Final Regulation

Page 1

Treasury Decisions
Copyright 2007 LexisNexis Group, All Rights Reserved
DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Part 1
57 FR 13019
Allocation and Apportionment of Interest Expense
T.D. 8410
DATE: April 15, 1992
ACTION: Final regulations.
SUMMARY: This document contains final Income Tax Regulations relating to the allocation and apportionment of
interest expense for purposes of computing taxable income from sources within and without the United States. The final
regulations require that, in certain circumstances, third party interest expense of an affiliated group of corporations be
allocated directly to foreign source income. These final regulations implement section 864(e) of the Internal Revenue
Code of 1986.
DATES:
EFFECTIVE DATE: These regulations are effective for and apply to taxable years beginning after December 31, 1991.
However, at the choice of the taxpayer, these regulations may be applied to taxable years beginning after December 31,
1987.Display Classification Information Display Classification Information Display Classification Information Display
Classification Information Display Classification Information Display Classification Information Display Classification
Information
ADDRESSES:
FOR FURTHER INFORMATION CONTACT: Judith Cavell of the Office of Associate Chief Counsel (International),
within the Office of Chief Counsel, Internal Revenue Service, 1111 Constitution Avenue, NW., Washington, DC 20224,
Attention: CC:CORP:T:R (INTL-0952-86) (202-566-6442, not a toll-free call).
SUPPLEMENTARY INFORMATION:
Background
Proposed regulations which would have implemented section 864(e) of the Internal Revenue Code of 1986 were
published in the Federal Register at 52 FR 34580 on September 11, 1987. Those proposed regulations were withdrawn
and replaced by temporary regulations and a notice of proposed rulemaking by cross-reference to temporary regulations

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published on September 14, 1988, in the Federal Register at 53 FR 35525 and 53 FR 35467, respectively.
On March 12, 1991, the Federal Register published proposed regulation § 1.861-10(e) withdrawing and replacing
the earlier regulation § 1.861-10(e) proposed by cross-reference, but not withdrawing and replacing the corresponding
temporary regulation § 1.861-10T(e). Written comments responding to this latest notice were received, and a public
hearing was held on June 21, 1991. The Treasury Department hereby issues final regulation § 1.861-10(e), which
incorporates, where appropriate, comments concerning the proposed regulations.
Explanation of Provisions
A. Summary of Regulation
Section 1.861-10(e) provides generally that a U.S. affiliated group ("U.S. group") which has both excess loans to
related controlled foreign corporations ("excess related group indebtedness") and excess borrowing by the U.S. group
from unrelated parties ("excess U.S. shareholder indebtedness") in the same taxable year must allocate directly to
foreign source income an amount of interest expense equal to the amount of interest income received by the U.S. group
with respect to excess related group indebtedness (or, if smaller, an amount of related group indebtedness equal to the
amount of excess of U.S. shareholder indebtedness).
Section 1.861-10(e) employs a three-step process. In Step One, a U.S. group determines the amount of excess
related group indebtedness (if any) for the current year by comparing its actual related group indebtedness for the year
to the amount of allowable related group indebtedness for the year. The amount of allowable related group indebtedness
is determined by multiplying the aggregate asset value of all related controlled foreign corporations (the "related CFC
group") by the foreign base period ratio for the year. The foreign base period ratio for any taxable year is the average of
the ratios of related group indebtedness to related CFC group assets for each of the five immediately preceding years.
In Step Two, the U.S. group determines the amount of excess of U.S. shareholder indebtedness (if any) for the
current year by comparing its actual U.S. shareholder indebtedness for the year to the amount of allowable U.S.
shareholder indebtedness for the year. The amount of allowable U.S. shareholder indebtedness is determined by
multiplying the aggregate asset value of the U.S. group by the U.S. base period ratio for the year. The U.S. base period
ratio for any taxable year is the average of the ratios of U.S. shareholder indebtedness to U.S. group assets for each of
the five immediately preceding years.
In Step Three, the U.S. group compares the Step One amount of excess related group indebtedness and the Step
Two amount of excess U.S. shareholder indebtedness. The amount of "allocable related group indebtedness" is the
smaller of the two amounts. Interest expense, in an amount equal to the amount of interest income received by the U.S.
group on allocable related group indebtedness, must be allocated directly to foreign source income of the U.S. group.
This interest expense is allocated to separate limitation categories for purposes of section 904(d) in proportion to the
amounts of related group indebtedness held by the U.S. group in each category. Several safe harbor rules and other
special rules are provided. In addition, § 1.861-10(e)(9) provides rules for the application of § 1.861-10(e) by start-up
companies and in the context of corporate acquisitions, dispositions and section 355 distributions.
B. Significant Comments and Revisions
Under § 1.861-10 (e)(2)(v)(A) and (e)(3)(v)(A), the foreign and U.S. base periods for any taxable year consist of
the five immediately preceding taxable years. Under § 1.861-10 (e)(2)(v)(B) and (e)(3)(v)(B), U.S. group may choose,
as its initial base years, the five years consisting of the 1982 taxable year through the 1986 taxable year. Under §
1.861-10 (e)(2)(v)(C) and (e)(3)(v)(C), a taxpayer that chooses to apply § 1.861-10(e) only with respect to taxable years
beginning after December 31, 1991 and that does not choose the initial base years described in § 1.861-10 (e)(2)(v)(B)
and (e)(3)(v)(B) may not include the taxable year immediately preceding the first effective taxable year within any base
period. Section 1.861-10 (e)(2)(v)(D) and (e)(3)(v)(D) clarify that the same initial base years must be chosen for the
foreign base period ratio and the U.S. base period ratio, and § 1.861-10 (e)(2)(iv) and (e)(3)(iv) have been revised to

