Sec. 1.882-5 Determination of interest deduction.

(1) Overview.

(2) Coordination with tax treaties. Except as expressly provided by or pursuant to a U.S. income tax treaty or accompanying documents (such as an exchange of notes), the provisions of this section provide the exclusive rules for determining the interest expense attributable to the business profits of a permanent establishment under a U.S. income tax treaty.

(3) Limitation on interest expense. In no event may the amount of interest expense computed under this section exceed the amount of interest on indebtedness paid or accrued by the taxpayer within the taxable year (translated into U.S. dollars at the weighted average exchange rate for each currency prescribed by section 1.989(b)-1 for the taxable year).

(4) Translation convention for foreign currency. For each computation required by this section, the taxpayer shall translate values and amounts into the relevant currency at a spot rate or a weighted average exchange rate consistent with the method such taxpayer uses for financial reporting purposes, provided such method is applied consistently from year to year. Interest expense paid or accrued, however, shall be translated under the rules of section 1.988-2. The district director or the Assistant Commissioner (International) may require that any or all computations required by this section be made in U.S. dollars if the functional currency of the taxpayer's home office is a hyperinflationary currency, as defined in section 1.985-1, and the computation in U.S. dollars is necessary to prevent distortions.

(5) Coordination with other sections. Any provision that disallows, defers, or capitalizes interest expense applies after determining the amount of interest expense allocated to ECI under this section. For example, in determining the amount of interest expense that is disallowed as a deduction under section 265 or 163(j), deferred under section 163(e)(3) or 267(a)(3), or capitalized under section 263A with respect to a United States trade or business, a taxpayer takes into account only the amount of interest expense allocable to ECI under this section.

(6) Special rule for foreign governments. The amount of interest expense of a foreign government, as defined in section 1.892-2T(a), that is allocable to ECI is the total amount of interest paid or accrued within the taxable year by the United States trade or business on U.S. booked liabilities (as defined in paragraph (d)(2) of this section). Interest expense of a foreign government, however, is not allocable to ECI to the extent that it is incurred with respect to U.S. booked liabilities that exceed 80 percent of the total value of U.S. assets for the taxable year (determined under paragraph (b) of this section). This paragraph (a)(6) does not apply to controlled commercial entities within the meaning of section 1.892-5T.

(7) Elections under § 1.882-5.

(8) Examples. The following examples illustrate the application of paragraph (a) of this section:

Example 1. Direct allocations.

(i) Facts: FC is a foreign corporation that conducts business through a branch, B, in the United States. Among B's U.S. assets is an interest in a partnership, P, that is engaged in airplane leasing solely in the U.S. FC contributes 200x to P in exchange for its partnership interest. P incurs qualified nonrecourse indebtedness within the meaning of section 1.861-10T to purchase an airplane. FC's share of the liability of P, as determined under section 752, is 800x.

(ii) Analysis: Pursuant to paragraph (a)(1)(ii)(B) of this section, FC is permitted to directly allocate its distributive share of the interest incurred with respect to the qualified nonrecourse indebtedness to FC's distributive share of the rental income generated by the airplane. A liability the interest on which is allocated directly to the income from a particular asset under paragraph (a)(1)(ii)(B) of this section is disregarded for purposes of paragraphs (b)(1), (c)(2)(vi), and (d)(2)(vii) or (e)(1)(ii) of this section. Consequently, for purposes of determining the value of FC's assets under paragraphs (b)(1) and (c)(2)(vi) of this section, FC's basis in P is reduced by the 800x liability as determined under section 752, but is not increased by the 800x liability that is directly allocated under paragraph (a)(1)(ii)(B) of this section. Similarly, pursuant to paragraph (a)(1)(ii)(B) of this section, the 800x liability is disregarded for purposes of determining FC's liabilities under paragraphs (c)(2)(vi) and (d)(2)(vii) of this section.

Example 2. Limitation on interest expense.

(i) FC is a foreign corporation that conducts a real estate business in the United States. In its 1997 tax year, FC has no outstanding indebtedness, and therefore incurs no interest expense. FC elects to use the 50% fixed ratio under paragraph (c)(4) of this section.

