CFR > Title 26 - Internal Revenue > CHAPTER I—INTERNAL REVENUE SERVICE, DEPARTMENT OF THE TREASURY > SUBCHAPTER A—INCOME TAX (Parts 1–19) > PART 1—INCOME TAXES > 1.882-5—Determination of interest deduction.

1.882-5—Determination of interest deduction.

(a) (1) Overview— The amount of interest expense of a foreign corporation that is allocable under section 882(c) to income which is (or is treated as) effectively connected with the conduct of a trade or business within the United States (ECI) is the sum of the interest allocable by the foreign corporation under the three-step process set forth in paragraphs (b), (c), and (d) of this section and the specially allocated interest expense determined under paragraph (a)(1)(ii) of this section. The provisions of this section provide the exclusive rules for allocating interest expense to the ECI of a foreign corporation under section 882(c). Under the three-step process, the total value of the U.S. assets of a foreign corporation is first determined under paragraph (b) of this section (Step 1). Next, the amount of U.S.-connected liabilities is determined under paragraph (c) of this section (Step 2). Finally, the amount of interest paid or accrued on U.S.-booked liabilities, as determined under paragraph (d)(2) of this section, is adjusted for interest expense attributable to the difference between U.S.-connected liabilities and U.S.-booked liabilities (Step 3). Alternatively, a foreign corporation may elect to determine its interest rate on U.S.-connected liabilities by reference to its U.S. assets, using the separate currency pools method described in paragraph (e) of this section.
(ii) Direct allocations— (A) In general. A foreign corporation that has a U.S. asset and indebtedness that meet the requirements of § 1.861-10T (b) or (c), as limited by § 1.861-10T(d)(1), shall directly allocate interest expense from such indebtedness to income from such asset in the manner and to the extent provided in § 1.861-10T. For purposes of paragraph (b)(1) or (c)(2) of this section, a foreign corporation that allocates its interest expense under the direct allocation rule of this paragraph (a)(1)(ii)(A) shall reduce the basis of the asset that meets the requirements of § 1.861-10T (b) or (c) by the principal amount of the indebtedness that meets the requirements of § 1.861- 10T (b) or (c). The foreign corporation shall also disregard any indebtedness that meets the requirements of § 1.861-10T (b) or (c) in determining the amount of the foreign corporation's liabilities under paragraphs (c)(2) and (d)(2) of this section and shall not take into account any interest expense paid or accrued with respect to such a liability for purposes of paragraph (d) or (e) of this section.
(B) Partnership interest. A foreign corporation that is a partner in a partnership that has a U.S. asset and indebtedness that meet the requirements of § 1.861-10T (b) or (c), as limited by § 1.861-10T(d)(1), shall directly allocate its distributive share of interest expense from that indebtedness to its distributive share of income from that asset in the manner and to the extent provided in § 1.861-10T. A foreign corporation that allocates its distributive share of interest expense under the direct allocation rule of this paragraph (a)(1)(ii)(B) shall disregard any partnership indebtedness that meets the requirements of § 1.861-10T (b) or (c) in determining the amount of its distributive share of partnership liabilities for purposes of paragraphs (b)(1), (c)(2)(vi), and (d)(2)(vii) or (e)(1)(ii) of this section, and shall not take into account any partnership interest expense paid or accrued with respect to such a liability for purposes of paragraph (d) or (e) of this section. For purposes of paragraph (b)(1) of this section, a foreign corporation that directly allocates its distributive share of interest expense under this paragraph (a)(1)(ii)(B) shall—
