[Title 26 CFR ]
[Code of Federal Regulations (annual edition) - April 1, 2016 Edition]
[From the U.S. Government Publishing Office]



[[Page i]]

          

          Title 26

Internal Revenue


________________________

Part 1 (Sec. Sec.  1.908 to 1.1000)

                         Revised as of April 1, 2016

          Containing a codification of documents of general 
          applicability and future effect

          As of April 1, 2016
                    Published by the Office of the Federal Register 
                    National Archives and Records Administration as a 
                    Special Edition of the Federal Register

[[Page ii]]

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[[Page iii]]




                            Table of Contents



                                                                    Page
  Explanation.................................................       v

  Title 26:
          Chapter I--Internal Revenue Service, Department of 
          the Treasury (Continued)                                   3
  Findings Aids:
      Table of CFR Titles and Chapters........................     799
      Alphabetical List of Agencies Appearing in the CFR......     819
      Table of OMB Control Numbers............................     829
      List of CFR Sections Affected...........................     847

[[Page iv]]





                     ----------------------------

                     Cite this Code: CFR
                     To cite the regulations in 
                       this volume use title, 
                       part and section number. 
                       Thus, 26 CFR 1.909-0 
                       refers to title 26, part 
                       1, section 909-0.

                     ----------------------------

[[Page v]]



                               EXPLANATION

    The Code of Federal Regulations is a codification of the general and 
permanent rules published in the Federal Register by the Executive 
departments and agencies of the Federal Government. The Code is divided 
into 50 titles which represent broad areas subject to Federal 
regulation. Each title is divided into chapters which usually bear the 
name of the issuing agency. Each chapter is further subdivided into 
parts covering specific regulatory areas.
    Each volume of the Code is revised at least once each calendar year 
and issued on a quarterly basis approximately as follows:

Title 1 through Title 16.................................as of January 1
Title 17 through Title 27..................................as of April 1
Title 28 through Title 41...................................as of July 1
Title 42 through Title 50................................as of October 1

    The appropriate revision date is printed on the cover of each 
volume.

LEGAL STATUS

    The contents of the Federal Register are required to be judicially 
noticed (44 U.S.C. 1507). The Code of Federal Regulations is prima facie 
evidence of the text of the original documents (44 U.S.C. 1510).

HOW TO USE THE CODE OF FEDERAL REGULATIONS

    The Code of Federal Regulations is kept up to date by the individual 
issues of the Federal Register. These two publications must be used 
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    To determine whether a Code volume has been amended since its 
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Sections Affected (LSA),'' which is issued monthly, and the ``Cumulative 
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Register page number of the latest amendment of any given rule.

EFFECTIVE AND EXPIRATION DATES

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OMB CONTROL NUMBERS

    The Paperwork Reduction Act of 1980 (Pub. L. 96-511) requires 
Federal agencies to display an OMB control number with their information 
collection request.

[[Page vi]]

Many agencies have begun publishing numerous OMB control numbers as 
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PAST PROVISIONS OF THE CODE

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for 1949-1963, 1964-1972, 1973-1985, and 1986-2000.

``[RESERVED]'' TERMINOLOGY

    The term ``[Reserved]'' is used as a place holder within the Code of 
Federal Regulations. An agency may add regulatory information at a 
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INCORPORATION BY REFERENCE

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This material, like any other properly issued regulation, has the force 
of law.
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Federal Register will approve an incorporation by reference only when 
the requirements of 1 CFR part 51 are met. Some of the elements on which 
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    (a) The incorporation will substantially reduce the volume of 
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alphabetical list of agencies publishing in the CFR are also included in 
this volume.

[[Page vii]]

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INQUIRIES

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    Oliver A. Potts,
    Director,
    Office of the Federal Register.
    April 1, 2016.







[[Page ix]]



                               THIS TITLE

    Title 26--Internal Revenue is composed of twenty-two volumes. The 
contents of these volumes represent all current regulations issued by 
the Internal Revenue Service, Department of the Treasury, as of April 1, 
2016. The first fifteen volumes comprise part 1 (Subchapter A--Income 
Tax) and are arranged by sections as follows: Sec. Sec.  1.0-1.60; 
Sec. Sec.  1.61-1.139; Sec. Sec.  1.140-1.169; Sec. Sec.  1.170-1.300; 
Sec. Sec.  1.301-1.400; Sec. Sec.  1.401-1.409; Sec. Sec.  1.410-1.440; 
Sec. Sec.  1.441-1.500; Sec. Sec.  1.501-1.640; Sec. Sec.  1.641-1.850; 
Sec. Sec.  1.851-1.907; Sec. Sec.  1.908-1.1000; Sec. Sec.  1.1001-
1.1400; Sec. Sec.  1.1401-1.1550; and Sec.  1.1551 to end of part 1. The 
sixteenth volume containing parts 2-29, includes the remainder of 
subchapter A and all of Subchapter B--Estate and Gift Taxes. The last 
six volumes contain parts 30-39 (Subchapter C--Employment Taxes and 
Collection of Income Tax at Source); parts 40-49; parts 50-299 
(Subchapter D--Miscellaneous Excise Taxes); parts 300-499 (Subchapter 
F--Procedure and Administration); parts 500-599 (Subchapter G--
Regulations under Tax Conventions); and part 600 to end (Subchapter H--
Internal Revenue Practice).

    The OMB control numbers for Title 26 appear in Sec.  602.101 of this 
chapter. For the convenience of the user, Sec.  602.101 appears in the 
Finding Aids section of the volumes containing parts 1 to 599.

    For this volume, Ann Worley was Chief Editor. The Code of Federal 
Regulations publication program is under the direction of John Hyrum 
Martinez, assisted by Stephen J. Frattini.

[[Page 1]]



                       TITLE 26--INTERNAL REVENUE




         (This book contains part 1, Sec. Sec. 1.908 to 1.1000)

  --------------------------------------------------------------------
                                                                    Part

chapter i--Internal Revenue Service, Department of the 
  Treasury (Continued)......................................           1

[[Page 3]]



    CHAPTER I--INTERNAL REVENUE SERVICE, DEPARTMENT OF THE TREASURY 
                               (CONTINUED)




  --------------------------------------------------------------------


  Editorial Note: IRS published a document at 45 FR 6088, Jan. 25, 1980, 
deleting statutory sections from their regulations. In Chapter I cross-
references to the deleted material have been changed to the 
corresponding sections of the IRS Code of 1954 or to the appropriate 
regulations sections. When either such change produced a redundancy, the 
cross-reference has been deleted. For further explanation, see 45 FR 
20795, Mar. 31, 1980.

                  SUBCHAPTER A--INCOME TAX (CONTINUED)
Part                                                                Page
1               Income taxes (Continued)....................           5

Supplementary Publications: Internal Revenue Service Looseleaf 
  Regulations System.

  Additional supplementary publications are issued covering Alcohol and 
Tobacco Tax Regulations and Regulations Under Tax Conventions.

[[Page 5]]



                   SUBCHAPTER A_INCOME TAX (CONTINUED)





PART 1_INCOME TAXES (CONTINUED)--Table of Contents



                  Normal Taxes and Surtaxes (Continued)

  Tax Based on Income From Sources Within or Without the United States

         Earned Income of Citizens or Residents of United States

Sec.
1.908 [Reserved]
1.909-0 Outline of regulation provisions for section 909.
1.909-1 Definitions and special rules.
1.909-2 Splitter arrangements.
1.909-3 Rules regarding related income and split taxes.
1.909-4 Coordination rules.
1.909-5 2011 and 2012 splitter arrangements.
1.909-6 Pre-2011 foreign tax credit splitting events.
1.910 [Reserved]
1.911-1 Partial exclusion for earned income from sources within a 
          foreign country and foreign housing costs.
1.911-2 Qualified individuals.
1.911-3 Determination of amount of foreign earned income to be excluded.
1.911-4 Determination of housing cost amount eligible for exclusion or 
          deduction.
1.911-5 Special rules for married couples.
1.911-6 Disallowance of deductions, exclusions, and credits.
1.911-7 Procedural rules.
1.911-8 Former deduction for certain expenses of living abroad.

               earned income of citizens of united states

1.912-1 Exclusion of certain cost-of-living allowances.
1.912-2 Exclusion of certain allowances of Foreign Service personnel.
1.921-1T Temporary regulations providing transition rules for DISCs and 
          FSCs.
1.921-2 Foreign Sales Corporation--general rules.
1.921-3T Temporary regulations; Foreign Sales Corporation general rules.
1.922-1 Requirements that a corporation must satisfy to be a FSC or a 
          small FSC.
1.923-1T Temporary regulations; exempt foreign trade income.
1.924(a)-1T Temporary regulations; definition of foreign trading gross 
          receipts.
1.924(c)-1 Requirement that a FSC be managed outside the United States.
1.924(d)-1 Requirement that economic processes take place outside the 
          United States.
1.924(e)-1 Activities relating to the disposition of export property.
1.925(a)-1 Transfer pricing rules for FSCs.
1.925(a)-1T Temporary regulations; transfer pricing rules for FSCs.
1.925(b)-1T Temporary regulations; marginal costing rules.
1.926(a)-1 Distributions to shareholders.
1.926(a)-1T Temporary regulations; distributions to shareholders.
1.927(a)-1T Temporary regulations; definition of export property.
1.927(b)-1T Temporary regulations; definition of gross receipts.
1.927(d)-1 Other definitions.
1.927(d)-2T Temporary regulations; definitions and special rules 
          relating to Foreign Sales Corporation.
1.927(e)-1 Special sourcing rule.
1.927(e)-2T Temporary regulations; effect of boycott participation on 
          FSC and small FSC benefits.
1.927(f)-1 Election and termination of status as a Foreign Sales 
          Corporation.

                    possessions of the united states

1.931-1 Exclusion of certain income from sources within Guam, American 
          Samoa, or the Northern Mariana Islands.
1.932-1 Coordination of United States and Virgin Islands income taxes.
1.933-1 Exclusion of certain income from sources within Puerto Rico.
1.934-1 Limitation on reduction in income tax liability incurred to the 
          Virgin Islands.
1.935-1 Coordination of individual income taxes with Guam and the 
          Northern Mariana Islands.
1.936-1 Elections.
1.936-4 Intangible property income in the absence of an election out.
1.936-5 Intangible property income when an election out is made: 
          Product, business presence, and contract manufacturing.
1.936-6 Intangible property income when an election out is made: cost 
          sharing and profit split options; covered intangibles.
1.936-7 Manner of making election under section 936 (h)(5); special 
          election for export sales; revocation of election under 
          section 936(a).
1.936-8T Qualified possession source investment income (temporary). 
          [Reserved]
1.936-9T Source of qualified possession source investment income 
          (temporary). [Reserved]
1.936-10 Qualified investments.
1.936-11 New lines of business prohibited.
1.937-1 Bona fide residency in a possession.
1.937-2 Income from sources within a possession.

[[Page 6]]

1.937-3 Income effectively connected with the conduct of a trade or 
          business in a possession.

                      china trade act corporations

1.941-1 Special deduction for China Trade Act corporations.
1.941-2 Meaning of terms used in connection with China Trade Act 
          corporations.
1.941-3 Illustration of principles.
1.943-1 Withholding by a China Trade Act corporation.

                     controlled foreign corporations

1.951-1 Amounts included in gross income of United States shareholders.
1.951-2 Coordination of subpart F with election of a foreign investment 
          company to distribute income.
1.951-3 Coordination of subpart F with foreign personal holding company 
          provisions.
1.952-1 Subpart F income defined.
1.952-2 Determination of gross income and taxable income of a foreign 
          corporation.
1.953-1 Income from insurance of United States risks.
1.953-2 Actual United States risks.
1.953-3 Risks deemed to be United States risks.
1.953-4 Taxable income to which section 953 applies.
1.953-5 Corporations not qualifying as insurance companies.
1.953-6 Relationship of sections 953 and 954.
1.954-0 Introduction.
1.954-1 Foreign base company income.
1.954-2 Foreign personal holding company income.
1.954-2T Foreign personal holding company income (temporary).
1.954-3 Foreign base company sales income.
1.954-4 Foreign base company services income.
1.954-5 Increase in qualified investments in less developed countries; 
          taxable years of controlled foreign corporations beginning 
          before January 1, 1976.
1.954-6 Foreign base company shipping income.
1.954-7 Increase in qualified investments in foreign base company 
          shipping operations.
1.954-8 Foreign base company oil related income.
1.955-0 Effective dates.
1.955-1 Shareholder's pro rata share of amount of previously excluded 
          subpart F income withdrawn from investment in less developed 
          countries.
1.955-2 Amount of a controlled foreign corporation's qualified 
          investments in less developed countries.
1.955-3 Election as to date of determining qualified investments in less 
          developed countries.
1.955-4 Definition of less developed country.
1.955-5 Definition of less developed country corporation.
1.955-6 Gross income from sources within less developed countries.
1.955A-1 Shareholder's pro rata share of amount of previously excluded 
          subpart F income withdrawn from investment in foreign base 
          company shipping operations.
1.955A-2 Amount of a controlled foreign corporation's qualified 
          investments in foreign base company shipping operations.
1.955A-3 Election as to qualified investments by related persons.
1.955A-4 Election as to date of determining qualified investment in 
          foreign base company shipping operations.
1.956-1 Shareholder's pro rata share of a controlled foreign 
          corporation's increase in earnings invested in United States 
          property.
1.956-1T Shareholder's pro rata share of a controlled foreign 
          corporation's increase in earnings invested in United States 
          property (temporary).
1.956-2 Definition of United States property.
1.956-2T Definition of United States property (temporary).
1.956-3T Certain trade or service receivables acquired from United 
          States persons (temporary).
1.957-1 Definition of controlled foreign corporation.
1.957-2 Controlled foreign corporation deriving income from insurance of 
          United States risks.
1.957-3 United States person defined.
1.958-1 Direct and indirect ownership of stock.
1.958-2 Constructive ownership of stock.
1.959-1 Exclusion from gross income of United States persons of 
          previously taxed earning and profits.
1.959-2 Exclusion from gross income of controlled foreign corporations 
          of previously taxed earnings and profits.
1.959-3 Allocation of distributions to earnings and profits of foreign 
          corporations.
1.959-4 Distributions to United States persons not counting as 
          dividends.
1.960-1 Foreign tax credit with respect to taxes paid on earnings and 
          profits of controlled foreign corporations.
1.960-2 Interrelation of section 902 and section 960 when dividends are 
          paid by third-, second-, or first-tier corporation.
1.960-3 Gross-up of amounts included in income under section 951.
1.960-4 Additional foreign tax credit in year of receipt of previously 
          taxed earnings and profits.
1.960-5 Credit for taxable year of inclusion binding for taxable year of 
          exclusion.
1.960-6 Overpayments resulting from increase in limitation for taxable 
          year of exclusion.

[[Page 7]]

1.960-7 Effective dates.
1.961-1 Increase in basis of stock in controlled foreign corporations 
          and of other property.
1.961-2 Reduction in basis of stock in foreign corporations and of other 
          property.
1.962-1 Limitation of tax for individuals on amounts included in gross 
          income under section 951(a).
1.962-2 Election of limitation of tax for individuals.
1.962-3 Treatment of actual distributions.
1.962-4 Transitional rules for certain taxable years.
1.963-0 Repeal of section 963; effective dates.
1.963-1 Exclusion of subpart F income upon receipt of minimum 
          distribution.
1.963-2 Determination of the amount of the minimum distribution.
1.963-3 Distributions counting toward a minimum distribution.
1.963-4 Limitations on minimum distribution from a chain or group.
1.963-5 Foreign corporations with variation in foreign tax rate because 
          of distributions.
1.963-6 Deficiency distribution.
1.963-7 Transitional rules for certain taxable years.
1.963-8 Determination of minimum distribution during the surcharge 
          period.
1.964-1 Determination of the earnings and profits of a foreign 
          corporation.
1.964-2 Treatment of blocked earnings and profits.
1.964-3 Records to be provided by United States shareholders.
1.964-4 Verification of certain classes of income.
1.964-5 Effective date of subpart F.

                        Export Trade Corporations

1.970-1 Export trade corporations.
1.970-2 Elections as to date of determining investments in export trade 
          assets.
1.970-3 Effective date of subpart G.
1.971-1 Definitions with respect to export trade corporations.
1.972-1 Consolidation of group of export trade corporations.
1.981-0 Repeal of section 981; effective dates.
1.981-1 Foreign law community income for taxable years beginning after 
          December 31, 1966, and before January 1, 1977.
1.981-2 Foreign law community income for taxable years beginning before 
          January 1, 1967.
1.981-3 Definitions and other special rules.
1.985-0 Outline of regulation.
1.985-1 Functional currency.
1.985-2 Election to use the United States dollar as the functional 
          currency of a QBU.
1.985-3 United States dollar approximate separate transactions method.
1.985-4 Method of accounting.
1.985-5 Adjustments required upon change in functional currency.
1.985-6 Transition rules for a QBU that uses the dollar approximate 
          separate transactions method for its first taxable year 
          beginning in 1987.
1.985-7 Adjustments required in connection with a change to DASTM.
1.985-8 Special rules applicable to the European Monetary Union 
          (conversion to the euro).
1.987-1 Profit and loss method of accounting for a qualified business 
          unit of a taxpayer having a different functional currency from 
          the taxpayer. [Reserved]
1.987-2 Accounting for gain or loss on certain transfers of property. 
          [Reserved]
1.987-3 Termination. [Reserved]
1.987-4 Special rules relating to QBU branches of foreign taxpayers. 
          [Reserved]
1.987-5 Transition rules for certain qualified business units using a 
          profit and loss method of accounting for taxable years 
          beginning before January 1, 1987.
1.988-0 Taxation of gain or loss from a section 988 transaction; table 
          of contents.
1.988-1 Certain definitions and special rules.
1.988-2 Recognition and computation of exchange gain or loss.
1.988-3 Character of exchange gain or loss.
1.988-4 Source of gain or loss realized on a section 988 transaction.
1.988-5 Section 988(d) hedging transactions.
1.988-6 Nonfunctional currency contingent payment debt instruments.
1.989(a)-1 Definition of a qualified business unit.
1.989(b)-1 Definition of weighted average exchange rate.
1.989(c)-1 Transition rules for certain branches of United States 
          persons using a net worth method of accounting for taxable 
          years beginning before January 1, 1987.

                Domestic International Sales Corporations

1.991-1 Taxation of a domestic international sales corporation.
1.992-1 Requirements of a DISC.
1.992-2 Election to be treated as a DISC.
1.992-3 Deficiency distributions to meet qualification requirements.
1.992-4 Coordination with personal holding company provisions in case of 
          certain produced film rents.
1.993-1 Definition of qualified export receipts.
1.993-2 Definition of qualified export assets.
1.993-3 Definition of export property.
1.993-4 Definition of producer's loans.
1.993-5 Definition of related foreign export corporation.
1.993-6 Definition of gross receipts.
1.993-7 Definition of United States.
1.994-1 Inter-company pricing rules for DISC's.

[[Page 8]]

1.994-2 Marginal costing rules.
1.995-1 Taxation of DISC income to shareholders.
1.995-2 Deemed distributions in qualified years.
1.995-3 Distributions upon disqualification.
1.995-4 Gain on disposition of stock in a DISC.
1.995-5 Foreign investment attributable to producer's loans.
1.995-6 Taxable income attributable to military property.
1.996-1 Rules for actual distributions and certain deemed distributions.
1.996-2 Ordering rules for losses.
1.996-3 Divisions of earnings and profits.
1.996-4 Subsequent effect of previous disposition of DISC stock.
1.996-5 Adjustment to basis.
1.996-6 Effectively connected income.
1.996-7 Carryover of DISC tax attributes.
1.996-8 Effect of carryback of capital loss or net operating loss to 
          prior DISC taxable year.
1.997-1 Special rules for subchapter C of the Code.
1.998-1.1000 [Reserved]

    Authority: 26 U.S.C. 7805.
    Sections 1.909-1 through 1.906-6 also issued under 26 U.S.C. 909(e).
    Section 1.911-7 also issued under 26 U.S.C. 911(d)(9).
    Sections 1.924(c)-1, 1.924(d)-1, and 1.924(e)-1 also issued under 26 
U.S.C. 924(d).
    Section 1.925(a)-1 also issued under 26 U.S.C. 925(b)(1) and (2) and 
927(d)(2)(B).
    Section 1.925(a)-1T is also issued under 26 U.S.C. 925(b)(1) and (2) 
and 927(d)(2)(B).
    Section 1.925(b)-1T is also issued under 26 U.S.C. 925(b)(1) and (2) 
and 927(d)(2)(B).
    Section 1.927(d)-1 also issued under 26 U.S.C. 927(d)(1)(B).
    Section 1.927(e)-1 also issued under 26 U.S.C. 927(e)(1).
    Section 1.927(e)-2T also issued under 26 U.S.C. 927(e)(2).
    Section 1.927(f)-1 also issued under 26 U.S.C. 927(f).
    Section 1.931-1 also issued under 26 U.S.C. 7654(e).
    Section 1.932-1 also issued under 26 U.S.C. 7654(e).
    Section 1.934-1 also issued under 26 U.S.C. 934(b)(4).
    Section 1.935-1 also issued under 26 U.S.C. 7654(e).
    Section 1.936-4 also issued under 26 U.S.C. 936(h).
    Section 1.936-5 also issued under 26 U.S.C. 936(h).
    Section 1.936-6 also issued under 26 U.S.C. 863(a) and (b), and 26 
U.S.C. 936(h).
    Section 1.936-7 also issued under 26 U.S.C. 936(h).
    Section 1.936-11 also issued under 26 U.S.C. 936(j).
    Section 1.937-1 also issued under 26 U.S.C. 937(a).
    Section 1.937-1T also issued under 26 U.S.C. 937(a).
    Section 1.937-2 also issued under 26 U.S.C. 937(b).
    Section 1.937-3 also issued under 26 U.S.C. 937(b).
    Section 1.952-11T is also issued under 26 U.S.C. 852(b)(3)(C), 
852(b)(8), and 852(c).
    Section 1.953-2 also issued under 26 U.S.C. 7701(b)(11).
    Section 1.954-0 also issued under 26 U.S.C. 954 (b) and (c).
    Section 1.954-1 also issued under 26 U.S.C. 954 (b) and (c).
    Section 1.954-2 also issued under 26 U.S.C. 954 (b) and (c).
    Section 1.956-1T also issued under 26 U.S.C. 956(d) and 956(e).
    Section 1.956-3T also issued under 26 U.S.C. 864(d)(8).
    Section 1.957-1 also issued under 26 U.S.C. 957.
    Section 1.957-3 also issued under 26 U.S.C. 957(c).
    Section 1.960-1 also issued under 26 U.S.C. 960(a).
    Sections 1.985-0 through 1.985-5 also issued under 26 U.S.C. 985.
    Sections 1.987-1 through 1.987-5 also issued under 26 U.S.C. 987.
    Sections 1.988-0 through 1.988-5 also issued under 26 U.S.C. 988.
    Sections 1.989(a)-0T and 1.989(a)-1T also issued under 26 U.S.C. 
989(c).
    Section 1.989(b)-1 also issued under 26 U.S.C. 989(b).
    Section 1.989-1(c) also issued under 26 U.S.C. 989(c).

    Source: T.D. 6500, 25 FR 11910, Nov. 26, 1960; 25 FR 14021, Dec. 31, 
1960, unless otherwise noted.

         Earned Income of Citizens or Residents of United States



Sec. 1.908  [Reserved]



Sec. 1.909-0  Outline of regulation provisions for section 909.

    This section lists the headings for Sec. Sec. 1.909-1 through 
1.909-6.

              Sec. 1.909-1 Definitions and special rules.

    (a) Definitions.
    (b) Taxes paid or accrued by a partnership, S corporation or trust.
    (c) Related income of a partnership, S corporation or trust.
    (d) Application of section 909 to pre-1987 accumulated profits and 
pre-1987 foreign income taxes.
    (e) Effective/applicability date.

[[Page 9]]

                  Sec. 1.909-2 Splitter arrangements.

    (a) Foreign tax credit splitting event.
    (1) In general.
    (2) Split taxes not taken into account.
    (b) Splitter arrangements.
    (1) Reverse hybrid splitter arrangements.
    (i) In general.
    (ii) Split taxes from a reverse hybrid splitter arrangement.
    (iii) Related income from a reverse hybrid splitter arrangement.
    (iv) Reverse hybrid.
    (v) Examples.
    (2) Loss-sharing splitter arrangements.
    (i) In general.
    (ii) U.S. combined income group.
    (iii) Income and shared loss of a U.S. combined income group.
    (iv) Split taxes from a loss-sharing splitter arrangement.
    (v) Related income from a loss-sharing splitter arrangement.
    (vi) Foreign group relief or other loss-sharing regime.
    (vii) Examples.
    (3) Hybrid instrument splitter arrangements.
    (i) U.S. equity hybrid instrument splitter arrangement.
    (ii) U.S. debt hybrid instrument splitter arrangement.
    (4) Partnership inter-branch payment splitter arrangements.
    (i) In general.
    (ii) Split taxes from a partnership inter-branch payment splitter 
arrangement.
    (iii) Related income from a partnership inter-branch payment 
splitter arrangement.
    (c) Effective/applicability date.

      Sec. 1.909-3 Rules regarding related income and split taxes.

    (a) Interim rules for identifying related income and split taxes.
    (b) Split taxes on deductible disregarded payments.
    (c) Effective/applicability date.

                    Sec. 1.909-4 Coordination rules.

    (a) Interim rules.
    (b) Effective/applicability date.

           Sec. 1.909-5 2011 and 2012 splitter arrangements.

    (a) Taxes paid or accrued in taxable years beginning in 2011.
    (b) Taxes paid or accrued in certain taxable years beginning in 2012 
with respect to a foreign consolidated group splitter arrangement.
    (c) Effective/applicability date.

       Sec. 1.909-6 Pre-2011 foreign tax credit splitting events.

    (a) Foreign tax credit splitting event.
    (1) In general.
    (2) Taxes not subject to suspension under section 909.
    (3) Taxes subject to suspension under section 909.
    (b) Pre-2011 splitter arrangements.
    (1) Reverse hybrid structure splitter arrangements.
    (2) Foreign consolidated group splitter arrangements.
    (3) Group relief or other loss-sharing regime splitter arrangements.
    (i) In general.
    (ii) Split taxes and related income.
    (4) Hybrid instrument splitter arrangements.
    (i) In general.
    (ii) U.S. equity hybrid instrument splitter arrangement.
    (iii) U.S. debt hybrid instrument splitter arrangement.
    (c) General rules for applying section 909 to pre-2011 split taxes 
and related income.
    (1) Annual determination.
    (2) Separate categories.
    (d) Special rules regarding related income.
    (1) Annual adjustments.
    (2) Effect of separate limitation losses and deficits.
    (3) Pro rata method for distributions out of earnings and profits 
that include both related income and other income.
    (4) Alternative method for distributions out of earnings and profits 
that include both related income and other income.
    (5) Distributions, deemed distributions, and inclusions out of 
related income.
    (6) Carryover of related income.
    (7) Related income taken into account by a section 902 shareholder.
    (8) Related income taken into account by a payor section 902 
corporation.
    (9) Related income taken into account by an affiliated group of 
corporations that includes a section 902 shareholder.
    (10) Distributions of previously-taxed earnings and profits.
    (e) Special rules regarding pre-2011 split taxes.
    (1) Taxes deemed paid pro rata out of pre-2011 split taxes and other 
taxes.
    (2) Pre-2011 split taxes deemed paid in pre-2011 taxable years.
    (3) Carryover of pre-2011 split taxes.
    (4) Determining when pre-2011 split taxes are no longer treated as 
pre-2011 split taxes.
    (f) Rules relating to partnerships and trusts.
    (1) Taxes paid or accrued by partnerships.
    (2) Section 704(b) allocations.
    (3) Trusts.
    (g) Interaction between section 909 and other Code provisions.
    (1) Section 904(c).
    (2) Section 905(a).
    (3) Section 905(c).
    (4) Other foreign tax credit provisions.

[[Page 10]]

    (h) Effective/applicability date.

[T.D. 9710, 80 FR 7327, Feb. 10, 2015]



Sec. 1.909-1  Definitions and special rules.

    (a) Definitions. For purposes of section 909, this section, and 
Sec. Sec. 1.909-2 through 1.909-5, the following definitions apply:
    (1) The term section 902 corporation means any foreign corporation 
with respect to which one or more domestic corporations meet the 
ownership requirements of section 902(a) or (b).
    (2) The term section 902 shareholder means any domestic corporation 
that meets the ownership requirements of section 902(a) or (b) with 
respect to a section 902 corporation.
    (3) The term payor means a person that pays or accrues a foreign 
income tax within the meaning of Sec. 1.901-2(f), and also includes a 
person that takes foreign income taxes paid or accrued by a partnership, 
S corporation, estate or trust into account pursuant to section 
702(a)(6), section 901(b)(5) or section 1373(a).
    (4) The term covered person means, with respect to a payor--
    (i) Any entity in which the payor holds, directly or indirectly, at 
least a 10 percent ownership interest (determined by vote or value);
    (ii) Any person that holds, directly or indirectly, at least a 10 
percent ownership interest (determined by vote or value) in the payor; 
or
    (iii) Any person that bears a relationship that is described in 
section 267(b) or 707(b) to the payor.
    (5) The term foreign income tax means any income, war profits, or 
excess profits tax paid or accrued to any foreign country or to any 
possession of the United States. A foreign income tax includes any tax 
paid or accrued in lieu of such a tax within the meaning of section 903.
    (6) The term post-1986 foreign income taxes has the meaning provided 
in Sec. 1.902-1(a)(8).
    (7) The term post-1986 undistributed earnings has the meaning 
provided in Sec. 1.902-1(a)(9).
    (8) The term disregarded entity means an entity that is disregarded 
as an entity separate from its owner, as provided in Sec. 301.7701-
2(c)(2)(i) of this chapter.
    (9) The term hybrid partnership means a partnership that is subject 
to income tax in a foreign country as a corporation (or otherwise at the 
entity level) on the basis of residence, place of incorporation, place 
of management or similar criteria.
    (b) Taxes paid or accrued by a partnership, S corporation or trust. 
Under section 909(c)(1), section 909 applies at the partner level, and 
similar rules apply in the case of an S corporation or trust. 
Accordingly, in the case of foreign income taxes paid or accrued by a 
partnership, S corporation or trust, taxes allocated to one or more 
partners, shareholders or beneficiaries (as the case may be) will be 
treated as split taxes to the extent such taxes would be split taxes if 
the partner, shareholder or beneficiary had paid or accrued the taxes 
directly on the date such taxes are taken into account by the partner 
under sections 702 and 706(a), by the shareholder under section 1373(a), 
or by the beneficiary under section 901(b)(5). Any such split taxes will 
be suspended in the hands of the partner, shareholder or beneficiary.
    (c) Related income of a partnership, S corporation or trust. For 
purposes of determining whether related income is taken into account by 
a covered person, related income of a partnership, S corporation or 
trust is considered to be taken into account by the partner, shareholder 
or beneficiary to whom the related income is allocated.
    (d) Application of section 909 to pre-1987 accumulated profits and 
pre-1987 foreign income taxes. Section 909 and Sec. Sec. 1.909-1 
through 1.909-5 will apply to pre-1987 accumulated profits (as defined 
in Sec. 1.902-1(a)(10)(i)) and pre-1987 foreign income taxes (as 
defined in Sec. 1.902-1(a)(10)(iii)) of a section 902 corporation 
attributable to taxable years beginning on or after January 1, 2012.
    (e) Effective/applicability date. This section applies to taxable 
years ending after February 9, 2015. See 26 CFR 1.909-1T (revised as of 
April 1, 2014) for rules applicable to taxable years beginning on or 
after January 1, 2011, and ending on or before February 9, 2015.

[T.D. 9710, 80 FR 7328, Feb. 10, 2015]

[[Page 11]]



Sec. 1.909-2  Splitter arrangements.

    (a) Foreign tax credit splitting event--(1) In general. There is a 
foreign tax credit splitting event with respect to foreign income taxes 
paid or accrued if and only if, in connection with an arrangement 
described in paragraph (b) of this section (a splitter arrangement) the 
related income was, is or will be taken into account for U.S. Federal 
income tax purposes by a person that is a covered person with respect to 
the payor of the tax. Foreign income taxes that are paid or accrued in 
connection with a splitter arrangement are split taxes to the extent 
provided in paragraph (b) of this section. Income (or, as appropriate, 
earnings and profits) that was, is or will be taken into account by a 
covered person in connection with a splitter arrangement is related 
income to the extent provided in paragraph (b) of this section.
    (2) Split taxes not taken into account. Split taxes will not be 
taken into account for U.S. Federal income tax purposes before the 
taxable year in which the related income is taken into account by the 
payor or, in the case of split taxes paid or accrued by a section 902 
corporation, by a section 902 shareholder of such section 902 
corporation. Therefore, in the case of split taxes paid or accrued by a 
section 902 corporation, split taxes will not be taken into account for 
purposes of sections 902 or 960, or for purposes of determining earnings 
and profits under section 964(a), before the taxable year in which the 
related income is taken into account by the payor section 902 
corporation, a section 902 shareholder of the section 902 corporation, 
or a member of the section 902 shareholder's consolidated group. See 
Sec. 1.909-3(a) for rules relating to when split taxes and related 
income are taken into account.
    (b) Splitter arrangements. The arrangements set forth in this 
paragraph (b) are splitter arrangements.
    (1) Reverse hybrid splitter arrangements--(i) In general. A reverse 
hybrid is a splitter arrangement when a payor pays or accrues foreign 
income taxes with respect to income of a reverse hybrid. A reverse 
hybrid splitter arrangement exists even if the reverse hybrid has a loss 
or a deficit in earnings and profits for a particular year for U.S. 
Federal income tax purposes (for example, due to a timing difference).
    (ii) Split taxes from a reverse hybrid splitter arrangement. The 
foreign income taxes paid or accrued with respect to income of the 
reverse hybrid are split taxes.
    (iii) Related income from a reverse hybrid splitter arrangement. The 
related income with respect to split taxes from a reverse hybrid 
splitter arrangement is the earnings and profits (computed for U.S. 
Federal income tax purposes) of the reverse hybrid attributable to the 
activities of the reverse hybrid that gave rise to income included in 
the payor's foreign tax base with respect to which the split taxes were 
paid or accrued. Accordingly, related income of the reverse hybrid 
includes items of income or expense attributable to a disregarded entity 
owned by the reverse hybrid only to the extent that the income 
attributable to the activities of the disregarded entity is included in 
the payor's foreign tax base.
    (iv) Reverse hybrid. The term reverse hybrid means an entity that is 
a corporation for U.S. Federal income tax purposes but is a fiscally 
transparent entity (under the principles of Sec. 1.894-1(d)(3)) or a 
branch under the laws of a foreign country imposing tax on the income of 
the entity.
    (v) Examples. The following examples illustrate the rules of 
paragraph (b)(1) of this section.

    Example 1. (i) Facts. USP, a domestic corporation, wholly owns DE, a 
disregarded entity for U.S. federal income tax purposes that is 
organized in country A and treated as a corporation for country A tax 
purposes. DE wholly owns RH, a corporation for U.S. Federal income tax 
purposes that is organized in country A and treated as a fiscally 
transparent entity for country A tax purposes. Country A imposes an 
income tax at the rate of 30% on DE with respect to the items of income 
earned by RH. Prior to year 1, RH had no income for country A purposes 
and had no post-1986 earnings and profits for U.S. Federal income tax 
purposes. In year 1, RH earns 200u of income on which DE pays 60u of 
country A tax. Pursuant to Sec. 1.901-2(f)(4)(ii), USP is treated as 
legally liable for the 60u of country A taxes paid by DE. DE has no 
other income. In year 2, RH earns no income and incurs no losses or 
expenses. At the end of year 2, RH distributes 100u to DE.
    (ii) Result. (A) Split taxes and related income. Pursuant to Sec. 
1.909-2(b)(1)(iv), RH is a reverse

[[Page 12]]

hybrid because it is a corporation for U.S. Federal income tax purposes 
and a fiscally transparent entity for country A purposes. Pursuant to 
Sec. 1.909-2(b)(1), RH is a covered person with respect to USP because 
USP wholly owns RH for U.S. Federal income tax purposes. Pursuant to 
Sec. 1.909-2(b)(1)(i), there is a splitter arrangement with respect to 
RH because USP paid country A tax with respect to the income of RH. All 
60u of taxes paid by USP in year 1 with respect to the income of RH are 
split taxes pursuant to Sec. 1.909-2(b)(1)(ii). The post-1986 earnings 
and profits of RH are 200u as of the end of year 1. Pursuant to Sec. 
1.909-2(b)(1)(iii), the related income in year 1 is the 200u of RH's 
earnings and profits that are attributable to the activities that gave 
rise to the split taxes. No additional split taxes or related income 
arise in year 2.
    (B) Distribution. Because DE is a disregarded entity, the 100u 
distribution by RH at the end of year 2 is treated as a dividend to USP. 
Pursuant to Sec. 1.909-6(d)(7) and Sec. 1.909-3(a), 100u of the 200u 
of related income of RH, or 50%, is taken into account by USP by reason 
of the 100u dividend. Accordingly, pursuant to Sec. 1.909-6(e)(4) and 
Sec. 1.909-3(a), a ratable portion of the split taxes, or 30u of taxes 
(50% of 60u), is no longer treated as split taxes and is taken into 
account by USP for U.S. Federal income tax purposes.
    Example 2. (i) Facts. The facts are the same as in Example 1, except 
that in year 2, RH has a 100u loss for U.S. Federal income tax purposes 
as well as for country A tax purposes. For country A tax purposes, DE 
takes the 100u loss into account in year 2 and may not carry back the 
100u loss to offset its country A taxable income for year 1. At the end 
of year 2, RH distributes 100u to DE.
    (ii) Result. (A) Split taxes and related income. The split taxes and 
related income for year 1 are the same as in Example 1. Pursuant to 
Sec. 1.909-2(b)(1)(iii), Sec. 1.909-6(d)(1) and Sec. 1.909-3(a), the 
total related income of RH is reduced to 100u (200u - 100u) in year 2 
because RH incurred a 100u loss in year 2 attributable to the activities 
that are included in DE's country A tax base.
    (B) Distribution. Because DE is a disregarded entity, the 100u 
distribution by RH at the end of year 2 is treated as a dividend to USP. 
Pursuant to Sec. 1.909-6(d)(7) and Sec. 1.909-3(a), 100u of the 100u 
of related income of RH, or 100%, is taken into account by USP by reason 
of the 100u dividend. Accordingly, pursuant to Sec. 1.909-6(e)(4) and 
Sec. 1.909-3(a), a ratable portion of the split taxes, or 60u of taxes 
(100% of 60u), is no longer treated as split taxes and is taken into 
account by USP for U.S. Federal income tax purposes.

    (2) Loss-sharing splitter arrangements--(i) In general. A foreign 
group relief or other loss-sharing regime is a loss-sharing splitter 
arrangement to the extent that a shared loss of a U.S. combined income 
group could have been used to offset income of that group in the current 
or in a prior foreign taxable year (usable shared loss) but is used 
instead to offset income of another U.S. combined income group.
    (ii) U.S. combined income group. The term U.S. combined income group 
means an individual or a corporation and all entities (including 
entities that are fiscally transparent for U.S. Federal income tax 
purposes under the principles of Sec. 1.894-1(d)(3)) that for U.S. 
Federal income tax purposes combine any of their respective items of 
income, deduction, gain or loss with the income, deduction, gain or loss 
of such individual or corporation. A U.S. combined income group can 
arise, for example, as a result of an entity being disregarded or, in 
the case of a partnership or hybrid partnership and a partner, as a 
result of the allocation of income or any other item of the partnership 
to the partner. For purposes of this paragraph (b)(2)(ii), a branch is 
treated as an entity, all members of a U.S. affiliated group of 
corporations (as defined in section 1504) that file a consolidated 
return are treated as a single corporation, and two or more individuals 
that file a joint return are treated as a single individual. A U.S. 
combined income group may consist of a single individual or corporation 
and no other entities, but cannot include more than one individual or 
corporation. In addition, an entity may belong to more than one U.S. 
combined income group. For example, a hybrid partnership with two 
corporate partners that do not combine any of their items of income, 
deduction, gain or loss for U.S. Federal income tax purposes is in a 
separate U.S. combined income group with each of its partners.
    (iii) Income and shared loss of a U.S. combined income group--(A) 
Income. Except as otherwise provided in this paragraph (b)(2)(iii)(A), 
the income of a U.S. combined income group is the aggregate amount of 
taxable income recognized or taken into account for foreign tax purposes 
by those members that have positive taxable income for foreign tax 
purposes. In the case of an entity that is fiscally transparent (under 
the principles of Sec. 1.894-1(d)(3))

[[Page 13]]

for foreign tax purposes and that is a member of more than one U.S. 
combined income group, the foreign taxable income of the entity is 
allocated between or among the groups under foreign tax law. In the case 
of an entity that is not fiscally transparent for foreign tax purposes 
and that is a member of more than one U.S. combined income group, the 
foreign taxable income of the entity is allocated between or among those 
groups based on U.S. Federal income tax principles. For example, in the 
case of a hybrid partnership, the foreign taxable income of the 
partnership is allocated between or among the groups in the manner the 
partnership allocates the income under section 704(b). To the extent the 
foreign taxable income would be income under U.S. Federal income tax 
principles in another year, the income is allocated between or among the 
groups based on how the hybrid partnership would allocate the income if 
the income were recognized for U.S. Federal income tax purposes in the 
year in which the income is recognized for foreign tax purposes. To the 
extent the foreign taxable income would not constitute income under U.S. 
Federal income tax principles in any year, the income is allocated 
between or among the groups in the same manner as the partnership items 
attributable to the activity giving rise to the foreign taxable income.
    (B) Shared loss. The term shared loss means a loss of one entity for 
foreign tax purposes that, in connection with a foreign group relief or 
other loss-sharing regime, is taken into account by one or more other 
entities. Except as otherwise provided in this paragraph (b)(2)(iii)(B), 
the amount of shared loss of a U.S. combined income group is the sum of 
the shared losses of all members of the U.S. combined income group. In 
the case of an entity that is fiscally transparent (under the principles 
of Sec. 1.894-1(d)(3)) for foreign tax purposes and that is a member of 
more than one U.S. combined income group, the shared loss of the entity 
is allocated between or among the groups under foreign tax law. In the 
case of an entity that is not fiscally transparent for foreign tax 
purposes and that is a member of more than one U.S. combined income 
group, the shared loss of the entity will be allocated between or among 
those groups based on U.S. Federal income tax principles. For example, 
in the case of a hybrid partnership, the shared loss of the partnership 
will be allocated between or among the groups in the manner the 
partnership allocates the loss under section 704(b). To the extent the 
shared loss would be a loss under U.S. Federal income tax principles in 
another year, the loss is allocated between or among the groups based on 
how the partnership would allocate the loss if the loss were recognized 
for U.S. Federal income tax purposes in the year in which the loss is 
recognized for foreign tax purposes. To the extent the shared loss would 
not constitute a loss under U.S. Federal income tax principles in any 
year, the loss is allocated between or among the groups in the same 
manner as the partnership items attributable to the activity giving rise 
to the shared loss.
    (iv) Split taxes from a loss-sharing splitter arrangement. Split 
taxes from a loss-sharing splitter arrangement are foreign income taxes 
paid or accrued by a member of the U.S. combined income group with 
respect to income from the current foreign taxable year, or, in the case 
of a foregone carryback loss, from the prior foreign taxable year, equal 
to the amount of the usable shared loss of that group that offsets 
income of another U.S. combined income group.
    (v) Related income from a loss-sharing splitter arrangement. The 
related income with respect to split taxes from a loss-sharing splitter 
arrangement is an amount of income of the individual or corporate member 
of the U.S. combined income group equal to the amount of income under 
foreign tax law of that U.S. combined income group that is offset by the 
usable shared loss of another U.S. combined income group.
    (vi) Foreign group relief or other loss-sharing regime. A foreign 
group relief or other loss-sharing regime exists when an entity may 
surrender its loss to offset the income of one or more other entities. A 
foreign group relief or other loss-sharing regime does not include an 
allocation of loss of an entity that is a partnership or other fiscally 
transparent entity (under the principles of Sec. 1.894-1(d)(3)) for 
foreign tax purposes

[[Page 14]]

or regimes in which foreign tax is imposed on combined income (such as a 
foreign consolidated regime), as described in Sec. 1.901-2(f)(3).
    (vii) Examples. The following examples illustrate the rules of 
paragraph (b)(2) of this section.

    Example 1. (i) Facts. USP, a domestic corporation, wholly owns CFC1, 
a corporation organized in country A. CFC1 wholly owns CFC2 and CFC3, 
both corporations organized in country A. CFC2 wholly owns DE, an entity 
organized in country A. DE is a corporation for country A tax purposes 
and a disregarded entity for U.S. Federal income tax purposes. Country A 
has a loss-sharing regime under which a loss of CFC1, CFC2, CFC3 or DE 
may be used to offset the income of one or more of the others. Country A 
imposes an income tax at the rate of 30% on the taxable income of 
corporations organized in country A. In year 1, before any loss sharing, 
CFC1 has no income, CFC2 has income of 50u, CFC3 has income of 200u, and 
DE has a loss of 100u. Under the provisions of country A's loss-sharing 
regime, the group decides to use DE's 100u loss to offset 100u of CFC3's 
income. After the loss is shared, for country A's tax purposes, CFC2 
still has 50u of income on which it pays 15u of country A tax. CFC3 has 
income of 100u (200u less the 100u shared loss) on which it pays 30u of 
country A tax. For U.S. Federal income tax purposes, the loss sharing 
with CFC3 is not taken into account. Because DE is a disregarded entity, 
its 100u loss is taken into account by CFC2 and reduces its earnings and 
profits for U.S. Federal income tax purposes. Accordingly, before 
application of section 909, CFC2 has a loss for earnings and profits 
purposes of 65u (50u income less 15u taxes paid to country A less 100u 
loss of DE). CFC2 also has the U.S. dollar equivalent of 15u of foreign 
income taxes to add to its post-1986 foreign income taxes pool. CFC3 has 
earnings and profits of 170u (200u income less 30u of taxes) and the 
dollar equivalent of 30u of foreign income taxes to add to its post-1986 
foreign income taxes pool.
    (ii) Result. Pursuant to Sec. 1.909-2(b)(2)(ii), CFC2 and DE 
constitute one U.S. combined income group, while CFC1 and CFC3 each 
constitute separate U.S. combined income groups. Pursuant to Sec. 
1.909-2(b)(2)(iii)(A), the income of the CFC2 U.S. combined income group 
is 50u (CFC2's country A taxable income of 50u). The income of the CFC3 
U.S. combined income group is 200u (CFC3's country A taxable income of 
200u). Pursuant to Sec. 1.909-2(b)(2)(iii)(B), the shared loss of the 
CFC2 U.S. combined income group includes the 100u of shared loss 
incurred by DE. The usable shared loss of the CFC2 U.S. combined income 
group is 50u, the amount of the group's shared loss that could have 
otherwise offset CFC2's 50u of country A taxable income that is included 
in the income of the CFC2 U.S. combined income group. There is a 
splitter arrangement because the 50u usable shared loss of the CFC2 U.S. 
combined income group was used instead to offset income of CFC3, which 
is included in the CFC3 U.S. combined income group. Pursuant to Sec. 
1.909-2(b)(2)(iv), the split taxes are the 15u of country A income taxes 
paid by CFC2 on 50u of income, an amount of income of the CFC2 U.S. 
combined income group equal to the amount of usable shared loss of that 
group that was used to offset income of the CFC3 U.S. combined income 
group. Pursuant to Sec. 1.909-2(b)(2)(v), the related income is the 50u 
of CFC3's income that equals the amount of income of the CFC3 U.S. 
combined income group that was offset by the usable shared loss of the 
CFC2 U.S. combined income group.
    Example 2. (i) Facts. USP, a domestic corporation, wholly owns CFC1, 
a corporation organized in country B. CFC1 wholly owns CFC2 and CFC3, 
both corporations organized in country B. CFC2 wholly owns DE, an entity 
organized in country B. DE is a corporation for country B tax purposes 
and a disregarded entity for U.S. Federal income tax purposes. CFC2 and 
CFC3 each own 50% of HP1, an entity organized in country B. HP1 is a 
corporation for country B tax purposes and a partnership for U.S. 
Federal income tax purposes. All items of income and loss of HP1 are 
allocated for U.S. Federal income tax purposes equally between CFC2 and 
CFC3, and all entities use the country B currency ``u'' as their 
functional currency. Country B has a loss-sharing regime under which a 
loss of any of CFC1, CFC2, CFC3, DE, and HP1 may be used to offset the 
income of one or more of the others. Country B imposes an income tax at 
the rate of 30% on the taxable income of corporations organized in 
country B. In year 1, before any loss sharing, CFC2 has income of 100u, 
CFC1 and CFC3 have no income, DE has a loss of 100u, and HP1 has income 
of 200u. Under the provisions of country B's loss-sharing regime, the 
group decides to use DE's 100u loss to offset 100u of HP1's income. 
After the loss is shared, for country B tax purposes, CFC2 has 100u of 
income on which it pays 30u of country B income tax, and HP1 has 100u of 
income (200u less the 100u shared loss) on which it pays 30u of country 
B income tax. For U.S. Federal income tax purposes, the loss sharing 
with HP1 is not taken into account, and, because DE is a disregarded 
entity, its 100u loss is taken into account by CFC2 and reduces CFC2's 
earnings and profits for U.S. Federal income tax purposes. The 200u 
income of HP1 is allocated 50/50 to CFC2 and CFC3, as is the 30u of 
country B income tax paid by HP1. Accordingly, before application of 
section 909, for U.S. Federal income tax purposes, CFC2 has earnings and 
profits of 55u (100u income

[[Page 15]]

plus 100u share of HP1's income less 100u loss of DE less 30u country B 
income tax paid by CFC2 less 15u share of HP1's country B income tax) 
and the dollar equivalent of 45u of country B income tax to add to its 
post-1986 foreign income taxes pool. CFC3 has earnings and profits of 
85u (100u share of HP1's income less 15u share of HP1's country B income 
taxes) and the dollar equivalent of 15u of country B income tax to add 
to its post-1986 foreign income taxes pool.
    (ii) U.S. combined income groups. Pursuant to Sec. 1.909-
2(b)(2)(ii), because the income and loss of HP1 are combined in part 
with the income and loss of both CFC2 and CFC3, it belongs to both of 
the separate CFC2 and CFC3 U.S. combined income groups. DE is a member 
of the CFC2 U.S. combined income group.
    (iii) Income of the U.S. combined income groups. Pursuant to Sec. 
1.909-2(b)(2)(iii)(A), the income of the CFC2 U.S. combined income group 
is the 200u country B taxable income of the members of the group with 
positive taxable incomes (CFC2's country B taxable income of 100u plus 
50% of HP1's country B taxable income of 200u, or 100u). Because DE does 
not have positive taxable income for country B tax purposes, its 100u 
loss is not included in the income of the CFC2 U.S. combined income 
group. The income of the CFC3 U.S. combined income group is 100u (50% of 
HP1's country B taxable income of 200u, or 100u).
    (iv) Shared loss of the U.S. combined income groups. Pursuant to 
Sec. 1.909-2(b)(2)(iii)(B), the shared loss of the CFC2 U.S. combined 
income group is the 100u loss incurred by DE that is used to offset 100u 
of HP1's income. The CFC3 U.S. combined income group has no shared loss. 
Pursuant to Sec. 1.909-2(b)(2)(i), the usable shared loss of the CFC2 
U.S. combined income group is 100u, the full amount of the group's 100u 
shared loss that could have been used to offset income of the CFC2 U.S. 
combined income group had the loss been used to offset 100u of CFC2's 
country B taxable income.
    (v) Income offset by shared loss. The shared loss of the CFC2 
combined income group is used to offset 100u country B taxable income of 
HP1. Because the taxable income of HP1 is allocated 50/50 between the 
CFC2 and CFC3 U.S. combined income groups, the shared loss is treated as 
offsetting 50u of the CFC2 U.S. combined income group's income and 50u 
of the CFC3 U.S. combined income group's income.
    (vi) Splitter arrangement. There is a splitter arrangement because 
50u of the 100u usable shared loss of the CFC2 U.S. combined income 
group was used to offset income of the CFC3 U.S. combined income group. 
Pursuant to Sec. 1.909-2(b)(2)(iv), the split taxes are the 15u of 
country B income tax paid by CFC2 on 50u of its income, which is equal 
to the amount of the CFC2 U.S. combined income group's usable shared 
loss that was used to offset income of another U.S. combined income 
group. Pursuant to Sec. 1.909-2(b)(2)(v), the related income is the 50u 
of CFC3's income that was offset by the usable shared loss of the CFC2 
U.S. combined income group.

    (3) Hybrid instrument splitter arrangements--(i) U.S. equity hybrid 
instrument splitter arrangement--(A) In general. A U.S. equity hybrid 
instrument is a splitter arrangement if:
    (1) Under the laws of a foreign jurisdiction in which the instrument 
owner is subject to tax, the instrument gives rise to income includible 
in the instrument owner's income and such inclusion results in foreign 
income taxes paid or accrued by the instrument owner;
    (2) Under the laws of a foreign jurisdiction in which the issuer is 
subject to tax, the instrument gives rise to deductions that are 
incurred or otherwise taken into account by the issuer; and
    (3) The events that give rise to income includible in the instrument 
owner's income for foreign tax purposes as described in paragraph 
(b)(3)(i)(A)(1) of this section, and to deductions for the issuer for 
foreign tax purposes as described in paragraph (b)(3)(i)(A)(2) of this 
section, do not result in an inclusion of income for the instrument 
owner for U.S. federal income tax purposes.
    (B) Split taxes from a U.S. equity hybrid instrument splitter 
arrangement. Split taxes from a U.S. equity hybrid instrument splitter 
arrangement equal the total amount of foreign income taxes paid or 
accrued by the owner of the hybrid instrument less the amount of foreign 
income taxes that would have been paid or accrued had the owner of the 
U.S. equity hybrid instrument not been subject to foreign tax on income 
from the instrument with respect to the events described in Sec. 1.909-
2(b)(3)(i)(A).
    (C) Related income from a U.S. equity hybrid instrument splitter 
arrangement. The related income with respect to split taxes from a U.S. 
equity hybrid instrument splitter arrangement is income of the issuer of 
the U.S. equity hybrid instrument in an amount equal to the amounts 
giving rise to the split taxes that are deductible by the issuer for 
foreign tax purposes, determined without regard to the actual amount of

[[Page 16]]

the issuer's income or earnings and profits for U.S. Federal income tax 
purposes.
    (D) U.S. equity hybrid instrument. The term U.S. equity hybrid 
instrument means an instrument that is treated as equity for U.S. 
Federal income tax purposes but for foreign income tax purposes either 
is treated as indebtedness or otherwise entitles the issuer to a 
deduction with respect to such instrument.
     (E) Example--(i) Facts. USP, a domestic corporation, wholly owns 
CFC1, which wholly owns CFC2. Both CFC1 and CFC2 are corporations 
organized in country A. CFC2 issues an instrument to CFC1 that is 
treated as indebtedness for country A tax purposes but equity for U.S. 
Federal income tax purposes. Under country A's income tax laws, the 
instrument accrues interest at the end of each month, which results in a 
deduction for CFC2 and an income inclusion and tax liability for CFC1 in 
country A. The accrual of interest does not result in an inclusion of 
income for CFC1 for U.S. Federal income tax purposes. Pursuant to the 
terms of the instrument, CFC2 makes a distribution at the end of the 
year equal to the amounts of interest that have accrued during the year, 
and such payment is treated as a dividend that is included in the income 
of CFC1 for U.S. Federal income tax purposes.
    (ii) Result. Pursuant to Sec. 1.909-2(b)(3)(i)(D), because the 
instrument is treated as equity for U.S. Federal income tax purposes but 
is treated as indebtedness for country A tax purposes, it is a U.S. 
equity hybrid instrument. Pursuant to Sec. 1.909-2(b)(3)(i)(A)(3), 
because the accrual of interest under foreign law does not result in an 
inclusion of income of CFC1 for U.S. Federal income tax purposes, there 
is a splitter arrangement. The fact that the payment of the accrued 
amount at the end of the year pursuant to the terms of the instrument 
gives rise to a dividend that is included in income of CFC1 for U.S. 
Federal income tax purposes does not change the result because it is the 
accrual of interest and not the payment that gives rise to income or 
deductions under foreign law. The payments will be treated as a 
distribution of related income to the extent provided by Sec. 1.909-3 
and Sec. 1.909-6(d).
    (ii) U.S. debt hybrid instrument splitter arrangement--(A) In 
general. A U.S. debt hybrid instrument is a splitter arrangement if 
foreign income taxes are paid or accrued by the issuer of a U.S. debt 
hybrid instrument with respect to income in an amount equal to the 
interest (including original issue discount) paid or accrued on the 
instrument that is deductible for U.S. Federal income tax purposes but 
that does not give rise to a deduction under the laws of a foreign 
jurisdiction in which the issuer is subject to tax.
    (B) Split taxes from a U.S. debt hybrid instrument splitter 
arrangement. Split taxes from a U.S. debt hybrid instrument splitter 
arrangement are the foreign income taxes paid or accrued by the issuer 
on the income that would have been offset by the interest paid or 
accrued on the U.S. debt hybrid instrument had such interest been 
deductible for foreign tax purposes.
    (C) Related income from a U.S. debt hybrid instrument splitter 
arrangement. The related income from a U.S. debt hybrid instrument 
splitter arrangement is the gross amount of the interest income 
recognized for U.S. Federal income tax purposes by the owner of the U.S. 
debt hybrid instrument, determined without regard to the actual amount 
of the owner's income or earnings and profits for U.S. Federal income 
tax purposes.
    (D) U.S. debt hybrid instrument. The term U.S. debt hybrid 
instrument means an instrument that is treated as equity for foreign tax 
purposes but as indebtedness for U.S. Federal income tax purposes.
    (4) Partnership inter-branch payment splitter arrangements--(i) In 
general. An allocation of foreign income tax paid or accrued by a 
partnership with respect to an inter-branch payment as described in 
Sec. 1.704-1(b)(4)(viii)(d)(3) (revised as of April 1, 2011) (the 
inter-branch payment tax) is a splitter arrangement to the extent the 
inter-branch payment tax is not allocated to the partners in the same 
proportion as the distributive shares of income in the CFTE category to 
which the inter-branch payment tax is or would be assigned under Sec. 
1.704-1(b)(4)(viii)(d) without regard to Sec. 1.704-
1(b)(4)(viii)(d)(3).

[[Page 17]]

    (ii) Split taxes from a partnership inter-branch payment splitter 
arrangement. The split taxes from a partnership inter-branch splitter 
arrangement equal the excess of the amount of the inter-branch payment 
tax allocated to a partner under the partnership agreement over the 
amount of the inter-branch payment tax that would have been allocated to 
the partner if the inter-branch payment tax had been allocated to the 
partners in the same proportion as the distributive shares of income in 
the CFTE category referred to in paragraph (b)(4)(i) of this section.
    (iii) Related income from a partnership inter-branch payment 
splitter arrangement. The related income from a partnership inter-branch 
payment splitter arrangement equals the amount of income allocated to a 
partner that exceeds the amount of income that would have been allocated 
to the partner if income in the CFTE category referred to in paragraph 
(b)(4)(i) of this section in the amount of the inter-branch payment had 
been allocated to the partners in the same proportion as the inter-
branch payment tax was allocated under the partnership agreement.
    (c) Effective/applicability date. This section applies to foreign 
income taxes paid or accrued in taxable years ending after February 9, 
2015. However, a taxpayer may choose to apply the provisions of Sec. 
1.909-2T (as contained in 26 CFR part 1, revised as of April 1, 2014) in 
lieu of this section to foreign income taxes paid or accrued in its 
first taxable year ending after February 9, 2015, and in taxable years 
of foreign corporations with respect to which the taxpayer is a domestic 
shareholder (as defined in Sec. 1.902-1(a)) that end with or within 
that first taxable year. See 26 CFR 1.909-2T (revised as of April 1, 
2014) for rules applicable to foreign income taxes paid or accrued in 
taxable years beginning on or after January 1, 2012, and ending on or 
before February 9, 2015.

[T.D. 9710, 80 FR 7328, Feb. 10, 2015]



Sec. 1.909-3  Rules regarding related income and split taxes.

    (a) Interim rules for identifying related income and split taxes. 
The principles of paragraphs (d) through (f) of Sec. 1.909-6 apply to 
related income and split taxes in taxable years beginning on or after 
January 1, 2011, except that the alternative method for identifying 
distributions of related income described in Sec. 1.909-6(d)(4) applies 
only to identify the amount of pre-2011 split taxes of a section 902 
corporation that are suspended as of the first day of the section 902 
corporation's first taxable year beginning on or after January 1, 2011.
    (b) Split taxes on deductible disregarded payments. Split taxes 
include taxes paid or accrued in taxable years beginning on or after 
January 1, 2011, with respect to the amount of a disregarded payment 
that is deductible by the payor of the disregarded payment under the 
laws of a foreign jurisdiction in which the payor of the disregarded 
payment is subject to tax on related income from a splitter arrangement. 
The amount of the deductible disregarded payment to which this paragraph 
(b) applies is limited to the amount of related income from such 
splitter arrangement.
    (c) Effective/applicability date. This section applies to taxable 
years ending after February 9, 2015. See 26 CFR 1.909-3T (revised as of 
April 1, 2014) for rules applicable to taxable years beginning on or 
after January 1, 2011, and ending on or before February 9, 2015.

[T.D. 9710, 80 FR 7332, Feb. 10, 2015]



Sec. 1.909-4  Coordination rules.

    (a) Interim rules. The principles of paragraph (g) of Sec. 1.909-6 
apply to taxable years beginning on or after January 1, 2011.
    (b) Effective/applicability date. This section applies to taxable 
years ending after February 9, 2015. See 26 CFR 1.909-4T (revised as of 
April 1, 2014) for rules applicable to taxable years beginning on or 
after January 1, 2011, and ending on or before February 9, 2015.

[T.D. 9710, 80 FR 7332, Feb. 10, 2015]



Sec. 1.909-5  2011 and 2012 splitter arrangements.

    (a) Taxes paid or accrued in taxable years beginning in 2011. (1) 
Foreign income taxes paid or accrued by any person in a taxable year 
beginning on or after January 1, 2011, and before January 1, 2012, in 
connection with a pre-2011 splitter arrangement (as defined in

[[Page 18]]

Sec. 1.909-6(b)), are split taxes to the same extent that such taxes 
would have been treated as pre-2011 split taxes if such taxes were paid 
or accrued by a section 902 corporation in a taxable year beginning on 
or before December 31, 2010. The related income with respect to split 
taxes from such an arrangement is the related income described in Sec. 
1.909-6(b), determined as if the payor were a section 902 corporation.
    (2) Foreign income taxes paid or accrued by any person in a taxable 
year beginning on or after January 1, 2011, and before January 1, 2012, 
in connection with a partnership inter-branch payment splitter 
arrangement described in Sec. 1.909-2(b)(4) are split taxes to the 
extent that such taxes are identified as split taxes in Sec. 1.909-
2(b)(4)(ii). The related income with respect to the split taxes is the 
related income described in Sec. 1.909-2(b)(4)(iii).
    (b) Taxes paid or accrued in certain taxable years beginning in 2012 
with respect to a foreign consolidated group splitter arrangement. 
Foreign income taxes paid or accrued by any person in a taxable year 
beginning on or after January 1, 2012, and on or before February 14, 
2012, in connection with a foreign consolidated group splitter 
arrangement described in Sec. 1.909-6(b)(2) are split taxes to the same 
extent that such taxes would have been treated as pre-2011 split taxes 
if such taxes were paid or accrued by a section 902 corporation in a 
taxable year beginning on or before December 31, 2010. The related 
income with respect to split taxes from such an arrangement is the 
related income described in Sec. 1.909-6(b)(2), determined as if the 
payor were a section 902 corporation.
    (c) Effective/applicability date. The rules of this section apply to 
foreign income taxes paid or accrued in taxable years beginning on or 
after January 1, 2011, and on or before February 14, 2012.

[T.D. 9710, 80 FR 7332, Feb. 10, 2015]



Sec. 1.909-6  Pre-2011 foreign tax credit splitting events.