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clarify that the 110 percent limitations imposed by those sections do not apply with respect to each of the five initial
base years.
Several commenters suggested that the foreign and U.S. base period ratios be calculated on a "weighted average"
basis. Under this method, the sum of the amounts of related group indebtedness or U.S. shareholder indebtedness for
each of the five base years would be divided by the sum of the aggregate values of related CFC group assets or U.S.
group assets, respectively, for each of the five base years. This method would effectively give greater weight to years in
which asset values are relatively large. The suggested method might thus be viewed as beneficial for some taxpayers
with growing domestic and foreign operations, since it would give greater weight to more recent years. However, it
could also penalize some taxpayers whose domestic or foreign operations are decreasing in size by giving less weight to
more recent years. The method of § 1.861-10 (e)(2)(iv) and (e)(3)(iv) gives equal weight to each base year and thus
results in a more accurate approximation of the average level of each indebtedness-to-asset ratio during the base period.
Several commenters suggested that direct allocation of interest expense be required only when a taxpayer's actual
amounts of related group indebtedness and U.S. shareholder indebtedness vary from its amounts of allowable related
group indebtedness and allowable U.S. shareholder indebtedness, respectively, by a specified percentage (e.g., by 10
percent). The commenters noted in particular that exchange rate fluctuation may cause uncontrollable fluctuations in
either or both of the two indebtedness-to-asset ratios. This suggestion was not adopted. The comparison of current yeas
amounts of related group and U.S. shareholder indebtedness to allowable amounts computed on the basis of average
historical indebtedness-to-asset ratios (rather than absolute amounts for a prior year) is intended to accommodate
year-to-year changes in the relevant indebtedness amounts for other than tax reasons. In addition, the translation rules
provided in § 1.861-10(e)(8)(i) should prevent any fluctuation in either inidebtedness-to-asset ratio that is due solely to
exchange rate fluctuations, and the provisions of § 1.861-10(e)(9) should accommodate fluctuations caused by
significant corporate events.
Section 1.861-10(e)(2)(iv) provides that, for purposes of computing the foreign base period ratio for any taxable
year, the ratio of related group indebtedness to related CFC group assets for any base year may not exceed 110 percent
of the foreign base period ratio for that base year. Section 1.861-10(e)(3)(iv) provides a corresponding limitation with
respect to the U.S. base period ratio. Several commenters stated that limitations of 110 percent place taxpayers with
initially low foreign and U.S. base period ratios at a disadvantage, relative to taxpayers with initially high base period
ratios. These commenters argued that a higher percentage limitation would reduce this disadvantage and better
accommodate non-abusive transactions. This suggestion has not been adopted, because the Service believes that a 110
percent limitation provides sufficient flexibility for gradual adjustments in the foreign and U.S. base period ratios and
that the rules of § 1.861-10 (e)(9) sufficiently accommodate significant corporate events. To reduce the potential for
disadvantage of taxpayers with initially low base period ratios, § 1.861-10 (e)(2)(iv) and (e)(3)(iv) have been amended
to provide that the 110 percent limitation does not apply with respect to any base period year for which the relevant
indebtedness-to-asset ratio does not exceed 0.10.
A number of commenters suggested that, for purposes of computing the foreign base period ratio, the ratio of
related group indebtedness to related CFC group assets taken into account for any base year be no less than 90 percent
of the foreign base period ratio for that base year. A corresponding limitation was suggested with respect to the U.S.
base period ratio. The commenters argued that these additional limitations were necessary to counterbalance the
restrictive effect of the 110 percent limitations imposed by § 1.861-10 (e)(2)(iv) and (e)(3)(iv). This suggestion was not
adopted. The 110 percent limitations of § 1.861-10 (e)(2)(iv) and (e)(3)(iv) are necessary to prevent avoidance of §
1.861-10 (e). As anti-avoidance rules, they provide no rationale for the inclusion of reciprocal rules beneficial to the
taxpayer. In addition, the Service believes that the suggested 90% limitation would have effectively preserved any
relative advantage now enjoyed by taxpayers with initially high foreign and U.S. base period ratios.
Redundant "safe harbor" language of proposed § 1.861-10 (e)(2)(vii)(B) and (e)(3)(vii) has been eliminated. In
response to taxpayer comments, a new safe harbor has been added to § 1.861-10(e)(3)(vii) under which a U.S. group is
considered to have no excess U.S. shareholder indebtedness in any taxable year in which its ratio of U.S. shareholder

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indebtedness to U.S. group assets does not exceed 0.10. This new safe harbor is intended to relieve taxpayers who, by
virtue of having historically low U.S. base period ratios, may trigger the application of § 1.861-10(e) with minimal
fluctuations in U.S. group borrowing. A suggestion that a higher safe harbor ratio be provided in § 1.861-10
(e)(2)(vii)(B) was not adopted.
A number of commenters argued that the foreign base period ratio used in determining excess related group
indebtedness under § 1.861-10 (e)(2)(i) for any taxable year should be no less than 0.10 (the safe harbor ratio provided
in § 1.861-10 (e)(2)(vii)(B) ). It was suggested that this rule would avoid disparate treatment of taxpayers with foreign
base period ratios slightly lower than 0.10 and taxpayers with foreign base period ratios slightly higher than 0.10. This
suggestion assumes incorrectly, however, that the safe harbor of § 1.861-10 (e)(2)(vii)(B) is intended to provide all
taxpayers with an exemption from direct allocation for related group indebtedness in an amount equal to 10 percent of
the value of related CFC group assets. In fact, the safe harbor rule is intended only to relieve taxpayers with relatively
low levels of related group indebtedness from the computational burdens of § 1.861-10 (e). The Service believes that
revised § 1.861-10 (e)(2)(iv), under which the 110 percent limitation imposed by paragraph (e)(2)(iv) does not apply
with respect to base years in which the ratio of related group indebtedness to related CFC group assets does not exceed
0.10, will mitigate any potential disparity in the treatment of taxpayers with foreign base period ratios slightly higher
and slightly lower, respectively, than 0.10. The new safe harbor rule of § 1.861-10 (e)(3)(vii), and revised § 1.861-10
(e)(3)(iv), will operate in an analogous manner with respect to the ratio of U.S. shareholder indebtedness to U.S. group
assets.
Several commenters recommended that the aggregate value of U.S. group assets used to compute allowable U.S.
shareholder indebtedness under § 1.861-10(e)(3)(iii)(A) not be reduced by the amount of excess related group
indebtedness for the year (as determined under Step One in § 1.861-10(e)(2)). This suggestion has not been adopted,
because this reduction is necessary to effectuate a dollar-for-dollar matching of disproportionate U.S. shareholder
indebtedness to excess related group indebtedness under § 1.861-10(e)(4).
In response to taxpayer comments, § 1.861-10(e)(6) has been revised to provide that the aggregate asset value of a
related CFC for any taxable year may be determined by reference to the asset values reflected on a Form 5471 (or
attachment thereto) filed for such taxable year. Form 5471 asset values must be used consistently, however, for all
related CFCs and for all taxable years. In addition, Form 5471 asset values may be used only if the taxable year of each
related CFC begins with, or no more than one month earlier than, the taxable year of the U.S. group. Beginning of year
asset values, whether for a related CFC or for the U.S. group, are the same as the corresponding asset values as of the
end of the immediately preceding year.
Several commenters suggested that a provision similar to the fixed stock writeoff method provided in proposed
regulation § 1.163(j)-5(e) be added to §1.861-10(e) to accommodate the acquisition of a related CFC or U.S. group
member by means of a stock acquisition for which a section 338 election is not made. The commenters noted that a
stock acquisition of this type can result in a substantial, non-abusive increase in the relevant indebtedness-to-asset ratio
for a U.S. group that values assets by reference to tax book value (rather than fair market value). The suggested
modification was not adopted. However, the Service intends to consider the proper treatment of such stock acquisitions
in the context of forthcoming final regulations under section 864(e) relating to the allocation and apportionment of
interest expense.
In response to taxpayer comments, § 1.861-10(e)(8)(i) has been added to provide that all amounts of related group
indebtedness and U.S. shareholder indebtedness and all related CFC group and U.S. group asset values that are
denominated in a currency other than U.S. dollars are to be translated into dollars at an average exchange rate for the
current taxable year. This translation rule applies with respect to indebtedness amounts and asset values for each of the
five base years, as well as to amounts and values for the current year, and thus will require taxpayers to redetermine
base year indebtedness amounts and asset values on an annual basis. Use of a current year exchange rate to translate all
non-dollar amounts should prevent the application of § 1.861-10(e) to any taxpayer solely by virtue of exchange rate
fluctuations.