(ii) Under paragraph (a)(3) of this section, FC is not allowed to deduct any interest expense that exceeds the amount of interest on indebtedness paid or accrued in that taxable year. Since FC incurred no interest expense in taxable year 1997, FC will not be entitled to any interest deduction for that year under section 1.882-5, notwithstanding the fact that FC has elected to use the 50% fixed ratio.

Example 3. Coordination with other sections.

(i) FC is a foreign corporation that is a bank under section 585(a)(2) and a financial institution under section 265(b)(5). FC is a calendar year taxpayer, and operates a U.S. branch, B. Throughout its taxable year 1997, B holds only two assets that are U.S. assets within the meaning of paragraph (b)(1) of this section. FC does not make a fair-market value election under paragraph (b)(2)(ii) of this section, and, therefore, values its U.S. assets according to their bases under paragraph (b)(2)(i) of this section. The first asset is a taxable security with an adjusted basis of $100. The second asset is an obligation the interest on which is exempt from federal taxation under section 103, with an adjusted basis of $50. The tax-exempt obligation is not a qualified tax-exempt obligation as defined by section 265(b)(3)(B).

(ii) FC calculates its interest expense under section 1.882-5 to be $12. Under paragraph (a)(5) of this section, however, a portion of the interest expense that is allocated to FC's effectively connected income under section 1.882-5 is disallowed in accordance with the provisions of section 265(b). Using the methodology prescribed under section 265, the amount of disallowed interest expense is $4, calculated as follows:

$12 x ($50 Tax-exempt U.S. assets / $150 Total U.S. assets) = $4

(iii) Therefore, FC deducts a total of $8 ($12 - $4) of interest expense attributable to its effectively connected income in 1997.

Example 4. Treaty exempt asset.

(i) FC is a foreign corporation, resident in Country X, that is actively engaged in the banking business in the United States through a permanent establishment, B. The income tax treaty in effect between Country X and the United States provides that FC is not taxable on foreign source income earned by its U.S. permanent establishment. In its 1997 tax year, B earns $90 of U.S. source income from U.S. assets with an adjusted tax basis of $900, and $12 of foreign source interest income from U.S. assets with an adjusted tax basis of $100. FC's U.S. interest expense deduction, computed in accordance with section 1.882-5, is $500.

(ii) Under paragraph (a)(5) of this section, FC is required to apply any provision that disallows, defers, or capitalizes interest expense after determining the interest expense allocated to ECI under section 1.882-5. Section 265(a)(2) disallows interest expense that is allocable to one or more classes of income that are wholly exempt from taxation under subtitle A of the Internal Revenue Code. Section 1.265-1(b) provides that income wholly exempt from taxes includes both income excluded from tax under any provision of subtitle A and income wholly exempt from taxes under any other law. Section 894 specifies that the provisions of subtitle A are applied with due regard to any relevant treaty obligation of the United States. Because the treaty between the United States and Country X exempts foreign source income earned by B from U.S. tax, FC has assets that produce income wholly exempt from taxes under subtitle A, and must therefore allocate a portion of its section 1.882-5 interest expense to its exempt income. Using the methodology prescribed under section 265, the amount of disallowed interest expense is $50, calculated as follows:

$500 x ($100 Treaty-exempt U.S. assets / $1000 Total U.S. assets) = $50

(iii) Therefore, FC deducts a total of $450 ($500 - $50) of interest expense attributable to its effectively connected income in 1997.

(1) Classification of an asset as a U.S. asset.

(2) Determination of the value of a U.S. asset.

(3) Computation of total value of U.S. assets.

(1) General rule. The amount of U.S.-connected liabilities for the taxable year equals the total value of U.S. assets for the taxable year (as determined under paragraph (b)(3) of this section) multiplied by the actual ratio for the taxable year (as determined under paragraph (c)(2) of this section) or, if the taxpayer has made an election in accordance with paragraph (c)(4) of this section, by the fixed ratio.

(2) Compution of the actual ratio.