    (a) Foreign tax credit splitting event--(1) In general. This section 
provides rules for determining whether foreign income taxes paid or 
accrued by a section 902 corporation (as defined in section 909(d)(5)) 
in taxable years beginning on or before December 31, 2010 (pre-2011 
taxable years and pre-2011 taxes) are suspended under section 909 in 
taxable years beginning after December 31, 2010, (post-2010 taxable 
years) of a section 902 corporation. Paragraph (b) of this section 
identifies an exclusive list of arrangements that will be treated as 
giving rise to foreign tax credit splitting events in pre-2011 taxable 
years (pre- 2011 splitter arrangements). Paragraphs (c), (d), and (e) of 
this section provide rules for determining the related income and pre-
2011 split taxes paid or accrued with respect to pre-2011 splitter 
arrangements. Paragraph (f) of this section provides rules concerning 
the application of section 909 to partnerships and trusts. Paragraph (g) 
of this section provides rules concerning the interaction between 
section 909 and other Internal Revenue Code (Code) provisions.
    (2) Taxes not subject to suspension under section 909. Pre-2011 
taxes that will not be suspended under section 909 or paragraph (a) of 
this section are:
    (i) Any pre-2011 taxes that were not paid or accrued in connection 
with a pre-2011 splitter arrangement identified in paragraph (b) of this 
section;
    (ii) Any pre-2011 taxes that were paid or accrued in connection with 
a pre-2011 splitter arrangement identified in paragraph (b) of this 
section (pre-2011 split taxes) but that were deemed paid under section 
902(a) or 960 on or before the last day of the section 902 corporation's 
last pre-2011 taxable year;
    (iii) Any pre-2011 split taxes if either the payor section 902 
corporation took the related income into account in a pre-2011 taxable 
year or a section 902 shareholder (as defined in Sec. 1.909-1(a)(2)) of 
the relevant section 902 corporation took the related income into 
account on or before the last day of the section 902 corporation's last 
pre-2011 taxable year; and
    (iv) Any pre-2011 split taxes paid or accrued by a section 902 
corporation in taxable years of such section 902 corporation beginning 
before January 1, 1997.
    (3) Taxes subject to suspension under section 909. To the extent 
that the section 902 corporation paid or accrued

[[Page 19]]

pre-2011 split taxes that are not described in paragraph (a)(2) of this 
section, section 909 and the regulations under that section will apply 
to such pre-2011 split taxes for purposes of applying sections 902 and 
960 in post-2010 taxable years of the section 902 corporation. 
Accordingly, these taxes will be removed from the section 902 
corporation's pools of post-1986 foreign income taxes and suspended 
under section 909 as of the first day of the section 902 corporation's 
first post-2010 taxable year. There is no increase to a section 902 
corporation's earnings and profits for the amount of any pre-2011 taxes 
to which section 909 applies that were previously deducted in computing 
earnings and profits in a pre-2011 taxable year.
    (b) Pre-2011 splitter arrangements. The arrangements set forth in 
this paragraph (b) are pre-2011 splitter arrangements.
    (1) Reverse hybrid structure splitter arrangements. A reverse hybrid 
structure exists when a section 902 corporation owns an interest in a 
reverse hybrid. A reverse hybrid is an entity that is a corporation for 
U.S. Federal income tax purposes but is a pass-through entity or a 
branch under the laws of a foreign country imposing tax on the income of 
the entity. As a result, the owner of the reverse hybrid is subject to 
tax on the income of the entity under foreign law. A pre-2011 splitter 
arrangement involving a reverse hybrid structure exists when pre-2011 
taxes are paid or accrued by a section 902 corporation with respect to 
income of a reverse hybrid that is a covered person with respect to the 
section 902 corporation. A pre-2011 splitter arrangement involving a 
reverse hybrid structure may exist even if the reverse hybrid has a 
deficit in earnings and profits for a particular year (for example, due 
to a timing difference). Such taxes paid or accrued by the section 902 
corporation are pre-2011 split taxes. The related income is the earnings 
and profits (computed for U.S. Federal income tax purposes) of the 
reverse hybrid attributable to the activities of the reverse hybrid that 
gave rise to income included in the foreign tax base with respect to 
which the pre-2011 split taxes were paid or accrued. Accordingly, 
related income of the reverse hybrid would not include any item of 
income or expense attributable to a disregarded entity (as defined in 
Sec. 301.7701-2(c)(2)(i) of this chapter) owned by the reverse hybrid 
if income attributable to the activities of the disregarded entity is 
not included in the foreign tax base.
    (2) Foreign consolidated group splitter arrangements. A foreign 
consolidated group exists when a foreign country imposes tax on the 
combined income of two or more entities. Tax is considered imposed on 
the combined income of two or more entities even if the combined income 
is computed under foreign law by attributing to one such entity the 
income of one or more entities. A foreign consolidated group is a pre-
2011 splitter arrangement to the extent that the taxpayer did not 
allocate the foreign consolidated tax liability among the members of the 
foreign consolidated group based on each member's share of the 
consolidated taxable income included in the foreign tax base under the 
principles of Sec. 1.901-2(f)(3) (revised as of April 1, 2011). A pre-
2011 splitter arrangement involving a foreign consolidated group may 
exist even if one or more members has a deficit in earnings and profits 
for a particular year (for example, due to a timing difference). Pre-
2011 taxes paid or accrued with respect to the income of a foreign 
consolidated group are pre-2011 split taxes to the extent that taxes 
paid or accrued by one member of the foreign consolidated group are 
imposed on a covered person's share of the consolidated taxable income 
included in the foreign tax base. The related income is the earnings and 
profits (computed for U.S. Federal income tax purposes) of such other 
member attributable to the activities of that other member that gave 
rise to income included in the foreign tax base with respect to which 
the pre-2011 split taxes were paid or accrued. No inference should be 
drawn from the treatment of foreign consolidated groups under section 
909 as to the determination of the person who paid the foreign income 
tax for U.S. Federal income tax purposes.
    (3) Group relief or other loss-sharing regime splitter 
arrangements--(i) In general. A foreign group relief or other loss-

[[Page 20]]

sharing regime exists when one entity with a loss permits the loss to be 
used to offset the income of one or more entities (shared loss). A pre-
2011 splitter arrangement involving a shared loss exists when the 
following three conditions are met:
    (A) There is an instrument that is treated as indebtedness under the 
laws of the jurisdiction in which the issuer is subject to tax and that 
is disregarded for U.S. Federal income tax purposes (disregarded debt 
instrument). Examples of a disregarded debt instrument include a debt 
obligation between two disregarded entities that are owned by the same 
section 902 corporation, two disregarded entities that are owned by a 
partnership with one or more partners that are section 902 corporations, 
a section 902 corporation and a disregarded entity that is owned by that 
section 902 corporation, or a partnership in which the section 902 
corporation is a partner and a disregarded entity that is owned by such 
partnership.
    (B) The owner of the disregarded debt instrument pays a foreign 
income tax attributable to a payment or accrual on the instrument.
    (C) The payment or accrual on the disregarded debt instrument gives 
rise to a deduction for foreign tax purposes and the issuer of the 
instrument incurs a shared loss that is taken into account under foreign 
law by one or more entities that are covered persons with respect to the 
owner of the instrument.
    (ii) Split taxes and related income. In situations described in 
paragraph (b)(3)(i) of this section, pre-2011 taxes paid or accrued by 
the owner of the disregarded debt instrument with respect to amounts 
paid or accrued on the instrument (up to the amount of the shared loss) 
are pre-2011 split taxes. The related income of a covered person is an 
amount equal to the shared loss, determined without regard to the actual 
amount of the covered person's earnings and profits.
    (4) Hybrid instrument splitter arrangements--(i) In general. A 
hybrid instrument for purposes of this paragraph (b)(4) is an instrument 
that either is treated as equity for U.S. Federal income tax purposes 
but is treated as indebtedness for foreign tax purposes (U.S. equity 
hybrid instrument), or is treated as indebtedness for U.S. Federal 
income tax purposes but is treated as equity for foreign tax purposes 
(U.S. debt hybrid instrument).
    (ii) U.S. equity hybrid instrument splitter arrangement. If the 
issuer of a U.S. equity hybrid instrument is a covered person with 
respect to a section 902 corporation that is the owner of the U.S. 
equity hybrid instrument, there is a pre-2011 splitter arrangement with 
respect to the portion of the pre-2011 taxes paid or accrued by the 
owner section 902 corporation with respect to the amounts on the 
instrument that are deductible by the issuer as interest under the laws 
of a foreign jurisdiction in which the issuer is subject to tax but that 
do not give rise to income for U.S. Federal income tax purposes. Pre-
2011 split taxes paid or accrued by the section 902 corporation equal 
the total amount of pre-2011 taxes paid or accrued by the section 902 
corporation less the amount of pre-2011 taxes that would have been paid 
or accrued had the section 902 corporation not been subject to tax on 
income from the U.S. equity hybrid instrument. The related income of the 
issuer of the U.S. equity hybrid instrument is an amount equal to the 
amounts that are deductible by the issuer for foreign tax purposes, 
determined without regard to the actual amount of the issuer's earnings 
and profits.
    (iii) U.S. debt hybrid instrument splitter arrangement. If the owner 
of a U.S. debt hybrid instrument is a covered person with respect to a 
section 902 corporation that is the issuer of the U.S. debt hybrid 
instrument, there is a pre-2011 splitter arrangement with respect to the 
portion of the pre-2011 taxes paid or accrued by the section 902 
corporation on income in an amount equal to the interest (including 
original issue discount) paid or accrued on the instrument that is 
deductible for U.S. Federal income tax purposes but that does not give 
rise to a deduction under the laws of a foreign jurisdiction in which 
the issuer is subject to tax. Pre-2011 split taxes are the pre-2011 
taxes paid or accrued by the section 902 corporation on the income that 
would have

[[Page 21]]

been offset by the interest paid or accrued on the U.S. debt hybrid 
instrument had such interest been deductible for foreign tax purposes. 
The related income with respect to a U.S. debt hybrid instrument is the 
gross amount of the interest income recognized for U.S. Federal income 
tax purposes by the owner of the U.S. debt hybrid instrument, determined 
without regard to the actual amount of the owner's earnings and profits.
    (c) General rules for applying section 909 to pre-2011 split taxes 
and related income--(1) Annual determination. The determination of 
related income, other income, pre-2011 split taxes, and other taxes, and 
the portion of these amounts that were distributed, deemed paid or 
otherwise transferred or eliminated must be made on an annual basis 
beginning with the first taxable year of the section 902 corporation 
beginning after December 31, 1996 (post-1996 taxable year) in which the 
section 902 corporation paid or accrued a pre-2011 tax with respect to a 
pre-2011 splitter arrangement and ending with the section 902 
corporation's last pre-2011 taxable year. Annual amounts of related 
income and pre-2011 split taxes are aggregated for each separate pre-
2011 splitter arrangement.
    (2) Separate categories. The determination of annual and aggregate 
amounts of related income and pre-2011 split taxes with respect to each 
pre-2011 splitter arrangement must be made for each separate category as 
defined in Sec. 1.904-4(m) of the section 902 corporation, each covered 
person, and any other person that succeeds to the related income and 
pre-2011 split taxes. In the case of a pre-2011 splitter arrangement 
involving a shared loss (as described in paragraph (b)(3) of this 
section), the amount of the related income in each separate category of 
the covered person is equal to the amount of income in that separate 
category that was offset by the shared loss for foreign tax purposes. In 
the case of a pre-2011 splitter arrangement involving a U.S. equity 
hybrid instrument (as described in paragraph (b)(4)(ii) of this 
section), the related income is assigned to the issuer's separate 
categories in the same proportions as the pre-2011 split taxes. Earnings 
and profits, including related income, are assigned to separate 
categories under the rules of Sec. Sec. 1.904-4, 1.904-5, and 1.904-7. 
Foreign income taxes, including pre-2011 split taxes, are assigned to 
separate categories under the rules of Sec. 1.904-6. A section 902 
shareholder must consistently apply methodologies for determining pre-
2011 split taxes and related income with respect to all pre-2011 
splitter arrangements.
    (d) Special rules regarding related income--(1) Annual adjustments. 
In the case of each pre-2011 splitter arrangement involving a reverse 
hybrid or a foreign consolidated group (as described in paragraphs 
(b)(1) and (2) of this section, respectively), a covered person's 
aggregate amount of related income must be adjusted each year by the net 
amount of income and expense attributable to the activities of the 
covered person that give rise to income included in the foreign tax 
base, even if the net amount is negative and regardless of whether the 
section 902 corporation paid or accrued any pre-2011 split taxes in such 
year.
    (2) Effect of separate limitation losses and deficits. Related 
income is determined without regard to the application of Sec. 1.960-
1(i)(4) (relating to the effect of separate limitation losses on 
earnings and profits in another separate category) or section 952(c)(1) 
(relating to certain earnings and profits deficits).
    (3) Pro rata method for distributions out of earnings and profits 
that include both related income and other income. If the earnings and 
profits of a covered person include amounts attributable to both related 
income and other income, including earnings and profits attributable to 
taxable years beginning before January 1, 1997, then distributions, 
deemed distributions, and inclusions out of earnings and profits (for 
example, under sections 301, 304, 367(b), 951(a), 964(e), 1248, or 1293) 
of the covered person are considered made out of related income and 
other income on a pro rata basis. Any reduction of a covered person's 
earnings and profits that results from a payment on stock that is not 
treated as a dividend for U.S. Federal income tax purposes (for example, 
pursuant to section 312(n)(7)) will

[[Page 22]]

also reduce related income and other income on a pro rata basis.
    (4) Alternative method for distributions out of earnings and profits 
that include both related income and other income. Solely for purposes 
of identifying the amount of pre-2011 split taxes of a section 902 
corporation that are suspended as of the first day of the section 902 
corporation's first post-2010 taxable year, in lieu of the rule set 
forth in paragraph (d)(3) of this section, a section 902 shareholder may 
choose to treat all distributions, deemed distributions, and inclusions 
out of earnings and profits of a covered person as attributable first to 
related income. A section 902 shareholder may choose to use this 
alternative method on a timely filed original income tax return for the 
first post-2010 taxable year in which the shareholder computes an amount 
of foreign income taxes deemed paid with respect to a section 902 
corporation that paid or accrued pre-2011 split taxes. Such choice by a 
section 902 shareholder is evidenced by employing the method on its 
income tax return; the section 902 shareholder need not file a separate 
statement. A section 902 shareholder that chooses this alternative 
method must consistently apply it with respect to all pre-2011 splitter 
arrangements.
    (5) Distributions, deemed distributions, and inclusions of related 
income. Distributions, deemed distributions, and inclusions of related 
income (including indirectly through a partnership) to persons other 
than the payor section 902 corporation retain their character as related 
income with respect to the associated pre-2011 split taxes.
    (6) Carryover of related income. Related income carries over to 
other corporations in the same manner as earnings and profits carry over 
under section 381, Sec. 1.367(b)-7, or similar rules, and retains its 
character as related income with respect to the associated pre-2011 
split taxes.
    (7) Related income taken into account by a section 902 shareholder. 
Related income will be considered taken into account by a section 902 
shareholder to the extent that the related income is recognized as gross 
income by the section 902 shareholder, or by an affiliated corporation 
described in paragraph (d)(9) of this section, upon a distribution, 
deemed distribution, or inclusion (such as under section 951(a)) out of 
the earnings and profits of the covered person attributable to such 
related income.
    (8) Related income taken into account by a payor section 902 
corporation. Related income will be considered taken into account by a 
payor section 902 corporation to the extent that:
    (i) The related income is reflected in the earnings and profits of 
such section 902 corporation for U.S. Federal income tax purposes by 
reason of a distribution, deemed distribution, or inclusion out of the 
earnings and profits of the covered person attributable to such related 
income; or
    (ii) The related income is reflected as a positive adjustment to the 
earnings and profits of such section 902 corporation for U.S. Federal 
income tax purposes by reason of the section 902 corporation and the 
covered person combining in a transaction described in section 381(a)(1) 
or (a)(2).
    (9) Related income taken into account by an affiliated group of 
corporations that includes a section 902 shareholder. A section 902 
shareholder will be considered to have taken related income into account 
if one or more members of an affiliated group of corporations (as 
defined in section 1504) that files a consolidated Federal income tax 
return that includes the section 902 shareholder takes the related 
income into account.
    (10) Distributions of previously-taxed earnings and profits. 
Distributions and deemed distributions described in paragraph (d) of 
this section (including in the case of a section 902 shareholder that 
has chosen the alternative method described in paragraph (d)(4) of this 
section) do not include distributions of amounts described in section 
959(c)(1) or (c)(2), which are distributed before amounts described in 
section 959(c)(3).
    (e) Special rules regarding pre-2011 split taxes--(1) Taxes deemed 
paid pro-rata out of pre-2011 split taxes and other taxes. If the pre-
2011 taxes of a section 902 corporation include both pre-2011 split 
taxes and other taxes, then foreign income taxes deemed paid under 
section 902 or 960 or otherwise removed from post-1986 foreign income 
taxes in pre-

[[Page 23]]

2011 taxable years will be treated as attributable to pre-2011 split 
taxes and other taxes on a pro-rata basis.
    (2) Pre-2011 split taxes deemed paid in pre-2011 taxable years. Pre-
2011 split taxes deemed paid in pre-2011 taxable years in connection 
with a dividend paid to a shareholder described in section 902(b) retain 
their character as pre-2011 split taxes. The section 902(b) shareholder 
will be treated as the payor section 902 corporation with respect to 
those pre-2011 split taxes.
    (3) Carryover of pre-2011 split taxes. Pre-2011 split taxes that 
carry over to another foreign corporation, including under section 381, 
Sec. 1.367(b)-7 or similar rules, retain their character as pre-2011 
split taxes. The transferee foreign corporation will be treated as the 
payor section 902 corporation with respect to those pre-2011 split 
taxes.
    (4) Determining when pre-2011 split taxes are no longer treated as 
pre-2011 split taxes. For each pre-2011 splitter arrangement, as related 
income is taken into account by the payor section 902 corporation or a 
section 902 shareholder as provided in paragraph (d) of this section, a 
ratable portion of the associated pre-2011 split taxes will no longer be 
treated as pre-2011 split taxes. In the case of a pre-2011 splitter 
arrangement involving a reverse hybrid or a foreign consolidated group 
(as described in paragraphs (b)(1) and (2) of this section, 
respectively), if aggregate related income is reduced to zero (other 
than as a result of a distribution, deemed distribution, or inclusion 
described in paragraph (d) of this section) or less than zero, pre-2011 
split taxes will retain their character as pre-2011 split taxes until 
the amount of aggregate related income is positive and the related 
income is taken into account by the payor section 902 corporation or a 
section 902 shareholder as provided in paragraph (d) of this section.
    (f) Rules relating to partnerships and trusts--(1) Taxes paid or 
accrued by partnerships. In the case of foreign income taxes paid or 
accrued by a partnership, the taxes will be treated as pre-2011 split 
taxes to the extent such taxes are allocated to one or more section 902 
corporations and would be pre-2011 split taxes if the partner section 
902 corporation had paid or accrued the taxes directly on the date such 
taxes are included by the section 902 corporation under sections 702 and 
706(a). Further, any foreign income taxes subject to section 909 will be 
suspended in the hands of the partner section 902 corporation.
    (2) Section 704(b) allocations. Partnership allocations that satisfy 
the requirements of section 704(b) and the regulations thereunder will 
not constitute pre-2011 splitter arrangements except to the extent the 
arrangement is otherwise described in paragraph (b) of this section (for 
example, a payment or accrual on a disregarded debt instrument that 
gives rise to a shared loss).
    (3) Trusts. Rules similar to the rules of paragraph (f)(1) of this 
section will apply in the case of any trust with one or more 
beneficiaries that is a section 902 corporation.
    (g) Interaction between section 909 and other Code provisions--(1) 
Section 904(c). Section 909 does not apply to excess foreign income 
taxes that were paid or accrued in pre-2011 taxable years and carried 
forward and deemed paid or accrued under section 904(c) in a post-2010 
taxable year.
    (2) Section 905(a). For purposes of determining in post-2010 taxable 
years the allowable deduction for foreign income taxes paid or accrued 
under section 164(a), the carryover of excess foreign income taxes under 
section 904(c), and the extended period for claiming a credit or refund 
under section 6511(d)(3)(A), foreign income taxes to which section 909 
applies are first taken into account and treated as paid or accrued in 
the year in which the related income is taken into account, and not in 
the earlier year to which the tax relates (determined without regard to 
section 909).
    (3) Section 905(c). If a redetermination of foreign income taxes 
claimed as a direct credit under section 901 occurs in a post-2010 
taxable year and the foreign tax redetermination relates to a pre-2011 
taxable year, to the extent such foreign tax redetermination increased 
the amount of foreign income taxes paid or accrued with respect to the 
pre-2011 taxable year (for example, due to an additional assessment of 
foreign tax or a payment of a previously accrued tax not paid within two 
years), section

[[Page 24]]

909 will not apply to such taxes. If a redetermination of foreign tax 
paid or accrued by a section 902 corporation occurs in a post-2010 
taxable year and increases the amount of foreign income taxes paid or 
accrued by the section 902 corporation with respect to a pre-2011 
taxable year (for example, due to an additional assessment of foreign 
tax or a payment of a previously accrued tax not paid within two years), 
such taxes will be treated as pre-2011 taxes. Section 909 will apply to 
such taxes if they are pre-2011 split taxes and the taxes will be 
suspended in the post-2010 taxable year in which they would otherwise be 
taken into account as a prospective adjustment to the section 902 
corporation's pools of post-1986 foreign income taxes.
    (4) Other foreign tax credit provisions. Section 909 does not affect 
the applicability of other restrictions or limitations on the foreign 
tax credit under existing law, including, for example, the 
substantiation requirements of section 905(b).
    (h) Effective/applicability date. This section applies to foreign 
income taxes paid or accrued by section 902 corporations in pre-2011 
taxable years for purposes of computing foreign income taxes deemed paid 
with respect to distributions or inclusions out of earnings and profits 
of section 902 corporations in taxable years of the section 902 
corporation ending after February 9, 2015. See 26 CFR 1.909-6T (revised 
as of April 1, 2014) for rules applicable to foreign income taxes paid 
or accrued by section 902 corporations in pre-2011 taxable years for 
purposes of computing foreign income taxes deemed paid with respect to 
distributions or inclusions out of earnings and profits of section 902 
corporations in taxable years of the section 902 corporation beginning 
after December 31, 2010, and ending on or before February 9, 2015.

[T.D. 9710, 80 FR 7332, Feb. 10, 2015]



Sec. 1.910  [Reserved]



Sec. 1.911-1  Partial exclusion for earned income from sources within
a foreign country and foreign housing costs.

    (a) In general. Section 911 provides that a qualified individual may 
elect to exclude the individual's foreign earned income and the housing 
cost amount from the individual's gross income for the taxable year. 
Foreign earned income is excludable to the extent of the applicable 
limitation for the taxable year. The housing cost amount for the taxable 
year is excludable to the extent attributable to employer provided 
amounts. If a portion of the housing cost amount for the taxable year is 
attributable to non-employer provided amounts, such amount may be 
deductible by the qualified individual subject to a limitation. The 
amounts excluded under section 911(a) and the amount deducted under 
section 911(c)(3)(A) for the taxable year shall not exceed the 
individual's foreign earned income for such taxable year. Foreign earned 
income must be earned during a period for which the individual qualifies 
to make an election under section 911(d)(1). A housing cost amount that 
would be deductible except for the application of this limitation may be 
carried over to the next taxable year and is deductible to the extent of 
the limitation for that year. Except as otherwise provided, Sec. Sec. 
1.911-1 through 1.911-7 apply to taxable years beginning after December 
31, 1981. These sections do not apply to any item of income, expense, 
deduction, or credit arising before January 1, 1982, even if such item 
is attributable to services performed after December 31, 1981.
    (b) Scope. Section 1.911-2 provides rules for determining whether an 
individual qualifies to make an election under section 911. Section 
1.911-3 provides rules for determining the amount of foreign earned 
income that is excludable under section 911(a)(1). Section 1.911-4 
provides rules for determining the housing cost amount and the portions 
excludable under section 911(a)(2) or deductible under section 
911(c)(3). Section 1.911-5 provides special rules applicable to married 
couples. Section 1.911-6 provides for the disallowance of deductions, 
exclusions, and credits attributable to amounts excluded under section 
911. Section 1.911-7 provides procedural rules for making or revoking an 
election under section 911. Section 1.911-8 provides a reference

[[Page 25]]

to rules applicable to taxable years beginning before January 1, 1982.

(Sec. 911 (95 Stat. 194; 26 U.S.C. 911) and sec. 7805 (68A Stat. 917; 26 
U.S.C. 7805) of the Internal Revenue Code of 1954)

[T.D. 8006, 50 FR 2964, Jan. 23, 1985]



Sec. 1.911-2  Qualified individuals.

    (a) In general. An individual is a qualified individual if:
    (1) The individual's tax home is in a foreign country or countries 
throughout--
    (i) The period of bona fide residence described in paragraph 
(a)(2)(i) of this section, or
    (ii) The 330 full days of presence described in paragraph (a)(2)(ii) 
of this section, and
    (2) The individual is either--
    (i) A citizen of the United States who establishes to the 
satisfaction of the Commissioner or his delegate that the individual has 
been a bona fide resident of a foreign country or countries for an 
uninterrupted period which includes an entire taxable year, or
    (ii) A citizen or resident of the United States who has been 
physically present in a foreign country or countries for at least 330 
full days during any period of twelve consecutive months.
    (b) Tax home. For purposes of paragraph (a)(i) of this section, the 
term ``tax home'' has the same meaning which it has for purposes of 
section 162(a)(2) (relating to travel expenses away from home). Thus, 
under section 911, an individual's tax home is considered to be located 
at his regular or principal (if more than one regular) place of business 
or, if the individual has no regular or principal place of business 
because of the nature of the business, then at his regular place of 
abode in a real and substantial sense. An individual shall not, however, 
be considered to have a tax home in a foreign country for any period for 
which the individual's abode is in the United States. Temporary presence 
of the individual in the United States does not necessarily mean that 
the individual's abode is in the United States during that time. 
Maintenance of a dwelling in the United States by an individual, whether 
or not that dwelling is used by the individual's spouse and dependents, 
does not necessarily mean that the individual's abode is in the United 
States.
    (c) Determination of bona fide residence. For purposes of paragraph 
(a)(2)(i) of this section, whether an individual is a bona fide resident 
of a foreign country shall be determined by applying, to the extent 
practical, the principles of section 871 and the regulations thereunder, 
relating to the determination of the residence of aliens. Bona fide 
residence in a foreign country or countries for an uninterrupted period 
may be established, even if temporary visits are made during the period 
to the United States or elsewhere on vacation or business. An individual 
with earned income from sources within a foreign country is not a bona 
fide resident of that country if:
    (1) The individual claims to be a nonresident of that foreign 
country in a statement submitted to the authorities of that country, and
    (2) The earned income of the individual is not subject, by reason of 
nonresidency in the foreign country, to the income tax of that country.


If an individual has submitted a statement of nonresidence to the 
authorities of a foreign country the accuracy of which has not been 
resolved as of any date when a determination of the individual's bona 
fide residence is being made, then the individual will not be considered 
a bona fide resident of the foreign country as of that date.
    (d) Determination of physical presence. For purposes of paragraph 
(a)(2)(ii) of this section, the following rules apply.
    (1) Twelve-month test. A period of twelve consecutive months may 
begin with any day but must end on the day before the corresponding day 
in the twelfth succeeding month. The twelve-month period may begin 
before or after arrival in a foreign country and may end before or after 
departure.
    (2) 330-day test. The 330 full days need not be consecutive but may 
be interrupted by periods during which the individual is not present in 
a foreign country. In computing the minimum 330 full days of presence in 
a foreign country or countries, all separate periods of such presence 
during the period

[[Page 26]]

of twelve consecutive months are aggregated. A full day is a continuous 
period of twenty-four hours beginning with midnight and ending with the 
following midnight. An individual who has been present in a foreign 
country and then travels over areas not within any foreign country for 
less than twenty-four hours shall not be deemed outside a foreign 
country during the period of travel. If an individual who is in transit 
between two points outside the United States is physically present in 
the United States for less than twenty-four hours, such individual shall 
not be treated as present in the United States during such transit but 
shall be treated as travelling over areas not within any foreign 
country. For purposes of this paragraph (d)(2), the term ``transit 
between two points outside the United States'' has the same meaning that 
it has when used in section 7701(b)(6)(C).
    (3) Illustrations of the physical presence requirement. The physical 
presence requirement of paragraph (a)(2)(ii) of this section is 
illustrated by the following examples:

    Example 1. B, a U.S. citizen, arrives in Venezuela from New York at 
12 noon on April 24, 1982. B remains in Venezuela until 2 p.m. on March 
21, 1983, at which time B departs for the United States. Among other 
possible twelve month periods, B is present in a foreign country an 
aggregate of 330 full days during each of the following twelve month 
periods: March 21, 1982 through March 20, 1983; and April 25, 1982 
through April 24, 1983.
    Example 2. C, a U.S. citizen, travels extensively from the time C 
leaves the United States on March 5, 1982, until the time C departs the 
United Kingdom on January 1, 1984, to return to the United States 
permanently. The schedule of C's travel and the number of full days at 
each location are listed below:

----------------------------------------------------------------------------------------------------------------
                                                                                                       Full days
                                                                                                           in
                   Country                      Time and date of arrival   Time and date of departure   foreign
                                                                                                        country
----------------------------------------------------------------------------------------------------------------
United States................................  ..........................  10 p.m. (by air) Mar. 5,
                                                                            1982.
United Kingdom...............................  9 a.m. Mar. 6, 1982.......  10 p.m. (by ship) June 25,        110
                                                                            1982.
United States................................  11 a.m. June 30, 1982.....  1 p.m. (by ship) July 19,           0
                                                                            1982.
France.......................................  3 p.m. July 24, 1982......  11 a.m. (by air) Aug. 22,         393
                                                                            1983.
United States................................  4 p.m. Aug. 22, 1983......  9 a.m. (by air) Sept. 4,            0
                                                                            1983.
United Kingdom...............................  9 a.m. Sept. 5, 1983......  9 a.m. (by air) Jan. 1,           117
                                                                            1984.
United States................................  1 p.m. Jan. 1, 1984.......  ..........................  .........
----------------------------------------------------------------------------------------------------------------

    Among other possible twelve-month periods, C is present in a foreign 
country or countries an aggregate of 330 full days during the following 
twelve-month periods: March 2, 1982 through March 1, 1983; and January 
21, 1983 through January 20, 1984. The computation of days with respect 
to each twelve month period may be illustrated as follows:
    First twelve-month period (March 2, 1982 through March 1, 1983):

------------------------------------------------------------------------
                                                               Full days
                                                                   in
                                                                foreign
                                                                country
------------------------------------------------------------------------
Mar. 2, 1982 through Mar. 6, 1982............................          0
Mar. 7, 1982 through June 24, 1982...........................        110
June 25, 1982 through July 24, 1982..........................          0
July 25, 1982 through Mar. 1, 1983...........................        220
                                                              ----------
    Total full days..........................................        330
------------------------------------------------------------------------

    Second twelve-month period (January 21, 1983 through January 20, 
1984):

------------------------------------------------------------------------
                                                               Full days
                                                                   in
                                                                foreign
                                                                country
------------------------------------------------------------------------
Jan. 21, 1983 through Aug. 21, 1983..........................        213
Aug. 22, 1983 through Sept. 5, 1983..........................          0
Sept. 6, 1983 through Dec. 31, 1983..........................        117
Jan. 1, 1984 through Jan. 20, 1984...........................          0
                                                              ----------
    Total full days..........................................        330
------------------------------------------------------------------------

    (e) Special rules. For purposes only of establishing that an 
individual is a qualified individual under paragraph (a) of this 
section, residence or presence in a foreign country while there employed 
by the U.S. government or any agency or instrumentality of the U.S. 
government counts towards satisfaction of the requirements of Sec. 
1.911-2(a). (But see section 911(b)(1)(B)(ii) and Sec. 1.911-3(c)(3) 
for the rule excluding amounts paid by the U.S. government to an 
employee from the definition of foreign earned income.) Time spent in a 
foreign country prior to January 1, 1982, counts toward satisfaction of 
the

[[Page 27]]

bona fide residence and physical presence requirements, even though no 
exclusion or deduction may be allowed under section 911 for income 
attributable to services performed during that time. For purposes or 
paragraph (a)(2)(ii) of this section, the term ``resident of the United 
States'' includes an individual for whom a valid election is in effect 
under section 6013 (g) or (h) for the taxable year or years during which 
the physical presence requirement is satisfied.
    (f) Waiver of period of stay in foreign country due to war or civil 
unrest. Notwithstanding the requirements of paragraph (a) of this 
section, an individual whose tax home is in, a foreign country, and who 
is a bona fide resident of, or present in a foreign country for any 
period, who leaves the foreign country after August 31, 1978, before 
meeting the requirements of paragraph (a) of this section, may as 
provided in this paragraph, qualify to make an election under section 
911(a) and Sec. 1.911-7(a). If the Secretary determines, after 
consultation with the Secretary of State or his delegate, that war, 
civil unrest, or similar adverse conditions existed in a foreign 
country, then the Secretary shall publish the name of the foreign 
country and the dates between which such conditions were deemed to 
exist. In order to qualify to make an election under this paragraph, the 
individual must establish to the satisfaction of the Secretary that the 
individual left a foreign country, the name of which has been published 
by the Secretary, during the period when adverse conditions existed and 
that the individual could reasonably have expected to meet the 
requirements of paragraph (a) of this section but for the adverse 
conditions. The individual shall attach to his return for the taxable 
year a statement that the individual expected to meet the requirements 
of paragraph (a) of this section but for the conditions in the foreign 
country which precluded the normal conduct of business by the 
individual. Such individual shall be treated as a qualified individual, 
but only for the actual period of residence or presence. Thus, in 
determining the number of the individual's qualifying days, only days 
within the period of actual residence or presence shall be counted.
    (g) United States. The term ``United States'' when used in a 
geographical sense includes any territory under the sovereignty of the 
United States. It includes the states, the District of Columbia, the 
possessions and territories of the United States, the territorial waters 
of the United States, the air space over the United States, and the 
seabed and subsoil of those submarine areas which are adjacent to the 
territorial waters of the United States and over which the United States 
has exclusive rights, in accordance with international law, with respect 
to the exploration and exploitation of natural resources.
    (h) Foreign country. The term ``foreign country'' when used in a 
geographical sense includes any territory under the sovereignty of a 
government other than that of the United States. It includes the 
territorial waters of the foreign country (determined in accordance with 
the laws of the United States), the air space over the foreign country, 
and the seabed and subsoil of those submarine areas which are adjacent 
to the territorial waters of the foreign country and over which the 
foreign country has exclusive rights, in accordance with international 
law, with respect to the exploration and exploitation of natural 
resources.

(Sec. 911 (95 Stat. 194; 26 U.S.C. 911) and sec. 7805 (68A Stat. 917; 26 
U.S.C. 7805) of the Internal Revenue Code of 1954)

[T.D. 8006, 50 FR 2965, Jan. 23, 1985]



Sec. 1.911-3  Determination of amount of foreign earned income
to be excluded.

    (a) Definition of foreign earned income. For purposes of section 911 
and the regulations thereunder, the term ``foreign earned income'' means 
earned income (as defined in paragraph (b) of this section) from sources 
within a foreign country (as defined in Sec. 1.911-2(h)) that is earned 
during a period for which the individual qualifies under Sec. 1.911-
2(a) to make an election. Earned income is from sources within a foreign 
country if it is attributable to services performed by an individual in 
a foreign country or countries. The place of receipt of earned income is 
immaterial in

[[Page 28]]

determining whether earned income is attributable to services performed 
in a foreign country or countries.
    (b) Definition of earned income--(1) In general. The term ``earned 
income'' means wages, salaries, professional fees, and other amounts 
received as compensation for personal services actually rendered 
including the fair market value of all remuneration paid in any medium 
other than cash. Earned income does not include any portion of an amount 
paid by a corporation which represents a distribution of earnings and 
profits rather than a reasonable allowance as compensation for personal 
services actually rendered to the corporation.
    (2) Earned income from business in which capital is material. In the 
case of an individual engaged in a trade or business (other than in 
corporate form) in which both personal services and capital are material 
income producing factors, a reasonable allowance as compensation for the 
personal services actually rendered by the individual shall be 
considered earned income, but the total amount which shall be treated as 
the earned income of the individual from such trade or business shall in 
no case exceed thirty percent of the individual's share of the net 
profits of such trade or business.
    (3) Professional fees. Earned income includes all fees received by 
an individual engaged in a professional occupation (such as doctor or 
lawyer) in the performance of professional activities. Professional fees 
constitute earned income even though the individual employs assistants 
to perform part or all of the services, provided the patients or clients 
are those of the individual and look to the individual as the person 
responsible for the services rendered.
    (c) Amounts not included in foreign earned income. Foreign earned 
income does not include an amount:
    (1) Excluded from gross income under section 119;
    (2) Received as a pension or annuity (including social security 
benefits);
    (3) Paid to an employee by an employer which is the U.S. government 
or any U.S. government agency or instrumentality;
    (4) Included in the individual's gross income by reason of section 
402(b) (relating to the taxability of a beneficiary of a nonexempt 
trust) or section 403(c) (relating to the taxability of a beneficiary 
under a nonqualified annuity or under annuities purchased by exempt 
organizations);
    (5) Included in gross income by reason of Sec. 1.911-6(b)(4)(ii); 
or
    (6) Received after the close of the first taxable year following the 
taxable year in which the services giving rise to the amounts were 
performed. For treatment of amounts received after December 31, 1962, 
which are attributable to services performed on or before December 31, 
1962, and with respect to which there existed on March 12, 1962, a right 
(whether forfeitable or nonforfeitable) to receive such amounts, see 
Sec. 1.72-8.
    (d) Determination of the amount of foreign earned income that may be 
excluded under section 911(a)(1)--(1) In general. Foreign earned income 
described in this section may be excluded under section 911(a)(1) and 
this paragraph only to the extent of the limitation specified in 
paragraph (d)(2) of this section. Income is considered to be earned in 
the taxable year in which the services giving rise to the income are 
performed. The determination of the amount of excluded earned income in 
this manner does not affect the time for reporting any amounts included 
in gross income.
    (2) Limitation--(i) In general. The term ``section 911(a)(1) 
limitation'' means the amount of foreign earned income for a taxable 
year which may be excluded under section 911(a)(1). The section 
911(a)(1) limitation shall be equal to the lesser of the qualified 
individual's foreign earned income for the taxable year in excess of 
amounts that the individual elected to exclude from gross income under 
section 911(a)(2) or the product of the annual rate for the taxable year 
(as specified in paragraph (d)(2)(ii) of this section) multiplied by the 
following fraction:
[GRAPHIC] [TIFF OMITTED] TC14NO91.137

    (ii) Annual rate for the taxable year. The annual rate for the 
taxable year is

[[Page 29]]

the rate set forth in section 911(b)(2)(A).
    (3) Number of qualifying days. For purposes of section 911 and the 
regulations thereunder, the number of qualifying days is the number of 
days in the taxable year within the period during which the individual 
met the tax home requirement and either the bona fide residence 
requirement or the physical presence requirement of Sec. 1.911-2(a). 
Although the period of bona fide residence must include an entire 
taxable year, the entire uninterrupted period of residence may include 
fractional parts of a taxable year. For instance, if an individual who 
was a calendar year taxpayer established a tax home and a residence in a 
foreign country as of November 1, 1982, and maintained the tax home and 
the residence through March 31, 1984, then the uninterrupted period of 
bona fide residence includes fractional parts of the years 1982 and 
1984, and all of 1983. The number of qualifying days in 1982 is sixty-
one. The number of qualifying days in 1983 is 365. The number of 
qualifying days in 1984 is ninety-one. The period during which the 
physical presence requirement of Sec. 1.911-2(a)(2)(ii) is met is any 
twelve consecutive month period during which the individual is 
physically present in one or more foreign countries for 330 days and the 
individual's tax home is in a foreign country during each day of such 
physical presence. Such period may include days when the individual is 
not physically present in a foreign country, and days when the 
individual does not maintain a tax home in a foreign country. Such 
period may include fractional parts of a taxable year. Thus, if an 
individual's period of physical, presence is the twelve-month period 
beginning June 1, 1982, and ending May 31, 1983, the number of 
qualifying days in 1982 is 214 and the number of qualifying days in 1983 
is 151.
    (e) Attribution rules--(1) In general. Foreign earned income is 
considered to be earned in the taxable year in which the individual 
performed the services giving rise to the income. If income is earned in 
one taxable year and received in another taxable year, then, for 
purposes of determining the amount of foreign earned income that the 
individual may exclude under section 911(a), the individual must 
attribute the income to the taxable year in which the services giving 
rise to the income were performed. Thus, any reimbursement would be 
attributable to the taxable year in which the services giving rise to 
the obligation to pay the reimbursement were performed, not the taxable 
year in which the reimbursement was received. For example, tax 
equalization payments are normally received in the year after the year 
in which the services giving rise to the obligation to pay the tax 
equalization payment were performed. Therefore, such payments will 
almost always have to be attributed to the prior year. Foreign earned 
income attributable to services performed in a preceding taxable year 
shall be excludable from gross income in the year of receipt only to the 
extent such amount could have been excluded under paragraph (d)(1) in 
the preceding taxable year, had such amount been received in the 
preceding taxable year. The taxable year to which income is attributable 
will be determined on the basis of all the facts and circumstances.
    (2) Priority of use of the section 911(a)(1) limitation. Foreign 
earned income received in the year in which it is earned shall be 
applied to the section 911(a)(1) limitation for that year before 
applying income earned in that year that is received in any other year. 
Foreign earned income that is earned in one year and received in another 
year shall be applied to the section 911(a)(1) limitation for the year 
in which it was earned, on a year by year basis, in any order that the 
individual chooses. (But see section 911(b)(1)(B)(iv)). An individual 
may not amend his return to change the treatment of income with respect 
to the section 911(a)(1) exclusion after the period provided by section 
6511(a). The special period of limitation provided by section 6511(d)(3) 
does not apply for this purpose. For example, C, a qualified individual, 
receives an advance bonus of $10,000 in 1982, salary of $70,000 in 1983, 
and a performance bonus of $10,000 in 1984, all of which are foreign 
earned income for 1983. C has a section 911(a)(1) limitation for 1983 of 
$80,000, and has no housing cost amount exclusion. On his income tax 
return for 1983, C elects to exclude

[[Page 30]]

foreign earned income of $70,000 received in 1983. C may also exclude 
his $10,000 advance bonus received in 1982 (by filing an amended return 
for 1982), or he may exclude the $10,000 performance bonus received in 
1984 on his 1984 income tax return. However, C may not exclude part of 
the 1982 bonus and part of the 1984 bonus.
    (3) Exception for year-end payroll period. Notwithstanding paragraph 
(e)(1) of this section, salary or wage payments of a cash basis taxpayer 
shall be attributed entirely to the year of receipt under the following 
circumstances:
    (i) The period for which the payment is made is a normal payroll 
period of the employer which regularly applies to the employee;
    (ii) The payroll period includes the last day of the employee's 
taxable year;
    (iii) The payroll period does not exceed 16 days; and
    (iv) The payment is part of a normal payroll of the employer that is 
distributed at the same time, in relation to the payroll period, that 
such payroll would normally be distributed, and is distributed before 
the end of the next succeeding payroll period.
    (4) Attribution of bonuses and substantially nonvested property to 
periods in which services were performed--(i) In general. Bonuses and 
substantially nonvested property are attributable to all of the services 
giving rise to the income on the basis of all the facts and 
circumstances. If an individual receives a bonus or substantially 
nonvested property (as defined in Sec. 1.83-3(b)) and it is determined 
to be attributable to services performed in more than one taxable year, 
then, for purposes of determining the amount eligible for exclusion from 
gross income in the year the bonus is received or the property vests, a 
portion of such amount shall be treated as attributable to services 
performed in each taxable year (or portion thereof) during the period 
when services giving rise to the bonus or the substantially nonvested 
property were performed. Such portion shall be determined by dividing 
the amount of the bonus or the excess of the fair market value of the 
vested property over the amount paid, if any, for the vested property, 
by the number of months in the period when services giving rise to such 
amount were performed, and multiplying the quotient by the number of 
months in such period in the taxable year. For purposes of this section, 
the term ``month'' means a calendar month. A fraction of a calendar 
month shall be deemed a month if it includes fifteen or more days.
    (ii) Examples. The following examples illustrate the application of 
this paragraph (e)(4).

    Example 1. A, an employee of M Corporation during all of 1983 and 
1984, worked in the United States from January 1 through April 30, 1983, 
and received $12,000 of salary for that period. A worked in country F 
from May 1, 1983 through the end of 1984, and is a qualified individual 
under Sec. 1.911-2(a) for that period. For the period from May 1 
through December 31, 1983, A received $32,000 of salary. M pays a bonus 
on December 20, 1983 to each of M's employees in an amount equal to 10 
percent of the employee's regular wages or salary for the 1983 calendar 
year. The amount of A's bonus is $4,400 for 1983. The portion of A's 
bonus that is attributable to services performed in country F and is 
foreign earned income for 1983 is $3,200, or $32,000 x 10 percent. The 
remaining $1,200 of A's bonus is attributable to services performed in 
the United States, and is not foreign earned income.
    Example 2. The facts are the same as in example 1, except that M 
determines bonuses separately for each country based on the productivity 
of the employees in that country. M pays a bonus to employees in country 
F, in the amount of 15 percent of each employee's wages or salary earned 
in country F. A's country F bonus is $4,800 for 1983 ($32,000 x 15 
percent), and is foreign earned income for 1983. If A also receives a 
bonus (or if A's bonus is increased) for working in the United States 
during 1983, that amount is not foreign earned income.
    Example 3. X corporation offers its employees a bonus of $40,000 if 
the employee accepts employment in a foreign country and remains in a 
foreign country for a period of at least four years. A, an employee of 
X, is a calendar year and cash basis taxpayer. A accepts employment with 
X in foreign country F. A begins work in F on July 1, 1983 and continues 
to work in F for X until June 30, 1987. In 1987 X pays A a $40,000 
bonus. The bonus is attributable to services A performed from July 1, 
1983 through June 30, 1987. The amount of the bonus attributable to 1987 
is $5,000 (($40,000 / 48) x 6). The amount of the bonus attributable to 
1986 is $10,000 (($40,000 /

[[Page 31]]

48) x 12). A may exclude the $10,000 attributable to 1986 only to the 
extent that amount could have been excluded under section 911(a)(1) had 
A received it in 1986. The remaining $25,000 is attributable to services 
performed in taxable years before 1986. Such amounts may not be excluded 
under section 911 because they are received after the close of the 
taxable year following the taxable year in which the services giving 
rise to the income were performed.

    (iii) Special rule for elections under section 83(b). If an 
individual receives substantially nonvested property and makes an 
election under section 83(b) and Sec. 1.83-2(a) to include in his gross 
income the amount determined under section 83(b)(1)(A) and (B) and Sec. 
1.83-2(a) for the taxable year in which the property is transferred (as 
defined in Sec. 1.83-3(a)), then, for the purpose of determining the 
amount eligible for exclusion in the year of receipt, the individual may 
elect either of the following options:
    (A) Substantially nonvested property may be treated as attributable 
entirely to services performed in the taxable year in which an election 
to include it in income is made. If so treated, then the amount 
otherwise included in gross income as determined under Sec. 1.83-2(a) 
will be excludable under section 911(a) for such year subject to the 
limitation provided in Sec. 1.911-3(d)(2) for such year.
    (B) A portion of the substantially nonvested property may be treated 
as attributable to services performed or to be performed in each taxable 
year during which the substantial risk of forfeiture (as defined in 
section 83(c) and Sec. 1.83-3(c)) exists. The portion treated as 
attributable to services performed or to be performed in each taxable 
year is determined by dividing the amount of the substantially nonvested 
property included in gross income as determined under Sec. 1.83-2(a) by 
the number of months during the period when a substantial risk of 
forfeiture exists. The quotient is multiplied by the total number of 
months in the taxable year during which a substantial risk of forfeiture 
exists. The amount determined to be attributable to services performed 
in the year the election is made shall be excluded from gross income for 
such year as provided in paragraph (d)(2) of this section. Amounts 
treated as attributable to services performed in subsequent taxable 
years shall be excludable in the year of receipt only to the extent such 
amounts could be excluded under paragraph (d)(2) of this section in such 
subsequent years. An individual may obtain such additional exclusion by 
filing an amended return for the taxable year in which the property was 
transferred. The individual may only amend his or her return within the 
period provided by section 6511(a) and the regulations thereunder.
    (5) Moving expense reimbursements--(i) Source of reimbursements. For 
the purpose of determining whether a moving expense reimbursement is 
attributable to services performed within a foreign country or within 
the United States, in the absence of evidence to the contrary, the 
reimbursement shall be attributable to future services to be performed 
at the new principal place of work. Thus, a reimbursement received by an 
employee from his employer for the expenses of a move to a foreign 
country will generally be attributable to services performed in the 
foreign country. A reimbursement received by an employee from his 
employer for the expenses of a move from a foreign country to the United 
States will generally be attributable to services performed in the 
United States. For purposes of this paragraph (e)(5), evidence to the 
contrary includes, but is not limited to, an agreement, between the 
employer and the employee, or a statement of company policy, which is 
reduced to writing before the move to the foreign country and which is 
entered into or established to induce the employee or employees to move 
to a foreign country. The writing must state that the employer will 
reimburse the employee for moving expenses incurred in returning to the 
United States regardless of whether the employee continues to work for 
the employer after the employee returns to the United States. The 
writing may contain conditions upon which the right to reimbursement is 
determined as long as the conditions set forth standards that are 
definitely ascertainable and the conditions can only be fulfilled prior 
to, or through completion of the employee's return move to the United 
States that is the subject of the writing. In no case

[[Page 32]]

will an oral agreement or statement of company policy concerning moving 
expenses be considered evidence to the contrary. For the purpose of 
determining whether a storage expense reimbursement is attributable to 
services performed within a foreign country, in the case of storage 
expenses incurred after December 31, 1983, the reimbursement shall be 
attributable to services performed during the period of time for which 
the storage expenses are incurred.
    (ii) Attribution of foreign source reimbursements to taxable years 
in which services are performed--(A) In general. If a reimbursement for 
moving expenses is determined to be from foreign sources under paragraph 
(e)(5)(i) of this section, then for the purpose of determining the 
amount eligible for exclusion in accordance with paragraphs (d)(2) and 
(e)(2) of this section, the reimbursement shall be considered 
attributable to services performed in the year of the move as long as 
the individual is a qualified individual for a period that includes 120 
days in the year of the move. The period that is used in determining the 
number of qualifying days for purposes of the individual's section 
911(a)(1) limitation (under paragraph (d)(2) of this section) must also 
be used in determining whether the individual is a qualified individual 
for a period that includes 120 days in the year of the move. If the 
individual is not a qualified individual for such period, then the 
individual shall treat a portion of the reimbursement as attributable to 
services performed in the year of the move, and a portion as 
attributable to services performed in the succeeding taxable year, if 
the move is from the United States to a foreign country, or to the prior 
taxable year, if the move is from a foreign country to the United 
States. The portion of the reimbursement treated as attributable to 
services performed in the year of the move shall be determined by 
multiplying the total reimbursement by the following fraction:
[GRAPHIC] [TIFF OMITTED] TC14NO91.138


The remaining portion of the reimbursement shall be treated as 
attributable to services performed in the year succeeding or preceding 
the year of the move. Amounts treated as attributable to services 
performed in a year succeeding or preceding the year of the move shall 
be excludable in the year of receipt only to the extent such amounts 
could be excluded under paragraph (d)(2) of this section in such 
succeeding or preceding year.
    (B) Moves beginning before January 1, 1984. Notwithstanding 
paragraph (e)(5)(ii)(A) of this section, this paragraph (e)(5)(ii)(B) 
shall apply for moves begun before January 1, 1984. If a reimbursement 
for moving expenses is determined to be from foreign sources under 
paragraph (e)(5)(i) of this section, then for the purpose of determining 
the amount eligible for exclusion in accordance with paragraphs (d)(2) 
and (e)(2) of this section, the reimbursement shall be considered 
attributable to services performed in the year of the move. However, if 
the individual does not qualify under section 911(d)(1) and Sec. 1.911-
2(a) for the entire taxable year of the move, then the individual shall 
treat a portion of the reimbursement as attributable to services 
performed in the succeeding taxable year, if the move is from the United 
States to a foreign country, or to the prior taxable year, if the move 
is from a foreign country to the United States. The portion of the 
reimbursement treated as attributable to services performed in the year 
succeeding or preceding the move shall be determined by multiplying the 
total reimbursement by the following fraction:

[[Page 33]]

[GRAPHIC] [TIFF OMITTED] TC14NO91.139


and subtracting the product from the total reimbursement. Amounts 
treated as attributable to services performed in a year succeeding or 
preceding the year of the move shall be excludable in the year of 
receipt only to the extent such amounts could be excluded under 
paragraph (d)(2) of this section in such succeeding or preceding year.
    (f) Examples. The following examples illustrate the application of 
this section.

    Example 1. A is a U.S. citizen and calendar year taxpayer. A's tax 
home was in foreign country F and A was physically present in F for 330 
days during the period from July 4, 1982 through July 3, 1983. The 
number of A's qualifying days in 1982 as determined under paragraph 
(d)(2) of this section is 181. In 1982 A receives $40,000 attributable 
to services performed in foreign country F in 1982. Under paragraph 
(d)(2) of this section A's section 911(a)(1) limitation is $37,192, that 
is the lesser of $40,000 (foreign earned income) or
[GRAPHIC] [TIFF OMITTED] TC09OC91.000

    Example 2. The facts are the same as in example 1 except that in 
1982 A receives $30,000 attributable to services performed in foreign 
country F. A excludes this amount from gross income under paragraph (d) 
of this section. In addition, in 1983 A receives $10,000 attributable to 
services performed in F in 1982 and $35,000 attributable to services 
performed in F in 1983. On his return for 1983, A must report $45,000 of 
income. A's section 911(a)(1) limitation for 1983 is the lesser of 
$35,000 (foreign earned income) or $49,329, the annual rate for the 
taxable year multiplied by a fraction the numerator of which is A's 
qualifying days in the taxable year and the denominator of which is the 
number of days in the taxable year ($80,000 x 184/365). On his tax 
return for 1983 A may exclude $35,000 attributable to services performed 
in 1983. A may only exclude $7,192 of the $10,000 received in 1983 
attributable to services performed in 1982 because such amount is only 
excludable in 1983 to the extent such amount could have been excluded in 
1982 subject to the section 911(a)(1) limitation for 1982 which is 
$37,192 ($75,000 x 181/365). No portion of amounts attributable to 
services performed in 1982 may be used in calculating A's section 
911(a)(1) limitation for 1983. Thus, even though A could have excluded 
an additional $5,329 in 1983 if A had had more foreign earned income 
attributable to 1983, A may not exclude the $2,808 of remaining foreign 
earned income attributable to 1982.
    Example 3. C is a U.S. citizen and calendar year taxpayer. C 
establishes a bona fide residence and a tax home in foreign country J on 
March 1, 1982, and maintains a tax home and a residence in J until 
December 31, 1986. In March of 1982 C's employer, Y corporation, 
transfers stock in Y to C. The stock is subject to forfeiture if C 
returns to the U.S. before January 1, 1985. C elects under section 83(b) 
to include $15,000, the amount determined with respect to such stock 
under section 83(b)(1), in gross income in 1982. C's other foreign 
earned income in 1982 is $58,000. C elects under paragraph 
(e)(4)(iii)(B) of this section to treat the stock as if earned over the 
period of the substantial risk of forfeiture. The number of months in 
the period of the substantial risk of forfeiture is thirty-four. The 
number of months in the taxable year 1982 within the period of foreign 
employment is ten. For purposes of determining C's section 911(a)(1) 
limitation, $4,412 (($15,000/34) x 10) of the amount included in gross 
income under section 83(b) is treated as attributable to services 
performed in 1982, $5,294 is treated as attributable to services to be 
performed in 1983, and $5,294 is treated as attributable to services to 
be performed in 1984. In 1982, C excludes $62,412 under section 
911(a)(1). That is the lesser of foreign earned income for 1982 ($58,000 
+ $4,412) or the annual rate for the taxable year multiplied by a 
fraction the numerator of which is C's qualifying days in the taxable 
year and the denominator of which is the number of days in the taxable 
year ($75,000 x 306/365). C continues to perform services in foreign 
country J throughout 1983 and 1984. C would be able to exclude the 
remaining $5,294 attributable

[[Page 34]]

to services performed in 1983 and $5,294 attributable to services 
performed in 1984 if those amounts would be excludable if they had been 
received in 1983 or 1984 respectively. If C is entitled to exclude the 
additional amounts, C must claim the exclusion by filing an amended 
return for 1982.
    Example 4. D is a U.S. citizen and a calendar year taxpayer. In 
September, 1984 D moves to a foreign country K. D is physically present 
in K, and D's tax home is in K, from September 15, 1984 through December 
31, 1985. D receives $6,000 in April, 1985 from his employer, as a 
reimbursement for expenses of moving to K, pursuant to a written 
agreement that such moving expenses would be reimbursed to D upon 
successful completion of 6 months employment in K. Under paragraph 
(e)(15)(i) of this section, the reimbursement is attributable to 
services performed in K. Under the physical presence test of Sec. 
1.911-2(a)(2)(ii), among other periods D is a qualified individual for 
the period of August 10, 1984 through August 9, 1985, which includes 144 
days in 1984. Under paragraph (e)(5)(ii)(A) of this section, for the 
purpose of determining the amount eligible for exclusion, the 
reimbursement is considered attributable to services performed in 1984 
(the year of the move) because D is a qualified individual under Sec. 
1.911-2(a) for a period that includes 120 days in 1984. The 
reimbursement may be excluded under paragraphs (d)(2) and (e)(2) of this 
section, to the extent that D's foreign earned income for 1984 that was 
earned and received in 1984 was less than the annual rate for the 
taxable year multiplied by the number of D's qualifying days in the 
taxable year over the number of days in D's taxable year ($80,000 x 144/
366), or $31,475.
    Example 5. The facts are the same as in example 4 except that D is 
not a qualified individual under the physical presence test, but is a 
qualified individual under the bona fide residence test for the period 
of September 15, 1984 through December 31, 1985. Under paragraph 
(e)(5)(ii)(A) of this section, for the purpose of determining the amount 
eligible for exclusion, the reimbursement is considered attributable to 
services performed in 1984 and 1985 because D is not a qualified 
individual for a period that includes 120 days in 1984 (the year of the 
move). The portion of the reimbursement treated as attributable to 
services performed in 1984 is $6,000 x 108/366, or $1,770, and may be 
excluded, subject to D's 1984 section 911(a)(1) limitation. The balance 
of the reimbursement, $4,230, is treated as attributable to services 
performed in 1985, and may be excluded to the extent provided in 
paragraphs (d)(2) and (e)(2) of this section.
    Example 6. The facts are the same as in example 4, with the 
following additions. Before D moved to K, D and his employer signed a 
written agreement that D would perform services for the employer for at 
least one year, primarily in country K, and, if D did not voluntarily 
cease to work for the employer primarily in country K before one year 
had elapsed, the employer would reimburse D for one half of D's 
expenses, up to a maximum of $4,000, of moving back to the United 
States. The agreement also stated that, if D did not voluntarily leave 
the employment in K before two years had elapsed, the employer would 
reimburse D for all of D's reasonable expenses of moving back to the 
United States. The agreement further stated that D's right to 
reimbursement would not be conditioned upon the performance of services 
after D ceased to work in K. D worked in country K for all of 1985. On 
January 1, 1986, D left K and moved to the United States. In February, 
1986 the employer paid D $3,500 as reimbursement for one-half of D's 
expenses of moving to the United States. Although D did not fulfill the 
condition in the agreement to receive full reimbursement, all of the 
conditions in the agreement set forth definitely ascertainable standards 
and no condition could be fulfilled after D moved back to the United 
States. The agreement fulfills the requirements of paragraph (e)(5)(i) 
of this section, and therefore is evidence that the reimbursement should 
not be attributable to future services to be performed at D's new 
principal place of work. Under the facts and circumstances, the 
reimbursement is attributable to services performed in K. Under 
paragraph (e)(5)(ii)(A) of this section, the entire reimbursement is 
attributable to services performed in 1985. The amount attributable to 
1985 may be excluded to the extent provided in paragraphs (d)(2) and 
(e)(2) of this section.

(Sec. 911 (95 Stat. 194; 26 U.S.C. 911) and sec. 7805 (68A Stat. 917; 26 
U.S.C. 7805) of the Internal Revenue Code of 1954)

[T.D. 8006, 50 FR 2966, Jan. 23, 1985]



Sec. 1.911-4  Determination of housing cost amount eligible for
exclusion or deduction.

    (a) Definition of housing cost amount. The term ``housing cost 
amount'' means an amount equal to the reasonable expenses paid or 
incurred (as defined in section 7701(a)(25)) during the taxable year by 
or on behalf of the individual attributable to housing in a foreign 
country for the individual and any spouse or dependents who reside with 
the individual (or live in a second foreign household described in 
paragraph (b)(5) of this section) less the base housing amount as 
defined in paragraph (c) of this section. The housing cost amount must 
be reduced by the amount of any military or section

[[Page 35]]

912 allowance or similar allowance excludable from gross income that is 
intended to compensate the individual or the individual's spouse in 
whole or in part for the expenses of housing during the same period for 
which the individual claims a housing cost amount exclusion or 
deduction.
    (b) Housing expenses--(1) Included expenses. For purposes of 
paragraph (a) of this section, housing expenses include rent, the fair 
rental value of housing provided in kind by the employer, utilities 
(other than telephone charges), real and personal property insurance, 
occupancy taxes not described in paragraph (b)(2)(v) of this section, 
nonrefundable fees paid for securing a leasehold, rental of furniture 
and accessories, household repairs, and residential parking.
    (2) Excluded expenses. Housing expenses do not include:
    (i) The cost of house purchase, improvements, and other costs that 
are capital expenditures;
    (ii) The cost of purchased furniture or accessories or domestic 
labor (maids, gardeners, etc.);
    (iii) Amortized payments of principal with respect to an evidence of 
indebtedness secured by a mortgage on the taxpayer's housing;
    (iv) Depreciation of housing owned by the taxpayer, or amortization 
or depreciation of capital improvements made to housing leased by the 
taxpayer;
    (v) Interest and taxes deductible under section 163 or 164 or other 
amounts deductible under section 216(a) (relating to deduction of 
interest and taxes by cooperative housing corporation tenant);
    (vi) The expenses of more than one foreign household except as 
provided in paragraph (b)(5) of this section;
    (vii) Expenses excluded from gross income under section 119;
    (viii) Expenses claimed as deductible moving expenses under section 
217; or
    (ix) The cost of a pay television subscription.
    (3) Limitation. Housing expenses are taken into account for purposes 
of this section only to the extent attributable to housing for portions 
of the taxable year within the period during which the individual 
satisfies the requirements of Sec. 1.911-2(a). Housing expenses are not 
taken into account for the period during which the value of the 
individual's housing is excluded from gross income under section 119, 
unless the individual maintains a second foreign household described in 
paragraph (b)(5) of this section. If an individual maintains two foreign 
households, only expenses incurred with respect to the abode which bears 
the closest relationship, not necessarily geographic, with respect to 
the individual's tax home shall be taken into account, unless one of the 
households is a second foreign household.
    (4) Reasonableness. An amount paid for housing shall not be treated 
as reasonable, for purposes of paragraph (a) of this section, to the 
extent that the expense is lavish or extravagant under the 
circumstances.
    (5) Expenses of a second foreign household--(i) In general. The term 
``second foreign household'' means a separate abode maintained by an 
individual outside of the U.S. for his or her spouse or dependents (who, 
if minors, are in the individual's legal custody or the joint custody of 
the individual and the individual's spouse) at a place other than the 
tax home of the individual because of adverse living conditions at the 
individual's tax home. If an individual maintains a second foreign 
household the expenses of the second foreign household may be included 
in the individual's housing expenses under paragraph (b)(1) of this 
section. Under no circumstances shall an individual be considered to 
maintain more than one second foreign household at the same time.
    (ii) Adverse living conditions. Solely for purposes of paragraph 
(b)(5)(i) of this section, adverse living conditions are living 
conditions which are dangerous, unhealthful, or otherwise adverse. 
Adverse living conditions include a state of warfare or civil 
insurrection in the general area of the individual's tax home. Adverse 
living conditions exist if the individual resides on the business 
premises of the employer for the convenience of the employer and, 
because of the nature of the business (for example, a construction site 
or drilling rig), it is not feasible for the employer to provide housing 
for the individual's spouse or dependents.

[[Page 36]]

The criteria used by the Department of State in granting a separate 
maintenance allowance are relevant, but not determinative, for purposes 
of determining whether a separate household is provided because of 
adverse living conditions.
    (c) Base housing amount--(1) In general. The base housing amount is 
equal to the product of 16 percent of the annual salary of an employee 
of the United States who is compensated at a rate equal to the annual 
salary rate paid for step 1 of grade GS-14, multiplied by the following 
fraction:
[GRAPHIC] [TIFF OMITTED] TC14NO91.140


For purposes of the above fraction, the number of qualifying days is 
determined in accordance with Sec. 1.911-3(d)(3).
    (2) Annual salary of step 1 of grade GS-14. The annual salary rate 
for a step 1 of grade GS-14 is determined on January first of the 
calendar year in which the individual's taxable year begins.
    (d) Housing cost amount exclusion--(1) Limitation. A qualified 
individual who has elected to exclude his or her housing cost amount may 
only exclude the lesser of the full amount of either the individual's 
housing cost amount attributable to employer provided amounts or the 
individual's foreign earned income for the taxable year. A qualified 
individual who elects to exclude his or her housing cost amount may not 
claim less than the full amount of the housing cost exclusion determined 
under this paragraph.
    (2) Employer provided amounts. For purposes of this section, the 
term ``employer provided amounts'' means any amounts paid or incurred on 
behalf of the individual by the individual's employer which are foreign 
earned income included in the individual's gross income for the taxable 
year (without regard to section 911). Employer provided amounts include, 
but are not limited to, the following amounts: Any salary paid by the 
employer to the employee; any reimbursement paid by the employer to the 
employee for housing expenses, educational expenses for the individual's 
dependents, or as part of a tax equalization plan; the fair market value 
of compensation provided in kind (including lodging, unless excluded 
under section 119, relating to meals and lodging furnished for the 
convenience of the employer); and any amount paid by the employer to any 
third party on behalf of the employee. An individual will only have 
earnings that are not employer provided amounts if the individual has 
earnings from self-employment.
    (3) Housing cost amount attributable to employer provided amounts. 
For the purpose of determining what portion of the housing cost amount 
is excludable and what portion is deductible the following rules apply. 
If the individual has no income from self-employment, then the entire 
housing cost amount is attributable to employer provided amounts and is, 
therefore, excludable to the extent of the limitation provided in 
paragraph (d)(1) of this section. If the individual only has income from 
self-employment, then the entire housing cost amount is attributable to 
non-employer provided amounts and is, therefore, deductible to the 
extent of the limitation provided in paragraph (e) of this section. In 
all other instances, the housing cost amount attributable to employer 
provided amounts shall be determined by multiplying the housing cost 
amount by the following fraction: Employer provided amounts over foreign 
earned income for the taxable year. The housing cost amount attributable 
to non-employer provided amounts shall be determined by subtracting the 
portion of the housing cost amount attributable to employer provided 
amounts from the total housing cost amount.
    (e) Housing cost amount deduction--(1) In general. If a portion of 
the individual's housing cost amount is determined under paragraph 
(d)(3) of this section to be attributable to non-employer provided 
amounts, the individual may deduct that amount from gross income for the 
taxable year but only to the extent of the individual's foreign earned 
income (as defined in Sec. 1.911-3) for the taxable year in excess of 
foreign earned income excluded and the housing cost amount excluded from 
gross income for the taxable year under Sec. 1.911-3 and this section.

[[Page 37]]

    (2) Carryover. If any portion of the individual's housing cost 
amount deduction is disallowed for the taxable year under paragraph 
(e)(1) of this section, such portion shall be carried over and treated 
as a deduction from gross income for the succeeding taxable year (but 
only for the succeeding taxable year) to the extent of the excess, if 
any, of:
    (i) The amount of foreign earned income for the succeeding taxable 
year less the foreign earned income and the housing cost amount excluded 
from gross income under Sec. 1.911-3 and this section for the 
succeeding taxable year over,
    (ii) The portion, if any, of the housing cost amount that is 
deductible under paragraph (e)(1) of this section for the succeeding 
taxable year.
    (f) Examples. The following examples illustrate the application of 
this section. In all examples the annual rate for a step 1 of GS-14 as 
of January first of the calendar year in which the individual's taxable 
year begins is $39,689.

    Example 1. B, a U.S. citizen is a calendar year taxpayer who was a 
bona fide resident of and whose tax home was located in foreign country 
G for the entire taxable year 1982. B receives an $80,000 salary from 
B's employer for services performed in G. B incurs no business expenses. 
B receives housing provided by B's employer with a fair rental value of 
$15,000. The value of the housing furnished by B's employer is not 
excluded from gross income under section 119. B pays $10,000 for housing 
expenses. B's gross income and foreign earned income for 1982 is 
$95,000. B elects the foreign earned income exclusion of section 
911(a)(1) and the housing cost amount exclusion of section 911(a)(2). B 
must first compute his housing cost amount exclusion. B's housing cost 
amount is $18,650 determined by reducing B's housing expenses, $25,000 
($15,000 fair rental value of housing and $10,000 of other expenses), by 
the base housing amount of $6,350 (($39,689 x .16) x 365/365). Because B 
has no income from self-employment, the entire amount is attributable to 
employer provided amounts and therefore, is excludable. B's section 
911(a)(1) limitation is $75,000. That is the lesser of $75,000 x 365/365 
or $95,000-18,650. B's total exclusion for 1982 under section 911(a)(1) 
and (2) is $93,650.
    Example 2. The facts are the same as in example 1 except that B's 
salary for 1982 is $70,000. B's foreign earned income for 1982 is 
$85,000. B's housing cost amount is $18,650, all of which is 
attributable to employer provided amounts. B's housing cost amount is 
excludable to the extent of the lesser of B's housing cost amount 
attributable to employer provided amounts, $18,650, or the foreign 
earned income for the taxable year, $85,000. Thus, B excludes $18,650 
under section 911(a)(2). B's section 911(a)(1) limitation for 1982 is 
$66,350 (the lesser of $75,000 x 365/365 or $85,000-18,650). B's total 
exclusion for 1982 under section 911(a)(1) and (2) is $85,000.
    Example 3. The facts are the same as in example 2 except that in 
1983, B receives $5,000 attributable to services performed in 1982. B 
may exclude the entire $5,000 in 1983 because such amount would have 
been excludable under Sec. 1.911-3(d)(1) had it been received in 1982.
    Example 4. C is a U.S. citizen self-employed and a calendar year and 
cash basis taxpayer. C arrived in foreign country H on October 3, 1982, 
and departed from H on March 8, 1984. C's tax home was located in H 
throughout that period. C was physically present for 330 full days 
during the twelve consecutive month period August 30, 1982, through 
August 29, 1983. The number of C's qualifying days in 1982 is 124. 
During 1982 C had $35,000 of foreign earned income, none of which was 
attributable to employer provided amounts and $8,000 of reasonable 
housing expenses. C's housing cost amount is $5,843 ($8,000-((39,689 x 
.16) x 124/365)). C elects to exclude her foreign earned income under 
Sec. 1.911-3(d)(1). C's section 911(a)(1) limitation for 1982 is 
$25,479 (the lesser of C's foreign earned income for the taxable year 
($35,000) or the annual rate for the taxable year multiplied by the 
number of C's qualifying days over the number of days in the taxable 
year ($75,000 x 124/365 = $25,479). C may not claim the housing cost 
amount exclusion under section 911(a)(2) because no portion of the 
housing cost amount is attributable to employer provided amounts. C may 
deduct the lesser of her housing cost amount ($5,843) or her foreign 
earned income in excess of amounts excluded under section 911(a) 
($35,000-25,479 = $9,521). Thus, C's housing cost amount deduction is 
$5,843.
    Example 5. The facts are the same as in example 4 except that C had 
$30,000 of foreign earned income for 1982, none of which was 
attributable to employer provided amounts. C elects to exclude $25,479 
under Sec. 1.911-3(d)(1). C may only deduct $4,521 of her housing cost 
amount under paragraph (e)(1) of this section because her foreign earned 
income in excess of amounts excluded under section 911(a) is 
$4,521($30,000-25,479). The $1,322 of unused housing cost amount 
deduction may be carried over to the subsequent taxable year.
    Example 6. The facts are the same as in example 4 except that C had 
$15,000 of foreign earned income of 1982, none of which was attributable 
to employer provided amounts. C elects to exclude the entire $15,000 
under Sec. 1.911-3(d)(1). C is not entitled to a housing cost amount 
deduction for 1982 since she has no foreign earned income in excess of

[[Page 38]]

amounts excluded under section 911(a). C may carry over her entire 
housing cost amount deduction to 1983.
    Example 7. The facts are the same as in example 6. In addition, 
during taxable year 1983 C had $115,000 of foreign earned income, none 
of which was attributable to employer provided amounts, and $40,000 of 
reasonable housing expenses C elects to exclude her foreign earned 
income under Sec. 1.911-3(d)(1). C's section 911(a)(1) limitation is 
the lesser of $115,000 or $80,000 ($80,000 x 365/365). C's housing cost 
amount for 1983 is $33,650 (40,000-(39,689 x .16) x 365/365). Since no 
portion of that amount is attributable to employer provided amounts, C 
may not claim a housing cost amount exclusion. C may deduct the lesser 
of her housing cost amount ($33,650) or her foreign earned income in 
excess of amounts excluded under section 911(a) ($115,000-80,000 = 
35,000). Thus, C may deduct her $33,650 housing cost amount in 1983. In 
addition, C may deduct $1,350 of the housing cost amount deduction 
carried over from taxable year 1982.

(($115.000-80,000)-33,650 = $1,350). The remaining $4,493 ($5,843-1,350) 
of the housing cost amount deduction carried over from taxable year 1982 
may not be deducted in 1983 or carried over to 1984.
    Example 8. D is a U.S. citizen and a calendar year and cash basis 
taxpayer. D is a bona fide resident of and maintains his tax home in 
foreign country J for all of taxable year 1984. In 1984, D earns $80,000 
of foreign earned income, $60,000 of which is an employer provided 
amount and $20,000 of which is a non-employer provided amount. D's total 
housing cost amount for 1984 is $25,000. D elects to exclude, under 
section 911(a)(2), the portion of his housing cost amount that is 
attributable to employer provided amounts. D's excludable housing cost 
amount is $18,750; that is the total housing cost amount ($25,000) 
multiplied by employer provided amounts for the taxable year ($60,000) 
over foreign earned income for the taxable year ($80,000). D also elects 
to exclude his foreign earned income under Sec. 1.911-3(d)(1). D's 
section 911(a)(1) limitation for 1984 is $61,250 (the lesser of $80,000-
$18,750 or $80,000 x 366/366). D's total exclusion for 1984 under 
section 911(a)(1) and (2) is $80,000. D cannot claim a housing cost 
amount deduction in 1984 because D has no foreign earned income in 
excess of his foreign earned income and housing cost amount excluded 
from gross income for the taxable year under Sec. 1.911-3 and this 
section. D may carry over his housing cost amount deduction of $6,250, 
the total housing cost amount less the portion attributable to employer 
provided amounts ($25,000-18,750), to taxable year 1985.

(Sec. 911 (95 Stat. 194; 26 U.S.C. 911) and sec. 7805 (68A Stat. 917; 26 
U.S.C. 7805) of the Internal Revenue Code of 1954)

[T.D. 8006, 50 FR 2970, Jan. 23, 1985]



Sec. 1.911-5  Special rules for married couples.

    (a) Married couples with two qualified individuals--(1) In general. 
In the case in which a husband and wife both are qualified individuals 
under Sec. 1.911-2(a), each individual may make one or more elections 
under Sec. 1.911-7 and exclude from gross income foreign earned income 
and exclude or deduct housing cost amounts subject to the rules of 
paragraphs (a)(2) and (3) of this section.
    (2) Computation of excluded foreign earned income. The amount of 
excludable foreign earned income is determined separately for each 
spouse under the rule of Sec. 1.911-3 on the basis of the income 
attributable to the services of that spouse. If the spouses file 
separate returns each may exclude the amount of his or her foreign 
earned income attributable to his or her services subject to the 
limitations of Sec. 1.911-3(d)(2). If the spouses file a joint return, 
the sum of these foreign earned income amounts so determined for each 
spouse may be excluded. For example, H and W both qualify under Sec. 
1.911-2(a)(2)(i) for the entire 1983 taxable year. During 1983 W earns 
$100,000 of foreign earned income and H earns $45,000 of foreign earned 
income. H and W file a joint return for 1983. On their joint return H 
and W may exclude from gross income a total of $125,000. That amount is 
determined by adding W's section 911(a)(1) limitation, $80,000 (the 
lesser of $80,000 x 365/365 or $100,000), and H's section 911(a)(1) 
limitation, $45,000 (the lesser of $80,000 x 365/365 or $45,000).
    (3) Computation of housing cost amount--(i) Spouses residing 
together. If the spouses reside together, and file a joint return, they 
may compute their housing cost amount either jointly or separately. If 
the spouses reside together and file separate returns, they must compute 
their housing cost amounts separately. If the spouses compute their 
housing cost amounts separately, they may allocate the housing expenses 
to either of them or

[[Page 39]]

between them for the purpose of calculating separate housing cost 
amounts, but each spouse claiming a housing cost amount exclusion or 
deduction must use his or her full base housing amount in such 
computation. If the spouses compute their housing cost amount jointly, 
then only one of the spouses may claim the housing cost amount exclusion 
or deduction.


Either spouse may claim the housing cost amount exclusion or deduction; 
however, if the spouses have different periods of residence or presence 
and the spouse with the shorter period of residence or presence claims 
the exclusion or deduction, then only the expenses incurred in that 
shorter period may be claimed as housing expenses. The spouse claiming 
the exclusion or deduction may aggregate the couple's housing expenses, 
and subtract his or her base housing amount. For example, H and W reside 
together and file a joint return. H was a bona fide resident of and 
maintained his tax home in foreign country M from August 17, 1982, 
through December 31, 1983. W was a bona fide resident of and maintained 
her tax home in foreign country M from September 15, 1982, through 
December 31, 1983. During 1982, H and W earn and receive, respectively, 
$25,000 and $10,000 of foreign earned income. H paid $10,000 for 
qualified housing expenses in 1982, $7,500 of that was for qualified 
housing expenses incurred from September 15, 1982, through December 31, 
1982. W paid $3,000 for qualified housing expenses in 1982 all of which 
were incurred during her period of residence. H and W may choose to 
compute their housing cost amount jointly. If they do so and H claims 
the housing cost amount exclusion his exclusion would be $10,617. H's 
housing expenses would be $13,000 ($10,000 + $3,000) and his base 
housing amount would be $2,383 ((39,689 x .16) x 137/365 = $2,383). If 
instead W claims the housing cost amount exclusion her exclusion would 
be $8,621. W's housing expenses would be $10,500 ($7,500 + 3,000) and 
her base housing amount would be $1,879 (($39,689 x .16) x 108/365 = 
$1,879). If H and W file jointly and both claim a housing cost amount 
exclusion, then H's and W's housing cost amounts would be, respectively, 
$7,617 ($10,000-2,383) and $1,121 ($3,000-1,879).
    (ii) Spouses residing apart. If the spouses reside apart, both 
spouses may exclude or deduct their housing cost amount if the spouses 
have different tax homes that are not within reasonable commuting 
distance (as defined in Sec. 1.119-1(d)(4)) of each other and neither 
spouse's residence is within a reasonable commuting distance of the 
other spouse's tax home. If the spouses' tax homes, or one spouse's 
residence and the other spouse's tax home, are within a reasonable 
commuting distance of each other, only one spouse may exclude or deduct 
his or her housing cost amount. Regardless of whether the spouses file 
joint or separate returns, the amount of the housing cost amount 
exclusion or deduction must be determined separately for each spouse 
under the rules of Sec. 1.911-4. If both spouses claim a housing cost 
amount exclusion or deduction directly as qualified individuals, neither 
may claim any such exclusion or deduction under section 
911(c)(2)(B)(ii), relating to a second foreign household maintained for 
the other spouse. If one spouse fails to claim a housing cost amount 
exclusion or deduction which that spouse could claim directly, the other 
spouse may claim such exclusion or deduction under section 
911(c)(2)(B)(ii), relating to a second foreign household maintained for 
the first spouse, provided that all the requirements of that section are 
met. Spouses may not claim more than one second foreign household and 
the expenses of such household may only be claimed by one spouse. For 
example, if both H and W are qualified individuals and H's tax home is 
in London and W's tax home is in Paris, then both H and W may exclude or 
deduct their housing cost amounts; however, H and W must compute these 
amounts separately regardless of whether they file joint or separate 
returns. If instead of living in Paris, W lives in an area where there 
are adverse living conditions and W maintains H's home in London, then W 
may add those housing expenses to her housing expenses and compute one 
base housing amount. In that case H may not claim a housing cost amount 
exclusion or deduction.

[[Page 40]]

    (iii) Housing cost amount attributable to employer provided amounts. 
Each spouse claiming a housing cost amount exclusion or deduction shall 
compute the portion of the housing cost amount that is attributable to 
employer provided amounts separately, based on his or her separate 
foreign earned income, in accordance with Sec. 1.911-4(d)(3).
    (b) Married couples with community income. The amount of excludable 
foreign earned income of a husband and wife with community income is 
determined separately for each spouse in accordance with paragraph (a) 
of this section on the basis of income attributable to that spouse's 
services without regard to community property laws. See sections 879 and 
6013 (g) and (h) for special rules regarding treatment of community 
income of a nonresident alien individual married to a U.S. citizen or 
resident.

(Sec. 911 (95 Stat. 194; 26 U.S.C. 911) and sec. 7805 (68A Stat. 917; 26 
U.S.C. 7805) of the Internal Revenue Code of 1954)

[T.D. 8006, 50 FR 2972, Jan. 23, 1985]



Sec. 1.911-6  Disallowance of deductions, exclusions, and credits.

    (a) In general. No deduction or exclusion from gross income under 
subtitle A of the Code or credit against the tax imposed by chapter 1 of 
the Code shall be allowed to the extent the deduction, exclusion, or 
credit is properly allocable to or chargeable against amounts excluded 
from gross income under section 911(a). For purposes of the preceding 
sentence, deductions, exclusions, and credits which are definitely 
related (as provided in Sec. 1.861-8), in whole or in part, to earned 
income shall be allocated and apportioned to foreign earned income and 
U.S. source earned income in accordance with the rules contained in 
Sec. 1.861-8. Deductions, exclusions, and credits which are definitely 
related to all gross income under Sec. 1.861-8, including deductions 
for interest described in Sec. 1.861-8(e)(2)(ii), are definitely 
related, in whole or in part, to earned income. In the case of interest 
expense allocable, in whole or in part, to foreign earned income under 
Sec. 1.861-8(e)(2)(ii), the expense shall normally be apportioned under 
option one of the optional gross income methods of apportionment (Sec. 
1.861-8(e)(2)(v)i(A)), but without regard to conditions (1) and (2) of 
subdivision (vi)(A) (the fifty percent conditions). Such interest 
expense shall not normally be apportioned under the asset method of 
Sec. 1.861-8(e)(2)(v). This is because, where section 911 is the 
operative section, the expense normally relates more closely to gross 
income generated from activities than to the amount of capital utilized 
or invested in activities or property. Deductions that are allocated and 
apportioned to foreign earned income must then be allocated and 
apportioned to foreign earned income that is excluded under section 
911(a). If an individual has foreign earned income from both self-
employment and other employment, the amount excluded under section 
911(a)(1) shall be deemed to include a pro rata amount of the self-
employment income and the income from other employment; thus, a pro rata 
portion of deductible expenses attributable to self-employment income 
must be disallowed. For purposes of section 911 (d)(6) and this section 
only, deductions, exclusions, or credits which are not definitely 
related to any class of gross income shall not be allocable or 
chargeable to excluded amounts and are, therefore, deductible to the 
extent allowed by chapter 1 of the Code. Examples of deductions that are 
not definitely related to a class of gross income are personal and 
family medical expenses, qualified retirement contributions (but see 
section 219(b)(1)), real estate taxes and mortgage interest on a 
personal residence, charitable contributions, alimony payments, and 
deductions for personal exemptions. In addition, for purposes of this 
section, amounts excludable or deductible under section 911 or 119 shall 
not be allocable or chargeable to other amounts excluded under section 
911(a). Thus, an individual's housing cost amount which is excludable or 
deductible under Sec. 1.911-4(d) for a taxable year is not apportioned 
in part to the individual's foreign earned income which is excluded for 
such year under Sec. 1.911-3(d). Therefore, the entire amount of such 
exclusion or deduction is allowed to the extent provided in Sec. 1.911-
4. This section does not affect the time for claiming any deduction, 
exclusion, or

[[Page 41]]

credit that is not allocated or apportioned to excluded amounts.
    (b) Moving expenses--(1) In general. No deduction shall be allowed 
for moving expenses under section 217 to the extent the deduction is 
properly allocable to or chargeable against amounts of foreign earned 
income excluded from gross income under section 911(a). If an 
individual's new principal place of work is in a foreign country, 
deductible moving expenses will be allocable to foreign earned income. 
If an individual treats a reimbursement from his employer for the 
expenses of a move from a foreign country to the United States as 
attributable to services performed in a foreign country under Sec. 
1.911-3(e)(5)(i), then deductible moving expenses attributable to that 
move will be allocable to foreign earned income. If the individual is a 
qualified individual who elects to exclude foreign earned income under 
section 911(a), then some or all of such moving expenses must be 
disallowed as a deduction.
    (2) Attribution of moving expense deduction to taxable years in 
which services are performed. If a moving expense deduction is properly 
allocable to foreign earned income, the deduction shall be considered 
attributable to services performed in the year of the move as long as 
the individual is a qualified individual under Sec. 1.911-2(a) for a 
period that includes 120 days in the year of the move. If the individual 
is not a qualified individual for such period, then the individual shall 
treat the deduction as attributable to services performed in both the 
year of the move and the succeeding taxable year, if the move is from 
the United States to the foreign country, or the prior taxable year, if 
the move is from a foreign country to the United States. Notwithstanding 
the preceding two sentences, storage expenses incurred after December 
31, 1983 shall be treated as attributable to services performed in the 
year in which the expenses are incurred.
    (3) Formula for disallowance of moving expense deduction. The 
portion of the moving expense deduction that is disallowed shall be 
determined by multiplying the moving expense deduction by a fraction the 
numerator of which is all amounts excluded under section 911(a) for the 
year or years to which the deduction is attributable (under paragraph 
(b)(2) of this section) and the denominator of which is foreign earned 
income (as defined in Sec. 1.911-3(a)) for that year or years.
    (4) Effect of disallowance based on attribution of deduction to 
subsequent year's income. An individual may claim a moving expense 
deduction in the taxable year in which the amount of the expense is paid 
or incurred even if attributable, in part, to the succeeding year. 
However, at such time as the individual excludes income under section 
911(a) for the year or years to which the deduction is attributable, the 
individual shall either--
    (i) File an amended return for the year in which the deduction was 
claimed that does not claim the portion of the deduction that is 
disallowed because it is chargeable against excluded income, or
    (ii) Include in income for the year following the year in which the 
deduction was claimed an amount equal to the amount of the deduction 
that is disallowed.


