laws that are designed to prevent overfunding of a pension fund and the funding of the pension fund is within the guidelines of such laws; or

(3) The pension fund is maintained to provide benefits to employees in a particular industry, profession, or group of industries or professions and employees of at least 10 companies (other than companies that are owned or controlled, directly or indirectly, by the same interests) contribute to the pension fund or receive benefits from the pension fund; and

(D) The trustees, directors or other administrators provide, with the pension fund's intermediary ownership statement described in paragraph (b)(6) of this section, a written statement signed under penalties of perjury certifying that the requirements in paragraphs (b)(8)(iv)(A), (B), and either (C)(1), (C)(2) or (C)(3) of this section have been met.

The statement described in paragraph (b)(8)(iv)(D) of this section may be combined, in a single statement, with the information required in paragraph (b)(8)(iii)(F) of this section.

(v) TIME FOR MAKING DETERMINATIONS. The determinations required to be made under this paragraph (b)(8) shall be made using information shown on the records of the pension fund for a date on or after the beginning of the foreign corporation's taxable year to which the determination is relevant.

(9) AVAILABILITY OF DOCUMENTS FOR INSPECTION -- (i) RETENTION OF DOCUMENTS BY THE FOREIGN CORPORATION. The documentation described in paragraphs (b)(3) and (b)(8) of this section must be retained by the foreign corporation until expiration of the period of limitations for the taxable year to which the documentation relates and must be made available for inspection by the District Director at such time and place as the District Director may request.

(ii) RETENTION OF DOCUMENTS BY AN INTERMEDIARY ISSUING AN INTERMEDIARY VERIFICATION STATEMENT. The documentation upon which an intermediary relies to issue an intermediary verification statement under paragraph (b)(7) of this section must be retained by the intermediary for a period of six years from the date of issuance of the intermediary verification statement and must be made available for inspection by the District Director at such time and place as the District Director may request.

(10) EXAMPLES. The application of this paragraph (b) is illustrated by the following examples.

EXAMPLE 1. Foreign corporation A is a resident of country L, which has an income tax treaty in effect with the United States. Foreign corporation A has one class of stock issued and outstanding consisting of 1,000 shares, which are beneficially owned by the following alien individuals, directly or by application of paragraph (b)(2) of this section:

                               Shares owned,

(ii) U and V own, respectively, an 80 percent and a 20 percent actuarial interest in foreign trust FT, (which interest does not differ from their respective interests in the stock owned by FT), which beneficially owns 100 percent of the stock of a foreign corporation B with bearer shares, which beneficially owns 500 shares of foreign corporation A. Foreign corporation B is incorporated in a country that does not have an income tax treaty with the United States. The foreign trust has deposited the bearer shares it owns in B with a bank in a foreign country that has an income tax treaty with the United States.

(iii) W beneficially owns all the shares of foreign corporation C, which are registered in the name of individual Z, a nominee, who resides in country L; foreign corporation C beneficially owns a 70 percent interest in foreign corporation D, which beneficially owns 300 shares of A. D's shares are bearer shares that C (not a resident of a country with which the United States has an income tax treaty) has deposited with a bank in a foreign country that has an income tax treaty with the United States.

(iv) X beneficially owns a 30 percent interest in foreign corporation D.

(v) A is a qualified resident of country L if it obtains the applicable documentation described in paragraph (b)(3) of this section either with respect to ownership by individuals U and W or with respect to ownership by individuals T and U, since either combination of qualifying shareholders of foreign corporation A will exceed 50 percent.

EXAMPLE 2. Assume the same facts as in EXAMPLE 1 and assume that foreign corporation A chooses to obtain documentation with respect to individuals T and U.

(i) A must obtain, pursuant to paragraph (b)(3)(i) of this section, an ownership statement (as described in paragraph (b)(4)(i) of this section) signed by T. T is not required to furnish a certificate of residency because T is a U.S. resident.