(3) Adjustments. The district director or the Assistant Commissioner (International) may make appropriate adjustments to prevent a foreign corporation from intentionally and artificially increasing its actual ratio. For example, the district director or the Assistant Commissioner (International) may offset a loan made from or to one person with a loan made to or from another person if any of the parties to the loans are related persons, within the meaning of section 267(b) or 707(b)(1), and one of the principal purposes for entering into the loans was to increase artificially the actual ratio of a foreign corporation. A purpose may be a principal purpose even though it is outweighed by other purposes (taken together or separately).

(4) Elective fixed ratio method of determining U.S. liabilities. A taxpayer that is a bank as defined in section 585(a)(2)(B) (without regard to the second sentence thereof or whether any such activities are effectively connected with a trade or business within the United States) may elect to use a fixed ratio of 95 percent in lieu of the actual ratio. A taxpayer that is neither a bank nor an insurance company may elect to use a fixed ratio of 50 percent in lieu of the actual ratio.

(5) Examples. The following examples illustrate the application of paragraph (c) of this section:

Example 1. Classification of item not in accordance with U.S. tax principles.

Bank Z, a resident of country X, has a branch in the United States through which it conducts its banking business. In preparing its financial statements in country X, Z treats an instrument documented as perpetual subordinated debt as a liability. Under U.S. tax principles, however, this instrument is treated as equity. Consequently, the classification of this instrument as a liability for purposes of paragraph (c)(2)(iii) of this section is not in accordance with U.S. tax principles.

Example 2. Valuation of item not substantially in accordance with U.S. tax principles.

Bank Z, a resident of country X, has a branch in the United States through which it conducts its banking business. Bank Z is a large bank as defined in section 585(c)(2). The tax rules of country X allow Bank Z to take deductions for additions to certain reserves. Bank Z decreases the value of the assets on its financial statements by the amounts of the reserves. The additions to the reserves under country X tax rules cause the value of Bank Z's assets to differ from the value of those assets determined under U.S. tax principles to a degree that materially affects the value of taxpayer's worldwide assets. Consequently, the valuation of Bank Z's worldwide assets under country X tax principles is not substantially in accordance with U.S. tax principles. Bank Z must increase the value of its worldwide assets under paragraph (c)(2)(iii) of this section by the amount of its country X reserves.

Example 3. Valuation of item substantially in accordance with U.S. tax principles.

Bank Z, a resident of country X, has a branch in the United States through which it conducts its banking business. In determining the value of its worldwide assets, Bank Z computes the adjusted basis of certain non-U.S. assets according to the depreciation methodology provided under country X tax laws, which is different than the depreciation methodology provided under U.S. tax law. If the depreciation methodology provided under country X tax laws does not differ from U.S. tax principles to a degree that materially affects the value of Bank Z's worldwide assets or Bank Z's actual ratio as computed under paragraph (c)(2) of this section, then the valuation of Bank Z's worldwide assets under paragraph (c)(2)(iv) of this section is substantially in accordance with U.S. tax principles.

Example 4. [Reserved]

Example 5. Adjustments.

FC is a foreign corporation engaged in the active conduct of a banking business through a branch, B, in the United States. P, an unrelated foreign corporation, deposits $100,000 in the home office of FC. Shortly thereafter, in a transaction arranged by the home office of FC, B lends $80,000 bearing interest at an arm's length rate to S, a wholly owned U.S. subsidiary of P. The district director or the Assistant Commissioner (International) determines that one of the principal purposes for making and incurring such loans is to increase FC's actual ratio. For purposes of this section, therefore, P is treated as having directly lent $80,000 to S. Thus, for purposes of paragraph (c) of this section (Step 2), the district director or the Assistant Commissioner (International) may offset FC's liability and asset arising from this transaction, resulting in a net liability of $20,000 that is not a booked liability of B. Because the loan to S from B was initiated and arranged by the home office of FC, with no material participation by B, the loan to S will not be treated as a U.S. asset.

(1) General rule. The adjustment to the amount of interest expense paid or accrued on U.S. booked liabilities is determined by comparing the amount of U.S.-connected liabilities for the taxable year, as determined under paragraph (c) of this section, with the average total amount of U.S. booked liabilities, as determined under paragraphs (d)(2) and (3) of this section. If the average total amount of U.S. booked liabilities equals or exceeds the amount of U.S.-connected liabilities, the adjustment to the interest expense on U.S. booked liabilities is determined under paragraph (d)(4) of this section. If the amount of U.S.-connected liabilities exceeds the average total amount of U.S. booked liabilities, the adjustment to the amount of interest expense paid or accrued on U.S. booked liabilities is determined under paragraph (d)(5) of this section.