(1) Reduce the partnership's basis in such asset by the amount of such indebtedness in allocating its basis in the partnership under § 1.884-1(d)(3)(ii); or
(2) Reduce the partnership's income from such asset by the partnership's interest expense from such indebtedness under § 1.884-1(d)(3)(iii).
(2) Coordination with tax treaties. Except as expressly provided by or pursuant to a U.S. income tax treaty or accompanying documents (such as an exchange of notes), the provisions of this section provide the exclusive rules for determining the interest expense attributable to the business profits of a permanent establishment under a U.S. income tax treaty.
(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 § 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 § 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 § 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 § 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 § 1.892-5T.
(7) Elections under (i) In general. A corporation must make each election provided in this section on the corporation's original timely filed Federal income tax return for the first taxable year it is subject to the rules of this section. An amended return does not qualify for this purpose, nor shall the provisions of § 301.9100-1 of this chapter and any guidance promulgated thereunder apply. Except as provided elsewhere in this section, each election under this section, whether an election for the first taxable year or a subsequent change of election, shall be made by indicating the method used on Schedule I (Form 1120-F) attached to the corporation's timely filed return. An elected method (other than the fair market value method under paragraph (b)(2)(ii) of this section, or the annual 30-day London Interbank Offered Rate (LIBOR) election in paragraph (d)(5)(ii) of this section) must be used for a minimum period of five years before the taxpayer may elect a different method. To change an election before the end of the requisite five-year period, a taxpayer must obtain the consent of the Commissioner or his delegate. The Commissioner or his delegate will generally consent to a taxpayer's request to change its election only in rare and unusual circumstances. After the five-year minimum period, an elected method may be changed for any subsequent year on the foreign corporation's original timely filed tax return for the first year to which the changed election applies.
(ii) Failure to make the proper election. If a taxpayer, for any reason, fails to make an election provided in this section in a timely fashion, the Director of Field Operations may make any or all of the elections provided in this section on behalf of the taxpayer, and such elections shall be binding as if made by the taxpayer.
(iii) Step 2 special election for banks. For the first taxable year for which an original income tax return is due (including extensions) after August 17, 2006, in which a taxpayer that is a bank as described in paragraph (c)(4) of this section is subject to the requirements of this section, a taxpayer may make a new election to use the fixed ratio on an original timely filed return. A new fixed ratio election may be made in any subsequent year subject to the timely filing and five-year minimum period requirements of paragraph (a)(7)(i) of this section. A new fixed ratio election under this paragraph (a)(7)(iii) is subject to the adjusted basis or fair market value conforming election requirements of paragraph (b)(2)(ii)(A)(2) of this section and may not be made if a taxpayer elects or maintains a fair market value election for purposes of paragraph (b) of this section. Taxpayers that already use the fixed ratio method under an existing election may continue to use the new fixed ratio at the higher percentage without having to make a new five-year election in the first year that the higher percentage is effective.
(8) Examples. The following examples illustrate the application of paragraph (a) of this section:

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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 200× to P in exchange for its partnership interest. P incurs qualified nonrecourse indebtedness within the meaning of § 1.861-10T to purchase an airplane. FC's share of the liability of P, as determined under section 752, is 800×.
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(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 800× liability as determined under section 752, but is not increased by the 800× 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 800× liability is disregarded for purposes of determining FC's liabilities under paragraphs (c)(2)(vi) and (d)(2)(vii) of this section.

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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 § 1.882-5 , notwithstanding the fact that FC has elected to use the 50% fixed ratio.

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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 § 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 § 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: [Please see PDF for Formula: ER08MR96.000 ] (iii) Therefore, FC deducts a total of $8 ($12-$4) of interest expense attributable to its effectively connected income in 1997.

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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 § 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 § 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 § 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: [Please see PDF for Formula: EC07OC91.029 ]
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(iii) Therefore, FC deducts a total of $450 ($500-$50) of interest expense attributable to its effectively connected income in 1997.
(b) Step 1: Determination of total value of U.S. assets for the taxable year— (1) Classification of an asset as a U.S. asset— Except as otherwise provided in this paragraph (b)(1), an asset is a U.S. asset for purposes of this section to the extent that it is a U.S. asset under § 1.884-1(d). For purposes of this section, the term determination date, as used in § 1.884-1(d), means each day for which the total value of U.S. assets is computed under paragraph (b)(3) of this section.
(ii) Items excluded from the definition of U.S. asset. For purposes of this section, the term U.S. asset excludes an asset to the extent it produces income or gain described in sections 883 (a)(3) and (b).
(iii) Items included in the definition of U.S. asset. For purposes of this section, the term U.S. asset includes—
(A) U.S. real property held in a wholly-owned domestic subsidiary of a foreign corporation that qualifies as a bank under section 585(a)(2)(B) (without regard to the second sentence thereof), provided that the real property would qualify as used in the foreign corporation's trade or business within the meaning of § 1.864-4(c) (2) or (3) if held directly by the foreign corporation and either was initially acquired through foreclosure or similar proceedings or is U.S. real property occupied by the foreign corporation (the value of which shall be adjusted by the amount of any indebtedness that is reflected in the value of the property);
(B) An asset that produces income treated as ECI under section 921(d) or 926(b) (relating to certain income of a FSC and certain dividends paid by a FSC to a foreign corporation);
(C) An asset that produces income treated as ECI under 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; and
(D) An asset that produces income treated as ECI under section 882(e) (relating to certain interest income of possessions banks).
(iv) Interbranch transactions. A transaction of any type between separate offices or branches of the same taxpayer does not create a U.S. asset.