(ii) U must provide foreign trust FT with an ownership statement and certificate of residency, as described in paragraphs (b)(4) and (b)(5) of this section. The trustees of FT must provide the depository bank holding foreign corporation B's bearer shares with an intermediary ownership statement concerning its beneficial ownership of B's shares and must attach to it the documentation provided by U. The depository bank must provide B with an intermediary ownership statement regarding its holding of B shares on behalf of FT and has the choice of attaching --

(A) The documentation from U and the intermediary ownership statement from FT; or

(B) An intermediary verification statement described in paragraph (b)(7) of this section, in which case foreign corporation B would not be provided with U's individual documentation or FT's intermediary ownership statement, both of which are retained by the depository bank.

(iii) In either case, B must then provide foreign corporation A with an intermediary ownership statement regarding its direct beneficial ownership of shares in A and, as the case may be, either --

(A) U's documentation and the intermediary ownership statements by FT and the depository bank; or

(B) The depository bank's intermediary ownership and verification statements.

(iv) Thus, with respect to U, A must obtain under paragraph (b)(3)(i) of this section the individual documentation regarding U and an intermediary ownership statement from each intermediary standing in the chain of U's indirect beneficial ownership of shares in A, i.e., from FT, the depository bank and B. In the alternative, A must obtain under paragraph (b)(3)(ii) of this section an intermediary verification statement issued by the depository bank and an intermediary ownership statement from the bank and from B, which, in this example, are the only intermediaries standing in the chain of ownership of the verifying intermediary (i.e., the depository bank).

EXAMPLE 3. Assume the same facts as in EXAMPLE 1. In addition, assume that foreign corporation A chooses to obtain documentation with respect to individuals U and W. With respect to U, A must obtain the same documentation that is described in EXAMPLE 2. With respect to W, A must obtain, under paragraph (b)(3)(i) of this section, individual documentation regarding W and an intermediary ownership statement from each intermediary standing in the chain of W's indirect beneficial ownership of shares in A, i.e., from individual Z, foreign corporation C, the depository bank in the foreign treaty country, and foreign corporation D. In the alternative, A must obtain, under paragraph (b)(3)(ii) of this section, either --

(i) An intermediary verification statement by the depository bank in the foreign treaty country and an intermediary ownership statement from the bank and from D; or

(ii) An intermediary verification statement from Z and an intermediary ownership statement from Z and from each intermediary standing in the chain of ownership of shares in foreign corporation A, i.e., from C, the depository bank in the foreign treaty country and D. C may not issue an intermediary verification statement because it is not a resident of a country with which the United States has an income tax treaty.

(c) BASE EROSION. A foreign corporation satisfies the requirement relating to base erosion for a taxable year if it establishes that less than 50 percent of its income for the taxable year is used (directly or indirectly) to make deductible payments in the current taxable year to persons who are not residents (or, in the case of foreign corporations, qualified residents) of the foreign country of which the foreign corporation is a resident and who are not citizens or residents (or, in the case of domestic corporations, qualified residents) of the United States. Whether a domestic corporation is a qualified resident of the United States shall be determined under the principles of this section. For purposes of this paragraph (c), the term "deductible payments" includes payments that would be ordinarily deductible under U.S. income tax principles without regard to other provisions of the Code that may require the capitalization of the expense, or disallow or defer the deduction. Such payments include, for example, interest, rents, royalties and reinsurance premiums. For purposes of this paragraph (c), the income of a foreign corporation means the corporation's gross income for the taxable year (or, if the foreign corporation has no gross income for the taxable year, the average of its gross income for the three previous taxable years) under U.S. tax principles, but not excluding items of income otherwise excluded from gross income under U.S. tax principles.