Any amount included in income under paragraph (b)(4)(ii) of this section 
is not foreign earned income.
    (5) Moves beginning before January 1, 1984. Notwithstanding 
paragraphs (b)(1) through (3) of this section, the rules of this 
paragraph (b)(5) shall apply for moves beginning before January 1, 1984.
    (i) Individual qualifies for the entire taxable year of the move. If 
the individual is a qualified individual for the entire taxable year of 
the move, then the amount of moving expense disallowed shall be 
determined by multiplying the moving expense deduction otherwise 
allowable by a fraction the numerator of which is the foreign earned 
income excluded under section 911(a) for the taxable year of the move 
and the denominator of which is the foreign earned income for the same 
taxable year.
    (ii) Individual qualifies for less than the entire taxable year of 
the move. If the individual is a qualified individual for less than the 
entire taxable year of the move, then, for the purpose of determining 
the portion of the otherwise allowable moving expense deduction that

[[Page 42]]

is disallowed, the individual must attribute a portion of the otherwise 
allowable moving expense deduction either to the succeeding taxable 
year, if the move is from the United States to a foreign country, or to 
the prior taxable year, if the move is from a foreign country to the 
United States. The portion of the moving expense deduction treated as 
attributable to services performed in the year of the move shall be 
determined by multiplying the otherwise allowable moving expense 
deduction by the following fraction:
[GRAPHIC] [TIFF OMITTED] TC14NO91.141


The portion of the moving expense deduction treated as attributable to 
the year succeeding or preceding the move shall be determined by 
subtracting the portion of the moving expense deduction that is 
attributable to the year of the move from the total moving expense 
deduction. The allocation of a portion of the moving expense deduction 
to a succeeding or preceding taxable year does not affect the time for 
claiming the allowable moving expense deduction. The portion of the 
moving expense deduction that is disallowed shall be determined by 
multiplying the moving expense deduction attributable to the year of the 
move or the succeeding or preceding year, as the case may be, by a 
fraction the numerator of which is amounts excluded under section 911(a) 
for that year and the denominator of which is foreign earned income for 
that year.
    (c) Foreign taxes--(1) Amount disallowed. No deduction or credit is 
allowed for foreign income, war profits, or excess profits taxes paid or 
accrued with respect to amounts excluded from gross income under section 
911. To determine the amount of disallowed foreign taxes, multiply the 
foreign tax imposed on foreign earned income (as defined in Sec. 1.911-
3(a)) received or accrued during the taxable year by a fraction, the 
numerator of which is amounts excluded under section 911(a) in such 
taxable year less deductible expenses properly allocated to such amounts 
(see paragraphs (a) and (b) of this section), and the denominator of 
which is foreign earned income (as defined in Sec. 1.911-3(a)) received 
or accrued during the taxable year less deductible expenses properly 
allocated or apportioned thereto. For the purpose of determining the 
extent to which foreign taxes are disallowed, the housing cost amount 
deduction is treated as definitely related to foreign earned income that 
is not excluded. If the foreign tax is imposed on foreign earned income 
and some other income (for example earned income from sources within the 
United States or an amount not subject to tax in the United States), and 
the taxes on the other amount cannot be segregated, then the denominator 
equals the total of the amounts subject to tax less deductible expenses 
allocable to all such amounts.
    (2) Definitions and special rules--(i) Taxable year. For purposes of 
paragraph (c)(1) of this section, the term ``taxable year'' means the 
individual's taxable year for U.S. tax purposes. Such term includes the 
portion of any foreign taxable year within the individual's U.S. taxable 
year and excludes the portion of any foreign taxable year not within the 
individual's U.S. taxable year.
    (ii) Apportionment of foreign taxes. For purposes of this paragraph 
(c), foreign taxes imposed on foreign earned income shall be deemed to 
accrue, on a pro rata basis, to income as the income is received or 
accrued. The taxes so accrued shall be apportioned to the taxable year 
during which the income is received or accrued. This rule applies for 
all individuals, regardless of their method of accounting.
    (iii) Effect of disallowance. The disallowance of foreign taxes 
under this paragraph (c) shall not affect the time for claiming any 
deduction or credit

[[Page 43]]

for foreign taxes paid. Rather, the disallowance shall only affect the 
amount of taxes considered paid or accrued to any foreign country.
    (iv) Interest on foreign taxes. Any interest expense incurred on a 
liability for foreign taxes is allocated and apportioned not under this 
paragraph (c) but under paragraph (a) of this section to foreign earned 
income and then to excluded foreign earned income and to that extent 
disallowed as a deduction under paragraph (a). In that regard, see also 
Sec. 1.861-8(e)(2) for the specific rules for allocation and 
apportionment of interest expense.
    (d) Examples. The following examples illustrate the application of 
this section.

    Example 1. In 1982 A, an architect, operates his business as a sole 
proprietorship in which capital is not a material income producing 
factor. A receives $1,000,000 in gross receipts, all of which is foreign 
source earned income, and incurs $500,000 of otherwise deductible 
business expenses definitely related to the foreign earned income. A 
elects to exclude $75,000 under section 911(a)(1). The expenses must be 
apportioned to excluded earned income as follows: $500,000 x $75,000/
1,000,000. Thus, $37,500 of the business expenses are not deductible.
    Example 2. The facts are the same as in example 1, except that 
$100,000 of A's gross receipts is U.S. source earned income and $68,000 
of A's business expenses are attributable to the U.S. source earned 
income. Thus, A has $900,000 of foreign earned income and $432,000 of 
deductions allocated to foreign earned income. The expenses apportioned 
to excluded earned income are $432,000 x $75,000/$900,000, or $36,000, 
which are not deductible.
    Example 3. B is a U.S. citizen, calendar year and cash basis 
taxpayer. B moves to foreign country N and maintains a tax home and is 
physically present there from July 1, 1984 through May 26, 1985. Among 
other possible periods, B is a qualified individual for 219 days in the 
year of the move. B pays $6,000 of otherwise deductible moving expenses 
in 1984. For 1984, B's foreign earned income is $60,000 and B excludes 
$47,869 ($80,000 x 219/366) under section 911(a). Under paragraph (b)(2) 
of this section, B's moving expenses are attributable to services 
performed in 1984. Under paragraph (b)(3) of this section, $6,000 x 
$47,869/$60,000, or $4,789, of B's moving expense deduction is 
disallowed. B may deduct $1,211 of moving expenses on his 1984 return.
    Example 4. The facts are the same as in example 3 except that B 
maintains a tax home and is physically present in foreign country N from 
October 9, 1984 through September 3, 1985. Among other possible periods, 
B is a qualified individual for no more than 119 days in 1984 and 281 
days in 1985. B's foreign earned income for 1984 is $60,000. B's foreign 
earned income for 1985 is $150,000. Because B is a qualified individual 
for less than 120 days in the year of the move, under paragraph (b)(2) 
of this section, B's moving expenses are attributable to services 
performed in 1984 and 1985. At the close of 1984, B may either seek an 
extension of time to file under Sec. 1.911-7(c) or may file an income 
tax return without claiming the exclusions or deduction under section 
911. B does not seek an extension and files without excluding foreign 
earned income; thus B may deduct his moving expenses in full. B later 
amends his 1984 return and excludes foreign earned income for that year. 
B excludes foreign earned income for 1985. B must determine the portion 
of the moving expense deduction that is disallowed. The portion of the 
moving expense deduction that is disallowed is determined by multiplying 
the otherwise allowable moving expense deduction by a fraction. The 
numerator of the fraction is the sum of amounts excluded under section 
911(a) for 1984 and 1985, that is $26,082 or $80,000 x 119/365, plus 
$61,589, or $80,000 x 281/365, which totals $87,671. The denominator of 
the fraction is the sum of foreign earned income for 1984 and 1985, that 
is $60,000 plus $150,000, or $210,000. B's allowable moving expense 
deduction is $3,495, or $6,000-($6,000 x $87,671/$210,000). If B does 
not file an amended 1984 return (and does not exclude foreign earned 
income for 1984), but excludes foreign earned income under section 
911(a) for 1985, a portion of his moving expense deduction is 
disallowed, based on the same formula. The amount disallowed is $6,000 x 
$61,589/$210,000, or $1,760. This amount may be recaptured either by 
filing an amended return for 1984 or by including it in income for 1985 
(in which case it is not foreign earned income).
    Example 5. C is a U.S. citizen, a self-employed individual, and a 
cash basis and calendar year taxpayer. For the entire 1982 taxable year 
C maintained his tax home and his bona fide residence in foreign country 
P. During 1982 C earned and received $120,000 of foreign earned income, 
none of which was attributable to employer provided amounts. C paid 
$40,000 of business expenses. C elected to exclude foreign earned income 
under section 911(a)(1) and claimed a housing cost amount deduction of 
$15,000. C received $10,000 of foreign source interest income which was 
included with C's earned income in a single tax base and taxed at 
graduated rates. For 1982, C paid $30,000 in income tax to foreign 
country P. The amount of C's business expenses that is properly 
apportioned to excluded amounts (and therefore, not deductible) equals 
$25,000, which is determined by multiplying the otherwise allowable 
deductions by C's excluded amounts over C's foreign earned

[[Page 44]]

income ($40,000 x 75,000/120,000). The amount of country P tax that is 
properly apportioned to excluded amounts (and therefore, not deductible 
or creditable) equals $20,000, which is determined by multiplying the 
tax of $30,000 by the following fraction:
[GRAPHIC] [TIFF OMITTED] TC14NO91.142

    Example 6. D is a U.S. citizen and an accrual basis and calendar 
year taxpayer for U.S. tax purposes. For the entire period from January 
1, 1982 through December 31, 1983, D maintains his tax home and his bona 
fide residence in foreign country R. For purposes of R's income tax, D 
is a cash basis taxpayer and uses a fiscal year that begins on April 1 
and ends on the following March 31. During his entire period of 
residence in R, D receives foreign earned income of $10,000 each month, 
all of which is attributable to employer provided amounts. For his 
foreign taxable year ending March 31, 1982, D pays $10,000 of income tax 
to R. For his foreign taxable year ending March 31, 1983, D pays $54,000 
of income tax to R. Under paragraph (c)(2)(ii) of this section, all of 
the $10,000 of tax paid for this foreign taxable year ending March 31, 
1982 is imposed on foreign earned income received in 1982, as is 
$40,500, or \9/12\ x $54,000, of tax paid for his foreign taxable year 
ending March 31, 1983. (D received $10,000 per month for the last 3 
months of his foreign taxable year ending March 31, 1982, all of which 
are within his U.S. taxable year ending December 31, 1982 under 
paragraph (c)(2)(i) of this section, and $10,000 per month for each 
month of his foreign taxable year ending March 31, 1983, of which the 
first 9 months are within his U.S. taxable year ending December 31, 
1982. Under paragraph (c)(2)(ii) of this section, foreign taxes are 
deemed to accrue on a pro rata basis to income as it is received or 
accrued. Thus, all of the $10,000 of foreign taxes imposed on the income 
received during D's foreign taxable year ending March 31, 1982 accrue to 
D's 1982 foreign earned income, as do \9/12\ (or $90,000/120,000) of 
foreign taxes imposed on income received during D's foreign taxable year 
ending March 31, 1983, for purposes of determining the amount of D's 
foreign taxes that is disallowed.) For 1982, D has no deductible 
expenses, and elects to exclude his housing cost amount of $21,000 under 
section 911(a)(2) and foreign earned income of $75,000 under section 
911(a)(1). The amount of D's foreign taxes disallowed for deduction or 
credit purposes for 1982 is $8,000 (that is, $10,000 x $96,000/$120,000) 
of the taxes for his foreign taxable year ending March 31, 1982, plus 
$32,400 (that is, $40,500 x $96,000/$120,000) of the taxes for his 
foreign taxable year ending March 31, 1983, or $40,400. From 1982, D has 
$2,000 ($10,000-$8,000) of deductible or creditable taxes accrued on 
March 31, 1982, and $8,100 ($40,500-$32,400) of deductible or creditable 
taxes accrued on March 31, 1983, after the disallowance based on his 
1982 excluded income.
    Example 7. E is a United States citizen, calendar year and cash 
basis taxpayer. E is physically present in and establishes his tax home 
in foreign country S on May 1, 1981. For purposes of country S, E's 
taxable year begins on April 1 and ends the following March 31. E 
receives foreign earned income of $15,000 each month beginning on May 1, 
1981. At the end of his foreign taxable year ending on March 31, 1982, E 
pays $70,000 of income tax to S on $165,000 of foreign earned income. 
Under section 911, as in effect for taxable years beginning before 
January 1, 1982, E may not exclude any income that is earned or received 
during 1981. None of E's taxes paid in 1982 that are attributable to 
income earned or received in 1981 are subject to disallowance because, 
under paragraph (c)(2)(ii) of this section, the only taxes disallowed 
are those deemed to accrue on income earned and received after December 
31, 1981, and excluded from gross income. The amount of E's taxes paid 
in 1982 that are attributable to 1981 is $50,909, or $70,000 x $120,000/
$165,000. E elects to exclude foreign earned income for 1982. The amount 
of E's taxes paid to S in 1982 that accrue to 1982 foreign earned 
income, and are therefore subject to disallowance based on excluded 
income, is $19,091, or $70,000 x $45,000/$165,000.

(Sec. 911 (95 Stat. 194; 26 U.S.C. 911) and sec. 7805 (68A Stat. 917; 26 
U.S.C. 7805) of the Internal Revenue Code of 1954)

[T.D. 8006, 50 FR 2973, Jan. 23, 1985]



Sec. 1.911-7  Procedural rules.

    (a) Elections of a qualified individual--(1) In general. In order to 
receive either exclusion provided by section 911(a), a

[[Page 45]]

qualified individual must elect, separately with respect to each 
exclusion, to exclude foreign earned income under section 911(a)(1) and 
the housing cost amount under section 911(a)(2). Any such elections may 
be made on Form 2555 or on a comparable form. Each election must be 
filed either with the income tax return, or with an amended return, for 
the first taxable year of the individual for which the election is to be 
effective. An election once made remains in effect for that year and all 
subsequent years unless revoked under paragraph (b) of this section. 
Each election shall contain information sufficient to determine whether 
the individual is a qualified individual as provided in Sec. 1.911-2. 
The statement shall include the following information:
    (i) The individual's name, address, and social security number;
    (ii) The name of the individual's employer;
    (iii) Whether the individual claimed exclusions under section 911 
for earlier years after 1981 and within the five preceding taxable 
years;
    (iv) Whether the individual has revoked a previously made election 
and the taxable year for which such revocation was effective;
    (v) The exclusion or exclusions the individual is electing;
    (vi) The foreign country or countries in which the individual's tax 
home is located and the date when such tax home was established;
    (vii) The status (either bona fide residence or physical presence) 
under which the individual claims the exclusion;
    (viii) The individual's qualifying period of residence or presence;
    (ix) The individual's foreign earned income for the taxable year 
including the fair market value of all noncash remuneration; and,
    (x) If the individual elects to exclude the housing cost amount, the 
individual's housing expenses.
    (2) Requirement of a return--(i) In general. In order to make a 
valid election under this paragraph (a), the election must be made:
    (A) With an income tax return that is timely filed (including any 
extensions of time to file),
    (B) With a later return filed within the period prescribed in 
section 6511(a) amending the foregoing timely filed income tax return,
    (C) With an original income tax return that is filed within one year 
after the due date of the return (determined without regard to any 
extension of time to file); this one year period does not constitute an 
extension of time for any purpose--it is merely a period during which a 
valid election may be made on a late return, or
    (D) With an income tax return filed after the period described in 
paragraphs (a)(2)(i)(A), (B), or (C) of this section provided--
    (1) The taxpayer owes no federal income tax after taking into 
account the exclusion and files Form 1040 with Form 2555 or a comparable 
form attached either before or after the Internal Revenue Service 
discovers that the taxpayer failed to elect the exclusion; or
    (2) The taxpayer owes federal income tax after taking into account 
the exclusion and files Form 1040 with Form 2555 or a comparable form 
attached before the Internal Revenue Service discovers that the taxpayer 
failed to elect the exclusion.
    (3) A taxpayer filing an income tax return pursuant to paragraph 
(a)(2)(i)(D)(1) or (2) of this section must type or legibly print the 
following statement at the top of the first page of the Form 1040: 
``Filed Pursuant to Section 1.911-7(a)(2)(i)(D).''
    (ii) Election for 1982 and 1983 taxable years. Solely for purposes 
of paragraph (a)(2)(i)(A) of this section, an income tax return for any 
taxable year beginning before January 1, 1984, shall be considered 
timely filed if it is filed on or before July 23, 1985.
    (3) Housing cost amount deduction. An individual does not have to 
make an election in order to claim the housing cost amount deduction. 
However, such individual must provide the Commissioner with information 
sufficient to determine the individual's correct amount of tax. Such 
information shall include the following: The individual's name, address, 
and social security number; the name of the individual's employer; the 
foreign country in which

[[Page 46]]

the individual's tax home was established; the status under which the 
individual claims the deduction; the individual's qualifying period of 
residence or presence; the individual's foreign earned income for the 
taxable year; and the individual's housing expenses.
    (4) Effect of immaterial error or omission. An inadvertent error or 
omission of information required to be provided to make an election 
under this paragraph (a) shall not render the election invalid if the 
error or omission is not material in determining whether the individual 
is a qualified individual or whether the individual intends to make the 
election.
    (b) Revocation of election--(1) In general. An individual may revoke 
any election made under paragraph (a) of this section for any taxable 
year. A revocation must be made separately with respect to each 
election. The individual may revoke an election for any taxable year, 
including the first taxable year for which an election was effective, by 
filing a statement that the individual is revoking one or more of the 
previously made elections. The statement must be filed with the income 
tax return, or with an amended return, for the first taxable year of the 
individual for which the revocation is to be effective. A revocation 
once made is effective for that year and all subsequent years. If an 
election is revoked for any taxable year, including the first taxable 
year for which the election was effective, the individual may not, 
without the consent of the Commissioner, again make the same election 
until the sixth taxable year following the taxable year for which the 
revocation was first effective. For example, a qualified individual 
makes an election to exclude foreign earned income under section 
911(a)(1) and files it with his 1982 income tax return. The individual 
files 1983 and 1984 income tax returns on which he excludes his foreign 
earned income. Then, within 3 years after filing his 1982 income tax 
return, the individual files an amended 1982 income tax return with a 
statement revoking his election to exclude foreign earned income under 
section 911(a)(1). The revocation of the election is effective for 
taxable years 1982, 1983, and 1984. The individual may not elect to 
exclude income under section 911(a)(1) for any taxable year before 1988, 
unless he obtains consent to reelect under paragraph (b)(2) of this 
section.
    (2) Reelection before sixth taxable year after revocation. If an 
individual revoked an election under paragraph (b)(1) of this section 
and within five taxable years the individual wishes to reelect the same 
exclusion, then the individual may apply for consent to the reelection. 
The application for consent shall be made by requesting a ruling from 
the Associate Chief Counsel (Technical), National Office, Internal 
Revenue Service, 1111 Constitution Avenue NW., Washington, DC 20224. In 
determining whether to consent to reelection the Associate Chief Counsel 
or his delegate shall consider any facts and circumstances that may be 
relevant to the determination. Relevant facts and circumstances may 
include the following: a period of United States residence, a move from 
one foreign country to another foreign country with differing tax rates, 
a substantial change in the tax laws of the foreign country of residence 
or physical presence, and a change of employer.
    (c) Returns and extensions--(1) In general. Any return filed before 
completion of the period necessary to qualify an individual for any 
exclusion of deduction provided by section 911 shall be filed without 
regard to any exclusion or deduction provided by that section. A claim 
for a credit or refund of any overpayment of tax may be filed, however, 
if the taxpayer subsequently qualifies for any exclusion or deduction 
under section 911. See section 6012(c) and Sec. 1.6012-1(a)(3), 
relating to returns to be filed and information to be furnished by 
individuals who qualify for any exclusion or deduction under section 
911.
    (d) Declaration of estimated tax. In estimating gross income for the 
purpose of determining whether a declaration of estimated tax must be 
made for any taxable year, an individual is not required to take into 
account income which the individual reasonably believes will be excluded 
from gross income under the provisions of section

[[Page 47]]

911. In computing estimated tax, however, the individual must take into 
account, among other things, the denial of the foreign tax credit for 
foreign taxes allocable to the excluded income (see Sec. 1.911-6(c)).
    (e) Effective/applicability date. This section applies to 
applications for extension of time to file returns filed after July 1, 
2008.

(Sec. 911 (95 Stat. 194; 26 U.S.C. 911) and sec. 7805 (68A Stat. 917; 26 
U.S.C. 7805) of the Internal Revenue Code of 1954)

[T.D. 8006, 50 FR 2976, Jan. 23, 1985, as amended by T.D. 8480, 58 FR 
34885, June 30, 1993; 73 FR 37365, July 1, 2008]



Sec. 1.911-8  Former deduction for certain expenses of living abroad.

    For rules relating to the deduction for certain expenses of living 
abroad applicable to taxable years beginning before January 1, 1982, see 
26 CFR 1.913-1 through 1.913-13 as they appeared in the Code of Federal 
Regulations revised as of April 1, 1982.

(Sec. 911 (95 Stat. 194; 26 U.S.C. 911) and sec. 7805 (68A Stat. 917; 26 
U.S.C. 7805) of the Internal Revenue Code of 1954)

[T.D. 8006, 50 FR 2977, Jan. 23, 1985]

               earned income of citizens of united states



Sec. 1.912-1  Exclusion of certain cost-of-living allowances.

    (a) Amounts received by Government civilian personnel stationed 
outside the continental United States as cost-of-living allowances in 
accordance with regulations approved by the President are, by the 
provisions of section 912(1), excluded from gross income. Such 
allowances shall be considered as retaining their characteristics under 
section 912(1) notwithstanding any combination thereof with any other 
allowance. For example, the cost-of-living portion of a ``living and 
quarters allowance'' would be excluded from gross income whether or not 
any other portion of such allowance is excluded from gross income.
    (b) For purposes of section 912(1), the term ``continental United 
States'' includes only the 48 States existing on February 25, 1944 (the 
date of the enactment of the Revenue Act of 1943 (58 Stat. 21)) and the 
District of Columbia.



Sec. 1.912-2  Exclusion of certain allowances of Foreign Service
personnel.

    Gross income does not include amounts received by personnel of the 
Foreign Service of the United States as allowances or otherwise under 
the provisions of chapter 9 of title I of the Foreign Service Act of 
1980 or the provisions of section 28 of the State Department Basic 
Authorities Act (formerly section 914 of title IX of the Foreign Service 
Act of 1946).

[T.D. 8256, 54 FR 28620, July 6, 1989]



Sec. 1.921-1T  Temporary regulations providing transition rules for
DISCs and FSCs.

    (a) Termination of a DISC--(1) At end of 1984.
    Q-1: What is the effect of the termination on December 31, 1984, of 
a DISC's taxable year?
    A-1: Without regard to the annual accounting period of the DISC, the 
last taxable year of each DISC beginning during 1984 shall be deemed to 
close on December 31, 1984. The corporation's DISC election also shall 
be deemed revoked at the close of business on December 31, 1984. (A DISC 
that does not elect to be an interest charge DISC as of January 1, 1985, 
in addition to a corporation described in section 992(a)(3), shall be 
referred to as a ``former DISC''.) A corporation which wishes to be 
treated as a FSC, a small FSC, or an interest charge DISC must make an 
election as provided under paragraph (b) (Q & A 1) of this section.
    (2) Deemed distributions for short taxable years.
    Q-2: If the termination of the DISC's taxable year on December 31, 
1984, results in a short taxable year, how are the deemed distributions 
under section 995(b)(1)(E) determined?
    A-2: The deemed distributions are determined on the basis of the 
DISC's taxable income for its short taxable year ending on December 31, 
1984. In computing the incremental distribution under section 
995(b)(1)(E), the export gross receipts for the short taxable year must 
be annualized.
    (3) Qualification as a DISC for 1984.
    Q-3: Must the DISC satisfy all the tests set forth in section 
992(a)(1) for the DISC's taxable year ending December 31, 1984?

[[Page 48]]

    A-3: All of the tests under section 992(a)(1), except the qualified 
assets test under section 992(a)(1)(B), must be satisfied.
    (4) Commissions for 1984.
    Q-4: Must commissions be paid by a related supplier to a DISC with 
respect to the DISC's taxable year ending December 31, 1984?
    A-4: No.
    Q-4A: Must commissions which were earned prior to January 1, 1985, 
be paid by a related supplier if the last date payment is required (as 
set forth in Sec. 1.994-1(e)(3)) is after December 31, 1984?
    A-4A: No.
    (5) Producer's loans of 1984.
    Q-5: Must the producer's loan rules under section 993(d) be 
satisfied with respect to the DISC's taxable year ending December 31, 
1984?
    A-5: Yes.
    (6) Accumulated DISC income.
    Q-6. Under what circumstances is any remaining accumulated DISC 
income treated as previously taxed income (and not taxed)?
    A-6. The accumulated DISC income of a DISC (but not a DISC described 
in section 992(a)(3)) as of December 31, 1984, is treated as previously 
taxed income when actually distributed after December 31, 1984. Any 
amounts distributed by the former DISC (including a DISC which has 
elected to be an interest charge DISC) after December 31, 1984, shall be 
treated as made first out of current earnings and profits and then out 
of previously taxed income to the extent thereof. For purposes of the 
preceding sentence, amounts distributed before July 1, 1985, shall be 
treated as made first out of previously taxed income to the extent 
thereof. If property other than money is distributed and if such 
property was a qualified export asset within the meaning of section 
993(b) on December 31, 1984, then for purposes of section 311, no gain 
or loss will be recognized on the distribution and the distributee will 
have the same basis in the property as the distributor.
    Q-7: May a DISC that was previously disqualified, but has 
requalified as of December 31, 1984, treat any accumulated DISC income 
as previously taxed income?
    A-7: If a DISC was previously disqualified, but has requalified as 
of December 31, 1984, any accumulated DISC income previously required to 
be taken into income upon prior disqualification shall not be treated as 
previously taxed income. All accumulated DISC income derived since 
requalification, however, will be treated as previously taxed income.
    (7) Distribution of previously taxed income.
    Q-8: What effect will the distribution of previously taxed income 
have on the earnings and profits of corporate shareholders of the former 
DISC?
    A-8: The earnings and profits of the corporate shareholders of the 
former DISC will be increased by the amount of money and the adjusted 
basis of any property which is distributed out of previously taxed 
income.
    Q-9: Will the distribution of the former DISC's accumulated DISC 
income as previously taxed income after December 31, 1984, result in a 
reduction in the shareholder's basis of the stock of the former DISC and 
consequent taxation of the excess of the distribution over such basis as 
capital gain under section 996(d)?
    A-9: No. This distribution will be treated both as amounts 
representing deemed distributions under section 995(b)(1) and as 
previously taxed income. Thus, no capital gain will arise.
    (8) Qualifying distributions.
    Q-10: How is a qualifying distribution to satisfy the qualified 
export receipts tests under section 992(c)(1)(A) which is made with 
respect to the DISC's taxable year ending on December 31, 1984, treated?
    A-10: The distribution will not be treated as previously taxed 
income but will be taxed to the shareholder of the former DISC, as 
provided under section 992(c) and 996(a)(2) and the regulations 
thereunder, in the shareholder's taxable year in which the distribution 
is made.
    (9) Deficiency distributions.
    Q-11: With respect to an audit adjustment made after December 31, 
1984, may a deficiency distribution be made, and if so, in what manner 
may it be made?
    A-11: A deficiency distribution may be made notwithstanding the fact 
that

[[Page 49]]

after December 31, 1984, the former DISC is a taxable corporation under 
subchapter C, has elected to be treated as an interest charge DISC, or 
has been liquidated, reorganized or is otherwise no longer in existence. 
However, such deficiency distribution shall be treated as made out of 
accumulated DISC income which is not previously taxed income because it 
will be treated as distributed prior to December 31, 1984, to the DISC's 
shareholders.
    Q-11A: Must a former DISC remain in existence in order for a former 
DISC shareholder to take advantage of the spread provided in section 
995(b)(2) with respect to DISC disqualification?
    A-11A: No. With respect to distributions deemed to be received by a 
former DISC shareholder under section 995(b)(2) for taxable years 
beginning after December 31, 1984, if the former DISC shareholder 
elects, the rules of section 995(b)(2)(B) shall apply even though the 
former DISC does not continue in existence. If the former DISC is no 
longer in existence, the former DISC's shareholders will be deemed to 
have received the distribution on the last day of their taxable years 
over the applicable period of time determined under section 995(b)(2) as 
if the former DISC had remained in existence.
    (10) Deemed distribution for 1984.
    Q-12: How is the deemed distribution to a shareholder for the DISC's 
taxable year ending December 31, 1984, taken into account?
    A-12 (i) If the taxable year of the DISC ending on December 31, 
1984, (A) is the first taxable year of the DISC which begins in 1984, 
(B) begins after the date in 1984 on which the taxable year of the 
DISC's shareholder begins, and (C) if the DISC's shareholder makes an 
election under section 805(b)(3) of the Tax Reform Act of 1984, the 
deemed distribution under section 995(b) with respect to income derived 
by the DISC for such taxable year of the DISC shall be treated as 
received by the shareholder in 10 equal installments (unless the 
shareholder elects to be treated as receiving the deemed distribution in 
income over a smaller number of equal installments). The first 
installment shall be treated as received by the shareholder on the last 
day of the shareholder's second taxable year beginning in 1984 (if any), 
or if the shareholder had only one taxable year which began in 1984, on 
the last day of the shareholder's first taxable year beginning in 1985. 
One installment shall be treated as received by the shareholder on the 
last day of each succeeding taxable year of the shareholder until the 
entire amount of the DISC's 1984 deemed distribution has been included 
in the shareholder's taxable income. To make the election under section 
805(b)(3) of the Tax Reform Act of 1984, the DISC shareholder must 
attach a statement to its timely filed tax return (including extensions) 
for its taxable year which includes December 31, 1984, indicating the 
total amount of the shareholder's pro rata share of the DISC's deemed 
distribution for 1984 (determined under section 995(b) of the Code 
without regard to the election under section 805(b)(3) of the Tax Reform 
Act of 1984), and the number of equal installments, if less than 10, 
over which the shareholder wishes to spread its pro rata share of the 
deemed distribution for 1984. If the election under section 805(b)(3) of 
the Tax Reform Act of 1984 is made, it may not be changed or revoked. In 
determining estimated tax payments, the portion of the deemed 
distribution includible in the shareholder's taxable income for any 
taxable year under this subdivision (i) shall be treated as received by 
the shareholder on the last day of such taxable year.
    (ii) Except as provided in subdivision (i), the deemed distribution 
under section 995(b) with respect to income derived by the DISC for its 
taxable year ending on December 31, 1984, shall be included in the 
shareholder's taxable income for its taxable year which includes 
December 31, 1984. Thus, if the taxable year of the DISC and the DISC's 
shareholder both begin on January 1, 1984, and end on December 31, 1984 
(or, if the taxable year of the DISC beginning in 1984 begins before the 
taxable year of the DISC's shareholder), the deemed distribution with 
respect to the DISC's taxable year ending on December 31, 1984, will be 
included in the DISC shareholder's taxable year ending on (or including) 
December 31, 1984, and the election described in subdivision (i) may not 
be made.

[[Page 50]]

    (iii) The provisions of this Question and Answer-12 apply without 
regard to any existence of the DISC after December 31, 1984, as an 
interest charge DISC.
    Q-12A: If under section 805(b)(3) of the Tax Reform Act of 1984 the 
shareholders of the DISC are permitted to make an election to treat the 
DISC's 1984 deemed distribution as received over a 10-year period, must 
the DISC distribute that amount to its shareholders ratably over the 10-
year period?
    A-12A: No. Under section 805(b)(3) of the Tax Reform Act of 1984, if 
the DISC's deemed distribution for its taxable year which ended on 
December 31, 1984, is a qualified distribution, the shareholders of the 
DISC are permitted to make an election to treat the distribution as 
received over a 10-year period. The 10-year treatment applies even 
though the amount of the deemed distribution is distributed to the 
DISC's shareholders prior to the period in which the distribution is 
taken into income by the shareholders. In addition, under section 996(e) 
of the Code, the shareholder's basis in the stock of the DISC will be 
considered as increased, as of the date of liquidation, by the 
shareholder's pro rata share of the amount of the undistributed 
qualified distribution even though that amount is treated as received by 
the shareholder in later years. Further, the actual distribution in 
liquidation of the former DISC after 1984 will increase the earnings and 
profits of a corporate distributee, and the amount actually distributed 
shall be treated under the rules of section 996.
    (11) Conformity of accounting period.
    Q-13: May a DISC be established or change its annual accounting 
period for taxable years beginning after March 21, 1984, and before 
January 1, 1985?
    A-13: A DISC that is established or that changes its annual 
accounting period after March 21, 1984, must conform its annual 
accounting period to that of its principal shareholder (the shareholder 
with the highest percentage of voting power as defined in section 
441(h)).
    (12) DISC gains and distributions from U.S. sources.
    Q-14: What is the effective date of the amendment to section 996(g), 
made by section 801(d)(10) of the Tax Reform Act of 1984, which treats 
certain DISC gains and distributions as derived from sources within the 
United States?
    A-14: Under section 805(a)(3) of the Act, the amendment to section 
996(g) shall apply to all gains referred to in section 995(c) and all 
distributions out of accumulated DISC income including deemed 
distributions made on or after June 22, 1984.
    (b) Establishing and electing status as a FSC, small FSC or interest 
charge DISC--(1) Ninety-day period.
    Q-1: How does a corporation elect to be treated as a FSC, a small 
FSC, or an interest charge DISC?
    A-1: A corporation electing FSC or small FSC status must file Form 
8279. A corporation electing interest charge DISC status must file Form 
4876A. A corporation electing to be treated as a FSC, small FSC, or 
interest charge DISC for its first taxable year shall make its election 
within 90 days after the beginning of that year. A corporation electing 
to be treated as a FSC, small FSC, or interest charge DISC for any 
taxable year other than its first taxable year shall make its election 
during the 90-day period immediately preceding the first day of that 
taxable year. The election to be a FSC, small FSC, or interest charge 
DISC may be made by the corporation, however, during the first 90 days 
of a taxable year, even if that taxable year is not the corporation's 
first taxable year, if that taxable year begins before July 1, 1985. 
Likewise, the election to be a FSC (or a small FSC) may be made during 
the first 90 days of any taxable year of a corporation if the 
corporation had in a prior taxable year elected small FSC (or FSC) 
status and the corporation revokes the small FSC (or FSC) election 
within the 90 day period. A corporation which was a DISC for its taxable 
year ending December 31, 1984, which wishes to be treated as an interest 
charge DISC beginning with its first taxable year beginning after 
December 31, 1984, may make the election to be treated as an interest 
charge DISC by filing Form 4876A on or before July 1, 1987. Also, if a 
corporation which has elected FSC, small FSC or interest charge DISC 
status, or a shareholder of that corporation, is acquired in a qualified 
stock

[[Page 51]]

purchase under section 338(d)(3), and if an election under section 
338(a) is effective with regard to that corporation, the corporation may 
re-elect FSC, small FSC or interest charge DISC status, (whichever is 
applicable) not later than the date of the election under section 
338(a), see section 338(g)(i) and Sec. 1.338-2(d). This re-election is 
necessary because the original elections are deemed terminated if an 
election is made under section 338(a). The rules contained in Sec. 
1.992-2 (a)(1), (b)(1) and (b)(3) shall apply to the manner of making 
the election and the manner and form of shareholder consent.
    (2) FSC incorporated in a possession.
    Q-2: Where does a FSC which is incorporated in a U.S. possession 
file its election?
    A-2: The election is filed with the Internal Revenue Service Center, 
Philadelphia, Pennsylvania 19255.
    (3) Information returns.
    Q-3: Must Form 5471 be filed with respect to the organization of a 
FSC pursuant to section 6046 or to provide information with respect to a 
FSC pursuant to section 6038?
    A-3: A Form 5471 required under section 6046 need not be filed with 
respect to the organization of a FSC. The requirements of section 6046 
shall be satisfied by the filing of a Form 8279 dealing with the 
election to be treated as a FSC or small FSC. However, a Form 5471 will 
be required with respect to a reorganization of a FSC (or small FSC) or 
an acquisition of stock of a FSC (or small FSC), as required under 
section 6046 and the regulations thereunder. Provided that a Form 1120 
FSC is filed, a Form 5471 need not be filed to satisfy the requirements 
of section 6038.
    (4) Conformity of accounting period.
    Q-4: Since a FSC, small FSC, and interest charge DISC must use the 
same annual accounting period as the principal shareholder, must such 
corporation delay the beginning of its first taxable year beyond January 
1, 1985 if the principal shareholder (the shareholder with the highest 
percentage of voting power as defined in section 441(h)) is not a 
calendar year taxpayer?
    A-4: No. Where the principal shareholder is not a calendar year 
taxpayer, a corporation may elect to be treated as a FFSC, small FSC, or 
interest charge DISC for a taxable year beginning January 1, 1985. 
However, such corporation must close its first taxable year and adopt 
the annual accounting period of its principal shareholder as of the 
first day of the principal shareholder's first taxable year beginning in 
1985. A FSC, small FSC, or interest charge DISC need not obtain the 
consent of the Commissioner under section 442 to conform its annual 
accounting period to the annual accounting period of its principal 
shareholder.
    (5) Dollar limitations for short taxable years.
    Q-5: If a small FSC or an interest charge DISC has a short taxable 
year, how are the dollar limitations on foreign trading export gross 
receipts and qualified export gross receipts, respectively, determined 
for small FSCs and interest charge DISCs?
    A-5: The dollar limitations are to be prorated on a daily basis. 
Thus, for example, if for its 1985 taxable year a small FSC has a short 
taxable year of 73 days, then in determining exempt foreign trade 
income, any foreign trading gross receipts that exceed $1 million (73/
365 x $5 million) will not be taken into account.
    (6) Change of accounting period.
    Q-6: If the principal shareholder of a FSC, a small FSC, or an 
interest charge DISC (hereinafter referred to as a ``FSC'') changes its 
annual accounting period or is replaced by a new principal shareholder 
during a taxable year, is it necessary for the FSC to change its annual 
accounting period?
    A-6: If the principal shareholder changes its annual accounting 
period, the FSC must also change its annual accounting period to conform 
to that of its principal shareholder. If the voting power of the 
principal shareholder is reduced by an amount equal to at least 10 
percent of the total shares entitled to vote and such shareholder is no 
longer the principal shareholder, the FSC must conform its accounting 
period to that of its new principal shareholder. However, in determining 
whether a shareholder is a principal shareholder, the voting power of 
the shareholders is determined as of the beginning of the FSC's taxable 
year. Thus, for example, assume that for 1985 a FSC adopts a calendar 
year period as

[[Page 52]]

its annual accounting period to conform to that of its principal 
shareholder. Assume further than in March 1985 there is a 10 percent 
change in voting power and a different shareholder whose annual 
accounting period begins on July 1 becomes the new principal 
shareholder. The FSC will not be required to adopt the annual accounting 
period of its new principal shareholder until July 1, 1986. The FSC will 
have a short taxable year for the period January 1 to June 30, 1986.
    (7) Transition transfers.
    Q-7. Under what circumstances may a DISC or former DISC transfer its 
assets to a FSC or small FSC without incurring any tax liability on the 
transfer?
    A-7. A DISC or former DISC will recognize no income, gain, or loss 
on a transfer of its qualified assets (as defined in section 993(b)) to 
a FSC or small FSC if all of the following conditions are met:
    (i) The assets transferred were held by the DISC on August 4, 1983, 
and were transferred by the DISC or former DISC to the FSC or small FSC 
in a transfer completed before January 1, 1986; and
    (ii) The assets are transferred in a transaction which would qualify 
for nonrecognition under subchapter C of chapter 1 of the Code, or would 
so qualify but for section 367 of the Code.
    In such case, section 367 shall not apply to the transfer.
    In addition, other provisions of subchapter C will apply to the 
transfer, such as section 358 (basis to shareholders), section 362 
(basis to corporations), and section 381 (carryovers in corporate 
acquisitions). In determining whether a transfer by a DISC to a FSC or 
small FSC qualifies for nonrecognition under subchapter C, a liquidation 
of the assets of the DISC into a parent corporation followed by a 
transfer by the parent of those assets to the FSC or small FSC will be 
treated as a transaction described in section 368(a)(1)(D).
    Notwithstanding the foregoing answer, a taxpayer which transfers a 
right to use its corporate name to a FSC in a transaction described in 
sections 332, 351, 354, 356 and 361 shall not be treated as having sold 
that right under section 367(d) or as having transferred that right to 
an entity that is not a corporation under section 367(a) provided that 
the corporate name is used only by the FSC and is not licensed or 
otherwise made available to others by the FSC.
    (8) Completed contract method.
    Q-8: Under what conditions is a taxpayer using the completed 
contract method of accounting as defined in Sec. 1.451-3(d) exempted 
from satisfying the foreign management and foreign economic process 
requirements of subsections (c) and (d) of section 924?
    A-8: If the taxpayer has entered into a binding contract before 
March 16, 1984, or has on March 15, 1984, and at all times thereafter a 
firm plan, evidenced in writing, to enter the contract and enters into a 
binding contract by December 31, 1984, then the taxpayer will be treated 
as having satisfied the foreign management tests of section 924(c) for 
periods before December 31, 1984, and the foreign economic process tests 
of section 924(d) with respect to costs incurred before December 31, 
1984, with respect to the transaction. The FSC rules will apply to the 
income from the long-term contract if an election is made and the 
general FSC requirements under section 922 are satisfied. However, such 
taxpayer need not satisfy the activities test under section 925(c) for 
activities which occur before January 1, 1985 in order to use the 
transfer pricing rules under section 925.
    (9) Long-term contract--before March 15, 1984.
    Q-9: Under what conditions is a taxpayer who enters into a binding 
long-term contract (i.e., a contract which is not completed in the 
taxable year in which it is entered into) before March 15, 1984, but 
does not use the completed contract method of accounting exempted from 
satisfying the foreign management and economic process requirements of 
subsections (c) and (d) of section 924?
    A-9: If a taxpayer enters into a binding contract before March 15, 
1984, the taxpayer will be treated as having satisfied the foreign 
management tests of section 924(c) for periods before December 31, 1984, 
and the foreign economic

[[Page 53]]

process tests of section 924(d) with respect to costs incurred before 
December 31, 1984, but only with respect to income attributable to such 
contracts that is recognized before December 31, 1986. The FSC rules 
will apply to the income from the long-term contract if an election is 
made and the general FSC requirements under section 922 are satisfied. 
However, such taxpayer need not satisfy the activities test under 
section 925(c) for activities which occur before January 1, 1985, in 
order to use the transfer pricing rules under section 925.
    (10) Long-term contract--after March 15, 1984.
    Q-10: Under what conditions is a taxpayer who has a long-term 
contract (i.e., a contract which is not completed in the taxable year in 
which it is entered into) but does not use the completed contract method 
of accounting exempted from satisfying the foreign management and 
economic process requirements of subsections (c) and (d) of section 924 
if such taxpayer enters into a binding contract after March 15, 1984 and 
before January 1, 1985?
    A-10: If a taxpayer enters into a contract after March 15, 1984, and 
before January 1, 1985, the taxpayer will be treated as having satisfied 
the foreign management tests of section 924(c) for periods before 
December 31, 1984, and the foreign economic process tests of section 
924(d) with respect to costs incurred before December 31, 1984, but only 
with respect to income attributable to such contract that is recognized 
before December 31, 1985.
    The FSC rules will apply to the income from the long-term contract 
if an election is made and the general requirements under section 922 
are satisfied. However, such taxpayer need not satisfy the activities 
test under section 925(c) for activities which occur before January 1, 
1985 in order to use the transfer pricing rules under section 925.
    (11) Incomplete transactions.
    Q-11: In computing its foreign trade income, how should a FSC treat 
transfers of export property from a related supplier to a DISC which is 
subsequently resold by a FSC after the DISC's termination?
    A-11: In applying the gross receipts and combined taxable income 
methods under section 925 (a)(1) and (a)(2), the transaction is treated 
as if the transfer of export property were made by the related supplier 
to the FSC except that the foreign management and economic processes 
tests under section 924 and the activities test under section 925(c) 
shall be deemed to be satisfied for purposes of the transaction.
    (12) Pre-effective date costs and activities.
    Q-12: Are costs incurred and activities performed prior to January 
1, 1985 taken into account for purposes of satisfying the foreign 
management and foreign economic processes requirements of subsections 
(c) and (d) of section 924 and the activities test under section 925(c)?
    A-12: For purposes of determining the costs incurred and the 
activities performed to be taken into account with respect to contracts 
entered into after December 31, 1984, only those costs incurred and 
activities performed after December 31, 1984, are taken into 
consideration. Costs incurred and activities performed by a related 
supplier prior to January 1, 1985 (or prior to the effective date of a 
corporation's election to be treated as a FSC if other than January 1, 
1985) with respect to transactions occurring after January 1, 1985 (or 
after the effective date of a corporation's election to be treated as a 
FSC) need not be taken into account for purposes of computing the FSC's 
profit under section 925 but are treated for section 925(c) purposes as 
if they were performed on behalf of the FSC.
    (13) FSC and interest charge DISC.
    Q-13: Can a FSC and an interest charge DISC be members of the same 
controlled group?
    A-13: A FSC and an interest charge DISC cannot be members of the 
same controlled group. If any controlled group of corporations of which 
an interest charge DISC is a member establishes a FSC, then any interest 
charge DISC which is a member of such group shall be treated as having 
terminated its status as an interest charge DISC.
    (c) Export Trade Corporations--(1) Previously taxed income.
    Q-1: Under what circumstances are earnings of an export trade 
corporation that have not been included in income under section 951 
treated as previously

[[Page 54]]

taxed income previously included in the income of a U.S. shareholder for 
purposes of section 959 (and not taxed)?
    A-1: A corporation which qualifies as an export trade corporation 
(ETC) with respect to its last taxable year beginning before January 1, 
1985, and elects to discontinue operations as an ETC for all taxable 
years beginning after December 31, 1984, shall not be required to take 
into income earnings attributable to previously excluded export trade 
income, as defined in Sec. 1.970-1(b), derived with respect to taxable 
years beginning before January 1, 1985. However, any amounts distributed 
by the former ETC (i.e. a corporation which was an ETC for its last 
taxable year beginning before January 1, 1985) shall be treated as being 
made out of current earnings and profits and then out of previously 
taxed income. For purposes of determining the shareholder's basis in the 
ETC stock, distributions of previously excluded export trade income 
shall be treated as if made out of previously taxed income which has 
already been included in gross income under section 951(a)(1)(B). Thus, 
no basis adjustment under section 961 is necessary. In addition, upon 
the sale or exchange of the stock of such corporation in a transaction 
described in section 1248(a), the earnings and profits of the 
corporation attributable to such previously untaxed income shall not be 
subject to section 1248(a).
    (2) Qualification as an ETC for last year.
    Q-2: Must an ETC satisfy all of the tests set forth in section 
971(a)(1) for the ETC's last taxable year beginning before January 1, 
1985?
    A-2: All of the tests in section 971(a)(1) must be satisfied, except 
that for purposes of the working capital requirements set forth in 
section 971(c)(1), the working capital of the ETC at the close of its 
last taxable year beginning before January 1, 1985 shall be deemed 
reasonable.
    (3) Continuation of ETC status.
    Q-3: May a corporation which chooses to remain an ETC after December 
31, 1984, continue to do so?
    A-3: Yes. However, previously untaxed income of such ETC shall not 
be treated as previously taxed income in accordance with Q&A 1 of this 
section.
    (4) Discontinuation of ETC status.
    Q-4: How does an ETC make an election to discontinue its operation 
as an ETC?
    A-4: The United States shareholders (as defined in section 951(b)) 
must file a statement of election on behalf of the ETC indicating the 
intent of the ETC to discontinue operations as an ETC for taxable years 
beginning after December 31, 1984. In addition, the statement of 
election must include the name, address, taxpayer identification number 
and stock interest of each United States shareholder. The statement must 
also indicate that the corporation on behalf of which the shareholders 
are making the election qualified as an ETC for its last taxable year 
beginning before January 1, 1985, and also the amount of earnings 
attributable to previously excluded export trade income. The statement 
must be jointly signed by each United States shareholder with each 
shareholder stating under penalties of perjury that he or she holds the 
stock interest specified for such shareholder in the statement of 
election. A copy of the statement of election must be attached to Form 
5471 (information return with respect to a foreign corporation) filed 
with respect to the ETC's last taxable year beginning before January 1, 
1985.
    (5) Transition transfers.
    Q-5: Under what circumstances may an electing ETC transfer its 
assets to a FSC without incurring any tax liability on the transfer?
    A-5: An electing ETC will recognize no income, gain, or loss on a 
transfer of its assets to a FSC but only if all of the following 
conditions are met:
    (i) The assets transferred were held by the ETC on August 4, 1983, 
and were transferred by the ETC to the FSC in a transfer completed 
before January 1, 1986; and
    (ii) The assets are transferred in a transaction which would qualify 
for nonrecognition under subchapter C of chapter 1 of the Code, or would 
so qualify but for section 367 of the Code.
    In such case, section 367 shall not apply to the transfer. In 
addition, other provisions of subchapter C will apply to the transfer 
such as section

[[Page 55]]

358 (basis to shareholders), section 362 (basis to corporation) and 
section 381 (carryovers in corporate acquisitions). In determining 
whether a transfer by an ETC to a FSC qualifies for nonrecognition under 
subchapter C, a liquidation of the assets of the ETC into a parent 
corporation followed by a transfer by the parent of those assets to the 
FSC will be treated as a transaction described in section 368(a)(1)(D).

(Secs. 803 and 805 of the Tax Reform Act of 1984 (98 Stat. 1001) and 
sec. 7805 of the Internal Revenue Code of 1954 (68A Stat. 917; 26 U.S.C. 
7805); sec. 805 (b)(3)(C) and (D) of the Tax Reform Act of 1984 (98 
Stat. 1002), and sec. 7805 of the Code (68A Stat. 917; 26 U.S.C. 7805); 
secs. 367, 927, and 7805 of the Internal Revenue Code of 1954 (98 Stat. 
662, 26 U.S.C. 367; 98 Stat. 663, 26 U.S.C. 367; 98 Stat. 993, 26 U.S.C. 
927; 98 Stat. 994, 26 U.S.C. 927; and 68A Stat. 917, 26 U.S.C. 7805); 
sec. 805 of the Tax Reform Act of 1984 (Pub. L. 98-69, 98 Stat. 1000))

[T.D. 7983, 49 FR 40013, Oct. 12, 1984, as amended by T.D. 7992, 49 FR 
48283, Dec. 12, 1984; T.D. 7993, 49 FR 48291, Dec. 12, 1984; T.D. 7992, 
49 FR 49450, Dec. 20, 1984; T.D. 8126, 52 FR 6434, 6435, Mar. 3, 1987; 
T.D. 8515, 59 FR 2984, Jan. 20, 1994; T.D. 8858, 65 FR 1237, Jan. 7, 
2000; T.D. 8940, 66 FR 9929, Feb. 13, 2001]



Sec. 1.921-2  Foreign Sales Corporation--general rules.

    (a) Definition of a FSC and the Effect of a FSC Election.
    Q-1. What is the definition of a Foreign Sales Corporation 
(hereinafter referred to as a ``FSC'' (All references to FSCs include 
small FSCs unless indicated otherwise))?
    A-1. As defined in section 922(a), an FSC must satisfy the following 
eight requirements.
    (i) The FSC must be a corporation organized or created under the 
laws of a foreign country that meets the requirements of section 
927(e)(3) (a ``qualifying foreign country'') or a U.S. possession other 
than Puerto Rico (an ``eligible possession''). See Q&As 3, 4, and 5 of 
Sec. 1.922-1.
    (ii) A FSC may not have more than 25 shareholders at any time during 
the taxable year. See Q&A 6 of Sec. 1.922-1.
    (iii) A FSC may not have any preferred stock outstanding during the 
taxable year. See Q&As 7 and 8 of Sec. 1.922-1.
    (iv) A FSC must maintain an office outside of the United States in a 
qualifying foreign country or an eligible possession and maintain a set 
of permanent books of account (including invoices or summaries of 
invoices) at such office. See Q&As 9, 10, 11, 12, 13, 14, and 15 of 
Sec. 1.922-1.
    (v) A FSC must maintain within the United States the records 
required under section 6001. See Q&A 16 of Sec. 1.922-1.
    (vi) The FSC must have a board of directors which includes at least 
one individual who is not a resident of the United States at all times 
during the taxable year. See Q&As 17, 18, 19, 20, and 21 of Sec. 1.922-
1.
    (vii) A FSC may not be a member, at any time during the taxable 
year, of any controlled group of corporations of which an interest 
charge DISC is a member. See Q&A 2 of this section and Q&A 13, of Sec. 
1.921-1T(b)(13).
    (viii) A FSC must have made an election under section 927(f)(1) 
which is in effect for the taxable year. See Q&A 1 of Sec. 1.921-
1T(b)(1) and Sec. 1.927(f)-1.


In addition, under section 441(h), the taxable year of a FSC must 
conform to the taxable year of its principal shareholder. See Q&A 4 of 
Sec. 1.921-1T(b)(4).
    Q-2. Does the reference to a DISC under section 922(a)(1)(F) which 
provides that a FSC cannot be a member, at any time during the taxable 
year, of any controlled group of corporations of which a DISC is a 
member refer solely to an interest charge DISC?
    A-2. Yes.
    (b) Small FSC.
    Q-3. What is a small FSC?
    A-3. A small FSC is a Foreign Sales Corporation which meets the 
requirements of section 922(a)(1) enumerated in Q&A 1 of this section as 
well as the requirements of section 922(b). Section 922(b) requires that 
a small FSC make a separate election to be treated as a small FSC. See 
Q&A 1 of Sec. 1.921-1T(b) and Sec. 1.927(f)-1. In addition, section 
922(b) requires that the small FSC not be a member, at any time during 
the taxable year, of a controlled group of corporations which includes a 
FSC unless such FSC is a small FSC.
    Q-4. What is the effect of an election as a small FSC?

[[Page 56]]

    A-4. Under section 924(b)(2), a small FSC need not meet the foreign 
management and economic processes tests of section 924(b)(1) in order to 
have foreign trading gross receipts. However, in determining the exempt 
foreign trade income of a small FSC, any foreign trading gross receipts 
for the taxable year in excess of $5 million are not taken into account. 
If the foreign trading gross receipts of a small FSC for the taxable 
year exceed the $5 million limitation, the FSC may select the gross 
receipts to which the limitation is allocated. In order to use the 
administrative pricing rules under section 925(a), a small FSC must 
satisfy the activities test under section 925(c). In addition, under 
section 441(h), the taxable year of a small FSC must conform to the 
taxable year of its principal shareholder (defined in Q&A 4 of Sec. 
1.921-1T(b)(4) as the shareholder with the highest percentage of its 
voting power).
    Q-5. What is the effect on a small FSC (or FSC) (``target'') if it 
is acquired, directly or indirectly, by a corporation if that acquiring 
corporation (``acquiring''), or a member of the acquiring corporation's 
controlled group, is a FSC (or small FSC)?
    A-5. Unless the corporations in the controlled group elect to 
terminate the FSC (or small (FSC) election of the acquiring corporation, 
the target's small FSC's (or FSC's) taxable year and election will 
terminate as of the day preceding the date the target small FSC and 
acquiring FSC became members of the same controlled group. The target 
small FSC will receive FSC benefits for the period prior to termination, 
but the $5 million small FSC limitation will be reduced to the amount 
which bears the same ratio to the $5 million as the number of days in 
the short year created by the termination bears to 365. The due date of 
the income tax return for the short taxable year created by this 
provision will be the date prescribed by section 6072(b), including 
extensions, starting with the last day of the short taxable year. If the 
short taxable year created by this provision ends prior to March 3, 
1987, the filing date of the tax return for the short taxable year will 
be automatically extended until the earlier of May 18, 1987 or the date 
under section 6072 (b) assuming a short taxable year had not been 
created by these regulations.
    (c) Comparison of FSC to DISC.
    Q-6. How does a FSC differ from a DISC?
    A-6. A DISC is a domestic corporation which is not itself taxable 
while a FSC must be created or organized under the laws of a 
jurisdiction which is outside of the United States (including certain 
U.S. possessions) and may be taxable on its income except for its exempt 
foreign trade income. The DISC provisions enable a shareholder to obtain 
a partial deferral of tax on income from export sales and certain 
services, if 95 percent of its receipts and assets are export related. 
The FSC provisions contain no assets test, but a portion of income for 
export sales and certain services is exempt from U.S. taxes if the FSC 
satisfies certain foreign presence, foreign management, and foreign 
economic processes tests.
    (d) Organization of a FSC.
    Q-7. Under the laws of what countries may a FSC be organized?
    A-7. A FSC may not be created or organized under the laws of the 
United States, a state, or other political subdivision. However, a FSC 
may be created or organized under the laws of a possession of the United 
States, including Guam. American Samoa, the Commonwealth of the Northern 
Mariana Islands and the Virgin Islands of the United States, but not 
Puerto Rico. These eligible possessions are located outside the U.S. 
customs territory. In addition, a FSC may incorporate under the laws of 
a foreign country that is a party to--
    (i) An exchange of information agreement that meets the standards of 
the Caribbean Basin Economic Recovery Act of 1983 (Code section 
274(h)(6)(C)), or
    (ii) A bilateral income tax treaty with the United States if the 
Secretary certifies that the exchange of information program under the 
treaty carries out the purpose of the exchange of information 
requirements of the FSC legislation as set forth in section 927(e)(3), 
if the company is covered under the exchange of information program 
under subdivision (i) or (ii). The Secretary may terminate the 
certification. Any termination by the Secretary will be

[[Page 57]]

effective six months after the date of the publication of the notice of 
such termination in the Federal Register.
    (e) Foreign Trade Income.
    Q-8. How is foreign trade income defined?
    A-8. Foreign trade income, defined in section 923(b), is gross 
income of an FSC attributable to foreign trading gross receipts. It 
includes both the profits earned by the FSC itself from exports and 
commissions earned by the FSC from products and services exported by 
others.
    (f) Investment Income and Carrying Charges.
    Q-9. What do the terms ``investment income'' and ``carrying 
charges'' mean?
    A-9.
    (i) Investment income means:
    (A) Dividends,
    (B) Interest,
    (C) Royalties,
    (D) Annuities,
    (E) Rents (other than rents from the lease or rental of export 
property for use by the lessee outside of the United States);
    (F) Gains from the sale of stock or securities,
    (G) Gains from future transactions in any commodity on, or subject 
to the rules of, a board of trade or commodity exchange (other than 
gains which arise out of a bona fide hedging transaction reasonably 
necessary to conduct the business of the FSC in the manner in which such 
business is customarily conducted by others),
    (H) Amounts includable in computing the taxable income of the 
corporation under part I of subchapter J, and
    (I) Gains from the sale or other disposition of any interest in an 
estate or trust.
    (ii) Carrying charges means:
    (A) Charges that are imposed by a FSC or a related supplier and that 
are identified as carrying charges, (``stated carrying charges'') and
    (B)(1) Charges that are considered to be included in the price of 
the property or services sold by an FSC or a related supplier, as 
provided under Q&As 1 and 2 of Sec. 1.927(d)-1, and
    (2) Any other unstated interest.
    Q-10. How are investment income and carrying charges treated?
    A-10. Investment income and carrying charges are not foreign trading 
gross receipts. Investment income and carrying charges are includable in 
the taxable income of an FSC, except in the case of a commission FSC 
where carrying charges are treated as income of the related supplier, 
and are treated as income effectively connected with a trade or business 
conducted through a permanent establishment within the United States. 
The source of investment income and carrying charges is determined under 
sections 861, 862, and 863 of the Code.
    (g) Small Businesses.
    Q-11. What options are available to small businesses engaged in 
exporting?
    A-11. A small business may elect to be treated as either a small FSC 
or an interest charge DISC. See Q&As 3 & 4 of Sec. 1.921-2 relating to 
a small FSC. Rules with respect to interest charge DISCs are the subject 
of another regulations project.

[T.D. 8127, 52 FR 6469, Mar. 3, 1987]



Sec. 1.921-3T  Temporary regulations; Foreign sales corporation 
general rules.

    (a) Exclusion--(1) Classifications of income. The extent to which 
income of a FSC (any further reference to a FSC in this section shall 
include a small FSC unless indicated otherwise) is subject to the 
corporate income tax of section 11, or, in the alternative, section 
1201(a), is dependent upon the allocation of the FSC's income to the 
following five categories:
    (i) Exempt foreign trade income determined under section 923 and 
Sec. 1.923-1T;
    (ii) Non-exempt foreign trade income determined with regard to the 
administrative pricing rules of section 925(a)(1) or (2);
    (iii) Non-exempt foreign trade income determined without regard to 
the administrative pricing rules of section 925(a)(1) or (2) (section 
923(a)(2) non-exempt income as defined in section 927(d)(6));
    (iv) Investment income and carrying charges; and
    (v) Other non-foreign trade income.
    (2) Source and characterization of FSC income--(i) Exempt foreign 
trade income. The exempt foreign trade income of a

[[Page 58]]

FSC determined under section 923 and Sec. 1.923-1T is treated as 
foreign source income which is not effectively connected with a United 
States trade or business. See Sec. 1.923-1T(a) for the definition of 
foreign trade income and Sec. 1.923-1T(b) for the definition of exempt 
foreign trade income.
    (ii) Non-exempt foreign trade income determined with regard to the 
administrative pricing rules. The FSC's non-exempt foreign trade income 
with respect to a transaction or group of transactions will be treated 
as United States source income which is effectively connected with the 
FSC's trade or business which is conducted through its permanent 
establishment within the United States if either of the administrative 
pricing rules of section 925(a)(1) or (2) is used to determine the FSC's 
foreign trade income from a transaction or group of transactions. See 
Sec. 1.923-1T(b) for the definition of non-exempt foreign trade income.
    (iii) Non-exempt foreign trade income determined without regard to 
the administrative pricing rules. The source and taxation of the FSC's 
non-exempt foreign trade income not classified in paragraph (a)(2)(ii) 
of this section will be determined under the appropriate sections of the 
Internal Revenue Code and the regulations under those sections. This 
type of income (section 923(a)(2) non-exempt income) includes both 
income that is not effectively connected with the conduct of a trade or 
business in the United States and income that is effectively connected.
    (iv) Investment income and carrying charges. All of the FSC's 
investment income and carrying charges will be treated as income which 
is effectively connected with the FSC's trade or business which is 
conducted through its permanent establishment within the United States. 
The source of that income will be determined under the appropriate 
sections of the Internal Revenue Code and the regulations under those 
sections. See Sec. 1.921-2(f) (Q & A9) for definition of investment 
income and carrying charges.
    (v) Non-foreign trade income (other than investment income and 
carrying charges). The source and taxation of the FSC's non-foreign 
trade income (other than investment income and carrying charges) will be 
determined under the appropriate sections of the Internal Revenue Code 
and the regulations under those sections.
    (b) Allocation and apportionment of deductions. Expenses, losses and 
deductions incurred by the FSC shall be allocated and apportioned under 
the rules set forth in Sec. 1.861-8 to the FSC's foreign trade income 
and to the FSC's non-foreign trade income. Any deductions incurred by 
the FSC on a transaction, or group of transactions, which are allocated 
and apportioned to the FSC's foreign trade income from that transaction, 
or group of transactions, shall be allocated on a proportionate basis 
between exempt foreign trade income and non-exempt foreign trade income.
    (c) Net operating losses and capital losses--(1) General rule. (i) 
If a FSC for any taxable year incurs a deficit in earnings and profits 
attributable to foreign trade income determined without regard to the 
administrative pricing rules of section 925(a)(1) or (2), that deficit 
shall be applied to reduce current earnings and profits, if any, 
attributable to--
    (A) First, exempt foreign trade income determined with regard to the 
administrative pricing rules,
    (B) Second, non-exempt foreign trade income determined with regard 
to the administrative pricing rules,
    (C) Third, investment income and carrying charges, and
    (D) Fourth, other non-foreign trade income.
    (ii) If a FSC for any taxable year incurs a deficit in earnings and 
profits attributable to non-foreign trade income (other than investment 
income, carrying charges and net capital losses), that deficit shall be 
applied to reduce current earnings and profits, if any, attributable 
to--
    (A) First, investment income and carrying charges,
    (B) Second, exempt foreign trade income determined with regard to 
the administrative pricing rules,
    (C) Third, exempt foreign trade income determined without regard to 
the administrative pricing rules,
    (D) Fourth, non-exempt foreign trade income determined with regard 
to the administrative pricing rules, and

[[Page 59]]

    (E) Fifth, section 923(a)(2) non-exempt income.
    (iii) If a FSC for any taxable year incurs a deficit in earnings and 
profits attributable to investment income and carrying charges, that 
deficit shall be applied to reduce current earnings and profits, if any, 
attributable to--
    (A) First, non-foreign trade income other than capital gains,
    (B) Second, exempt foreign trade income determined with regard to 
the administrative pricing rules,
    (C) Third, exempt foreign trade income determined without regard to 
the administrative pricing rules,
    (D) Fourth, non-exempt foreign trade income determined with regard 
to the administrative pricing rules, and
    (E) Fifth, section 923(a)(2) non-exempt income.
    (iv) Net capital losses will be available for carryback or carryover 
pursuant to paragraph (c)(2) of this section.
    (v) Because the no-loss rules provide that a related supplier may 
always compensate the FSC for its expenses either as part of the 
commission payment or as part of the transfer price if the 
administrative pricing rules are used (see Sec. 1.925(a)-1T(e)(1)(i)), 
a FSC will not have a deficit in its earnings and profits relating to 
foreign trade income determined with regard to the administrative 
pricing rules. To determine the amount of any division of earnings and 
profits for the purpose of determining under Sec. 1.926(a)-1T (a) and 
(b) the treatment and order of distributions, the portion of a deficit 
in earnings and profits chargeable under this paragraph to such division 
prior to such distribution shall be determined in a manner consistent 
with the rules in Sec. 1.316-2(b) for determining the amount of 
earnings and profits available on the date of any distribution.
    (2) Carryback or carryover of net operating losses and capital 
losses to other taxable years of a FSC (or former FSC). (i) The amount 
of the deduction for the taxable year under section 172 for a net 
operating loss carryback or carryover, or under section 1212 for a 
capital loss carryback or carryover, shall be determined in the same 
manner as if the FSC were a foreign corporation which had not elected to 
be treated as a FSC. Thus, the amount of the deduction will be the same 
whether or not the corporation was a FSC in the year of the loss or in 
the year to which the loss is carried.
    (ii) Any carryback or carryover of a FSC's (or former FSC's) net 
operating loss which is attributable to transactions which give rise to 
foreign trade income shall be charged--
    (A) First, to earnings and profits attributable to exempt foreign 
trade income which is determined without regard to the administrative 
pricing rules,
    (B) Second, to earnings and profits attributable to section 
923(a)(2) non-exempt income,
    (C) Third, to earnings and profits attributable to exempt foreign 
trade income determined with regard to the administrative pricing rules,
    (D) Fourth, to earnings and profits attributable to non-exempt 
foreign trade income determined with regard to the administrative 
pricing rules,
    (E) Fifth, to earnings and profits attributable to investment income 
and carrying charges (other than capital gain income), and
    (F) Sixth, to earnings and profits attributable to non-foreign trade 
income (other than investment income, carrying charges and capital gain 
income).
    (iii) Any carryback or carryover of a FSC's (or former FSC's) net 
operating loss which is attributable to non-foreign trade income (other 
than capital gain income) shall be charged--
    (A) First, to earnings and profits attributable to non-foreign trade 
income (other than investment income, carrying charges and capital gain 
income),
    (B) Second, to earnings and profits attributable to investment 
income and carrying charges,
    (C) Third, to earnings and profits attributable to exempt foreign 
trade income determined with regard to the administrative pricing rules,
    (D) Fourth, to earnings and profits attributable to non-exempt 
foreign trade income determined with regard to the administrative 
pricing rules,
    (E) Fifth, to earnings and profits attributable to exempt foreign 
trade income which is determined without regard to the administrative 
pricing rules, and

[[Page 60]]

    (F) Sixth, to earnings and profits attributable to section 923(a)(2) 
non-exempt income.
    (iv) Any carryback or carryover of a net operating loss to a year in 
which the corporation was (or is) a FSC from a taxable year in which the 
corporation was not a FSC shall be applied in a manner consistent with 
subdivision (iii) of this paragraph.
    (d) Credits against tax--(1) General rule. Notwithstanding any other 
provision of chapter 1, subtitle A, a FSC is allowed under section 
921(c) as credits against tax only the following credits:
    (i) The foreign tax credit, section 27(a);
    (ii) The credit for tax withheld at source on foreign corporations, 
section 33; and
    (iii) The certain uses of gasoline and special fuels credit, section 
34.
    (2) Foreign tax credit. (i) The direct foreign tax credit of section 
901(b)(4) as determined under section 906 for income, war profits, and 
excess profits taxes (or taxes in lieu thereof) paid or accrued to any 
foreign country or possession of the United States is allowed a FSC only 
to the extent that those taxes are attributable to the FSC's foreign 
source non-foreign trade income which is effectively connected with its 
conduct of a trade or business within the United States. See section 
906(b)(5).
    (ii) The foreign tax credit for domestic corporate shareholders in 
foreign corporations (the deemed paid credit) provided under section 
901(a) as determined under section 902 is allowed for income, war 
profits, and excess profits taxes deemed paid or accrued by a FSC (or 
former FSC) only to the extent those taxes are deemed paid or accrued 
with respect to the FSC's (or former FSC's) section 923(a)(2) non-exempt 
income and its non-foreign trade income.
    (iii) The foreign tax credit allowed by sections 901 and 903 for tax 
withheld at source is allowed only to the extent the dividends paid to 
the FSC's (or former FSC's) shareholder are attributable to the FSC's 
(or former FSC's) section 923(a)(2) non-exempt income and its non-
foreign trade income.
    (3) Foreign tax credit limitation. (i) For purposes of computation 
of the direct foreign tax credit of section 901(b)(4) as determined 
under section 906, the separate limitation of section 904(d)(1)(C) for 
the FSC's taxable income attributable to its foreign trade income will 
apply. The direct foreign tax credit is not allowed to a FSC with regard 
to taxes it paid which are attributable to its foreign trade income. 
Since the foreign tax credit is not allowed for that type of income, the 
effect of the separate limitation is to remove the FSC's foreign trade 
income from the numerator of the fraction used to compute the FSC's 
overall foreign tax credit limitation.
    (ii) A separate limitation under section 904(d)(1)(D) is provided 
for distributions from a FSC (or former FSC) that arise through 
operation of the deemed paid credit of section 902 and are attributable 
to foreign trade income earned during the period when the distributing 
corporation was a FSC. This limitation is computed by multiplying the 
FSC's shareholder's tentative United States tax by a fraction the 
numerator of which is the foreign source dividend (determined with 
regard to section 78) attributable to the foreign trade income less 
dividends received deductions and other expenses allocated and 
apportioned under Sec. 1.861-8 allowed to the shareholder and the 
denominator of which is the shareholder's worldwide income. The effect 
of this separate limitation is to remove dividends attributable to the 
FSC's foreign trade income from the numerator of the fraction used to 
compute the overall foreign tax credit limitation of the FSC's 
shareholder.
    (iii) The separate limitation under section 904(d)(1)(D) also 
applies to the foreign tax credit allowed to a FSC shareholder by 
sections 901 and 903 for tax withheld at source on dividends paid by the 
FSC. The numerator of this fraction is the part of the dividend 
attributable to the FSC's foreign trade income and the denominator is 
the shareholder's worldwide income. The effect of this separate 
limitation is to remove dividends attributable to foreign trade income 
of a FSC (or former FSC) from the numerator of the fraction used to 
compute the overall foreign tax credit limitation of the FSC's 
shareholder.
    (e) Deduction for foreign income, war profits and excess profits 
taxes. Under

[[Page 61]]

section 275(a)(4)(B), income, war profits and excess profits taxes 
imposed by a foreign country or possession of the United States may not 
be deducted by a FSC to the extent those taxes are paid or accrued with 
respect to its foreign trade income.
    (f) Payment of estimated tax. Every FSC which is subject to tax 
under section 11 or 1201(a) and section 882 must make payment of its 
estimated tax in accordance with section 6154 and the regulations under 
that section. In determining the amount of the estimated tax, the FSC 
must treat the tax imposed by section 881 as though it were a tax 
imposed by section 11. See section 6154(g).
    (g) Accumulated earnings, personal holding company and foreign 
personal holding company. The provisions covering the accumulated 
earnings tax (sections 531 through 537), personal holding companies 
(sections 541 through 547) and foreign personal holding companies 
(sections 551 through 558) apply to FSCs to the extent they would apply 
to foreign corporations that are not FSCs.
    (h) Subpart F income and increase of earnings invested in U.S. 
property. For the mandatory inclusion in the gross income of the U.S. 
shareholders of the subpart F income and of the increase in earnings 
invested in U.S. property of a FSC, see sections 951 through 964 and the 
regulations under those sections. However, the foreign trade income 
(other than section 923(a)(2) non-exempt income) and, generally, the 
investment income and carrying charges of a FSC and any deductions which 
are allocated and apportioned to those classes of income, are not taken 
into account under sections 951 through 964. See sections 951(e) and 
952(b).
    (i) Certain accumulations of earnings and profits. For the inclusion 
in the gross income of U.S. persons as a dividend on the gain recognized 
on certain sales or exchanges of stock in a FSC, to the extent of 
certain earnings and profits attributable to the stock which were 
accumulated while the FSC was a controlled foreign corporation, see 
section 1248 and the regulations under that section. However, section 
1248 and the regulations under that section do not apply to a FSC's 
earnings and profits attributable to foreign trade income, see section 
1248(d)(6).
    (j) Limitations on certain multiple tax benefits. The provisions of 
section 1561, Limitations on Certain Multiple Tax Benefits in the Case 
of Certain Controlled Corporations, and section 1563, Definitions and 
Special Rules, and the regulations under those sections apply to a FSC 
and its controlled group.

