On August 15, 2006, Treasury and the IRS issued temporary and proposed regulations (the "2006 regulations") that update the current rules (the "1996 regulations") for determining the interest expense deduction of foreign corporations that have branches in the United States. These regulations are critically important to foreign-based banks and other financial institutions that typically operate in branch form in the United States and that typically have significant amounts of interest expense, particularly if they also have significant intangible assets. The 2006 regulations seek to conform the apportionment rules with the "non-exclusive" approach taken in the recent U.S. income tax treaties with the U.K. and Japan, to resolve issues raised and preliminarily addressed in Notice 2005-53, and to make certain consistent modifications to the branch profits tax rules. These regulations are generally effective starting the tax year-end for which the original tax return due date (including extensions) is after August 17, 2006. Consequently, for calendar year taxpayers, the applicability date is for the taxable year ended December 31, 2006. In addition, except as noted below, the 2006 regulations provide an additional 180-day period to make certain elections on an amended return, provided the original return due date is not later than December 31, 2006.

1. Coordination of § 1.882-5 with U.S. tax treaties. In the preamble to the 1996 regulations, the government took the position that the regulations were fully consistent with then-existing treaty obligations and would be the exclusive mechanism for attributing interest expense to the business profits to a U.S. permanent establishment. Acknowledging that the 1996 regulations could produce inappropriate results, and implicitly in response to preliminary rulings in the National Westminster Bank case and to the OECD’s work on profits attribution to financial institution permanent establishments, the United States agreed to attribution provisions in treaties with the U.K. and Japan, which incorporated the principles of the OECD Transfer Pricing Guidelines. The application of these general principles would produce different results than the formulaic rules of the 1996 regulations. Consistent with these developments, the 2006 regulations allow the use of alternative apportionment principles, if expressly authorized under an applicable tax treaty.
    
2. Adoption of a 95% fixed ratio. The 2006 regulations also make some modifications to the three-step apportionment calculation for financial institutions that apply the formulaic rules of § 1.882-5. For banks, the 2006 regulations adopt a new fixed ratio of 95% in place of the current ratio of 93%, which is believed to better reflect current average banking-industry balance-sheet ratios. Foreign banks that are currently using the fixed ratio may use the new fixed ratio for the first year in which the original tax return due date (including extensions) is after August 17, 2006, or for any subsequent year. Foreign banks currently using the actual ratio may elect to use the new fixed ratio for the first year the 2006 regulations are effective, on either an original return or on an amended return filed within 180 days of the extended due date.
    
3. Expanded eligibility for use of the fixed ratio. Under the 1996 regulations, the fixed ratio election was only available to foreign banks that were engaged in a licensed U.S. banking business. The 2006 regulations expand eligibility for the fixed ratio election by allowing foreign banks to qualify as a "bank" on a worldwide basis, and without regard to whether it is engaged in a licensed U.S. banking business.
    
4. Restriction on FMV method. In addition, although taxpayers generally have the option to elect fair market or book value for valuing their U.S. assets, the 2006 regulations require a taxpayer electing the fair market value method to calculate U.S. connected liabilities using actual, as opposed to the fixed, ratio of U.S.-to-worldwide liabilities. This addresses the government’s concern that a bank’s fair market valuation of intangibles, when paired with the elective use of the fixed ratio, could give rise to a distorted apportionment. Note, taxpayers currently having both a fair market value election and a fixed ratio election are required to conform their elections to the new rules.
    
5. Amended definition of "U.S.-booked liabilities." The 1996 regulations defined "U.S.-booked liabilities" to include (for banks) liabilities recorded on the books of the U.S. trade or business, provided they were recorded contemporaneously with their acquisition; no tracing was required to link specific borrowings to specific effectively connected uses. The 2006 regulations clarify that, in the case of a bank, the liability must be recorded on a set of books of the U.S. trade or business that may include books maintained in a foreign branch. However, the liability must be recorded before the end of the day on which it is incurred and must be related to an activity that produces effective connected income.
    
6. Elective use of average LIBOR. Under the 1996 regulations, taxpayers allocating excess interest expense were required to apply the foreign bank’s average U.S.-dollar borrowing rate to the excess U.S.-connected liabilities. The 2006 regulations adopt the suggestion in Notice 2005-53, to allow foreign banks to elect use of a published 30-day average LIBOR rate, or to continue use of an actual U.S.-dollar borrowing rate. Note, the actual U.S.-dollar borrowing rate must be determined only with regard to U.S. dollar liabilities that are booked outside the United States and that do not constitute "U.S.-booked liabilities." 
    
7. Changes to the branch profit tax rules. The branch profits tax rules (section 884) make a formulary imputation of equity capital to a U.S. branch, under a method that treats a portion of reinvested earnings as debt-funded. The general effect of such treatment is a reduction in the foreign person’s "U.S. net equity" and, consequently, a taxable dividend-equivalent amount. A foreign person may elect to treat reinvested earnings as equity capital, as opposed to debt-funded capital, base don a calculation that references "U.S.-connected liabilities and "U.S. booked liabilities" under Treas. Reg. § 1.882-5. In order to align the two sets of rules more closely, the 2006 regulations permit a foreign person to reduce U.S. liabilities (but not below zero) to the extent necessary to prevent recognition of a dividend-equivalent amount.

Although the IRS and Treasury do not explicitly invite comments, the preamble to the 2006 regulations notes their continued consideration regarding the consistent application of Treas. Reg. § 1.882-5, the interaction of the expense apportionment rules with U.S. tax treaties, and the application of the branch profits tax under alternative rules for determining interest expense attributable to business profits. The Treasury and IRS are specifically soliciting comments regarding the allocation, sourcing, and apportionment of currency gain or loss from unhedged third-party borrowings, between effectively connected and non-effectively connected income. Taxpayers should begin assessing the potential value of the various elections discussed above, particularly in light of the ability to make limited retroactive elections. In addition, foreign banks that had not previously qualified for the fixed ratio election should consider whether they are eligible under the new rules.

For more information, please contact any of the following lawyers:

Rocco Femia, rfemia@milchev.com, 202-626-5823

Kimberly Tan Majure

The information contained in this communication is not intended as legal advice or as an opinion on specific facts. This information is not intended to create, and receipt of it does not constitute, a lawyer-client relationship. For more information, please contact one of the senders or your existing Miller & Chevalier lawyer contact. The invitation to contact the firm and its lawyers is not to be construed as a solicitation for legal work. Any new lawyer-client relationship will be confirmed in writing.

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