(d) PUBLICLY-TRADED CORPORATIONS -- (1) GENERAL RULE. A foreign corporation that is a resident of a foreign country shall be treated as a qualified resident of that country for any taxable year in which --

(i) Its stock is primarily and regularly traded (as defined in paragraphs (d)(3) and (4) of this section) on one or more established securities markets (as defined in paragraph (d)(2) of this section) in that country, or in the United States, or both; or

(ii) At least 90 percent of the total combined voting power of all classes of stock of such foreign corporation entitled to vote and at least 90 percent of the total value of the stock of such foreign corporation is owned, directly or by application of paragraph (b)(2) of this section, by a foreign corporation that is a resident of the same foreign country or a domestic corporation and the stock of such parent corporation is primarily and regularly traded on an established securities market in that foreign country or in the United States, or both.

(2) ESTABLISHED SECURITIES MARKET -- (i) GENERAL RULE. For purposes of section 884, the term "established securities market" means, for any taxable year --

(A) A foreign securities exchange that is officially recognized, sanctioned, or supervised by a governmental authority of the country in which the market is located, is the principal exchange in that country, and has an annual value of shares traded on the exchange exceeding $1 billion during each of the three calendar years immediately preceding the beginning of the taxable year;

(B) A national securities exchange that is registered under section 6 of the Securities Act of 1934 (15 U.S.C. 78f); and

(C) A domestic over-the-counter market (as defined in paragraph (d)(2)(iv) of this section).

(ii) EXCHANGES WITH MULTIPLE TIERS. If a principal exchange in a foreign country has more than one tier or market level on which stock may be separately listed or traded, each such tier shall be treated as a separate exchange.

(iii) COMPUTATION OF DOLLAR VALUE OF STOCK TRADED. For purposes of paragraph (d)(2)(i)(A) of this section, the value in U.S. dollars of shares traded during a calendar year shall be determined on the basis of the dollar value of such shares traded as reported by the International Federation of Stock Exchanges, located in Paris, or, if not so reported, then by converting into U.S. dollars the aggregate value in local currency of the shares traded using an exchange rate equal to the average of the spot rates on the last day of each month of the calendar year.

(iv) DEFINITION OF OVER-THE-COUNTER MARKET. An over-the-counter market is any market reflected by the existence of an interdealer quotation system. An interdealer quotation system is any system of general circulation to brokers and dealers that regularly disseminates quotations of stocks and securities by identified brokers or dealers, other than by quotation sheets that are prepared and distributed by a broker or dealer in the regular course of business and that contain only quotations of such broker or dealer.

(v) DISCRETION TO DETERMINE THAT AN EXCHANGE QUALIFIES AS AN ESTABLISHED SECURITIES MARKET. The Commissioner may, in his sole discretion, determine in a published document that a securities exchange that does not meet the requirements of paragraph (d)(2)(i)(A) of this section qualifies as an established securities market. Such a determination will be made only if it is established that --

(A) The exchange, in substance, has the attributes of an established securities market (including adequate trading volume, and comparable listing and financial disclosure requirements);

(B) The rules of the exchange ensure active trading of listed stocks; and

(C) The exchange is a member of the International Federation of Stock Exchanges.

(vi) DISCRETION TO DETERMINE THAT AN EXCHANGE DOES NOT QUALIFY AS AN ESTABLISHED SECURITIES MARKET. The Commissioner may, in his sole discretion, determine in a published document that a securities exchange that meets the requirements of paragraph (d)(2)(i) of this section does not qualify as an established securities market. Such determination shall be made if, in the view of the Commissioner --

(A) The exchange does not have adequate listing, financial disclosure, or trading requirements (or does not adequately enforce such requirements); or

(B) There is not clear and convincing evidence that the exchange ensures the active trading of listed stocks.

(3) PRIMARILY TRADED. For purposes of this section, stock of a corporation is "primarily traded" on one or more established securities markets in the corporation's country of residence or in the United States in any taxable year if, with respect to each class described in paragraph (d)(4)(i)(A) of this section (relating to classes of stock relied on to meet the regularly traded test) --

(i) The number of shares in each such class that are traded during the taxable year on all established securities markets in the corporation's country of residence or in the United States during the taxable year exceeds

(ii) The number of shares in each such class that are traded during that year on established securities markets in any other single foreign country.