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Although proposed § 1.861-10(e)(8)(i) has been deleted, the Service will apply, for purposes of § 1.861-10(e), the
definition of "indebtedness" contained in § 1.861-13T(a)(3). The Service anticipates that final regulations forthcoming
under section 864(e) will incorporate a definition of "indebtedness" similar to that of § 1.861-13T(a)(3) and applicable
for all purposes of the regulations under section 864(e).
Section § 1.861-10(e)(8)(iii) has been added to clarify that indebtedness which qualifies for direct allocation of
interest expense under § 1.861-10T (b) or (c) is excluded from related group indebtedness or U.S. shareholder
indebtedness, and the value of any asset which is the subject of qualified non-recourse indebtedness under §
1.861-10T(b) or an integrated financial transaction under § 1.861-10T(c) is excluded from the aggregate asset value of
the related CFC group or the U.S. group. Exempt assets (within the meaning of § 1.861-8T(d)) are included, however,
in determining aggregate asset values under § 1.861-10(e)(8)(ii).
New § 1.861-10(e)(8)(iv) has been added to clarify that receivables arising between related CFCs (or between
members of the U.S. group) do not constitute assets of the related CFC (or U.S. group member) holding such
receivables.
The special reclassification rule of § 1.861-10(e)(8)(v) has been revised to apply in the context of multiple tiers of
CFCs. Section 1.861-10(e)(8)(vi) clarifies that its special reclassification rule does not apply to CFC stock that gives
rise to a CFC deduction for dividends paid under an integrated tax system.
Several commenters suggested that § 1.861-10(e)(9)(i) provide a higher presumed ratio of related group
indebtedness to related CFC group assets for base years in which a U.S. group holds no related CFC stock. This
suggestion has not been adopted.
Several commenters requested additional guidance under § 1.861-10(e)(9)(iii)(A) and (v)(A) as to the manner in
which the values of assets acquired or divested near the end or beginning of a year should be weighted to avoid
substantial distortions. These sections have been revised to clarify that the Service is concerned only with transactions
occurring within three months of the end or beginning of a year. While the appropriate weighting method will vary,
depending upon the facts of a particular situation, one method likely to produce reasonable results in many situations
would be to prorate asset values acquired or divested within three months of the end or beginning of a year.
The separate group acquisition and disposition elections of proposed § 1.861-10(e)(9) (iv) and (vi) have been
replaced with new elections under which taxpayers may recompute base period ratios as if acquired (or divested)
corporations had (or had not) been members of the taxpayer's U.S. group or related CFC group at the beginning of the
acquisition (or disposition) year and during base years prior to the acquisition (or disposition) year. The Service believes
that these new elections will be less complex to apply and will provide greater relief.
Several commenters suggested that relief be provided in § 1.861-10(e)(9) for acquisitions and dispositions of
substantial assets. This suggestion was not adopted, in view of the many options available to taxpayers in structuring
asset transactions. As a result, specific relief provisions would be prohibitively complex to contruct and administer. In
addition, because taxpayers have greater flexibility in structuring asset transactions, relief provisions are less necessary
in this context than in the context of stock transactions.
Commenters on the alternative version of Step Two described in the preamble to the proposed regulations
suggested that this alternative be available on an elective basis. This suggestion was not adopted.
Special Analyses
It has been determined that these rules are not major rules as defined in Executive Order 12291. Therefore, a
Regulatory Impact Analysis is not required. It also has been determined that section 553(b) of the Administrative
Procedure Act (5 U.S.C. chapter 5) and the Regulatory Flexibility Act (5 U.S.C chapter 6) do not apply to these
regulations, and therefore, a final Regulatory Flexibility Analysis is not required. Pursuant to section 7805(f) of the

