Allocable interest is initially defined as “any interest which is allocable to income which is effectively connected (or treated as effectively connected) with the conduct of a trade or business in the United States.” (§884(f)(2)) The regulations go on to define the amount of interest allocable to the branch as a function of the excess interest definition. In order to determine how much interest is considered to be in excess of the amount the branch paid, one subtracts the amount of interest paid by the branch and the amount of interest paid by any partnerships from the amount of interest defined as effectively connected in §1.882-5 modified by §1.884-1(e)(3). (§1.884-4(a)(2)) The amount described in §1.882-5 is the normal rules for determining the amount of interest deduction is effectively connected to a trade or business. The modification of §1-884-1(e)(3) is an election to reduce the amount of liabilities effectively connected to the trade or business. When elected, it also reduces the amount of interest allocated in a corresponding amount. Once this has been done, all effectively connected interest expenses become the allocable amount for the purpose of the branch interest tax.
Now that the amount allocable has been determined, one must calculated how much was ‘paid by the branch’. This amount, as stated above, is the amount that is deemed paid by a domestic corporation.
Interest Paid by the Branch
While the statute states that any amount paid by the branch is deemed paid by a domestic corporation, the regulations set forth tests that have nothing to do with the physical payment of the interest. Whether the interest is paid by the branch or by the foreign parent, is practically immaterial when determining if the branch paid the interest. The tests look more at the underlying nature of the liability. If the liability is considered to be a US booked liability, generally defined as secured mostly be US assets, then the branch pays the associated interest. (§1.884-4(b)(1)(i)(A))
The second test or requirement is if the liability is specifically identified as a liability of a US trade or business. (§1.884-4(b)(1)(ii)) For a liability to be identified as such, it must be reported as a US liability before the first interest payment is made or the foreign corporation’s income tax return is due, which ever occurs first (1.884-4(b)(1)(ii)), and the liability was not incurred during the ordinary course of a foreign business. (1.884-4(b)(1)(ii)(C)) Such liabilities cannot have associated interest payments that exceed 85% of the total excess interest, if this election were not made. (1.884-4(b)(1)(ii)(A)) And, the recipient of the interest payment, must be notified that the interest is US sourced. The liability cannot have been incurred during the normal course of a foreign business. (1.884-4(b)(1)(ii)(B))
The final test is based on the amount assets held by the branch in relation to the total assets held by the foreign corporation. If the branch holds 80% or more of the worldwide assets and produces 80% and more than 80% of the foreign corporation’s E&P basis, then all interest paid by the foreign corporation and the branch are treated as branch interest. (1.884-4(b)(5))