(4) REGULARLY TRADED -- (i) GENERAL RULE. For purposes of this section, stock of a corporation is "regularly traded" on one or more established securities markets in the foreign corporation's country of residence or in the United States for the taxable year if --

(A) One or more classes of stock of the corporation that, in the aggregate, represent 80 percent or more of the total combined voting power of all classes of stock of such corporation entitled to vote and of the total value of the stock of such corporation are listed on such market or markets during the taxable year;

(B) With respect to each class relied on to meet the 80 percent requirement of paragraph (d)(4)(i)(A) of this section --

(1) Trades in each such class are effected, other than in de minimis quantities, on such market or markets on at least 60 days during the taxable year (or 1/6 of the number of days in a short taxable year); and

(2) The aggregate number of shares in each such class that is traded on such market or markets during the taxable year is at least 10 percent of the average number of shares outstanding in that class during the taxable year (or, in the case of a short taxable year, a percentage that equals at least 10 percent of the number of days in the short taxable year divided by 365).

If stock of a foreign corporation fails the 80 percent requirement of paragraph (d)(4)(i)(A) of this section, but a class of such stock meets the trading requirements of paragraph (d)(4)(i)(B) of this section, such class of stock may be taken into account under paragraph (b)(1)(iii) of this section as owned by qualifying shareholders for purposes of meeting the ownership test of paragraph (b)(1) of this section.

(ii) CLASSES OF STOCK TRADED ON A DOMESTIC ESTABLISHED SECURITIES MARKET TREATED AS MEETING TRADING REQUIREMENTS. A class of stock that is traded during the taxable year on an established securities market located in the United States shall be treated as meeting the trading requirements of paragraph (d)(4)(i)(B) of this section if the stock is regularly quoted by brokers or dealers making a market in the stock. A broker or dealer makes a market in a stock only if the broker or dealer holds himself out to buy or sell the stock at the quoted price.

(iii) CLOSELY-HELD CLASSES OF STOCK NOT TREATED AS MEETING TRADING REQUIREMENT -- (A) GENERAL RULE. A class of stock shall not be treated as meeting the trading requirements of paragraph (d)(4)(i)(B) of this section (or the requirements of paragraph (d)(4)(ii) of this section) for a taxable year if, at any time during the taxable year, one or more persons who are not qualifying shareholders (as defined in paragraph (b)(1) of this section) and who each beneficially own 5 percent or more of the value of the outstanding shares of the class of stock own, in the aggregate, 50 percent or more of the outstanding shares of the class of stock for more than 30 days during the taxable year. For purposes of the preceding sentence, shares shall not be treated as owned by a qualifying shareholder unless such shareholder provides to the foreign corporation, by the time prescribed in paragraph (b)(3) of this section, the documentation described in paragraph (b)(3) of this section necessary to establish that it is a qualifying shareholder. For purposes of this paragraph (d)(4)(iii)(A), shares of stock owned by a pension fund, as defined in paragraph (b)(8)(i)(A) of this section, shall be treated as beneficially owned by the beneficiaries of such fund, as defined in paragraph (b)(8)(i)(B) of this section.

(B) TREATMENT OF RELATED PERSONS. Persons related within the meaning of section 267(b) shall be treated as one person for purposes of this paragraph (d)(4)(iii). In determining whether two or more corporations are members of the same controlled group under section 267(b)(3), a person is considered to own stock owned directly by such person, stock owned with the application of section 1563(e)(1), and stock owned with the application of section 267(c). Further, in determining whether a corporation is related to a partnership under section 267(b)(10), a person is considered to own the partnership interest owned directly by such person and the partnership interest owned with the application of section 267(e)(3).