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Internal Revenue Code, the proposed regulations were submitted to the Administrator of the Small Business
Administration for comment on their impact on small business.
Drafting Information
The principal author of these regulations is Judith Cavell of the Office of the Associate Chief Counsel
(International), within the Office of Chief Counsel, Internal Revenue Service. Other personnel from the Internal
Revenue Service and Treasury Department participated in developing the regulations.
List of Subjects in 26 CFR 1.861-1 Through 1.864-12
Income taxes, United States investments abroad.
Adoption of Amendments to the Regulations
Accordingly, 26 CFR part 1 is amended as follows:
PART 1 -- INCOME TAX: TAXABLE YEARS BEGINNING AFTER DECEMBER 31, 1953
Paragraph 1. The authority citation for part 1 is amended by adding the following citation:
Authority: 26 U.S.C. 7805 * * *
Section 1.861-10(e) also issued under 26 U.S.C. 863(a), 26 U.S.C. 864(e), 26 U.S.C. 865(i) and 26 U.S.C. 7701(f).
***
Par. 2. Section 1.861-10 is added to read as follows:
§ 1.861-10 Special allocations of interest expense.
(a) through (d). [Reserved]
(e) Treatment of certain related group indebtedness -- (1) In general. If, for any taxable year beginning after
December 31, 1991, a U.S. shareholder (as defined in paragraph (e)(5)(i) of this section) has both -(i) Excess related group indebtedness (as determined under Step One in paragraph (e)(2) of this section) and
(ii) Excess U.S. shareholder indebtedness (as determined under Step Two in paragraph (e)(3) of this section),
the U.S. shareholder shall allocate, to its gross income in the various separate limitation categories described
in section 904(d)(1), a portion of its interest expense paid or accrued to any obligee who is not a member of the
affiliated group (as defined in § 1.861-11T(d)) of the U.S. shareholder ("third party interest expense"), excluding
amounts allocated under paragraphs (b) and (c) of § 1.861-10T. The amount of third party interest expense so
allocated shall equal the total amount of interest income derived by the U.S. shareholder during the year from
related group indebtedness, multiplied by the ratio of the lesser of the foregoing two amounts of excess
indebtedness for the year to related group indebtedness for the year. This amount of third party interest expense
is allocated as described in Step Three in paragraph (e)(4) of this section.
(2) Step One: Excess related group indebtedness. (i) The excess related group indebtedness of a U.S. shareholder
for the year equals the amount by which its related group indebtedness for the year exceeds its allowable related group
indebtedness for the year.
(ii) The "related group indebtedness" of the U.S. shareholder is the average of the aggregate amounts at the
beginning and end of the year of indebtedness owed to the U.S. shareholder by each controlled foreign corporation

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which is a related person (as defined in paragraph (e)(5)(ii) of this section) with respect to the U.S. shareholder.
(iii) The "allowable related group indebtedness" of a U.S. shareholder for the year equals -(A) The average of the aggregate values at the beginning and end of the year of the assets (including stock holdings
in and obligations of related persons, other than related controlled foreign corporations) of each related controlled
foreign corporation, multiplied by
(B) The foreign base period ratio of the U.S. shareholder for the year.
(iv) The "foreign base period ratio" of the U.S. shareholder for the year is the average of the related group
debt-to-asset ratios of the U.S. shareholder for each taxable year comprising the foreign base period for the current year
(each a "base year"). For this purpose, however, the related group debt-to-asset ratio of the U.S. shareholder for any
base year may not exceed 110 percent of the foreign base period ratio for that base year. This limitation shall not apply
with respect to any of the five taxable years chosen as initial base years by the U.S. shareholder under paragraph
(e)(2)(v) of this section or with respect to any base year for which the related group debt-to-asset ratio does not exceed
0.10.
(v)(A) The foreign base period for any current taxable year (except as described in paragraphs (e)(2)(v) (B) and (C)
of this section) shall consist of the five taxable years immediately preceding the current year.
(B) The U.S. shareholder may choose as foreign base periods for all of its first five taxable years for which this
paragraph (e) is effective the following alternative base periods:
(1) For the first effective taxable year, the 1982, 1983, 1984, 1985 and 1986 taxable years;
(2) For the second effective taxable year, the 1983, 1984, 1985 and 1986 taxable years and the first effective
taxable year;
(3) For the third effective taxable year, the 1984, 1985 and 1986 taxable years and the first and second effective
taxable years;
(4) For the fourth effective taxable year, the 1985 and 1986 taxable years and the first, second and third effective
taxable years; and
(5) For the fifth effective taxable year, the 1986 taxable year and the first, second, third and fourth effective taxable
years.
(C) If, however, the U.S. shareholder does not choose, under paragraph (e)(10)(ii) of this section, to apply this
paragraph (e) to one or more taxable years beginning before January 1, 1992, the U.S. shareholder may not include
within any foreign base period the taxable year immediately preceding the first effective taxable year. Thus, for
example, a U.S. shareholder for which the first effective taxable year is the taxable year beginning on October 1, 1992,
may not include the taxable year beginning on October 1, 1991, in any foreign base period. Assuming that the U.S.
shareholder does not elect the alternative base periods described in paragraph (e)(2)(v)(B) of this section, the initial
foreign base period for the U.S. shareholder will consist of the taxable years beginning on October 1 of 1986, 1987,
1988, 1989, and 1990. The foreign base period for the U.S. shareholder for the following taxable year, beginning on
October 1, 1993, will consist of the taxable years beginning on October 1 of 1987, 1988, 1989, 1990, and 1992.
(D) If the U.S. shareholder chooses the base periods described in paragraph (e)(2)(v)(B) of this section as foreign
base periods, it must make a similar election under paragraph (e)(3)(v)(B) of this section with respect to its U.S. base
periods.
(vi) The "related group debt-to-asset ratio" of a U.S. shareholder for a year is the ratio between --