(2) U.S. booked liabilities.

(3) Average total amount of U.S. booked liabilities. The average total amount of U.S. booked liabilities for the taxable year is the average of the sums of the amounts (determined under paragraph (d)(2) of this section) of U.S. booked liabilities. The amount of U.S. booked liabilities shall be computed at the most frequent, regular intervals for which data are reasonably available. In no event shall the amount of U.S. booked liabilities be computed less frequently than monthly by a large bank (as defined in section 585(c)(2)) and semi-annually by any other taxpayer.

(4) Interest expense where U.S. booked liabilities equal or exceed U.S. liabilities.

(5) U.S.-connected interest rate where U.S. booked liabilities are less than U.S.-connected liabilities.

(6) Examples. The following examples illustrate the rules of this section:

Example 1. Compution of interest expense; actual ratio.

(i) Facts. (A) FC is a foreign corporation that is not a bank and that actively conducts a real estate business through a branch, B, in the United States. For the taxable year, FC's balance sheet and income statement is as follows (assume amounts are in U.S. dollars and computed in accordance with paragraphs (b)(2) and (b)(3) of this section):

(B) Asset 1 is the stock of FC's wholly-owned domestic subsidiary that is also actively engaged in the real estate business. Asset 2 is a building in the United States producing rental income that is entirely ECI to FC. Asset 3 is a building in the home country of FC that produces rental income. Liabilities 1 and 2 are loans that bear interest at the rates of 7% and 8%, respectively. Liability 1 is a booked liability of B, and Liability 2 is booked in FC's home country. Assume that FC has not elected to use the fixed ratio in Step 2.

(ii) Step 1. Under paragraph (b)(1) of this section, Assets 1 and 3 are not U.S. assets, while Asset 2 qualifies as a U.S. asset. Thus, under paragraph (b)(3) of this section, the total value of U.S. assets for the taxable year is $2,500, the value of Asset 2.

(iii) Step 2. Under paragraph (c)(1) of this section, the amount of FC's U.S.-connected liabilities for the taxable year is determined by multiplying $2,500 (the value of U.S. assets determined under Step 1) by the actual ratio for the taxable year. The actual ratio is the average amount of FC's worldwide liabilities divided by the average value of FC's worldwide assets. The amount of Liability 1 is $800, and the amount of Liability 2 is $3,200. Thus, the numerator of the actual ratio is $4,000. The average value of worldwide assets is $10,000 (Asset 1 + Asset 2 + Asset 3). The actual ratio, therefore, is 40% ($4,000/$10,000), and the amount of U.S.-connected liabilities for the taxable year is $1,000 ($2,500 U.S. assets x 40%).

(iv) Step 3. Because the amount of FC's U.S.-connected liabilities ($1,000) exceeds the average total amount of U.S. booked liabilities of B ($800), FC determines its interest expense in accordance with paragraph (d)(5) of this section by adding the interest paid or accrued on U.S. booked liabilities, and the interest expense associated with the excess of its U.S.- connected liabilities over its average total amount of U.S. booked liabilities. Under paragraph (d)(5)(ii) of this section, FC determines the interest rate attributable to its excess U.S.- connected liabilities by dividing the interest expense paid or accrued by the average amount of U.S.-dollar denominated liabilities, which produces an interest rate of 8% ($256/$3200). Therefore, FC's allocable interest expense is $72 ($56 of interest expense from U.S. booked liabilities plus $16 ($200 x 8%) of interest expense attributable to its excess U.S.- connected liabilities).

Example 2. Computation of interest expense; fixed ratio.

(i) The facts are the same as in Example 1, except that FC makes a fixed ratio election under paragraph (c)(4) of this section. The conclusions under Step 1 are the same as in Example 1.