[T.D. 8126, 52 FR 6435, Mar. 3, 1987]



Sec. 1.922-1  Requirements that a corporation must satisfy to be 
a FSC or a small FSC.

    (a) FSC requirements.
    Q-1. What are the requirements that a corporation must satisfy to be 
an FSC?
    A-1. A corporation must satisfy all of the requirements of section 
922(a).
    (b) Small FSC requirements.
    Q-2. What are the requirements that a corporation must satisfy to be 
a small FSC?
    A-2. A corporation must satisfy all of the requirements of sections 
922(a)(1) and (b).
    (c) Definition of corporation.
    Q-3. What type of entity is considered a corporation for purposes of 
qualifying as an FSC or a small FSC under section 922?
    A-3. A foreign entity that is classified as a corporation under 
section 7701(a)(3) (other than an insurance company) is considered a 
corporation for purposes of this requirement.
    (d) Eligible possession.
    Q-4. For purposes of meeting the place of incorporation requirement 
of section 922(a)(1)(A), what is a possession of the United States?
    A-4. For purposes of section 922(a)(1)(A), the possessions of the 
United States are Guam, American Samoa, the Commonwealth of the Northern 
Mariana Islands, and the Virgin Islands of the United States (``eligible 
possessions''). Puerto Rico, although a possession for certain tax 
purposes, does not qualify as a jurisdiction in which a FSC or small FSC 
may be incorporated.
    (e) Qualifying countries.
    Q-5. For purposes of meeting the place of incorporation requirement 
of section 922(a)(1)(A), what is a foreign country and which foreign 
countries

[[Page 62]]

meet the requirements of section 927(e)(3)?
    A-5. (i) A foreign country is a jurisdiction outside the 50 states, 
the District of Columbia, the Commonwealth of Puerto Rico, and the 
possessions of the United States. (ii) A list of the foreign countries 
that meet the requirements of section 927(e)(3) (''qualifying 
countries'') will be published from time to time in the Federal Register 
and the Internal Revenue Bulletin. A corporation is considered to be 
created or organized under the laws of a foreign country that meets the 
requirements of section 927(e)(3) only if the foreign country is a party 
to (A) an exchange of information agreement under the Caribbean Basin 
Economic Recovery Act (Code section 274(h)(6)(C)), or (B) a bilateral 
income tax treaty with the United States if the Secretary certifies that 
the exchange of information program under the treaty carries out the 
purposes of the exchange of information requirements of the FSC 
legislation as set forth in Code section 927(e)(3) and if the 
corporation is covered under exchange of information program under 
subdivision (A) or (B).
    (f) Number of shareholders.
    Q-6. Who is counted as a shareholder of a corporation for purposes 
of determining whether a corporation meets the limitation on the number 
of shareholders to no more than 25 under section 922(a)(1)(B)?
    A-6. Solely for purposes of the limitation on the number of 
shareholders, the following rules apply:
    (i) In general, an individual who owns an interest in stock of the 
corporation is counted as a shareholder. In the case of joint owners, 
each joint owner is counted as a shareholder. A member of a 
corporation's board of directors who holds qualifying shares that are 
required to be owned by a resident of the country of incorporation is 
not counted as a shareholder.
    (ii) A corporation that owns an interest in stock of the corporation 
is counted as a single shareholder.
    (iii) An estate that owns an interest in stock of the corporation is 
counted as a single shareholder. If the limitation on number of 
shareholders is not satisfied by reason of the closing of an estate, the 
FSC will continue to qualify for the taxable year of the FSC in which 
the estate is closed.
    (iv) A trust is not counted as a shareholder. In the case of a trust 
all of which is treated as owned by one or more persons under sections 
671 through 679, those persons are counted as shareholders. In the case 
of all other trusts, a beneficiary is counted as a shareholder.
    (v) A partnership is not counted as a shareholder. A general or 
limited partner is counted as a shareholder if it is a corporation, an 
individual, or an estate, under the rules contained in subdivisions (i) 
through (iii). A general or limited partner is not counted as a 
shareholder if it is a partnership or a trust; the rules contained in 
subdivision (iv) and this subdivision (v) apply to the determination of 
who is counted as a shareholder.
    (g) Class of stock.
    Q-7. What is preferred stock for purposes of determining whether a 
corporation satisfies the requirement under section 922(a)(1)(C) that no 
preferred stock be outstanding?
    A-7. Preferred stock is stock that is limited and preferred as to 
dividends or distributions in liquidation.
    Q-8. Can a corporation have outstanding more than one class of 
common stock?
    A-8. Yes. However, the rights of a class of stock will be 
disregarded if the right has the effect of avoidance of Federal income 
tax. For instance, dividend rights may not be used to direct dividends 
from exempt foreign trade income to shareholders that have taxable 
income and to direct other dividends to shareholders that have met 
operating loss carryovers.
    (h) Office.
    Q-9. What is an office for purposes of determining whether a 
corporation satisfies the requirement of section 922(a)(1)(D)(i)?
    A-9. An office is a place for the transaction of the business of the 
corporation. To be an office a place must meet all of the following 
requirements;
    (i) It must have a fixed location. A transient location is not a 
fixed location.
    (ii) It must be a building or a portion of a building consisting of 
at least one room.

[[Page 63]]

A room is a partitioned part of the inside of a building. The building 
or portion thereof used as the corporation's office must be large enough 
to accommodate the equipment required in subdivison (iii) of this answer 
9 and the activity required in subdivision (iv) of this answer 9. 
However, an office is not limited to a room with communication equipment 
or an adjacent room. Non-contiguous space within the same building will 
also constitute an office if it is equipped for the retention of the 
documentation required to be stored by the FSC and if access to the 
necessary communication equipment is available for use by the FSC.
    (iii) It must be equipped for the performance of the corporation's 
business. An office must be equipped for the communication and retention 
of information and must be supplied with communication services.
    (iv) It must be regularly used for some business activity of the 
corporation. A corporation's business activities must include the 
maintenance of the documentation described in Q&A 12 of this section. 
These documents need not be prepared at the office. Any person, whether 
or not related to the corporation, may perform the business activities 
of the corporation at the office if the activity is performed pursuant 
to a contract, oral or written, for the performance of the activity on 
behalf of the corporation.
    (v) It must be operated, and owned or leased, by the corporation or 
by a person, whether or not related to the corporation, under contract 
to the corporation.
    (vi) It must be maintained by the corporation or by a person, 
whether or not related, to the corporation, under contract to the 
corporation at all times during the taxable year. In the case of a 
corporation newly organized as a FSC, thirty days may elapse between the 
time the corporation is organized as a FSC (i.e., the first day for 
which the FSC election is effective) and the time an office is 
maintained by the corporation or a person under contract with the 
corporation. A place that meets the requirements in subdivision (i) 
through (vi) of this answer 9 can also be used for activities that are 
unrelated to the business activity of the corporation.
    Q-10 Can a corporation locate an office in any foreign country if it 
has at least one office in a U.S. possession or in a foreign country 
that meets the requirements of section 927 (e)(3) as provided Q&A 5 of 
this section?
    A-10. Yes.
    Q-11. Must a corporation locate the office that is required under 
section 922(a)(1)(D)(i) in the country or possession of its 
incorporation?
    A-11. No.
    (i) Documentation.
    Q-12. What documentation must be maintained at the corporation's 
office for purposes of section 922(a)(1)(D)(ii)?
    A-12. At least the following documentation must be maintained at the 
corporation's office under section 922(a)(1)(D)(ii):
    (i) The quarterly income statements, a final year-end income 
statement and a year-end balance sheet of the FSC; and
    (ii) All final invoices (or a summary of them) or statements of 
account with respect to (A) sales by the FSC, and (B) sales by a related 
person if the FSC realizes income with respect to such sales. A final 
invoice is an invoice upon which payment is made by the customer. A 
invoice must contain, at a minimum, the customer's name or idenfitying 
number and, with respect to the transaction or transactions, the date, 
product or product code or service of service code, quantity, price, and 
amount due. In the alternative, a document will be acceptable as a final 
invoice even though it does not include all of the above listed 
information if the FSC establishes that the document is considered to be 
a final invoice under normal commercial practices. An invoice forwarded 
to the customer after payment has been tendered or received pursuant to 
a letter of credit, as a receipt for payment, satisfies this definition. 
A single final invoice may cover more than one transaction with a 
customer.
    (iii) A summary of final invoices may be in any reasonable form 
provided that the summary contains all substantive information from the 
invoices. All substantive information includes the customer's name or 
identifying number, the invoice number, date, product or product code, 
and amount

[[Page 64]]

owed. In the alternative, all substantive information includes a summary 
of the information that is included on documents considered to be final 
invoices under normal commercial practice. A statement of account is any 
summary statement forwarded to a customer to inform of, or confirm, the 
status of transactions occurring within an accounting period during a 
taxable year that is not less than one month. A statement of account 
must contain, at a minimum, the customer's name or identifying number, 
date of the statement of account and the balance due (even if the 
balance due is zero) as of the last day of the accounting period covered 
by the statement of account. In the alternative, a document will be 
accepted as a statement of account even though it does not include all 
of the above listed information if the FSC establishes that the document 
is considered a statement of account under normal commercial practice. 
For these purposes, a document will be considered to be a statement of 
account under normal commercial practice if it is sent to domestic as 
well as to export customers in order to inform the customers of the 
status of transactions during an accounting period. With regard to 
quarterly income statements, a reasonable estimate of the FSC's income 
and expense items will be acceptable. If the FSC is a commission FSC, 
1.83% of the related supplier's gross receipts will be considered a 
reasonable estimate of the FSC's income. The documents required by this 
Q&A 12 need not be prepared by the FSC. In addition they need not be 
prepared at the FSC's office.
    (iv) The FSC will satisfy the requirement that the documents be 
maintained at its office even if not all final invoices (or summaries) 
or statements of account or items to be included on statements of 
account are maintained at its office as long as it makes a good faith 
effort to do so and provided that any failure to maintain the required 
documents is cured within a reasonable time of discovery of the failure.
    Q-13. If the required documents are not prepared at the FSC's 
office, by what date must the documents be maintained at its office?
    A-13. With regard to the applicable quarters of years prior to March 
3, 1987, the quarterly income statements, final invoices (or summaries), 
or statements of account and the year-end balance sheet must be 
maintained at the FSC's office no later than the due date, including 
extensions, of the FSC tax return for the applicable taxable year in 
which the period ends. With regard to the applicable quarters or years 
ending after March 3, 1987, the quarterly income statements for the 
first three quarters of the FSC year must be maintained at the FSC's 
office no later than 90 days after the end of the quarter. The quarterly 
income statement for the fourth quarter of the FSC year, the final year-
end income statement, the year-end balance sheet, and the final invoices 
(or summaries) or statements of account must be maintained at the FSC's 
office no later than the due date, including extensions, of the FSC tax 
return for the applicable taxable year.
    Q-14. In what form must the documentation required under section 
922(a)(1)(D)(ii) be maintained?
    A-14. The documentation required to be maintained by the office may 
be originals or duplicates and may be in any form that qualifies as a 
record under Rev. Rul. 71-20, 1971-1 C.B. 392. Therefore, documentation 
may be maintained in the form of punch cards, magnetic tapes, disks, and 
other machine-sensible media used for recording, consolidating, and 
summarizing accounting transactions and records within a taxpayer's 
automatic data processing system. The corporation need not maintain at 
its office equipment capable of reading the machine-sensible media. That 
equipment, however, must be situated in a location that is readily 
accessible to the corporation. The equipment need not be owned by the 
corporation.
    Q-15. How long must the documentation required under section 
922(a)(1)(D)(ii) be maintained?
    A-15. The documentation required under section 922(a)(1)(D)(ii) for 
a taxable year must be maintained at the FSC's office described in 
section 922(a)(1)(D)(i) until the period of limitations for assessment 
of tax for the

[[Page 65]]

taxable year has expired under section 6501.
    Q-16. Under what circumstances will a coporation be considered to 
satisfy the requirement of section 922(a)(1)(D)(iii) that it maintain 
the records it is required to keep under section 6001 at a location 
within the United States?
    A-16. A corporation will be considered to satify this requirement if 
the records required under section 6001 are kept by any person at any 
location in the United States provided that the records are retained in 
accordance with section 6001 and the regulations thereunder.
    (j) Board of directors.
    Q-17. What is a corporation's ``board of directors'' for purposes of 
the requirement under section 922(a)(1)(E) that, at all times during the 
taxable year, the corporation must have a board of directors which 
includes at least one individual who is not a resident of the United 
States?
    A-17. The ``board of directors'' is the body that manages and 
directs the corporation according to the law of the qualifying country 
or eligible possession under the laws of which the corporation was 
created or organized.
    Q-18. Can the member of the board of directors who is a nonresident 
of the United States be a citizen of the United States?
    A-18. Yes. For purposes of meeting the requirement under section 
922(a)(1)(E), the member of the board who cannot be a United States 
resident can be a United States citizen. The principles of section 
7701(b) shall be used to determine whether a United States citizen is a 
United States resident.
    Q-19. If the only member of the board of directors who is not a 
resident of the United States dies, or resigns, is removed from the 
board or becomes a resident of the United States will the corporation be 
considered to fail the requirement under section 922(a)(1)(E)?
    A-19. If the corporation appoints a new member who is a nonresident 
of the United States to the board within 30 days after the death, 
resignation or removal of the former nonresident member, the corporation 
will be considered to satisfy the requirement under section 
922(a)(1)(E). Also, the corporation will be considered to satisfy the 
requirement under section 922(a)(1)(E) if the corporation appoints a new 
member who is a nonresident of the United States to the board within 30 
days after the corporation has knowledge, or reason to know, that the 
board's former nonresident member was in fact a resident of the United 
States.
    Q-20. Is a nonresident alien individual who elects to be treated as 
a resident of the United States for a taxable year under section 6013(g) 
considered a nonresident of the United States for purposes of the 
requirement under section 922(a)(1)(E)?
    A-20. Yes.
    Q-21. Will the requirement that a FSC's board of directors have a 
nonresident member at all times during the taxable year be satisfied if 
the nonresident member is elected or appointed to the board of directors 
no later than 30 days after the first day for which the FSC election is 
effective?
    A-21. Yes.

[T.D. 8127, 52 FR 6470, Mar. 3, 1987]



Sec. 1.923-1T  Temporary regulations; exempt foreign trade income.

    (a) Foreign trade income. Foreign trade income of a FSC is the FSC's 
gross income attributable to its foreign trading gross receipts. (Any 
further reference to a FSC in this section shall include a small FSC 
unless indicated otherwise.) If the FSC is the principal on the sale of 
export property which it purchased from a related supplier, the FSC's 
gross income is determined by subtracting from its foreign trading gross 
receipts the transfer price determined under the transfer pricing 
methods of section 925(a). If the FSC is the commission agent on the 
sale of export property by its related supplier, the FSC's gross income 
is the commission paid or payable by the related supplier to the FSC 
with respect to the transactions that would have generated foreign 
trading gross receipts had the FSC been the principal on the 
transaction. See Sec. 1.925(a)-1T(f) Examples 1 and 6 for illustrations 
of the computation of a FSC's foreign trade income, exempt foreign trade 
income and taxable income.

[[Page 66]]

    (b) Exempt foreign trade income--(1) Determination. (i) If a FSC 
uses either of the two administrative pricing rules, provided for by 
sections 925(a)(1) and (2), to determine its income from a transaction, 
or group of transactions, to which section 925 applies (see Sec. 
1.925(a)-1T(b)(2) (ii) and (iii)), 15/23 of the foreign trade income 
that it earns from the transaction, or group of transactions, will be 
exempt foreign trade income. If a FSC has a non-corporate shareholder 
(shareholders), 16/23 of its foreign trade income attributable to the 
noncorporate shareholder's (shareholders') proportionate interest in the 
FSC will be exempt foreign trade income. See section 291(a)(4).
    (ii) If a FSC does not use the administrative pricing rules to 
determine its income from a transaction, or group of transactions, which 
gives rise to foreign trade income, 30 percent of its foreign trade 
income will be exempt foreign trade income. If a FSC has a non-corporate 
shareholder (shareholders), 32 percent of its foreign trade income 
attributable to the non-corporate shareholder's (shareholders') 
proportionate interest in the FSC will be exempt foreign trade income. 
See section 291(a)(4).
    (iii) Exempt foreign trade income so determined under subdivisions 
(1)(i) and (ii) of this paragraph is treated as foreign source income 
which is not effectively connected with the conduct of a trade or 
business within the United States. See section 921(a).
    (2) Special rule for foreign trade income allocable to a qualified 
cooperative. (i) Pursuant to section 923(a)(4), if a qualified 
cooperative is a shareholder of a FSC, the FSC's non-exempt foreign 
trade income determined by use of either of the administrative pricing 
methods of section 925(a)(1) or (2) which is allocable to the marketing 
of agricultural or horticultural products, or the providing of related 
services, for any taxable year will be treated as exempt foreign trade 
income to the extent that it is distributed to the qualified cooperative 
shareholder. A qualified cooperative is defined as any organization to 
which chapter 1, subchapter T, part 1 of the Code applies. See section 
1381(a).
    (ii) This special rule of section 923(a)(4) shall apply only if the 
distribution is made before the due date under section 6072(b), 
including extensions, for filing the FSC's income tax return for that 
year. Any distribution which satisfies this requirement will be treated 
as made on the last day of the FSC's taxable year. In addition, this 
special rule shall apply only if the income of the cooperative is based 
on arm's length transactions between the cooperative and its members or 
patrons.
    (iii) Income attributable to the marketing of agricultural or 
horticultural products, or the providing of related services, shall be 
allocated to the FSC shareholders on a per share basis. See Sec. 
1.926(a)-1T(b) for ordering rules for distributions from a FSC.
    (3) Special rule for military property. (i) Under section 923(a)(5), 
the exempt foreign trade income of a FSC relating to the disposition of, 
or services relating to, military property shall be equal to 50 percent 
of the amount which, but for section 923(a)(5), would be treated as 
exempt foreign trade income under section 923(a)(2) or (3). The foreign 
trade income no longer treated as exempt because of this special rule of 
section 923(a)(5) will remain income of the FSC and will be treated as 
non-exempt foreign trade income.
    (ii) The term ``military property'' is defined in section 
995(b)(3)(B) and includes any property which is an arm, ammunition, or 
implement of war designated in the munitions list published pursuant to 
section 38 of the International Security Assistance and Arms Export 
Control Act of 1976 (22 U.S.C. 2778) (which repealed and replaced the 
Military Security Act of 1954).

[T.D. 8126, 52 FR 6438, Mar. 3, 1987]



Sec. 1.924(a)-1T  Temporary regulations; definition of foreign
trading gross receipts.

    (a) In general. The term ``foreign trading gross receipts'' means 
any of the five amounts described in paragraphs (b) through (f) of this 
section, except to the extent that any of the five amounts is an 
excluded receipt within the meaning of paragraph (g) of this section. 
These amounts will not be foreign trading gross receipts if the

[[Page 67]]

FSC is not managed outside the United States, pursuant to section 
924(c), or if the economic processes with regard to a transaction, or 
group of transactions, that are required of a FSC by section 924(d) do 
not take place outside the United States. The requirement that these 
activities take place outside the United States does not apply to a 
small FSC. The activities required by sections 924 (c) and (d) may be 
performed either by the FSC or by any person (whether or not related to 
the FSC) acting under contract with the FSC for the performance of the 
required activities. Sections 1.924(c)-1 and 1.924(d)-1 provide rules to 
determine whether these requirements have been met. For purposes of this 
section--
    (1) FSC. All references to a FSC in this section mean a FSC, except 
when the context indicates that such term means a corporation in the 
process of meeting the conditions necessary for that corporation to 
become a FSC. All references to a FSC in this section shall include a 
small FSC unless indicated otherwise.
    (2) Sale and lease. The term ``sale'' includes an exchange or other 
disposition and the term ``lease'' includes a rental or a sublease. The 
term ``license'' includes a sublicense. All rules under this section 
applicable to leases of export property apply in the same manner to 
licenses of export property. See Sec. 1.927(a)-1T(f)(3) for a 
description of intangible property which cannot be export property.
    (3) Gross receipts. The term ``gross receipts'' is defined by 
section 927(b) and Sec. 1.927(b)-1T.
    (4) Export property. The term ``export property'' is defined by 
section 927(a) and Sec. 1.927(a)-1T.
    (5) Controlled group. The term ``controlled group'' is defined by 
paragraph (h) of this section.
    (6) Related supplier and related party. The terms related supplier 
and related party are defined by Sec. 1.927(d)-2T.
    (b) Sales of export property. Foreign trading gross receipts of a 
FSC include gross receipts from the sale of export property by the FSC, 
or by any principal for whom the FSC acts as a commission agent (whether 
or not the principal is a related supplier), pursuant to the terms of a 
contract entered into with a purchaser by the FSC or by the principal at 
any time or by any other person and assigned to the FSC or the principal 
at any time prior to the shipment of the property to the purchaser. Any 
agreement, oral or written, which constitutes a contract at law, 
satisfies the contractual requirements of this paragraph. Gross receipts 
from the sale of export property, whenever received, do not constitute 
foreign trading gross receipts unless the seller (or the corporation 
acting as commission agent for the seller) is a FSC at the time of the 
shipment of the property to the purchaser. For example, if a corporation 
which sells export property under the installment method is not a FSC 
for the taxable year in which the property is shipped to the purchaser, 
gross receipts from the sale do not constitute foreign trading gross 
receipts for any taxable year of the corporation.
    (c) Leases of export property--(1) In general. Foreign trading gross 
receipts of a FSC include gross receipts from the lease of export 
property provided that--
    (i) The property is held by the FSC (or by a principal for whom the 
FSC acts as commission agent with respect to the lease) either as an 
owner or lessee at the beginning of the term of the lease, and
    (ii) The FSC qualified (or was treated) as a FSC for its taxable 
year in which the term of the lease began.
    (2) Prepayment of lease receipts. If the gross receipts from a lease 
of export property are prepaid, then--
    (i) All the prepaid gross receipts are foreign trading gross 
receipts of a FSC if it is reasonably expected at the time of the 
prepayment that, throughout the term of the lease, the lease will meet 
the requirements of this paragraph and the property will be export 
property; or
    (ii) If it is reasonably expected at the time of the prepayment that 
the prepaid receipts would not be foreign trading gross receipts 
throughout the term of the lease if those receipts were not received as 
a prepayment, then only those prepaid receipts, for the taxable years of 
the FSC for which they would be foreign trading gross receipts, are 
foreign trading gross receipts. Thus,

[[Page 68]]

for example, if a lessee makes a prepayment of the first and last years' 
rent, and it is reasonably expected that the leased property will be 
export property for the first half of the lease period but not the 
second half of such period, the amount of the prepayment which 
represents the first year's rent will be considered foreign trading 
gross receipts if it would otherwise qualify, whereas the amount of the 
prepayment which represents the last year's rent will not be considered 
foreign trading gross receipts.
    (d) Related and subsidiary services--(1) In general. Foreign trading 
gross receipts of a FSC include gross receipts from services furnished 
by the FSC which are related and subsidiary to any sale or lease (as 
described in paragraph (b) or (c) of this section) of export property by 
the FSC or with respect to which the FSC acts as a commission agent, 
provided that the FSC derives foreign trading gross receipts from the 
sale or lease. The services may be performed within or without the 
United States.
    (2) Services furnished by the FSC. Services are considered to be 
furnished by a FSC for purposes of this paragraph if the services are 
provided by--
    (i) The person who sold or leased the export property to which the 
services are related and subsidiary, provided that the FSC acts as a 
commission agent with respect to the sale or lease of the property and 
with respect to the services,
    (ii) The FSC as principal, or any other person pursuant to a 
contract with the FSC, provided the FSC acted as principal or commission 
agent with respect to the sale or lease of the property, or
    (iii) A member of the same controlled group as the FSC if the sale 
or lease of the export property is made by another member of the 
controlled group provided, however, that the FSC acts as principal or 
commission agent with respect to the sale or lease and as commission 
agent with respect to the services.
    (3) Related services. Services which may be related to a sale or 
lease of export property include but are not limited to warranty 
service, maintenance service, repair service, and installation service. 
Transportation (including insurance related to such transportation) will 
be related to a sale or lease of export property, if the cost of the 
transportation is included in the sale price or rental of the property 
or, if the cost is separately stated, is paid by the FSC (or its 
principal) which sold or leased the property to the person furnishing 
the transportation service. Financing or the obtaining of financing for 
a sale or lease is not a related service for purposes of this paragraph. 
A service is related to a sale or lease of export property if--
    (i) The service is of the type customarily and usually furnished 
with the type of transaction in the trade or business in which the sale 
or lease arose, and
    (ii) The contract to furnish the service--
    (A) Is expressly provided for in or is provided for by implied 
warranty under the contract of sale or lease,
    (B) Is entered into on or before the date which is 2 years after the 
date on which the contract under which the sale or lease was entered 
into, provided that the person described in paragraph (d)(2) of this 
section which is to furnish the service delivers to the purchaser or 
lessor a written offer or option to furnish the services on or before 
the date on which the first shipment of goods with respect to which the 
service is to be performed is delivered, or
    (C) Is a renewal of the services contract described in subdivisions 
(ii)(A) and (B) of this paragraph.
    (4) Subsidiary services--(i) In general. Services related to a sale 
or lease of export property are subsidiary to the sale or lease only if 
it is reasonably expected at the time of the sale or lease that the 
gross receipts from all related services furnished by the FSC (as 
defined in this paragraph (d)(2)) will not exceed 50 percent of the sum 
of the gross receipts from the sale or lease and the gross receipts from 
related services furnished by the FSC (as described in this paragraph 
(d)(2)). In the case of a sale, reasonable expectations at the time of 
the sale are based on the gross receipts from all related services which 
may reasonably be performed at any time before the end of the 10-year 
period following the date of the sale. In

[[Page 69]]

the case of a lease, reasonable expectations at the time of the lease 
are based on the gross receipts from all related services which may 
reasonably be performed at any time before the end of the term of the 
lease (determined without regard to renewal options).
    (ii) Allocation of gross receipts from services. In determining 
whether the services related to a sale or lease of export property are 
subsidiary to the sale or lease, the gross receipts to be treated as 
derived from the furnishing of services may not be less than the amount 
of gross receipts reasonably allocated to the services as determined 
under the facts and circumstances of each case without regard to 
whether--
    (A) The services are furnished under a separate contract or under 
the same contract pursuant to which the sale or lease occurs, or
    (B) The cost of the services is specified in the contract of sale or 
lease.
    (iii) Transactions involving more than one item of export property. 
If more than one item of export property is sold or leased in a single 
transaction pursuant to one contract, the total gross receipts from the 
transaction and the total gross receipts from all services related to 
the transaction are each taken into account in determining whether the 
services are subsidiary to the transaction. However, the provisions of 
this subdivision apply only if the items could be included in the same 
product line, as determined under Sec. 1.925(a)-1T(c)(8).
    (iv) Renewed service contracts. If under the terms of a contract for 
related services, the contract is renewable within 10 years after a sale 
of export property, or during the term of a lease of export property, 
related services to be performed under the renewed contract are 
subsidiary to the sale or lease if it is reasonably expected at the time 
of the renewal that the gross receipts from all related services which 
have been and which are to be furnished by the FSC (as described in 
paragraph (d)(2) of this section) will not exceed 50 percent of the sum 
of the gross receipts from the sale or lease and the gross receipts from 
related services furnished by the FSC (as so described). Reasonable 
expectations are determined as provided in subdivision (i) of this 
paragraph.
    (v) Parts used in services. If a services contract described in 
paragraph (d)(3) of this section provides for the furnishing of parts in 
connection with the furnishing of related services, gross receipts from 
the furnishing of the parts are not taken into account in determining 
whether under this paragraph (d)(4) the services are subsidiary. See 
paragraph (b) or (c) of this section to determine whether the gross 
receipts from the furnishing of parts constitute foreign trading gross 
receipts. See Sec. 1.927(a)-1T (c)(2) and (e)(3) for rules regarding 
the treatment of the parts with respect to the manufacture of export 
property and the foreign content of the property, respectively.
    (5) Relation to leases. If the gross receipts for services which are 
related and subsidiary to a lease of property have been prepaid at any 
time for all the services which are to be performed before the end of 
the term of the lease, then the rules in paragraph (c)(2) of this 
section (relating to prepayment of lease receipts) will determine 
whether prepaid services under this paragraph (d)(5) are foreign trading 
gross receipts. Thus, for example, if it is reasonably expected that 
leased property will be export property for the first year of the term 
of the lease but will not be export property for the second year of the 
term, prepaid gross receipts for related and subsidiary services to be 
furnished in the first year may be foreign trading gross receipts. 
However, any prepaid gross receipts for the services to be furnished in 
the second year cannot be foreign trading gross receipts.
    (6) Relation with export property determination. The determination 
as to whether gross receipts from the sale or lease of export property 
constitute foreign trading gross receipts does not depend upon whether 
services connected with the sale or lease are related and subsidiary to 
the sale or lease. Thus, for example, assume that a FSC receives gross 
receipts of $1,000 from the sale of export property and gross receipts 
of $1,100 from installation and maintenance services which are to be 
furnished by the FSC within 10 years after the sale and which are 
related to

[[Page 70]]

the sale. The $1,100 which the FSC receives for the services would not 
be foreign trading gross receipts since the gross receipts from the 
services exceed 50 percent of the sum of the gross receipts from the 
sale and the gross receipts from the related services furnished by the 
FSC. The $1,000 which the FSC receives from the sale of export property 
would, however, be foreign trading gross receipts if the sale met the 
requirements of paragraph (b) of this section.
    (e) Engineering and architectural services--(1) In general. Foreign 
trading gross receipts of a FSC include gross receipts from engineering 
services (as described in paragraph (e)(5) of this section) or 
architectural services (as described in paragraph (e)(6) of this 
section) furnished by such FSC (as described in paragraph (e)(7) of this 
section) for a construction project (as defined in paragraph (e)(8) of 
this section) located, or proposed for location, outside the United 
States. Such services may be performed within or without the United 
States.
    (2) Services included. Engineering and architectural services 
include feasibility studies for a proposed construction project whether 
or not such project is ultimately initiated.
    (3) Excluded services. Engineering and architectural services do not 
include--
    (i) Services connected with the exploration for oil or gas, or
    (ii) Technical assistance or know-how. For purposes of this 
paragraph, the term ``technical assistance or know-how'' includes 
activities or programs designed to enable business, commerce, industrial 
establishments, and governmental organizations to acquire or use 
scientific, architectural, or engineering information.
    (4) Other services. Receipts from the performance of construction 
activities other than engineering and architectural services constitute 
foreign trading gross receipts to the extent that the activities are 
related and subsidiary services (within the meaning of paragraph (d) of 
this section) with respect to a sale or lease of export property.
    (5) Engineering services. For purposes of this paragraph, 
engineering services in connection with any construction project (within 
the meaning of paragraph (e)(8) of this section) include any 
professional services requiring engineering education, training, and 
experience and the application of special knowledge of the mathematical, 
physical, or engineering sciences to those professional services as 
consultation, investigation, evaluation, planning, design, or 
responsible supervision of construction for the purpose of assuring 
compliance with plans, specifications, and design.
    (6) Architectural services. For purposes of this paragraph, 
architectural services include the offering or furnishing of any 
professional services such as consultation, planning, aesthetic and 
structural design, drawings and specifications, or responsible 
supervision of construction (for the purpose of assuring compliance with 
plans, specifications, and design) or erection, in connection with any 
construction project (within the meaning of paragraph (e)(8) of this 
section).
    (7) Definition of ``furnished by the FSC''. For purposes of this 
paragraph, the term ``furnished by the FSC'' means architectural and 
engineering services furnished:
    (i) By the FSC,
    (ii) By another person (whether or not that person is a United 
States person) pursuant to a contract entered into with the FSC at any 
time prior to the furnishing of the services, provided that the FSC acts 
as principal, or
    (iii) By another person (whether or not that person is a United 
States person) pursuant to a contract for the furnishing of the services 
entered into by, or assigned to, the person at any time, provided that 
the FSC acts as a commission agent for the furnishing of the services.
    (8) Definition of ``construction project''. For purposes of this 
paragraph, the term ``construction project'' includes the erection, 
expansion, or repair (but not including minor remodeling or minor 
repairs) of new or existing buildings or other physical facilities 
including, for example, roads, dams, canals, bridges, tunnels, railroad 
tracks, and pipelines. The term also includes site grading and 
improvement and installation of equipment necessary for the 
construction. Gross receipts from the

[[Page 71]]

sale or lease of construction equipment are not foreign trading gross 
receipts unless the equipment is export property.
    (f) Managerial services--(1) In general. Foreign trading gross 
receipts of a first FSC for its taxable year include gross receipts from 
the furnishing of managerial services provided for an unrelated FSC or 
unrelated interest charge DISC to aid the unrelated FSC or unrelated 
interest charge DISC in deriving foreign trading gross receipts or 
qualified export receipts, as the case may be, provided that at least 50 
percent of the first FSC's gross receipts for such year consists of 
foreign trading gross receipts derived from the sale or lease of export 
property and the furnishing of related and subsidiary services. For 
purposes of this paragraph, managerial services are considered furnished 
by a FSC if the services are provided--
    (i) By the first FSC,
    (ii) By another person (whether or not a United States person) 
pursuant to a contract entered into by that person with the first FSC at 
any time prior to the furnishing of the services, provided that the 
first FSC acts as principal with respect to the furnishing of the 
services, or
    (iii) By another person (whether or not a United States person) 
pursuant to a contract for the furnishing of services entered into at 
any time prior to the furnishing of the services provided that the first 
FSC acts as commission agent with respect to those services.
    (2) Definition of ``managerial services''. The term ``managerial 
services'' as used in this paragraph means activities relating to the 
operation of an unrelated FSC or an unrelated interest charge DISC which 
derives foreign trading gross receipts or qualified export receipts as 
the case may be from the sale or lease of export property and from the 
furnishing of services related and subsidiary to those sales or leases. 
The term includes staffing and operational services necessary to operate 
the unrelated FSC or unrelated interest charge DISC, but does not 
include legal, accounting, scientific, or technical services. Examples 
of managerial services are: conducting export market studies, making 
shipping arrangements, and contacting potential foreign purchasers.
    (3) Status of recipient of managerial services. Foreign trading 
gross receipts of a first FSC include receipts from the furnishing of 
managerial services during any taxable year of a recipient of such 
services if the recipient qualifies as a FSC or interest charge DISC for 
the taxable year. For purposes of this paragraph, a recipient is deemed 
to qualify as a FSC or interest charge DISC for its taxable year if the 
first FSC obtains from the recipient a copy of the recipient's election 
to be treated as a FSC or interest charge DISC together with the 
recipient's sworn statement that an election has been timely filed with 
the Internal Revenue Service Center. The recipient may mark out the 
names of its shareholders on a copy of its election to be treated as a 
FSC or interest charge DISC before submitting it to the first FSC. The 
copy of the election and the sworn statement of the recipient must be 
received by the first FSC within six months after the first FSC 
furnishes managerial services for the recipient. The copy of the 
election and the sworn statement of the recipient need not be obtained 
by the first FSC for subsequent taxable years of the recipient. A 
recipient of managerial services is not treated as a FSC or interest 
charge DISC with respect to the services performed during a taxable year 
for which the recipient does not qualify as a FSC or interest charge 
DISC if the first FSC performing such services does not believe or if a 
reasonable person would not believe (taking into account the furnishing 
FSC's managerial relationship with such recipient FSC or interest charge 
DISC) at the beginning of such taxable year that the recipient will 
qualify as a FSC or an interest charge DISC for such taxable year.
    (g) Excluded receipts--(1) In general. Notwithstanding the 
provisions of paragraphs (b) through (f) of this section, foreign 
trading gross receipts of a FSC do not include any of the six amounts 
described in paragraphs (g)(2) through (7) of this section.
    (2) Sales and leases of property for ultimate use in the United 
States. Property which is sold or leased for ultimate use

[[Page 72]]

in the United States does not constitute export property. See Sec. 
1.927(a)-1T(d)(4) relating to determination of where the ultimate use of 
the property occurs. Thus, foreign trading gross receipts of a FSC 
described in paragraph (b) or (c) of this section do not include gross 
receipts of the FSC from the sale or lease of this property.
    (3) Sales or leases of export property and furnishing of services 
accomplished by subsidy. Foreign trading gross receipts of a FSC do not 
include gross receipts described in paragraphs (b) through (f) of this 
section if the sale or lease of export property or the furnishing of 
services is accomplished by a subsidy granted by the United States or 
any instrumentality thereof, see section 924(f)(1)(B). Subsidies covered 
by section 924(f)(1)(B) are listed in subdivisions (i) through (vi) of 
this paragraph.
    (i) The development loan program, or grants under the technical 
cooperation and development grants program of the Agency for 
International Development, or grants under the military assistance 
program administered by the Department of Defense, pursuant to the 
Foreign Assistance Act of 1961, as amended (22 U.S.C. 2151) unless the 
FSC shows to the satisfaction of the Commissioner that, under the 
conditions existing at the time of the sale (or at the time of lease or 
at the time the services were rendered), the purchaser (or lessor or 
recipient of the services) had a reasonable opportunity to purchase (or 
lease or contract for services) on competitive terms and from a seller 
(or lessor or performer of services) who was not a U.S. person, goods 
(or services) which were substantially identical to such property (or 
services) and which were not manufactured, produced, grown, or extracted 
in the United States (or performed by a U.S. person);
    (ii) The Public Law 480 program authorized under title I of the 
Agricultural Trade Development and Assistance Act of 1954, as amended (7 
U.S.C. 1691, 1701-1714);
    (iii) The Export Payment program of the Commodity Credit Corporation 
authorized by sections 5 (d) and (f) of the Commodity Credit Corporation 
Charter Act, as amended (15 U.S.C. 714c (d) and (f));
    (iv) The section 32 export payment programs authorized by section 32 
of the Act of August 24, 1935, as amended (7 U.S.C. 612c);
    (v) The Export Sales program of Commodity Credit Corporation 
authorized by sections 5 (d) and (f) of the Commodity Credit Corporation 
Charter Act, as amended (15 U.S.C. 714c (d) and (f)), other than the 
GSM-4 program provided under 7 CFR part 1488, and section 407 of the 
Agricultural Act of 1949, as amended (7 U.S.C. 1427), for the purpose of 
disposing of surplus agricultural commodities and exporting or causing 
to be exported agricultural commodities; and
    (vi) The Foreign Military Sales direct credit program (22 U.S.C. 
2763) or the Foreign Military Sales loan guaranty program (22 U.S.C. 
2764) if--
    (A) The borrowing country is released from its contractual liability 
to repay the United States government with respect to those credits or 
guaranteed loans;
    (B) The repayment period exceeds twelve years; or
    (C) The interest rate charged is less than the market rate of 
interest as defined in 22 U.S.C. 2763(c)(2)(B);


unless the FSC shows to the satisfaction of the Commissioner that, under 
the conditions existing at the time of the sale, the purchaser had a 
reasonable opportunity to purchase, on competitive terms from a seller 
who was not a U.S. person, goods which were substantially identical to 
this property and which were not manufactured, produced, grown, or 
extracted in the United States. Information regarding whether an export 
is financed, in whole or in part, with funds derived from the programs 
identified in this subdivision may be obtained from the Comptroller, 
Defense Security Assistance Agency, Department of Defense, Washington, 
DC 20301.
    (4) Sales or leases of export property and furnishing of 
architectural or engineering services for use by the United States--(i) 
In general. Foreign trading gross receipts of a FSC do not include gross 
receipts described in paragraph (b), (c), or (e) of this section if a 
sale or lease of export property, or the furnishing of architectural or 
engineering services, is for use by the United States

[[Page 73]]

or an instrumentality thereof in any case in which any law or regulation 
requires in any manner the purchase or lease of property manufactured, 
produced, grown, or extracted in the United States or requires the use 
of architectural or engineering services performed by a United States 
person. See section 924(f)(1)(A)(ii). For example, a sale by a FSC of 
export property to the Department of Defense for use outside the United 
States would not produce foreign trading gross receipts for the FSC if 
the Department of Defense purchased the property from appropriated funds 
subject to either any provision of the Department of Defense Federal 
Acquisition Regulations Supplement (48 CFR chapter 2) or any 
appropriations act for the Department of Defense for the applicable year 
if the regulations or appropriations act requires that the items 
purchased must have been grown, reprocessed, reused, or produced in the 
United States. The Department of Defense's regulations do not require 
that items purchased by the Department for resale in post or base 
exchanges and commissary stores located on United States military 
installations in foreign countries be items grown, reprocessed, reused 
or produced in the United States. Therefore, receipts arising from the 
sale by a FSC to those post or base exchanges and commissary stores will 
not be excluded from the definition of foreign trading gross receipts by 
this paragraph (g)(4).
    (ii) Direct or indirect sales or leases. Any sale or lease of export 
property is for use by the United States or an instrumentality thereof 
if such property is sold or leased by a FSC (or by a principal for whom 
the FSC acts as commission agent) to--
    (A) A person who is a related person with respect to the FSC or such 
principal and who sells or leases the property for use by the United 
States or an instrumentality thereof, or
    (B) A person who is not a related person with respect to the FSC or 
such principal if, at the time of the sale or lease, there is an 
agreement or understanding that the property will be sold or leased for 
use by the United States or an instrumentality thereof (or if a 
reasonable person would have known at the time of the sale or lease that 
the property would be sold or leased for use by the United States or an 
instrumentality thereof) within 3 years after the sale or lease.
    (iii) Excluded programs. The provisions of subdivisions (4)(i) and 
(ii) of this paragraph do not apply in the case of a purchase by the 
United States or an instrumentality thereof if the purchase is pursuant 
to--
    (A) The Foreign Military Sales Act, as amended (22 U.S.C. 2751 et 
seq.), or a program under which the United States government purchases 
property for resale, on commercial terms, to a foreign government or 
agency or instrumentality thereof, or
    (B) A program (whether bilateral or multilateral) under which sales 
to the United States government are open to international competitive 
bidding.
    (5) Services. Foreign trading gross receipts of a FSC do not include 
gross receipts described in paragraph (d) of this section (concerning 
related and subsidiary services) if the services from which such gross 
receipts are derived are related and subsidiary to the sale or lease of 
property which results in excluded receipts under this paragraph.
    (6) Receipts within controlled group. (i) For purposes of the 
transfer pricing methods of section 925(a), gross receipts of a 
corporation do not constitute foreign trading gross receipts for any 
taxable year of the corporation if at the time of the sale, lease, or 
other transaction resulting in the gross receipts, the corporation and 
the person from whom the gross receipts are directly or indirectly 
derived (whether or not such corporation and such person are the same 
person) are members of the same controlled group, and either
    (A) The corporation and the person each qualifies as a FSC (or if 
related FSCs are commission agents of each party to the transaction) for 
its taxable year in which its receipts arise, or
    (B) With regard to sale transactions, a sale of export property to a 
FSC (or to a related person if the FSC is the commission agent of the 
related person) by a non-FSC within the same controlled group follows 
any sale of the export property to a FSC (or to a related person if the 
FSC is the commission agent of the related person) within

[[Page 74]]

the same controlled group if foreign trading gross receipts resulted 
from the sale. Thus for example, assume that R, S, X, and Y are members 
of the same controlled group and that X and Y are FSCs. If R sells 
property to S and pays X a commission relating to that sale and if S 
sells the same property to an unrelated foreign party and pays Y a 
commission relating to that sale, the receipts received by X from the 
sale of such property by R to S will be considered to be derived from Y, 
a FSC which is a member of the same controlled group as X, and thus will 
not result in foreign trading gross receipts to X. The receipts received 
by Y from the sale to an unrelated foreign party may, however, result in 
foreign trading gross receipts to Y. For another example, if R and S 
both assign the commissions to X, receipts derived from the sale from R 
to S will be considered to be derived from X acting as commission agent 
for S and will not result in foreign trading gross receipts to X. 
Receipts derived by X from the sale of property by S to an unrelated 
foreign party may, however, constitute foreign trading gross receipts.
    (ii) Section 1.927(a)-1T(f)(2) provides rules regarding property not 
constituting export property in certain cases where such property is 
leased to any corporation which is a member of the same controlled group 
as the lessor.
    (7) Factoring of receivables by a related supplier. If an account 
receivable arising with respect to export property is transferred to any 
person for an amount reflecting a discount from the selling price of the 
export property, then the gross receipts from the sale which are treated 
as foreign trading gross receipts for purposes of computing a FSC's 
profit under the administrative pricing methods of section 925(a)(1) and 
(2) shall be reduced by the amount of the discount. See Sec. 1.925(a)-
1T(f) Example 11 for illustration of how this special rule affects 
computation of combined taxable income of a FSC and its related 
supplier.
    (h) Definition of ``controlled group''. For purposes of sections 921 
through 927 and the regulations under those sections, the term 
``controlled group'' has the same meaning as is assigned to the term 
``controlled group of corporations'' by section 1563(a), except that (1) 
the phrase ``more than 50 percent'' is substituted for the phrase ``at 
least 80 percent'' each place the latter phrase appears in section 
1563(a), and (2) section 1563(b) shall not apply. Thus, for example, a 
foreign corporation subject to tax under section 882 may be a member of 
a controlled group. Furthermore, two or more corporations (including a 
foreign corporation) are members of a controlled group at any time such 
corporations meet the requirements of section 1563(a) (as modified by 
this paragraph).
    (i) FSC's entitlement to income--(1) Application of administrative 
pricing rules of section 925(a). A corporation which meets the 
requirements of section 922(a) (or section 922(b) if the corporation 
elects small FSC status) and Sec. 1.921-2(a) (Q&A1) to be treated as a 
FSC (or small FSC) for a taxable year is entitled to income, and the 
administrative pricing rules of section 925(a)(1) or (2) apply, in the 
case of any transaction described in Sec. 1.925(a)-1T(b)(iii) between 
the FSC and its related supplier (as defined in Sec. 1.927(d)-2T(a)) as 
long as the FSC, or someone under contract to it, satisfies the 
requirements of section 925(c). The requirements of section 925(c) must 
be met by a commission FSC as well as by a buy-sell FSC. See Sec. 1.925 
(a)-1T(a)(3)(i) and (b)(2)(ii).
    (2) Other transactions. In the case of a transaction to which the 
provisions of paragraph (i)(1) of this section do not apply but from 
which a FSC derives gross receipts, the income to which the FSC is 
entitled as a result of the transaction is determined pursuant to the 
terms of the contract for the transaction and, if applicable, section 
482 and the regulations under that section. For applicability of the 
section 482 transfer pricing method, see Sec. 1.925(a)-1T (a)(3)(ii) 
and (b)(2)(i).
    (j) Small FSC limitation--(1) In general. Under section 
924(b)(2)(B), in determining exempt foreign trade income of a small FSC, 
the foreign trading gross receipts of the small FSC for the taxable year 
which exceed $5 million are not taken into account. The foreign trading 
gross receipts of the small FSC not taken into account for purposes of

[[Page 75]]

computing the small FSC's exempt foreign trade income shall be taken 
into account in computing the small FSC's non-exempt foreign trade 
income. If the foreign trading gross receipts of the small FSC exceed 
the $5 million limitation, the small FSC may select the gross receipts 
to which the limitation is allocated. See section 922(b) and Sec. 
1.921-2(b) (Q&A3) for a definition of a small FSC.
    (2) Members of a controlled group limited to one $5 million amount--
(i) General rule. All small FSCs which are members of a controlled group 
on a December 31, shall, for their taxable years which include that 
December 31, be limited to one $5 million amount. The $5 million amount 
shall be allocated equally among the member small FSCs of the controlled 
group for their taxable years including that December 31, unless all of 
the member small FSCs consent to an apportionment plan providing for an 
unequal allocation of the $5 million amount. The apportionment plan 
shall provide for the apportionment of a fixed dollar amount to one or 
more of the corporations, and the sum of the amounts so apportioned 
shall not exceed the $5 million amount. If the taxable year including 
the December 31 of any member small FSC is a short period (as defined in 
section 443), the portion of the $5 million amount allocated to that 
member small FSC for that short period under the preceding sentence 
shall be reduced to the amount which bears the same ratio to the amount 
so allocated as the number of days in such short period bears to 365. 
The consent of each member small FSC to the apportionment plan for the 
taxable year shall be signified by completing the form (i.e., Schedule O 
or any successor to that form) which satisfies the requirements of and 
is filed in the manner specified in Sec. 1.1561-3. An apportionment 
plan may be amended in the manner prescribed in Sec. 1.1561-3(a), 
except that an original or an amended plan may not be adopted with 
respect to a particular December 31 if at the time the original or 
amended plan is sought to be adopted, less than 12 full months remain in 
the statutory period (including extensions) for the assessment of a 
deficiency against any shareholder of a member small FSC the tax 
liability of which would change by the adoption of the original or 
amended plan. If less than 12 full months of the period remain with 
respect to any such shareholder, the director of the service center with 
which the shareholder files its income tax return will, upon request, 
enter into an agreement extending the statutory period for the limited 
purpose of assessing any deficiency against that shareholder 
attributable to the adoption of the original or amended apportionment 
plan.
    (ii) Membership determined under section 1563(b). For purposes of 
this paragraph (j)(2), the determination of whether a small FSC is a 
member of a controlled group of corporations with respect to any taxable 
year shall be made in the manner prescribed in section 1563(b) and the 
regulations under that section.
    (iii) Certain short taxable years--(A) General rule. If a small FSC 
has a short period (as defined in section 443) which does not include a 
December 31, and that small FSC is a member of a controlled group of 
corporations which includes one or more other small FSC's with respect 
to the short period, then the amount described in section 924(b)(2)(B) 
with respect to the short period of that small FSC shall be determined 
by--
    (1) Dividing $5 million by the number of small FSCs which are 
members of that group on the last day of the short period, and
    (2) Multiplying the result by a fraction, the numerator of which is 
the number of days in the short period and the denominator of which is 
365.


For purposes of the preceding sentence, section 1563(b) shall be applied 
as if the last day of the short period were substituted for December 31. 
Except as provided in subdivision (2)(iii)(B) of this paragraph, the 
small FSC having a short period not including a December 31 may not 
enter into an apportionment plan with respect to the short period.
    (B) Exception. If the short period not including a December 31 of 
two or more small FSCs begins on the same date and ends on the same date 
and those small FSCs are members of the same controlled group, those 
small FSCs may enter into an apportionment plan

[[Page 76]]

for such short period in the manner provided in subdivision (2)(i) of 
this paragraph with respect to the combined amount allowed to each of 
those small FSCs under subdivision (2)(iii)(A) of this paragraph.

[T.D. 8126, 52 FR 6438, Mar. 3, 1987, as amended by T.D. 9304, 71 FR 
76907, Dec. 22, 2006; T.D. 9476, 74 FR 68531, Dec. 28, 2009]



Sec. 1.924(c)-1  Requirement that a FSC be managed outside the 
United States.

    (a) In general. Section 924(b)(1)(A) provides that a FSC shall be 
treated as having foreign trading gross receipts for the taxable year 
only if the management of the FSC during the year takes place outside 
the United States, as provided in section 924(c). Section 924(c) and 
this section set forth the management activities that must take place 
outside the United States in order to satisfy the requirement of section 
924(b)(1)(A). Paragraph (b) of this section provides rules for 
determining whether the requirements of section 924(c)(1) have been met. 
Section 924(c)(1) requires that all meetings of the board of directors 
of the FSC during the taxable year and all meetings of the shareholders 
of the FSC during the taxable year take place outside the United States. 
Paragraph (c) of this section provides rules for maintaining the FSC's 
principal bank account outside the United States as provided in section 
924(c)(2). Paragraph (d) of this section provides rules for 
disbursements required by section 924(c)(3) to be made from bank 
accounts of the FSC maintained outside the United States.
    (b) Meetings of board of directors and meetings of shareholders must 
be outside the United States. All meetings of the board of directors of 
the FSC and all meetings of the shareholders of the FSC that take place 
during a taxable year must take place outside the United States to meet 
the requirements of section 924(c)(1). Only meetings that are formally 
convened as meetings of the board of directors or as shareholder 
meetings will be taken into account in determining whether those 
requirements have been met. In addition, all such meetings must comply 
with the local laws of the foreign country or possession of the United 
States in which the FSC was created or organized. The local laws 
determine whether a meeting must be held, when and where it must be held 
(if it is held at all), who must be present, quorum requirements, use of 
proxies, and so on. Where the local law permits action by the board of 
directors or shareholders to be taken by written consent without a 
meeting, use of such procedure will not constitute a meeting for 
purposes of section 924(c)(1). Section 924(c)(1) and this section impose 
no other requirements except the requirement that meetings that are 
actually held take place outside the United States. If the participants 
in a meeting are not all physically present in the same location, the 
location of the meeting is determined by the location of the persons 
exercising a majority of the voting power (including proxies) 
participating in the meeting. For example, a FSC has five directors, and 
is organized in country A. Country A's law requires that a majority of 
the directors of a corporation must participate in a meeting to 
constitute a quorum (and, thus, a meeting), but there is no requirement 
that the meeting be held in country A or that the directors must be 
physically present to participate. One director is in country A, another 
director is in country B, and a third director is in the United States.
    These three directors convene a meeting by telephone that 
constitutes a meeting under the law of country A. The meeting occurs 
outside the United States because the persons exercising a majority of 
the voting power participating in the meeting are located outside the 
United States.
    (c) Maintenance of the principal bank account outside the United 
States--(1) In general. For purposes of section 924(c), the bank account 
that shall be regarded as the principal bank account of a FSC is the 
bank account from which the disbursements described in paragraph (d) of 
this section are made. A FSC may have more than one principal bank 
account. The bank account that is regarded as the principal bank account 
must be maintained in a foreign country which meets the requirements of 
section 927(e)(3), or in any possession

[[Page 77]]

of the United States (as defined in section 927(d)(5)), and it must be 
so maintained at all times during the taxable year. For taxable years 
beginning on or after February 19, 1987, a principal bank account or 
accounts must be designated on the annual return of the FSC by providing 
the bank name(s) and account number(s).
    (2) Maintenance of the account in a bank. The bank account that is 
regarded as the principal bank account must be maintained in an 
institution that is engaged in the conduct of a banking, financing, or 
similar business, as defined in Sec. 1.954-2(d)(2)(ii) (without regard 
to whether it is a controlled foreign corporation). The institution may 
be a U.S. bank, provided that the account is maintained in a branch 
outside the United States.
    (3) Maintenance of an account outside the United States. Maintenance 
of the principal bank account outside the United States means that the 
account regarded as the principal bank account must be an account 
maintained on the books of the banking institution at an office outside 
the United States, but does not require that access to the account may 
be made only outside the United States. Instructions providing for 
deposits into or disbursements from the account may originate in the 
United States without affecting the status of maintenance of the account 
outside the United States.
    (4) Maintenance of the account at all times during the taxable year. 
The term ``at all times during the taxable year'' generally means for 
each day of the taxable year. In the case of a newly created or 
organized corporation, thirty days may elapse between the effective date 
of the corporation's election to be treated as a FSC and the date a bank 
account is opened without causing the FSC to fail the requirement that 
it maintain its principal bank account outside the United States at all 
times during the taxable year. For example, if a corporation is created 
or organized prior to January 1, 1985, and makes an election to be 
treated as a FSC within the first 90 days of 1985, the election is 
effective as of January 1, 1985. Thus, the FSC must open a bank account 
within 30 days of January 1, or as of January 31, 1985, to satisfy this 
requirement. Also, a FSC shall be treated as satisfying this requirement 
if the account that is regarded as its principal bank account is 
terminated during the taxable year, provided that (i) such termination 
is the result of circumstances beyond the FSC's control, and (ii) the 
FSC establishes a new principal bank account within thirty days after 
such termination. A FSC may close its principal bank account and replace 
it with another account that qualifies under this paragraph (c) as a 
principal bank account at any time provided that no lapse of time occurs 
between the closing of the principal bank account and the opening of the 
replacement account.
    (5) Other accounts. The FSC may maintain other bank accounts in 
addition to its principal bank account. Such other accounts may be 
located anywhere, without limitation. The mere existence of such other 
accounts will not cause the FSC to fail to satisfy the requirements of 
section 924(c).
    (d) Disbursement of dividends, legal and accounting fees, and 
salaries of officers and directors out of the principal bank account of 
the FSC--(1) In general. All dividends, legal fees, accounting fees, 
salaries of officers of the FSC, and salaries or fees paid to members of 
the board of directors of the FSC that are disbursed during the taxable 
year must be disbursed out of bank account(s) of the FSC maintained 
outside the United States. Such an account is treated as the principal 
bank account of the FSC for purposes of section 924(c). Dividends, 
however, may be netted against amounts owed to the FSC (e.g., 
commissions) by a related supplier through book entries. If the FSC 
regularly disburses its legal or accounting fees, salaries of officers, 
and salaries or fees of directors out of its principal bank account, the 
occasional, inadvertent payment by mistake of fact or law of such 
amounts out of another bank account will not be considered a 
disbursement by the FSC if, upon determination that such payment was 
made from another account, reimbursement to such other account is made 
from the principal bank account of the FSC within a reasonable period 
from the date of the determination. Disbursement out of the principal 
bank account of the FSC may

[[Page 78]]

be made by transferring funds from the principal bank account to a U.S. 
account of the FSC provided that (i) the payment of the dividends, 
salaries or fees to the recipients is made within 12 months of the 
transfer, (ii) the purpose of the expenditures is designated and, (iii) 
the payment of the dividends, salaries or fees is actually made out of 
the same U.S. account that received the disbursement from the principal 
bank account.
    (2) Reimbursement. Legal or accounting fees, salaries of officers, 
and salaries or fees of directors that are paid by a related person 
wholly or partially on behalf of a FSC must be reimbursed by the FSC. 
The amounts paid by the related person are not considered disbursed by 
the FSC until the related person is reimbursed by the FSC. The related 
person must be reimbursed no later than the last date prescribed for 
filing the FSC's tax return (including extensions) for the taxable year 
to which the reimbursement relates. Any reimbursement for amounts paid 
on behalf of the FSC must be disbursed out of the FSC's principal bank 
account (and not netted against any obligation owed by the related 
person to the FSC), as set forth in paragraph (c) of this section. To 
determine the amounts paid on behalf of the FSC, the FSC may rely upon a 
written statement or invoice furnished to it by the related person which 
shows the following:
    (i) The actual fees charged for performing the legal or accounting 
services for the FSC or, if such fees cannot be ascertained by the 
related person, a good faith estimate thereof, and the actual salaries 
or fees paid for services as officers and directors of the FSC, and
    (ii) The person who performed or provided the services.
    (3) Good faith exception. If, after the FSC has filed its tax 
return, a determination is made by the Commissioner that all or a part 
of the legal or accounting fees, salaries of officers, and salaries or 
fees of directors of the FSC were paid by a related person without 
receiving reimbursement, the FSC may, nonetheless, satisfy the 
requirements of section 924(c)(3) if the fees and salaries were paid by 
the related person in good faith, and the FSC reimburses the related 
person for the fees and salaries paid within 90 days after the 
determination. The reimbursement shall be treated as made as of the end 
of the taxable year of the FSC for which the reimbursement is made.
    (4) Dividends--(i) Definition. For purposes of section 924(c) and 
this section only, the term ``dividends'' refers solely to cash 
dividends (including a dividend paid in a foreign functional currency) 
actually paid pursuant to a declaration or authorization by the FSC. 
Accordingly, a ``dividend'' will not include a constructive dividend 
that is deemed to be paid (regardless of the source of such constructive 
dividend) or a distribution of property that is a dividend under section 
316 other than a distribution of U.S. dollars or a foreign functional 
currency.
    (ii) Offset accounting entries. Payment of dividends by the FSC to 
its related supplier may be in the form of an accounting entry 
offsetting an amount payable to the related supplier for the dividend 
against an existing debt owed to the FSC. The offset accounting entries 
must be clearly identified in the books of account of both the related 
supplier and the FSC.
    (5) Legal and accounting fees. For purposes of this section, legal 
and accounting fees do not include salaries paid to legal and accounting 
employees of the FSC (or a related person). Legal and accounting fees 
are limited to fees paid to independent persons performing legal or 
accounting services for or with respect to the FSC.
    (6) Salaries of officers and directors. For purposes of this 
section, salaries of officers and salaries or fees of directors are only 
those salaries or fees paid for services as officers or directors of the 
FSC. Salaries do not include reimbursed travel and entertainment 
expenses. If an individual officer, director, or employee of a related 
person is also an officer or director of a FSC and receives additional 
compensation for services performed for the FSC, the portion of the 
compensation paid to the individual which is for services performed for 
the FSC is required to be disbursed out of the FSC's principal

[[Page 79]]

bank account. For purposes of this section, the term ``compensation'' is 
defined as set forth Sec. 1.415(c)-2(b) and (c).

[T.D. 8125, 52 FR 5089, Feb. 19, 1987, as amended by T.D. 9319, 72 FR 
16894, Apr. 5, 2007]



Sec. 1.924(d)-1  Requirement that economic processes take place 
outside the United States.

    (a) In general. Section 924(b)(1)(B) provides that a FSC has foreign 
trading gross receipts from any transaction only if economic processes 
with respect to such transaction take place outside the United States as 
provided in section 924(d). Section 924(d) and this section set forth 
the rules for determining whether a sufficient amount of the economic 
processes of a transaction take place outside the United States. 
Generally, a transaction will qualify if the FSC satisfies two different 
requirements: Participation outside the United States in the sales 
portion of the transaction, and satisfaction of either the 50-percent or 
the 85-percent foreign direct cost test. The activities comprising these 
economic processes may be performed by the FSC or by any other person 
acting under contract with the FSC. (All references to ``FSC'' in 
Sec. Sec. 1.924(d)-1 and 1.924(e)-1 shall mean the FSC or, if 
applicable, the person performing the relevant activity under contract 
on behalf of the FSC.) The FSC may act upon standing instructions from 
another person in the performance of any activity, whether a sales 
activity under paragraph (c) of this section or an activity relating to 
the disposition of export property under paragraph (d) of this section 
and Sec. 1.924(e)-1. The identity of the FSC as a separate entity is 
not required to be disclosed in the performance of any of the activities 
comprising the economic processes. Except as otherwise provided, the 
location of any activity is determined by the place where the activity 
is initiated by the FSC, and not by the location of any person 
transmitting instructions to the FSC.
    (b) Activities performed by another person--(1) In general. Any 
person, whether domestic or foreign, and whether related or unrelated to 
the FSC, may perform any activity required to satisfy this section, 
provided that the activity is performed pursuant to a contract for the 
performance of that activity on behalf of the FSC. Such a contract may 
be any oral or written agreement which constitutes a contract at law. 
The person performing the activity is not required to enter into a 
contract directly with the FSC and, thus, may be a direct or indirect 
subcontractor of a person under contract with the FSC. For example, 
assume that a buy-sell FSC enters into an agreement with its related 
supplier in which the related supplier agrees to perform on behalf of 
the FSC all sales activities with respect to the FSC's transactions with 
its foreign customers. Through its existing agreements with a domestic 
unrelated person, the related supplier subcontracts the performance of 
these activities to the domestic unrelated person, who, in turn, 
subcontracts the performance of the sales activities to foreign sales 
agents. The sales activities performed by the foreign sales agents are 
considered to be performed on behalf of the FSC for purposes of meeting 
the requirements of section 924(d)(1)(A).
    (2) Proof of compliance. If the FSC does not perform the activity 
itself, it must maintain records adequate to establish, with respect to 
each transaction or group of transactions, that the activity was 
performed and that the performance of such activity took place outside 
the United States. If the person who performed the activity on behalf of 
the FSC is an independent contractor, the FSC may rely upon a written 
declaration from that person stating that the activities were performed 
by that person on behalf of the FSC, and were performed outside the 
United States. An invoice or a receipt for payment will be considered to 
be such a written declaration if it specifies that the activities were 
performed outside the United States or specifies a particular place 
outside the United States where the activities were performed. If the 
person performing the activities on behalf of the FSC is a related 
person, the FSC must maintain records adequate to establish that the 
activities were actually performed and where the activities were 
performed. Such records may be stored with the related person provided 
that the FSC

[[Page 80]]

makes such records available to the Commissioner upon request.
    (c) Participation outside the United States in the sales portion of 
the transaction--(1) In general. The requirement of section 924(d)(1)(A) 
is met with respect to the gross receipts of a FSC derived from any 
transaction if the FSC has participated outside the United States in the 
solicitation, the negotiation, or the making of the contract relating to 
such transaction (hereinafter described as ``sales activities''), as 
provided in this paragraph (c). A sale need not occur in order that the 
solicitation or negotiation tests be satisfied. Once the FSC has 
participated outside the United States in an activity that constitutes 
the solicitation, negotiation, or the making of the contract with 
respect to a transaction, any prior or subsequent activity by the FSC 
with respect to such transaction that would otherwise constitute the 
sales activity will be disregarded for purposes of determining whether 
the FSC has met the requirements of section 924(d)(1)(A). For example, 
if a FSC sells a product to a foreign customer by first meeting with the 
customer in New York to discuss the product and then by mailing to it 
from outside the United States a brochure describing the product, the 
prior meeting is disregarded and only the mailing is considered in 
determining whether there was solicitation outside the United States by 
the FSC with respect to the transaction which has occurred.
    (2) Solicitation (other than advertising). For purposes of this 
paragraph (c), ``solicitation'' refers to any communication (by any 
method, including, but not limited to, telephone, telegraph, mail, or in 
person) by the FSC, at any time during the 12 month period (measured 
from the date the communication is mailed or transmitted) immediately 
preceding the execution of a contract relating to the transaction to a 
specific, targeted customer or potential customer, that specifically 
addresses the customer's attention to the product or service which is 
the subject of the transaction. For purposes of paragraph (c)(2) of this 
section, communication by mail means depositing the communication in a 
mailbox. Except as provided in Sec. 1.924(e)-1(a)(1) with respect to 
second mailings, activities that would otherwise constitute advertising 
(such as sending sales literature to a customer or potential customer) 
will be considered solicitation if the activities are directed at a 
specific, targeted customer or potential customer, and the costs of the 
activity are not taken into account as advertising under the foreign 
direct cost tests. Activities that would otherwise constitute sales 
promotion (such as a promotional meeting in person with a customer) will 
be considered to be solicitation if the activities are directed at a 
specific, targeted customer or potential customer, and the costs of the 
activity are not taken into account as sales promotion under the foreign 
direct cost tests. Except as provided in Sec. 1.924(e)-1(a)(1) with 
respect to second mailings, the same or similar activities cannot be 
considered both solicitation and advertising, or both solicitation and 
sales promotion, with respect to the same customer. Solicitation, 
however, may take place at the same time as, and in conjunction with, 
another sales activity. Additionally, it may take place with respect to 
any person, whether domestic or foreign, and whether or not related to 
the FSC.
    (3) Negotiation. For purposes of this paragraph (c), ``negotiation'' 
refers to any communication by the FSC to a customer or potential 
customer aimed at an agreement on one or more of the terms of a 
transaction, including, but not limited to, price, credit terms, 
quantity, or time or manner of delivery. For purposes of this paragraph 
(c)(3), communication by mail has the same meaning as provided in 
paragraph (c)(2) of this section. Negotiation does not include the mere 
receipt of a communication from a customer (such as an order) that 
includes terms of a sale. Negotiation may take place at the same time 
as, and in conjunction with, another sales activity. Additionally, it 
may take place with respect to any person, whether domestic or foreign, 
and whether or not related to the FSC.
    (4) Making of a contract. For purposes of this paragraph (c), 
``making of a contract'' refers to performance by the FSC of any of the 
elements necessary to complete a sale, such as making an

[[Page 81]]

offer or accepting an offer. A requirements contract is considered an 
open offer to be accepted from time to time when the customer submits an 
order for a specified quantity. Thus, the acceptance of such an order 
will be considered the making of a contract. The written confirmation by 
the FSC to the customer of the acceptance of the open order will also be 
considered the making of a contract. Acceptance of an unsolicited bid or 
order is considered the ``making of a contract'' even if no solicitation 
or negotiation occurred with respect to the transaction. The written 
confirmation by the FSC to the customer of an oral or written agreement 
which confirms variable contract terms, such as price, credit terms, 
quantity, or time or manner of delivery, or specifies (directly or by 
cross-reference) additional contract terms will be considered the making 
of a contract. A written confirmation is any confirmation expressed in 
writing, including a telegram, telex, or other similar written 
communication. The making of a contract may take place at the same time 
as, and in conjunction with, another sales activity. Additionally, it 
may take place with respect to any person, whether domestic or foreign, 
and whether or not related to the FSC.
    (5) Grouping transactions. Generally, the sales activities under 
this paragraph (c) are to be applied on a transaction-by-transaction 
basis. By annual election of the FSC, however, any of the sales 
activities may be applied on the basis of a group as set forth in this 
paragraph (c)(5). Any groupings used must be supported by adequate 
documentation of performance of activities relating to the groupings 
used. An election by the FSC to group transactions must be made on its 
annual income tax return. The FSC, however, may amend its tax return to 
group in a manner different from that elected on its original return 
before the expiration of the statute of limitations.
    (i) Standards of groups. A determination by a FSC as to a grouping 
will be accepted by a district director if such determination conforms 
to any of the following standards:
    (A) Product or product line groupings. A product or product line 
grouping may be based upon either a recognized trade or industry usage, 
or upon a two digit major group (or on any inferior classification or 
combination of inferior classifications within a major group) of the 
Standard lndustrial Classification as prepared by the Statistical Policy 
Division of the Office of Management and Budget, Executive Office of the 
President. For taxable years beginning on or before February 19, 1987, 
any sales activity that is performed outside the United States with 
respect to any transaction covered by the product or product line 
grouping during the FSC's taxable year shall apply to all transactions 
covered by the product or product line. However, for taxable years 
beginning after February 19, 1987, the requirement of section 
924(d)(1)(A) is met with respect to all transactions covered by the 
product or product line grouping only if the sales activities are 
performed outside the United States with respect to customers with sales 
representing either:
    (i) 20 percent or more of the foreign trading gross receipts of the 
product or product line grouping during the current year or
    (ii) 50 percent or more of the foreign trading gross receipts of the 
product or product line grouping for the prior year irrespective of 
whether any sales occurred within the current year to the prior year 
customers.


If during the prior taxable year, the controlled group of which the FSC 
is a member had a DISC or interest charge DISC, the FSC may use the 50 
percent rule with respect to the preceding DISC or interest charge DISC 
year, substituting qualified export receipts for foreign trading gross 
receipts. A corporation which has not been treated in the prior year as 
a FSC, interest charge DISC, or DISC does not have to meet either the 20 
percent test or the 50 percent test for the first year in which it is 
treated as a FSC.
    (B) Customer groupings. A customer grouping includes all 
transactions of the FSC with a particular customer during the FSC's 
taxable year. Thus, any sales activity that is performed outside the 
United States with respect to any transaction with the customer during 
the taxable year shall apply to

[[Page 82]]

all transactions within the customer grouping.
    (C) Contract groupings. A contract grouping includes all 
transactions of the FSC under a particular contract for a taxable year. 
Thus, any sales activity that is performed outside the United States 
with respect to any transaction under the contract will apply to all 
transactions under the contract for such taxable year. For long-term 
contracts between unrelated parties, the sales activities tests need be 
satisfied only once for the life of the contract. With respect to 
requirements contracts and long-term contracts between related parties, 
the sales activities test must be satisfied annually.
    (D) Product or product line groupings within customer or contract 
groupings. Groupings may be based upon product or product line groupings 
within customer or contract groupings. If, however, the primary grouping 
is a customer or contract grouping, the 20 percent test set forth in 
subdivision (A) of this paragraph relating to product or product line 
grouping will not be applicable.
    (ii) Transactions included in a grouping. A choice by a FSC to group 
transactions shall generally apply to all transactions within the scope 
of that grouping. The choice of a grouping, however, applies only to 
transactions covered by the grouping and, for transactions not 
encompassed by the grouping, the determinations may be made on a 
transaction-by-transaction basis or other grouping basis. For example, a 
FSC may choose a product grouping with respect to one product and use 
the transaction-by-transaction method for another product within the 
same taxable year. In addition, if a FSC applies sales activity rules on 
the basis of other types of groupings, such as all sales to a particular 
customer, transactions included in those other groupings shall be 
excluded from product groupings.
    (iii) Different groupings allowed for different purposes. A choice 
by the FSC to group transactions may be made separately for each of the 
sales activities under section 924(d)(1)(A). Groupings used for purposes 
of section 924(d)(1)(A) will have no relationship to groupings used for 
other purposes, such as satisfying the foreign direct cost tests. This 
paragraph (c)(5) does not apply for purposes of section 925.
    (6) Examples. The provisions of this paragraph (c) may be 
illustrated by the following examples:

    Example 1. In November, a calendar year FSC mailed from its foreign 
office its catalog to a potential foreign customer. The catalog 
displayed numerous products along with a brief description and the price 
of each. In February of the following year, the FSC sold to the customer 
a product displayed in the catalog. Since the FSC communicated with the 
customer during the 12-month period prior to the sale, although during 
the previous taxable year, the FSC participated outside the United 
States in the solicitation relating to the transaction.
    Example 2. A FSC with a taxable year ending April 30, 1986, solicits 
customer X during that taxable year with respect to Product A. In the 
previous taxable year, the FSC sold product A to customers V, W, X, Y, 
Z, none of whom were customers in the taxable year ending April 30, 
1986. The sales proceeds from sales to customer X represented 50 percent 
of the foreign trading gross receipts for the previous FSC year. The FSC 
meets the 50 percent test for product or product line grouping for the 
taxable year ending April 30, 1986. If the facts were changed so that 
there was not a FSC, DISC or interest charge DISC in the same controlled 
group in the previous taxable year, the single solicitation directed to 
any customer would qualify all transactions within the product group as 
meeting the solicitation requirement for that taxable year. For 
subsequent taxable years, the 50 percent test or the 20 percent test 
would be applicable.
    Example 3. A FSC earns commissions on the sale of export property by 
its domestic related supplier to United States wholesalers for final 
sale to foreign customers. The related supplier receives an order from 
one of its United States wholesalers. The related supplier telephones 
the United States wholesaler to inform it of the new price and the 
probability of another price increase soon. The United States wholesaler 
orally agrees to the new price and the related supplier instructs the 
FSC to telex the wholesaler from its foreign office a confirmation that 
the product will be sold at the current new price. The written 
confirmation by the FSC of an oral agreement on a variable contract term 
constitutes the making of a contract. Thus, the requirements of section 
924(d)(1)(A) are met with respect to the transaction relating to the 
product.