(iv) ANTI-ABUSE RULE. Trades between persons described in section 267(b)(as modified in paragraph (d)(4)(iii)(B) of this section) and trades conducted in order to meet the requirements of paragraph (d)(4)(i)(B) of this section shall be disregarded. A class of stock shall not be treated as meeting the trading requirements of paragraph (d)(4)(i)(B) of this section if there is a pattern of trades conducted to meet the requirements of that paragraph. For example, trades between two persons that occur several times during the taxable year may be treated as an arrangement or a pattern of trades conducted to meet the trading requirements of paragraph (d)(4)(i)(B) of this section.

(5) BURDEN OF PROOF FOR PUBLICLY-TRADED CORPORATIONS. A foreign corporation that relies on this paragraph (d) to establish that it is a qualified resident of a country with which the United States has an income tax treaty shall have the burden of proving all the facts necessary for the corporation to be treated as a qualified resident, except that with respect to paragraphs (d)(4)(iii) and (iv) of this section, a foreign corporation, with either registered or bearer shares, will meet the burden of proof if it has no reason to know and no actual knowledge of facts that would cause the corporation's stock not to be treated as regularly traded under such paragraphs. A foreign corporation that has shareholders of record must also maintain a list of such shareholders and, on request, make available to the District Director such list and any other relevant information known to the foreign corporation.

(e) ACTIVE TRADE OR BUSINESS -- (1) GENERAL RULE. A foreign corporation that is a resident of a foreign country shall be treated as a qualified resident of that country with respect to any U.S. trade or business if, during the taxable year --

(i) It is engaged in the active conduct of a trade or business (as defined in paragraph (e)(2) of this section) in its country of residence;

(ii) It has a substantial presence (within the meaning of paragraph (e)(3) of this section) in its country of residence; and

(iii) Either --

(A) Such U.S. trade or business is an integral part (as defined in paragraph (e)(4) of this section) of an active trade or business conducted by the foreign corporation in its country of residence; or

(B) In the case of interest received by the foreign corporation for which a treaty exemption or rate reduction is claimed pursuant to section 1.884-4(b)(8)(ii), the interest is derived in connection with, or is incidental to, a trade or business described in paragraph (e)(1)(i) of this section.

A foreign corporation may determine whether it is a qualified resident under this paragraph (e) by applying the rules of this paragraph (e) to the entire affiliated group (as defined in section 1504(a) without regard to section 1504(b)(2) or (3)) of which the foreign corporation is a member rather than to the foreign corporation separately. If a foreign corporation chooses to apply the rules of this paragraph (e) to its entire affiliated group as provided in the preceding sentence, then it must apply such rules consistently to all of its U.S. trades or businesses conducted during the taxable year.

(2) ACTIVE CONDUCT OF A TRADE OR BUSINESS. A foreign corporation is engaged in the active conduct of a trade or business only if either --

(i) It is engaged in the active conduct of a trade or business within the meaning of section 367(a)(3) and the regulations thereunder; or

(ii) It qualifies as a banking or financing institution under the laws of the foreign country of which it is a resident, it is licensed to do business with residents of its country of residence, and it is engaged in the active conduct of a banking, financing, or similar business within the meaning of section 1.864-4(c)(5)(i) in its country of residence.

A foreign corporation that is an insurance company within the meaning of section 1.801-3(a) or (b) is engaged in the active conduct of a trade or business only if it is predominantly engaged in the active conduct of an insurance business within the meaning of section 952(c)(1)(B)(v) and the regulations thereunder.

(3) SUBSTANTIAL PRESENCE TEST -- (i) GENERAL RULE. Except as provided in paragraph (e)(3)(ii) of this section, a foreign corporation that is engaged in the active conduct of a trade or business in its country of residence has a substantial presence in that country if, for the taxable year, the average of the following three ratios exceeds 25 percent and each ratio is at least equal to 20 percent --

(A) The ratio of the value of the assets of the foreign corporation used or held for use in the active conduct of a trade or business in its country of residence at the close of the taxable year to the vaue of all assets of the foreign corporation at the close of the taxable year;

(B) The ratio of gross income from the active conduct of the foreign corporation's trade or business in its country of residence that is derived from sources within such country for the taxable year to the worldwide gross income of the foreign corporation for the taxable year; and

(C) The ratio of the payroll expenses in the foreign corporation's country of residence for the taxable year to the foreign corporation's worldwide payroll expenses for the taxable year.

