On February 19, 2016, the Internal Revenue Service (IRS) released a 30-plus-page practice unit regarding interest expense of a foreign corporation engaged in a U.S. trade or business. As is the case with all practice units, the IRS cautions that practice units are not official pronouncements of law or directives and cannot be used, cited or relied upon as such. Even so, the IRS generally acknowledges that practice units provide a general discussion of a concept, process or transaction. This can be helpful from a taxpayer’s perspective. This is especially true for interest expense allocation calculations under Treasury Regulation § 1.882-5, one of the more complicated calculations for taxpayers to make.
The practice unit begins with a graph that illustrates possible circumstances where the interest expense allocation process described in the practice unit can apply. The practice unit then breaks down the four steps for determining interest expense allocations. The four steps are:
- Determine the amount of U.S. assets.
- Determine the amount of U.S. booked liabilities.
- Determine what elections the taxpayer has made to compute the interest expense deduction.
- Calculate the allocable interest expense to the U.S. trade or business.
For each step, the practice unit delineates issues that should be considered and provides the regulatory citations and other sources that should be consulted in conjunction with the practice unit. For example, a taxpayer must determine what is included in the term “U.S. assets.” The practice unit provides the general rule that a U.S. asset generally means an asset held on the determination date if: (1) all income provided by the asset is (or would have been) effectively connected income (ECI) and (2) all gain from the disposition of the asset would be ECI if disposed of on the determination date. The practice unit also sets forth special rules whereby other assets may be treated as U.S. assets.
For each step, the practice unit also includes “audit tips.” These may be particularly helpful for taxpayers who can use the tips as a check against their calculations or to chart out an audit defense strategy. As an example, the IRS may confirm that if the taxpayer is making a fair market value election, the taxpayer is applying the election consistently to all assets on the balance sheet.
In addition, the practice unit provides related considerations including (1) the effects on the branch-level interest tax and branch-profits tax calculation, and (2) a reminder that in no event may the amount of interest expense exceed the amount of interest on indebtedness paid or accrued by the taxpayer within the taxable year.