    (d) Satisfaction of either the 50-percent or the 85-percent foreign 
direct cost test--

[[Page 83]]

(1) In general. Section 924(d)(1)(B) requires, in order for the gross 
receipts of a transaction to qualify as foreign trading gross receipts, 
that the foreign direct costs incurred by the FSC attributable to the 
transaction equal or exceed 50 percent of the total direct costs 
incurred by the FSC attributable to the transaction. The direct costs 
are those costs attributable to activities described in the five 
categories of section 924(e). Section 924(d)(2) provides that, instead 
of satisfying the 50-percent foreign direct cost test of section 
924(d)(1)(B), the FSC may incur foreign direct costs attributable to 
activities described in each of two of those categories that equal or 
exceed 85 percent of the total direct costs incurred by the FSC 
attributable to the activity described in each of the two categories. If 
no direct costs are incurred by the FSC in a particular category, that 
category shall not be taken into account for purposes of determining 
satisfaction of either the 50-percent or the 85-percent foreign direct 
cost test. If any amount of direct costs is incurred in a particular 
category, that category shall be taken into account for purposes of the 
foreign direct costs tests.
    (2) Direct costs--(i) Definition of direct costs. For purposes of 
section 924 (d), direct costs are those costs which are incident to and 
necessary for the performance of any activity described in section 
924(e). Direct costs include the cost of materials which are consumed in 
the performance of the activity, and the cost of labor which can be 
identified or associated directly with the performance of the activity 
(but only to the extent of wages, salaries, fees for professional 
services, and other amounts paid for personal services actually 
rendered, such as bonuses or compensation paid for services on the basis 
of a percentage of profits). Direct costs also include the allowable 
depreciation deduction for equipment or facilities (or the rental cost 
for use thereof) that can be specifically identified or associated with 
the activity, as well as the contract price of an activity performed on 
behalf of the FSC by a contractor. If costs of services or the use of 
facilities are only incidentally related to the performance of an 
activity described in section 924(e), only the incremental cost is 
considered to be identified directly with the activity. For example, 
supervisory, administrative, and general overhead expenses, such as 
telephone service, normally are not identified directly with particular 
activities described in section 924(e). The cost of a long distance 
telephone call made to arrange for delivery of export property, however, 
is identified directly with the activities described in section 
924(e)(2). Direct costs for purposes of section 924(d) do not 
necessarily include all of the expenses taken into account for purposes 
of determining the taxable income of the FSC or the combined taxable 
income of the FSC and its related supplier.
    (ii) Allocation of direct costs. For purposes of this section only, 
if costs are identified with more than one activity (whether or not all 
of the activities are described in section 924(e)), the portion of the 
costs attributable to each activity shall be determined by allocating 
the costs among the activities in any manner that is consistently 
applied and, if applicable, that reasonably reflects relative costs that 
would be incurred by performing each activity independently. If costs of 
an activity are attributable to more than one transaction or grouping of 
transactions, the portion of the costs attributable to each transaction 
or grouping shall be determined by allocating the costs among the 
transactions or groupings in any manner that is consistently applied 
and, if applicable, that reasonably reflects relative costs that would 
be incurred by performing the activity independently with respect to 
each transaction or grouping.
    (3) Total direct costs. The term ``total direct costs'' means all of 
the direct costs of any transaction attributable to activities described 
in any paragraph of section 924(e). For purposes of the 50-percent 
foreign direct cost test of section 924(d)(1)(B), total direct costs are 
determined based on the direct costs of all activities described in all 
of the paragraphs of section 924(e). For purposes of the 85-percent 
foreign direct cost test of section 924(d)(2), however, the total direct 
costs are determined separately for each paragraph of section 924(e). If 
more than one activity is included within a paragraph of

[[Page 84]]

section 924(e), direct costs must be incurred with respect to at least 
one activity listed in the paragraph. If costs are incurred with respect 
to more than one activity, all direct costs must be considered for 
purposes of satisfying the direct costs test.
    (4) Foreign direct costs. The term ``foreign direct costs'' means 
the portion of the total direct costs of any transaction which is 
attributable to activities performed outside the United States. For 
purposes of the 50-percent foreign direct cost test, foreign direct 
costs are determined based on the direct costs of all activities 
described in all of the paragraphs of section 924(e). For purposes of 
the 85-percent foreign direct cost test, however, foreign direct costs 
are determined separately for each paragraph of section 924(e).
    (5) Fifty percent foreign direct cost test. To satisfy the 
requirement of section 924(d)(1)(B), the foreign direct costs incurred 
by the FSC attributable to the transaction must equal or exceed 50 
percent of the total direct costs attributable to the transaction. This 
test looks to the cost of the activities described in section 924(e) on 
an aggregate basis; therefore, it is not necessary that the foreign 
direct costs of each activity, or of each paragraph of section 924(e), 
equal or exceed 50 percent of the total direct costs of that activity or 
paragraph.
    (6) Eighty-five percent foreign direct cost test--(i) General rule. 
To satisfy the requirement of section 924(d)(2), the foreign direct 
costs of a transaction incurred by the FSC attributable to activities 
described in each of at least two paragraphs of section 924(e) must 
equal or exceed 85 percent of the total direct costs attributable to 
activities described in that paragraph. This test looks to costs of the 
activities on a paragraph-by-paragraph basis (but not on an activity-by-
activity basis). As an example, the foreign direct costs of advertising 
and sales promotion are aggregated with each other for this purpose, but 
they are not aggregated with the foreign direct costs of transportation.
    (ii) Satisfaction of the 85-percent test. If, after the FSC files 
its tax return indicating that it has satisfied the 85-percent foreign 
direct cost test with respect to each of at least two paragraphs of 
subsection 924(e) and a determination is made by the Commissioner that 
the foreign direct costs attributable to one or both of the two 
paragraphs of section 924(e) specified on the return did not equal or 
exceed 85 percent of the total direct costs attributable to such 
activities, the FSC may, nonetheless, satisfy the 85-percent foreign 
direct cost test if the foreign direct costs attributable to any two 
paragraphs of section 924 (e) equal or exceed 85 percent of the total 
direct costs attributable to those other paragraphs.
    (e) Grouping transactions. Generally, the foreign direct cost tests 
under paragraph (d) of this section are to be applied on a transaction-
by-transaction basis. By annual election of the FSC, however, the 
foreign direct cost tests may be applied on a customer, contract or 
product or product line grouping basis. Any groupings used must be 
supported by adequate documentation of performance of activities and 
costs of activities relating to the groupings used. An election by the 
FSC to group transactions must be made on its annual income tax return. 
The FSC may, however, amend its tax return before the expiration of the 
statute of limitations under section 6501 of the Code to group in a 
manner different from that elected on its original return.
    (1) Standards for groupings. A determination by a FSC as to a 
grouping will be accepted by the district director if such determination 
conforms to any of the following standards:
    (i) Product or product line groupings. A product or product line 
grouping may be based either on a recognized trade or industry usage, or 
on a two digit major grouping (or on any inferior classification or 
combination of inferior classifications within a major grouping) of the 
Standard Industrial Classification as prepared by the Statistical Policy 
Division of the Office of Management and Budget, Executive Office of the 
President.
    (ii) Customer groupings. A customer grouping includes all 
transactions of the FSC with a particular customer during the FSC's 
taxable year.

[[Page 85]]

    (iii) Contract groupings. A contract grouping includes all 
transactions of the FSC under a particular contract, including a 
requirements contract. The tests will be applied to all transactions 
within a contract grouping during each taxable year of the FSC; however, 
by election of the FSC, all transactions under a contract that occur in 
the first or the last year of the contract may be included with, 
respectively, the next succeeding or the immediately preceding taxable 
year in applying these tests. For example, if with respect to 
transactions during the first calendar year of a 5-year contract, a 
calendar year FSC incurs direct costs attributable to the transactions 
of $100X for advertising, all of which are foreign direct costs, and 
$10X for processing of customers orders and for arranging for delivery, 
$9X (or 90 percent of the total direct costs) of which are foreign 
direct costs, the FSC has satisfied the 85-percent foreign direct cost 
test with respect to those transactions for the taxable year. If with 
respect to transactions during the second year of the contract, the FSC 
only incurs $18X of direct costs for processing of customer orders and 
arranging for delivery, $15X (83.3 percent of the total direct costs) of 
which are foreign direct costs, the FSC may include the transactions 
from the first year of the contract to meet the 85-percent foreign 
direct cost test in the second taxable year. Thus, with respect to the 
transactions in the second year, the FSC satisfies the foreign direct 
costs test for advertising (because the entire $100X of direct costs are 
foreign direct costs) and for processing of customer orders and 
arranging for delivery (because of the $28X of direct costs, $24X or 
85.7 percent of the total direct costs are foreign direct costs). If, 
however, with respect to transactions in the third year, the FSC 
satisfies the foreign direct costs test, those transactions cannot be 
included with the transactions in the fourth year. The FSC may aggregate 
the direct costs in the fourth and fifth years in the same manner as for 
the first and second years as described above in order to satisfy the 85 
percent foreign direct costs test.
    (iv) Product or product line groupings within customer or contract 
groupings. Groupings may be based on product or product line groupings 
within customer or contract groupings.
    (2) Transactions included in a grouping. An election by the FSC to 
group transactions shall generally apply to all transactions within the 
scope of that grouping. The election of a grouping, however, applies 
only to transactions covered by the grouping and, as to transactions not 
encompassed by the grouping, the determinations may be made on a 
transaction-by-transaction basis or other grouping basis. For example, 
the FSC may elect a product grouping with respect to one product and 
elect the transaction-by-transaction method for another product within 
the same taxable year. In addition, if a FSC is permitted to apply 
either the 50-percent or the 85-percent foreign direct cost test on the 
basis of other types of groupings, such as all transactions with respect 
to a particular customer, transactions included in those other groupings 
shall be excluded from product groupings.
    (3) Different groupings allowed for different purposes. An election 
by the FSC to group transactions may be made separately for each of the 
activities relating to disposition of export property under section 
924(d)(1)(B) or section 924(d)(2). Groupings used for purposes of 
section 924 will have no bearing on groupings for other purposes. This 
paragraph (e) does not apply for purposes of section 925.
    (f) Exception for foreign military property--(1) General rule. The 
requirements of this section do not apply to any activities performed in 
connection with foreign military sales except those activities described 
in section 924(e). The FSC is deemed to have satisfied the requirements 
of section 924(d)(1)(A).
    (2) Example. The principles of paragraph (f)(1) of this section may 
be illustrated by the following example:

    Example. A FSC earns commissions on foreign military sales by its 
related supplier. All solicitation, negotiation, and contract making 
activities occur in the United States solely between the related 
supplier and the United States government. The property is delivered, 
title passes, and payment is made in the United States in accordance 
with standard United States government practices. The FSC incurs direct 
costs in the amount of $155X to process the government's

[[Page 86]]

orders and arrange for delivery of the goods, all of which are foreign 
direct costs. In addition, it incurs foreign direct costs in the amount 
of $250X for assembling and transmitting its final invoice to the 
government from outside the U.S. and foreign direct costs of $200X 
associated with receiving payment from the related supplier in 
accordance with the rules of Sec. 1.924(e)-1(d)(2)(iii). No other 
activities occur with respect to the foreign military sales. The FSC has 
satisfied the 85-percent foreign direct cost test and thus has foreign 
trading gross receipts with respect to the foreign military sales. The 
fact that the FSC did not participate outside the United States in any 
of the sales activities has no bearing on the qualification of the 
receipts since the FSC is deemed to have met the requirements of section 
924(d)(1)(A).

[T.D. 8125, 52 FR 5090, Feb. 19, 1987]



Sec. 1.924(e)-1  Activities relating to the disposition of export 
property.

    (a) Advertising and sales promotion. For purposes of section 924(e), 
advertising and sales promotion are defined as follows.
    (1) Advertising--(i) Advertising defined--(A) General rule. 
Advertising means the announcement or description of property or 
services described in section 924(a), in some medium of mass 
communication (such as radio, television, newspaper, trade journals, 
mass mailings, or billboards), in order to induce multiple customers or 
potential customers to buy or rent the property or services from the FSC 
or related supplier. Advertising is not required to be directed to the 
general public, but may be focused toward any group of export customers 
or potential export customers. Advertising except for the advertising 
described in Sec. 1.924(e)-1(a)(1)(B) must describe one or more 
specific products or product lines (or services) and identify the 
product as a product offered by the FSC or related supplier. Advertising 
intended solely to build a favorable image of a company or group of 
companies is not included in this definition of advertising. 
Additionally, advertising primarily directed at customers or potential 
customers in the United States is not included in this definition of 
advertising, nor is advertising related to property or services not 
described in section 924(a).
    (B) Special rules for sales to distributors. If the customer is a 
distributor (whether domestic or foreign, related or unrelated to the 
FSC), an expense that is incurred by the distributor and charged to the 
FSC or related supplier as a reduction in the purchase price or as a 
separate charge for an announcement or description described in 
paragraph (a)(1)(A) of this section to induce the distributor's 
customers, potential customers, or the ultimate users to buy or rent the 
property or services is advertising for these purposes (i) if the FSC 
incurs 20 percent or more of the total advertising costs of the 
distributor or (ii) if the FSC pays the total charge of an advertisement 
either directly or indirectly. For these purposes, a distributor is 
anyone other than an end user or a final consumer. A FSC may incur 
direct advertising costs to a foreign end consumer even though the FSC 
sells to a U.S. distributor.
    (ii) Direct costs of advertising. Direct costs of advertising 
include costs of transmitting, displaying, or distributing the 
advertising to customers or potential customers and the costs of 
printing in the case of sales literature, but do not include fees paid 
to an independent advertising agency to develop the announcement or 
description, translation costs, or costs of preparing the announcement 
or description for potential use as advertising. Direct costs of sending 
sales literature to customers or potential customers may be taken into 
account as advertising costs as long as the activity is not taken into 
account for purposes of the sales activity requirements of Sec. 
1.924(d)-1(c).
    (iii) Location of advertising--(A) General rule. The location of 
advertising activity is the place to which the advertising is 
transmitted, displayed, distributed, mailed, or otherwise conveyed to 
the customers or potential customers (or in the case of advertising 
described in paragraph (a)(i)(B) of this section, the distributor's 
customers, or the ultimate users). For example, a television 
advertisement that is broadcast to a foreign country constitutes 
advertising activity outside the United States even though the broadcast 
signal originates in the United States. Therefore, the cost of that 
advertising activity is a foreign cost. The FSC may rely upon the 
distribution statistics of the publisher of print media or the

[[Page 87]]

broadcaster of broadcast media through which the advertising is 
distributed. If the distribution statistics show that 85 percent or more 
of the readership, radio listeners, or viewership are outside the United 
States, all direct costs of advertising are considered foreign direct 
costs of advertising.
    (B) Foreign editions of journals, magazines, etc. Costs related to 
advertising in foreign English editions of U.S. publications as well as 
advertising in any publication in a foreign language are foreign direct 
costs.
    (C) United States editions. Costs related to advertising in United 
States publications are not treated as direct costs even if the 
publication also has a foreign edition in English.
    (iv) Second mailings. In general, direct costs of sending sales 
literature to customers may be treated as solicitation or advertising, 
but not both. A distinction may be made, however, between a first and 
second mailing so that one may be treated as advertising and the other 
may be treated as solicitation. To qualify under this second mailing 
rule, the two mailings must be generically different items such as a 
price list and a description of the product itself. An amended price 
list would not be distinguishable from an original price list and would, 
therefore, not constitute a second mailing.
    (v) Examples. The principles of paragraph (a)(1) of this section may 
be illustrated by the following examples:

    Example 1. The related supplier, under contract with a buy-sell FSC 
to advertise export product D on the ``FSC's'' behalf to its foreign 
unrelated customers, engaged a French advertising agency to develop an 
advertising campaign to induce French customers to buy the product. As a 
part of the advertising campaign, the agency places a one-page 
advertisement in a relevant French trade journal. The advertisement 
constitutes advertising within the meaning of paragraph (a)(1) of this 
section.
    Example 2. A United States weekly magazine publishes, in addition to 
its United States edition, a Canadian edition in English and a Mexican 
edition in Spanish. A FSC incurs costs of $200 X for a one-page display 
in each of the three editions for a total advertising cost of $600 X. 
The $200 X cost relating to the advertising in the United States edition 
is not a direct cost because it relates to United States sales. The 
total costs of $400 X relating to advertising in the English language 
Canadian edition and the Spanish language Mexican edition are foreign 
direct costs.
    Example 3. A FSC earns commissions on the sale of export product E 
by its domestic related supplier to United States distributors for 
resale to Canadian retail customers. The related supplier, under 
contract with the FSC to advertise product E, pays an amount equal to 1 
percent of its annual gross receipts with respect to product E under a 
cooperative advertising arrangement with the distributor. The amount, 
which represents 20 percent of the total advertising costs for product 
E, is reimbursed by the FSC. The 20-percent amount represents a 
significant portion of the total advertising costs and thus constitutes 
advertising within the meaning of paragraph (a)(1)(i) of this section.
    Example 4. A FSC mails two items to each customer on its customer 
list within one taxable year. The first mailing consists of a price list 
which merely lists the various products by name and provides a price 
next to each product name. The second mailing consists of a brochure 
which fully describes and illustrates each product. The two mailings are 
generically different. Therefore, one mailing may be counted as 
advertising while the other mailing may be counted as solicitation.

    (2) Sales promotion--(i) Sales promotion defined. Sales promotion 
means an appeal made in person to an export customer or potential export 
customer for the sale or rental of property or services described in 
section 924(a), made in the context of a trade show or customer meeting. 
A customer meeting means a periodic meeting (e.g., quarterly, semi-
annual, or annual) in which 10 or more customers or potential customers 
are reasonably expected to attend. However, for taxable years beginning 
before February 19, 1987, a customer meeting may, at the option of the 
taxpayer, mean any meeting with a customer or potential customer 
regardless of the frequency of the meetings or the number of customers 
or potential customers in attendance. A meeting, show or event in the 
United States that is primarily aimed at the export of goods or services 
described in section 924(a) constitutes sales promotion. Sales promotion 
does not include an appeal made in the context of any meeting, show or 
event primarily aimed at U.S. customers or an appeal for the sale or 
rental of property or services not described in section 924(a).

[[Page 88]]

Whether any meeting, show or event is primarily aimed at U.S. customers 
or at the export of goods or services described in section 924(a) shall 
be determined by all of the facts and circumstances including the 
announced objective of the meeting, show or event; the attendees; the 
location of the meeting, show or event; and the product or special 
feature of the product.
    (ii) Direct costs of sales promotion. Direct costs of sales 
promotion include costs such as rental of space at trade shows, payments 
to organizers or other persons hired for the event, rental of display 
equipment and decorations for the event, and costs of maintaining a 
showroom. Direct costs of sales promotion also include costs for travel, 
meals, and lodging for direct sales people attending the event if these 
costs are paid by the FSC or related supplier. In the case of a customer 
meeting, direct costs of sales promotion include the costs of materials 
printed specifically for the meeting and the costs of travel, lodging, 
and food for both the direct sales people and customers or potential 
customers attending the meeting. Direct costs of sales promotion do not 
include the cost of salaries and commissions of direct sales people or 
the cost of discount coupons, samples of the product, or printed 
advertising materials that are used for general advertising as well as 
sales promotion.
    (iii) Location of sales promotion. The location of sales promotion 
activity is the place where the trade show or customer meeting is held.
    (iv) Examples. The principles of paragraph (a)(2)(i) of this section 
may be illustrated by the following examples:

    Example 1. The related supplier sells various export products 
described in section 924(a) to its foreign customers. As a commission 
agent for the related supplier with respect to such sales, the FSC 
performs sales promotion. It contracts with the related supplier to 
serve as its agent for such purposes. To stimulate the sale of its 
export products, the related supplier conducts semi-annual meetings with 
the purchasing agents of its customers at its Kansas City headquarters. 
Ten or more purchasing agents are reasonably expected to attend each 
meeting. At such meetings, the purchasing agents see the related 
supplier's manufacturing facilities, visit with its executives, attend 
technical updates, and see new export products. These semi-annual 
customer meetings constitute sales promotion within the meaning of 
paragraph (a)(2)(i) of this section. Direct costs incurred with respect 
to the customer meetings are U.S. direct costs because the sales 
promotion activities occur within the United States.
    Example 2. Assume the same facts as in Example 1, except that the 
related supplier exhibits products that only operate on 220 volts at a 
trade show in the United States. According to the trade show sponsors, 
the purpose of the show is to increase sales abroad of United States-
manufactured products. Since the products exhibited are designed for 
operation in foreign countries and the purpose of the trade show is to 
boost sales in those countries, the trade show held in the United States 
is primarily aimed at the export products described in section 924(a) 
and not at United States customers. Thus, the trade show constitutes 
sales promotion within the meaning of paragraph (a)(2)(i) of this 
section and the direct costs incurred in connection with the trade show 
are treated as United States direct costs.

    (b) Processing of customer orders and arranging for delivery of the 
export property. For purposes of section 924(e), the processing of 
customer orders and the arranging for delivery of the export property 
are defined in paragraph (b)(1) and paragraph (b)(2), respectively, of 
this section. For taxable years beginning after February 19, 1987, if 
the FSC performs the activities of processing of customer orders and 
arranging for delivery of the export property and elects to group its 
transactions, it is considered to have performed the activities with 
respect to all transactions in the grouping elected by the FSC under 
Sec. 1.924(d)-1(e) during the taxable year if it performs the 
activities of processing of customer orders and arranging for delivery 
of the export property with respect to customers generating 20 percent 
or more of foreign trading gross receipts within the elected grouping.
    (1) Processing of customer orders--(i) Processing of customer orders 
defined. The processing of customer orders means notification by the FSC 
to the related supplier of the order and of the requirements for 
delivery. The related supplier may have independent knowledge of the 
order and requirements for delivery. If the FSC does not have a related 
supplier, the processing of customer orders means communication

[[Page 89]]

with the customer by any method such as telephone, telegram, or mail to 
acknowledge receipt of the order and requirements for delivery. Once the 
related supplier has been notified by the FSC, or the customer has 
received an acknowledgement from the FSC, of the order and requirements 
for delivery, subsequent or prior communications with respect to an 
order (such as changes in quantity or prospective delivery date) are not 
included in the definition of processing of customer orders.
    (ii) Direct costs of processing customer orders. Direct costs of 
processing of customer orders include salaries of clerical personnel and 
costs of telephone, telegram, mail, or other communication media 
(including the costs of operating transmission equipment).
    (iii) Location of processing of customer orders. The location of 
this activity is the place where the communication is initiated by the 
FSC.
    (iv) Examples. The principles of paragraph (b)(1) of this section 
may be illustrated by the following examples:

    Example 1. A domestic related supplier, using a FSC as its 
commission agent on the sale of export property to foreign customers, 
receives an order from one of its foreign customers. Information 
concerning the receipt of such order and its requirements for delivery 
are transmitted to the FSC. The FSC from its office outside the United 
States notifies the related supplier of the order and the requirements 
for delivery by telex. This notification by the FSC to the related 
supplier constitutes the processing of the customer's order within the 
meaning of paragraph (b)(1)(i) of this section. In addition, its direct 
costs of processing the customer's order are foreign direct costs 
because the communication is initiated by the FSC from outside the 
United States.
    Example 2. A domestic unrelated supplier manufactures a product 
which it sells to a buy-sell FSC located in Germany for resale to the 
FSC's German customers. Upon receiving an order from one of its 
customers, the FSC telephones the customer from its German office to 
acknowledge receipt of the order and the requirements for delivery. The 
acknowledgement constitutes the processing of the customer's order 
within the meaning of paragraph (b)(1)(i) of this section and the direct 
costs attributable thereto are foreign direct costs.

    (2) Arranging for delivery--(i) Arranging for delivery defined. The 
arranging for delivery of export property means the taking of necessary 
steps to have the export property delivered to the customer in 
accordance with the requirements of the order. Arranging for delivery 
does not include preparation of shipping documents (e.g., bill of 
lading) or the property for shipment (i.e., packaging or crating), or 
shipment of property (i.e., transportation). Arranging for delivery does 
include communications with a carrier or freight forwarder to provide 
transportation (as defined in Sec. 1.924(e)-1(c)(1), but without regard 
to when the commission relationship for purposes of transportation 
begins) for the export property from the FSC or related supplier to the 
place where the customer takes possession of the property. Arranging for 
delivery also includes communications with the customer to notify the 
customer of the time and place of delivery. The carrier or freight 
forwarder and the customer may already have knowledge of the information 
communicated. If the FSC has communicated with the carrier or freight 
forwarder, where applicable, and the customer to notify it of the time 
and place of delivery, prior or subsequent communications to either 
about delivery are not included in the definition of arranging for 
delivery.
    (ii) Direct costs of arranging for delivery. The direct costs of 
arranging for delivery include salaries of clerical personnel and costs 
of telephone, telegraph, mail, and other communications media, but do 
not include any actual shipping costs.
    (iii) Location of arranging for delivery. The location of arranging 
for delivery activity is the place where the activity is initiated by 
the FSC.
    (iv) Examples. The principles of paragraph (b)(2)(i) of this section 
may be illustrated by the following examples:

    Example 1. A FSC earns commissions on the sale of export property by 
its domestic related supplier to foreign customers. The shipment term of 
all of the related supplier's sales is F.O.B. (Free on Board) its 
manufacturing plant in Gary, Indiana. Thus, there is no transportation 
as defined in Sec. 1.924(e)-1(c)(1) with respect to its sales. From its 
shipping department at the plant, the related supplier telephones 
carriers to arrange for delivery. It also notifies the FSC by mail

[[Page 90]]

of the time and place of delivery of the customer's orders. The FSC from 
its office outside the United States transmits the received information 
to the customers. Because there is no transportation to be arranged, 
this communication alone by the FSC to the customers to notify them of 
the time and place of delivery constitutes arranging for delivery within 
the meaning of paragraph (b)(2)(i) of this section.
    Example 2. Assume the same facts as in Example 1, except that the 
shipment term of all of the related supplier's sales is C.I.F. (Cost, 
Insurance, Freight) and that the commission relationship for 
transportation begins after the export property leaves the United States 
customs territory. The related supplier telephones a trucking firm and 
an overseas carrier from its plant in Gary, Indiana to ascertain 
information on transporting its property by truck to the docks, and by 
overseas carrier from the docks to the place where the customer takes 
possession. Upon receiving the necessary information, the related 
supplier electronically transmits to the FSC the shipping information 
and the time and place of delivery to the customer. In addition, it 
instructs the FSC to communicate the necessary shipping information to 
the carriers to ensure shipment and to notify the customer of the time 
and place of delivery. The FSC does both from its office located outside 
of the United States. The communications by the FSC to the carriers and 
the customer constitute arranging for delivery within the meaning of 
paragraph (b)(2)(i) of this section.

    (c) Transportation--(1) Transportation defined. For purposes of 
section 924(e), transportation means moving or shipping the export 
property during the period when the FSC owns or is responsible for the 
property, or, if the FSC is acting as a commission agent, during the 
period when the related supplier owns or is responsible for the property 
but after the commission relationship for purposes of transportation 
begins (even if the relationship begins after the property leaves the 
U.S. customs territory). The FSC or related supplier is treated as 
responsible for the property when it either has title, bears the risk of 
loss, or insures the property during shipment. Since a commission FSC 
will not generally have title or bear the risk of loss, it will, 
nevertheless, satisfy the transportation test if the related supplier 
has either title, bears the risk of loss, or insures the property during 
shipment. Examples of methods of shipping which would qualify as 
transportation include F.O.B. (Free on Board) destination, C.I.F. (Cost, 
Insurance, Freight), Ex Ship, and Ex Quay, but do not include C. & F. 
(Cost and Freight) or F.O.B. shipping point.
    (2) Direct costs of transportation. The direct costs of 
transportation include the expenses of shipping, such as fees paid to 
carriers and freight forwarders, costs of freight insurance, and 
documentation fees. With respect to fungible commodities, direct costs 
include only those costs incurred after the goods have been identified 
to a contract. Transportation costs do not include any of the costs of 
arranging for delivery. The FSC is considered to engage in 
transportation activity whenever it pays the costs of shipping the 
export property and the property is shipped during the period when the 
FSC owns or is responsible for the property as provided in paragraph 
(c)(1) of this section. If the customer pays the shipping costs 
directly, the FSC is not considered to engage in transportation 
activity. If, however, the FSC pays the shipping costs, the ultimate 
transfer of those costs to the customer will not disqualify the FSC from 
engaging in transportation for purposes of section 924(e) regardless of 
whether the costs are included in the sale price of the export property 
or separately stated.
    (3) Location of transportation. The location of transportation 
activity is the area over which the property is transported. Thus, the 
portion of total direct costs of transportation treated as foreign 
direct costs is the portion attributable to transportation outside the 
United States, determined on the basis of the ratio of mileage outside 
the U.S. customs territory to total mileage. For purposes of determining 
mileage outside U.S. customs territory, goods are treated as leaving 
U.S. customs territory when they have been tendered to an international 
carrier for shipment to a foreign location, as long as they are not 
removed from the custody of the carrier before they reach a point 
outside U.S. customs territory. The same rule for determining mileage 
outside the U.S. customs territory will apply to freight forwarders if 
(i) the forwarder has the risk of loss or is an insurer of the goods, 
and (ii) the property is shipped on a single bill of lading

[[Page 91]]

issued to the FSC or its agent as the shipper.
    (4) Examples. The principles of paragraph (c) of this section may be 
illustrated by the following examples:

    Example 1. A buy-sell FSC sells export property to a customer 
located in Canada. The contract between the FSC and the customer 
requires that the property be shipped F.O.B. its Canadian destination. 
Under this shipment term, the FSC holds title and bears the risk of loss 
until the property is tendered at its Canadian destination. Thus, it is 
responsible for the property during shipment. The FSC instructs its 
related supplier to ship the property from its manufacturing facilities 
in St. Louis. The related supplier negotiates two contracts, one for 
domestic transportation and the second for foreign transportation. A 
domestic trucking firm transports the property to the Canadian border 
where a Canadian trucking company is used to transport the property to 
its Canadian destination. The documentation fees and the fees for the 
two trucking firms are paid by the FSC. Because the FSC paid the costs 
of shipping and the property was shipped during the period when the FSC 
was responsible for the property, the FSC has engaged in transportation 
activity, the direct costs of which are the fees paid by the FSC. If 70 
percent of the mileage from St. Louis to the Canadian destination is 
associated with the transportation from the Canadian border to the 
Canadian destination, 70 percent of the FSC's direct transportation 
costs are foreign direct costs. If, instead of using two trucking firms, 
the FSC had tendered the goods to a freight forwarder for shipment to a 
foreign location and the freight forwarder assumed the risk of loss for 
the goods and issued a single bill of lading, all of the fees paid by 
the FSC to the freight forwarder would be foreign direct costs.
    Example 2. A related supplier sells export property to its foreign 
customer in Liverpool, England. The contract between the related 
supplier and the customer requires that the property be shipped C.I.F. 
Liverpool. The related supplier engages the FSC as its commission agent 
with respect to its sales to the customer, requiring the FSC to provide 
transportation to the customer. The FSC contracts with the related 
supplier to provide the transportation on behalf of the FSC. The 
commission agreement between the related supplier and the FSC provides 
that the FSC's responsibilities with respect to transportation of the 
export property begins after the property leaves the U.S. customs 
territory. The related supplier hires a domestic trucking firm to 
transport the shipment to a New York City port where it is loaded on a 
cargo ship destined for Liverpool at a total cost of $3,000X, $2,750X of 
which is allocable to mileage from the U.S. customs territory to 
Liverpool, England. Because the related supplier insures the property 
during shipment under C.I.F., the property is shipped during the period 
when the related supplier is treated as responsible for the property. 
Thus, the FSC, as the related supplier's commission agent, has satisfied 
the transportation test. In addition, because the FSC's responsibilities 
with respect to transportation begins when the property leaves U.S. 
customs territory, the FSC's payment of $2,750X is a foreign direct cost 
of transportation. The remaining $250X is not a direct cost of 
transportation to the FSC because the amount was expended before the 
commission relationship between the FSC and related supplier began.
    Example 3. A FSC earns commissions on sales by the related supplier 
of export property, all of which falls within a single two-digit SIC 
group. The related supplier is under contract to the FSC to perform on 
the FSC's behalf all of the section 924(e) activities attributable to 
the sales. Of all of the sales made during the year, the FSC has no 
transportation costs with respect to the sales to customer R because the 
shipment term is F.O.B. the related supplier's Chicago plant. With 
respect to the sales to customer S, the FSC ships the property F.O.B. 
its destination and pays 100 percent of the transportation costs, all of 
which are foreign direct costs because the commission relationship for 
transportation begins outside the U.S. customs territory. For purposes 
of determining whether the FSC has satisfied the 85-percent foreign 
direct cost test for transportation, the FSC groups the sales by 
product. Because the transportation costs for sales to customer S are 
100-percent foreign direct costs and because there are no transportation 
costs on sales to customer R, the FSC is considered to have met the 85-
percent foreign direct cost test for transportation for all the sales in 
the single two-digit SIC group.

    (d) Determination and transmittal of a final invoice or statement of 
account and receipt of payment. For purposes of section 924(e), the 
determination and transmittal of a final invoice or statement of account 
and the receipt of payment are defined as follows.
    (1) Determination and transmittal of a final invoice or statement of 
account--(i) Definitions--(A) In general. The determination and 
transmittal of a final invoice or statement of account means the 
assembly of either a final invoice or statement of account and the 
forwarding of that document to the customer. A FSC may elect to send 
either final invoices or statements of account

[[Page 92]]

and disregard any costs of the alternative not elected. For taxable 
years beginning after February 19, 1987, a special grouping rule is 
provided. If the FSC assembles and forwards either a statement of 
account or a final invoice from outside the United States to customers 
with sales representing 50 percent of the current year foreign trading 
gross receipts within a product or product line grouping or to customers 
with sales representing 50 percent of the prior year foreign trading 
gross receipts within a product or product line grouping utilized for 
the current year, all other U.S. costs will be disregarded and the FSC 
will be deemed to have no U.S. costs with respect to the determination 
and transmittal of a final invoice or statement of account. If, during 
the prior taxable year, the controlled group of which the FSC is a 
member had a DISC or interest charge DISC, the FSC may apply the 50 
percent rule by taking into account the customers and sales of the DISC 
or interest charge DISC for the preceding taxable year. If no foreign 
trading gross receipts (or qualified export receipts for DISC purposes) 
were received in the prior year either by the FSC or by a DISC or 
interest charge DISC within the controlled group of which the FSC is a 
member, the FSC must apply the 50 percent rule taking into account 
customers and foreign trading gross receipts for the current year. In 
the event that the 50 percent rule is not satisfied, all costs 
associated with assembly and forwarding of the selected documents 
(invoices or statements of account) must be included in the costs 
attributable to activities described in section 924(e)(4).
    (B) Final invoice defined. A final invoice is an invoice upon which 
payment is made by the customer. A final invoice must contain the 
customer's name or identifying number and, with respect to the 
transaction or transactions, the date, product or service, quantity, 
price, and amount due. In the alternative, a document will be acceptable 
as a final invoice even though it does not include all of the above 
listed information if the FSC establishes that the document is 
considered to be a final invoice under normal commercial practices. An 
invoice forwarded to the customer after payment has been tendered or 
received pursuant to a letter of credit as a receipt for payment 
satisfies this definition.
    (C) Statement of account defined. A statement of account is any 
summary statement forwarded to a customer to inform of, or confirm, the 
status of transactions occurring within an accounting period during a 
taxable year that is not less than one month. A statement of account 
must contain, at a minimum, the customer's name or identifying number, 
date of the statement of account as of the last day of the accounting 
period covered by the statement of account and the balance due (even if 
the balance due is zero). A single final invoice or statement of account 
can cover more than one transaction with one customer. In the 
alternative, a document will be accepted as a statement of account even 
though it does not include all of the above listed information if the 
FSC establishes that the document is considered a statement of account 
under normal commercial practice. For these purposes, a document will be 
considered to be a statement of account under normal commercial 
practices if it is sent to domestic as well as to export customers in 
order to inform the customers of the status of transactions during an 
accounting period. Additional information may be sent separately, such 
as summary statements forwarded to a related party for purposes of 
reconciling intercompany accounts for financial reporting requirements. 
If the information is sent separately, the direct costs associated with 
the assembly and forwarding of that information are not considered for 
purposes of section 924(d).
    (D) Assembly and forwarding defined. Assembly means folding the 
documents (where applicable), filling envelopes, and addressing 
envelopes (if window envelopes are not used). Forwarding means mailing 
or delivery.
    (ii) Direct costs of determination and transmittal of final invoice 
or statement of account. Direct costs of this activity include costs of 
office supplies, office equipment, clerical salaries and costs of 
mailing or other delivery services, if the costs can be identified or 
associated directly with the assembly and

[[Page 93]]

transmittal of a final invoice or statement of account. Costs of 
establishing a price, or of communicating prices or other billing 
information between the FSC and a related supplier are not direct costs 
of this activity. In addition, the costs of preparing and mailing the 
final invoices or statements of account to the FSC and the costs of 
accumulating and formatting data for invoicing or statements of account 
on computer discs, tapes, or some other storage media along with the 
costs of transmitting or transporting this data to the FSC are not 
direct costs of this activity.
    (iii) Location of determination and transmittal of a final invoice 
or statement of account. For taxable years beginning before February 19, 
1987, the location of this activity is the place where the final invoice 
or statement of account is assembled for forwarding to the customer or 
the place from which it is forwarded to the customer. Thus, the 
forwarding of the final invoice or statement of account from outside the 
United States is sufficient to source this activity outside the United 
States. For all other taxable years, the location of this activity is 
the place where the final invoice or statement of account is both 
assembled and forwarded to the customer.
    (iv) Examples. The principles of paragraph (d)(1) of this section 
may be illustrated by the following examples, all of which apply to 
taxable years beginning on or after February 19, 1987.

    Example 1. A related supplier sells export property to its foreign 
customers. The related supplier engages the FSC as its commission agent 
with respect to the sales, requiring the FSC to determine and transmit 
final invoices or statements of account to the customers with respect to 
the sales. Annually, the FSC assembles and forwards statements of 
account to customers representing 40 percent of current year export 
sales and 35 percent of prior year sales. The statements are sent from 
its office outside of the United States. The remaining statements of 
account are sent from the Albany, New York office of the related 
supplier. The statements are recognized in its industry as a statement 
of account. Although the statement does not contain all of the 
information described in Sec. 1.924(e)-1(d)(1)(i), it is sent to both 
domestic and foreign customers of the related supplier to inform the 
customer of the status of its transactions with the related supplier. 
The document qualifies as a statement of account under Sec. 1.924(e)-
1(d)(1)(i); however, the 50 percent test set forth in Sec. 1.924(e)-
1(d)-1(d)(1)(i)(A) is not satisfied. Therefore, the FSC must take into 
account all domestic direct costs attributable to assembly and 
forwarding of statements of account from its domestic office in 
determining whether the FSC has satisfied the direct costs test with 
respect to section 924(e)(4) and Sec. 924 (e)-1(d).
    Example 2. Employees of a FSC, in the FSC's foreign office, fold and 
place in envelopes the sheet or sheets that constitute the final 
invoices provided by the related supplier. In addition, the employees 
address, affix postage to, and mail the envelopes. These activities 
constitute the determination and transmittal of the final invoices 
within the meaning of paragraph (d)(1)(i) of this section and, because 
the final invoices are assembled and forwarded to the customers from 
outside the United States, all the direct costs of the activities are 
foreign direct costs.
    Example 3. The related supplier sends to the FSC's foreign office a 
computer tape to be used to prepare a statement of account. A management 
company, working under contract with the FSC, transcribes the data to a 
piece of paper which is a statement of account for purposes of Sec. 
1.924(d)(1)(i), folds the document, and fills, affixes postage to, and 
mails the envelopes. Only the costs performed by the management company 
under contract with the FSC that constitute the assembly and forwarding 
of a statement of account under Sec. 1.924(e)-1(d)(1)(i)(D) are direct 
costs. Therefore, the costs attributable to transcribing the data to a 
piece of paper are not direct costs for purposes of section 924(e)(4).

    (2) Receipt of payment--(i) Receipt of payment defined. Receipt of 
payment means the crediting of the FSC's bank account by an amount which 
is not less than 1.83 percent of the gross receipts (``gross receipts 
amount'') associated with the transaction. The FSC's bank account is not 
credited unless the FSC has the authority to withdraw the amount 
deposited. Where sales proceeds are factored or where payments from 
related foreign subsidiaries are netted against amounts owed to these 
foreign subsidiaries in an intercompany account, crediting of the FSC's 
bank account with no less than the gross receipts amount of the 
factoring proceeds or the proceeds, net of offsets, respectively, 
qualifies as receipt of payment. In addition, where a FSC is precluded 
from receiving a portion of

[[Page 94]]

the proceeds of the export transaction, the FSC may satisfy receipt of 
payment by receiving no less than the gross receipts amount of the 
remaining portion of the proceeds in its bank account. In the case of 
advance or progress payments, each payment constitutes a payment for 
receipt of payment purposes.
    (ii) Direct costs of receipt of payment. Direct costs of receiving 
payment include the expenses of maintaining a bank account of the FSC in 
which payment is deposited, any fees or service charges incurred for 
converting the payment into U.S. currency, and any transfer fees 
incurred with respect to the transfer of funds into and out of the FSC's 
bank account in accordance with the 35 calendar day rule in paragraph 
(d)(2)(iii) of this section. The transfer fees and the fees or service 
charges incurred for currency conversion are considered to be foreign 
direct costs of receiving payment; however, exchange losses are not 
costs of receiving payment.
    (iii) Location of receipt of payment. The location of this activity 
is the office of the banking institution at which the account is 
maintained. If payment is made by the purchaser directly to the FSC or 
the related supplier in the United States, and the FSC or related 
supplier transfers the gross receipts amount associated with the 
transaction to a bank account of the FSC outside the United States after 
receipt of payment (i.e., cash, check, wire transfer, etc.), but no 
later than 35 calendar days after receipt of good funds (i.e., the 
clearance of the check) the FSC is considered to have received payment 
outside the United States. Therefore, all transfer fees and the costs of 
the foreign bank account are treated as foreign direct costs. The United 
States bank costs are disregarded. If, however, the related supplier 
does not transfer the gross receipts amount within 35 calendar days, 
United States bank costs are not disregarded and are domestic direct 
costs. In either case, the transfer costs, currency conversion charges, 
and foreign bank costs remain foreign direct costs. The preceding rules 
apply both to commission FSCs and buy-sell FSCs.
    (iv) Examples. The principles of paragraph (d)(2) of this section 
may be illustrated by the following examples:

    Example 1. A FSC earns commissions on sales of export property by 
its related supplier. The related supplier manufactures and sells its 
export property to its foreign subsidiaries for resale in their 
respective countries. From time to time, the foreign subsidiaries will 
return products to the related supplier for credit and, from time to 
time, the foreign subsidiaries purchase products in their respective 
countries and sell such products to the related supplier. These 
transactions result in various amounts being owed to the foreign 
subsidiaries. Each month the various inter-company obligations are 
reviewed. The result of such review of inter-company indebtedness is a 
netting out of the various intercompany liabilities on the books, to the 
extent possible, and a flow of funds for the net obligation. Due to the 
nature of these transactions, the amounts owed by the foreign 
subsidiaries exceed the amounts which the related supplier owes to the 
foreign subsidiaries. The gross receipts amount (i.e., 1.83 percent of 
this net amount) is credited to the FSC's bank account. This constitutes 
receipt of payment for purposes of paragraph (d)(2)(i) of this section.
    Example 2. In a leveraged lease transaction, a FSC-lessor obtains 
purchase financing from a lending institution. The lending institution 
retains a security interest in the proceeds and requires that a portion 
of each rental payment be paid by the lessee directly to the lending 
institution. Since the FSC is precluded from receiving a portion of the 
proceeds of the export transaction, the FSC may satisfy the receipt of 
payment requirement by receiving the gross receipts amount with respect 
to the remaining proceeds.
    Example 3. A buy-sell FSC sells its export property to a foreign 
customer and is paid by means of a ``draw-down'' letter of credit. Over 
a substantial period of time prior to delivery of the export property, 
amounts are advanced to the FSC under the letter of credit. At delivery, 
the remaining amount available is paid. Each payment made to the FSC 
constitutes a payment for receipt of payment purposes and thus the gross 
receipts amount related to each payment must be credited to the FSC's 
bank account.
    Example 4. An FSC earns commissions on sales of export property by 
its related supplier. The related supplier regularly collects payments 
from its foreign customers in a San Francisco bank account and, after 
the San Francisco bank has collected on the checks, transfers, within 35 
calendar days, the gross receipts amounts from its New York bank account 
to the FSC's bank account located outside the United States. The FSC 
incurred transfer fees of $160X in addition to a fee of $35X for the 
maintenance of

[[Page 95]]

the FSC's bank account outside the United States during the 35 calendar 
day period. The maintenance fee relating to the United States bank 
account for the 35 calendar day period is $45X. The receipt of payment 
test is met because the gross receipts amounts are transferred after 
payment but within 35 calendar days to the FSC's bank account located 
outside the United States. The transfer fees of $160X and the 
maintenance fee of $35X relating to the FSC's foreign bank account are 
foreign direct costs. The $45X maintenance fee related to the United 
States bank account is not a direct cost. If the gross receipts amounts 
had not been transferred to the FSC's foreign bank account within 35 
calendar days, the $45X maintenance fee related to the United States 
bank account would be considered a United States direct cost. The 
transfer fee of $160X and the maintenance fee of $35X relating to the 
FSC's foreign bank account, however, would, nonetheless, be considered 
as foreign direct costs. The same funds received in San Francisco need 
not be transferred to the FSC's foreign bank account because money is 
fungible. For the same reason, the gross receipts amounts need not be 
transferred from the same bank account in which the payments are 
received.

    (e) Assumption of credit risk--(1) Assumption of credit risk 
defined. For purposes of section 924(e), the assumption of credit risk 
means bearing the economic risk of nonpayment with respect to a 
transaction. If the FSC is acting as a commission agent for the related 
supplier, this risk is borne by the FSC if the commission contract 
transfers the costs of the economic risk of nonpayment with respect to 
the transaction from the related supplier to the FSC. The FSC may elect 
on its annual return to bear the economic risk of nonpayment with 
respect to its transactions during a taxable year by either--
    (i) Assuming the risk of a bad debt in accordance with the rules of 
paragraph (e)(4)(i) of this section,
    (ii) Obtaining insurance to cover nonpayment,
    (iii) Investigating credit of a customer or a potential customer,
    (iv) Factoring trade receivables, or
    (v) Selling by means of letters of credit or banker's acceptances.


Only the alternative elected to be performed by the FSC during a taxable 
year is relevant for purposes of section 924(d). For example, if a buy-
sell FSC elects to bear the economic risk of nonpayment with respect to 
its transaction during a taxable year by assuming the risk of a bad debt 
in accordance with the rules of paragraph (e)(4)(i) of this section, and 
also factors the transaction's trade receivables, only the direct costs 
of assuming the risk of a bad debt are relevant for purposes of section 
924(d). For purposes of this paragraph, a potential customer is an 
unrelated person who is engaged in the purchase or sale of export 
property on whom an investigation is performed, but with whom no export 
sales contract is executed.
    (2) Direct costs of assumption of credit risk. (i) With respect to 
assuming the risk of a bad debt, the direct costs of the assumption of 
credit risk in the case of a buy-sell FSC include debts that become 
uncollectible and charges taken into account in determining additions to 
bad debt reserves of the FSC. In the case of a commission FSC, the 
direct costs of the assumption of credit risk include the assumption of 
the debts and charges of the related supplier attributable to export 
sales that are allowed as deductions under section 166.
    (ii) With respect to insurance, the direct costs of the assumption 
of credit risk are the costs of obtaining insurance against the risk of 
nonpayment. Qualifying insurance must be obtained from an unrelated 
insurer and must cover the risk of nonpayment due to default and 
bankruptcy by the purchaser. Insurance obtained from a related insurer, 
or insurance that covers default and bankruptcy due to risks of war or 
political unrest without covering ordinary default or bankruptcy is not 
sufficient.
    (iii) With respect to investigating credit, the direct costs of 
assumption of credit risk are the external costs of investigating credit 
for customers or potential customers, including costs of membership in a 
credit agency or association for that purpose (but not the costs of 
approving credit by an internal credit agency).
    (iv) With respect to factoring trade receivables, the direct costs 
of assumption of credit risk are the costs of factoring trade 
receivables of related and unrelated customers (e.g. the amount of the 
discount and the fees relating to factoring).

[[Page 96]]

    (v) With respect to letters of credit or banker's acceptances, the 
direct costs of assumption of credit risk are the costs of letters of 
credit or banker's acceptances and the documentary collection costs.
    (3) Location of assumption of credit risk. The location of the 
activity of assumption of credit risk is the location of the customer or 
obligor whose payment is at risk, except that the location of 
investigating credit is the location of the credit agency or association 
performing the investigation. A foreign branch of a United States 
corporation and a foreign office of the United States government are not 
foreign obligors for purposes of this test. A foreign branch of a United 
States credit investigation agency or association, however, is treated 
as located outside the United States.
    (4) Special rules--(i) Assuming the risk of a bad debt--(A) In 
general. If a FSC chooses to bear the economic risk of nonpayment by 
assuming the risk of a bad debt with respect to a transaction or 
grouping of transactions and an actual bad debt loss on a foreign 
trading gross receipt is not incurred in any three consecutive years, 
the FSC will be deemed to have performed this activity during the first 
two years of the three year period. For the third year, the FSC will not 
be deemed to have performed this activity and must satisfy the 85 
percent foreign direct costs test by satisfying any two paragraphs 
included within section 924(e) other than assumption of credit risk 
activity under section 924(e)(5). An actual bad debt loss will only 
satisfy the activity test with respect to a single three consecutive 
year period.
    (B) Example. The principles of this paragraph may be illustrated by 
the following example:

    Example. In year 1, a related supplier of a commission FSC incurs a 
bad debt with respect to foreign trading gross receipts owed by a 
foreign obligor. This expense is the only bad debt incurred with respect 
to foreign trading gross receipts in year 1. Therefore, the direct costs 
for the bearing of the economic risk of nonpayment for year 1 are all 
foreign direct costs and the 85-percent test is satisfied. In year 2, 
the FSC incurs a bad debt with respect to a U.S. broker/consolidator. 
The direct costs for year 2 are U.S. direct costs and, therefore, the 
85-percent test is not satisfied. No bad debt is incurred in year 3. 
Because a bad debt with respect to a foreign obligor is incurred in year 
1, the FSC is deemed to have satisfied the economic risk of nonpayment 
for each of years 1, 2 and 3.

    (ii) Grouping with respect to other risk activities. For taxable 
years beginning after February 19, 1987, if a FSC elects to bear the 
economic risk of nonpayment by performing one of the activities 
described in paragraph (e) of this section and elects to group 
transactions, it is considered to have performed the elected activity 
with respect to all transactions within the group during the taxable 
year if it performs the activity in accordance with the following rules. 
If a FSC elects to factor trade receivables, at least 20 percent of the 
face amount of a group's receivables must be factored. If a FSC elects 
to sell by means of letters of credit or banker's acceptances, a fee 
must be incurred with respect to 20 percent of the foreign trading gross 
receipts attributable to sales within the group. If the FSC elects to 
obtain insurance to cover nonpayment, 20 percent of the face amount of 
receivables attributable to sales included in the Sec. 1.924(d)-1(e) 
grouping elected by the FSC must be insured. If a FSC elects to 
investigate credit of customers or potential customers, 20 percent of 
new or potential customers for which a credit investigation is performed 
must be investigated.

[T.D. 8125, 52 FR 5094, Feb. 19, 1987]



Sec. 1.925(a)-1  Transfer pricing rules for FSCs.

    (a)-(c)(7) [Reserved]. For further guidance, see Sec. 1.925(a)-
1T(a) through (c)(7).
    (c)(8) Grouping transactions. (i) The determinations under this 
section are to be made on a transaction-by-transaction basis. However, 
at the annual choice made by the related supplier if the administrative 
pricing methods are used, some or all of these determinations may be 
made on the basis of groups consisting of products or product lines. The 
election to group transactions shall be evidenced on Schedule P of the 
FSC's U.S. income tax return for the taxable year. No untimely or 
amended returns filed later than one

[[Page 97]]

year after the due date of the FSC's timely filed (including extensions) 
U.S. income tax return will be allowed to elect to group, to change a 
grouping basis, or to change from a grouping basis to a transaction-by-
transaction basis (collectively ``grouping redeterminations''). The rule 
of the previous sentence is applicable to taxable years beginning after 
December 31, 1999. For any taxable year beginning before January 1, 
2000, a grouping redetermination may be made no later than the due date 
of the FSC's timely filed (including extensions) U.S. income tax return 
for the FSC's first taxable year beginning on or after January 1, 2000. 
Notwithstanding the time limits for filing grouping redeterminations 
otherwise specified in the previous three sentences, a grouping 
redetermination may be made at any time during the one-year period 
commencing upon notification of the related supplier by the Internal 
Revenue Service of an examination, provided that both the FSC and the 
related supplier agree to extend their respective statutes of 
limitations for assessment by one year. In addition, any grouping 
redeterminations made under this paragraph must meet the requirements 
under Sec. 1.925(a)-1T(e)(4) with respect to redeterminations other 
than grouping. The language ``or grouping of transactions'' is removed 
from the fourth sentence of Sec. 1.925(a)-1T(e)(4), applicable to 
taxable years beginning after December 31, 1997. See also Sec. 
1.925(b)-1T(b)(3)(i).
    (c)(8)(ii)-(f) [Reserved]. For further guidance, see Sec. 1.925(a)-
1T(c)(8)(ii) through (f).
    (g) Effective date. The provisions of this section apply on or after 
March 2, 2001.

[T.D. 8944, 66 FR 13428, Mar. 6, 2001]



Sec. 1.925(a)-1T  Temporary regulations; transfer pricing rules
for FSCs.

    (a) Scope--(1) Transfer pricing rules. In the case of a transaction 
described in paragraph (b) of this section, section 925 permits a 
related party to a FSC to determine the allowable transfer price charged 
the FSC (or commission paid to the FSC) by its choice of the three 
transfer pricing methods described in paragraphs (c)(2), (3), and (4) of 
this section: The ``1.83 percent'' gross receipts method and the ``23 
percent'' combined taxable income method (the administrative pricing 
rules) of section 925(a)(1) and (2), respectively, and the section 482 
method of section 925(a)(3). (Any further reference to a FSC in this 
section shall include a small FSC unless indicated otherwise.) Subject 
to the special no-loss rule of Sec. 1.925(a)-1T(e)(1)(iii), any, or 
all, of the transfer pricing methods may be used in the same taxable 
year of the FSC for separate transactions (or separate groups of 
transactions). If either of the administrative pricing methods (the 
gross receipts method or combined taxable income method) is applied to a 
transaction, the Commissioner may not make distributions, 
apportionments, or allocations as provided by section 482 and the 
regulations under that section. The transfer price charged the FSC (or 
the commission paid to the FSC) on a transaction with a person that is 
not a related party to the FSC may be determined in any manner agreed to 
by the FSC and that person. However, the Commissioner will use special 
scrutiny to determine whether a person selling export property to a FSC 
(or paying a commission to a FSC) is a related party to the FSC with 
respect to a transaction if the FSC earns a profit on the transaction in 
excess of the profit it would have earned had the administrative pricing 
rules applied to the transaction.
    (2) Special rules. For rules as to certain ``incomplete 
transactions'' and for computing full costing combined taxable income, 
see paragraphs (c)(5) and (6) of this section. For a special rule as to 
cooperatives and computation of their combined taxable incomes, see 
paragraph (c)(7) of this section. Grouping of transactions for purposes 
of applying the administrative pricing method chosen is provided for by 
paragraph (c)(8) of this section.


The rules in paragraph (c) of this section are directly applicable only 
in the case of sales or exchanges of export property to a FSC for 
resale, and are applicable by analogy to leases, commissions, and 
services as provided in paragraph (d) of this section. For a rule 
providing for the recovery of the FSC's costs in an overall loss 
situation, see

[[Page 98]]

paragraph (e)(1)(i) of this section. Paragraph (e)(2) of this section 
provides for the applicability of section 482 to resales by the FSC to 
related persons or to sales between related persons prior to the sale to 
the FSC. Paragraph (e)(3) of this section provides for the creation of 
receivables if the transfer price, rental payment, commission or payment 
for services rendered is not paid by the due date of the FSC's income 
tax return for the taxable year under section 6072(b), including 
extensions provided for by section 6081. Provisions for the subsequent 
determination and further adjustment to the relevant amounts are set 
forth in paragraphs (e)(4) and (5) of this section. Paragraph (f) of 
this section has several examples illustrating the provisions of this 
section. Section 1.925(b)-1T prescribes the marginal costing rules 
authorized by section 925(b)(2). Section 1.927(d)-2T provides 
definitions of related supplier and related party.
    (3) Performance of substantial economic functions--(i) 
Administrative pricing methods. The application of the administrative 
pricing methods of section 925 (a)(1) and (2) does not depend on the 
extent to which the FSC performs substantial economic functions beyond 
those required by section 925(c). See paragraph (b)(2)(ii) of this 
section and Sec. 1.924(a)-1T(i)(1).
    (ii) Section 482 method. In order to apply the section 482 method of 
section 925(a)(3), the arm's length standards of section 482 and the 
regulations under that section must be satisfied. In applying the 
standards of section 482, all of the rules of section 482 will apply. 
Thus, if the FSC would not be recognized as a separate entity, it would 
also not be recognized on application of the section 482 method. 
Similarly, if a FSC performs no substantial economic function with 
respect to a transaction, no income will be allocable to the FSC under 
the section 482 method. See Sec. 1.924(a)-1T(i)(2). If a related 
supplier performs services under contract with a FSC, the FSC will not 
be deemed to have performed substantial economic functions for purposes 
of the section 482 method unless it compensates the related supplier 
under the provisions of Sec. 1.482-2(b)(1) through (7). See Sec. 
1.925(a)-1T(c)(6)(ii) for the applicability of the regulations under 
section 482 in determination of the FSC's profit under the 
administrative pricing methods.
    (b) Transactions to which section 925 applies--(1) In general. The 
transfer pricing methods of section 925 (the administrative pricing 
methods and the section 482 method) will apply, generally, only if a 
transaction, or group of transactions, gives rise to foreign trading 
gross receipts (within the meaning of section 924(a) and Sec. 1.924(a)-
1T) to the FSC (or small FSC, as defined in section 922(b) and Sec. 
1.921-2(b) (Q&A3)). However, the transfer pricing methods will apply as 
well if the FSC is acting as commission agent for a related supplier 
with regard to a transaction, or group of transactions, on which the 
related supplier is the principal if the transaction, or group of 
transactions, would have resulted in foreign trading gross receipts had 
the FSC been the principal.
    (2) Application of the transfer pricing rules--(i) Section 482 
method. The section 482 transfer pricing method may be applied to any 
transaction between a related supplier and a FSC if the requirements of 
paragraph (a)(3)(ii) of this section have been met.
    (ii) Administrative pricing methods. The administrative pricing 
methods may be applied in situations in which the FSC is either the 
principal or commission agent on the transaction, or group of 
transactions, only if the requirements of section 925(c) are met. 
Section 925(c) requires that the FSC performs all the activities 
described in subsections (d)(1)(A) and (e) of section 924 that are 
attributable to a particular transaction, or group of transactions. The 
FSC need not perform any activities with respect to a particular 
transaction merely to comply with section 925(c) if that activity would 
not have been performed but for the requirements of that subsection. The 
FSC need not perform all of the activities outside the United States. 
None of the activities need be performed outside the United States by a 
small FSC. Rather than the FSC itself performing the activities required 
by section 925(c), another person under contract, written or oral, 
directly or indirectly,

[[Page 99]]

with the FSC may perform the activities (see Sec. 1.924(d)-1(b)). If a 
related supplier is performing the required activities on behalf of the 
FSC with regard to a transaction, or group of transactions, the 
requirements of section 925(c) will be met if the FSC pays the related 
supplier an amount equal to the direct and indirect expenses related to 
the required activities. See paragraph (c)(6)(ii) of this section for 
the amount of compensation due the related supplier. The payment made to 
the related supplier must be reflected on the FSC's books and must be 
taken into account in computing the FSC's and related supplier's 
combined taxable income. If it is determined that the related supplier 
was not compensated for all the expenses related to the required 
activities or if the entire payment is not reflected on the FSC's books 
or in computing combined taxable income, the administrative pricing 
methods may be used but proper adjustments will be made to the FSC's and 
related supplier's books or income. At the election of the FSC and 
related supplier, the requirements of section 925(c) will be deemed to 
have been met if the related supplier is paid by the FSC an amount equal 
to all of the costs under paragraph (c)(6)(iii)(D) of this section 
(limited by paragraph (c)(6)(ii) of this section) related to the export 
sale, other than expenses relating to activities performed directly by 
the FSC or by a person other than the related supplier, and if that 
payment is reflected on the FSC's books and in computing the FSC's and 
related supplier's combined taxable income on the transaction, or group 
of transactions. If it is determined that the related supplier was not 
compensated for all its expenses or if the entire payment is not 
reflected on the FSC's books or in computing combined taxable income, 
the administrative pricing methods may be used but proper adjustments 
will be made to the FSC's and related supplier's books or income. All 
activities that are performed in connection with foreign military sales 
are considered to be performed by the FSC, or under contract with the 
FSC, if they are performed by the United States government even though 
the United States government has not contracted for the performance of 
those activities. All actual costs incurred by the FSC and related 
supplier in connection with the performance of those activities must be 
taken into account, however, in determining the combined taxable income 
of the FSC and related supplier.
    (iii) Allowable transactions for purposes of the administrative 
pricing methods. If the required performance of activities has been met, 
the administrative pricing methods may be applied to a transaction 
between a related supplier and a FSC only in the following 
circumstances.
    (A) The related supplier sells export property (as defined in 
section 927(a) and Sec. 1.927(a)-1T) to the FSC for resale or the FSC 
acts as a commission agent for the related supplier on sales by the 
related supplier of export property to third parties, whether or not 
related parties. For purposes of this section, references to sales 
include references to exchanges or other dispositions.
    (B) The related supplier leases export property to the FSC for 
sublease for a comparable period with comparable terms of payment, or 
the FSC acts as commission agent for the related supplier on leases of 
export property by the related supplier, to third parties whether or not 
related parties.
    (C) Services are furnished by a FSC as principal or by a related 
supplier if a FSC is a commission agent for the related supplier which 
are related and subsidiary to any sale or lease by the FSC, acting as 
principal or commission agent, of export property under subdivision 
(iii)(A) and (B) of this paragraph.
    (D) Engineering or architectural services for construction projects 
located (or proposed for location) outside of the United States are 
furnished by the FSC if the FSC is acting as principal, or by the 
related supplier if the FSC is a commission agent for the related 
supplier, with respect to the furnishing of the services to a third 
party whether or not a related party.
    (E) The FSC acting as principal, or the related supplier where the 
FSC is a

[[Page 100]]

commission agent, furnishes managerial services in furtherance of the 
production of foreign trading gross receipts of an unrelated FSC or the 
production of qualified export receipts of an unrelated interest charge 
DISC.


This subdivision (iii)(E) shall not apply for any taxable year unless at 
least 50 percent of the gross receipts for such taxable year of the FSC 
or of the related supplier, whichever party furnishes the managerial 
services, is derived from activities described in subdivision (iii)(A), 
(B), or (C) of this paragraph.
    (c) Transfer price for sales of export property--(1) In general. 
Under this paragraph, rules are prescribed for computing the allowable 
price for a transfer from a related supplier to a FSC in the case of a 
sale, described in paragraph (b)(2)(iii)(A) of this section, of export 
property.
    (2) The ``1.83 percent'' gross receipts method. Under the gross 
receipts method of pricing, described in section 925(a)(1), the transfer 
price for a sale by the related supplier to the FSC is the price as a 
result of which the profit derived by the FSC from the sale will not 
exceed 1.83 percent of the foreign trading gross receipts of the FSC 
derived from the sale of the export property. Pursuant to section 
925(d), the amount of profit derived by the FSC under this method may 
not exceed twice the amount of profit determined under, at the related 
supplier's election, either the combined taxable income method of Sec. 
1.925(a)-1T(c)(3) or the marginal costing rules of Sec. 1.925(b)-1T. 
For FSC taxable years beginning after December 31, 1986, if the related 
supplier elects to determine twice the profit determined under the 
combined taxable income method using the marginal costing rules, because 
of the no-loss rule of Sec. 1.925(a)-1T(e)(1)(i), the profit that may 
be earned by the FSC is limited to 100% of the full costing combined 
taxable income as determined under Sec. 1.925(a)-1T(c)(3) and (6). 
Interest or carrying charges with respect to the sale are not foreign 
trading gross receipts.
    (3) The ``23 percent'' combined taxable income method. Under the 
combined taxable income method of pricing, described in section 
925(a)(2), the transfer price for a sale by the related supplier to the 
FSC is the price as a result of which the profit derived by the FSC from 
the sale will not exceed 23 percent of the full costing combined taxable 
income (as defined in paragraph (c)(6) of this section) of the FSC and 
the related supplier attributable to the foreign trading gross receipts 
from such sale.
    (4) Section 482 method. If the methods of paragraph (c)(2) and (3) 
of this section are inapplicable to a sale or if the related supplier 
does not choose to use them, the transfer price for a sale by the 
related supplier to the FSC is to be determined on the basis of the 
sales price actually charged but subject to the rules provided by 
section 482 and the regulations for that section and by Sec. 1.925(a)-
1T(a)(3)(ii).
    (5) Incomplete transactions. (i) For purposes of the gross receipts 
and combined taxable income methods, if export property which the FSC 
purchased from the related supplier is not resold by the FSC before the 
close of either the FSC's taxable year or the taxable year of the 
related supplier during which the export property was purchased by the 
FSC from the related supplier, then--
    (A) The transfer price of the export property sold by the FSC during 
that year shall be computed separately from the transfer price of the 
export property not sold by the FSC during that year.
    (B) With respect to the export property not sold by the FSC during 
that year, the transfer price paid by the FSC for that year shall be the 
related supplier's cost of goods sold (see paragraph (c)(6)(iii)(C) of 
this section) with respect to the property.
    (C) For the subsequent taxable year during which the export property 
is resold by the FSC, an additional amount shall be paid by the FSC (to 
be treated as income for the later year in which it is received or 
accrued by the related supplier) equal to the excess of the amount which 
would have been the transfer price under this section had the transfer 
to the FSC by the related supplier and the resale by the FSC taken place 
during the taxable year of the FSC during which it resold the property 
over the amount already paid under subdivision (B) of this paragraph.