(ii) SPECIAL RULES -- (A) ASSET RATIO. For purposes of paragraph (e)(3)(i)(A) of this section, the value of an asset shall be determined using the method used by the taxpayer in keeping its books for purposes of financial reporting in its country of residence. An asset shall be treated as used or held for use in a foreign corporation's trade or business if it meets the requirements of section 1.367(a)-2T(b)(5). Stock held by a foreign corporation shall not be treated as an asset of the foreign corporation for purposes of paragraph (e)(3)(i)(A) of this section if the foreign corporation owns 10 percent or more of the total combined voting power of all classes of stock of such corporation entitled to vote. The rules of section 1.954-2T(b)(3)(other than section 1.954-2T(b)(3)(X)) shall apply to determine the location of assets used or held for use in a trade or business. Loans originated or acquired in the course of the normal customer loan activities of a banking, financing or similar institution, and securities and derivative financial instruments held by dealers, traders and insurance companies for use in a trade or business shall be treated as located in the country in which an office or other fixed place of business is primarily responsible for the acquisition of the asset and the realization of income, gain or loss with respect to the asset.

(B) GROSS INCOME RATIO -- (1) GENERAL RULE. For purposes of paragraph (e)(3)(i)(B) of this section, the term "gross income" means the gross income of a foreign corporation for purposes of financial reporting in its country of residence. Gross income shall not include, however, dividends, interest, rents, or royalties unless such corporation derives such dividends, interest, rents, or royalties in the active conduct of its trade or business. Gross income shall also not include gain from the disposition of stock if the foreign corporation owns 10 percent or more of the total combined voting power of all classes of stock of such corporation entitled to vote. Except as provided in this paragraph (e)(3)(ii)(B), the principles of sections 861 through 865 shall apply to determine the amount of gross income of a foreign corporation derived within its country of residence.

(2) BANKS, DEALERS, AND TRADERS. Dividend income and gain from the sale of securities, or from entering into or disposing of derivative financial instruments by dealers and traders in such securities or derivative financial instruments shall be treated as derived within the country where the assets are located under paragraph (e)(3)(ii)(A) of this section. Other income, including interest and fees, earned in the active conduct of a banking, financing or similar business shall be treated as derived within the country where the payor of such interest or other income resides. For purposes of the preceding sentence, if a branch or similar establishment outside the country in which the payor resides makes a payment of interest or other income, such amounts shall be treated as derived within the country in which the branch or similar establishment is located.

(3) INSURANCE COMPANIES. The gross income of a foreign insurance company shall include only gross premiums received by the company.

(4) OTHER CORPORATIONS. Gross income from the performance of services, including transportation services, shall be treated as derived within the country of residence of the person for whom the services are performed. Gross income from the sale of property by a foreign corporation shall be treated as derived within the country in which the purchaser resides.

(5) ANTI-ABUSE RULE. The Commissioner may disregard the source of income from a transaction determined under this paragraph (e)(3)(ii)(B) if it is determined that one of the principal purposes of the transaction was to increase the source of income derived within the country of residence of the foreign corporation for purposes of this section.

(C) PAYROLL RATIO. For purposes of paragraph (e)(3)(i)(C) of this section, the payroll expenses of a foreign corporation shall include expenses for "leased employees" (within the meaning of section 414(n)(2) but without regard to subdivision (B) of that section) and commission expenses paid to employees and agents for services performed for or on behalf of the corporation. Payroll expense for an employee, agent or a "leased employee" shall be treated as incurred where the employee, agent or "leased employee" performs services on behalf of the corporation.

