Rev. Rul. 85-7

1985-1 C.B. 188, 1985-5 I.R.B. 28.

INCOME SOURCE; WITHIN U.S.; FOREIGN BANK; WORLDWIDE INTEREST EXPENSE

Published: February 4, 1985

Section 882.-Tax on Income of Foreign Corporations Connected With United States Business, 26 CFR 1.882-5: Determination of interest deduction.

(Also Section 861; 1.861-8; Part II, United States-Japan Income Tax Convention, 1973-1 C.B. 630.)

  Income source; within U.S.; foreign bank; worldwide interest expense. Section 1.882-5 of the Income Tax Regulations will apply to the determination of a foreign bank's worldwide interest expenses as a deduction under Art. 8(3) of the U.S.-Japan Income Tax Treaty for purposes of computing the U.S. taxable income of the bank's U.S. permanent establishment. Rev. Rul. 78-423 obsoleted.

ISSUE

  Does section 1.882-5 of the Income Tax Regulations apply to the determination of a foreign bank's worldwide interest expenses allowed as deductions under Article 8(3) of the United States-Japan Income Tax Convention (Convention) TIAS 7365, 1973-1 C.B. 630, for purposes of computing the U.S. taxable income of the bank's United States permanent establishment?

FACTS

  The taxpayer, P, is a foreign bank organized under the laws of Japan with its home office located in Japan. P has a United States branch, P-1, which is engaged in the banking business within the United States. P-1 is a permanent establishment of P in the United States. In March 1981, P-1 borrowed money within the United States for use in its banking operations. In September 1981, P borrowed money in Japan for use in its banking operations.

LAW AND ANALYSIS

  Article 8(1) of the Convention provides for the taxation by the United States of the industrial and commercial profits of a resident of Japan that are attributable to a permanent establishment in the United States.

  Article 8(2) of the Convention provides that there shall be attributed to the permanent establishment the industrial and commercial profits attributable to the permanent establishment as if it were an independent entity dealing wholly independently with the Japanese resident of which it is a permanent establishment.

  Article 8(3) of the Convention provides that in determining the industrial and commercial profits attributable to the permanent establishment, there shall be allowed as deductions expenses that are reasonably connected with such profits, whether incurred in the United States or elsewhere.

  Article 2(2) of the Convention provides that any term used in the Convention and not otherwise defined shall have the meaning which it has under the laws of that Contracting State relating to the taxes which are the subject of this Convention.

  Section 882(a) of the Code provides that a foreign corporation engaged in a trade or business within the United States during the taxable year is taxable only on its taxable income which is effectively connected with the conduct of a trade or business within the United States. In computing such taxable income, section 882(c) provides that deductions shall be allowed only if and to the extent that they are connected with income which is effectively connected with the conduct of a trade or business within the United States; and the proper apportionment and allocation of the deductions for this purpose shall be determined as provided in regulations prescribed by the Secretary.

  Section 1.861-8(e)(2) of the regulations prescribes rules for the allocation and apportionment of interest in the computation of taxable income from sources within the United States and from other sources.

  Section 1.882-5 of the regulations provides a three-step process for determining the interest deduction allowed a foreign corporation under section 882(c) of the Code.

  Section 1.882-5 of the regulations applies to periods after February 6, 1981, or, at the option of the taxpayer, to: (1) taxable years beginning after the last taxable year ending before February 6, 1981, or (2) all open taxable years beginning after 1976, or (3) all open taxable years. See T.D. 7939, 1984-1 C.B. 171.

  Rev. Rul. 78-423, 1978-2 C.B. 194, holds that Articles 8(1), 8(2), and 8(3) of the Convention do not affect the allocation and apportionment of a foreign bank's worldwide interest expense under section 1.861-8 of the regulations. Rev. Rul. 78-423 states that the Convention does not provide a specific rule for the allocation of expenses and that, in the absence of such a rule, Article 2(2) of the Convention indicates that the general domestic law of the United States is to be applied for determining the expenses 'reasonably connected' with the profits of a United States permanent establishment. Therefore, Rev. Rul. 78-423 applies the general allocation rule found in section 1.861-8 to the allocation and apportionment of a foreign bank's worldwide interest expense to a United States permanent establishment.

  Subsequent to the publication of Rev. Rul. 78-423, regulations applicable to foreign corporations were issued under section 882(c) of the Code. For periods to which it applies, section 1.882-5 of the regulations is the general domestic law of the United States to be applied in determining the interest expenses that are 'reasonably connected' with the profits of a U.S. permanent establishment. Therefore, section 1.882-5, rather than section 1.861-8, applies to determine the interest expenses that are 'reasonably connected' with the profits of a United States permanent establishment.

HOLDING

  Section 1.882-5 of the regulations applies to the determination of a foreign bank's worldwide interest expenses allowed as deductions under Article 8(3) of the Convention for purposes of computing the U.S. taxable income of the bank's United States permanent establishment.

EFFECT ON OTHER REVENUE RULINGS

  Rev. Rul. 78-423 is obsolete.

Rev. Rul. 85-7, 1985-1 C.B. 188, 1985-5 I.R.B. 28.