[[Page 101]]

    (D) The time and manner of payment of transfer prices required by 
subdivisions (i)(B) and (C) of this paragraph shall be determined under 
paragraphs (e)(3), (4) and (5) of this section.
    (ii) For purposes of this paragraph, a FSC may determine the year in 
which it received property from a related supplier and the year in which 
it resells property in accordance with the method of identifying goods 
in its inventory properly used under section 471 or section 472 
(relating respectively to the general rule for inventories and to the 
rule for LIFO inventories). Transportation expense of the related 
supplier in connection with a transaction to which this paragraph 
applies shall be treated as an item of cost of goods sold with respect 
to the property if the related supplier includes the cost of 
intracompany transportation between its branches, divisions, plants, or 
other units in its cost of goods sold (see paragraph (c)(6)(iii)(C) of 
this section).
    (6) Full costing combined taxable income--(i) In general. For 
purposes of section 925 and this section, if a FSC is the principal on 
the sale of export property, the full costing combined taxable income of 
the FSC and its related supplier from the sale is the excess of the 
foreign trading gross receipts of the FSC from the sale over the total 
costs of the FSC and related supplier including the related supplier's 
cost of goods sold and its and the FSC's noninventoriable costs (see 
Sec. 1.471-11(c)(2)(ii)) which relate to the foreign trading gross 
receipts. Interest or carrying charges with respect to the sale are not 
foreign trading gross receipts.
    (ii) Section 482 applicability. Combined taxable income under this 
paragraph shall be determined after taking into account under paragraph 
(e)(2) of this section all adjustments required by section 482 with 
respect to transactions to which the section is applicable. If a related 
supplier performs services under contract with a FSC, the FSC shall 
compensate the related supplier an arm's length amount under the 
provisions of Sec. 1.482-2(b) (1) through (6). Section 1.482-2(b)(7), 
which provides that an arm's length charge shall not be deemed equal to 
costs or deductions with respect to services which are an integral part 
of the business activity of either the member rendering the services 
(i.e., the related supplier) or the member receiving the benefit of the 
services (i.e., the FSC), shall not apply if the administrative pricing 
methods of section 925(a)(1) and (2) are used to compute the FSC's 
profit and if the related supplier is the person rendering the services. 
Section 1.482-2(b)(7) shall apply, however, if a related person other 
than the related supplier is the person rendering the services or if the 
section 482 method of section 925(a)(3) is used to compute the FSC's 
profit. See Sec. 1.925(a)-1T(a)(3)(ii). For a special rule for 
computation of combined taxable income where the related supplier is a 
qualified cooperative shareholder of the FSC, see paragraph (c)(7) of 
this section.
    (iii) Rules for determination of gross receipts and total costs. In 
determining the gross receipts of the FSC and the total costs of the FSC 
and related supplier which relate to such gross receipts, the rules set 
forth in subdivisions (iii)(A) through (E) of this paragraph shall 
apply.
    (A) Subject to the provisions of subdivisions (iii)(B) through (E) 
of this paragraph, the methods of accounting used by the FSC and related 
supplier to compute their taxable incomes will be accepted for purposes 
of determining the amounts of items of income and expense (including 
depreciation) and the taxable year for which those items are taken into 
account.
    (B) A FSC may, generally, choose any method of accounting 
permissible under section 446(c) and the regulations under that section. 
However, if a FSC is a member of a controlled group (as defined in 
section 927(d)(4) and Sec. 1.924(a)-1T(h)), the FSC may not choose a 
method of accounting which, when applied to transactions between the FSC 
and other members of the controlled group, will result in a material 
distortion of the income of the FSC or of any other member of the 
controlled group. Changes in the method of accounting of a FSC are 
subject to the requirements of section 446(e) and the regulations under 
that section.
    (C) Cost of goods sold shall be determined in accordance with the 
provisions of Sec. 1.61-3. See sections 471 and 472

[[Page 102]]

and the regulations thereunder with respect to inventories. With respect 
to property to which an election under section 631 applies (relating to 
cutting of timber considered as a sale or exchange), cost of goods sold 
shall be determined by applying Sec. 1.631-1 (d)(3) and (e) (relating 
to fair market value as of the beginning of the taxable year of the 
standing timber cut during the year considered as its cost).
    (D) Costs (other than cost of goods sold) which shall be treated as 
relating to gross receipts from sales of export property are the 
expenses, losses, and deductions definitely related, and therefore 
allocated and apportioned thereto, and a ratable part of any other 
expenses, losses, or deductions which are not definitely related to any 
class of gross income, determined in a manner consistent with the rules 
set forth in Sec. 1.861-8. The deduction for depletion allowed by 
section 611 relates to gross receipts from sales of export property and 
shall be taken into account in computing the combined taxable income of 
the FSC and its related supplier.
    (7) Cooperatives and combined taxable income method. If a qualified 
cooperative, as defined in section 1381(a), sells export property to a 
FSC of which it is a shareholder, the combined taxable income of the FSC 
and the cooperative shall be computed without taking into account 
deductions allowed under section 1382 (b) and (c) for patronage 
dividends, per-unit retain allocations and nonpatronage distributions. 
The FSC and cooperative must take into account, however, when computing 
combined taxable income, the cooperative's cost of goods sold, or cost 
of purchases.
    (8) Grouping transactions. (i) [Reserved]. For further guidance, see 
Sec. 1.925(a)-1(c)(8)(i).
    (ii) A determination by the related supplier as to a product or a 
product line will be accepted by a district director if such 
determination conforms to either of the following standards: Recognized 
trade or industry usage, or the two-digit major groups (or any inferior 
classifications or combinations thereof, within a major group) of the 
Standard Industrial Classification as prepared by the Statistical Policy 
Division of the Office of Management and Budget, Executive Office of the 
President. A product shall be included in only one product line for 
purposes of this section if a product otherwise falls within more than 
one product line classification.
    (iii) A choice by the related supplier to group transactions for a 
taxable year on a product or product line basis shall apply to all 
transactions with respect to that product or product line consummated 
during the taxable year. However, the choice of a product or product 
line grouping applies only to transactions covered by the grouping and, 
as to transactions not encompassed by the grouping, the determinations 
are to be made on a transaction-by-transaction basis. For example, the 
related supplier may choose a product grouping with respect to one 
product and use the transaction-by-transaction method for another 
product within the same taxable year. Sale transactions may not be 
grouped, however, with lease transactions.
    (iv) For purposes of this section, transactions involving military 
property, as defined in section 923(a)(5) and Sec. 1.923-1T(b)(3)(ii), 
may be grouped only with other military property included within the 
same product or product line grouping determined under the standards of 
subdivision (8)(ii) of this paragraph. Non-military property included 
within a product or product line grouping which includes military 
property may be grouped, at the election of the related supplier, under 
the general grouping rules of subdivisions (i) through (iii) of this 
paragraph.
    (v) A special grouping rule applies to agricultural and 
horticultural products sold to the FSC by a qualified cooperative if the 
FSC satisfies the requirements of section 923(a)(4). Section 923(a)(4) 
increases the amount of the FSC's exempt foreign trade income with 
regard to sales of these products, see Sec. 1.923-1T(b)(2). This 
special grouping rule provides that if the related supplier elects to 
group those products that no other export property may be included 
within that group. Export property which would have been grouped under 
the general grouping rules of subdivisions (i) through (iii) of this 
paragraph with the export property covered by this special grouping

[[Page 103]]

rule may be grouped, however, at the election of the related supplier, 
under the general grouping rules.
    (vi) For rules as to grouping certain related and subsidiary 
services, see paragraph (d)(3)(ii) of this section.
    (vii) If there is more than one FSC (or more than one small FSC) 
within a controlled group of corporations, the same grouping of 
transactions, if any, must be used by all FSCs (or small FSCs) within 
the controlled group. If the same grouping of transactions is required 
by this subdivision, and if grouping is elected, the same transfer 
pricing method must be used to determine each FSC's (or small FSC's) 
taxable income with respect to that grouping.
    (viii) The product or product line groups that are established for 
purposes of determining combined taxable income may be different from 
the groups that are established with regard to economic processes (see 
Sec. 1.924(d)-1(e)).
    (d) Rules under section 925(a)(1) and (2) for transactions other 
than sales by a FSC. The following rules are prescribed for purposes of 
applying the gross receipts method or combined taxable income method to 
transactions other than sales by a FSC.
    (1) Leases. In the case of a lease of export property by a related 
supplier to a FSC for sublease by the FSC, the amount of rent the FSC 
must pay to the related supplier shall be computed in a manner 
consistent with the rules in paragraph (c) of this section for computing 
the transfer price in the case of sales and resales of export property 
under the gross receipts method or combined taxable income method. 
Transactions may not be so grouped on a product or product line basis 
under the rules of paragraph (c)(8) of this section as to combine in any 
one group of transactions both lease transactions and sale transactions.
    (2) Commissions. If any transaction to which section 925 applies is 
handled on a commission basis for a related supplier by a FSC and if 
commissions paid to the FSC give rise to gross receipts to the related 
supplier which would have been foreign trading gross receipts under 
section 924(a) had the FSC made the sale directly then--
    (i) The administrative pricing methods of section 925(a)(1) and (2) 
may be used to determine the FSC's commission income only if the 
requirements of section 925(c) (relating to activities that must be 
performed in order to use the administrative pricing methods) are met, 
see Sec. 1.925(a)-1T(b)(2)(ii).
    (ii) The amount of the income that may be earned by the FSC in any 
year is the amount, computed in a manner consistent with paragraph (c) 
of this section, which the FSC would have been permitted to earn under 
the gross receipts method, the combined taxable income method, or the 
section 482 method if the related supplier had sold (or leased) the 
property or service to the FSC and the FSC had in turn sold (or 
subleased) to a third party, whether or not a related party.
    (iii) The combined taxable income of a FSC and the related supplier 
from the transaction is the excess of the related supplier's gross 
receipts from the transaction which would have been foreign trading 
gross receipts had the sale been made by the FSC directly over the 
related supplier's and the FSC's total costs, excluding the commission 
paid or payable to the FSC, but including the related supplier's cost of 
goods sold and its and the FSC's noninventoriable costs (see Sec. 
1.471-11(c)(2)(ii)) which relate to the gross receipts from the 
transaction. The related supplier's gross receipts for purposes of the 
administrative pricing methods shall be reduced by carrying charges, if 
any, as computed under Sec. 1.927(d)-1(a)(Q&A2). These carrying charges 
shall remain income of the related supplier.
    (iv) The maximum commission the FSC may charge the related supplier 
is the amount of income determined under subdivisions (ii) and (iii) of 
this paragraph plus the FSC's total costs for the transaction as 
determined under paragraph (c)(6) of this section.
    (3) Receipts from services--(i) Related and subsidiary services 
attributable to the year of the export transaction. The gross receipts 
for related and subsidiary services described in paragraph 
(b)(2)(iii)(C) of this section shall be treated as part of the receipts 
from the export transaction to which such services are related and 
subsidiary, but only if, under the arrangement between

[[Page 104]]

the FSC and its related supplier and the accounting method otherwise 
employed by the FSC, the income from such services is includible for the 
same taxable year as income from such export transaction.
    (ii) Other services. Income from the performance of related and 
subsidiary services will be treated as a separate type of income if 
subdivision (i) of this paragraph does not apply. Income from the 
performance of engineering and architectural services and certain 
managerial services, as defined in paragraphs (b)(2)(iii)(D) and (E), 
respectively, of this section, will in all situations be treated as 
separate types of income. If this subdivision (ii) applies, the amount 
of taxable income which the FSC may derive for any taxable year shall be 
determined under the arrangement between the FSC and its related 
supplier and shall be computed in a manner consistent with the rules in 
paragraph (c) of this section for computing the transfer price in the 
case of sales for resale of export property under the transfer pricing 
rules of section 925. Related and subsidiary services to which the above 
subdivision (i) of this paragraph does not apply may be grouped, under 
the rules for grouping of transactions in paragraph (c)(8) of this 
section, with the products or product lines to which they are related 
and subsidiary, so long as the grouping of services chosen is consistent 
with the grouping of products or product lines chosen for the taxable 
year in which either the products or product lines were sold or in which 
payment for the services is received or accrued. Grouping of 
transactions shall not be allowed with respect to the determination of 
taxable income which the FSC may derive from services described in 
paragraph (b)(2)(iii)(D) or (E) of this section whether performed by the 
FSC or by the related supplier. Those determinations shall be made only 
on a transaction-by-transaction basis.
    (e) Special rules for applying paragraphs (c) and (d) of this 
section--(1) Limitation on FSC income (``no loss'' rules). (i) If there 
is a combined loss on a transaction or group of transactions, a FSC may 
not earn a profit under either the combined taxable income method or the 
gross receipts method. Also, for FSC taxable years beginning after 
December 31, 1986, in applying the gross receipts method, the FSC's 
profit may not exceed 100% of full costing combined taxable income 
determined under the full costing method of Sec. 1.925(a)-1T(c)(3) and 
(6). This rule prevents pricing at a loss to the related supplier. The 
related supplier may in all situations set a transfer price or rental 
payment or pay a commission in an amount that will allow the FSC to 
recover an amount not in excess of its costs, if any, even if to do so 
would create, or increase, a loss in the related supplier.
    (ii) For purposes of determining whether a combined loss exists, the 
basis for grouping transactions chosen by the related supplier under 
paragraph (c)(8) of this section for the taxable year shall apply.
    (iii) If a FSC recognizes income while the related supplier 
recognizes a loss on a sale transaction under the section 482 method, 
neither the combined taxable income method nor the gross receipts method 
may be used by the FSC and related supplier (or by a FSC in the same 
controlled group and the related supplier) for any other sale 
transaction, or group of sale transactions, during a year which fall 
within the same three digit Standard Industrial Classification as the 
subject sale transaction. The reason for this rule is to prevent the 
segregation of transactions for the purposes of allowing the related 
supplier to recognize a loss on the subject transactions, while allowing 
the FSC to earn a profit under the administrative pricing methods on 
other transactions within the same three digit Standard Industrial 
Classification.
    (2) Relationship to section 482. In applying the administrative 
pricing methods, it may be necessary to first take into account the 
price of a transfer (or other transaction) between the related supplier 
(or FSC) and a related party which is subject to the arm's length 
standard of section 482. Thus, for example, if a related supplier sells 
to a FSC export property which the related supplier purchased from 
related parties, the costs taken into account in

[[Page 105]]

computing the combined taxable income of the FSC and the related 
supplier are determined after any necessary adjustment under section 482 
of the price paid by the related supplier to the related parties. In 
applying section 482 to a transfer by a FSC to a related party, the 
parties are treated as if they were a single entity carrying on all the 
functions performed by the FSC and the related supplier with respect to 
the transaction. The FSC shall be allowed to receive under the section 
482 standard the amount the related supplier would have received had 
there been no FSC.
    (3) Creation of receivables. (i) If the amount of the transfer price 
or rental payment actually charged by a related supplier to a FSC or the 
sales commission actually charged by a FSC to a related supplier has not 
been paid, an account receivable and payable will be deemed created as 
of the due date under section 6072(b), including extensions provided for 
under section 6081, of the FSC's tax return for the taxable year of the 
FSC during which a transaction to which section 925 is applicable 
occurs. The receivable and payable will be in an amount equal to the 
difference between the amount of the transfer price or rental payment or 
commission determined under section 925 and this section and the amount 
(if any) actually paid or received. For example, a calendar year FSC's 
related supplier paid the FSC on July 1, 1985, a commission of $50 on 
the sale of export property. On September 15, 1986, the extended due 
date of the FSC's income tax return for taxable year 1985, the related 
supplier determined that the commission should have been $60. The 
additional $10 of commission had not been paid. Accordingly, an 
interest-bearing payable to the FSC from the related supplier in the 
amount of $10 was created as of September 15, 1986. A $10 interest 
bearing receivable was also created on the FSC's books.
    (ii) An indebtedness arising under the above subdivision (i) shall 
bear interest at an arm's length rate, computed in the manner provided 
by Sec. 1.482-2(a)(2), from the due date under section 6072(b), 
including extensions provided for under section 6081, of the FSC's tax 
return for the taxable year of the FSC in which the transaction occurred 
which gave rise to the indebtedness to the date of payment of the 
indebtedness. The interest so computed shall be accrued and included in 
the taxable income of the person to whom the indebtedness is owed for 
each taxable year during which the indebtedness is unpaid if that person 
is an accrual basis taxpayer or when the interest is paid if a cash 
basis taxpayer. Because the transactions covered by this subdivision are 
between the related supplier and FSC, the carrying charges provisions of 
Sec. 1.927(d)-1(a) do not apply.
    (iii) Payment of dividends, transfer prices, rents, commissions, 
service fees, receivables, or payables may be in the form of money, 
property, sales discount, or an accounting entry offsetting the amount 
due the related supplier, or FSC, whichever applies, against an existing 
debt of the other party to the transaction. This provision does not 
eliminate the requirement that actual cash payments be made by the 
related supplier to a commission FSC if the receipt of payment test of 
section 924(e)(4) is used to meet the foreign economic process 
requirements of section 924(d). The offset accounting entries must be 
clearly identified in both the related supplier's and FSC's books of 
account.
    (4) Subsequent determination of transfer price, rental income or 
commission. The FSC and its related supplier would ordinarily determine 
under section 925 and this section the transfer price or rental payment 
payable by the FSC or the commission payable to the FSC for a 
transaction before the FSC files its return for the taxable year of the 
transaction. After the FSC has filed its return, a redetermination of 
those amounts by the Commissioner may only be made if specifically 
permitted by a Code provision or regulations under the Code. Such a 
redetermination would include a redetermination by reason of an 
adjustment under section 482 and the regulations under that section or 
section 861 and Sec. 1.861-8 which affects the amounts which entered 
into the determination. In addition, a redetermination may be made by 
the FSC and related supplier if their taxable years are still open under 
the statute of limitations for making

[[Page 106]]

claims for refund under section 6511 if they determine that a different 
transfer pricing method may be more beneficial. Also, the FSC and 
related supplier may redetermine the amount of foreign trading gross 
receipts and the amount of the costs and expenses that are used to 
determine the FSC's and related supplier's profits under the transfer 
pricing methods. Any redetermination shall affect both the FSC and the 
related supplier. The FSC and the related suppler may not redetermine 
that the FSC was operating as a commission FSC rather than a buy-sell 
FSC, and vice versa.
    (5) Procedure for adjustments to redeterminations. (i) If a 
redetermination under paragraph (e)(4) of this section is made of the 
transfer price, rental payment or commission for a transaction, or group 
of transactions, the person who was underpaid under this redetermination 
shall establish (or be deemed to have established), at the date of the 
redetermination, an account receivable from the person with whom it 
engaged in the transaction equal to the difference between the amounts 
as redetermined and the amounts (if any) previously paid and received, 
plus the amount (if any) of the account receivable determined under 
paragraph (e)(3) of this section that remains unpaid. A corresponding 
account payable will be established by the person who underpaid the 
amount due.
    (ii) An account receivable established in accordance with the above 
subdivision (5)(i) of this paragraph shall bear interest at an arm's 
length rate, computed in the manner provided by Sec. 1.482-2(a)(2), 
from the day after the date the account receivable is deemed established 
to the date of payment. The interest so computed shall be accrued and 
included in the taxable income for each taxable year during which the 
account receivable is outstanding of an accrual basis taxpayer or when 
paid if a cash basis taxpayer.
    (iii) In lieu of establishing an account receivable in accordance 
with the above subdivision (5)(i) of this paragraph for all or part of 
an amount due a related supplier, the related supplier and FSC are 
permitted to treat all or part of any current or prior distribution 
which was made by the FSC as an additional payment of transfer price or 
rental payment or repayment of commission (and not as a distribution) 
made as of the date the distribution was made. Any additional amount 
arising on the redetermination due the related supplier after this 
treatment shall be represented by an account receivable established 
under the above subdivision (5)(i) of this paragraph. To the extent that 
a distribution is so treated under this subdivision (5)(iii), it shall 
cease to qualify as a distribution for any Federal income tax purpose. 
If all or part of any distribution made to a shareholder other than the 
related supplier is recharacterized under this subdivision (5)(iii), the 
related supplier shall establish an account receivable from that 
shareholder for the amount so recharacterized. The Commissioner may 
prescribe by Revenue Procedure conditions and procedures that must be 
met in order to obtain the relief provided by this subdivision (5)(iii).
    (iv) The procedure for adjustments to transfer price provided by 
this paragraph does not apply to incomplete transactions described in 
paragraph (c)(5) of this section. Such procedure will, however, be 
applied to any such transaction with respect to the taxable year in 
which the transaction is completed.
    (f) Examples. The provisions of this section may be illustrated by 
the following examples:

    Example 1. In 1985, F, a FSC, purchases export property from R, a 
domestic manufacturer of export property A. R is F's related supplier. 
The sale from R to F is made under a written agreement which provides 
that the transfer price between R and F shall be that price which 
allocates to F the maximum amount permitted to be received under the 
transfer pricing rules of section 925. F resells property A in 1985 to 
an unrelated purchaser for $1,000. The terms of the sales contract 
between F and the unrelated purchaser provide that payment of the $1,000 
sales price will be made within 90 days after sale. The purchaser pays 
the entire sales price within 60 days. F incurs indirect and direct 
expenses in the amount of $260 attributable to the sale which relate to 
the activities and functions referred to in section 924 (c), (d) and 
(e). In addition, F incurs additional expenses attributable to the sale 
in the amount of $35. R's cost of goods sold attributable to the export

[[Page 107]]

property is $550. R incurred direct selling expenses in connection with 
the sale of $50. R's deductible general and administrative expenses 
allocable to all gross income are $200. Apportionment of those 
supportive expenses on the basis of gross income does not result in a 
material distortion of income and is a reasonable method of 
apportionment. R's direct selling expenses and its general and 
administrative expenses were not required to be incurred by F. R's gross 
income from sources other than the transaction is $17,550 resulting in 
total gross income of R and F (excluding the transfer price paid by F) 
of $18,000 ($450 plus $17,550). For purposes of this example, it is 
assumed that if R sold the export property to F for $690, the price 
could be justified as satisfying the standards of section 482. Under 
these facts, F may earn, under the combined taxable income method, the 
more favorable of the three transfer pricing rules, a profit of $23 on 
the sale. (Unless otherwise indicated, all examples in this section 
assume that the marginal costing method of Sec. 1.925(b)-1T does not 
result in a higher profit than the profit under the full costing 
combined taxable income method of paragraphs (c)(3) and (6) of this 
section.) F's profit and the transfer price to F from the transaction, 
using the administrative pricing methods, and F's profit if the transfer 
price is determined under section 482, would be as follows:

Combined taxable income:
  F's foreign trading gross receipts.......................   $1,000.00
  R's cost of goods sold...................................     (550.00)
                                                            ------------
      Combined gross income................................      450.00
                                                            ------------
  Less:
    R's direct selling expenses............................       50.00
    F's expenses...........................................      295.00
 
  Apportionment of R's general and administrative expenses:
    R's total G/A expenses.................................      200.00
    Combined gross income..................................      450.00
    R's and F's total gross income (foreign and domestic)..   18,000.00
 
  Apportionment of G/A expenses:
    $200 x $450/$18,000....................................        5.00
                                                            ------------
      Total................................................     (350.00)
                                                            ------------
  Combined taxable income..................................      100.00
                                                            ============
 


The section 482 method--Transfer price to F and F's profit:
  Transfer price to F......................................     $690.00
                                                            ============
  F's profit:
    F's foreign trading gross receipts.....................    1,000.00
                                                            ------------
    Less:
      F's cost of goods sold...............................      690.00
      F's expenses.........................................      295.00
                                                            ------------
          Total............................................     (985.00)
                                                            ------------
    F's profit.............................................       15.00
                                                            ============
The gross receipts method--
F's profit and transfer price to F:
  F's profit--lesser of 1.83% of F's foreign trading gross        18.30
   receipts ($18.30) or two times F's profit under the
   combined taxable income method ($46.00) (See below)
   (Unless otherwise indicated, all examples in this
   section assume that the marginal costing method of Sec.
    1.925(b)-1T does not result in a higher profit than the
   profit under the full costing combined taxable income
   method).................................................
                                                            ============
  Transfer price to F:
    F's foreign trading gross receipts.....................    1,000.00
                                                            ------------
    Less:
      F's expenses.........................................      295.00
      F's profit...........................................       18.30
                                                            ------------
          Total............................................     (313.30)
                                                            ------------
    Transfer price.........................................      686.70
                                                            ============
 


The combined taxable income method--F's profit and transfer
 price to F:
  F's profit--23% of combined taxable income ($100)........      $23.00
                                                            ============
  Transfer price to F:
    F's foreign trading gross receipts.....................    1,000.00
                                                            ------------
    Less:
      F's expenses.........................................      295.00
      F's profit...........................................       23.00
                                                            ------------
        Total..............................................     (318.00)
                                                            ------------
  Transfer price...........................................      682.00
                                                            ============
 


With a profit of $23 under the most favorable of the transfer pricing 
methods, F's exempt foreign trade income under section 923 would be 
$207.39, computed as follows:

  F's foreign trading gross receipts.......................   $1,000.00
  F's costs of purchases (transfer price)..................     (682.00)
                                                            ------------
  F's foreign trade income.................................      318.00
                                                            ============
  F's exempt foreign trade income $318 x 15/23.............      207.39
                                                            ============
F's taxable income would be $8.00, computed as follows:
  F's foreign trade income.................................     $318.00
  F's exempt foreign trade income..........................     (207.39)
                                                            ------------
    F's non-exempt foreign trade income....................      110.61
 
  Less:
    F's expenses allocable to non-exempt foreign trade          (102.61)
     income $295 x $110.61/$318............................
                                                            ------------
    F's taxable income.....................................        8.00
                                                            ============
 

Of F's total expenses, $192.39 ($295 x $207.39/$318) are allocated to 
F's exempt foreign trade income and are disallowed for purposes of 
computing F's taxable income.
    Example 2. Assume the same facts as in Example 1 except that the 
purchaser pays the entire sales price 96 days after delivery, well 
beyond the 60 day period in which payment

[[Page 108]]

must be made to avoid recharacterization of part of the contract price 
as carrying charges. Therefore, the contract price of $1,000 includes 
$10 of carrying charges, assuming a discount rate of 10%. See Sec. 
1.927(d)-1(a) (Q & A2) for computation method for determining amount of 
carrying charges. Under these facts, F may earn, under the combined 
taxable income method, the most favorable of the three transfer pricing 
rules, a profit of $20.73 on the sale. F's profit and the transfer price 
to F under the transfer pricing rules, assuming that a carrying charge 
is incurred, would be as follows:

Combined taxable income:
  F's foreign trading gross receipts.......................     $990.00
  R's cost of goods sold...................................     (550.00)
                                                            ------------
      Combined gross income................................      440.00
                                                            ------------
Less:
  R's direct selling expenses..............................       50.00
R's apportioned G/A expenses:
  $200 x $440/$18,000......................................        4.89
  F's expenses.............................................      295.00
                                                            ------------
      Total................................................     (349.89)
                                                            ------------
      Combined taxable income..............................       90.11
                                                            ============
The combined taxable income method--F's profit and transfer
 price to F:
  F's profit--23% of combined taxable income ($90.11)......      $20.73
                                                            ============
Transfer price to F:
  F's foreign trading gross receipts.......................      990.00
                                                            ------------
Less:
  F's expenses.............................................      295.00
  F's profit...............................................       20.73
                                                            ------------
      Total................................................     (315.73)
                                                            ------------
      Transfer price.......................................      674.27
                                                            ============
 


The gross receipts method--F's profit and transfer price to
 F:
  F's profit--lesser of 1.83% of F's foreign trading gross       $18.12
   receipts ($18.12) or two times F's profit under the
   combined taxable income method ($41.46).................
                                                            ============
  Transfer price to F: F's foreign trading gross receipts..      990.00
                                                            ------------
    Less:
      F's expenses.........................................      295.00
      F's profit...........................................       18.12
                                                            ------------
        Total..............................................     (313.12)
                                                            ------------
  Transfer price...........................................      676.88
                                                            ============
The section 482 method--Transfer price to F and F's profit:
  Transfer price to F......................................      690.00
                                                            ============
  F's profit:
    F's foreign trading gross receipts.....................      990.00
                                                            ------------
    Less:
      F's cost of goods sold...............................      690.00
      F's expenses.........................................      295.00
                                                            ------------
        Total..............................................     (985.00)
                                                            ------------
  F's profit...............................................        5.00
                                                            ============
 

    Example 3. R and F are calendar year taxpayers. R, a domestic 
manufacturing company, owns all the stock of F, a FSC for the taxable 
year. During 1985, R produces and sells a product line of export 
property to F for $157, a price which can be justified as satisfying the 
arm's length price standard of section 482. The sale from R to F is made 
under a written agreement which provides that the transfer price between 
R and F shall be that price which allocates to F the maximum amount 
permitted to be received under the transfer pricing rules of section 
925. F resells the export property for $200. R's cost of goods sold 
attributable to the export property is $115 so that the combined gross 
income from the sale of the export property is $85 (i.e., $200 minus 
$115). R incurs $18 in direct selling expenses in connection with the 
sale of the property. R's deductible general and administrative expenses 
allocable to all gross income are $120. R's direct selling and its 
general and administrative expenses were not required to be incurred by 
F. R's gross income from sources other than the transaction is $5,015 
resulting in total gross income of R and F (excluding the transfer price 
paid by F) of $5,100 (i.e., $85 plus $5,015). F incurs $50 in direct and 
indirect expenses attributable to resale of the export property. Of 
those expenses, $45 relate to activities and functions referred to in 
section 924 (c), (d) and (e). The maximum profit which F may earn with 
respect to the product line is $3.66, computed as follows:

Combined taxable income:
  F's foreign trading gross receipts.......................     $200.00
  R's cost of goods sold...................................     (115.00)
                                                            ------------
    Combined gross income..................................       85.00
                                                            ------------
  Less:
    R's direct selling expenses............................       18.00
    R's apportioned G/A expenses: $120 x $85/$5,100........        2.00
    F's expenses...........................................       50.00
                                                            ------------
      Total................................................      (70.00)
                                                            ------------
  Combined taxable income..................................       15.00
                                                            ============
 


The combined taxable income method--F's profit:
  F's profit--23% of combined taxable income ($15).........      $ 3.45
                                                            ============
The gross receipts method--F's profit:
  F's profit--lesser of 1.83% of F's foreign trading gross        $3.66
   receipts ($3.66) or two times F's profit under the
   combined taxable income method ($6.90)..................
                                                            ============
The section 482 method--F's profit:
  F's foreign trading gross receipts.......................      200.00
                                                            ------------
  Less:
    F's cost of goods sold.................................      157.00

[[Page 109]]

 
    F's expenses...........................................       50.00
                                                            ------------
        Total..............................................     (207.00)
                                                            ------------
  F's profit (loss)........................................       (7.00)
                                                            ============
 


Since the gross receipts method results in a greater profit to F ($3.66) 
than does either the combined taxable income method ($3.45) or the 
section 482 method (a loss of $7), and does not exceed twice the profit 
under the combined taxable income method, F may earn a maximum profit of 
$3.66. Accordingly, the transfer price from R to F may be readjusted as 
long as the transfer price is not readjusted below $146.34, computed as 
follows:

Transfer price to F:
  F's foreign trading gross receipts.......................    $ 200.00
  Less:
    F's expenses...........................................       50.00
    F's profit.............................................        3.66
                                                            ------------
        Total..............................................      (53.66)
                                                            ------------
  Transfer price...........................................      146.34
                                                            ============
 

    Example 4. R and F are fiscal year May 31 year-end taxpayers. R, a 
domestic manufacturing company, owns all the stock of F, a FSC for the 
taxable year. During August of 1987, R produces and sells 100 units of 
export property A to F under a written agreement which provides that the 
transfer price between R and F shall be that price which allocates to F 
the maximum profit permitted to be received under the transfer pricing 
rules of section 925. Thereafter, the 100 units are resold for export by 
F for $950. R's cost of goods sold attributable to the 100 units is 
$650. R incurs costs, both direct and indirect, in the amount of $270 
with regard to activities and functions referred to in section 924 (c), 
(d) and (e) which it was under contract with F to perform for F. R's 
direct selling expenses are $40. Those expenses were not required to be 
incurred by F. For purposes of this example, assume that R has no 
general and administrative expenses other than those relating to the 
section 924 (c), (d) and (e) activities and functions. F incurs expenses 
in the amount of $290 attributable to the resale which relate to the 
activities and functions referred to in section 924 (c), (d) and (e). Of 
that amount, $270 was paid to R under contract to perform the activities 
in section 924. The remaining $20 was paid to independent contractors. R 
chooses not to apply the section 482 transfer pricing method to 
determine F's profit on the transaction. F may not earn any income under 
either the gross receipts (see the special no-loss rule of paragraph 
(e)(1)(i) of this section) or the combined taxable income administrative 
pricing methods with respect to resale of the 100 units because there is 
a combined loss of $(30) on the transaction, computed as follows:

Combined taxable income:
  F's foreign trading gross receipts.......................    $ 950.00
  R's cost of goods sold...................................     (650.00)
                                                            ------------
      Combined gross income................................      300.00
                                                            ------------
  Less:
    R's direct selling expenses............................       40.00
    F's expenses...........................................      290.00
                                                            ------------
        Total..............................................     (330.00)
                                                            ------------
  Combined taxable income (loss)...........................      (30.00)
                                                            ============
 


Under paragraph (e)(1)(i) of this section, F is permitted to recover its 
expenses attributable to the sale ($290) even though such recovery 
results in a loss or increased loss to the related supplier. 
Accordingly, the transfer price from R to F may be readjusted as long as 
the transfer price is not readjusted below $660, computed as follows:

Transfer price to F:
  F's foreign trading gross receipts.......................     $950.00
  Less:
    F's expenses...........................................     (290.00)
                                                            ------------
      Transfer price.......................................      660.00
                                                            ============
 

    Example 5. Assume the same facts as in Example 4 except that F 
performs the section 924 (c), (d) and (e) activities and functions and 
that R chooses to apply the section 482 transfer pricing method. Under 
the standards of section 482, a transfer price from R to F of $650 is an 
arm's length price. Accordingly, the transfer price to F and F's profit 
on the subsequent resale of product A ($10) are as follows:

The section 482 method--Transfer price to F and F's profit:
  Transfer price to F......................................     $650.00
                                                            ============
F's profit:
    F's foreign trading gross receipts.....................      950.00
    F's cost of purchases..................................     (650.00)
                                                            ------------
    F's gross income.......................................      300.00
                                                            ------------
  Less:
    F's expenses...........................................     (290.00)
                                                            ------------
  F's profit...............................................       10.00
                                                            ============
 


This sale of product A results in a loss to R of $40 (transfer price of 
$650 less R's cost of goods sold of $650 and direct selling expenses of 
$40). Since R chose to use the section 482 transfer pricing method on 
this loss transaction, under the special no loss rule of paragraph 
(e)(1)(iii) of this section, the administrative pricing methods of 
section 925(a)(1) and (2) may not be used for any other sale 
transactions, or group of sale transactions, during the same year of 
other products which fall within the same three digit Standard 
Industrial Classification as product A. F's profit, if any, on these 
sales must be

[[Page 110]]

computed under the section 482 transfer pricing method.
    Example 6. R and F are calendar year taxpayers. R, a domestic 
manufacturing company, owns all the stock of F, a FSC for the taxable 
year. During 1985, R manufactures 100 units of export property A. R 
enters into a written agreement with F whereby F is granted a sales 
franchise with respect to export property A and F will receive 
commissions with respect to these exports equal to the maximum amount 
permitted to be received under the administrative pricing rules of 
section 925 (a)(1) and (2). Thereafter, the 100 units are sold for 
export by R for $1,000. The total sales price of $1,000 was paid by the 
purchaser to R within 60 days of the sales transaction. The entire 
$1,000 would have been foreign trading gross receipts had F been the 
principal on the sale. R's cost of goods sold attributable to the 100 
units is $650. R's direct selling expenses so attributable are $50. R's 
deductible general and administrative expenses, other than those 
attributable to the section 924 (c), (d) and (e) activities and 
functions, allocable to all gross income are $200. Apportionment of 
those supportive expenses on the basis of gross income does not result 
in a material distortion of income and is a reasonable method of 
apportionment. R's direct selling expenses and the portion of the 
general and administrative expenses not relating to the activities and 
functions referred to in section 924 (c), (d) and (e) were not required 
to be incurred by F. R's gross income from sources other than the 
transaction is $17,650 resulting in total gross income of $18,000 ($350 
plus $17,650). R and a related person perform on F's behalf the 
activities and functions referred to in section 924 (c), (d) and (e). In 
performing these activities, R and the related person incurred expenses, 
both direct and indirect, of $200 and $45, respectively. F pays $200 to 
R under contract and $50 to the related person. The maximum profit which 
F may earn under the franchise pursuant to the administrative pricing 
rules is $18.30, computed as follows:

Combined taxable income:
  R's gross receipts from the sale.........................   $1,000.00
  R's cost of goods sold...................................     (650.00)
                                                            ------------
    Combined gross income..................................      350.00
                                                            ------------
  Less:
    R's direct selling expenses............................       50.00
    F's expenses...........................................      250.00
 
    Apportionment of R's general and administrative
     expenses:
      R's total G/A expenses...............................      200.00
      Combined gross income................................      350.00
      R's and F's total gross income (foreign and domestic)   18,000.00
                                                            ============
      Apportionment of G/A expenses:
        $200 x $350/$18,000................................        3.89
 
          Total............................................     (303.89)
                                                            ------------
  Combined taxable income..................................       46.11
                                                            ============
 


As reflected in the above computation, F included on its books $200 of 
expenses related to the section 924 activities and performed by R on 
behalf of F. R incurred $253.89 of expenses. These expenses were 
reflected on its books. Under paragraph (b)(2)(ii) of this section, R 
and F may elect to include all of the expenses related to the export 
sales on F's books. This will satisfy the requirements of section 925(c) 
without requiring an allocation of the expenses between R and F. Under 
this election, as reflected in the following computation, combined 
taxable income will still be $46.11 but, as reflected in a later part of 
this example, the commission due F will be increased by $253.89:

Combined taxable income:
  R's gross receipts from the sale.........................   $1,000.00
  R's cost of goods sold...................................     (650.00)
                                                            ------------
      Combined gross income................................      350.00
                                                            ------------
Less:
  F's expenses.............................................     (303.89)
                                                            ------------
      Combined taxable income..............................       46.11
                                                            ============
 


The combined taxable income method--F's profit:
  F's profit--23% of combined taxable income ($46.11)......      $10.61
                                                            ============
The gross receipts method--F's profit:
  F's profit--lesser of 1.83% of R's gross receipts              $18.30
   ($18.30) or two times F's profit under the combined
   taxable income method ($21.22)..........................
                                                            ============
 
If the election provided for in paragraph (b)(2)(ii) of this section is
 not made, F may receive a commission from R in the amount of $268.30,
 computed as follows:
 
  F's expenses.............................................     $250.00
  F's profit...............................................       18.30
                                                            ------------
      F's commission.......................................      268.30
                                                            ============
 
This $268.30 is F's foreign trade income. F's exempt foreign trade
 income is $174.98 ($268.30 x 15/23). F's taxable income is $6.37,
 computed as follows:
 
  F's foreign trade income.................................     $268.30
  F's exempt foreign trade income..........................     (174.98)
                                                            ------------
      F's non-exempt foreign trade income..................       93.32
                                                            ------------
Less:
  F's expenses allocable to non-exempt foreign trade income      (86.95)
   $250 x $93.32/$268.30...................................
                                                            ------------
      F's taxable income...................................        6.37
                                                            ============
 

Of F's total expenses, $163.05 ($250 x $174.98/$268.30) are allocated to 
F's exempt foreign trade income and are disallowed for purposes of 
computing F's taxable income.


[[Page 111]]


If R and F make the election provided for in paragraph (b)(2)(ii) of 
this section, F may receive a commission from R in the amount of 
$322.19, computed as follows:

  F's expenses.............................................     $303.89
  F's profit...............................................       18.30
                                                            ------------
    F's commission.........................................      322.19
                                                            ============
 
With this election, this $322.19 is F's foreign trade income. F's exempt
 foreign trade income is $210.12 ($322.19 x 15/23). F's taxable income
 is still $6.37, computed as follows:
 
  F's foreign trade income.................................     $322.19
  F's exempt foreign trade income..........................     (210.12)
                                                            ------------
    F's non-exempt foreign trade income....................      112.07
                                                            ------------
  Less:
    F's expenses allocable to non-exempt foreign trade          (105.70)
     income $303.89 x $112.07/$322.19......................
                                                            ------------
    F's taxable income.....................................        6.37
                                                            ============
 
Of F's total expenses, $198.19 ($303.89 x $210.12/$322.19) are allocated
 to F's exempt foreign trade income and are disallowed for purposes of
 computing F's taxable income.
 

    Example 7. Assume the same facts as in Example 6 except that R's 
direct selling expenses are $60. The profit which F may earn under the 
franchise pursuant to the administrative pricing rules is $16.62, 
computed as follows:

Combined taxable income:
  R's gross receipts from the sale.........................   $1,000.00
  R's cost of goods sold...................................     (650.00)
                                                            ------------
    Combined gross income..................................      350.00
                                                            ------------
  Less:
    R's direct selling expenses............................       60.00
    R's apportioned G/A expenses...........................        3.89
    F's expenses...........................................      250.00
                                                            ------------
                                                                (313.89)
 
  Combined taxable income..................................       36.11
                                                            ============
The combined taxable income method--F's profit:
  F's profit--23% of combined taxable income ($36.11)......        8.31
                                                            ============
The gross receipts method--F's profit:
  F's profit--lesser of 1.83% of R's gross receipts ($            16.62
   18.30) or two times F's profit under the combined
   taxable income method ($16.62)..........................
                                                            ============
 
F may receive a commission from R in the amount of $266.62, computed as
 follows:
 
  F's expenses.............................................     $250.00
  F's profit...............................................       16.62
                                                            ------------
    F's commission.........................................      266.62
                                                            ============
 


If the election provided for in paragraph (b)(2)(ii) of this section is 
made by R and F, the profit which F may earn under the franchise 
pursuant to the administrative pricing rules will remain at $16.62 but 
will be computed as follows:

Combined taxable income:
  R's gross receipts from the sale.........................   $1,000.00
  R's cost of goods sold...................................     (650.00)
                                                            ------------
    Combined gross income..................................      350.00
                                                            ------------
  Less: F's expenses.......................................     (313.89)
                                                            ------------
  Combined taxable income..................................       36.11
                                                            ============
The combined taxable income method--F's profit:
  F's profit--23% of combined taxable income ($36.11)......        8.31
                                                            ============
The gross receipts method--F's profit:
  F's profit--lesser of 1.83% of R's gross receipts               16.62
   ($18.30) or two times F's profit under the combined
   taxable income method ($16.62)..........................
                                                            ============
F may receive a commission from R in the amount of $330.51,
 computed as follows:
  F's expenses.............................................      313.89
  F's profit...............................................       16.62
                                                            ------------
    F's commission.........................................      330.51
                                                            ============
 

As illustrated by Example 6, F's exempt taxable income and taxable 
income will be the same regardless of which method is used to compute 
F's commission.
    Example 8. Assume the same facts as in Example 6 except that F's 
expenses are $300. With this assumption, there is a combined loss of 
$(3.89) on the transaction under the full costing combined taxable 
income method, computed as follows:

Combined taxable income:
  R's gross receipts from the sale.........................   $1,000.00
  R's cost of goods sold...................................     (650.00)
                                                            ------------
    Combined gross income..................................      350.00
                                                            ------------
  Less:
    R's direct selling expenses............................       50.00
    R's apportioned G/A expenses...........................        3.89
    F's expenses...........................................      300.00
                                                            ------------
                                                                (353.89)
                                                            ------------
  Combined taxable income (loss)...........................       (3.89)
                                                            ============
 


Since there is a combined loss, F will not have a profit under the full 
costing combined taxable income method. However, for purposes of this 
example, it is assumed that under the marginal costing rules of Sec. 
1.925(b)-1T the maximum combined taxable income is $75 and the overall 
profit percentage limitation is $30. Accordingly, F's profit would be 
$6.90 (23% of $30) under the marginal costing rules. F's profit under 
the gross receipts method will be $13.80 (1.83% of $1,000 limited by 
section 925(d) to two times the profit determined under marginal 
costing). The commission F may receive from R is $313.80. Had all of the 
expenses been reflected on F's books pursuant to the election of 
paragraph (b)(2)(ii) of this section, F's commission would have been 
$367.69.

[[Page 112]]

    Example 9. Assume the same facts as in Example 6 except that F's 
expenses are $300 and that the transaction occurred in 1987. F will not 
earn a profit under the sales franchise pursuant to the administrative 
pricing rules. This is shown by the following computation:

Combined taxable income:
  R's gross receipts from the sale................             $1,000.00
  R's cost of goods sold..........................              (650.00)
                                                   ---------------------
    Combined gross income.........................                350.00
                                                   ---------------------
  Less:
    R's direct selling expenses...................                 50.00
    R's apportioned G/A expenses..................                  3.89
    F's expenses..................................                300.00
                                                   ---------------------
                                                                (353.89)
                                                   ---------------------
  Combined taxable income (loss)..................                (3.89)
                                                   =====================
 


F will not have a profit under the full costing combined taxable income 
method since there is a combined loss of $(3.89). Also, F will not have 
a profit under the gross receipts method due to section 925(d) and the 
special no loss rule of paragraph (e)(1)(i) of this section. In 
addition, F will not have a profit under the marginal costing rules 
because the profit may not exceed full costing combined taxable income, 
see Sec. 1.925 (b)-1T(b)(4). Although F may not earn a profit, it is 
entitled to recoup its expenses. Therefore, the commission F may receive 
from R is $300.00. R will bear the entire loss. Had all of the expenses 
been reflected on F's books pursuant to the election of paragraph 
(b)(2)(ii) of this section, F's commission would have been $353.89.
    Example 10. Assume the same facts as in Example 6 except that R 
receives total payment of the sale price of $1,000 on the 96th day after 
delivery, well beyond the 60 day period in which payment must be made to 
avoid recharacterization of part of the contract price as carrying 
charges. Therefore, the contract price of $1,000 includes $10 of 
carrying charges, assuming a discount rate of 10%. See Sec. 1.927(d)-1 
(a) (Q & A2) for computation method for determining amount of carrying 
charges. This $10 of carrying charges is R's income. The profit which F 
may earn under the franchise pursuant to the administrative pricing 
rules is $16.66, computed as follows (the election of paragraph 
(b)(2)(ii) of this section is not made by R and F):

Combined taxable income:
  R's gross receipts from the sale..........................    $990.00
  R's cost of goods sold....................................    (650.00)
                                                             -----------
    Combined gross income...................................     340.00
                                                             -----------
  Less:
    R's direct selling expenses.............................      50.00
    R's apportioned G/A expenses: $200 x $340/$18,000.......       3.78
    F's expenses............................................     250.00
                                                             -----------
      Total.................................................    (303.78)
                                                             -----------
  Combined taxable income...................................      36.22
                                                             ===========
The combined taxable income method--F's profit: F's profit--      $8.33
 23% of combined taxable income ($36.22)
                                                             ===========
The gross receipts method--F's profit:
  F's profit--lesser of 1.83% of R's gross receipts ($18.12)     $16.66
   or two times F's profit under the combined taxable income
   method ($16.66)..........................................
                                                             ===========
F may receive a commission from R in the amount of $266.66,
 computed as follows:
  F's expenses..............................................    $250.00
  F's profit................................................      16.66
                                                             -----------
    F's commission..........................................     266.66
                                                             ===========
 

    Example 11. Assume the same facts as in Example 6. In addition, 
assume that R also manufactures products K, L, M, N, and P all of which 
are export property as defined in section 927(a). Product K is military 
property as defined in section 923(a)(5) and Sec. 1.923-1T(b)(3)(ii). 
Assume further that products A, L, and P are included within product 
line X and that products K, L, M, and N are included within product line 
W. R has entered into a written agreement with F under which F is 
granted a sales franchise with respect to exporting the products. Under 
this agreement, F will receive commissions with respect to those exports 
equal to the maximum amount permitted to be received under the 
administrative pricing rules. The table set forth below details F's 
foreign trading gross receipts, R's cost of goods sold and R's and F's 
expenses allocable and apportioned under Sec. 1.861-8 to the sale of 
products A, L, M, N, and P. For purposes of this example, it is assumed 
that R does not incur any general and administrative expenses. Because 
of the special grouping rule of paragraph (c)(8)(ii) of this section, 
product L may be included for purposes of the administrative pricing 
rules in only one product line, at the option of R. Also for these 
purposes, product K, which is military property, may not be grouped with 
products L, M, and N. See paragraph (c)(8)(iv) of this section. Under 
these facts, F will have profits under the franchise agreement from the 
sale of products A, L, M, N, and P and may receive commissions from R 
relating to the sale of those products, assuming the election of 
paragraph (b)(2)(ii) of this section is not made, in the following 
amounts:

 
                                                      F's
                                          Profit   Expenses  Commissions
 
Product Line X (products A and P)......    $36.34   $490.00     $526.34
Product Line W (products L, M, and N)..    $40.48   $421.00     $461.48
 


On the sale of product K, R received gross receipts of $150. R's cost of 
goods sold was $130.

[[Page 113]]

R's and F's expenses allocable to product K totaled $10 ($7 of R's 
expenses and $3 of F's). Under the gross receipts method, F earned a 
profit of $2.75 (1.83% of $150) and $2.30 under the combined taxable 
income method. F may receive a commission, assuming the election of 
paragraph (b)(2)(ii) of this section is made by R and F, from R in the 
amount of $12.75, computed as follows:

F's expenses..................................................    $10.00
F's profit....................................................      2.75
                                                               ---------
    F's commission............................................    $12.75
                                                               =========
 


----------------------------------------------------------------------------------------------------------------
                                           Product A   Product L   Product M   Product N   Product P     Total
----------------------------------------------------------------------------------------------------------------
Product Line X
  Combined Taxable Income
    R's GR From sale....................    $1,000    ..........  ..........  ..........    $1,000      $2,000
    R's cost of goods sold..............      (650)   ..........  ..........  ..........      (650)     (1,300)
                                         -----------------------------------------------------------------------
      Combined gross income.............       350    ..........  ..........  ..........       350         700
                                         -----------------------------------------------------------------------
    Less:
      R's expenses......................        50    ..........  ..........  ..........        81         131
      F's expenses......................       250    ..........  ..........  ..........       240         490
                                         -------------
        Total...........................      (300)   ..........  ..........  ..........      (321)       (621)
                                         -------------
    Combined taxable income (loss)......       $50    ..........  ..........  ..........       $29         $79
                                         =============
  23% of CTI............................    $11.50    ..........  ..........  ..........     $6.67      $18.17
                                         =============
  1.83% of GR from sale.................    $18.30    ..........  ..........  ..........    $13.34      $36.34
                                         =============
Product Line W
  Combined Taxable Income
    R's GR from sale....................  ..........    $1,000        $625      $1,800    ..........    $3,425
    R's cost of goods sold..............  ..........      (650)       (445)     (1,600)   ..........    (2,695)
                                         -------------
      Combined gross income.............  ..........       350         180         200    ..........       730
                                         -------------
    Less:
      R's expenses......................  ..........        81          70          70    ..........       221
      F's expenses......................  ..........       230          60         131    ..........       421
                                         -------------
        Total...........................  ..........      (311)       (130)       (201)   ..........      (642)
                                         -------------
    Combined taxable income (loss)......  ..........       $39         $50         $(1)   ..........       $88
                                         =============
  23% of CTI............................  ..........     $8.97      $11.50          $0    ..........    $20.24
                                         =============
  1.83% of GR From sale.................  ..........    $17.94      $11.44          $0    ..........    $40.48
                                         =============
----------------------------------------------------------------------------------------------------------------

    Example 12. R and F are calendar year taxpayers. R owns all the 
stock of F, an FSC for the taxable year. During 1985, R purchases 100 
units of export property A from B, an unrelated domestic manufacturing 
company for $850. R's direct selling expenses so attributable are $20. R 
enters into a written agreement with F whereby F is granted a sales 
franchise with respect to export product A and F will receive 
commissions with respect to these exports equal to the maximum amount 
permitted to be received under the administrative pricing rules of 
section 925. Thereafter, the 100 units are sold for export by R for 
$1,050. R factors the trade receivable to unrelated person X for $1,000. 
Under Sec. 1.924(a)-1T(g)(7), total gross receipts for purposes of 
computing R's and F's combined taxable income is $1,000 (total receipts 
($1,050) less the discount ($50)). This $1,000 would have been foreign 
trading gross receipts had F been the principal on the sale. For 
purposes of this example, it is assumed that R did not incur any general 
and administrative expenses. F incurs expenses in the amount of $110, 
all of which were performed by R under contract to F. The profit which F 
may earn under the franchise pursuant to the administrative pricing 
rules is $9.20 computed as follows:

Combined taxable income:
  R's gross receipts from the sale.........................   $1,000.00
  R's cost of goods sold...................................     (850.00)
                                                            ------------
                                                                 150.00
                                                            ------------
  Less:
    R's direct selling expenses............................       20.00
    F's expenses...........................................      110.00
                                                            ------------
      Total................................................      130.00
                                                            ------------
  Combined taxable income..................................      $20.00
                                                            ============

[[Page 114]]

 
The combined taxable income method--F's profit:
  F's profit--23% of combined taxable income ($20).........       $4.60
                                                            ============
The gross receipts method--F's profit:
  F's profit--lesser of 1.83% of R's gross receipts               $9.20
   ($18.30) or two times F's profit under the combined
   taxable income, method ($9.20)..........................
                                                            ============
F may receive a commission from R in the amount of $119.20,
 computed as follows (the election of Sec. 1.925(a)-
 1T(b)(2)(ii) has not been made):
  F's expenses.............................................     $110.00
  F's profit...............................................        9.20
                                                            ------------
    F's commission.........................................     $119.20
                                                            ============
 

    Example 13. R and F are calendar year taxpayers. R, a domestic 
manufacturing company, owns all the stock of F, an FSC for the taxable 
year. During March 1985, R manufactures office equipment, export 
property within the definition of section 927(a)(1), which it leases on 
April 1, 1985, to F for a term of 1 year at a monthly rental of $1,000, 
a rent which satisfies the standard of arm's length rental under section 
482. F subleases the product on April 1, 1985, for a term of 1 year at a 
monthly rental of $1,200. R's cost for the product leased is $40,000. 
R's other deductible expenses attributable to the product are $200, all 
of which are incurred in 1985. Those expenses were not incurred under 
contract to F. F's expenses attributable to sublease of the export 
property are $1,150, all of which are incurred in 1985 directly by F. R 
depreciates the property on a straight line basis, using a half-year 
convention, assuming a 10 year recovery period (see section 
168(f)(2)(C), Sec. 1.48-1(g)). The profit which F may earn with respect 
to the transaction is $1,483.50 for 1985 and $600 for 1986, computed as 
follows:

                          Computation for 1985

Combined taxable income:
  F's sublease rental receipts for year ($1,200 x 9          $10,800.00
   months)................................................
                                                           -------------
Less:
  R's depreciation (($40,000 x 1/10) x 9/12)..............     3,000.00
  R's expenses............................................       200.00
  F's expense.............................................     1,150.00
                                                           -------------
      Total...............................................    (4,350.00)
                                                           -------------
Combined taxable income...................................     6,450.00
                                                           =============
The combined taxable income method--F's profit:
  F's profit--23% of combined taxable income ($6,450).....    $1,483.50
                                                           =============
The gross receipts method--F's profit:
  F's profit--lesser of 1.83% of F's foreign trading gross      $197.64
   receipts ($197.64) or two times F's profit under the
   combined taxable income method ($2,967)................
                                                           =============
The section 482 method--F's profit:
  F's sublease rental receipts for year...................   $10,800.00
                                                           -------------
Less:
  F's lease rental payments for year......................     9,000.00
  F's expenses............................................     1,150.00
                                                           -------------
      Total...............................................   (10,150.00)
                                                           -------------
      F's profit..........................................       650.00
                                                           =============
 


Since the combined taxable income method results in greater profit to F 
($1,483.50) than does either the gross receipts method ($197.64) or the 
section 482 method ($650), F may earn a profit of $1,483.50 for 1985. 
Accordingly, the monthly rental payable by F to R for 1985 may be 
readjusted as long as the monthly rental payable is not readjusted below 
$907.39, computed as follows:

Monthly rental payable by F to R for 1985:
  F's sublease rental receipts for year...................   $10,800.00
                                                           -------------
Less:
  F's expenses............................................     1,150.00
  F's profit..............................................     1,483.50
                                                           -------------
      Total...............................................    (2,633.50)
                                                           -------------
      Rental payable for 1985.............................     8,166.50
                                                           =============
      Rental payable each month ($8,166.50/9 months)......      $907.39
                                                           =============
 

                          Computation for 1986

Combined taxable income:
  F's sublease rental receipts for year ($1,200 x 3 months)   $3,600.00
                                                            ------------
Less:
  R's depreciation (($40,000 x \1/10\) x \3/12\)...........   (1,000.00)
                                                            ------------
      Combined taxable income..............................    2,600.00
                                                            ============
The combined taxable income method--F's profit:
  F's profit--23% of combined taxable income ($2,600)......      598.00
                                                            ============
The gross receipts method--F's profit:
  F's profit--lesser of 1.83% of F's foreign trading gross        65.88
   receipts ($3,600) or two times F's profit under the
   combined taxable income method ($1,196).................
                                                            ============
The section 482 method--F's profit:
  F's sublease rental receipts for year....................   $3,600.00
                                                            ------------
Less:
  F's lease rental payments for year.......................   (3,000.00)
                                                            ------------
      F's profit...........................................      600.00
                                                            ============
 

Since the section 482 method results in a greater profit to F ($600) 
than does either the combined taxable income method ($598) or the gross 
receipts method ($65.88), F may earn a profit of $600 for 1986. 
Accordingly, the monthly rental payable by F to R for 1986 may be 
readjusted as long as the monthly rental payable is not readjusted below 
$1,000, computed as follows:

[[Page 115]]


Monthly rental payable by F to R for 1986:
  F's sublease rental receipts for year....................   $3,600.00
                                                            ------------
Less:
  F's profit...............................................     (600.00)
                                                            ------------
  Rental payable for 1986..................................    3,000.00
                                                            ============
  Rental payable for each month ($3,000/3 months)..........    1,000.00
                                                            ============
 


    (g) Effective date. The provisions of this section and Sec. 
1.925(b)-1T apply with respect to taxable year ending after December 31, 
1984, except that a corporation may not be a FSC for any taxable year 
beginning before January 1, 1985.

[T.D. 8126, 52 FR 6443, Mar. 3, 1987, as amended by T.D. 8764, 63 FR 
10306, Mar. 3, 1998; T.D. 8944, 66 FR 13426, Mar. 6, 2001]



Sec. 1.925(b)-1T  Temporary regulations; marginal costing rules.

    (a) In general. This section prescribes the marginal costing rules 
authorized by section 925(b)(2). If under paragraph (c)(1) of this 
section a FSC is treated for its taxable year as seeking to establish or 
maintain a foreign market for sales of an item, product, or product line 
of export property (as defined in Sec. 1.927(a)-1T) from which foreign 
trading gross receipts (as defined in Sec. 1.924(a)-1T) are derived, 
the marginal costing rules prescribed in paragraph (b) of this section 
may be applied at the related supplier's election to compute combined 
taxable income of the FSC and related supplier derived from those sales. 
(Any further reference to a FSC in this section shall include a small 
FSC unless indicated otherwise.) The combined taxable income determined 
under these marginal costing rules may be used to determine whether the 
``twice the amount determined under the combined taxable income method'' 
limitation for the 1.83% of gross receipts test of section 925(d) has 
been met.


For FSC taxable years beginning after December 31, 1986, if the marginal 
costing rules are used to determine the section 925(d) limitation, the 
FSC may not earn more than 100% of full costing combined taxable income 
determined under the full costing combined taxable income method of 
Sec. 1.925(a)-1T(c)(3) and (6). The marginal costing rules may be 
applied even if the related supplier does not manufacture, produce, 
grow, or extract the export property sold. The marginal costing rules do 
not apply to sales of export property which in the hands of a purchaser 
related under section 954(d)(3) to the seller give rise to foreign base 
company sales income as described in section 954(d) unless, for the 
purchaser's year in which it resells the export property, section 
954(b)(3)(A) is applicable or that income is under the exceptions in 
section 954(b)(4). In addition, the marginal costing rules do not apply 
to leases of property or to the performances of any services even if 
they are related and subsidiary services (as defined in Sec. 1.924(a)-
1T(d) and Sec. 1.925(a)-1T(b)(2)(iii)(C)).
    (b) Marginal costing rules--(1) In general. Marginal costing is a 
method under which only direct production costs of producing a 
particular item, product, or product line are taken into account for 
purposes of computing the combined taxable income of the FSC and its 
related supplier under section 925(a)(2). The costs to be taken into 
account are the related supplier's direct material and labor costs (as 
defined in Sec. 1.471-11(b)(2)(i)). Costs which are incurred by the FSC 
and which are not taken into account in computing combined taxable 
income are deductible by the FSC only to the extent of the FSC's non-
foreign trade income. If the related supplier is not the manufacturer or 
producer of the export property that is sold, the related supplier's 
purchase price shall be taken into account.
    (2) Overall profit percentage limitation. Under marginal costing, 
the combined taxable income of the FSC and its related supplier may not 
exceed the overall profit percentage (determined under paragraph (c)(2) 
of this section) multiplied by the FSC's foreign trading gross receipts 
if the FSC is the principal on the sale (or the related supplier's gross 
receipts if the FSC is a commission agent) from the sale of export 
property.
    (3) Grouping of transactions. (i) In general, for purposes of this 
section, an item, product, or product line is the item or group 
consisting of the product or product line pursuant to Sec. 1.925(a)-

[[Page 116]]

1T(c)(8) used by the taxpayer for purposes of applying the full costing 
combined taxable income method of Sec. 1.925(a)-1T(c)(3) and (6).
    (ii) However, for purposes of determining the overall profit 
percentage under paragraph (c)(2) of this section, any product or 
product line grouping permissible under Sec. 1.925(a)-1T(c)(8) may be 
used at the annual choice of the FSC even though it may not be the same 
item or grouping referred to in subdivision (i) of this paragraph as 
long as the grouping chosen for determining the overall profit 
percentage is at least as broad as the grouping referred to in the above 
subdivision (i) of this paragraph. A product may be included for this 
purpose, however, in only one product group even though under the 
grouping rules it would otherwise fall in more than one group. Thus, the 
marginal costing rules will not apply with respect to any regrouping if 
the regrouping does not include any product (or products) that was 
included in the group for purposes of the full costing method.
    (4) Application of limitation on FSC income (``no loss'' rules). The 
marginal costing rules of this section will not apply if there is a 
combined loss of the related supplier and the FSC determined in 
accordance with paragraph (b)(1) of this section. In addition, for FSC 
taxable years beginning after December 31, 1986, the profit determined 
under the marginal costing method may be allowed to the FSC only to the 
extent it does not exceed the FSC's and the related supplier's full 
costing combined taxable income determined under the full costing 
combined taxable income method of Sec. 1.925(a)-1T(c)(3) and (6). This 
rule prevents pricing at a loss to the related supplier. If either of 
these ``no loss'' rules apply, the related supplier may nonetheless 
charge a transfer price or pay a commission in an amount that will allow 
the FSC to recover an amount not in excess of its full costs, if any, 
even if to do so would create or increase a loss in the related 
supplier. The effect of these no-loss rules and of the overall profit 
percentage limitation of paragraph (c)(2) of this section is that the 
FSC's profit under these marginal costing rules is limited to the lesser 
of the following:
    (i) 23% of maximum combined taxable income determined under the 
marginal costing rules,
    (ii) 23% of the overall profit percentage limitation, or
    (iii) For FSC taxable years beginning after December 31, 1986, 100% 
of the full costing combined taxable income determined under the full 
costing combined taxable income method of Sec. 1.925(a)-1T(c)(3) and 
(6).
    (c) Definitions--(1) Establishing or maintaining a foreign market. A 
FSC shall be treated for its taxable year as seeking to establish or 
maintain a foreign market with respect to sales of an item, product, or 
product line of export property from which foreign trading gross 
receipts are derived if the combined taxable income computed under 
paragraph (b) of this section is greater than the full costing combined 
taxable income computed under the full costing combined taxable income 
method of Sec. 1.925(a)-1T(c)(3) and (6).
    (2) Overall profit percentage. (i) For purposes of this section, the 
overall profit percentage for a taxable year of the FSC for a product or 
product line is the percentage which--
    (A) The combined taxable income of the FSC and its related supplier 
from the sale of export property plus all other taxable income of its 
related supplier from all sales (domestic and foreign) of such product 
or product line during the FSC's taxable year, computed under the full 
costing method, is of
    (B) The total gross receipts (determined under Sec. 1.927(b)-1T) of 
the FSC and related supplier from all sales of the product or product 
line.
    (ii) At the annual option of the related supplier, the overall 
profit percentage for the FSC's taxable year for all products and 
product lines may be determined by aggregating the amounts described in 
subdivisions (i)(A) and (B) of this paragraph of the FSC, and all 
domestic members of the controlled group (as defined in section 
927(d)(4) and Sec. 1.924(a)-1T(h)) of which the FSC is a member, for 
the FSC's taxable year and for taxable years of the members ending with 
or within the FSC's taxable year.
    (iii) For purposes of determining the amounts in subdivisions (i) 
and (ii) of

[[Page 117]]

this paragraph, a sale of property between a FSC and its related 
supplier or between domestic members of the controlled group shall be 
taken into account only during the FSC's taxable year (or taxable year 
of the member ending within the FSC's taxable year) during which the 
property is ultimately sold to a person which is not related to the FSC 
or if related, is a foreign person that is not a FSC.
    (3) Full costing method. For purposes of section 925 and this 
section, the term ``full costing combined taxable income method'' is the 
method for determining full costing combined taxable income set forth in 
Sec. 1.925(a)-1T(c)(3) and (6).
    (d) Examples. The provisions of this section may be illustrated by 
the following examples:

    Example 1. R and F are calendar year taxpayers. R, a domestic 
manufacturing company, owns all the stock of F, a FSC for the taxable 
year. During 1985, R produces and sells 100 units of export property A 
to F under a written agreement which provides that the transfer price 
between R and F shall be that price which allocates to F the maximum 
profit permitted to be received under the administrative pricing rules 
of section 925(a)(1) and (2). Thereafter, the 100 units are resold for 
export by F for $950. R's cost of goods sold attributable to the 100 
units is $650 consisting in part of $400 of direct materials and $200 of 
direct labor. R incurs selling expenses directly attributable to the 
sale in the amount of $100. Those expenses were not required to be 
incurred by F. For purposes of this example, it is assumed that R does 
not have general and administrative expenses that are not definitely 
allocable to any item of gross income. F's expenses attributable to the 
resale of the 100 units are $120. For purposes of this example, R and F 
have gross receipts of $4,000 from all domestic and foreign sales. R's 
total cost of goods sold and total expenses relating to its foreign and 
domestic sales are $2,730 and $450, respectively. Under full costing, 
the combined taxable income will be $80, computed as follows:

Combined taxable income--full costing:
  F's foreign trading gross receipts........................    $950.00
  R's cost of goods sold....................................    (650.00)
                                                             -----------
    Combined gross income...................................     300.00
                                                             -----------
  Less:
    R's direct selling expenses.............................     100.00
    F's expenses............................................     120.00
                                                             -----------
      Total.................................................    (220.00)
                                                             -----------
  Combined taxable income (loss)............................      80.00
                                                             ===========
 


F's profit under the full costing combined taxable income method is 
$18.40, i.e., 23% of full costing combined taxable income ($80). F's 
profit under the gross receipts method will be $17.39, i.e., 1.83% of 
F's foreign trading gross receipts ($950). However, under the marginal 
costing rules, F would have a profit attributable to the export sale in 
the amount of $38.24, i.e., 23% of combined taxable income as determined 
under the marginal costing rules (23% of $166.25). As shown by the 
computation below, the combined taxable income under marginal costing is 
limited to the overall profit percentage limitation ($166.25) since that 
amount is less than the maximum combined taxable income amount ($350):

Maximum combined taxable income (determined under paragraph
 (b)(1) of this section):
 
  F's foreign trading gross receipts........................    $950.00
                                                             -----------
  Less:
    R's direct materials....................................     400.00
    R's direct labor........................................     200.00
                                                             -----------
      Total.................................................    (600.00)
                                                             -----------
  Maximum combined total income.............................     350.00
                                                             ===========
 


Overall profit percentage limitation calculation
 (determined under paragraph (c)(2) of this section):
  Gross receipts of R and F from all domestic and foreign     $4,000.00
   sales...................................................
  R's cost of goods sold...................................   (2,730.00)
                                                            ------------
      Combined gross income................................    1,270.00
                                                            ------------
  Less:
    R's expenses...........................................      450.00
    F's expenses...........................................      120.00
                                                            ------------
      Total................................................     (570.00)
                                                            ------------
      Total taxable income from all sales computed on a          700.00
       full costing method.................................
                                                            ============
  Overall profit percentage (total taxable income ($700)          17.5%
   divided by total gross receipts ($4,000)................
                                                            ============
  Overall profit percentage limitation Overall profit           $166.25
   percentage times F's foreign trading gross receipts
   (17.5% times $950.00)...................................
                                                            ============
 

The transfer price from R to F may be set at $791.76, computed as 
follows:

Transfer price to F:
  F's foreign trading gross receipts.......................     $950.00
                                                            ------------
Less:
  F's expenses.............................................      120.00
  F's profit...............................................       38.24
                                                            ------------
      Total................................................     (158.24)
                                                            ------------
  Transfer price...........................................      791.76
                                                            ============
 

    Example 2. Assume the same facts as in Example 1 except that F's 
expenses are $170.

[[Page 118]]

Under full costing, the combined taxable income will be $30, computed as 
follows:

Combined taxable income--full costing:
  F's foreign trading gross receipts.........................   $950.00
  R's cost of goods sold.....................................   (650.00)
                                                              ----------
      Combined gross income..................................    300.00
                                                              ----------
Less:
  R's expenses...............................................    100.00
  F's expenses...............................................    170.00
                                                              ==========
      Total..................................................   (270.00)
                                                              ----------
      Combined taxable income (loss).........................     30.00
                                                              ----------
 


F's profit under the full costing combined taxable income method is 
$6.90, i.e., 23% of combined taxable income, $30. Under the marginal 
costing rules, F may earn a profit attributable to the export sale in 
the amount of $35.51, i.e., 23% of combined taxable income as determined 
under the marginal costing rules (23% of $154.38). Had the transaction 
occurred in 1987, F would have had a profit attributable to the export 
sale under these marginal costing rules of only $30, i.e., 23% of 
combined taxable income as determined under the marginal costing rules 
(23% of $154.38) limited, for FSC taxable years beginning after December 
31, 1986, to combined taxable income determined under full costing 
($30), see paragraph (b)(4) of this section. F's profit under the gross 
receipts method will be $17.39 i.e., 1.83% of F's foreign trading gross 
receipts ($950). The computations are as follows:

Maximum combined taxable income (determined under paragraph
 (b)(1) of this section):
  F's foreign trading gross receipts.......................     $950.00
                                                            ------------
  Less:
    R's direct materials...................................      400.00
    R's direct labor.......................................      200.00
                                                            ------------
      Total................................................     (600.00)
                                                            ------------
  Maximum combined taxable income                                350.00
                                                            ============
Overall profit percentage limitation calculation
 (determined under paragraph (c)(2) of this section):
  Gross receipts of R and F from all domestic and foreign      4,000.00
   sales...................................................
  R's cost of goods sold...................................   (2,730.00)
                                                            ------------
  Combined gross income....................................    1,270.00
                                                            ------------
  Less:
    R's expenses...........................................      450.00
    F's expenses...........................................      170.00
                                                            ------------
      Total................................................     (620.00)
                                                            ------------
  Total taxable income from all sales computed on a full         650.00
   costing method..........................................
                                                            ============
Overall profit percentage (total taxable income ($650)           16.25%
 divided by total gross receipts ($4,000)).................
                                                            ============
Overall profit percentage limitation Overall profit              154.38
 percentage times F's foreign trading gross receipts
 (16.25% times $950.00)....................................
                                                            ============
The transfer price from R to F may be set at $744.49,
 computed as follows:
 
  Transfer price to F:
    F's foreign trading gross receipts.....................      950.00
                                                            ------------
    Less:
      F's expenses.........................................      170.00
      F's profit...........................................       35.51
                                                            ------------
        Total..............................................     (205.51)
                                                            ------------
    Transfer price.........................................      744.49
                                                            ============
 

    Example 3. Assume the same facts as in Example 1 except that the 
transaction occurs in 1987 and that F incurs expenses in the amount of 
$250. Since a $50 combined loss, as computed below, is incurred, F will 
not have any profit under either the full costing combined taxable 
income method, the gross receipts method or the marginal costing rules:

  Combined taxable income--full costing:
    F's foreign trading gross receipts.....................     $950.00
    R's cost of goods sold.................................     (650.00)
                                                            ------------
      Combined gross income................................      300.00
                                                            ------------
    Less:
      R's expenses.........................................      100.00
      F's expenses.........................................      250.00
                                                            ------------
        Total..............................................     (350.00)
                                                            ------------
    Combined taxable income (loss).........................      (50.00)
                                                            ============
 


The transfer price to R may be set at $700 so that F may recover its 
expenses.
    Example 4. R and F are calendar year taxpayers. R, a domestic 
manufacturing company, owns all the stock of F, a FSC for the taxable 
year. During 1985, R manufactures export property A. R enters into a 
written agreement with F whereby F will receive a commission with 
respect to sales of export property A by R which result in gross 
receipts to R which would have been foreign trading gross receipts had F 
and not R been the principal on the sale. F will receive commissions 
with respect to such export sales equal to the maximum amount permitted 
to be received under the transfer pricing rules of section 925. The 
maximum commission may be earned by F under these marginal costing 
rules. In this example, R received $950 from the sale of export property 
A. R's cost of goods sold for that property was $620. R incurred direct 
selling expenses of $20. Also, it is assumed that R incurred total 
general and administrative expenses, in addition to those incurred 
relating to its contract to perform on behalf of F the functions and 
activities of section 924 (c), (d) and (e), of $50. R incurred direct 
and indirect expenses of $130 in performing those functions and 
activities on behalf of F. During 1985, R had

[[Page 119]]

gross receipts from all domestic and foreign sales of $3,500, total cost 
of goods sold and total expenses relating to the domestic and foreign 
sales of $1,600 and $259, respectively. The election provided for in 
Sec. 1.925(a)-1T(b)(2)(ii) was not made by R and F.

  Combined taxable income--full costing:
    R's gross receipts from the sale of the export  .......     $950.00
     property.....................................
    R's cost of goods sold........................  .......     (620.00)
                                                   ---------------------
      Combined gross income.......................  .......      330.00
                                                   ---------------------
    Less:
      R's direct selling expenses.................  .......       20.00
      F's expenses................................  .......      130.00
    Apportionment of R's general and
     administrative expenses:
      R's total G/A expenses......................      $50
      Combined gross income.......................      330
      R's total gross income......................    1,900
      Apportionment of G/A expenses $50 x $330/     .......        8.68
       $1,900.....................................
                                                            ------------
        Total.....................................  .......     (158.68)
                                                            ------------
    Combined taxable income (loss)................  .......      171.32
                                                            ============
 


Maximum combined taxable income (determined under paragraph
 (b)(1) of this section):
  R's gross receipts from the sale of the export property..     $950.00
                                                            ------------
  Less:
    R's direct materials...................................      450.00
    R's direct labor.......................................      100.00
                                                            ------------
      Total................................................     (550.00)
                                                            ------------
  Maximum combined taxable income..........................      400.00
                                                            ============
Overall profit percentage limitation calculation
 (determined under paragraph (c)(2) of this section):
  Gross receipts of R from all domestic and foreign sales..    3,500.00
  R's cost of goods sold...................................   (1,600.00)
                                                            ------------
    Combined gross income..................................    1,900.00
                                                            ------------
  Less:
    R's total expenses.....................................      259.00
    F's total expenses.....................................      130.00
                                                            ------------
      Total................................................     (450.00)
                                                            ------------
  Total taxable income from all sales computed on a full       1,511.00
   costing method..........................................
                                                            ============
Overall profit percentage (total taxable income ($1,511)         43.17%
 divided by total gross receipts ($3,500)).................
                                                            ============
Overall profit percentage limitation Overall profit              410.12
 percentage times R's gross receipts from the sale of
 export property (i.e., 43.17% times $950.00)..............
                                                            ============
 


Since the overall profit percentage limitation ($410.12) is greater than 
the maximum combined taxable income ($400), combined taxable income 
under marginal costing and for purposes of computing F's commission is 
limited to $400. Under these marginal costing rules, F will have a 
profit attributable to the sale of $92, i.e., 23% of combined taxable 
income as determined under the marginal costing rules (23% of $400). 
Accordingly, the commission F receives from R is $222, i.e., F's 
expenses ($130) plus F's profit ($92).
    Example 5. Assume the same facts as in Example 4, except that R's 
gross receipts from the sale of export property which would have been 
foreign trading gross receipts had F been the principal on the sale are 
$1,050 and gross receipts from all sales, domestic and foreign, remain 
at $3,500. For purposes of applying the combined taxable income method, 
R and F may compute their combined taxable income attributable to the 
product line of export property under the marginal costing rules as 
follows:

  Combined taxable income--full costing:
  R's gross receipts from the sale of the export property..   $1,050.00
  R's cost of goods sold...................................     (620.00)
                                                            ------------
    Combined gross income..................................      430.00
                                                            ------------
  Less:
    R's direct selling expenses............................       20.00
    F's expenses...........................................      130.00
    Apportionment of R's G/A expenses $50 x $430/$1,900....       11.32
                                                            ------------
      Total................................................     (161.32)
                                                            ------------
  Combined taxable income (loss)...........................      268.68
                                                            ============
 


Maximum combined taxable income (determined under
 paragraph (b)(1) of this section):
  R's gross receipts from the sale of export property...   $1,050.00
                                                         ---------------
Less:
  R's direct materials..................................      450.00
  R's direct labor......................................      100.00
                                                         ---------------
      Total.............................................     (550.00)
                                                         ---------------
  Maximum combined taxable income.......................      500.00
                                                         ===============
  Overall profit percentage (see example 4).............       43.17%
                                                         ===============
  Overall profit percentage limitation (determined under      453.29
   paragraph (c)(2) of this section) (R's gross receipts
   from sale ($1,050.00) times the overall profit
   percentage (43.17%)).................................
                                                         ===============
 


Since maximum combined taxable income ($500) is greater than the overall 
profit percentage limitation ($453.29), combined taxable income under 
marginal costing and for purposes of computing F's commission is limited 
to $453.29. Under these marginal costing rules, F will have a profit 
attributable to

[[Page 120]]

the sales of $104.26, i.e., 23% of combined taxable income (23% of 
$453.29). Accordingly, the commission F receives from R is $234.26, 
i.e., F's expenses ($130) plus F's profit ($104.26).
    Example 6. Assume the same facts as in Example 5, except that F has 
expenses of $140 and R's cost of goods sold for the export sale was 
$900. R does not incur any direct selling expenses. Since cost of goods 
sold has increased by $280, R's total gross income has been reduced from 
$1,900 to $1,620. For purposes of applying the combined taxable income 
method, R and F may compute their combined taxable income under the 
marginal costing rules as follows:

Combined taxable income--full costing:
  R's gross receipts from the sale of export property.....   $1,050.00
  R's cost of goods sold..................................     (900.00)
                                                           -------------
    Combined gross income.................................      150.00
                                                           -------------
Less:
  F's expenses............................................      140.00
  Apportionment of R's G/A expenses $50 x $150/$1,620.....        4.63
                                                           -------------
      Total...............................................     (144.63)
                                                           -------------
  Combined taxable income (loss)..........................        5.37
                                                           =============
Maximum combined taxable income (determined under
 paragraph (b)(1) of this section):
  R's gross receipts from the sale of export property.....   $1,050.00
                                                           -------------
Less:
  R's direct materials....................................      630.00
  R's direct labor........................................      200.00
                                                           -------------
      Total...............................................     (830.00)
                                                           -------------
  Maximum combined taxable income.........................      220.00
                                                           =============
 


Overall profit percentage limitation calculation
 (determined under paragraph (c)(2) of this section):
  Gross receipts of R and F from all domestic and foreign    $3,500.00
   sales..................................................
  R's cost of goods sold..................................   (1,880.00)
                                                           -------------
      Combined gross income...............................    1,620.000
                                                           -------------
Less:
  R's total expenses......................................      259.00
  F's total expenses......................................      140.00
                                                           -------------
      Total...............................................     (399.00)
                                                           -------------
  Total taxable income from all sales computed on a full     $1,221.00
   costing method.........................................
                                                           -------------
  Overall profit percentage (total taxable income ($1,221)       34.89%
   divided by total gross receipts ($3,500))..............
                                                           =============
  Overall profit percentage limitation--overall profit         $366.35
   percentage times R's gross receipts from the sale of
   export property (i.e., 34.89% times $1,050)............
                                                           =============
 


Since the overall profit percentage limitation ($366.35) is greater than 
the maximum combined taxable income ($220), combined taxable income 
under marginal costing and for purposes of computing F's commission is 
limited to $220. Under these marginal costing rules, F will have a 
profit attributable to the sale of $50.60, i.e., 23% of combined taxable 
income as determined under the marginal costing rules (23% of $220). If 
the transaction occurred in 1987, F's profit would be limited, however, 
by paragraph (b)(4) of this section to the full costing combined taxable 
income of $5.37.

[T.D. 8126, 52 FR 6455, Mar. 3, 1987, as amended by T.D. 8764, 63 FR 
10306, Mar. 3, 1998; T.D. 8944, 66 FR 13429, Mar. 6, 2001]



Sec. 1.926(a)-1  Distributions to shareholders.

    (a) Treatment of distributions. [Reserved]. For guidance, see Sec. 
1.926(a)-1T(a).
    (b) Order of distribution--(1) In general--(i) Distributions by a 
FSC received by a shareholder in a taxable year of the shareholder 
beginning before January 1, 1990. Any actual distribution to a 
shareholder by a FSC (all references to a FSC in this section shall 
include a small FSC and a former FSC) that is received by the 
shareholder in a taxable year of the shareholder beginning before 
January 1, 1990, and made out of earnings and profits shall be treated 
as made in the following order, to the extent thereof--
    (A) Out of earnings and profits attributable to exempt foreign trade 
income determined solely because of operation of section 923(a)(4),
    (B) Out of earnings and profits attributable to other exempt foreign 
trade income,
    (C) Out of earnings and profits attributable to non-exempt foreign 
trade income determined under either of the administrative pricing 
methods of section 925(a)(1) or (2),
    (D) Out of earnings and profits attributable to section 923(a)(2) 
non-exempt income, and
    (E) Out of other earnings and profits.
    (ii) Distributions by a FSC received by a shareholder in a taxable 
year of the shareholder beginning after December 31, 1989. Any actual 
distribution to a shareholder by a FSC that is received by the 
shareholder in a taxable year beginning after December 31, 1989, and

[[Page 121]]

that is made out of earnings and profits shall be treated as made in the 
following order, to the extent thereof--
    (A) Out of earnings and profits attributable to exempt foreign trade 
income determined solely because of the operation of section 923(a)(4),
    (B) Out of earnings and profits attributable to foreign trade income 
(other than exempt foreign trade income determined solely because of the 
operation of section 923(a)(4)) allocable to the marketing of 
agricultural or horticultural products (or the providing of related 
services) by a qualified cooperative which is a shareholder of the FSC,
    (C) Out of earnings and profits attributable to non-exempt foreign 
trade income and other exempt foreign trade income determined under 
either of the administrative pricing methods of section 925(a)(1) and 
(2). Distributions out of this classification will be made on a pro rata 
basis so that 15/23 (16/23 with regard to distribution to a non-
corporate shareholder) of each distribution will be out of earnings and 
profits attributable to exempt foreign trade income and the remainder 
will be out of earnings and profits attributable to non-exempt foreign 
trade income. To the extent the distributions are out of earnings and 
profits attributable to the disposition of, or services related to, 
military property, 7.5/23 (8/23 with regard to distributions to a non-
corporate shareholder) of each distribution will be out of earnings and 
profits attributable to exempt foreign trade income and the remainder 
will be out of earnings and profits attributable to non-exempt foreign 
trade income,
    (D) Out of earnings and profits attributable to other exempt foreign 
trade income determined under the transfer pricing method of section 
925(a)(3),
    (E) Out of earnings and profits attributable to section 923(a)(2) 
non-exempt income,
    (F) Out of earnings and profits attributable to effectively 
connected income, as defined in section 245(c)(4)(B), and
    (G) Out of other earnings and profits.
    (2) Determination of earnings and profits. [Reserved]. For guidance, 
see Sec. 1.926(a)-1T(b)(1).
    (c) Definition of ``former FSC''. [Reserved]. For guidance, see 
Sec. 1.926(a)-1T(c).
    (d) Personal holding company income. [Reserved]. For guidance, see 
Sec. 1.926(a)-1T(d).
    (e) Sale of stock if section 1248 applies. [Reserved]. For guidance, 
see Sec. 1.926(a)-1T(e).

