this section (Step 2)) exceeds the average total amount of U.S. booked liabilities, 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, plus the excess of the amount of U.S.-connected liabilities over the average total amount of U.S. booked liabilities multiplied by the interest rate determined under paragraph (d)(5)(ii) of this section.

(ii) Interest rate on excess U.S.-connected liabilities. The applicable interest rate on excess U.S.-connected liabilities is determined by dividing the total interest expense paid or accrued for the taxable year on U.S.-dollar liabilities shown on the books of the offices or branches of the foreign corporation outside the United States by the average U.S.-dollar denominated liabilities (whether interest-bearing or not) shown on the books of the offices or branches of the foreign corporation outside the United States for the taxable year.

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

Example 1. Computation 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 whollyowned 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 × 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 × 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 × 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 +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 3⁄4 ($300 + $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]

(e) Separate currency pools method-(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.

(i) Determine the value of U.S. assets in each currency pool. First, the foreign corporation must determine the amount of its U.S. assets, using the methodology in paragraph (b) of this section, in each currency pool. The foreign corporation may convert into U.S. dollars any currency pool in which the foreign corporation holds less than 3% of its U.S. assets. A transaction (or transactions) that hedges a U.S. asset shall be taken into account for purposes of determining the currency denomination and the value of the U.S. asset.

(ii) Determine the U.S.-connected liabilities in each currency pool. Second, the foreign corporation must determine the amount of its U.S.-connected liabilities in each currency pool by mul

tiplying the amount of U.S. assets (as determined under paragraph (b)(3) of this section) in the currency pool by the foreign corporation's actual ratio (as determined under paragraph (c)(2) of this section) for the taxable year or, if the taxpayer has made an election in accordance with paragraph (c)(4) of this section, by the fixed ratio.

(iii) Determine the interest expense attributable to each currency pool. Third, the foreign corporation must determine the interest expense attributable to each currency pool by multiplying the U.S.-connected liabilities in each currency pool by the prescribed interest rate as defined in paragraph (e)(2) of this section.

(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]

а

(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 hyperinflationary currency, as defined in §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

(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]

(f) Effective date-(1) General rule. This section is effective for taxable years beginning on or after June 6, 1996.

(2) Special rules for financial products. [Reserved]

[T.D. 8658, 61 FR 9329, Mar. 8, 1996; 61 FR 15891, Apr. 10, 1996]

§1.883-1 Exclusions from gross income

of foreign corporations.

(a) Earnings of foreign ships or aircraft (1) Basic rule. So much of the income from sources within the United

States of a foreign corporation as consists of earnings derived from the operation of a ship or ships documented, or of aircraft registered, under the laws of a foreign country which grants an equivalent exemption to citizens of the United States nonresident in that foreign country and to corporations organized in the United States shall not be included in gross income.

(2) Equivalent exemption-(i) Ships. A foreign country which either imposes no income tax, or, in imposing that tax, exempts from taxation so much of the income of a citizen of the United States nonresident in that foreign country and of a corporation organized in the United States as consists of earnings derived from the operation of a ship or ships documented under the laws of the United States is considered as granting an equivalent exemption for purposes of the exclusion from gross income of the earnings of a foreign ship or ships.

(ii) Aircraft. A foreign country which either imposes no income tax, or, in imposing that tax, exempts from taxation so much of the income of a citizen of the United States nonresident in that foreign country and of a corporation organized in the United States as consists of earnings derived from the operation of aircraft registered under the laws of the United States is considered as granting an equivalent exemption for purposes of the exclusion from gross income of the earnings of foreign aircraft.

(b) Income tax conventions. Generally, income of any kind which is exempt, under the provisions of an income tax convention to which the United States is a party, from any tax imposed by subtitle A (relating to income taxes) is not included in the gross income of a foreign corporation. However, see paragraph (a) of §1.894-1 for certain exceptions to this rule. Income on any tax which imposed by such subtitle is limited by an income tax convention is included in the gross income of a foreign corporation if it is not otherwise excluded from gross income. For the determination of the tax when the taxpayer has income upon which the tax is limited by an income tax convention, see § 1.871-12.

(c) Other exclusions. Income which is from sources without the United States, as determined under the provisions of sections 861 through 863 and the regulations thereunder, is not included in the gross income of a foreign corporation unless such income is effectively connected for the taxable year with the conduct of a trade or business in the United States by that corporation. To determine specific exclusions in the case of other items which are from sources within the United States, see the applicable sections of the Code. For special rules under a tax convention for determining the sources of income and for excluding, from gross income, income from sources without the United States which is effectively connected with the conduct of a trade or business in the United States, see the applicable tax convention. For determining which income from sources without the United States is effectively connected with the conduct of a trade or business within the United States see section 864(c)(4) and §1.864-5.

(d) Effective date. This section applies for taxable years beginning after December 31, 1966. For corresponding rules applicable to taxable years beginning before January 1, 1967, see 26 CFR 1.883-1 (Revised as of January 1, 1971). [T.D. 6500, 25 FR 11910, Nov. 26, 1960, as amended by T.D. 7293, 38 FR 32799, Nov. 28, 1973; 38 FR 34203, Dec. 12, 1973]

§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 September 11, 1992, 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, §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 §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 form, 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

194-088 D-01--14

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 §1.8844(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 §§1.884–1 through 1.884-5.

$1.884-1 Branch profits tax.

(a) General rule.

(b) Dividend equivalent amount.

(1) Definition.

(2) Adjustment for increase in U.S. net equity.

(3) Adjustment for decrease in U.S. net equity.

(4) Examples.

(c) U.S. net equity.

(1) Definition.

(2) Definition of amount of a U.S. asset.

(3) Definition of determination date.

(d) U.S. assets.

(1) Definition of a U.S. asset.

(2) Special rules for certain assets.

(3) Interest in a partnership.

(4) Interest in a trust or estate.

(5) Property that is not a U.S. asset.

(6) E&P basis of a U.S. asset.

(e) U.S. liabilities.

(1) Liabilities based on §1.882-5.

(2) Insurance reserves.

(3) Election to reduce liabilities.