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(A) The related group indebtedness of the U.S. shareholder for the year (as determined under paragraph (e)(2)(ii) of
this section); and
(B) The average of the aggregate values at the beginning and end of the year of the assets (including stock holdings
in and obligations of related persons, other than related controlled foreign corporations) of each related controlled
foreign corporation.
(vii) Notwithstanding paragraph (e)(2)(i) of this section, a U.S. shareholder is considered to have no excess related
group indebtedness for the year if -(A) Its related group indebtedness for the year does not exceed its allowable related group indebtedness for the
immediately preceding year (as determined under paragraph (e)(2)(iii) of this section); or
(B) Its related group debt-to-asset ratio (as determined under paragraph (e)(2)(vi) of this section) for the year does
not exceed 0.10.
(3) Step Two: Excess U.S. shareholder indebtedness. (i) The excess indebtedness of a U.S. shareholder for the year
equals the amount by which its unaffiliated indebtedness for the year exceeds its allowable indebtedness for the year.
(ii) The "unaffiliated indebtedness of the U.S. shareholder is the average of the aggregate amounts at the beginning
and end of the year of indebtedness owed by the U.S. shareholder to any obligee, other than a member of the affiliated
group (as defined § 1.861-11T(d)) of the U.S shareholder.
(iii) The "allowable indebtedness" of a U.S. shareholder for the year equals -(A) The average of the aggregate values at the beginning and end of the year of the assets of the U.S. shareholder
(including stock holdings in and obligations of related controlled foreign corporations, but excluding stock holdings in
the obligations of members of the affiliated group (as defined in § 1.861-11T(d)) of the U.S. shareholder), reduced by
the amount of the excess related group indebtedness of the U.S. shareholder for the year (as determined under Step One
in paragraph (e)(2) of this section), multiplied by
(B) The U.S. base period ratio of the U.S. shareholder for the year.
(iv) The "U.S. base period ratio" of the U.S. shareholder for the year is the average of the debt-to-asset ratios of the
U.S. shareholder for each taxable year comprising the U.S. base period for the current year (each a "base year"). For this
purpose, however, the debt-to-asset ratio of the U.S. shareholder for any base year may not exceed 110 percent of the
U.S. base period ratio for that base year. This limitation shall not apply with respect to any of the five taxable years
chosen as initial base years by the U.S. shareholder under paragraph (e)(3)(v) of this section or with respect to any base
year for which of the debt-to-asset ratio does not exceed 0.10.
(v)(A) The U.S. base period for any current taxable year (except as described in paragraphs (e)(3)(v) (B) and (C) of
this section) shall consist of the five taxable years immediately preceding the current year.
(B) The U.S. shareholder may choose as U.S. base periods for all of its first five taxable years for which this
paragraph (e) is effective the following alternative base periods:
(1) For the first effective taxable year, the 1982, 1983, 1984, 1985 and 1986 taxable years;
(2) For the second effective taxable year, the 1983, 1984, 1985 and 1986 taxable years and the first effective
taxable year;
(3) For the third effective taxable year, the 1984, 1985 and 1986 taxable years and the first and second effective
taxable years;

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(4) For the fourth effective taxable year, the 1985 and 1986 taxable years and the first, second and third effective
taxable years; and
(5) For the fifth effective taxable year, the 1986 taxable year and the first, second, third and fourth effective taxable
years.
(C) If, however, the U.S. shareholder does not choose, under paragraph (e)(10)(ii) of this section, to apply this
paragraph (e) to one or more taxable years beginning before January 1, 1992, the U.S. shareholder may not include
within any U.S. base period the taxable year immediately preceding the first effective taxable year. Thus, for example, a
U.S. shareholder for which the first effective taxable year is the taxable year beginning on October 1, 1992, may not
include the taxable year beginning on October 1, 1991, in any U.S. base period. Assuming that the U.S. shareholder
does not elect the alternative base periods described in paragraph (e)(3)(v)(B) of this section, the initial U.S. base period
for the U.S. shareholder will consist of the taxable years beginning on October 1, of 1986, 1987, 1988, 1989, and 1990.
The U.S. base period for the U.S. shareholder for the following taxable year, beginning on October 1, 1993, will consist
of the taxable years beginning on October 1, 1987, 1988, 1989, 1990, and 1992.
(D) If the U.S. shareholder chooses the base periods described in paragraph (e)(3)(v)(B) of this section as U.S. base
periods, it must make a similar election under paragraph (e)(2)(v)(B) of this section with respect to its foreign base
periods.
(vi) The "debt-to-asset ratio" of a U.S. shareholder for a year is the ratio between -(A) The unaffiliated indebtedness of the U.S. shareholder for the year (as determined under paragraph (e)(3)(ii) of
this section); and
(B) The average of the aggregate values at the beginning and end of the year of the assets of the U.S. shareholder.
For this purpose, the assets of the U.S. shareholder include stock holdings in and obligations of related controlled
foreign corporations but do not include stock holdings in and obligations of members of the affiliated group (as defined
in § 1.861-11T(d)).
(vii) A U.S. shareholder is considered to have no excess indebtedness for the year if its debt-to-asset ratio (as
determined under paragraph (e)(3)(vi) of this section) for the year does not exceed 0.10.
(4) Step Three: Allocation of third party interest expense. (i) A U.S. shareholder shall allocate to its gross income in
the various separate limitation categories described in section 904(d)(1) a portion of its third party interest expense
incurred during the year equal in amount to the interest income derived by the U.S. shareholder during the year from
allocable related group indebtedness.
(ii) The "allocable related group indebtedness" of a U.S. shareholder for any year is an amount of related group
indebtedness equal to the lesser of -(A) The excess related group indebtedness of the U.S. shareholder for the year (determined under Step One in
paragraph (e)(2) of this section); or
(B) The excess U.S. shareholder indebtedness for the year (determined under Step Two in paragraph (e)(3) of this
section).
(iii) The amount of interest income derived by a U.S. shareholder from allocable related group indebtedness during
the year equals the total amount of interest income derived by the U.S. shareholder during the year with respect to
related group indebtedness, multiplied by the ratio of allocable related group indebtedness for the year to the aggregate
amount of related group indebtedness for the year.

