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Income Tax Regs. In the second step, the amount of U.S.-
connected liabilities is determined based on a "fixed" or
"actual" ratio. The latter is the ratio of the foreign
corporation's worldwide liabilities to its worldwide assets.
Sec. 1.882-5(b)(2), Income Tax Regs. In the third step, the
U.S.-connected liabilities are multiplied by an appropriate
interest rate to arrive at the interest expense allocable to
ECI.17 Sec. 1.882-5(b)(3), Income Tax Regs. The branch interest
is subtracted from the interest so allocable to ECI to determine
the excess interest. The parties disagree over the application
of the three-step process; in particular, whether the Ginter and
Gomes properties are step 1 assets (assets that produce income
effectively connected with the conduct of a U.S. trade or
business).
17 Sec. 1.882-5(b), Income Tax Regs., was amended for
taxable years beginning on or after June 6, 1996. Amended sec.
1.882-5(b)(1), Income Tax Regs., retains the three-step process
for allocation of interest expense to ECI but relies on sec.
1.884-1(d), Income Tax Regs., for the definition of a step 1
"U.S. asset". Sec. 1.884-1(d)(1), Income Tax Regs., provides
that an asset is a U.S. asset if "All income produced by the
asset on the determination date is ECI * * * and * * * All gain
from the disposition of the asset would be ECI if the asset were
disposed of on * * * [the determination date] and the disposition
produced gain." As an example of real property which is not
connected to a U.S. business, the regulation describes a U.S.
condominium apartment owned by the foreign corporation which
would not produce ECI if sold. See sec. 1.884-1(d)(2)(xi),
Example (3), Income Tax Regs.
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