(iii) EXCEPTION TO GROSS INCOME TEST FOR FOREIGN CORPORATIONS ENGAGED IN CERTAIN TRADES OR BUSINESSES. In determining whether a foreign corporation engaged primarily in selling tangible property or in manufacturing, producing, growing, or extracting tangible property has a substantial presence in its country of residence for purposes of paragraph (e)(3)(i) of this section, the foreign corporation may apply the ratio provided in this paragraph (e)(3)(iii) instead of the ratio described in paragraph (e)(3)(i)(B) of this section (relating to the ratio of gross income derived from its country of residence). This ratio shall be the ratio of the direct material costs of the foreign corporation with respect to tangible property manufactured, produced, grown, or extracted in the foreign corporation's country of residence to the total direct material costs of the foreign corporation.

(4) INTEGRAL PART OF AN ACTIVE TRADE OR BUSINESS IN A FOREIGN CORPORATION'S COUNTRY OF RESIDENCE -- (i) IN GENERAL. A U.S. trade or business of a foreign corporation is an integral part of an active trade or business conducted by a foreign corporation in its country of residence if the active trade or business conducted by the foreign corporation in both its country of residence and in the United States comprise, in principal part, complementary and mutually interdependent steps in the United States and its country of residence in the production and sale or lease of goods or in the provision of services. Subject to the presumption and de minimis rule in paragraphs (e)(4)(iii) and (iv) of this section, if a U.S. trade or business of a foreign corporation sells goods that are not, in principal part, manufactured, produced, grown, or extracted by the foreign corporation in its country of residence, such business shall not be treated as an integral part of an active trade or business conducted in the foreign corporation's country of residence unless the foreign corporation takes physical possession of the goods in a warehouse or other storage facility that is located in its country of residence and in which goods of such type are normally stored prior to sale to customers in such country.

(ii) PRESUMPTION FOR BANKS. A U.S. trade or business of a foreign corporation that is described in section 1.884-4(b)(2) shall be presumed to be an integral part of an active banking business conducted by the foreign corporation in its country of residence provided that a substantial part of the business of the foreign corporation in its country of residence consists of receiving deposits and making loans and discounts.

(iii) PRESUMPTION IF BUSINESS PRINCIPALLY CONDUCTED IN COUNTRY OF RESIDENCE. A U.S. trade or business of a foreign corporation shall be treated as an integral part of an active trade or business of a foreign corporation in its country of residence with respect to the sale or lease of property (or the performance of services) if at least 50 percent of the foreign corporation's worldwide gross income from the sale or lease of property of the type sold in the United States (or from the performance of services of the type performed in the United States) is derived from the sale or lease of such property for consumption, use, or disposition in the foreign corporation's country of residence (or from the performance of such services in the foreign corporation's country of residence). In determining whether property or services are of the same type, a foreign corporation shall follow recognized industry or trade usage or the three-digit major groups (or any narrower classification) of the Standard Industrial Classification as prepared by the Statistical Policy Division of the Office of Management and Budget, Executive Office of the President. The determination of whether income is of the same kind must be made in a consistent manner from year-to-year.

(iv) DE MINIMIS RULE. If a foreign corporation is engaged in more than one U.S. trade or business and if at least 80 percent of the sum of the ECEP from the current year and the preceding two years is attributable to one or more trades or businesses that meet the integral part test of this paragraph (e)(4), all of the U.S. trades or businesses of the foreign corporation shall be treated as an integral part of an active trade or business conducted by the foreign corporation. If a foreign corporation has more than one U.S. trade or business and does not meet the requirements of the preceding sentence but otherwise meets the requirements of this paragraph (e)(4) with regard to one or more trade or business, see section 1.884-1(g)(1) to determine the extent to which treaty benefits apply to such corporation.

(f) QUALIFIED RESIDENT RULING -- (1) BASIS FOR RULING. In his or her sole discretion, the Commissioner may rule that a foreign corporation is a qualified resident of its country of residence if the Commissioner determines that individuals who are not residents of the foreign country of which the foreign corporation is a resident do not use the treaty between that country and the United States in a manner inconsistent with the purposes of section 884. The purposes of section 884 include, but are not limited to, the prevention of treaty shopping by an individual with respect to any article of an income tax treaty between the country of residence of the foreign corporation and the United States.