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T.D. 8410

(iv) The portion of third party interest expense described in paragraph (e)(4)(i) of this section shall be allocated in
proportion to the relative average amounts of related group indebtedness held by the U.S. shareholder in each separate
limitation category during the year. The remaining portion of third party interest expense of the U.S. shareholder for the
year shall be apportioned as provided in §§ 1.861-8T through 1.861-13T, excluding paragraph (e) of § 1.861-10T and
this paragraph (e).
(v) The average amount of related group indebtedness held by the U.S. shareholder in each separate limitation
category during the year equals the average of the aggregate amounts of such indebtedness in each separate limitation
category at the beginning and end of the year. Solely for purposes of this paragraph (e)(4), each debt obligation of a
related controlled foreign corporation held by the U.S. shareholder at the beginning or end of the year is attributed to
separate limitation categories in the same manner as the stock of the obligor would be attributed under the rules of §
1.861-12T(c)(3), whether or not such stock is held directly by the U.S. shareholder.
(vi) The amount of third party interest expense of a U.S. shareholder allocated pursuant to this paragraph (e)(4)
shall not exceed the total amount of the third party interest expense of the U.S. shareholder for the year (excluding any
third party interest expense allocated under paragraphs (b) and (c) of § 1.861-10T).
(5) Definitions. For purposes of this paragraph (e), the following terms shall have the following meanings.
(i) U.S. shareholder. The term "U.S. shareholder" has the same meaning as the term "United States shareholder"
when used in section 957, except that, in the case of a United States shareholder that is a member of an affiliated group
(as defined in § 1.861-11T(d)), the entire affiliated group is considered to constitute a single U.S. shareholder.
(ii) Related person. For the definition of the term "related person", see § 1.861-8T(c)(2). A controlled foreign
corporation is considered "related" to a U.S. shareholder if it is a related person with respect to the U.S. shareholder.
(6) Determination of asset values. A U.S. shareholder shall determine the values of the assets of each related
controlled foreign corporation (for purposes of Step One in paragraph (e)(2) of this section) and the assets of the U.S.
shareholder (for purposes of Step Two in paragraph (e)(3) of this section) for any year in accordance with the valuation
method (tax book value of fair market value) elected for that year pursuant to § 1.861-9T(g). However, solely for
purposes of this paragraph (e), a U.S. shareholder may instead choose to determine the values of the assets of all related
controlled foreign corporations by reference to their values as reflected on Forms 5471 (the annual information return
with respect to each related controlled foreign corporation), subject to the translation rules of paragraph (e)(8)(i) of this
section. This method of valuation may be used only if the taxable years of each of the related controlled foreign
corporations begin with, or no more than one month earlier than, the taxable year of the U.S. shareholder. Once chosen
for a taxable year, this method of valuation must be used in each subsequent taxable year and may be changed only with
the consent of the Commissioner.
(7) Adjustments to asset value. For purposes of apportioning remaining interest expense under § 1.861-9T, a U.S.
shareholder shall reduce (but not below zero) the value of its assets for the year (as determined under § 1.861-9T (g) (3)
or (h)) by an amount equal to the allocable related group indebtedness of the U.S. shareholder for the year (as
determined under Step Three in paragraph (e)(4)(ii) of this section). This reduction is allocated among assets in each
separate limitation category in proportion to the average amount of related group indebtedness held by the U.S.
shareholder in each separate limitation category during the year (as determined under Step Three in paragraph (e)(4)(v)
of this section).
(8) Special rules -- (i) Exchange rates. All indebtedness amounts and asset values (including current year and base
year amounts and values) denominated in a foreign currency shall be translated into U.S. dollars at the exchange rate for
the current year. The exchange rate for the current year may be determined under any reasonable method (e.g., average
of month-end exchange rates for each month in the current year) if it is consistently applied to the current year and all
base years. Once chosen for a taxable year, a method for determining an exchange rate must be used in each subsequent

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T.D. 8410

taxable year and will be treated as a method of accounting for purposes of section 446. A taxpayer may apply a different
translation rule only with the prior consent of the Commissioner. In this regard, the Commissioner will be guided by the
extent to which a different rule would reduce the comparability of dollar amounts of indebtedness and dollar asset
values for the base years and the current year.
(ii) Exempt assets. Solely for purposes of this paragraph (e), any exempt assets otherwise excluded under section
864(e)(3) and § 1.861-8T(d) shall be included as assets of the U.S. shareholder or related controlled foreign corporation.
(iii) Exclusion of certain directly allocated indebtedness and assets. Qualified nonrecourse indebtedness (as defined
in § 1.861-10T(b)(2)) and indebtedness incurred in connection with an integrated financial transaction (as defined in §
1.861-10T(c)(2)) shall be excluded from U.S. shareholder indebtedness and related group indebtedness. In addition,
assets which are the subject of qualified nonrecourse indebtedness or integrated financial transactions shall be excluded
from the assets of the U.S. shareholder and each related controlled foreign corporation.
(iv) Exclusion of certain receivables. Receivables between related controlled foreign corporations (or between
members of the affiliated group constituting the U.S. shareholder) shall be excluded from the assets of the related
controlled foreign corporation (or affiliated group member) holding such receivables. See also § 1.861-11T(e)(1).
(v) Classification of certain loans as related group indebtedness. If -(A) A U.S. shareholder owns stock in a related controlled foreign corporation which is a resident of a country that
-(1) Does not impose a withholding tax of 5 percent or more upon payments of dividends to a U.S. shareholder; and
(2) Does not, for the taxable year of the controlled foreign corporation, subject the income of the controlled foreign
corporation to an income tax which is greater than that percentage specified under § 1.954-1T(d)(1)(i) of the maximum
rate of tax specified under section 11 of the Code, and
(B) The controlled foreign corporation has outstanding a loan or loans to one or more other related controlled
foreign corporations, or the controlled foreign corporation has made a direct or indirect capital contribution to one or
more other related controlled foreign corporations which have outstanding a loan or loans to one or more other related
controlled foreign corporations,
then, to the extent of the aggregate amount of its capital contributions in taxable years beginning after
December 31, 1986, to the related controlled foreign corporation that made such loans or additional
contributions, the U.S. shareholder itself shall be treated as having made the loans decribed in paragraph
(e)(8)(v)(B) of this section and, thus, such loan amounts shall be considered related group indebtedness.
However, for purposes of paragraph (e)(4) of this section, interest income derived by the U.S. shareholder during
the year from related group indebtedness shall not include any income derived with respect to the U.S.
shareholder's ownership of stock in the related controlled foreign corporation that made such loans or additional
contributions.
(vi) Classification of certain stock as related person indebtedness. In determining the amount of its related group
indebtedness for any taxable year, a U.S. shareholder must treat as related group indebtedness its holding of stock in a
related controlled foreign corporation if, during such taxable year, such related controlled foreign corporation claims a
deduction for interest under foreign law for distributions on such stock. However, for purposes of paragraph (e)(4) of
this section, interest income derived by the U.S. shareholder during the year from related group indebtedness shall not
include any income derived with respect to the U.S. shareholder's ownership of stock in the related controlled foreign
corporation.
(9) Corporate events -- (i) Initial acquisition of a controlled foreign corporation. If the foreign base period of the