(ii) Step 2. Under paragraph (c)(1) of this section, the amount of U.S.-connected liabilities for the taxable year is determined by multiplying $2,500 (the value of U.S. assets determined under Step 1) by the fixed ratio for the taxable year, which, under paragraph (c)(4) of this section is 50 percent. Thus, the amount of U.S.-connected liabilities for the taxable year is $1,250 ($2,500 U.S. assets x 50%).

(iii) Step 3. As in Example 1, the amount of FC's U.S.- connected liabilities exceed the average total amount of U.S. booked liabilities of B, requiring FC to determine its interest expense under paragraph (d)(5) of this section. In this case, however, FC has excess U.S.-connected liabilities of $450 ($1,250 of U.S.-connected liabilities - $800 U.S. booked liabilities). FC therefore has allocable interest expense of $92 ($56 of interest expense from U.S. booked liabilities plus $36 ($450 x 8%) of interest expense attributable to its excess U.S.-connected liabilities).

Example 3. Scaling ratio.

(i) Facts. Bank Z, a resident of country X, has a branch in the United States through which it conducts its banking business. For the taxable year, Z has U.S.-connected liabilities, determined under paragraph (c) of this section, equal to $300. Z, however, has U.S. booked liabilities of $300 and U500. Therefore, assuming an exchange rate of the U to the U.S. dollar of 5:1, Z has U.S. booked liabilities of $400 ($300 + (U500 section 5)).

(ii) U.S.-connected liabilities. Because Z's U.S. booked liabilities of $400 exceed its U.S.-connected liabilities by $100, all of Z's interest expense allocable to its U.S. trade or business must be scaled back pro-rata. To determine the scaling ratio, Z divides its U.S.-connected liabilities by its U.S. booked liabilities, as required by paragraph (d)(4) of this section. Z's interest expense is scaled back pro rata by the resulting ratio of section ($300 section $400). Z's income, expense, gain or loss from hedging transactions described in paragraph (d)(2)(vi) of this section must be similarly reduced.

Example 4. [Reserved]

Example 5. U.S. booked liabilities -- direct relationship.

(i) Facts. Bank A, a resident of Country X maintains a banking office in the U.S. that records transactions on three sets of books for State A, an International Banking Facility (IBF) for its bank regulatory approved international transactions, and a shell branch licensed operation in Country C. Bank A records substantial ECI assets from its bank lending and placement activities and a mix of interbranch and non-ECI producing assets from the same or similar activities on the books of State A branch and on its IBF. Bank A's Country C branch borrows substantially from third parties, as well as from its home office, and lends all of its funding to its State A branch and IBF to fund the mix of ECI, interbranch and non-ECI activities on those two books. The consolidated books of State A branch and IBF indicate that a substantial amount of the total book assets constitute U.S. assets under paragraph (b) of this section. Some of the third-party borrowings on the books of the State A branch are used to lend directly to Bank A's home office in Country X. These borrowings reflect the average borrowing rate of the State A branch, IBF and Country C branches as a whole. All third-party borrowings reflected on the books of State A branch, the IBF and Country C branch were recorded on such books before the close of business on the day the liabilities were acquired by Bank A.

(ii) U.S. booked liabilities. The facts demonstrate that the separate State A branch, IBF and Country C branch books taken together, constitute a set of books within the meaning of paragraph (d)(2)(iii)(A)(1) of this section. Such set of books as a whole has a direct relationship to an ECI activity under paragraph (d)(2)(iii)(A)(2) of this section even though the Country C branch books standing alone would not. The third-party liabilities recorded on the books of Country C constitute U.S. booked liabilities because they were timely recorded and the overall set of books on which they were reflected has a direct relationship to a bank lending and interbank placement ECI producing activity. The third-party liabilities that were recorded on the books of State A branch that were used to lend funds to Bank A's home office also constitute U.S. booked liabilities because the interbranch activity the funds were used for is a lending activity of a type that also gives rise to a substantial amount of ECI that is properly reflected on the same set of books as the interbranch loans. Accordingly, the liabilities are not traced to their specific interbranch use but to the overall activity of bank lending and interbank placements which gives rise to substantial ECI. The facts show that the liabilities were not acquired to increase artificially the interest expense of Bank A's U.S. booked liabilities as a whole under paragraph (d)(2)(v) of this section. The third-party liabilities also constitute U.S. booked liabilities for purposes of determining Bank A's branch interest under § 1.884-4(b)(1)(i)(A) regardless of whether Bank A uses the Adjusted U.S. booked liability method, or the Separate Currency Pool method to allocate its interest expense under paragraph 5(e) of this section.

