Allocation
of Interest Expense to Branch Income
Where
a foreign corporation operates its business in the US via
a branch structure, the income of the foreign corporation
that is effectively connected with the US trade or business
(“effectively connected income”; ECI) is subject
to US tax. In determining taxable income of the branch, the
IRC and the Treasury Regulations generally allow foreign
corporations to allocate all direct costs (e.g., cost of
goods sold) and reasonable amounts of indirect costs (e.g.,
overhead) against ECI. Special rules apply to determine the
amount of interest expense that may be deducted. These interest
allocation rules apply to foreign corporations that are banks
and to other foreign corporations. This summary focuses on
the rules applicable to foreign corporations that are not
banks.
The
calculation of the interest deduction is determined under
Treasury
Regulation § 1.882-5, which provides
the rules for allocating interest expense to the ECI of a
foreign corporation under one of two methods:
- the
adjusted US booked liabilities method
- the
elective separate currency pools method
Both methods involve a three-step calculation: 1. Determine the total value of US assets for the taxable
year
2. Determine the total amount of US connected liabilities
for the taxable year
3. Determine thee amount of interest expense allocable to
ECI.
Step 1: Determine the total value of US assets for the taxable
year
The
corporation must first determine the total value of its
assets that
generate, have generated, or could reasonably
be expected to generate income, gain, or loss effectively
connected with the conduct of a trade or business in the
US (“US assets”). The value of such assets for
this purpose is the average value of such assets for the
taxable year, which is determined using the most frequent,
regular interval for which information is reasonably available
for all assets; however, in no event should the value of
any asset be computed less frequently than semi-annually
(i.e., beginning, middle and end of year).
Generally, the value of a US asset is the adjusted basis
of the asset for determining gain or loss from its disposition.
Alternatively, the taxpayer may elect to value all US assets
on the basis of fair market value. If elected, the fair market
value must be used by the taxpayer for both step 1 and 2
of the calculation for all subsequent years, unless the taxpayer
obtains consent to change.
Step 2: Determine US Connected Liabilities
US connected liabilities are determined as a percentage
of the US assets as determined in step 1 above. The corporation
may use either a fixed percentage or a percentage based on
its actual worldwide liability-to-asset ratio. This choice
is made on the corporation's tax return for the first year
(or a portion thereof) in which it calculates an interest
deduction. The selected method must be used for a minimum
period of five years before a different method may be used.
For foreign corporations not engaged in a US banking business,
the fixed percentage is 50%
If
the corporation elects to use its actual percentage, the
percentage
is determined by dividing the average amount
of the taxpayer’s worldwide liabilities for the taxable
year by the average total value of its worldwide assets for
the taxable year. Such averages must be computed annually
(i.e., beginning and end of year) for any foreign corporations
other than a bank. The actual percentage may be calculated
in either US dollars or in the currency of the country in
which the head office of the corporation is located; however,
the worldwide assets and liabilities must be determined consistently
from year in accordance with US tax principles.
Step 3: Interest Expense Allocable to ECI The final step requires the corporation to determine the
allowable interest deduction, generally using one of two
methods:
- US
booked liabilities method
- Separate
currency pools method.
An election to use the separate currency pools method is
generally binding for five years.
US Booked Liabilities Method
The interest allocable to ECI under the US booked liabilities
method depends on whether the US connected liabilities are
less than or exceed the average US booked liabilities. The
average US booked liabilities should be determined at least
semi-annually. A liability, whether interest-bearing or not,
is a US booked liability if:
- The
liability is secured predominately by a US asset of
the foreign corporation
- The
foreign corporation enters the liability on a set of
books relating to the US branch at a time reasonably
contemporaneous
with the time at which the liability is incurred, or
- The
foreign corporation maintains a set of books and records
relating to the US branch activities and the District
Director or Assistant Commissioner determines there is
a direct relationship
between the liability and the US branch activity.
If the US booked liabilities exceed the US connected liabilities,
the US branch is considered to be net lender to the non-US
branches of the foreign corporation, and therefore it is
allowed a deduction for only a pro-rata portion of the interest
expense actually incurred. In this situation, the interest
expense allocable to the effectively connected income of
the branch is calculated as follows:
Interest
paid on US booked liabilities × US connected
liabilities
US
booked liabilities
If the US booked liabilities are less than the US connected
liabilities, the US branch is considered to be a net borrower
from the non-US branches of the foreign corporation, and
thus, in addition to the interest the US branch paid or accrued
to third parties, the US branch will obtain an interest deduction
related to the funds it is deemed to have borrowed from other
branches of the corporation. In this situation, the interest
expense allocable to the US branch is calculated as follows:
Interest
paid on US + (US connected liabilities – US
booked liabilities) × Interest rate on US dollar liabilities
of the booked liabilities foreign corporation booked outside
of US
The interest rate on the US dollar liabilities of the foreign
corporation booked outside of the US equals the total interest
expense paid on US dollar-denominated liabilities shown on
the books of the foreign corporation (excluding the US branch)
divided by the average US dollar-denominated liabilities
shown on such books.
(2) Separate Currency Pools Method
The
interest rates to be applied to the US connected liabilities
under
the separate currency pools method depend on the denomination
of the currencies in which the third party liabilities recorded
on the books of the US branch. The US connected liabilities
are divided into currency groupings proportionate to the
relative currency make-up of third party liabilities shown
on the books of the US branch. This applies whether the US
connected liabilities are greater or less than the US branch’s
third party liabilities. Each currency grouping of US-connected
liabilities is then multiplied by the corporation's average
worldwide interest rate for that particular currency grouping.
The total interest expense allowed is equal to the sum of
the separate interest deductions calculated for each currency.
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