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T.D. 8410

U.S. shareholder for any year includes a base year in which the U.S. shareholder did not hold stock in any related
controlled foreign corporation, then, in computing the foreign base period ratio, the related group debt-to-asset ratio of
the U.S. shareholder for any such base year shall be deemed to be 0.10.
(ii) Incorporation of U.S. shareholder -- (A) Nonapplication. This paragraph (e) does not apply to the first taxable
year of the U.S. shareholder. However, this paragraph (e) does apply to all following years, including years in which
later members of the affiliated group may be incorporated.
(B) Foreign and U.S. base period ratios. In computing the foreign and U.S. base period ratios, the foreign and U.S.
base periods of the U.S. shareholder shall be considered to be only the period prior to the current year that the U.S.
shareholder was in existence if this prior period is less than five taxable years.
(iii) Acquisition of additional corporations. (A) If a U.S. shareholder acquires (directly or indirectly) stock of a
foreign or domestic corporation which, by reason of the acquisition, then becomes a related controlled foreign
corporation or a member of the affiliated group, then in determining excess related group indebtedness or excess U.S.
shareholder indebtedness, the indebtedness and assets of the acquired corporation shall be taken into account only at the
end of the acquisition year and in following years. Thus, amounts of indebtedness and assets and the various
debt-to-asset ratios of the U.S. shareholder existing at the beginning of the acquisition year or relating to preceding
years are not recalculated to take account of indebtedness and assets of the acquired corporation existing as of dates
before the end of the year. If, however, a major acquisition is made within the last three months of the year and a
substantial distortion of values for the year would otherwise result, the taxpaper must take into account the average
values of the acquired indebtedness and assets weighted to reflect the time such indebtedness is owed and such assets
are held by the taxpayer during the year.
(B) In the case of a reverse acquisition subject to this paragraph (e)(9), the rules of § 1.1502-75(d)(3) apply in
determining which corporations are the acquiring and acquired corporations. For this purpose, whether corporations are
affiliated is determined under § 1.861-11T(d).
(C) If the stock of a U.S. shareholder is acquired by (and, by reason of such acquisition, the U.S. shareholder
becomes affiliated with) a corporation described below, then such U.S. shareholder shall be considered to have acquired
such corporation for purposes of the application of the rules of this paragraph (e). A corporation to which this paragraph
(e)(9)(iii)(C) applies is -(1) A corporation which is not affiliated with any other corporation (other than other similarly described
corporation); and
(2) Substantially all of the assets of which consist of cash, securities and stock.
(iv) Election to compute base period ratios by including acquired corporations. A U.S. shareholder may choose,
solely for purposes of paragraph (e)(9) (i) and (iii) of this section, to compute its foreign and U.S. base period ratios for
the acquisition year and all subsequent years by taking into account the indebtedness and asset values of the acquired
corporation or corporations (including related group indebtedness owed to a former U.S. shareholder) at the beginning
of the acquisition year and in each of the five base years preceding the acquisition year. This election, if made for an
acquisition, must be made for all other acquisitions occurring during the same taxable year or initiated in that year and
concluded in the following year.
(v) Dispositions. If a U.S. shareholder disposes of stock of a foreign or domestic corporation which, by reason of
the disposition, then ceases to be a related controlled foreign corporation or a member of the affiliated group (unless
liquidated or merged into a related corporation), in determining excess related group indebtedness or excess U.S.
shareholder indebtedness, the indebtedness and assets of the divested corporation shall be taken into account only at the
beginning of the disposition year and for the relevant preceding years. Thus, amounts of indebtedness and assets and the
various debt-to-asset ratios of the U.S. shareholder existing at the end of the year or relating to following years are not

Page 13
T.D. 8410

affected by indebtedness and assets of the divested corporation existing as of dates after the beginning of the year. If,
however, a major disposition is made within the first three months of the year and a substantial distortion of values for
the year would otherwise result, the taxpayer must take into account the average values of the divested indebtedness and
assets weighted to reflect the time such indebtedness is owed and such assets are held by the taxpayer during the year.
(vi) Election to compute base period ratios by excluding divested corporations. A U.S. shareholder may choose,
solely for purposes of paragraph (e) (9) (v) and (vii) of this section, to compute its foreign and U.S. base period ratios
for the disposition year and all subsequent years without taking into account the indebtedness and asset values of the
divested corporation or corporations at the beginning of the disposition year and in each of the five base years preceding
the disposition year. This election, if made for a disposition, must be made for all other dispositions occurring during
the same taxable year or initiated in that year and concluded in the following year.
(vii) Section 355 transactions. A U.S. corporation which becomes a separate U.S. shareholder as a result of a
distribution of its stock to which section 355 applies shall be considered -(A) As disposed of by the U.S. shareholder of the affiliated group of which the distributing corporation is a
member, with this disposition subject to the rules of paragraphs (e) (9) (v) and (vi) of this section; and
(B) As having the same related group debt-to-asset ratio and debt-to-asset ratio as the distributing U.S. shareholder
in each year preceding the year of distribution for purposes of applying this paragraph (e) to the year of distibution and
subsequent years of the distributed corporation.
(10) Effective date -- (i) Taxable years beginning after December 31, 1991. The provisions of this paragraph (e)
apply to all taxable years beginning after December 31,1991.
(ii) Taxable years beginning after December 31, 1987 and before January 1, 1992. The provisions of § 1.861-10T
(e) apply to taxable years beginning after December 31, 1987, and before January 1, 1992. The taxpayer may elect to
apply the provisions of this paragraph (e) (in lieu of the provisions of § 1.861-10T (e)) for any taxable year beginning
after December 31, 1987, but this paragraph (e) must then be applied to all subsequent taxable years.
(11) The following example illustrates the provisions of this paragraph (e):
Example. (i) Facts. X, a domestic corporation, elects to apply this paragraph (e) to its 1990 tax year. X has a
calendar taxable year and apportions its interest expense on the basis of the tax book value of its assets. In 1990, X
incurred deductible third-party interest expense of $24,960 on an average amount of indebtedness (determined on the
basis of beginning-of-year and end-of-year amounts) of $249,600. X manufactures widgets, all of which are sold in the
United States. X owns all of the stock of Y, a controlled foreign corporation that also has a calendar taxable year and is
also engaged in the manufacture and sale of widgets. Y has no earnings and profits or deficit of earnings and profits
attributable to taxable years prior to 1987. X's total assets and their average tax book values (determined on the basis of
beginning-of-year and end-of-year tax book values) for 1990 are:

Asset

Average
tax book
value

Plant and equipment

$315,000

Corporate headquarters

60,000

Y stock

75,000

Page 14
T.D. 8410

Y note

50,000

Total

500,000

Y had $25,000 of income before the deduction of any interest expense. Of this total, $5,000 is high withholding tax
interest income. The remaining $20,000 is derived from widget sales, and constitutes foreign source general limitation
income. Assume that Y has no deductions from gross income other than interest expense. During 1990, Y paid $5,000
of interest expense to X on the Y note and $10,000 of interest expense to third parties, giving Y total interest expense of
$15,000. X elects pursuant to § 1.861-9T to apportion Y's interest expense under the gross income method prescribed in
section 1.861-9T (j).
(ii) Step 1: Using a beginning and end of year average, X (the U.S. shareholder) held the following average
amounts of indebtedness of Y and Y had the following average asset values:

1985
(A) Related group indebtedness

1986-88

1989

1990

$11,000

24,000

26,000

50,000

100,000

200,000

200,000

250,000

.11

.12

.13

.20

(B) Average Value of Assets of Related
CFC
(C) Related Group Debt-to-Asset Ratio

(1) X's "foreign base period ratio" for 1990, an average of its ratios of related group indebtedness to related group
assets for 1985 through 1989, is:
(.11+.12+.12+.12+.13)/5=.12
(2) X's "allowable related group indebtedness" for 1990 is:
$250,000 X .12=$30,000.
(2) X's "excess related group indebtedness" for 1990 is:
$50,000-X. 12=$30,000
X's related group indebtedness of $50,000 for 1990 is greater than its allowable related group indebtedness of
$24,000 for 1989 (assuming a foreign base period ratio in 1989 of .12), and X's related group debt-to-asset ratio for
1990 is .20, which is greater than the ratio of .10 described in paragraph (e)(2)(vii)(B) of this section. Therefore, X's
excess related group indebtedness for 1990 remains at 20,000.
(iii) Step 2: Using a beginning and end of year average, X has the following average amounts of U.S. and foreign
indebtedness and average asset values:
1985

1986

1987

1988

1989

1990

Page 15
T.D. 8410

(1)

$231,400

225,000

225,000

225,000

220,800

249,600

(2)

445,000

450,000

450,000

450,000

460,000

480,000
(a)

(3)

.52

.50

.50

.50

.48

.52

(1) U.S. and foreign indebtedness
(2) Average value of assets of U.S. shareholder
(3) Debt-to-Asset ratio of U.S. shareholder
(a) [500,000-20,000 (excess related group indebtedness determined in Step 1)]
X's "U.S. base period ratio" for 1990 is:
(.52+.50+.50+.50+.48)/5=.50
X's "allowable indebtedness" for 1990 is:
$480,000 X .50=$240,000
X's "excess U.S. shareholder indebtedness" for 1990 is:
$249,000-$240,000=$9,600
X's debt-to-asset ratio for 1990 is .52, which is greater than the ratio of .10 described in paragraph (e)(3)(vii) of this
section. Therefore, X's excess U.S. shareholder indebtedness for 1990 remains at $9,600.
(iv) Step 3: (a) Since X's excess U.S. shareholder indebtedness of $9,600 is less than its excess related group
indebtedness of $20,000, X's allocable related group indebtedness for 1990 is $9,600. The amount of interest received
by X during 1990 on allocable related group indebtedness is:
$5,000 X $9,600/$50,000=$960
(b) Therefore, $969 of X's third party interest expense ($24,960) shall be allocated among various separate
limitation categories in proportion to the relative average amounts of Y obligations held by X in each such category.
The amount of Y obligations in each limitation category is determined in the same manner as the stock of Y would be
attributed under the rules of § 1.861-12T(c)(3). Since Y's interest expense is apportioned under the gross income
method prescribed in § 1.861-9T (j), the Y stock must be characterized under the gross income method described in §
1.861-12T(c)(3)(iii). Y's gross income net of interest expense is determined as follows:
Foreign source high withholding tax interest income -=$5,000-[($15,000) multiplied by ($5,000)/($5,000+$20,000)]
=$2,000
and
Foreign source general limitation income --

Page 16
T.D. 8410

=$20,000-[($15,000) multiplied by ($20,000)/($5,000+$20,000)]
=$8,000.
(c) Therefore, $192 [($960 X $2,000/($2,000+$8,000)] of X's third party interest expense is allocated to foreign
source high withholding tax interest income and $768 [$960 X $8,000/($2,000+$8,000)] is allocated to foreign source
general limitation income.
(v) As a result of these direct allocations, for purposes of apportioning X's remaining interest expense under §
1.861-9T, the value of X's assets generating foreign source general limitation income is reduced by the principal amount
of indebtedness the interest on which is directly allocated to foreign source general limitation income ($7,680), and the
value of X's assets generating foreign source high withholding tax interest income is reduced by the principal amount of
indebtedness the interest on which is directly allocated to foreign source high withholding tax interest income ($1,920),
determined as follows:
Reduction of X's assets generating foreign source general limitation income:

X's allocable related group indebtedness

X Y's Foreign source general limitation income
DY's
Foreign
sourc
e income

$9,600

X

$8,000/($8,000+$2,000)
=$7,680

Reduction of X's assets generating foreign source high withholding tax interest income:

X's allocable related group indebtedness

X

DY's
For-

Y's Foreign source high
withholding tax interest
income

Page 17
T.D. 8410

eign
sourc
e income

$9,600

X

$2,000/($8,000+$2,000)
=$1,920

David G. Blattner,
Acting Commissioner of Internal Revenue.
Approved: January 24, 1992.
Kenneth W. Gideon.
Assistant Secretary of the Treasury.
[FR Doc. 92-8495 Filed 4-14-92; 8:45 am]
BILLING CODE 4830-01-M

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