(1) General rule. If a foreign corporation elects to use the method in this paragraph, its total interest expense allocable to ECI is the sum of the separate interest deductions for each of the currencies in which the foreign corporation has U.S. assets. The separate interest deductions are determined under the following three-step process.

(2) Prescribed interest rate. For each currency pool, the prescribed interest rate is determined by dividing the total interest expense that is paid or accrued for the taxable year with respect to the foreign corporation's worldwide liabilities denominated in that currency, by the foreign corporation's average worldwide liabilities (whether interest bearing or not) denominated in that currency. The interest expense and liabilities are to be stated in that currency.

(3) Hedging transactions. [Reserved]

(4) Election not available if excessive hyperinflationary assets. The election to use the separate currency pools method of this paragraph (e) is not available if the value of the foreign corporation's U.S. assets denominated in a hyperinflationary currency, as defined in section 1.985-1, exceeds ten percent of the value of the foreign corporation's total U.S. assets. If a foreign corporation made a valid election to use the separate currency pools method in a prior year but no longer qualifies to use such method pursuant to this paragraph (e)(4), the taxpayer must use the method provided by paragraphs (b) through (d) of this section.

(5) Examples. The separate currency pools method of this paragraph (e) is illustrated by the following examples:

Example 1. Separate currency pools method.

(i) Facts.

(A) Bank Z, a resident of country X, has a branch in the United States through which it conducts its banking business. For its 1997 taxable year, Z has U.S. assets, as defined in paragraph (b) of this section, that are denominated in U.S. dollars and in U, the country X currency. Accordingly, Z's U.S. assets are as follows:

(B) Z's worldwide liabilities are also denominated in U.S. Dollars and in U. The average interest rates on Z's worldwide liabilities, including those in the United States, are 6% on its U.S. dollar liabilities, and 12% on its liabilities denominated in U. Assume that Z has properly elected to use its actual ratio of 95% to determine its U.S.-connected liabilities in Step 2, and has also properly elected to use the separate currency pools method provided in paragraph (e) of this section.

(ii)Determination of interest expense. Z determines the interest expense attributable to its U.S.-connected liabilities according to the steps described below.

(A) First, Z separates its U.S. assets into two currency pools, one denominated in U.S. dollars ($20,000) and the other denominated in U (U5,000).

(B) Second, Z multiplies each pool of assets by the applicable ratio of worldwide liabilities to assets, which in this case is 95%. Thus, Z has U.S.-connected liabilities of $19,000 ($20,000 x 95%), and U4750 (U5000 x 95%).

(C) Third, Z calculates its interest expense by multiplying each pool of its U.S.-connected liabilities by the relevant interest rates. Accordingly, Z's allocable interest expense for the year is $1140 ($19,000 x 6%), the sum of the expense associated with its U.S. dollar liabilities, plus U570 (U4750 x 12%), the interest expense associated with its liabilities denominated in U. Z must translate its interest expense denominated in U in accordance with the rules provided in section 988, and then must determine whether it is subject to any other provision of the Code that would disallow or defer any portion of its interest expense so determined.

Example 2. [Reserved]

(1) General rule. Except as provided in paragraph (f)(3) of this section, this section is applicable for tax years ending on or after August 15, 2009. A taxpayer, however, may choose to apply § 1.882-5T, rather than applying the regulations in this section, for any taxable year beginning on or after August 16, 2008, but before August 15, 2009.

(2) [Reserved]

(3) Applicability date for published rate election. Paragraphs (a)(7)(i) and (d)(5)(ii)(B) of this section apply to taxable years ending after June 30, 2023. For taxable years ending before July 1, 2023, see § 1.882-5(d)(5)(ii)(B) (as contained in 26 CFR part 1, revised as of April 1, 2023).