(2) FACTORS. In order to make this determination, the Commissioner may take into account the following factors, including, but not limited to:

(i) The business reasons for establishing and maintaining the foreign corporation in its country of residence;

(ii) The date of incorporation of the foreign corporation in relation to the date that an income tax treaty between the United States and the foreign corporation's country of residence entered into force;

(iii) The continuity of the historical business and ownership of the foreign corporation;

(iv) The extent to which the foreign corporation meets the requirements of one or more of the tests described in paragraphs (b) through (e) of this section;

(v) The extent to which the U.S. trade or business is dependent on capital, assets, or personnel of the foreign trade or business;

(vi) The extent to which the foreign corporation receives special tax benefits in its country of residence;

(vii) Whether the foreign corporation is a member of an affiliated group (as defined in section 1504(a) without regard to section 1504(b)(2) or (3)), that has no members resident outside the country of residence of the foreign corporation; and

(viii) The extent to which the foreign corporation would be entitled to comparable treaty benefits with respect to all articles of an income tax treaty that would apply to that corporation if it had been incorporated in the country or countries of residence of the majority of its shareholders. For purposes of the preceding sentence, shareholders taken into account shall generally be limited to persons described in paragraph (b)(1)(i) of this section but for the fact that they are not residents of the foreign corporation's country of residence.

(3) PROCEDURAL REQUIREMENTS. A request for a ruling under this paragraph (f) must be submitted on or before the due date (including extensions) of the foreign corporation's income tax return for the taxable year for which the ruling is requested. A foreign corporation receiving a ruling will be treated as a qualified resident of its country of residence for the taxable year for which the ruling is requested and for the succeeding two taxable years. If there is a material change in any fact that formed the basis of the ruling, such as the ownership or the nature of the trade or business of the foreign corporation, the foreign corporation must notify the Secretary within 90 days of such change and submit a new private letter ruling request. The Commissioner will then rule whether the change affects the foreign corporation's status as a qualified resident, and such ruling will be valid for the taxable year in which the material change occurred and the two succeeding taxable years, subject to the requirement in the preceding sentence to notify the Commissioner of a material change.

(g) EFFECTIVE DATES. This section is effective for taxable years beginning on or after [THE DATE THAT IS 30 DAYS AFTER THESE REGULATIONS ARE PUBLISHED AS FINAL REGULATIONS IN THE FEDERAL REGISTER.] With respect to a taxable year beginning before [THE DATE THAT IS 30 DAYS AFTER THESE REGULATIONS ARE PUBLISHED AS FINAL REGULATIONS IN THE FEDERAL REGISTER] and after December 31, 1986, a foreign corporation may elect to apply this section in lieu of the temporary regulations under 1.884-5T (as contained in the CFR edition revised as of April 1, 1992), but only if the statute of limitations for assessment of a deficiency has not expired for that taxable year. Once an election has been made, an election shall apply to all subsequent taxable years.

(h) TRANSITION RULE. If a foreign corporation elects to apply this section in lieu of section 1.884-5T (as contained in the CFR edition revised as of April 1, 1992) as provided in paragraph (g) of this section, and the application of paragraph (b) of this section results in additional documentation requirements in order for the foreign corporation to be treated as a qualified resident, the foreign corporation must obtain the documentation required under that paragraph on or before [THE DATE THAT IS SIX MONTHS AFTER THE DATE THESE REGULATIONS ARE PUBLISHED AS FINAL REGULATIONS.]

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

Par. 6. The authority citation for part 602 continues to read as follows:

Authority: 26 U.S.C. 7805.

Par. 7. Section 602.101(c) is amended by removing the entries for "1.884-0T, 1.884-1T, and 1.884-5T" and adding the following entries to the table:

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