(v) Assets acquired to increase U.S. assets artificially. An asset shall not be treated as a U.S. asset if one of the principal purposes for acquiring or using that asset is to increase artificially the U.S. assets of a foreign corporation on the determination date. Whether an asset is 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 a related person, and whether the aggregate value of the U.S. assets of the foreign corporation increased temporarily on or around the determination date. A purpose may be a principal purpose even though it is outweighed by other purposes (taken together or separately).
(2) Determination of the value of a U.S. asset— (i) General rule. The value of a U.S. asset is the adjusted basis of the asset for determining gain or loss from the sale or other disposition of that item, further adjusted as provided in paragraph (b)(2)(iii) of this section.
(ii) Fair-market value election—
(A) In general— (1) Fair market value conformity requirement. A taxpayer may elect to value all of its U.S. assets on the basis of fair market value, subject to the requirements of § 1.861-9T(g)(1)(iii), and provided the taxpayer is eligible and uses the actual ratio method under paragraph (c)(2) of this section and the methodology prescribed in § 1.861-9T(h). Once elected, the fair market value must be used by the taxpayer for both Step 1 and Step 2 described in paragraphs (b) and (c) of this section, and must be used in all subsequent taxable years unless the Commissioner or his delegate consents to a change.
(2) Conforming election requirement. Taxpayers that as of the effective date of this paragraph (b)(2)(ii)(A)(2) have elected and currently use both the fair market value method for purposes of paragraph (b) of this section and a fixed ratio for purposes of paragraph (c)(4) of this section must conform either the adjusted basis or fair market value methods in Step 1 and Step 2 of the allocation formula by making an adjusted basis election for paragraph (b) of this section purposes while continuing the fixed ratio for Step 2, or by making an actual ratio election under paragraph (c)(2) of this section while remaining on the fair market value method under paragraph (b) of this section. Taxpayers who elect to conform Step 1 and Step 2 of the formula to the adjusted basis method must remain on both methods for the minimum five-year period in accordance with the provisions of paragraph (a)(7) of this section. Taxpayers that elect to conform Step 1 and Step 2 of the formula to the fair market value method must remain on the actual ratio method until the consent of the Commissioner or his delegate is obtained to switch to the adjusted basis method. If consent to use the adjusted basis method in Step 1 is granted in a later year, the taxpayer must remain on the actual ratio method for the minimum five-year period unless consent to use the fixed ratio is independently obtained under the requirements of paragraph (a)(7) of this section. For the first taxable year for which an original income tax return is due (including extensions) after August 17, 2006, taxpayers that are required to make a conforming election under this paragraph (b)(2)(ii)(A)(2 ), may do so on an original timely filed return. If a conforming election is not made within the timeframe provided in this paragraph, the Director of Field Operations or his delegate may make the conforming elections in accordance with the provisions of paragraph (a)(7)(ii) of this section.
(B) Adjustment to partnership basis. If a partner makes a fair market value election under paragraph (b)(2)(ii) of this section, the value of the partner's interest in a partnership that is treated as an asset shall be the fair market value of his partnership interest, increased by the fair market value of the partner's share of the liabilities determined under paragraph (c)(2)(vi) of this section. See § 1.884-1(d)(3).
(iii) Reduction of total value of U.S. assets by amount of bad debt reserves under (A) In general. The total value of loans that qualify as U.S. assets shall be reduced by the amount of any reserve for bad debts additions to which are allowed as deductions under section 585.
(B) Example. The following example illustrates the provisions of paragraph (b)(2)(iii)(A) of this section:

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Example. Foreign banks; bad debt reserves. FC is a foreign corporation that qualifies as a bank under section 585(a)(2)(B) (without regard to the second sentence thereof), but is not a large bank as defined in section 585(c)(2). FC conducts business through a branch, B, in the United States. Among B's U.S. assets are a portfolio of loans with an adjusted basis of $500. FC accounts for its bad debts for U.S. federal income tax purposes under the reserve method, and B maintains a deductible reserve for bad debts of $50. Under paragraph (b)(2)(iii) of this section, the total value of FC's portfolio of loans is $450 ($500−$50).
(3) Computation of total value of U.S. assets— (i) General rule. The total value of U.S. assets for the taxable year is the average of the sums of the values (determined under paragraph (b)(2) of this section) of U.S. assets. For each U.S. asset, value shall be computed at the most frequent regular intervals for which data are reasonably available. In no event shall the value of any U.S. asset be computed less frequently than monthly (beginning of taxable year and monthly thereafter) by a large bank (as defined in section 585(c)(2)) or a dealer in securities (within the meaning of section 475) and semi-annually (beginning, middle and end of taxable year) by any other taxpayer.
(ii) Adjustment to basis of financial instruments. For purposes of determining the total average value of U.S. assets in this paragraph (b)(3), the value of a security or contract that is marked to market pursuant to section 475 or section 1256 shall be determined as if each determination date is the most frequent regular interval for which data are reasonably available that reflects the taxpayer's consistent business practices for reflecting mark-to-market valuations on its books and records.
(c) Step 2: Determination of total amount of U.S.-connected liabilities for the taxable year— (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) Computation of the actual ratio— (i) In general. A taxpayer's actual ratio for the taxable year is the total amount of its worldwide liabilities for the taxable year divided by the total value of its worldwide assets for the taxable year. The total amount of worldwide liabilities and the total value of worldwide assets for the taxable year is the average of the sums of the amounts of the taxpayer's worldwide liabilities and the values of its worldwide assets (determined under paragraphs (c)(2) (iii) and (iv) of this section). In each case, the sums must be computed semi-annually (beginning, middle and end of taxable year) by a large bank (as defined in section 585(c)(2)) and annually (beginning and end of taxable year) by any other taxpayer.
(ii) Classification of items. The classification of an item as a liability or an asset must be consistent from year to year and in accordance with U.S. tax principles.
(iii) Determination of amount of worldwide liabilities. The amount of a liability must be determined consistently from year to year and must be substantially in accordance with U.S. tax principles. To be substantially in accordance with U.S. tax principles, the principles used to determine the amount of a liability must not differ from U.S. tax principles to a degree that will materially affect the value of taxpayer's worldwide liabilities or the taxpayer's actual ratio.
(iv) Determination of value of worldwide assets. The value of an asset must be determined consistently from year to year and must be substantially in accordance with U.S. tax principles. To be substantially in accordance with U.S. tax principles, the principles used to determine the value of an asset must not differ from U.S. tax principles to a degree that will materially affect the value of the taxpayer's worldwide assets or the taxpayer's actual ratio. The value of an asset is the adjusted basis of that asset for determining the gain or loss from the sale or other disposition of that asset, adjusted in the same manner as the basis of U.S. assets are adjusted under paragraphs (b)(2) (ii) through (iv) of this section. The rules of paragraph (b)(3) of this section apply in determining the total value of applicable worldwide assets for the taxable year, except that the minimum number of determination dates are those stated in paragraph (c)(2)(i) of this section.
(v) Hedging transactions. [Reserved]
(vi) Treatment of partnership interests and liabilities. For purposes of computing the actual ratio, the value of a partner's interest in a partnership that will be treated as an asset is the partner's adjusted basis in its partnership interest, reduced by the partner's share of liabilities of the partnership as determined under section 752 and increased by the partner's share of liabilities determined under this paragraph (c)(2)(vi). If the partner has made a fair market value election under paragraph (b)(2)(ii) of this section, the value of its interest in the partnership shall be increased by the fair market value of the partner's share of the liabilities determined under this paragraph (c)(2)(vi). For purposes of this section a partner shares in any liability of a partnership in the same proportion that it shares, for income tax purposes, in the expense attributable to that liability for the taxable year. A partner's adjusted basis in a partnership interest cannot be less than zero.
(vii) Computation of actual ratio of insurance companies. [Reserved]
(viii) Interbranch transactions. A transaction of any type between separate offices or branches of the same taxpayer does not create an asset or a liability.
(ix) Amounts must be expressed in a single currency. The actual ratio must be computed in either U.S. dollars or the functional currency of the home office of the taxpayer, and that currency must be used consistently from year to year. For example, a taxpayer that determines the actual ratio annually using British pounds converted at the spot rate for financial reporting purposes must translate the U.S. dollar values of assets and amounts of liabilities of the U.S. trade or business into pounds using the spot rate on the last day of its taxable year. The district director or the Assistant Commissioner (International) may require that the actual ratio be computed in dollars if the functional currency of the taxpayer's home office is a hyperinflationary currency, as defined in § 1.985-1, that materially distorts 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:

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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.

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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.

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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.

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Example 4. [Reserved]

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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.
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(d) Step 3: Determination of amount of interest expense allocable to ECI under the adjusted U.S. booked liabilities method— (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— (i) In general. A liability is a U.S. booked liability if it is properly reflected on the books of the U.S. trade or business, within the meaning of paragraph (d)(2)(ii) or (iii) of this section.
(ii) Properly reflected on the books of the U.S. trade or business of a foreign corporation that is not a bank— (A) In general. A liability, whether interest bearing or non-interest bearing, is properly reflected on the books of the U.S. trade or business of a foreign corporation that is not a bank as described in section 585(a)(2)(B) (without regard to the second sentence thereof) if—
(1) The liability is secured predominantly by a U.S. asset of the foreign corporation;
(2) The foreign corporation enters the liability on a set of books reasonably contemporaneously with the time at which the liability is incurred and the liability relates to an activity that produces ECI.
(3) The foreign corporation maintains a set of books and records relating to an activity that produces ECI and the Director of Field Operations determines that there is a direct connection or relationship between the liability and that activity. Whether there is a direct connection between the liability and an activity that produces ECI depends on the facts and circumstances of each case.
(B) Identified liabilities not properly reflected. A liability is not properly reflected on the books of the U.S. trade or business merely because a foreign corporation identifies the liability pursuant to § 1.884-4(b)(1) ((ii) and (b)(3).
(iii) Properly reflected on the books of the U.S. trade or business of a foreign corporation that is a bank—
(A) In general. A liability, whether interest bearing or non-interest bearing, is properly reflected on the books of the U.S. trade or business of a foreign corporation that is a bank as described in section 585(a)(2)(B) (without regard to the second sentence thereof) if—
(1) The bank enters the liability on a set of books before the close of the day on which the liability is incurred, and the liability relates to an activity that produces ECI; and
(2) There is a direct connection or relationship between the liability and that activity. Whether there is a direct connection between the liability and an activity that produces ECI depends on the facts and circumstances of each case. For example, a liability that is used to fund an interbranch or other asset that produces non-ECI may have a direct connection to an ECI producing activity and may constitute a U.S.-booked liability if both the interbranch or non-ECI activity is the same type of activity in which ECI assets are also reflected on the set of books (for example, lending or money market interbank placements), and such ECI activities are not de minimis. Such U.S. booked liabilities may still be subject to paragraph (d)(2)(v) of this section.
(B) Inadvertent error. If a bank fails to enter a liability in the books of the activity that produces ECI before the close of the day on which the liability was incurred, the liability may be treated as a U.S. booked liability only if, under the facts and circumstances, the taxpayer demonstrates a direct connection or relationship between the liability and the activity that produces ECI and the failure to enter the liability in those books was due to inadvertent error.
(iv) Liabilities of insurance companies. [Reserved]
(v) Liabilities used to increase artificially interest expense on U.S. booked liabilities. U.S. booked liabilities shall not include a liability if one of the principal purposes for incurring or holding the liability is to increase artificially the interest expense on the U.S. booked liabilities of a foreign corporation. Whether a liability is incurred or held for the purpose of artificially increasing interest expense will depend upon all the facts and circumstances of each case. Factors to be considered in determining whether one of the principal purposes for incurring or holding a liability is to increase artificially the interest expense on U.S. booked liabilities of a foreign corporation include whether the interest expense on the liability is excessive when compared to other liabilities of the foreign corporation denominated in the same currency and whether the currency denomination of the liabilities of the U.S. branch substantially matches the currency denomination of the U.S. branch's assets. A purpose may be a principal purpose even though it is outweighed by other purposes (taken together or separately).
(vi) Hedging transactions. [Reserved]
(vii) Amount of U.S. booked liabilities of a partner. A partner's share of liabilities of a partnership is considered a booked liability of the partner provided that it is properly reflected on the books (within the meaning of paragraph (d)(2)(ii) of this section) of the U.S. trade or business of the partnership.
(viii) Interbranch transactions. A transaction of any type between separate offices or branches of the same taxpayer does not result in the creation of a liability.
(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— (i) In general. If the average total amount of U.S. booked liabilities (as determined in paragraphs (d)(2) and (3) of this section) exceeds the amount of U.S.-connected liabilities (as determined under paragraph (c) of this section (Step 2)), the interest expense allocable to ECI is the product of the total amount of interest paid or accrued within the taxable year by the U.S. trade or business on U.S. booked liabilities and the scaling ratio set out in paragraph (d)(4)(ii) of this section. For purposes of this section, the reduction resulting from the application of the scaling ratio is applied pro-rata to all interest expense paid or accrued by the foreign corporation. A similar reduction in income, expense, gain, or loss from a hedging transaction (as described in paragraph (d)(2)(vi) of this section) must also be determined by multiplying such income, expense, gain, or loss by the scaling ratio. If the average total amount of U.S. booked liabilities (as determined in paragraph (d)(3) of this section) equals the amount of U.S.-connected liabilities (as determined under Step 2 ), the interest expense allocable to ECI is the total amount of interest paid or accrued within the taxable year by the U.S. trade or business on U.S. booked liabilities.
(ii) Scaling ratio. For purposes of this section, the scaling ratio is a fraction the numerator of which is the amount of U.S.-connected liabilities and the denominator of which is the average total amount of U.S. booked liabilities.
(iii) Special rules for insurance companies. [Reserved]
(5) U.S.-connected interest rate where U.S. booked liabilities are less than U.S.-connected liabilities— (i) In general. If the amount of U.S.-connected liabilities (as