[T.D. 8340, 56 FR 11093, Mar. 15, 1991]



Sec. 1.926(a)-1T  Temporary regulations; distributions to shareholders.

    (a) Treatment of distributions. Any distribution by a FSC (or former 
FSC) to its shareholder with respect to its stock will be includible in 
the shareholder's gross income in accordance with the provisions of 
section 301. (Any further reference to a FSC in this section shall 
include a small FSC unless indicated otherwise.) See section 245(c) for 
treatment of distributions to domestic corporate shareholders of the 
FSC. If earnings and profits of a FSC (or former FSC) attributable to 
foreign trade income are distributed to a shareholder which is a foreign 
person (or a nonresident alien individual), that distribution shall be 
treated as United States source income which is effectively connected 
with the conduct of a trade or business conducted through a permanent 
establishment of such shareholder within the United States. For this 
purpose, distributions to a foreign partnership, foreign trust, foreign 
estate or other foreign entities that would be treated as pass-through 
entities under U.S. law shall be treated as made directly to the 
partners of beneficiaries in proportion to their respective interest in 
the entity.
    (b) Order of distributions--(1) In general. For guidance, see Sec. 
1.926(a)-1(b)(1).
    (2) Determination of earnings and profits. For purposes of this 
section, the earnings and profits of a FSC (or former FSC) shall be the 
earnings and profits computed in accordance with the rules, where 
applicable, prescribed in Sec. 1.964-1 (relating to determination of 
the earnings and profits of a foreign corporation) other than 
subsections (d) and (e) of that section.
    (c) Definition of ``former FSC''. Under section 926(c), the term 
``former FSC'' refers to a corporation which is not a FSC for a taxable 
year but which was a

[[Page 122]]

FSC for a prior taxable year. However, a corporation is not a former FSC 
for a taxable year unless such corporation has, at the beginning of such 
taxable year, earnings and profits attributable to foreign trade income. 
A corporation which is a former FSC for a taxable year is a former FSC 
for all purposes of the Code.
    (d) Personal holding company income--(1) Treatment of dividends. Any 
amount includible in a shareholder's gross income as a dividend with 
respect to the stock of a FSC (or former FSC) under paragraph (a) of 
this section shall be treated as a dividend for all purposes of the 
Code, except that that part of the dividend attributable to foreign 
trade income, other than an amount attributable to section 923(a)(2) 
non-exempt income, shall not be considered in applying the personal 
holding company and foreign personal holding company provisions 
(sections 541 through 547 and 551 through 558, respectively).
    (2) Look through option. With regard to distributions from a FSC (or 
former FSC) which are not treated as personal holding company income 
under paragraph (d)(1) of this section, the shareholder may, however, 
treat any amount of that distribution as an item of income described 
under section 543 (or section 553) (for example, rents) if it 
establishes to the satisfaction of the Commissioner that such amount is 
attributable to earnings and profits of the FSC derived from such item 
of income. For example, distributions from a FSC relating to section 
923(a)(2) non-exempt income will be treated as dividends for purposes of 
the personal holding company provisions of sections 541 through 547 
unless the look through option is elected. Under this option, if 
earnings and profits out of which those distributions are made are 
attributable to the lease of export property, the FSC shareholder may 
treat the distribution for purposes of the personal holding company 
provisions as rents rather than as dividends. This may be beneficial to 
the shareholder because rents are not considered under section 543(a)(2) 
as personal holding company income, if in general, rents constitute 50% 
or more of the shareholder's adjusted ordinary gross income.
    (e) Sale of stock if section 1248 applies. For purposes of section 
1248, the earnings and profits of a FSC (or former FSC) shall not 
include earnings and profits attributable to foreign trade income.

[T.D. 8126, 52 FR 6458, Mar. 3, 1987, as amended by T.D. 8340, 56 FR 
11093, Mar. 15, 1991]



Sec. 1.927(a)-1T  Temporary regulations; definition of export property.

    (a) General rule. Under section 927(a), except as otherwise provided 
with respect to excluded property in paragraphs (f), (g) and (h) of this 
section and with respect to certain short supply property in paragraph 
(i) of this section, export property is property in the hands of any 
person (whether or not a FSC) (any further reference to a FSC in this 
section shall include a small FSC unless indicated otherwise)--
    (1) U.S. manufactured, produced, grown or extracted. Manufactured, 
produced, grown, or extracted in the United States by any person or 
persons other than a FSC (see paragraph (c) of this section),
    (2) Foreign use, consumption or disposition. Held primarily for 
sale, lease or rental in the ordinary course of a trade or business by a 
FSC to a FSC or to any other person for direct use, consumption, or 
disposition outside the United States (see paragraph (d) of this 
section),
    (3) Foreign content. Not more than 50 percent of the fair market 
value of which is attributable to articles imported into the United 
States (see paragraph (e) of this section), and
    (4) Non-related FSC purchaser or user. Which is not sold, leased or 
rented by a FSC, or with a FSC as commission agent, to another FSC which 
is a member of the same controlled group (as defined in section 
927(d)(4) and Sec. 1.924(a)-1T(h)) as the FSC.
    (b) Services. For purposes of this section, services (including the 
written communication of services in any form) are not export property. 
Whether an item is property or services shall be determined on the basis 
of the facts and circumstances attending the development and disposition 
of the item. Thus, for example, the preparation of a map of a particular 
construction site

[[Page 123]]

would constitute services and not export property, but standard maps 
prepared for sale to customers generally would not constitute services 
and would be export property if the requirements of this section were 
otherwise met.
    (c) Manufacture, production, growth, or extraction of property--(1) 
By a person other than a FSC. Export property may be manufactured, 
produced, grown, or extracted in the United States by any person, 
provided that that person does not qualify as a FSC. Property held by a 
FSC which was manufactured, produced, grown or extracted by it at a time 
when it did not qualify as a FSC is not export property of the FSC. 
Property which sustains further manufacture, production or processing 
outside the United States prior to sale or lease by a person but after 
manufacture, production, processing or extraction in the United States 
will be considered as manufactured, produced, grown or extracted in the 
United States by that person only if the property is reimported into the 
United States for further manufacturing, production or processing prior 
to final export sale. In order to be considered export property, the 
property manufactured, produced, grown or extracted in the United States 
must satisfy all of the provisions of section 927(a) and this section.
    (2) Manufactured, produced or processed. For purposes of this 
section, property which is sold or leased by a person is considered to 
be manufactured, produced or processed by that person or by another 
person pursuant to a contract with that person if the property is 
manufactured or produced, as defined in Sec. 1.954-3(a)(4). For 
purposes of this section, however, in determining if the 20% conversion 
test of Sec. 1.954-3(a)(4)(iii) has been met, conversion costs include 
assembly and packaging costs but do not include the value of parts 
provided pursuant to a services contract as described in Sec. 1.924(a)-
1T(d)(3). In addition, for purposes of this section, the 20% conversion 
test is extended and applied to the export property's adjusted basis 
rather than to its cost of goods sold if it is leased or held for lease.
    (d) Foreign use, consumption or disposition--(1) In general. (i) 
Under paragraph (a)(2) of this section, export property must be held 
primarily for the purpose of sale, lease or rental in the ordinary 
course of a trade or business, by a FSC to a FSC or to any other person, 
and the sale or lease must be for direct use, consumption, or 
disposition outside the United States. Thus, property cannot qualify as 
export property unless it is sold or leased for direct use, consumption, 
or disposition outside the United States. Property is sold or leased for 
direct use, consumption, or disposition outside the United States if the 
sale or lease satisfies the destination test described in subdivision 
(2) of this paragraph, the proof of compliance requirements described in 
subdivision (3) of this paragraph, and the use outside the United States 
test described in subdivision (4) of this paragraph.
    (ii) Factors not taken into account. In determining whether property 
which is sold or leased to a FSC is sold or leased for direct use, 
consumption, or disposition outside the United States, the fact that the 
acquiring FSC holds the property in inventory or for lease prior to the 
time it sells or leases it for direct use, consumption, or disposition 
outside the United States will not affect the characterization of the 
property as export property. Fungible export property must be physically 
segregated from non-export property at all times after purchase by or 
rental by a FSC or after the start of the commission relationship 
between the FSC and related supplier with regard to the export property. 
Non-fungible export property need not be physically segregated from non-
export property.
    (2) Destination test. (i) For purposes of paragraph (d)(1) of this 
section, the destination test of this paragraph is satisfied with 
respect to property sold or leased by a seller or lessor only if it is 
delivered by the seller or lessor (or an agent of the seller or lessor) 
regardless of the F.O.B. point or the place at which title passes or 
risk of loss shifts from the seller or lessor--
    (A) Within the United States to a carrier or freight forwarder for 
ultimate delivery outside the United States to a purchaser or lessee (or 
to a subsequent purchaser or sublessee),

[[Page 124]]

    (B) Within the United States to a purchaser or lessee, if the 
property is ultimately delivered outside the United States (including 
delivery to a carrier or freight forwarder for delivery outside the 
United States) by the purchaser or lessee (or a subsequent purchaser or 
sublessee) within 1 year after the sale or lease,
    (C) Within or outside the United States to a purchaser or lessee 
which, at the time of the sale or lease, is a FSC or an interest charge 
DISC and is not a member of the same controlled group as the seller or 
lessor,
    (D) From the United States to the purchaser or lessee (or a 
subsequent purchaser or sublessee) at a point outside the United States 
by means of the seller's or lessor's own ship, aircraft, or other 
delivery vehicle, owned, leased, or chartered by the seller or lessor,
    (E) Outside the United States to a purchaser or lessee from a 
warehouse, storage facility, or assembly site located outside the United 
States, if the property was previously shipped by the seller or lessor 
from the United States, or
    (F) Outside the United States to a purchaser or lessee if the 
property was previously shipped by the seller or lessor from the United 
States and if the property is located outside the United States pursuant 
to a prior lease by the seller or lessor, and either (1) the prior lease 
terminated at the expiration of its term (or by the action of the prior 
lessee acting alone), (2) the sale occurred or the term of the 
subsequent lease began after the time at which the term of the prior 
lease would have expired, or (3) the lessee under the subsequent lease 
is not a related person with respect to the lessor and the prior lease 
was terminated by the action of the lessor (acting alone or together 
with the lessee).
    (ii) For purposes of this paragraph (d)(2) (other than paragraphs 
(d)(2)(i)(C) and (F)(3)), any relationship between the seller or lessor 
and any purchaser, subsequent purchaser, lessee, or sublessee is 
immaterial.
    (iii) In no event is the destination test of this paragraph (d)(2) 
satisfied with respect to property which is subject to any use (other 
than a resale or sublease), manufacture, assembly, or other processing 
(other than packaging) by any person between the time of the sale or 
lease by such seller or lessor and the delivery or ultimate delivery 
outside the United States described in this paragraph (d)(2).
    (iv) If property is located outside the United States at the time it 
is purchased by a person or leased by a person as lessee, such property 
may be export property in the hands of such purchaser or lessee only if 
it is imported into the United States prior to its further sale or lease 
(including a sublease) outside the United States. Paragraphs (a)(3) and 
(e) of this section (relating to the 50 percent foreign content test) 
are applicable in determining whether such property is export property. 
Thus, for example, if such property is not subjected to manufacturing or 
production (as defined in paragraph (c) of this section) within the 
United States after such importation, it does not qualify as export 
property.
    (3) Proof of compliance with destination test--(i) Delivery outside 
the United States. For purposes of paragraph (d)(2) of this section 
(other than subdivision (i)(C) thereof), a seller or lessor shall 
establish ultimate delivery, use, or consumption of property outside the 
United States by providing--
    (A) A facsimile or carbon copy of the export bill of lading issued 
by the carrier who delivers the property,
    (B) A certificate of an agent or representative of the carrier 
disclosing delivery of the property outside the United States,
    (C) A facsimile or carbon copy of the certificate of lading for the 
property executed by a customs officer of the country to which the 
property is delivered,
    (D) If that country has no customs administration, a written 
statement by the person to whom delivery outside the United States was 
made,
    (E) A facsimile or carbon copy of the Shipper's Export Declaration, 
a monthly shipper's summary declaration filed with the Bureau of 
Customs, or a magnetic tape filed in lieu of the Shipper's Export 
Declaration, covering the property, or
    (F) Any other proof (including evidence as to the nature of the 
property

[[Page 125]]

or the nature of the property or the nature of the transaction) which 
establishes to the satisfaction of the Commissioner that the property 
was ultimately delivered, or directly sold, or directly consumed outside 
the United States within 1 year after the sale or lease.
    (ii) The requirements of subdivision (i)(A), (B), (C), or (E) of 
this paragraph will be considered satisfied even though the name of the 
ultimate consignee and the price paid for the goods is marked out 
provided that, in the case of a Shipper's Export Declaration or other 
document listed in subdivision (i)(E) of this paragraph or a document 
such as an export bill of lading, such document still indicates the 
country in which delivery to the ultimate consignee is to be made and, 
in the case of a certificate of an agent or representative of the 
carrier, that the document indicates that the property was delivered 
outside the United States.
    (iii) A seller or lessor shall also establish the meeting of the 
requirement of paragraph (d)(2)(i) of this section (other than 
subdivision (i)(C) thereof), that the property was delivered outside the 
United States without further use, manufacture, assembly, or other 
processing within the United States.
    (iv) For purposes of paragraph (d)(2)(i)(C) of this section, a 
purchaser or lessee of property is deemed to qualify as a FSC or an 
interest charge DISC for its taxable year if the seller or lessor 
obtains from the purchaser or lessee a copy of the purchaser's or 
lessee's election to be treated as a FSC or interest charge DISC 
together with the purchaser's or lessee's sworn statement that the 
election has been timely filed with the Internal Revenue Service Center. 
The copy of the election and the sworn statement of the purchaser or 
lessee must be received by the seller or lessor within 6 months after 
the sale or lease. A purchaser or lessee is not treated as a FSC or 
interest charge DISC with respect to a sale or lease during a taxable 
year for which the purchaser or lessee does not qualify as a FSC or 
interest charge DISC if the seller or lessor does not believe or if a 
reasonable person would not believe at the time the sale or lease is 
made that the purchaser or lessee will qualify as a FSC or interest 
charge DISC for the taxable year.
    (v) If a seller or lessor fails to provide proof of compliance with 
the destination test as required by this paragraph (d)(3), the property 
sold or leased is not export property.
    (4) Sales and leases of property for ultimate use in the United 
States--(i) In general. For purposes of paragraph (d)(1) of this 
section, the use test in this paragraph (d)(4) is satisfied with respect 
to property which--
    (A) Under subdivision (4)(ii) through (iv) of this paragraph is not 
sold for ultimate use in the United States, or
    (B) Under subdivision (4)(v) of this paragraph is leased for 
ultimate use outside the United States.
    (ii) Sales of property for ultimate use in the United States. For 
purposes of subdivision (4)(i) of this paragraph, a purchaser of 
property (including components, as defined in subdivision (4)(vii) of 
this paragraph) is deemed to use the property ultimately in the United 
States if any of the following conditions exist:
    (A) The purchaser is a related party with respect to the seller and 
the purchaser ultimately uses the property, or a second product into 
which the property is incorporated as a component, in the United States.
    (B) At the time of the sale, there is an agreement or understanding 
that the property, or a second product into which the property is 
incorporated as a component, will be ultimately used by the purchaser in 
the United States.
    (C) At the time of the sale, a reasonable person would have believed 
that the property or the second product would be ultimately used by the 
purchaser in the United States unless, in the case of a sale of 
components, the fair market value of the components at the time of 
delivery to the purchaser constitutes less than 20 percent of the fair 
market value of the second product into which the components are 
incorporated (determined at the time of completion of the production, 
manufacture, or assembly of the second product).


For purposes of subdivision (4)(ii)(B) of this paragraph, there is an 
agreement or understanding that property will ultimately be used in the 
United States

[[Page 126]]

if, for example, a component is sold abroad under an express agreement 
with the foreign purchaser that the component is to be incorporated into 
a product to be sold back to the United States. As a further example, 
there would also be such an agreement or understanding if the foreign 
purchaser indicated at the time of the sale or previously that the 
component is to be incorporated into a product which is designed 
principally for the United States market. However, such an agreement or 
understanding does not result from the mere fact that a second product, 
into which components exported from the United States have been 
incorporated and which is sold on the world market, is sold in 
substantial quantities in the United States.
    (iii) Use in the United States. For purposes of subdivision (4)(ii) 
of this paragraph, property (including components incorporated into a 
second product) is or would be ultimately used in the United States by 
the purchaser if, at any time within 3 years after the purchase of such 
property or components, either the property is or the components (or the 
second product into which the components are incorporated) are resold by 
the purchaser for use by a subsequent purchaser within the United States 
or the purchaser or subsequent purchaser fails, for any period of 365 
consecutive days, to use the property or second product predominantly 
outside the United States (as defined in subdivision (4)(vi) of this 
paragraph).
    (iv) Sales to retailers. For purposes of subdivision (4)(ii)(C) of 
this paragraph, property sold to any person whose principal business 
consists of selling from inventory to retail customers at retail outlets 
outside the United States will be considered to be used predominantly 
outside the United States.
    (v) Leases of property for ultimate use outside the United States. 
For purposes of subdivision (4)(i) of this paragraph, a lessee of 
property is deemed to use property ultimately outside the United States 
during a taxable year of the lessor if the property is used 
predominantly outside the United States (as defined in subdivision 
(4)(vi) of this paragraph) by the lessee during the portion of the 
lessor's taxable year which is included within the term of the lease. A 
determination as to whether the ultimate use of leased property 
satisfies the requirements of this subdivision is made for each taxable 
year of the lessor. Thus, leased property may be used predominantly 
outside the United States for a taxable year of the lessor (and thus, 
constitute export property if the remaining requirements of this section 
are met) even if the property is not used predominantly outside the 
United States in earlier taxable years or later taxable years of the 
lessor.
    (vi) Predominant use outside the United States. For purposes of this 
paragraph (d)(4), property is used predominantly outside the United 
States for any period if, during that period, the property is located 
outside the United States more than 50 percent of the time. An aircraft, 
railroad rolling stock, vessel, motor vehicle, container, or other 
property used for transportation purposes is deemed to be used 
predominantly outside the United States for any period if, during that 
period, either the property is located outside the United States more 
than 50 percent of the time or more than 50 percent of the miles 
traversed in the use of the property are traversed outside the United 
States. However, property is deemed to be within the United States at 
all times during which it is engaged in transport between any two points 
within the United States, except where the transport constitutes 
uninterrupted international air transportation within the meaning of 
section 4262(c)(3) and the regulations under that section (relating to 
tax on air transportation of persons). An orbiting satellite is deemed 
to be located outside the United States. For purposes of applying 
section 4262(c)(3) to this subdivision, the term ``United States'' 
includes the Commonwealth of Puerto Rico.
    (vii) Component. For purposes of this paragraph (d)(4), a component 
is property which is (or is reasonably expected to be) incorporated into 
a second product by the purchaser of such component by means of 
production, manufacture, or assembly.
    (e) Foreign content of property--(1) The 50 percent test. Under 
paragraph (a)(3) of

[[Page 127]]

this section, no more than 50 percent of the fair market value of export 
property may be attributable to the fair market value of articles which 
were imported into the United States. For purposes of this paragraph 
(e), articles imported into the United States are referred to as 
``foreign content.'' The fair market value of the foreign content of 
export property is computed in accordance with paragraph (e)(4) of this 
section. The fair market value of export property which is sold to a 
person who is not a related person with respect to the seller is the 
sale price for such property (not including interest, finance or 
carrying charges, or similar charges.)
    (2) Application of 50 percent test. The 50 percent test is applied 
on an item-by-item basis. If, however, a person sells or leases a large 
volume of substantially identical export property in a taxable year and 
if all of that property contains substantially identical foreign content 
in substantially the same proportion, the person may determine the 
portion of foreign content contained in that property on an aggregate 
basis.
    (3) Parts and services. If, at the time property is sold or leased 
the seller or lessor agrees to furnish parts pursuant to a services 
contract (as provided in Sec. 1.924(a)-1T(d)(3)) and the price for the 
parts is not separately stated, the 50 percent test is applied on an 
aggregate basis to the property and parts. If the price for the parts is 
separately stated, the 50 percent test is applied separately to the 
property and to the parts.
    (4) Computation of foreign content--(i) Valuation. For purposes of 
applying the 50 percent test, it is necessary to determine the fair 
market value of all articles which constitutes foreign content of the 
property being tested to determine if it is export property. The fair 
market value of the imported articles is determined as of the time the 
articles are imported into the United States.
    (A) General rule. Except as provided in paragraph (e)(4)(i)(B), the 
fair market value of the imported articles which constitutes foreign 
content is their appraised value, as determined under section 403 of the 
Tariff Act of 1930 (19 U.S.C. 1401a) in connection with their 
importation. The appraised value of the articles is the full dutiable 
value of the articles, determined, however, without regard to any 
special provision in the United States tariff laws which would result in 
a lower dutiable value.
    (B) Special election. If all or a portion of the imported article 
was originally manufactured, produced, grown, or extracted in the United 
States, the taxpayer may elect to determine the fair market value of the 
imported articles which constitutes foreign content under the provisions 
of this paragraph (e)(4)(i)(B) if the property is subjected to 
manufacturing or production (as defined in paragraph (c) of this 
section) within the United States after importation. A taxpayer making 
the election under this paragraph may determine the fair market value of 
the imported articles which constitutes foreign content to be the fair 
market value of the imported articles reduced by the fair market value 
at the time of the initial export of the portion of the property that 
was manufactured, produced, grown, or extracted in the United States. 
The taxpayer must establish the fair market value of the imported 
articles and of the portion of the property manufactured, produced, 
grown, or extracted in the United States at the time of the initial 
export in accordance with subdivision (4)(ii)(B) of this paragraph.
    (ii) Evidence of fair market value--(A) General rule. For purposes 
of subdivision (4)(i)(A) of this paragraph, the fair market value of the 
imported articles is their appraised value, which may be evidenced by 
the customs invoice issued on the importation of such articles into the 
United States. If the holder of the articles is not the importer (or a 
related person with respect to the importer), the appraised value of the 
articles may be evidenced by a certificate based upon information 
contained in the customs invoice and furnished to the holder by the 
person from whom the articles (or property incorporating the articles) 
were purchased. If a customs invoice or certificate described in the 
preceding sentences is not available to a person purchasing property, 
the person shall establish that no more than 50 percent of the fair 
market value of such property is attributable

[[Page 128]]

to the fair market value of articles which were imported into the United 
States.
    (B) Special election. For purposes of the special election set forth 
in subdivision (4)(i)(B) of this paragraph, if the initial export is 
made to a controlled person within the meaning of section 482, the fair 
market value of the imported articles and of the portion of the articles 
that are manufactured, produced, grown, or extracted within the United 
States shall be established by the taxpayer in accordance with the rules 
under section 482 and the regulations under that section. If the initial 
export is not made to a controlled person, the fair market value must be 
established by the taxpayer under the facts and circumstances.
    (iii) Interchangeable component articles. (A) If identical or 
similar component articles can be incorporated interchangeably into 
property and a person acquires component articles that are imported into 
the United States and other component articles that are not imported 
into the United States, the determination whether imported component 
articles were incorporated in the property that is exported from the 
United States shall be made on a substitution basis as in the case of 
the rules relating to drawback accounts under the customs laws. See 
section 313(b) of the Tariff Act of 1930, as amended (19 U.S.C. 
1313(b)).
    (B) The provisions of subdivision (4)(iii)(A) of this paragraph may 
be illustrated by the following example:

    Example. Assume that a manufacturer produces a total of 20,000 
electronic devices. The manufacturer exports 5,000 of the devices and 
subsequently sells 11,000 of the devices to a FSC which exports the 
11,000 devices. The major single component article in each device is a 
tube which represents 60 percent of the fair market value of the device 
at the time the device is sold by the manufacturer. The manufacturer 
imports 8,000 of the tubes and produces the remaining 12,000 tubes. For 
purposes of this subdivision, in accordance with the substitution 
principle used in the customs drawback laws, the 5,000 devices exported 
by the manufacturer are each treated as containing an imported tube 
because the devices were exported prior to the sale to the FSC. The 
remaining 3,000 imported tubes are treated as being contained in the 
first 3,000 devices purchased and exported by the FSC. Thus, since the 
50 percent test is not met with respect to the first 3,000 devices 
purchased and exported by the FSC, those devices are not export 
property. The remaining 8,000 devices purchased and exported by the FSC 
are treated as containing tubes produced in the United States, and those 
devices are export property (if they otherwise meet the requirements of 
this section).

    (f) Excluded property--(1) In general. Notwithstanding any other 
provision of this section, the following property is not export 
property--
    (i) Property described in subdivision (2) of this paragraph 
(relating to property leased to a member of controlled group),
    (ii) Property described in subdivision (3) of this paragraph 
(relating to certain types of intangible property),
    (iii) Products described in paragraph (g) of this section (relating 
to oil and gas products), and
    (iv) Products described in paragraph (h) of this section (relating 
to certain export controlled products).
    (2) Property leased to member of controlled group--(i) In general. 
Property leased to a person (whether or not a FSC) which is a member of 
the same controlled group as the lessor constitutes export property for 
any period of time only if during the period--
    (A) The property is held for sublease, or is subleased, by the 
person to a third person for the ultimate use of the third person;
    (B) The third person is not a member of the same controlled group; 
and
    (C) The property is used predominantly outside the United States by 
the third person.
    (ii) Predominant use. The provisions of paragraph (d)(4)(vi) of this 
section apply in determining under subdivision (2)(i)(C) of this 
paragraph whether the property is used predominantly outside the United 
States by the third person.
    (iii) Leasing rule. For purposes of this paragraph (f)(2), leased 
property is deemed to be ultimately used by a member of the same 
controlled group as the lessor if such property is leased to a person 
which is not a member of the controlled group but which subleases the 
property to a person which is a member of the controlled group. Thus, 
for example, if X, a FSC for the taxable year, leases a movie film to Y, 
a foreign corporation which is not a

[[Page 129]]

member of the same controlled group as X, and Y then subleases the film 
to persons which are members of the controlled group for showing to the 
general public, the film is not export property. On the other hand, if 
X, a FSC for the taxable year, leases a movie film to Z, a foreign 
corporation which is a member of the same controlled group as X, and Z 
then subleases the film to Y, another foreign corporation, which is not 
a member of the same controlled group for showing to the general public, 
the film is not disqualified from being export property.
    (iv) Certain copyrights. With respect to a copyright which is not 
excluded by subdivision (3) of this paragraph from being export 
property, the ultimate use of the property is the sale or exhibition of 
the property to the general public. Thus, if A, a FSC for the taxable 
year, leases recording tapes to B, a foreign corporation which is a 
member of the same controlled group as A, and if B makes records from 
the recording tape and sells the records to C, another foreign 
corporation, which is not a member of the same controlled group, for 
sale by C to the general public, the recording tape is not disqualified 
under this paragraph from being export property, notwithstanding the 
leasing of the recording tape by A to a member of the same controlled 
group, since the ultimate use of the tape is the sale of the records 
(i.e., property produced from the recording tape).
    (3) Intangible property. Export property does not include any 
patent, invention, model, design, formula, or process, whether or not 
patented, or any copyright (other than films, tapes, records, or similar 
reproductions, for commercial or home use), goodwill, trademark, 
tradebrand, franchise, or other like property. Although a copyright such 
as a copyright on a book or computer software does not constitute export 
property, a copyrighted article (such as a book or standardized, mass 
marketed computer software) if not accompanied by a right to reproduce 
for external use is export property if the requirements of this section 
are otherwise satisfied. Computer software referred to in the preceding 
sentence may be on any medium, including, but not limited to, magnetic 
tape, punched cards, disks, semi-conductor chips and circuit boards. A 
license of a master recording tape for reproduction outside the United 
States is not disqualified under this paragraph from being export 
property.
    (g) Oil and gas--(1) In general. Under section 927(a)(2)(C), export 
property does not include oil or gas (or any primary product thereof).
    (2) Primary product from oil or gas. A primary product from oil or 
gas is not export property. For purposes of this paragraph--
    (i) Primary product from oil. The term ``primary product from oil'' 
means crude oil and all products derived from the destructive 
distillation of crude oil, including--
    (A) Volatile products,
    (B) Light oils such as motor fuel and kerosene,
    (C) Distillates such as naphtha,
    (D) Lubricating oils,
    (E) Greases and waxes, and
    (F) Residues such as fuel oil.


For purposes of this paragraph, a product or commodity derived from 
shale oil which would be a primary product from oil if derived from 
crude oil is considered a primary product from oil.
    (ii) Primary product from gas. The term ``primary product from gas'' 
means all gas and associated hydrocarbon components from gas wells or 
oil wells, whether recovered at the lease or upon further processing, 
including--
    (A) Natural gas,
    (B) Condensates,
    (C) Liquefied petroleum gases such as ethane, propane, and butane, 
and
    (D) Liquid products such as natural gasoline.
    (iii) Primary products and changing technology. The primary products 
from oil or gas described in subdivisions (2)(i) and (ii) of this 
paragraph and the processes described in those subdivisions are not 
intended to represent either the only primary products from oil or gas, 
or the only processes from which primary products may be derived under 
existing and future technologies. For example, petroleum coke, although 
not derived from the destructive distillation of crude oil, is a primary 
product from oil derived from an existing technology.

[[Page 130]]

    (iv) Non-primary products. For purposes of this paragraph, 
petrochemicals, medicinal products, insecticides and alcohols are not 
considered primary products from oil or gas.
    (h) Export controlled products--(1) In general. Section 927(a)(2)(D) 
provides that an export controlled product is not export property. A 
product or commodity may be an export controlled product at one time but 
not an export controlled product at another time. For purposes of this 
paragraph, a product or commodity is an ``export controlled product'' at 
a particular time if at that time the export of such product or 
commodity is prohibited or curtailed under section 7(a) of the Export 
Administration Act of 1979, to effectuate the policy relating to the 
protection of the domestic economy set forth in paragraph (2)(C) of 
section 3 of the Export Administration Act of 1979. That policy is to 
use export controls to the extent necessary to protect the domestic 
economy from the excessive drain of scarce materials and to reduce the 
serious inflationary impact of foreign demand.
    (2) Products considered export controlled products--(i) In general. 
For purposes of this paragraph, an export controlled product is a 
product or commodity, which is subject to short supply export controls 
under 15 CFR part 377. A product or commodity is considered an export 
controlled product for the duration of each control period which applies 
to such product or commodity. A control period of a product or commodity 
begins on and includes the initial control date (as defined in 
subdivision (2)(ii) of this paragraph) and ends on and includes the 
final control date (as defined in subdivision (2)(iii) of this 
paragraph).
    (ii) Initial control date. The initial control date of a product or 
commodity which is subject to short supply export controls is the 
effective date stated in the regulations to 15 CFR part 377 which 
subjects the product or commodity to short supply export controls. If 
there is no effective date stated in these regulations, the initial 
control date of the product or commodity will be thirty days after the 
effective date of the regulations which subject the product or commodity 
to short supply export controls.
    (iii) Final control date. The final control date of a product or 
commodity is the effective date stated in the regulations to 15 CFR part 
377 which removes the product or commodity from short supply export 
controls. If there is no effective date stated in those regulations, the 
final control date of the product or commodity is the date which is 
thirty days after the effective date of the regulations which remove the 
product or commodity from short supply export control.
    (iv) Expiration of Export Administration Act. An initial control 
date and final control date cannot occur after the expiration date of 
the Export Administration Act under the authority of which the short 
supply export controls were issued.
    (3) Effective dates--(i) Products controlled on January 1, 1985. If 
a product or commodity was subject to short supply export controls on 
January 1, 1985, this paragraph shall apply to all sales, exchanges, 
other dispositions, or leases of the product or commodity made after 
January 1, 1985, by the FSC or by the FSC's related supplier if the FSC 
is the commission agent on the transaction.
    (ii) Products first controlled after January 1, 1985. If a product 
or commodity becomes subject to short supply export controls after 
January 1, 1985, this paragraph applies to sales, exchanges, other 
dispositions, or leases of such product or commodity made on or after 
the initial control date of such product or commodity, and to owning 
such product or commodity on or after such date.
    (iii) Date of sales, exchange, lease, or other disposition. For 
purposes of this paragraph (h)(3), the date of sale, exchange, or other 
disposition of a product or commodity is the date as of which title to 
such product or commodity passes. The date of a lease is the date as of 
which the lessee takes possession of a product or commodity. The 
accounting method of a person is not determinative of the date of sale, 
exchange, other disposition, or lease.
    (i) Property in short supply. If the President determines that the 
supply of any property which is otherwise export property as defined in 
this section

[[Page 131]]

is insufficient to meet the requirements of the domestic economy, he may 
by Executive Order designate such property as in short supply. Any 
property so designated will be treated under section 927(a)(3) as 
property which is not export property during the period beginning with 
the date specified in such Executive Order and ending with the date 
specified in an Executive Order setting forth the President's 
determination that such property is no longer in short supply.

[T.D. 8126, 52 FR 6459, Mar. 3, 1987]



Sec. 1.927(b)-1T  Temporary regulations; Definition of gross receipts.

    (a) General rule. Under section 927(b), for purposes of sections 921 
through 927, the gross receipts of a person for a taxable year are--
    (1) Business income. The total amounts received or accrued by the 
person from the sale or lease of property held primarily for sale or 
lease in the ordinary course of a trade or business, and
    (2) Other income. Gross income recognized from whatever source 
derived, such as, for example, from--
    (i) The furnishing of services (whether or not related to the sale 
or lease of property described in subdivision (1) of this paragraph),
    (ii) Dividends and interest (including tax exempt interest),
    (iii) The sale at a gain of any property not described in 
subdivision (1) of this paragraph, and
    (iv) Commission transactions to the extent described in paragraph 
(e) of this section.
    (b) Non-gross receipts items. For purposes of paragraph (a) of this 
section, gross receipts do not include amounts received or accrued by a 
person from--
    (1) Loan transactions. The proceeds of a loan or of the repayment of 
a loan, or
    (2) Non-taxable transactions. A receipt of property in a transaction 
to which section 118 (relating to contribution to capital) or section 
1032 (relating to exchange of stock for property) applies.
    (c) Non-reduction of total amounts. For purposes of paragraph (a) of 
this section, the total amounts received or accrued by a person are not 
reduced by costs of goods sold, expenses, losses, a deduction for 
dividends received, or any other deductible amounts. The total amounts 
received or accrued by a person are reduced by returns and allowances.
    (d) Method of accounting. For purposes of paragraph (a) of this 
section, the total amounts received or accrued by a person shall be 
determined under the method of accounting used in computing its taxable 
income. If, for example, a FSC receives advance or installment payments 
for the sale or lease of property described in paragraph (a)(1) of this 
section, for the furnishing of services, or which represent recognized 
gain from the sale of property not described in paragraph (a)(1) of this 
section, any amount of such advance payments is considered to be gross 
receipts of the FSC for the taxable year for which such amount is 
included in the gross income of the FSC.
    (e) Commission transactions--(1) In general--(i) With a related 
supplier. In the case of transactions which give rise to a commission 
from the FSC's related supplier on the sale or lease of property or the 
furnishing of services by a principal, the FSC's gross income from all 
such transactions is the commission paid or payable to the FSC by the 
related supplier. The FSC's gross receipts for purposes of computing its 
profit under the administrative pricing methods of section 925(a)(1) and 
(2) shall be the gross receipts (other than gross receipts which would 
not be foreign trading gross receipts had they been received by the FSC) 
derived by the related supplier from the sale or lease of the property 
or from the furnishing of services, with respect to which the 
commissions are derived. Also, in determining whether the 50% test in 
section 924(a) has been met, the relevant gross receipts are the gross 
receipts of the related supplier.
    (ii) With an unrelated principal. In the case of transactions which 
give rise to a commission from an unrelated principal to a FSC on the 
sale or lease of property or the furnishing of services by a principal, 
the amount recognized by the FSC as gross income from all such 
transactions shall be the commission received from the principal.
    (2) Selective commission arrangements--(i) In general. A commission 
arrangement between the FSC and its related

[[Page 132]]

supplier may provide that the FSC will not be the related supplier's 
commission agent with respect to sales or leases of export property, or 
the furnishing of services, which do not result in foreign trading gross 
receipts. In addition, the commission agreement may provide that the FSC 
will not be the related supplier's commission agent on transactions 
which would result in a loss to the related supplier under the transfer 
pricing rules of section 925(a). In a buy-sell FSC situation, selective 
commission arrangements are not applicable. Determination of which 
transactions fall within the selective commission arrangement may be 
made up to the due date under section 6072(b), including extensions 
provided for under section 6081, of the FSC's income tax return for the 
taxable year of the FSC during which a transaction occurs.
    (ii) Example. The treatment of a selective commission arrangement 
may be illustrated by the following example:

    Example. A calendar year commission FSC (``F'') entered into a 
selective commission arrangement with related supplier RS which provided 
that F will not be RS's commission agent on transactions which would 
result in a loss to RS under the transfer pricing rules of section 
925(a). During 1987, RS sold three different articles of export property 
A, B and C, all of which fall within the same three digit Standard 
Industrial Classification. In July of 1988, while preparing the FSC's 
1987 income tax return, RS determined that the sale of export property A 
resulted in a loss to RS under the section 482 method of section 
925(a)(3) and that applying that method to the sales of export property 
B and C resulted in only a small amount of income to both RS and F. In 
addition, RS determined that grouping export property B and C, while 
excluding export property A from the grouping, resulted in the highest 
profit to F under the combined taxable income administrative pricing 
method of section 925(a)(2). Using the same grouping, the gross receipts 
method of section 925(a)(1) would result in a lower profit to F. Under 
the special no-loss rule of Sec. 1.925(a)-1T(e)(1)(iii), RS would be 
prohibited from using the combined taxable income administrative pricing 
method to determine F's profit for the grouping of export property B and 
C if it used the section 482 method on the sale of export property A. 
This results because there was a loss to RS on the sale of export 
property A. Under the selective commission arrangement, RS could 
exercise its option and exclude the sale of export property A. Since F 
is no longer deemed to have been operating as RS's commission agent on 
that sale, the combined taxable income method may be used to compute F's 
profit on the grouping of the sales of export property B and C.

    (f) Example. The definition of gross receipts under this section may 
be illustrated by the following example:

    Example. During 1985, M, a related supplier of N, is engaged in the 
manufacture of machines in the United States. N, a calendar year FSC, is 
engaged in the sale and lease of such machines in foreign countries. N 
furnishes services which are related and subsidiary to its sale and 
lease of those machines. N also acts as a commission agent in foreign 
countries for Z, an unrelated supplier, with respect to Z's sale of 
products. N receives dividends on stock owned by it, interest on loans, 
and proceeds from sales of business assets located outside the United 
States resulting in recognized gains and losses. N's gross receipts for 
1985 are $3,550, computed on the basis of the additional facts assumed 
in the table below:

N's sales receipts for machines manufactured by M (without        $1,500
 reduction for cost of goods sold and selling expenses).......
N's lease receipts for machines manufactured by M (without           500
 reduction for depreciation and leasing expenses).............
N's gross income from related and subsidiary services for            400
 machines manufactured by M (without reduction for service
 expenses)....................................................
N's sales receipts for products manufactured by Z (without           550
 reduction for Z's cost of goods sold, commissions on sales
 and commission sales expenses)...............................
Dividends received by N.......................................       150
Interest received by N........................................       200
Proceeds received by N representing recognized gain (but not         250
 losses) for sales of business assets located outside the
 United States................................................
                                                               ---------
N's gross receipts............................................     3,550
                                                               =========
 


[T.D. 8126, 52 FR 6464, Mar. 3, 1987]



Sec. 1.927(d)-1  Other definitions.

    (a) Carrying Charges.
    Q-1. Under what circumstances is the sales price of property or 
services sold by a FSC or a related supplier considered to include 
carrying charges as defined in subdivision (ii)(B)(1) of Q&A-9 of Sec. 
1.921-2?
    A-1. (i) The proceeds received from a sale of export property by a 
FSC or a related supplier (or the amount paid for services rendered or 
from rental of export property) may include carrying charges if any part 
of the sale proceeds (or service or rental payment) is paid after the 
end of the normal payment

[[Page 133]]

period. If the export property is sold or leased by, or if the services 
are rendered by, the FSC, the entire carrying charges amount as 
determined in Q&A-2 of this section will be the income of the FSC. If, 
however, the FSC is the commission agent of a related supplier on these 
transactions, the carrying charges amount so determined is income of the 
related supplier. The commission payable to the FSC will be computed by 
reducing the related supplier's gross receipts from the transaction by 
the amount of the carrying charges. No carrying charges will be assessed 
on the commissions paid by the related supplier to the FSC. The carrying 
charges provisions, likewise, do not apply to any other transaction that 
does not give rise to foreign trading gross receipts.
    (ii) The normal payment period for a sale transaction is 60 days 
from the earlier of date of sale or date of exchange of property under 
the contract. For this purpose, the date of sale will be the date the 
sale is recorded on the seller's books of account under its normal 
accounting method. The date the transaction was recorded on the seller's 
books of account shall be disregarded if recording is delayed in order 
to delay the start of the normal payment period. In these circumstances, 
the earlier of the date of the contract or date of exchange of property 
will be deemed the date of sale. For related and subsidiary services 
that are not separately stated from the sale or lease transaction, the 
earlier of the date of the sale or date the export property is delivered 
to the purchaser is the applicable date. For related and subsidiary 
services which are separately stated from the sale or lease transaction 
and for other services, such as engineering and architectural services, 
the normal payment period is 60 days from the earlier of the date 
payment is due for the services or the date services under the contract 
are completed. The date of completion of a services contract is the date 
of final approval of the services by the recipient. With regard to 
transactions involving the lease or rental of export property, the 
normal payment period will begin on the date the rental payment is due 
under the lease. The date the normal payment period begins under this 
subdivision (ii) will be the same whether or not the transaction is with 
a related person.
    (iii) The carrying charges are computed for the period beginning 
with the first day after the end of the normal payment period and ending 
with the date of payment. A FSC may elect at any time prior to the close 
of the statute of limitations of section 6501(a) for the FSC taxable 
year to treat the final date of payment stated in the contract as the 
date of payment if--
    (A) The contracts for all transactions completed during the taxable 
year require that payment be received within the normal payment period,
    (B) No more than 20% of transactions for which final payment is 
received in the taxable year involve payment after the end of the normal 
payment period. For FSC taxable years beginning after March 3, 1987, the 
20% test will apply only to the dollar value of the transactions and not 
to the number of transactions. For prior taxable years, the 20% test 
will apply to either the dollar value of the transactions or to the 
number of transactions. The special grouping rules applicable to 
determination of the FSC's profit under the administrative pricing rules 
of section 925 may be applied to this elective provision. Accordingly, 
transactions may be grouped into product or product-line groupings to 
determine whether 20% or less of the dollar value (or number of 
transactions, if applicable) of the grouped transactions involve payment 
after the end of the normal payment period.
    Q-2. How are carrying charges as defined in subdivision (ii)(B)(1) 
of Q&A 9 of Sec. 1.921-9 computed?
    A-2. If carrying charges as defined in subdivision (ii)(B)(1) of Q&A 
9 of Sec. 1.921-9 are considered to be included in the sale price of 
property income or rental payment services, the amount of the carrying 
charges is equal to the amount in subdivision (i) of this answer if the 
contract provides for stated interest or the amount in subdivisions (ii) 
or (iii) of this answer, whichever is applicable, if the contract does 
not so provide.
    (i) If a contract provides for stated interest beginning on the day 
after the

[[Page 134]]

end of the normal payment period, carrying charges will accrue only if 
the stated interest rate is less than the short-term, monthly Federal 
rate as of the day after the end of normal payment period and then only 
to the extent the stated interest is less than the short-term, monthly 
Federal rate. The short-term, monthly Federal rate is that rate as 
determined for purposes of section 1274(d) and which is published in the 
Internal Revenue Bulletin. Carrying charges will not accrue, however, 
unless payments are made after the end of the normal payment period.
    (ii) If a contract for a transaction does not provide for stated 
interest, and if the taxpayer does not elect the method described in 
subdivision (iii) of this answer, the amount of carrying charges is 
equal to the excess of--
    (A) The amount of the sales price of property, services income or 
rental payment that is unpaid on the day after the end of the normal 
payment period, over
    (B) The present value, as of the day after the end of the normal 
payment period, of all payments that are required to be made under the 
contract and that are unpaid on the day after the end of the normal 
payment period. The amount of the sales price of property, service 
income or rental payment is the amount under the contract whether it be 
the sales price, amount paid for services or the rental amount 
determined as of the actual payment date unless a FSC makes the election 
provided under subdivision (iii) of Q&A 1. If a FSC makes the election 
provided under subdivision (III) of Q&A 1, the amount of the sales price 
is the sales price, services income or rental payment under the contract 
determined as of the final payment date stated in the contract. All 
payments that are required to be made under the contract include the 
stated sales price, services income or rental payment as well as stated 
amounts of interest and carrying charges. The discount rate for the 
present value computation is simple interest at the short-term monthly 
Federal rate published in the Internal Revenue Bulletin, determined as 
of the day after the end of the normal payment period. The present value 
of a payment is calculated as follows:
[GRAPHIC] [TIFF OMITTED] TC14NO91.143

P = present value of a payment that is required and unpaid after the end 
          of the normal payment period
S = amount of a payment that is required and unpaid after the end of the 
          normal payment period
i = the short-term monthly Federal rate
t = the number of days after the end of the normal payment period and 
          before date of payment divided by 365.


If a sale is made, or if services are completed, or if rent is due under 
a lease in a taxable year and the required date of payment is in a later 
taxable year, carrying charges for the first taxable year are computed 
for the number of days after the end of the normal payment period and 
before the end of the taxable year. For the following taxable year, 
carrying charges are computed for the number of days after the beginning 
of the taxable year and before the date of payment.
    (iii) At the election of the taxpayer, the amount of carrying 
charges may be determined under the method described in this subdivision 
(iii). If the taxpayer elects this method, it must be used for all 
applicable transactions within the taxable year of the FSC. If this 
optional method is used, the computation of carrying charges must be 
made separately for transactions involving related persons and for those 
transactions involving unrelated persons. In addition, the computation 
of carrying charges must be made separately for each of the five types 
of income of the FSC (or of the related supplier if the related supplier 
is the principal on the transaction) listed in subparagraph (1) through 
(5) of section 924(a). These groupings are separate and distinct from 
the groupings that are established for purposes of determining the FSC's 
profit on the export transactions. The optional method allowed in this 
subdivision provides that the amount of carrying charges for a taxable 
year of a FSC (or related supplier if the related supplier is the 
principal on the export transaction) is computed using the average of 
receivables of unrelated persons (or of related persons) and the average 
time those receivables are outstanding. Receivables are included in

[[Page 135]]

this computation only if they are from transactions on which foreign 
trading gross receipts, as defined in section 924(a), are received by 
the FSC (or which are received by a related supplier of a FSC and which 
would have been foreign trading gross receipts had they been received by 
the FSC). Carrying charges are calculated under this method as follows:

CC = (AR) (I/365) (X) (Y)

CC = Carrying charges
AR = Average monthly receivables balance for the taxable year
I = The average short-term, monthly Federal rate for the year
X = The number of times receivables turn over in the year
Y = The number of days the average receivables are outstanding over 60 
          days.


This optional method is illustrated in Example 5 in subdivision (v) of 
this answer.
    (iv) The computation of carrying charges under this answer 2 applies 
only to the determination of carrying charges under subdivision 
(ii)(B)(1) of Q&A 9 of Sec. 1.921-2 and does not apply to the 
determination of any other unstated interest or for any other purpose.
    (v) The following examples illustrate the computation of carrying 
charges under this section:

    Example 1. On January 1, 1985, a FSC sells export property for 
$10,000. The export property is delivered to the purchaser on January 
10, 1985. The terms of the contract require payment within 90 days after 
sale. The normal payment period is 60 days. The FSC does not make an 
election under subdivision (iii) of Q&A. The contract does not require 
the payment of any interest or carrying charges. The purchaser pays the 
entire sales price on March 1, 1985. The sales price is not considered 
to include any carrying charges because the purchase paid the entire 
sales price within the normal payment period.
    Example 2. The facts are the same as in example 1 except that the 
purchaser pays the entire sales price on April 6, 1985, 96 days after 
the earlier of the date of sale or date of delivery (i.e., January 1, 
1985). Therefore, the sales price is considered to include carrying 
charges computed as follows:
    Step 1: Determines the short-term monthly Federal rate as of the 
earlier of date of sale or date of delivery. For purposes of this 
example, the rate is 10%.
    Step 2: Determine the fraction of the year represented by the number 
of days after 60 days and before date of payment. In this example, the 
number of days beyond 60 is 96-60 = 36, which is divided by 365
[GRAPHIC] [TIFF OMITTED] TC09OC91.001

    Step. 3: Using the short-term monthly Federal rate and the fraction 
of the year, compute the present value of the payment.
[GRAPHIC] [TIFF OMITTED] TC09OC91.002

[GRAPHIC] [TIFF OMITTED] TC09OC91.003

P = $10,000 (.99)
P = $9,900
    Step 4: Using the present value of all payments, compute the 
carrying charges.
    Carrying Charges = Sales Price less Present Value.
    [GRAPHIC] [TIFF OMITTED] TC09OC91.004
    
    Example 3. On October 15, 1985, F, a FSC, leases export property to 
X for one month with a total rental due of $20,000. Under the terms of 
the lease, A agreed to pay F $10,000 on October 15, 1985, and the 
remaining $10,000 on January 15, 1986. The contract does not require the 
payment of any interest or carrying charges. The second $10,000 payment 
is made on January 3, 1986. This payment does not include any carrying 
charges because X paid the $10,000 before the start of the normal 
payment period.
    Example 4. On October 15, 1985, F, a FSC, leases export property to 
X, for one month with a total amount due under the lease of $10,000, 
payable on October 15, 1985. X delays payment until January 19, 1986, 
which was 96 days after the start of the normal payment period. The 60 
day normal payment period terminated on December 14, 1985. Therefore, 
the lease payment is considered to include carrying charges of $100 
computed in the same manner as in Example 2. Of this $100, 17/36, or 
$47.22, is carrying charges for 1985 (i.e., 17 days in December), and 
19/36, or $52.78, is carrying charges for 1986.
    Example 5. During 1986, F, a FSC, sold on account export properties 
A and B to related and unrelated persons.
    (A) Unrelated persons. During 1986, the sales on account to 
unrelated persons totaled $6,000. On the last day of each of the months 
of 1986, F had total receivables from unrelated persons from sales of 
export properties A and B, as follows:

[[Page 136]]



January 31.....................................................   $1,400
February 28....................................................    1,400
March 31.......................................................    1,000
April 30.......................................................    1,000
May 31.........................................................    1,200
June 30........................................................    1,300
July 31........................................................    1,000
August 31......................................................    1,300
September 30...................................................    1,500
October 31.....................................................    1,100
November 30....................................................    1,200
December 31....................................................    1,000
                                                                --------
                                                                  14,400
                                                                ========
 


Carrying charges for 1986 with unrelated persons under the optional 
method of subdivision (iii) of this answer will be $19.23, computed as 
follows:
    Step 1: Determine the average short-term, monthly Federal rate for 
the year. For purposes of this example, the rate is assumed to be 9%.
    Step 2: Determine the average receivables for the year. This average 
is calculated by totaling the end of the month receivables balance of 
each month of the year and dividing by twelve. In this example, the 
average monthly receivables balance is $1,200, calculated as follows:

$1,200 = $14,400 / 12

    Step 3: Determine the number of times the receivables turn over 
during the year. This is calculated by dividing the sales on account for 
the year by the average monthly receivables balance for the year. For 
purposes of this example, receivables turned over 5 times for 1986, 
computed as follows:
[GRAPHIC] [TIFF OMITTED] TC09OC91.005

    Step 4: Determine the number of days the average receivables are 
outstanding in excess of 60 days. In this example, there are 13 
receivable days in excess of 60 days, computed as follows:
[GRAPHIC] [TIFF OMITTED] TC09OC91.071

    Step 5: The amount of carrying charges, $19.23, is calculated by 
using the following equation:

CC = (AR) (I/365) (X)(Y)

CC = Carrying charges
AR = Average monthly receivables balance for the taxable year (step 2)
I = The average short-term monthly Federal rate for the year (step 1)
X = The number of times receivables turn over in the year (step 3)
Y = The number of days the average receivables are outstanding over 60 
          days (step 4).
CC = $19.23 = ($1,200) (.09/365) (5) (13)

    (B) Related persons. Carrying charges, if any, on the sales on 
account to related persons must be computed separately using this 
optional method.

    Q-3. Is a discount from the sales price of property or services for 
prompt payment considered to be stated carrying charges as defined in 
subdivision (ii)(A) of Q&A 9 of Sec. 1.921-2?
    A-3. No.
    Q-4. Is the receipt of an arm's length factoring payment from an 
unrelated person considered a payment of the sales proceeds for purposes 
of determining whether payment is made within the normal payment period 
and the possible imposition of carrying charges?
    A-4. Yes.

[T.D. 8127, 52 FR 6473, Mar. 3, 1987]



Sec. 1.927(d)-2T  Temporary regulations; definitions and special rules
relating to Foreign Sales Corporation.

    (a) Definition of related supplier. For purposes of sections 921 
through 927 and the regulations under those sections, the term ``related 
supplier'' means a related party which directly supplies to a FSC any 
property or services which the FSC disposes of in a transaction 
producing foreign trading gross receipts, or a related party which uses 
the FSC as a commission agent in the disposition of any property or 
services producing foreign trading gross receipts. A FSC may have 
different related suppliers with respect to different transactions. If, 
for example, X owns all the stock of Y, a corporation, and of F, a FSC, 
and X sells a product to Y which is resold to F, only Y is the related 
supplier of F. If, however, X sells directly to F and Y also sells 
directly to F, then, as to the transactions involving direct sales to F, 
each of X and Y is a related supplier of F.
    (b) Definition of related party. The term ``related party'' means a 
person which is owned or controlled directly or indirectly by the same 
interests as the FSC within the meaning of section 482 and Sec. 1.482-
1(a).

[T.D. 8126, 52 FR 6465, Mar. 3, 1987]



Sec. 1.927(e)-1  Special sourcing rule.

    (a) Source rules for related persons--(1) In general. The income of 
a person described in section 482 from a sale of export property giving 
rise to foreign trading gross receipts of a FSC that is

[[Page 137]]

treated as from sources outside the United States shall not exceed the 
amount that would be treated as foreign source income earned by such 
person if the pricing rule under section 994 that corresponds to the 
rule used under section 925 with respect to such transaction applied to 
such transaction. This special sourcing rule also applies if the FSC is 
acting as a commission agent for the related supplier with respect to 
the transaction described in the first sentence of this paragraph (a)(1) 
that gives rise to foreign trading gross receipts and the transfer 
pricing rules of section 925 are used to determine the commission 
payable to the FSC. No limitation results under this section with 
respect to a transaction to which the section 482 pricing rule under 
section 925(a)(3) applies.
    (2) Grouping of transactions. If, for purposes of determining the 
FSC's profits under the administrative pricing rules of sections 925(a) 
(1) and (2), grouping of transactions under Sec. 1.925(a)-1T(c)(8) was 
elected, the same grouping shall be used for making the determinations 
under the special sourcing rule in this section.
    (3) Corresponding DISC pricing rules--(i) In general. For purposes 
of this section--
    (A) The DISC gross receipts pricing rule of section 994(a)(1) 
corresponds to the gross receipts pricing rule of section 925(a)(1);
    (B) The DISC combined taxable income pricing rule of section 
994(a)(2) corresponds to the combined taxable income pricing rule of 
section 925(a)(2); and
    (C) The DISC section 482 pricing rule of section 994(a)(3) 
corresponds to the section 482 pricing rule of section 925(a)(3).
    (ii) Special rules. For purposes of this section--
    (A) The DISC pricing rules of section 994(a)(1) and (2) shall be 
determined without regard to export promotion expenses;
    (B) Qualified export receipts under section 994(a)(1) and
    (2) Shall be deemed to be an amount equal to the foreign trading 
gross receipts arising from the transaction; and
    (C) Combined taxable income for purposes of section 994(a)(2) shall 
be deemed to be an amount equal to the combined taxable income for 
purposes of section 925(a)(2) arising from the transaction.
    (b) Examples. The provisions of this section may be illustrated by 
the following examples:

    Example 1. (i) R and F are calendar year taxpayers. R, a domestic 
manufacturing company, owns all the stock of F, which is a FSC acting as 
a commission agent for R. For the taxable year, R and F used the 
combined taxable income pricing rule of section 925(a)(2). For the 
taxable year, the combined taxable income of R and F is $100 from the 
sale of export property, as defined in section 927(a), manufactured by R 
using production assets located in the United States. Title to the 
export property passed outside of the United States.
    (ii) Under section 925(a)(2), 23 percent of the $100 combined 
taxable income of R and F ($23) is allocated to F and the remaining $77 
is allocated to R. Absent the special sourcing rule, under section 
863(b) the $77 income allocated to R would be sourced $38.50 U.S. source 
and $38.50 foreign source. Under the special sourcing rule, the amount 
of foreign source income earned by a related supplier of a FSC shall not 
exceed the amount that would result if the corresponding DISC pricing 
rule applied. The DISC combined taxable income pricing rule of section 
994(a)(2) corresponds to the combined taxable income pricing rule of 
section 925(a)(2). Under section 994(a)(2), $50 of the combined taxable 
income ($100 x .50) would be allocated to the DISC and the remaining $50 
would be allocated to the related supplier. Under section 863(b), the 
$50 income allocated to the DISC's related supplier would be sourced $25 
U.S. source and $25 foreign source. Accordingly, under the special 
sourcing rule, the foreign source income of R shall not exceed $25.
    Example 2. (i) Assume the same facts as in Example 1 except that R 
and F used the gross receipts pricing rule of section 925(a)(1). In 
addition, for the taxable year foreign trading gross receipts derived 
from the sale of the export property are $2,000.
    (ii) Under section 925(a)(1), 1.83 percent of the $2,000 foreign 
trading gross receipts ($36.60) is allocated to F and the $63.40 
remaining combined taxable income ($100-$36.60) is allocated to R. 
Absent the special sourcing rule, under section 863(b) the $63.40 income 
allocated to R would be sourced $31.70 U.S. source and $31.70 foreign 
source. Under the special sourcing rule, the amount of foreign source 
income earned by a related supplier of a FSC shall not exceed the amount 
that would result if the corresponding DISC pricing rule applied. The

[[Page 138]]

DISC gross receipts pricing rule of section 994(a)(1) corresponds to the 
gross receipts pricing rule of section 925(a)(1). Under section 
994(a)(1), $80 ($2,000 x .04) would be allocated to the DISC and the $20 
remaining combined taxable income would be allocated to the related 
supplier. Under section 863(b), the $20 income allocated to the DISC's 
related supplier would be sourced $10 U.S. source and $10 foreign 
source. Accordingly, under the special sourcing rule, the foreign source 
income of R shall not exceed $10.

    (c) Effective date. The rules of this section are applicable to 
taxable years beginning after December 31, 1997.

[T.D. 8782, 63 FR 50144, Sept. 21, 1998]



Sec. 1.927(e)-2T  Temporary regulations; effect of boycott
participation on FSC and small FSC benefits.

    (a) International boycott factor. If the FSC (or small FSC) or any 
member of the FSC's (or small FSC's) controlled group participates in or 
cooperates with an international boycott within the meaning of section 
999, the FSC's (or small FSC's) exempt foreign trade income as 
determined under section 923 (a) shall be reduced by an amount equal to 
the product of the FSC's (or small FSC's) exempt foreign trade income 
multiplied by the international boycott factor determined under section 
999. The amount of the reduction will be considered as non-exempt 
foreign trade income.
    (b) Specifically attributable taxes and income method. If the 
taxpayer clearly demonstrates that the income earned for the taxable 
year is attributable to specific operations, then in lieu of applying 
the international boycott factor for such taxable year, the amount of 
the exempt foreign trade income as determined under section 923(a) that 
will be reduced by this section shall be the amount specifically 
attributable to the operations in which there was participation in or 
cooperation with an international boycott under section 999(b)(1). The 
amount of the reduction will be considered as non-exempt foreign trade 
income.

[T.D. 8126, 52 FR 6465, Mar. 3, 1987]



Sec. 1.927(f)-1  Election and termination of status as a 
Foreign Sales Corporation.

    (a) Election of status as a FSC or a small FSC.
    Q-1. What is the effect of an election by a corporation to be 
treated as a FSC or small FSC?
    A-1. A valid election to be treated as a FSC or a small FSC applies 
to the taxable year of the corporation for which made and remains in 
effect for all succeeding taxable years in which the corporation 
qualifies to be a FSC unless revoked by the corporation or unless the 
corporation fails for five consecutive years to qualify as a FSC (in 
case of a FSC election) or as a small FSC (in case of a small FSC 
election).
    Q-2. Can a corporation established prior to January 1, 1985 be 
treated as a FSC or a small FSC prior to making a FSC or a small FSC 
election?
    A-2. A corporation cannot be treated as a FSC or a small FSC until 
it has made a FSC or a small FSC election. An election made within the 
first 90 days of 1985 relates back to January 1, 1985 unless the 
taxpayer indicates otherwise.
    Q-3. If a shareholder who has not consented to a FSC or small FSC 
election transfers some or all of its shares before or during the first 
taxable year for which the election is made, may the holder of the 
transferred shares consent to the election?
    A-3. A holder of the transferred shares may consent to a FSC or 
small FSC elction under the circumstances described in Sec. 1.922-
2(c)(1). The rules contained in Sec. 1.992-(c) shall apply to the 
consent by a holder of transferred shares.
    Q-4. If a shareholder who has consented to a FSC or a small FSC 
election transfers some or all of its shares before the first taxable 
year for which the election is made, must the holder of the transferred 
shares consent to the election?
    A-4. Yes. Consent must be made by any recipient of such shares on or 
before the 90th day after the first day of such first taxable year. If 
such recipient fails to file his consent on or before such 90th day, and 
extension of time for filing such consent may be granted

[[Page 139]]

in the manner, and subject to the conditions, described in paragraph 
(b)(3) of Sec. 1.992-2.
    Q-5. May an election of a corporation to be a FSC or a small FSC be 
effective as of a time other than the start of the corporation's taxable 
year?
    A-5. No.
    Q-6. If a fiscal year foreign corporation was in existence on 
December 31, 1984, must it wait until the first day of its taxable year 
beginning after January 1, 1985, to elect FSC status?
    A-6. No. If a fiscal year foreign corporation was in existence on 
December 31, 1984, its taxable year will be deemed to have terminated on 
that date if the foreign corporation elects FSC status to be effective 
January 1, 1985. An income tax return will be required for any short 
years created by the deemed closing of the taxable year unless the 
corporation is relieved from the necessity of making a return by section 
6012 and the regulations under that section. If the corporation's 
taxable year is deemed closed by operation of this regulation, the 
filing date of tax returns for the short taxable year ended on December 
31, 1984, will be automatically extended until May 18, 1987.
    Q-7. What is the effect of an election to be treated as a FSC or as 
a small FSC if the corporation or any other member of the controlled 
group has in effect an election to be treated as an interest charge 
DISC?
    A-7. The interest charge DISC election shall be treated as revoked 
for all purposes under the Code as of the date the FSC election is 
effective. An affirmative revocation of the DISC election is 
unnecessary. The FSC election shall take effect. As long as the FSC 
election remains in effect, neither the corporation nor any other member 
of the controlled group is permitted to elect to be treated as an 
interest charge DISC for any taxable year including any part of a 
taxable year during which the corporation's FSC election continues to be 
effective.
    Q-8. What is the effect of an election to be treated as a small FSC 
if the corporation or any other member of the controlled group has in 
effect an election to be treated as a FSC?
    A-8. As long as a FSC election remains in effect, neither the 
corporation nor any other member of the controlled group is permitted to 
elect to be treated as a small FSC for any taxable year including any 
part of a taxable year during which a FSC election continues to be 
effective. Any FSC within the controlled group must affirmatively revoke 
its FSC election for a taxable year including any part of a taxable year 
for which small FSC status is elected.
    Q-9. What is the effect of an election to be treated as a FSC if the 
corporation or any other member of the controlled group has in effect an 
election to be treated as a small FSC?
    A-9. As long as a small FSC election remains in effect, neither the 
corporation nor any other member of the controlled group is permitted to 
elect to be treated as a FSC for any taxable year including any part of 
the taxable year during which a small FSC election continues to be 
effective. Any small FSC within the controlled group must affirmatively 
revoke its small FSC election for a taxable year including any part of a 
taxable year for which FSC status is elected. An election to be treated 
as a small FSC is permitted if the corporation or any other member of 
the controlled group has in effect an election to be treated as a small 
FSC. For a special rule providing for conversion of a small FSC to a FSC 
within one taxable year, see Sec. 1.921-1T(b)(1) (Q&A-1).
    (b) Termination of election of status as a FSC or a small FSC.
    Q-10. How is the status of a corporation as a FSC or as a small FSC 
terminated?
    A-10. The status of a corporation as a FSC or as a small FSC is 
terminated through revocation or by its continued failure to be a FSC.
    Q-11. For what taxable year may a corporation revoke its election to 
be treated as a FSC or as a small FSC?
    A-11. A corporation may revoke its election to be treated as a FSC 
or as a small FSC for any taxable year of the corporation after the 
first taxable year for which the election is effective.
    Q-12. When must a corporation revoke a FSC or a small FSC election 
if revocation is to be effective for the taxable year in which 
revocation takes place?

[[Page 140]]

    A-12. If a corporation files a statement revoking its election to be 
treated as a FSC or as a small FSC during the first 90 days of a taxable 
year (other than the first taxable year for which such election is 
effective), such revocation will be effective for such taxable year and 
all taxable years thereafter. If the corporation files a statement 
revoking its election to be treated as a FSC or a small FSC after the 
firs 90 days of a taxable year, the revocation will be effective for all 
taxable years following such taxable year.
    Q-13. Can a FSC change its status to a small FSC, or can a small FSC 
change its status to a FSC as of a date other than the first day of a 
taxable year?
    A-13. No. Since a revocation of an election to be a FSC or a small 
FSC is effective only for entire taxable year, a corporation's change 
between FSC and small FSC status is effective as of the first day of a 
taxable year.
    Q-14. How may a corporation revoke an election by a corporation to 
be treated as a FSC or a small FSC?
    A-14. A corporation may revoke its election by filing a statement 
that the corporation revokes its election under section 922(a) to be 
treated as a FSC or under section 922(b) to be treated as a small FSC. 
Such statement shall indicate the corporation's name, address, employer 
identification number, and the first taxable year of the corporation for 
which the revocation is to be effective. The statement shall be signed 
by any person authorized to sign a corporate return under section 6062. 
Such revocation shall be filed with the Service Center with which the 
corporation filed its return.
    Q-15. What if the effect is a corporation that has elected to be 
treated as a FSC or a small FSC fails to qualify as a FSC because it 
does not meet the requirements of section 922 for a taxable year?
    A-15. If a corporation that has elected to be treated as a FSC or a 
small FSC does not qualify as a FSC or a small FSC for a taxable year, 
the corporation will not be treated as a FSC or a small FSC for the 
taxable year. However, the failure of a corporation to qualify to be 
treated as a FSC or a small FSC for a taxable year does not terminate 
the election of the corporation to be treated as FSC or a small FSC 
unless the corporation does not qualify under section 922 for each of 5 
consecutive taxable years, as provided in Q&A 16 of this section.
    Q-16. Under what circumstances is the FSC or small FSC election 
terminated for continued failure to be a FSC?
    A-16. If a corporation that has elected to be treated as a FSC or a 
small FSC does not qualify under section 922 to be treated as a FSC or 
small FSC for each of 5 consecutive taxable years, such election 
terminates and will not be effective for any taxable year after such 
fifth taxable year. Such termination will be effective automatically 
without notice to such corporation or to the Internal Revenue Service.

[T.D. 8127, 52 FR 6475, Mar. 3, 1987]

                    possessions of the united states



Sec. 1.931-1  Exclusion of certain income from sources within Guam,
American Samoa, or the Northern Mariana Islands.

    (a) General rule. (1) An individual (whether a United States citizen 
or an alien), who is a bona fide resident of a section 931 possession 
during the entire taxable year, will exclude from gross income the 
income derived from sources within any section 931 possession and the 
income effectively connected with the conduct of a trade or business by 
such individual within any section 931 possession, except amounts 
received for services performed as an employee of the United States or 
any agency thereof. For purposes of section 931(d) and this section, an 
employee of the government of a section 931 possession will not be 
considered an employee of the United States or of an agency of the 
United States.
    (2) The following example illustrates the application of the general 
rule in paragraph (a)(1) of this section:

    Example. D, a United States citizen, files returns on a calendar 
year basis. In April 2008, D moves to American Samoa, where he purchases 
a house and accepts a permanent position with a local employer. For the 
remainder of the year and for the following three taxable years, D 
continues to live and work in American Samoa and has a closer connection 
to American Samoa than to the

[[Page 141]]

United States or any foreign country. Assuming that D otherwise meets 
the requirements under section 937(a) and Sec. 1.937-1(b) and (f)(1) 
(year-of-move exception), D is considered a bona fide resident of 
American Samoa for 2008. Accordingly, under section 931 and paragraph 
(a)(1) of this section, D should exclude from his 2008 Federal gross 
income any income from sources within American Samoa and any income that 
is effectively connected with the conduct of a trade or business within 
American Samoa, as determined under section 937(b) and Sec. Sec. 1.937-
2 and 1.937-3, as applicable.

    (b) Deductions and credits. In any case in which any amount 
otherwise constituting gross income is excluded from gross income under 
the provisions of section 931, there will not be allowed as a deduction 
from gross income any items of expenses or losses or other deductions 
(except the deduction under section 151, relating to personal 
exemptions), or any credit, properly allocable to, or chargeable 
against, the amounts so excluded from gross income. For purposes of the 
preceding sentence, the rules of Sec. 1.861-8 will apply (with 
creditable expenditures treated in the same manner as deductible 
expenditures).
    (c) Definitions. For purposes of this section--
    (1) The term section 931 possession means a possession that is a 
specified possession and that has entered into an implementing 
agreement, as described in section 1271(b) of the Tax Reform Act of 
1986, Public Law 99-514 (100 Stat. 2085), with the United States that is 
in effect for the entire taxable year;
    (2) The term specified possession means Guam, American Samoa, or the 
Northern Mariana Islands;
    (3) The rules of Sec. 1.937-1 will apply for determining whether an 
individual is a bona fide resident of a section 931 possession;
    (4) The rules of Sec. 1.937-2 will apply for determining whether 
income is from sources within a section 931 possession; and
    (5) The rules of Sec. 1.937-3 will apply for determining whether 
income is effectively connected with the conduct of a trade or business 
within a section 931 possession.
    (d) Effective/applicability date. This section applies to taxable 
years ending after April 9, 2008.

[T.D. 9391, 73 FR 19360, Apr. 9, 2008]



Sec. 1.932-1  Coordination of United States and Virgin Islands income
taxes.

    (a) Scope--(1) In general. Section 932 and this section set forth 
the special rules relating to the filing of income tax returns and 
income tax liabilities of individuals described in paragraph (a)(2) of 
this section. Paragraph (h) of this section also provides special rules 
requiring consistent treatment of business entities in the United States 
and in the United States Virgin Islands (Virgin Islands).
    (2) Individuals covered. This section will apply to any individual 
who--
    (i) Is a bona fide resident of the Virgin Islands during the entire 
taxable year;
    (ii)(A) Is a citizen or resident of the United States (other than a 
bona fide resident of the Virgin Islands) during the entire taxable 
year; and
    (B) Has income derived from sources within the Virgin Islands, or 
effectively connected with the conduct of a trade or business within the 
Virgin Islands, for the taxable year; or
    (iii) Files a joint return for the taxable year with any individual 
described in paragraph (a)(2)(i) or (ii) of this section.
    (3) Definitions. For purposes of this section--
    (i) The rules of Sec. 1.937-1 will apply for determining whether an 
individual is a bona fide resident of the Virgin Islands;
    (ii) The rules of Sec. 1.937-2 will apply for determining whether 
income is from sources within the Virgin Islands; and
    (iii) The rules of Sec. 1.937-3 will apply for determining whether 
income is effectively connected with the conduct of a trade or business 
within the Virgin Islands.
    (b) U.S. individuals with Virgin Islands income--(1) Dual filing 
requirement. Subject to paragraph (d) of this section, an individual 
described in paragraph (a)(2)(ii) of this section must make an income 
tax return for the taxable year to the United States and file a copy of 
such return with the Virgin Islands. Such individuals must also attach 
Form 8689, ``Allocation of Individual Income Tax to the U.S. Virgin 
Islands,'' to the U.S. income tax return and to the income tax return 
filed with the Virgin Islands.

