What Is the 1.882-5 Interest Expense Calculation?

U.S. Treasury Regulation Section 1.882-5 provides a framework for foreign corporations to determine the interest expense they can deduct on their U.S. income tax returns. The regulation allocates a portion of a company’s global interest expense to the income from its U.S. operations, ensuring the deduction is connected to the activities that produce taxable income in the United States. The rules treat a foreign corporation’s U.S. operations as a separate entity for this calculation. The company must identify assets and liabilities associated with its U.S. business to apportion interest costs based on the capital supporting the U.S. business.

Determining Applicability

The regulation’s requirements apply to entities meeting two conditions. First, the entity must be a “foreign corporation” for U.S. tax purposes. This designation depends on the place of incorporation; a corporation organized under the laws of a jurisdiction outside the United States is a foreign corporation.

The second condition is that the foreign corporation must be “engaged in a U.S. trade or business” (ETBUS). This is a factual determination based on the nature and extent of the corporation’s activities within the United States. A corporation is considered ETBUS if it conducts considerable, continuous, and regular business activities in the U.S., such as operating a factory or maintaining an office. Sporadic or isolated transactions are not sufficient to meet this threshold.

When a foreign corporation is ETBUS, the income generated from those activities is classified as “Effectively Connected Income” (ECI). ECI is the specific pool of income against which the allocable interest expense is deducted. While this regulation is the exclusive method for this calculation under U.S. domestic tax law, certain U.S. income tax treaties may provide alternative rules. Absent a specific treaty provision, a foreign corporation with ECI must use this framework to prevent a disproportionate allocation of global interest costs to its U.S. income.

Required Information and Key Elections

Before beginning the calculation, a foreign corporation must gather specific financial data. The initial task is to compile a comprehensive list of all “U.S. assets,” which are any assets held to generate Effectively Connected Income. This includes tangible assets like machinery and real estate, and intangible assets like patents connected to the U.S. business. The corporation must also have its complete worldwide balance sheet to determine the value of its total global assets and liabilities.

For asset valuation, the regulations provide a choice known as the Fair Market Value (FMV) election. By default, a corporation must value its assets using their adjusted tax basis, but it can elect to use the fair market value instead. This election is made on an original, timely-filed tax return and is binding for a minimum of five years. The choice between tax basis and FMV can have a substantial impact on the calculation, particularly for corporations with highly appreciated assets.

Another strategic decision is the Fixed Ratio Election, which pertains to determining a corporation’s U.S.-connected liabilities. Instead of calculating the actual ratio of its U.S. assets to worldwide assets, a corporation may elect to use a predetermined percentage. For most non-financial corporations, this fixed ratio is 50%, while for banks it is 95%. This election simplifies the process and, like the FMV election, is binding for five years once made on a timely-filed return.

The Three-Step Calculation Method

The calculation of the deductible interest expense is a formal, three-step process. The methodology systematically links a portion of the foreign corporation’s worldwide interest expense to its U.S. business activities. Each step builds upon the previous one to determine the final deductible amount.

Step 1: Determine U.S. Assets

The first step is to determine the average value of the corporation’s U.S. assets for the taxable year. The regulations require a calculation that reflects the asset values over the entire period, not just a year-end snapshot. The most common method is to average the values of the U.S. assets at the beginning and end of the tax year. If there have been substantial acquisitions or dispositions of assets, a more frequent averaging period, such as quarterly or monthly, is required. The value is determined by either the adjusted tax basis or the fair market value, depending on whether the FMV election was made.

Step 2: Determine U.S.-Connected Liabilities

The second step quantifies the U.S.-connected liabilities, which are derived from the U.S. asset value determined in Step 1. If the corporation has not made the Fixed Ratio Election, it must calculate its actual ratio by dividing the average value of its U.S. assets by the average value of its total worldwide assets. This ratio is then multiplied by the corporation’s average total worldwide liabilities. If the corporation has made the Fixed Ratio Election, the average value of U.S. assets from Step 1 is multiplied by the applicable fixed ratio to determine the U.S.-connected liabilities.

Step 3: Determine the Deductible Interest Expense

The final step determines the actual amount of interest expense that can be deducted. The regulations provide two mutually exclusive methods for this calculation: the Adjusted U.S. Booked Liabilities (AUSBL) method and the Separate Currency Pools method. The corporation must choose one method and use it consistently.

Under the AUSBL method, U.S.-connected liabilities from Step 2 are compared to the average amount of “U.S. booked liabilities,” which are liabilities on the books of the U.S. branch. If U.S.-connected liabilities exceed U.S. booked liabilities, the deductible interest is the sum of two parts. The first is interest on the U.S. booked liabilities, and the second is interest on the “excess” liabilities, calculated using the average interest rate on the corporation’s U.S. dollar liabilities held outside the U.S. If U.S. booked liabilities exceed U.S.-connected liabilities, the deductible interest is limited to the U.S.-connected liabilities multiplied by the average interest rate on the U.S. booked liabilities.

The Separate Currency Pools method allocates the U.S.-connected liabilities from Step 2 among the various currencies in which the corporation’s worldwide liabilities are denominated. This apportionment is based on the proportion of the corporation’s worldwide liabilities in each currency. A separate average interest rate is then determined for each currency pool. The total deductible interest expense is the sum of the amounts calculated by multiplying the liability amount in each currency pool by its corresponding interest rate.

Reporting the Interest Expense Deduction

Once the interest expense deduction has been calculated, it must be properly reported to the IRS on Form 1120-F, U.S. Income Tax Return of a Foreign Corporation. This form is the primary tax return for foreign corporations engaged in a U.S. trade or business. The detailed calculation is not shown on the face of the form but is reported on a specific attachment.

This attachment is Schedule I, titled “Interest Expense Allocation Under Regulations Section 1.882-5.” This schedule provides a standardized format for documenting how the final deduction was derived. The taxpayer must enter the key figures from each step of the calculation onto the appropriate lines of Schedule I, including the U.S. asset value and U.S.-connected liabilities.

The schedule guides the taxpayer through the chosen Step 3 methodology. The final calculated interest expense from Schedule I is the amount that the foreign corporation is permitted to deduct. This final figure is then carried from Schedule I to the main body of Form 1120-F and included as a deduction against the corporation’s Effectively Connected Income.