[[Page 142]]

    (2) Tax payments. (i) Each individual to whom this paragraph (b) 
applies for the taxable year must pay the applicable percentage of the 
taxes imposed by this chapter for such taxable year (determined without 
regard to paragraph (b)(2)(ii) of this section) to the Virgin Islands.
    (ii) A credit against the tax imposed by this chapter for the 
taxable year will be allowed in an amount equal to the taxes that are 
required to be paid to the Virgin Islands under paragraph (b)(2)(i) of 
this section and are so paid. Such taxes will be considered creditable 
in the same manner as taxes paid to the United States (for example, 
under section 31) and not as taxes paid to a foreign government (for 
example, under sections 27 and 901).
    (iii) For purposes of this paragraph (b)(2)--
    (A) The term applicable percentage means the percentage that Virgin 
Islands adjusted gross income bears to adjusted gross income;
    (B) The term Virgin Islands adjusted gross income means adjusted 
gross income determined by taking into account only income derived from 
sources within the Virgin Islands and deductions properly apportioned or 
allocable to such income. For purposes of the preceding sentence, the 
rules of Sec. 1.861-8 will apply; and
    (C) Pursuant to Sec. 1.937-2(a), the rules of Sec. 1.937-
2(c)(1)(ii) and (c)(2) do not apply.
    (c) Bona fide residents of the Virgin Islands. Subject to paragraph 
(d) of this section, an individual described in paragraph (a)(2)(i) of 
this section will be subject to the following income tax return filing 
requirements:
    (1) Virgin Islands filing requirements. An individual to whom this 
paragraph (c) applies must file an income tax return for the taxable 
year with the Virgin Islands. On this return, the individual must report 
income from all sources and identify the source of each item of income 
shown on the return.
    (2) U.S. filing requirements. (i) For purposes of calculating the 
income tax liability to the United States of an individual to whom this 
paragraph (c) applies, gross income will not include any amount included 
in gross income on the return filed with the Virgin Islands pursuant to 
paragraph (c)(1) of this section, and deductions and credits allocable 
to such income will not be taken into account, provided that--
    (A) The individual fully satisfied the reporting requirements of 
paragraph (c)(1) of this section; and
    (B) The individual fully paid the tax liability referred to in 
section 934(a) to the Virgin Islands with respect to such income.
    (ii) For purposes of the U.S. statute of limitations under section 
6501(a), an income tax return filed with the Virgin Islands by an 
individual who takes the position that he or she is a bona fide resident 
of the Virgin Islands described in paragraph (a)(2)(i) of this section 
(or an individual who files a joint return with such an individual under 
paragraph (d) of this section) will be deemed to be a U.S. income tax 
return, provided that the United States and the Virgin Islands have 
entered into an agreement for the routine exchange of income tax 
information satisfying the requirements of the Commissioner. The working 
arrangement announced in Notice 2007-31 satisfies the condition of the 
preceding sentence. See Notice 2007-31 (2007-16 IRB 971) (applicable to 
taxable years ending on or after December 31, 2006, unless and until 
arrangement terminates). In the absence of such an agreement, 
individuals to whom this paragraph (c) applies generally must file an 
income tax return for the taxable year with the United States to begin 
the period of limitations for Federal income tax purposes as provided in 
section 6501(a), and in such circumstances the Commissioner may by 
revenue procedure, notice, or other administrative pronouncement specify 
U.S. filing and other information reporting requirements for such 
individuals. For taxable years ending before December 31, 2006, the 
rules provided in section 3 of Notice 2007-19 (2007-11 IRB 689) will 
apply. See Sec. 601.601(d)(2)(ii)(b).
    (3) U.S. tax payments. In the case of an individual who is required 
to file an income tax return with the United States as a consequence of 
failing to satisfy the requirements of paragraphs (c)(2)(i)(A) or (B) of 
this section, there will be allowed as a credit against the tax imposed 
by this chapter for the

[[Page 143]]

taxable year an amount equal to the amount of the tax liability referred 
to in section 934(a) to the extent paid to the Virgin Islands. Such 
taxes shall be considered creditable in the same manner as taxes paid to 
the United States (for example, under section 31) and not as taxes paid 
to a foreign government (for example, under sections 27 and 901).
    (d) Joint returns. In the case of married persons, if one or both 
spouses is an individual described in paragraph (a)(2) of this section 
and they file a joint return of income tax, the spouses must file their 
joint return with, and pay the tax due on such return to, the 
jurisdiction (or jurisdictions) where the spouse who has the greater 
adjusted gross income for the taxable year would be required under 
paragraph (b) or (c) of this section to file a return if separate 
returns were filed and all of their income were the income of such 
spouse. For this purpose, adjusted gross income of each spouse is 
determined under section 62 and the regulations under that section but 
without regard to community property laws; and, if one of the spouses 
dies, the taxable year of the surviving spouse will be treated as ending 
on the date of such death.
    (e) Place for filing returns--(1) U.S. returns. Except as otherwise 
provided for returns filed under paragraph (c)(2)(ii) of this section, a 
return required under the rules of paragraphs (b) and (c) of this 
section to be filed with the United States must be filed as directed in 
the applicable forms and instructions.
    (2) Virgin Islands returns. A return required under the rules of 
paragraphs (b) and (c) of this section to be filed with the Virgin 
Islands must be filed as directed in the applicable forms and 
instructions.
    (f) Tax accounting standards--(1) In general. A dual filing taxpayer 
must use the same tax accounting standards on the returns filed with the 
United States and the Virgin Islands. A taxpayer who has filed a return 
only with the United States or only with the Virgin Islands as a single 
filing taxpayer for a prior taxable year and is required to file a 
return only with the other jurisdiction as a single filing taxpayer for 
a later taxable year may not, for such later taxable year, use different 
tax accounting standards unless the second jurisdiction consents to such 
change. However, such change will not be effective for returns filed 
thereafter with the first jurisdiction unless before such later date of 
filing the taxpayer also obtains the consent of the first jurisdiction 
to make such change. Any request for consent to make a change pursuant 
to this paragraph (f) must be made to the office where the return is 
required to be filed under paragraph (e) of this section and in 
sufficient time to permit a copy of the consent to be attached to the 
return for the taxable year.
    (2) Definitions. For purposes of this paragraph (f), the terms--
    (i) Dual filing taxpayer means a taxpayer who is required to file 
returns with the United States and the Virgin Islands for the same 
taxable year under the rules of paragraph (b) or (c) of this section;
    (ii) Single filing taxpayer means a taxpayer who is required to file 
a return only with the United States (because the individual is not 
described in paragraph (a)(2) of this section) or only with the Virgin 
Islands (because the individual is described in paragraph (a)(2)(i) of 
this section and satisfies the conditions of paragraphs (c)(2)(i) and 
(ii) of this section) for the taxable year; and
    (iii) Tax accounting standards includes the taxpayer's accounting 
period, methods of accounting, and any election to which the taxpayer is 
bound with respect to the reporting of taxable income.
    (g) Extension of territory--(1) Section 932(a) taxpayers--(i) 
General rule. With respect to an individual to whom section 932(a) 
applies for a taxable year, for purposes of taxes imposed by Chapter 1 
of the Internal Revenue Code (Code), the United States generally will be 
treated, in a geographical and governmental sense, as including the 
Virgin Islands. The purpose of this rule is to facilitate the 
coordination of the tax systems of the United States and the Virgin 
Islands. Accordingly, the rule will have no effect where it is 
manifestly inapplicable or its application would be incompatible with 
the intent of any provision of the Code.

[[Page 144]]

    (ii) Application of general rule. Contexts in which the general rule 
of paragraph (g)(1)(i) of this section apply include--
    (A) The characterization of taxes paid to the Virgin Islands. An 
individual to whom section 932(a) applies may take income tax required 
to be paid to the Virgin Islands under section 932(b) into account under 
sections 31, 6315, and 6402(b) as payments to the United States. Taxes 
paid to the Virgin Islands and otherwise satisfying the requirements of 
section 164(a) will be allowed as a deduction under that section, but 
income taxes required to be paid to the Virgin Islands under section 
932(b) will be disallowed as a deduction under section 275(a);
    (B) The determination of the source of income for purposes of the 
foreign tax credit (for example, sections 901 through 904). Thus, for 
example, after an individual to whom section 932(a) applies determines 
which items of income constitute income from sources within the Virgin 
Islands under the rules of section 937(b), such income will be treated 
as income from sources within the United States for purposes of section 
904;
    (C) The eligibility of a corporation to make a subchapter S election 
(sections 1361 through 1379). Thus, for example, for purposes of 
determining whether a corporation created or organized in the Virgin 
Islands may make an election under section 1362(a) to be a subchapter S 
corporation, it will be treated as a domestic corporation and a 
shareholder to whom section 932(a) applies will not be treated as a 
nonresident alien individual with respect to such corporation. While 
such an election is in effect, the corporation will be treated as a 
domestic corporation for all purposes of the Internal Revenue Code. For 
the consistency requirement with respect to entity status elections, see 
paragraph (h) of this section;
    (D) The treatment of items carried over from other taxable years. 
Thus, for example, if an individual to whom section 932(a) applies has 
for a taxable year a net operating loss carryback or carryover under 
section 172, a foreign tax credit carryback or carryover under section 
904, a business credit carryback or carryover under section 39, a 
capital loss carryover under section 1212, or a charitable contributions 
carryover under section 170, the carryback or carryover will be reported 
on the return filed in accordance with paragraph (b)(1) of this section, 
even though the return of the taxpayer for the taxable year giving rise 
to the carryback or carryover was required to be filed with the Virgin 
Islands under section 932(c); and
    (E) The treatment of property exchanged for property of a like kind 
(section 1031). Thus, for example, if an individual to whom section 
932(a) applies exchanges real property located in the United States for 
real property located in the Virgin Islands, notwithstanding the 
provisions of section 1031(h), such exchange may qualify as a like-kind 
exchange under section 1031 (provided that all the other requirements of 
section 1031 are satisfied).
    (iii) Nonapplication of the general rule. Contexts in which the 
general rule of paragraph (g)(1)(i) of this section does not apply 
include--
    (A) The application of any rules or regulations that explicitly 
treat the United States and any (or all) of its possessions as separate 
jurisdictions (for example, sections 931 through 937, 7651, and 7654).
    (B) The determination of any aspect of an individual's residency 
(for example, sections 937(a) and 7701(b)). Thus, for example, an 
individual whose principal place of abode is in the Virgin Islands is 
not considered to have a principal place of abode in the United States 
for purposes of section 32(c);
    (C) The characterization of a corporation for purposes other than 
subchapter S (for example, sections 367, 951 through 964, 1291 through 
1298, 6038, and 6038B). Thus, for example, if an individual to whom 
section 932(a) applies transfers appreciated tangible property to a 
corporation created or organized in the Virgin Islands in a transaction 
described in section 351, he or she must recognize gain unless an 
exception under section 367(a) applies. Also, if a corporation created 
or organized in the Virgin Islands qualifies as a passive foreign 
investment company under sections 1297 and 1298 with respect to an

[[Page 145]]

individual to whom section 932(a) applies, a dividend paid to such 
shareholder does not constitute qualified dividend income under section 
1(h)(11)(B).
    (2) Section 932(c) taxpayers--(i) General rule. With respect to an 
individual to whom section 932(c) applies for a taxable year, for 
purposes of the territorial income tax of the Virgin Islands (that is, 
mirrored sections of the Code), the Virgin Islands generally will be 
treated, in a geographical and governmental sense, as including the 
United States. The purpose of this rule is to facilitate the 
coordination of the tax systems of the United States and the Virgin 
Islands. Accordingly, the rule will have no effect where it is 
manifestly inapplicable or its application would be incompatible with 
the intent of any provision of the Code.
    (ii) Application of general rule. Contexts in which the general rule 
of paragraph (g)(2)(i) of this section apply include--
    (A) The characterization of taxes paid to the United States. A 
taxpayer described in section 932(c)(1) may take income tax paid to the 
United States into account under mirrored sections 31, 6315, and 6402(b) 
as payments to the Virgin Islands;
    (B) The determination of the source of income for purposes of the 
foreign tax credit (for example, mirrored sections 901 through 904). 
Thus, for example, any item of income that constitutes income from 
sources within the United States under the rules of sections 861 through 
865 will be treated as income from sources within the Virgin Islands for 
purposes of mirrored section 904;
    (C) The eligibility of a corporation to make a subchapter S election 
(mirrored sections 1361 through 1379). Thus, for example, for purposes 
of determining whether a corporation created or organized in the United 
States may make an election under mirrored section 1362(a) to be a 
subchapter S corporation, it will be treated as a domestic corporation 
and a shareholder to whom section 932(c) applies will not be treated as 
a nonresident alien individual with respect to such corporation. While 
such an election is in effect, the corporation will be treated as a 
domestic corporation for all purposes of the territorial income tax. For 
the consistency requirement with respect to entity status elections, see 
paragraph (h) of this section;
    (D) The treatment of items carried over from other taxable years. 
Thus, for example, if an individual to whom section 932(c) applies has 
for a taxable year a net operating loss carryback or carryover under 
mirrored section 172, a foreign tax credit carryback or carryover under 
mirrored section 904, a business credit carryback or carryover under 
mirrored section 39, a capital loss carryover under mirrored section 
1212, or a charitable contributions carryover under mirrored section 
170, the carryback or carryover will be reported on the return filed in 
accordance with paragraph (c)(1) of this section, even though the return 
of the taxpayer for the taxable year giving rise to the carryback or 
carryover was required to be filed with the United States; and
    (E) The treatment of property exchanged for property of a like kind 
(mirrored section 1031). Thus, for example, if an individual to whom 
section 932(c) applies exchanges real property located in the United 
States for real property located in the Virgin Islands, notwithstanding 
the provisions of mirrored section 1031(h), such exchange may qualify as 
a like-kind exchange under mirrored section 1031 (provided that all the 
other requirements of mirrored section 1031 are satisfied).
    (iii) Nonapplication of general rule. Contexts in which the general 
rule of paragraph (g)(2)(i) of this section does not apply include--
    (A) The determination of any aspect of an individual's residency 
(for example, mirrored section 7701(b)). Thus, for example, an 
individual whose principal place of abode is in the United States is not 
considered to have a principal place of abode in the Virgin Islands for 
purposes of mirrored section 32(c).
    (B) The determination of the source of income for purposes other 
than the foreign tax credit (for example, sections 932(a) and (b), 
934(b), and 937). Thus, for example, compensation for services performed 
in the United States and rentals or royalties from property located in 
the United States do not constitute income from sources within

[[Page 146]]

the Virgin Islands for purposes of section 934(b); and
    (C) The definition of wages (mirrored section 3401). Thus, for 
example, services performed by an employee for an employer in the United 
States do not constitute services performed in the Virgin Islands under 
mirrored section 3401(a)(8).
    (h) Entity status consistency requirement--(1) In general. Taxpayers 
should make consistent entity status elections (as defined in paragraph 
(h)(3) of this section), where applicable, in both the United States and 
the Virgin Islands. In the case of a business entity to which this 
paragraph (h) applies--
    (i) If an entity status election is filed with the Internal Revenue 
Service (IRS) but not with the Virgin Islands Bureau of Internal Revenue 
(BIR), the Director of the BIR or his delegate, at his discretion, may 
deem the election also to have been made for Virgin Islands tax 
purposes;
    (ii) If an entity status election is filed with the BIR but not with 
the IRS, the Commissioner, at his discretion, may deem the election also 
to have been made for Federal tax purposes; and
    (iii) If inconsistent entity status elections are filed with the BIR 
and the IRS, both the Commissioner and the Director of the BIR or his 
delegate may, at their individual discretion, treat the elections they 
each received as invalid and may deem the election filed in the other 
jurisdiction to have been made also for tax purposes in their own 
jurisdiction. See Rev. Proc. 2006-23 (2006-1 CB 900) (see Sec. 
601.601(d)(2)(ii)(b) of this chapter) for procedures for requesting the 
assistance of the IRS when a taxpayer is or may be subject to 
inconsistent tax treatment by the IRS and a U.S. possession tax agency.
    (2) Scope. This paragraph (h) applies to the following business 
entities:
    (i) A business entity (as defined in Sec. 301.7701-2(a) of this 
chapter) that is domestic (as defined in Sec. 301.7701-5 of this 
chapter), or otherwise treated as domestic for purposes of the Code, and 
that is owned in whole or in part by any person who is either a bona 
fide resident of the Virgin Islands or a business entity created or 
organized in the Virgin Islands.
    (ii) A business entity that is created or organized in the Virgin 
Islands and that is owned in whole or in part by any U.S. person (other 
than a bona fide resident of the Virgin Islands).
    (3) Definition. For purposes of this section, the term entity status 
election includes an election under Sec. 301.7701-3(c) of this chapter, 
an election under section 1362(a), and any other similar elections.
    (4) Default status. Solely for the purpose of determining 
classification of an eligible entity under Sec. 301.7701-3(b) of this 
chapter and under that section as mirrored in the Virgin Islands, an 
eligible entity subject to this paragraph (h) will be classified for 
both Federal and Virgin Islands tax purposes using the rule that applies 
to domestic eligible entities.
    (5) Transition rules--(i) In the case of an election filed prior to 
April 11, 2005, except as provided in paragraph (h)(5)(ii) of this 
section, the rules of paragraph (h)(1) of this section will apply as of 
the first day of the first taxable year of the entity beginning after 
April 11, 2005.
    (ii) In the unlikely circumstance that inconsistent elections 
described in paragraph (h)(1)(iii) of this section are filed prior to 
April 11, 2005, and the entity cannot change its classification to 
achieve consistency because of the sixty-month limitation described in 
Sec. 301.7701-3(c)(1)(iv) of this chapter, then the entity may 
nevertheless request permission from the Commissioner or the Director of 
the BIR or his delegate to change such election to avoid inconsistent 
treatment by the Commissioner and the Director of the BIR or his 
delegate.
    (iii) Except as provided in paragraphs (h)(5)(i) and (h)(5)(ii) of 
this section, in the case of an election filed with respect to an entity 
before it became an entity described in paragraph (h)(2) of this 
section, the rules of paragraph (h)(1) of this section will apply as of 
the first day that such entity is described in paragraph (h)(2) of this 
section.
    (iv) In the case of an entity created or organized prior to April 
11, 2005, paragraph (h)(4) of this section will

[[Page 147]]

take effect for Federal income tax purposes (or Virgin Islands income 
tax purposes, as the case may be) as of the first day of the first 
taxable year of the entity beginning after April 11, 2005.
    (i) Examples. The rules of this section are illustrated by the 
following examples:

    Example 1. (i) A is a U.S. citizen who resides in State R. For 2008, 
A files with the IRS a Form 1040, ``U.S. Individual Income Tax Return,'' 
reporting adjusted gross income of $90x, which includes $30x from 
sources in the Virgin Islands. The income tax liability reported on A's 
Form 1040 is $18x. A files a copy of his Form 1040 with the Virgin 
Islands as required by section 932(a)(2) and paragraph (b)(1) of this 
section. A pays to the Virgin Islands the applicable percentage of his 
Federal income tax liability as required by section 932(b) and paragraph 
(b)(2) of this section, computed as follows: $30x/$90x x $18x = $6x 
income tax liability to the Virgin Islands.
    (ii) A claims a credit in the amount of $6x against his Federal 
income tax liability reported on his Form 1040. A attaches a Form 8689, 
``Allocation of Individual Income Tax to the U.S. Virgin Islands,'' to 
the Form 1040 filed with the IRS and to the copy filed with the Virgin 
Islands.
    Example 2. (i) B, a U.S. citizen, files returns on a calendar year 
basis. In November 2008, B moves to the Virgin Islands, purchases a 
house, and accepts a permanent position with a local employer. For the 
remainder of the year and throughout 2009, B continues to live and work 
in the Virgin Islands and has a closer connection to the Virgin Islands 
than to the United States or any foreign country. As a consequence of 
his employment in the Virgin Islands, B earns income from the 
performance of services in the Virgin Islands during 2008 and 2009.
    (ii) For 2008, B does not qualify as a bona fide resident under 
section 937(a) and Sec. 1.937-1(b) and (f)(1). Therefore, B is subject 
to the rules of sections 932(a) and (b) and paragraph (b) of this 
section for 2008 because he has income derived from sources within the 
Virgin Islands as determined under the rules of section 937(b) and Sec. 
1.937-2.
    (iii) For 2009, assuming that B otherwise satisfies the requirements 
of section 937(a) and Sec. 1.937-1(b), B qualifies as a bona fide 
resident of the Virgin Islands. Therefore, section 932(c) and paragraph 
(c) of this section apply to B for 2009, and he must file his income tax 
return with the Virgin Islands under paragraph (c)(1) of this section. 
Provided that B fully satisfies the reporting requirements of paragraph 
(c)(1) of this section and fully pays the tax liability referred to in 
section 934(a), B will have no Federal income tax filing requirement or 
liability under paragraphs (c)(2) and (3) of this section.
    Example 3. H and W are U.S. citizens. H resides in State T and W is 
a bona fide resident of the Virgin Islands. For 2008, H and W prepare a 
joint Form 1040, ``U.S. Individual Income Tax Return,'' reporting total 
adjusted gross income of $75x, of which $40x is attributable to 
compensation that W received for services performed in the Virgin 
Islands and $35x to compensation that H received for services performed 
in State T. Pursuant to section 932(d) and paragraph (d) of this 
section, because W would have the greater adjusted gross income if 
computed separately, H and W must file their joint Form 1040 with the 
Virgin Islands as required by section 932(c) and paragraph (c)(1) of 
this section. H and W may claim a tax credit on such return for income 
tax withheld during 2008 and paid to the IRS.
    Example 4. (i) The facts are the same as in Example 3, except that H 
also earns $25x for services performed in the Virgin Islands, so that H 
and W's total adjusted gross income is $100x, and their total income tax 
liability is $20x.
    (ii) Pursuant to section 932(d) and paragraph (d) of this section, 
because H would have the greater adjusted gross income if computed 
separately, H and W must file their joint Form 1040 with the IRS and 
must file a copy of that joint Form 1040 with the Virgin Islands as 
required by section 932(a)(2) and paragraph (b)(1) of this section. H 
and W must pay the applicable percentage of their Federal income tax 
liability to the Virgin Islands as required by section 932(b) and 
paragraph (b)(2) of this section, computed as follows: $65x /$100x x 
$20x = $13x income tax liability to the Virgin Islands.
    (iii) H and W claim a credit against their Federal income tax 
liability reported on their joint Form 1040 in the amount of $13x, the 
portion of their Federal income tax liability required to be paid to the 
Virgin Islands. H and W attach a Form 8689, ``Allocation of Individual 
Income Tax to the U.S. Virgin Islands,'' to their joint Form 1040 filed 
with the IRS and to the copy filed with the Virgin Islands.
    Example 5. N, a U.S. citizen and calendar year taxpayer, takes the 
position that he is a bona fide resident of the Virgin Islands for the 
2007 taxable year. On April 15, 2008, N files a Form 1040, ``U.S. 
Individual Income Tax Return,'' with the Virgin Islands for his 2007 
taxable year. N does not file a Form 1040 with the IRS. Because there is 
an agreement in force between the United States and the Virgin Islands 
for the routine exchange of income tax information, under paragraph 
(c)(2)(ii) of this section, the Federal 3-year period of limitations 
under section 6501(a) will expire on April 15, 2011, and the IRS will 
make no further assessment of income tax

[[Page 148]]

after that date for N's 2007 taxable year except as otherwise authorized 
by section 6501.
    Example 6. (i) J is a U.S. citizen and a bona fide resident of the 
Virgin Islands. In 2008, J receives compensation for services performed 
as an employee in the Virgin Islands in the amount of $40x. J files with 
the Virgin Islands a Form 1040, ``U.S. Individual Income Tax Return,'' 
reporting gross income of only $30x. Based on these facts, J has not 
satisfied the conditions of section 932(c)(4) and paragraph (c) of this 
section for an exclusion from gross income for Federal income tax 
purposes.
    (ii) The facts are the same as in paragraph (i) of this Example 6 
except that on or before the last day prescribed for filing an income 
tax return for J's 2008 taxable year, J files with the Virgin Islands an 
amended Form 1040 for 2008, correctly reporting the full $40x of 
compensation. Provided that J otherwise fully satisfies the reporting 
requirements of paragraph (c)(1) of this section and fully pays the tax 
liability referred to in section 934(a), J will have no Federal income 
tax filing requirement or liability under paragraphs (c)(2) and (3) of 
this section.
    Example 7. (i) N is a U.S. citizen and a bona fide resident of the 
Virgin Islands. In 2008, N receives compensation for services performed 
in Country M. N files with the Virgin Islands a Form 1040, ``U.S. 
Individual Income Tax Return,'' reporting the compensation as income 
effectively connected with the conduct of a trade or business in the 
Virgin Islands. N claims a special credit against the tax on this 
compensation pursuant to a Virgin Islands law enacted within the limits 
of its authority under section 934.
    (ii) Under the principles of section 864(c)(4) as applied pursuant 
to section 937(b)(1) and Sec. 1.937-3(b), compensation for services 
performed outside the Virgin Islands may not be treated as income 
effectively connected with the conduct of a trade or business in the 
Virgin Islands for purposes of section 934(b). Consequently, N is not 
entitled to claim the special credit under Virgin Islands law with 
respect to N's income from services performed in Country M. Because N 
has not fully paid his tax liability referred to in section 934(a), he 
has not satisfied the conditions of section 932(c)(4) and paragraph (c) 
of this section for an exclusion from gross income for Federal income 
tax purposes. Therefore, income reported on the Form 1040 as filed with 
the Virgin Islands must be included in N's Federal gross income. Under 
paragraph (c)(3) of this section, the amount of tax paid to the Virgin 
Islands on such income will be allowed as a credit against N's Federal 
income tax liability.

    (j) Effective/applicability date. Except as otherwise provided in 
this paragraph (j), this section applies to taxable years ending after 
April 9, 2008. Taxpayers may choose to apply paragraph (c)(2)(ii) of 
this section to open taxable years ending on or after December 31, 2006.

[T.D. 9391, 73 FR 19361, Apr. 9, 2008, as amended at T.D. 9391, 73 FR 
27728, May 14, 2007; T.D. 9391, 76 FR 4244, Jan. 25, 2011]



Sec. 1.933-1  Exclusion of certain income from sources within
Puerto Rico.

    (a) General rule. (1) An individual (whether a United States citizen 
or an alien), who is a bona fide resident of Puerto Rico during the 
entire taxable year, will exclude from gross income the income derived 
from sources within Puerto Rico, except amounts received for services 
performed as an employee of the United States or any agency thereof. For 
purposes of section 933 and this section, an employee of the government 
of Puerto Rico will not be considered an employee of the United States 
or of an agency of the United States.
    (2) The following example illustrates the application of the general 
rule in paragraph (a)(1) of this section:

    Example. E, a United States citizen, files returns on a calendar 
year basis. In April 2008, E moves to Puerto Rico, where he purchases a 
house and accepts a permanent position with a local employer. For the 
remainder of the year and for the following three taxable years, E 
continues to live and work in Puerto Rico and has a closer connection to 
Puerto Rico than to the United States or any foreign country. Assuming 
that E otherwise meets the requirements under section 937(a) and Sec. 
1.937-1(b) and (f)(1) (year-of-move exception), E is considered a bona 
fide resident of Puerto Rico for 2008. Accordingly, under section 933(1) 
and paragraph (a)(1) of this section, E should exclude from his 2008 
Federal gross income any income from sources within Puerto Rico, as 
determined under section 937(b) and Sec. 1.937-2.

    (b) Taxable year of change of residence from Puerto Rico. A citizen 
of the United States who changes his residence from Puerto Rico after 
having been a bona fide resident thereof for a period of at least two 
years immediately preceding the date of such change in residence shall 
exclude from his gross income the income derived from sources within 
Puerto Rico which is attributable to that part of such period of Puerto 
Rican residence which preceded the date of such change in

[[Page 149]]

residence, except amounts received for services performed as an employee 
of the United States or any agency thereof.
    (c) Deductions and credits. In any case in which any amount 
otherwise constituting gross income is excluded from gross income under 
the provisions of section 933, there will not be allowed as a deduction 
from gross income any items of expenses or losses or other deductions 
(except the deduction under section 151, relating to personal 
exemptions), or any credit, properly allocable to, or chargeable 
against, the amounts so excluded from gross income. For purposes of the 
preceding sentence, the rules of Sec. 1.861-8 will apply (with 
creditable expenditures treated in the same manner as deductible 
expenditures).
    (d) Definitions. For purposes of this section--
    (1) The rules of Sec. 1.937-1 will apply for determining whether an 
individual is a bona fide resident of Puerto Rico; and
    (2) The rules of Sec. 1.937-2 will apply for determining whether 
income is from sources within Puerto Rico.
    (e) Effective/applicability date. Paragraphs (a), (c), (d), and (e) 
of this section apply to taxable years ending after April 9, 2008.

[T.D. 6500, 25 FR 11910, Nov. 26, 1960; 25 FR 14021, Dec. 31, 1960, as 
amended by T.D. 9194, 70 FR 18934, Apr. 11, 2005; T.D. 9391, 73 FR 
19365, Apr. 9, 2008]



Sec. 1.934-1  Limitation on reduction in income tax liability incurred
to the Virgin Islands.

    (a) General rule. Section 934(a) provides that tax liability 
incurred to the United States Virgin Islands (Virgin Islands) must not 
be reduced or remitted in any way, directly or indirectly, whether by 
grant, subsidy, or other similar payment, by any law enacted in the 
Virgin Islands, except to the extent provided in section 934(b). For 
purposes of the preceding sentence, the term ``tax liability'' means the 
liability incurred to the Virgin Islands pursuant to subtitle A of the 
Internal Revenue Code (Code), as made applicable in the Virgin Islands 
by the Act of July 12, 1921 (48 U.S.C. 1397), or pursuant to section 
28(a) of the Revised Organic Act of the Virgin Islands (48 U.S.C. 1642), 
as modified by section 7651(5)(B).
    (b) Exception for Virgin Islands income--(1) In general. Section 
934(b)(1) provides an exception to the application of section 934(a). 
Under this exception, section 934(a) does not apply with respect to tax 
liability incurred to the Virgin Islands to the extent that such tax 
liability is attributable to income derived from sources within the 
Virgin Islands or income effectively connected with the conduct of a 
trade or business within the Virgin Islands.
    (2) Limitation. Section 934(b)(2) limits the scope of the exception 
provided by section 934(b)(1). Pursuant to this limitation, the 
exception does not apply with respect to an individual who is a citizen 
or resident of the United States (other than a bona fide resident of the 
Virgin Islands). For the rules for determining tax liability incurred to 
the Virgin Islands by such an individual, see section 932(a) and the 
regulations under that section.
    (3) Computation rule--(i) Operative rule. For purposes of section 
934(b)(1) and this paragraph (b), tax liability incurred to the Virgin 
Islands for the taxable year attributable to income derived from sources 
within the Virgin Islands or income effectively connected with the 
conduct of a trade or business within the Virgin Islands will be 
computed as follows:
    (A) Add to the income tax liability incurred to the Virgin Islands 
any credit against the tax allowed under mirrored section 901(a).
    (B) Multiply by taxable income from sources within the Virgin 
Islands and income effectively connected with the conduct of a trade or 
business within the Virgin Islands (applying the rules of Sec. 1.861-8 
to determine deductions allocable to such income).
    (C) Divide by total taxable income.
    (D) Subtract the portion of any credit allowed under mirrored 
section 901 (other than credits for taxes paid to the United States) 
determined by multiplying the amount of taxable income from sources 
outside the Virgin Islands or the United States that is effectively 
connected to the conduct of a trade or business in the Virgin Islands 
divided by the total amount of taxable income from such sources.
    (ii) Limitation. Tax liability incurred to the Virgin Islands 
attributable to

[[Page 150]]

income derived from sources within the Virgin Islands or income 
effectively connected with the conduct of a trade or business within the 
Virgin Islands, as computed in this paragraph (b)(3), however, will not 
exceed the total amount of income tax liability actually incurred.
    (4) Definitions. For purposes of this section--
    (i) Bona fide resident. The rules of Sec. 1.937-1 will apply for 
determining whether an individual is a bona fide resident of the Virgin 
Islands;
    (ii) Source. The rules of Sec. 1.937-2 will apply for determining 
whether income is from sources within the Virgin Islands; and
    (iii) Effectively connected income. The rules of Sec. 1.937-3 will 
apply for determining whether income is effectively connected with the 
conduct of a trade or business in the Virgin Islands.
    (c) Exception for qualified foreign corporations--(1) In general. 
Section 934(b)(3) provides an exception to the application of section 
934(a). Under this exception, section 934(a) does not apply with respect 
to tax liability incurred to the Virgin Islands by a qualified foreign 
corporation to the extent that such tax liability is attributable to 
income that is derived from sources outside the United States and that 
is not effectively connected with the conduct of a trade or business 
within the United States.
    (2) Qualified foreign corporation. For purposes of paragraph (c)(1) 
of this section, the term qualified foreign corporation means any 
foreign corporation if 1 or more United States persons own or are 
treated as owning (within the meaning of section 958) less than 10 
percent of--
    (i) The total voting power of the stock of such corporation; and
    (ii) The total value of the stock of such corporation.
    (3) Computation rule--(i) Operative rule. For purposes of section 
934(b)(3) and this paragraph (c), tax liability incurred to the Virgin 
Islands for the taxable year attributable to income that is derived from 
sources outside the United States and that is not effectively connected 
with the conduct of a trade or business within the United States will be 
computed as follows:
    (A) Add to the income tax liability incurred to the Virgin Islands 
any credit against the tax allowed under mirrored section 901(a).
    (B) Multiply by taxable income that is derived from sources outside 
the United States and that is not effectively connected with the conduct 
of a trade or business within the United States (applying the rules of 
Sec. 1.861-8 to determine deductions allocable to such income).
    (C) Divide by total taxable income.
    (D) Subtract any credit allowed under mirrored section 901 (other 
than credits for taxes paid to the United States or taxes for which a 
credit is allowable for Federal income tax purposes under section 906 of 
the Code).
    (ii) Limitation. Tax liability incurred to the Virgin Islands 
attributable to income that is derived from sources outside the United 
States and that is not effectively connected with the conduct of a trade 
or business within the United States, as computed in this paragraph 
(c)(3), however, will not exceed the total amount of income tax 
liability actually incurred.
    (4) U.S. income--(i) In general. For purposes of this section, 
except as provided in paragraph (c)(4)(ii) of this section, the rules of 
sections 861 through 865 and the regulations under those provisions will 
apply for determining whether income is from sources outside the United 
States or effectively connected with the conduct of a trade or business 
within the United States.
    (ii) Conduit arrangements. Income will be considered to be from 
sources within the United States for purposes of paragraph (c)(1) of 
this section if, pursuant to a plan or arrangement--
    (A) The income is received in exchange for consideration provided to 
another person; and
    (B) Such person (or another person) provides the same consideration 
(or consideration of a like kind) to a third person in exchange for one 
or more payments constituting income from sources within the United 
States.
    (d) Examples. The rules of this section are illustrated by the 
following examples:

    Example 1. (i) S is a U.S. citizen and a bona fide resident of the 
Virgin Islands. For 2008, S files a Form 1040INFO, ``Non-Virgin Islands

[[Page 151]]

Source Income of Virgin Islands Residents,'' with the Virgin Islands on 
which S reports total gross income as follows:

Compensation for services performed in the Virgin Islands--$50,000
Compensation for services performed in the United States--$40,000
Compensation for services performed in Mexico--$30,000
Income from inventory sales in Latin America attributable to Virgin 
Islands office--$20,000
Interest on a U.S. bank account--$6,000
Interest on a V.I. bank account--$5,000
Dividends from a U.S. corporation--$4,000

    (ii) Accordingly, S has total gross income of $155,000, comprising 
income from sources within the Virgin Islands or effectively connected 
to the conduct of a trade or business in the Virgin Islands (Virgin 
Islands ECI) of $75,000, income from sources within the United States of 
$50,000, and income from other sources (not Virgin Islands ECI) of 
$30,000. After taking into account allowable deductions, S's total 
taxable income is $120,000, of which $45,000 is taxable income from 
sources within the Virgin Islands, $15,000 is taxable income from other 
sources that is Virgin Islands ECI under the rules of section 937(b) and 
Sec. Sec. 1.937-2 and 1.937-3, and $22,500 is taxable income from 
sources outside the Virgin Islands (and outside the United States) that 
is not Virgin Islands ECI. S's tax liability incurred to the Virgin 
Islands pursuant to the Internal Revenue Code as applicable in the 
Virgin Islands (mirror code) is $30,000. S is entitled to claim a credit 
under section 901 of the mirror code in the amount of $10,000 for income 
tax paid to Mexico and other Latin American countries, for a net income 
tax liability of $20,000.
    (iii) Pursuant to a Virgin Islands law that was duly enacted within 
the limits of its authority under section 934, S may claim a special 
deduction relating to his business activities in the Virgin Islands. 
However, under section 934(b), S's ability to claim this special 
deduction is limited. Specifically, the maximum amount of the reduction 
in S's mirror code tax liability that may result from claiming this 
deduction, computed in accordance with paragraph (b)(3) of this section, 
is as follows: [($20,000 + $10,000) x (($45,000 + $15,000) / $120,000)] 
- [$10,000 x ($15,000 / ($15,000 + $22,500))] = [$30,000 x ($60,000 / 
$120,000)] - [$10,000 x ($15,000 / $37,500)] = ($30,000 x 0.5) - 
($10,000 x 0.4) = $15,000 - $4,000 = $11,000
    (iv) Accordingly, S's net tax liability incurred to the Virgin 
Islands must be at least $19,000 ($30,000 - $11,000), prior to taking 
into account any foreign tax credit.
    Example 2. The facts are the same as Example 1, except that S is a 
U.S. citizen who resides in the United States. As required by section 
932(a) and (b), S files with the Virgin Islands a copy of his Federal 
income tax return and pays to the Virgin Islands the portion of his 
Federal income tax liability that his Virgin Islands adjusted gross 
income bears to his adjusted gross income. Under section 934(b)(2), S 
may not claim the special deduction offered under Virgin Islands law 
relating to business activities like his in the Virgin Islands to reduce 
any of his tax liability payable to the Virgin Islands under section 
932(b).
    Example 3. (i) Z is a nonresident alien who resides in Country FC. 
In 2008, Z receives dividends from a corporation organized under the law 
of the Virgin Islands in the amount of $90x. Z's tax liability incurred 
to the Virgin Islands pursuant to section 871(a) of the Code as 
applicable in the Virgin Islands (mirror code) is $27x.
    (ii) Pursuant to a Virgin Islands law that was duly enacted within 
the limits of its authority under section 934, Z may claim a special 
exemption for income relating to his investment in the Virgin Islands. 
The maximum amount of the reduction in Z's mirror code tax liability 
that may result from claiming this exemption, computed in accordance 
with paragraph (b)(3) of this section, is as follows: $27x x ($90x/$90x) 
= $27x.
    (iii) Accordingly, depending on the terms of the exemption as 
provided under Virgin Islands law, Z's net tax liability incurred to the 
Virgin Islands may be reduced or eliminated entirely.
    Example 4. (i) A Corp is organized under the laws of the Virgin 
Islands and is engaged in a trade or business in the United States 
through an office in State N. All of A Corp's outstanding stock is owned 
by U.S. citizens who are bona fide residents of the Virgin Islands. 
During 2008, A Corp had $50x in gross income from sources within the 
Virgin Islands (as determined under section 937(b) and Sec. 1.937-2) 
that is not effectively connected with the conduct of a trade or 
business in the United States; $20x in gross income from sources in 
Country H that is effectively connected with the conduct of A Corp's 
trade or business in the United States; and $10x in gross income from 
sources in Country R that is not effectively connected with the conduct 
of A Corp's trade or business in the United States.
    (ii) Section 934(b)(3) permits the Virgin Islands to reduce or remit 
the income tax liability of a qualified foreign corporation arising 
under the Code as applicable in the Virgin Islands (mirror code) with 
respect to income that is derived from sources outside the United States 
and that is not effectively connected with the conduct of a trade or 
business in the United States. A foreign corporation constitutes a 
``qualified foreign corporation'' under section 934(b)(3)(B) if less 
than 10 percent of the total voting power and value of the stock of the 
corporation is

[[Page 152]]

owned or treated as owned (within the meaning of section 958) by one or 
more United States persons. A U.S. citizen is a ``United States person'' 
as defined in section 7701(a)(30)(A). Given that 10 percent or more of 
the voting power and value of its stock is owned by U.S. citizens, A 
Corp does not constitute a ``qualified foreign corporation'' under 
section 934(b)(3)(B). Accordingly, the Virgin Islands may only reduce or 
remit A Corp's mirror code income tax liability with respect to its $50x 
in gross income from sources within the Virgin Islands.
    Example 5. (i) The facts are the same as in Example 4, except that 
the outstanding stock of A Corp is owned by the following individuals:
U.S. citizens who are bona fide residents of the Virgin Islands--5%
U.S. citizens who are not bona fide residents of the Virgin Islands--3%
Nonresident aliens who are bona fide residents of the Virgin Islands--
42%
Nonresident aliens who are not bona fide residents of the Virgin 
Islands--50%

    (ii) Given that less than 10 percent of the voting power and value 
of its stock is owned by United States persons, A Corp constitutes a 
qualified foreign corporation under section 934(b)(3)(B). Accordingly, 
the Virgin Islands may reduce or remit A Corp's mirror code income tax 
liability with respect to its $50x in gross income from sources within 
the Virgin Islands and its $10x in gross income from sources in Country 
R that is not effectively connected with the conduct of A Corp's trade 
or business in the United States. In no event, however, may the Virgin 
Islands reduce or remit A Corp's mirror code income tax liability with 
respect to its $20x in gross income from sources in Country H that is 
effectively connected with the conduct of A Corp's trade or business in 
the United States.

    (e) Effective/applicability date. This section applies for taxable 
years ending after April 9, 2008.

[T.D. 9391, 73 FR 19365, Apr. 9, 2008]



Sec. 1.935-1  Coordination of individual income taxes with Guam and
the Northern Mariana Islands.

    (a) Application of section--(1) Scope. Section 935 and this section 
set forth the special rules relating to the filing of income tax 
returns, income tax liabilities, and estimated income tax of individuals 
described in paragraph (a)(2) of this section. Paragraph (e) of this 
section also provides special rules requiring consistent treatment of 
business entities in the United States and in section 935 possessions.
    (2) Individuals covered. This section applies to any individual 
who--
    (i) Is a bona fide resident of a section 935 possession during the 
entire taxable year, whether or not such individual is a citizen of the 
United States or a resident alien (as defined in section 7701(b)(1)(A));
    (ii) Is a citizen of a section 935 possession but not otherwise a 
citizen of the United States;
    (iii) Has income from sources within a section 935 possession for 
the taxable year, is a citizen of the United States or a resident alien 
(as defined in section 7701(b)(1)(A)) and is not a bona fide resident of 
a section 935 possession during the entire taxable year; or
    (iv) Files a joint return for the taxable year with any individual 
described in paragraph (a)(2)(i), (ii), or (iii) of this section.
    (3) Definitions. For purposes of this section, the following 
definitions apply:
    (i) The term section 935 possession means Guam or the Northern 
Mariana Islands, unless such possession has entered into an implementing 
agreement, as described in section 1271(b) of the Tax Reform Act of 
1986, Public Law 99-514 (100 Stat. 2085), with the United States that is 
in effect for the entire taxable year.
    (ii) The term relevant possession means--
    (A) With respect to an individual described in paragraph (a)(2)(i) 
of this section, the section 935 possession of which such individual is 
a bona fide resident;
    (B) With respect to an individual described in paragraph (a)(2)(ii) 
of this section, the section 935 possession of which such individual is 
a citizen; and
    (C) With respect to an individual described in paragraph (a)(2)(iii) 
of this section, the section 935 possession from which such individual 
derives income.
    (iii) The rules of Sec. 1.937-1 will apply for determining whether 
an individual is a bona fide resident of a section 935 possession.
    (iv) The rules of Sec. 1.937-2 generally will apply for determining 
whether income is from sources within a section 935 possession. Pursuant 
to Sec. 1.937-2(a), however, the rules of Sec. 1.937-2(c)(1)(ii) and 
(c)(2) do not apply for purposes of

[[Page 153]]

section 935(a)(3) (as in effect before the effective date of its repeal) 
and paragraph (a)(2)(iii) of this section.
    (v) The term citizen of the United States means any individual who 
is a citizen within the meaning of Sec. 1.1-1(c), except that the term 
does not include an individual who is a citizen of a section 935 
possession but not otherwise a citizen of the United States. The term 
citizen of a section 935 possession but not otherwise a citizen of the 
United States means any individual who has become a citizen of the 
United States by birth or naturalization in the section 935 possession.
    (vi) With respect to the United States, the term resident means an 
individual who is a citizen (as defined in Sec. 1.1-1(c)) or resident 
alien (as defined in section 7701(b)) and who does not have a tax home 
(as defined in section 911(d)(3)) in a foreign country during the entire 
taxable year. The term does not include an individual who is a bona fide 
resident of a section 935 possession.
    (vii) The term U.S. taxpayer means an individual described in 
paragraph (b)(1)(i) or (iii)(B) of this section.
    (b) Filing requirement--(1) Tax jurisdiction. An individual 
described in paragraph (a)(2) of this section must file an income tax 
return for the taxable year--
    (i) With the United States if such individual is a resident of the 
United States;
    (ii) With the relevant possession if such individual is described in 
paragraph (a)(2)(i) of this section; or
    (iii) If neither paragraph (b)(1)(i) nor paragraph (b)(1)(ii) of 
this section applies--
    (A) With the relevant possession if such individual is described in 
paragraph (a)(2)(ii) of this section; or
    (B) With the United States if such individual is a citizen of the 
United States, as defined in paragraph (a)(3) of this section.
    (2) Joint returns. In the case of married persons, if one or both 
spouses is an individual described in paragraph (a)(2) of this section 
and they file a joint return of income tax, the spouses shall file their 
joint return with, and pay the tax due on such return to, the 
jurisdiction where the spouse who has the greater adjusted gross income 
for the taxable year would be required under subparagraph (1) of this 
paragraph to file his return if separate returns were filed. For this 
purpose, adjusted gross income of each spouse is determined under 
section 62 and the regulations thereunder but without regard to 
community property laws; and, if one of the spouses dies, the taxable 
year of the surviving spouse shall be treated as ending on the date of 
such death.
    (3) Place for filing returns--(i) U.S. returns. A return required 
under this paragraph (b) to be filed with the United States must be 
filed as directed in the applicable forms and instructions.
    (ii) Guam returns. A return required under this paragraph (b) to be 
filed with Guam must be filed as directed in the applicable forms and 
instructions.
    (iii) NMI returns. A return required under this paragraph (b) to be 
filed with the Northern Mariana Islands must be filed as directed in the 
applicable forms and instructions.
    (4) Tax accounting standards. A taxpayer who has filed his return 
with one of the jurisdictions named in subparagraph (1) of this 
paragraph for a prior taxable year and is required to file his return 
for a later taxable year with the other such jurisdiction may not, for 
such later taxable year, change his accounting period, method of 
accounting, or any election to which he is bound with respect to his 
reporting of taxable income to the first jurisdiction unless he obtains 
the consent of the second jurisdiction to make such change. However, 
such change will not be effective for returns filed thereafter with the 
first jurisdiction unless before such later date of filing he also 
obtains the consent of the first jurisdiction to make such change. Any 
request for consent to make a change pursuant to this subparagraph must 
be made to the office where the return is required to be filed under 
subparagraph (3) of this paragraph and in sufficient time to permit a 
copy of the consent to be attached to the return for the taxable year.
    (5) Tax payments. The tax shown on the return must be paid to the 
jurisdiction with which such return is required to be filed and must be 
determined by

[[Page 154]]

taking into account any credit under section 31 for tax withheld by the 
relevant possession or the United States on wages, any credit under 
section 6402(b) for an overpayment of income tax to the relevant 
possession or the United States, and any payments under section 6315 of 
estimated income tax paid to the relevant possession or the United 
States.
    (6) Liability to other jurisdiction--(i) Filing with the relevant 
possession. In the case of an individual who is required under paragraph 
(b)(1) of this section to file a return with the relevant possession for 
a taxable year, if such individual properly files such return and fully 
pays his or her income tax liability to the relevant possession, such 
individual is relieved of liability to file an income tax return with, 
and to pay an income tax to, the United States for the taxable year.
    (ii) Filing with the United States. In the case of an individual who 
is required under paragraph (b)(1) of this section to file a return with 
the United States for a taxable year, such individual is relieved of 
liability to file an income tax return with, and to pay an income tax 
to, the relevant possession for the taxable year.
    (7) [Reserved]
    (c) Extension of territory--(1) U.S. taxpayers--(i) General rule. 
With respect to a U.S. taxpayer, for purposes of taxes imposed by 
Chapter 1 of the Internal Revenue Code (Code), the United States 
generally will be treated, in a geographical and governmental sense, as 
including the relevant possession. The purpose of this rule is to 
facilitate the coordination of the tax systems of the United States and 
the relevant possession. Accordingly, the rule will have no effect where 
it is manifestly inapplicable or its application would be incompatible 
with the intent of any provision of the Code.
    (ii) Application of general rule. Contexts in which the general rule 
of paragraph (c)(1)(i) of this section apply include--
    (A) The characterization of taxes paid to the relevant possession. 
Income tax paid to the relevant possession may be taken into account 
under sections 31, 6315, and 6402(b) as payments to the United States. 
Taxes paid to the relevant possession and otherwise satisfying the 
requirements of section 164(a) will be allowed as a deduction under that 
section, but income taxes paid to the relevant possession will be 
disallowed as a deduction under section 275(a);
    (B) The determination of the source of income for purposes of the 
foreign tax credit (for example, sections 901 through 904). Thus, for 
example, after a U.S. taxpayer determines which items of income 
constitute income from sources within the relevant possession under the 
rules of section 937(b), such income will be treated as income from 
sources within the United States for purposes of section 904;
    (C) The eligibility of a corporation to make a subchapter S election 
(sections 1361 through 1379). Thus, for example, for purposes of 
determining whether a corporation created or organized in the relevant 
possession may make an election under section 1362(a) to be a subchapter 
S corporation, it will be treated as a domestic corporation and a U.S. 
taxpayer shareholder will not be treated as a nonresident alien 
individual with respect to such corporation. While such an election is 
in effect, the corporation will be treated as a domestic corporation for 
all purposes of the Code. For the consistency requirement with respect 
to entity status elections, see paragraph (e) of this section;
    (D) The treatment of items carried over from other taxable years. 
Thus, for example, if a U.S. taxpayer has for a taxable year a net 
operating loss carryback or carryover under section 172, a foreign tax 
credit carryback or carryover under section 904, a business credit 
carryback or carryover under section 39, a capital loss carryover under 
section 1212, or a charitable contributions carryover under section 170, 
the carryback or carryover will be reported on the return filed with the 
United States in accordance with paragraph (b)(1)(i) or (b)(1)(iii)(B) 
of this section, even though the return of the taxpayer for the taxable 
year giving rise to the carryback or carryover was required to be filed 
with a section 935 possession; and
    (E) The treatment of property exchanged for property of a like kind 
(section 1031). Thus for example, if a

[[Page 155]]

U.S. taxpayer exchanges real property located in the United States for 
real property located in the relevant possession, notwithstanding the 
provisions of section 1031(h), such exchange may qualify as a like-kind 
exchange under section 1031 (provided that all the other requirements of 
section 1031 are satisfied).
    (iii) Nonapplication of general rule. Contexts in which the general 
rule of paragraph (c)(1)(i) of this section does not apply include--
    (A) The application of any rules or regulations that explicitly 
treat the United States and any (or all) of its possessions as separate 
jurisdictions (for example, sections 931 through 937, 7651, and 7654);
    (B) The determination of any aspect of an individual's residency 
(for example, sections 937(a) and 7701(b)). Thus, for example, an 
individual whose principal place of abode is in the relevant possession 
is not considered to have a principal place of abode in the United 
States for purposes of section 32(c);
    (C) The determination of the source of income for purposes other 
than the foreign tax credit (for example, sections 935, 937, and 7654). 
Thus, for example, income determined to be derived from sources within 
the relevant possession under section 937(b) will not be considered 
income from sources within the United States for purposes of Form 5074, 
``Allocation of Individual Income Tax to Guam or the Commonwealth of the 
Northern Mariana Islands (CNMI)'';
    (D) The definition of wages (section 3401). Thus, for example, 
services performed by an employee for an employer in the relevant 
possession do not constitute services performed in the United States 
under section 3401(a)(8); and
    (E) The characterization of a corporation for purposes other than 
subchapter S (for example, sections 367, 951 through 964, 1291 through 
1298, 6038, and 6038B). Thus, for example, if a U.S. taxpayer transfers 
appreciated tangible property to a corporation created or organized in 
the relevant possession in a transaction described in section 351, he or 
she must recognize gain unless an exception under section 367(a) 
applies. Also, if a corporation created or organized in the relevant 
possession qualifies as a passive foreign investment company under 
sections 1297 and 1298 with respect to a U.S. taxpayer, a dividend paid 
to such shareholder does not constitute qualified dividend income under 
section 1(h)(11)(B).
    (2) Application in relevant possession. In applying the territorial 
income tax of the relevant possession, such possession generally will be 
treated, in a geographical and governmental sense, as including the 
United States. Thus, for example, income tax paid to the United States 
may be taken into account under sections 31, 6315, and 6402(b) as 
payments to the relevant possession. Moreover, a citizen of the United 
States (as defined in paragraph (a)(3) of this section) not a resident 
of the relevant possession will not be treated as a nonresident alien 
individual for purposes of the territorial income tax of the relevant 
possession. Thus, for example, a citizen of the United States (as so 
defined), or a resident of the United States, will not be treated as a 
nonresident alien individual for purposes of section 1361(b)(1)(C) of 
the Guam territorial income tax.
    (d) Special rules for estimated income tax--(1) In general. An 
individual must make each payment of estimated income tax (and any 
amendment to the estimated tax payment) to the jurisdiction with which 
the individual reasonably believes, as of the date of that payment (or 
amendment), that he or she will be required to file a return for the 
taxable year under paragraph (b)(1) of this section. In determining the 
amount of such estimated income tax, income tax paid to the relevant 
possession may be taken into account under sections 31 and 6402(b) as 
payments to the United States, and vice versa. For other rules relating 
to estimated income tax, see section 6654.
    (2) Joint estimated income tax. In the case of married persons 
making a joint payment of estimated income tax, the taxpayers must make 
each payment of estimated income tax (and any amendment to the estimated 
tax payment) to the jurisdiction where the spouse who has the greater 
estimated adjusted gross income for the taxable year would be required 
under paragraph (d)(1) of this section to pay estimated income tax if 
separate payments were

[[Page 156]]

made. For this purpose, estimated adjusted gross income of each spouse 
for the taxable year is determined without regard to community property 
laws.
    (3) Erroneous payment. If the individual or spouses erroneously pay 
estimated income tax to the United States instead of the relevant 
possession or vice versa, only subsequent payments or amendments of the 
payments are required to be made pursuant to paragraph (d)(1) or (d)(2) 
of this section with the other jurisdiction.
    (4) Place for payment. Estimated income tax required under this 
paragraph (d) to be paid to Guam or the Northern Mariana Islands must be 
paid as directed in the applicable forms and instructions issued by the 
relevant possession. Estimated income tax required under paragraph 
(d)(1) of this section to be paid to the United States must be paid as 
directed in the applicable forms and instructions.
    (5) Liability to other jurisdiction--(i) Filing with Guam or the 
Northern Mariana Islands. Subject to paragraph (d)(6) of this section, 
an individual required under this paragraph (d) to pay estimated income 
tax (and amendments thereof) to Guam or the Northern Mariana Islands is 
relieved of liability to pay estimated income tax (and amendments 
thereof) to the United States.
    (ii) Filing with the United States. Subject to paragraph (d)(6) of 
this section, an individual required under this paragraph (d) to pay 
estimated income tax (and amendments thereof) to the United States is 
relieved of liability to pay estimated income tax (and amendments 
thereof) to the relevant possession.
    (6) Underpayments. The liability of an individual described in 
paragraph (a)(2) of this section for underpayments of estimated income 
tax for a taxable year, as determined under section 6654, will be to the 
jurisdiction with which the individual is required under paragraph (b) 
of this section to file his or her return for the taxable year.
    (e) Entity status consistency requirement--(1) In general. Taxpayers 
should make consistent entity status elections (as defined in paragraph 
(e)(3)(ii) of this section), when applicable, in both the United States 
and section 935 possessions. In the case of a business entity to which 
this paragraph (e) applies--
    (i) If an entity status election is filed with the Internal Revenue 
Service (IRS) but not with the relevant possession, the appropriate tax 
authority of the relevant possession, at his discretion, may deem the 
election also to have been made for the relevant possession tax 
purposes;
    (ii) If an entity status election filed with the relevant possession 
but not with the IRS, the Commissioner, at his discretion, may deem the 
election also to have been made for Federal tax purposes; and
    (iii) If inconsistent entity status elections are filed with the 
relevant possession and the IRS, both the Commissioner and the 
appropriate tax authority of the relevant possession may, at their 
individual discretion, treat the elections they each received as invalid 
and may deem the election filed in the other jurisdiction to have been 
made also for tax purposes in their own jurisdiction. See Rev. Proc. 
2006-23 (2006-1 C.B. 900) (see Sec. 601.601(d)(2)(ii)(b) of this 
chapter) for procedures for requesting the assistance of the IRS when a 
taxpayer is or may be subject to inconsistent tax treatment by the IRS 
and a U.S. possession tax agency.)
    (2) Scope. This paragraph (e) applies to the following business 
entities:
    (i) A business entity (as defined in Sec. 301.7701-2(a) of this 
chapter) that is domestic (as defined in Sec. 301.7701-5 of this 
chapter), or otherwise treated as domestic for purposes of the Code, and 
that is owned in whole or in part by any person who is either a bona 
fide resident of a section 935 possession or a business entity created 
or organized in a section 935 possession.
    (ii) A business entity that is created or organized in a section 935 
possession and that is owned in whole or in part by any U.S. person 
(other than a bona fide resident of such possession).
    (3) Definitions. For purposes of this section--
    (i) The term appropriate tax authority of the relevant possession 
means the individual responsible for tax administration in such 
possession or his delegate; and
    (ii) The term entity status election includes an election under 
Sec. 301.7701-3(c)

[[Page 157]]

of this chapter, an election under section 1362(a), and any other 
similar elections.
    (4) Default status. Solely for the purpose of determining 
classification of an eligible entity under Sec. 301.7701-3(b) of this 
chapter and under that section as mirrored in the relevant possession, 
an eligible entity subject to this paragraph (e) will be classified for 
both Federal and the relevant possession tax purposes using the rule 
that applies to domestic eligible entities.
    (5) Transition rules--(i) In the case of an election filed prior to 
April 11, 2005, except as provided in paragraph (e)(5)(ii) of this 
section, the rules of paragraph (e)(1) of this section will apply as of 
the first day of the first taxable year of the entity beginning after 
April 11, 2005.
    (ii) In the unlikely circumstance that inconsistent elections 
described in paragraph (e)(1)(iii) of this section are filed prior to 
April 11, 2005, and the entity cannot change its classification to 
achieve consistency because of the sixty-month limitation described in 
Sec. 301.7701-3(c)(1)(iv) of this chapter, then the entity may 
nevertheless request permission from the Commissioner or appropriate tax 
authority of the relevant possession to change such election to avoid 
inconsistent treatment by the Commissioner and the appropriate tax 
authority of the relevant possession.
    (iii) Except as provided in paragraphs (e)(5)(i) and (e)(5)(ii) of 
this section, in the case of an election filed with respect to an entity 
before it became an entity described in paragraph (e)(2) of this 
section, the rules of paragraph (e)(1) of this section will apply as of 
the first day that such entity is described in paragraph (e)(2) of this 
section.
    (iv) In the case of an entity created or organized prior to April 
11, 2005, paragraph (e)(4) of this section will take effect for Federal 
income tax purposes (or the relevant possession income tax purposes, as 
the case may be) as of the first day of the first taxable year of the 
entity beginning after April 11, 2005.
    (f) Examples. The application of this section is illustrated by the 
following examples:

    Example 1. (i) B, a United States citizen, files returns on a 
calendar year basis. In November 2008, B moves to Possession G, a 
section 935 possession; purchases a house; and accepts a permanent 
position with a local employer. For the remainder of the year and 
throughout 2009, B continues to live and work in Possession G and has a 
closer connection to Possession G than to the United States or any 
foreign country. As a consequence of his employment in Possession G, B 
earns income from the performance of services in Possession G during 
2008 and 2009.
    (ii) For 2008, B does not qualify as a bona fide resident of 
Possession G under section 937(a) and Sec. 1.937-1(b) and (f)(1). 
Therefore, B is subject to the rules applicable to individuals described 
in paragraph (a)(2)(iii) of this section for 2008 because he has income 
derived from sources within Possession G as determined under the rules 
of section 937(b) and Sec. 1.937-2.
    (iii) For 2009, assuming that B otherwise satisfies the requirements 
of section 937(a) and Sec. 1.937-1(b), B qualifies as a bona fide 
resident of Possession G. Therefore, section 935(b)(1)(B) and paragraph 
(b)(1)(ii) of this section apply to B for 2009, and he must file his 
income tax return with Possession G under paragraph (b)(1) of this 
section. Provided that B properly files such return and pays his income 
tax liability to Possession G, B is relieved of liability to file an 
income tax return with, and to pay an income tax to, the United States 
for 2009 under paragraph (b)(6) of this section.
    Example 2. (i) The facts are the same as in Example 1 except that 
B's employment terminates in June 2011. B properly pays his April 2008 
estimated tax to the United States, continues to pay estimated tax for 
the 2008 taxable year to the United States under paragraph (d) of this 
section, and properly files his 2008 return with the United States.
    (ii)(A) On the date of each payment of estimated tax in 2009, B 
reasonably believes that he would be required to file his return for 
2009 with Possession G under paragraph (b)(1) of this section.
    (B) In August 2009, B determines that he has overpaid tax for the 
previous year in the amount of $1000. B properly pays all estimated 
taxes to Possession G for 2009, subtracting the $1000 overpayment from 
his estimated tax payments pursuant to section 6402(b), and properly 
files his tax return with Possession G.
    (iii) In April 2010, B reasonably believes that he would be 
returning to the United States in the Fall of 2010, and properly pays 
estimated tax to the United States. By June 2010, B reasonably believes 
that he would not be moving from Possession G and would be a bona fide 
resident of Possession G for the entire taxable year. B makes his 
remaining estimated tax payments to Possession G. On

[[Page 158]]

his 2010 tax return filed with Possession G, pursuant to section 6315, B 
properly takes into account payments made to both the United States and 
Possession G as estimated taxes.
    (iv) In April 2011, B reasonably believes that he would be a bona 
fide resident of Possession G for the entire taxable year 2011 and 
properly pays estimated taxes to Possession G. By the time B pays his 
estimated taxes for June 2011, B's employment terminates and he moves to 
State H. B properly makes his remaining estimated tax payments to the 
United States. On his return for 2011, properly filed with the United 
States, B determines that he has underpaid estimated taxes throughout 
2011 in an amount subject to penalty under section 6654. B owes the 
United States an estimated tax penalty under section 6654.

    (g) Effective/applicability date. Paragraphs (a), (b)(1), (b)(3), 
(b)(5) through (b)(7), and (c) through (f) of this section apply to 
taxable years ending after April 9, 2008.

(Secs. 7805 (68A Stat. 917; 26 U.S.C. 7805) and 7654(e) (86 Stat. 1496; 
26 U.S.C. 7654 (e)) of the Internal Revenue Code of 1954)

[T.D. 7385, 40 FR 50261, Oct. 29, 1975, as amended by T.D. 9194, 70 FR 
18937, Apr. 11, 2005; T.D. 9391, 73 FR 19367, Apr. 9, 2008]



Sec. 1.936-1  Elections.

    (a) Making an election. A domestic corporation shall make an 
election under section 936(e), for any taxable year beginning after 
December 31, 1975, by filing Form 5712 on or before the later of--
    (1) The date on which such corporation is required, pursuant to 
sections 6072(b) and 6081, to file its Federal income tax return for the 
first taxable year for which the election is made; or
    (2) April 8, 1980.


Form 5712 shall be filed with the Internal Revenue Service Center, 11601 
Roosevelt Boulevard, Philadelphia, Pennsylvania 19155 (Philadelphia 
Center).
    (b) Revoking an election. Any corporation to which an election under 
section 936 (e) applies on February 8, 1980 is hereby granted the 
consent of the Secretary to revoke that election for the first taxable 
year to which the election applied. (The corporation may make a new 
election under Sec. 1.936-1 (a) for any subsequent taxable year.) The 
corporation shall make this revocation by sending to the Philadelphia 
Center a written statement of revocation on or before April 8, 1980.

(Secs. 7805 and 936(e) of the Internal Revenue Code of 1954 (68A Stat. 
917 and 90 Stat. 1644; 26 U.S.C. 7805 and 936(e)))

[T.D. 7673, 45 FR 8588, Feb. 8, 1980; T.D. 7673, 45 FR 16174, Mar. 13, 
1980]



Sec. 1.936-4  Intangible property income in the absence of an election 
out.

    The rules in this section apply for purposes of section 936(h) and 
also for purposes of section 934(e), where applicable.
    Q. 1: If a possessions corporation and its affiliates do not make an 
election under either the cost sharing or 50/50 profit split option, 
what rules will govern the treatment of income attributable to 
intangible property owned or leased by the possessions corporation?
    A. 1: Intangible property income will be allocated to the 
possessions corporation's U.S. shareholders with the proration of income 
based on shareholdings. If a shareholder of the possessions corporation 
is a foreign person or a tax-exempt person, the possessions corporation 
will be taxable on that shareholder's pro rata amount of the intangible 
property income. If any class of the stock of a possessions corporation 
is regularly traded on an established securities market, then the 
intangible property income will be taxable to the possessions 
corporation rather than the corporation's U.S. shareholders. For these 
purposes, a United States shareholder includes any shareholder who is a 
United States person as described under section 7701(a)(30). The term 
``intangible property income'' means the gross income of a possessions 
corporation attributable to any intangible property other than 
intangible property which has been licensed to such corporation since 
prior to 1948 and which was in use by such corporation on September 3, 
1982.
    Q. 2: What is the source of the intangible property income described 
in question 1?
    A. 2: The intangible property income is U.S. source, whether taxed 
to U.S. shareholders or taxed to the possessions corporation. Such 
intangible property income, if treated as income of the possessions 
corporation, does not

[[Page 159]]

enter into the calculation of the 80-percent possessions source test or 
the 65-percent active trade or business test of section 936(a)(2)(A) and 
(B).
    Q. 3: How will the amount of income attributable to intangible 
property be measured?
    A. 3: Income attributable to intangible property includes the amount 
received by a possessions corporation from the sale, exchange, or other 
disposition of any product or from the rendering of a service which is 
in excess of the reasonable costs it incurs in manufacturing the product 
or rendering the service (other than costs incurred in connection with 
intangibles) plus a reasonable profit margin. A reasonable profit margin 
shall be computed with respect to direct and indirect costs other than 
(i) costs incurred in connection with intangibles, (ii) interest 
expense, and (iii) the cost of materials which are subject to processing 
or which are components in a product manufactured by the possessions 
corporation. Notwithstanding the above, certain taxpayers who have been 
permitted by the Internal Revenue Service in taxable years beginning 
before January 1, 1983, to use the cost-plus method of pricing without 
reflecting a return from intangibles, but including the cost of 
materials in the cost base, will not be precluded from doing so. (Sec. 
3.02(3), Rev. Proc. 63-10, 1963-1 C.B. 490.) Thus, the Internal Revenue 
Service may continue in appropriate cases to permit such taxpayers to 
continue to report their income as they have been under existing 
procedures described in the previous sentence if it is appropriate under 
all the facts and circumstances and does not distort the income of the 
taxpayer.
    Q. 4: If there is no intangible property related to a product 
produced in whole or in part by a possessions corporation, what method 
may the possessions corporation use to compute its income?
    A. 4: The taxpayer may compute its income using the appropriate 
method as provided under section 482 and the regulations thereunder. The 
taxpayer may also elect the cost sharing or profit split method.

[T.D. 8090, 51 FR 21524, June 13, 1986]



Sec. 1.936-5  Intangible property income when an election out is made:
Product, business presence, and contract manufacturing.

    The rules in this section apply for purposes of section 936(h) and 
also for purposes of section 934(e), where applicable.
    (a) Definition of product.
    Q. 1: What does the term ``product'' mean?
    A. 1: The term ``product'' means an item of property which is the 
result of a production process. The term ``product'' includes component 
products, integrated products, and end-product forms. A component 
product is a product which is subject to further processing before sale 
to an unrelated party. A component product may be produced from other 
items of property, and if it is so produced, may be treated as including 
or not including (at the choice of the possessions corporation) one or 
more of such other items of property for all purposes of section 
936(h)(5). An integrated product is a product which is not subject to 
any further processing before sale to an unrelated party and which 
includes all component products from which it is produced. An end-
product form is a product which--
    (1) Is not subject to any further processing before sale to an 
unrelated party;
    (2) Is produced from a component product or products; and
    (3) Is treated as not including certain component products for all 
purposes of section 936(h)(5).


A possessions corporation may treat a component product, integrated 
product, or end-product form as its possession product even though the 
final stage or stages of production occur outside the possession. 
Further processing includes transformation, incorporation, assembly, or 
packaging.
    Q. 2: If a possessions corporation produces both a component product 
and an integrated product (which by definition includes the end-product 
form), may the possessions corporation use the options under section 
936(h)(5) to compute its income with respect to either the component 
product, the integrated product or the end-product form?

[[Page 160]]

    A. 2: Yes. The possessions corporation may choose to treat the 
component product, the integrated product, or the end-product form as 
the product for purposes of determining whether the possessions 
corporation satisfies the significant business presence test. The 
possessions corporation must treat the same item of property as its 
product (the possession product) for all purposes of section 936(h)(5) 
for that taxable year, including the significant business presence test 
under section 936(h)(5)(B)(ii), the possessions sales calculation under 
section 936(h)(5)(C)(i)(I), the determination of income under section 
936(h)(5)(C)(i)(II), and the combined taxable income computations under 
section 936(h)(5)(C)(ii). Although the possessions corporation must 
treat the same item of property as its product for all purposes of 
section 936(h)(5) in a particular taxable year, its choice of the 
component product, integrated product or end-product form may be 
different from year to year. The possessions corporation must specify 
the possession product on a statement attached to its return (Schedule P 
of Form 5735). The possessions corporation may specify its choice by 
either listing the components that are included in the possession 
product or the components that are excluded from the possession product. 
The possessions corporation must file a separate Schedule P with respect 
to each possession product. The possessions corporation must attach to 
each Schedule P detailed computations indicating how the significant 
business presence test is satisfied with respect to the possession 
product identified in that Schedule P.
    Q. 3: A possessions corporation produces a product that is sometimes 
sold to unrelated parties without further processing and is sometimes 
sold to unrelated parties after further processing. May the possessions 
corporation choose to treat the same item of property as the possession 
product even though in some cases it is an integrated product and in 
some cases it is a component product?
    A. 3: Yes. Except as provided in questions and answers 4 and 5, the 
possessions corporation must designate a single possession product even 
though it is sometimes a component product and sometimes an integrated 
product.
    Q. 4: A possessions corporation produces a product that is sometimes 
sold without further processing by any member of the affiliated group to 
unrelated parties or to related parties for their own consumption and is 
sometimes sold after further processing by any member of the affiliated 
group to unrelated parties or to related parties for their own 
consumption. May the possessions corporation designate two products as 
possession products?
    A. 4: The possessions corporation may designate two or more 
possession products. The possessions corporation must use a consistent 
definition of the possession product for all items of property that are 
sold to unrelated parties or consumed by related parties at the same 
stage in the production process. The significant business presence test 
shall apply separately to each product designated by the possessions 
corporation. The possessions corporation shall compute its income 
separately with respect to each product.
    Q. 5: A possessions corporation produces a product in one taxable 
year and does not sell all of the units that it produced. In the next 
taxable year the possessions corporation produces a product which 
includes the product produced in the prior year. The possessions 
corporation could not have satisfied the significant business presence 
test with respect to the units produced the first taxable year if the 
larger possession product had been designated. May the possessions 
corporation designate two possession products in the second year?
    A. 5: Yes. The possessions corporation may designate two possession 
products. However, once a product has been designated for a particular 
year all sales of units produced in that year must be defined in the 
same manner. In addition, the taxpayer must maintain a significant 
business presence in a possession with respect to that product. Sales 
shall be deemed made first out of the current year's production. If all 
of the current year's production is sold and some inventory is 
liquidated, then the taxpayer's method of inventory accounting shall be 
applied to determine

[[Page 161]]

what year's layer of inventory is liquidated.

    Example 1. A possessions corporation S, manufactures a bulk 
pharmaceutical in a possession. S transfers the bulk pharmaceutical to 
its U.S. parent, P, for encapsulation and sale by P to customers. S 
satisifes the significant business presence test with respect to the 
bulk pharmaceutical (the component product) and the combination of the 
bulk pharmaceutical and the capsule (the integrated product). S may use 
the cost sharing or profit split method to compute its income with 
respect to either the component product or the integrated product.
    Example 2. The facts are the same as in example 1 except that S does 
not satisfy the significant business presence test with respect to the 
integrated product. S may use the cost sharing or profit split method to 
compute its income only with respect to the component product. However, 
if in a later taxable year S satisfies the significant business presence 
test with respect to the integrated product, then S may use the cost 
sharing or profit split method to compute its income with respect to 
that integrated product for that later taxable year.
    Example 3. P, a domestic corporation, produces in bulk form in the 
United States the active ingredient for a pharmaceutical product, P 
transfers the bulk form to S, a wholly owned possessions corporation. S 
uses the bulk form to produce in Puerto Rico the finished dosage form 
drug. S transfers the drug in finished dosage form to P, which sells the 
drug to unrelated customers in the U.S. The direct labor costs incurred 
in Puerto Rico by S during its taxable year in formulating, filling and 
finishing the dosage form are at least 65 percent of the total direct 
labor costs incurred by the affiliated group in producing the bulk and 
finished forms during that period. S manufactures (within the meaning of 
section 954(d)(1)(A)) the finished dosage form. S has elected out under 
section 936(h)(5) under the profit split option for the drug product 
area (SIC 283). P and S may treat the bulk and finished dosage forms as 
parts of an integrated product. Since S satisfies the significant 
business presence requirement with respect to the integrated product, it 
is entitled to 50 percent of the combined taxable income on the 
integrated product.
    Example 4. A possessions corporation, S. produces the keyboard of an 
electric typewriter and incorporates the keyboard with components 
acquired from a related corporation into finished typewriters. S does 
not satisfy the significant business presence test with respect to the 
typewriters (the integrated product). Therefore, S may use the cost 
sharing or profit split method to compute its income only with respect 
to a component product or end-product form. For taxable year 1983, S 
specifies on a statement attached to its return (Schedule P of Form 
5735) that the possession product is the end-product form. The statement 
indentifies the components--for example, the keyboard structure and 
frame--which are included in the possession product. S's definition of 
the possession product will apply to all units of the electric 
typewriters which S produces in whole or in part in the possession and 
which are sold in 1983. Thus, all units of a given component 
incorporated into such typewriters will be treated in the same way. For 
example, all keyboards and all frames will be included in the possession 
product, and all electric drive mechanisms and rollers will be excluded 
from the possession product.
    Example 5. Possessions corporation A produces printed circuit boards 
in a possession. The printed circuit boards are sold to unrelated 
parties. A also uses the boards to produce personal computers in the 
possession. A may designate two possession products: printed circuit 
boards and personal computers. The significant business presence test 
applies separately with respect to each of these products. Thus, for 
those printed circuit boards that are sold to unrelated parties, only 
the costs of the possessions corporation and the other members of the 
affiliated group that are incurred with respect to units of the printed 
circuit boards which are produced in whole or in part in the possessions 
and sold to third parties shall be taken into account. Conversely, with 
respect to personal computers, only the costs incurred with respect to 
the personal computers shall be taken into account. This would include 
the costs with respect to printed circuit boards that are incorporated 
into personal computers but not the costs incurred with respect to 
printed circuit boards that are sold without further processing to 
unrelated parties.
    Example 6. Possessions corporation S produces integrated circuits in 
a possession. P, an affilate of S, produces circuit boards in the United 
States. P transfers the circuit boards to S. S assembles the integrated 
circuits and the circuit boards. S sells some of the loaded circuit 
boards to third parties. S retains some of the loaded circuit boards and 
incorporates them into central processing units. The central processing 
units are then sold to third parties. S may designate two possession 
products. S must use a consistent definition of the possession product 
for all units that are sold at the same stage in the production process. 
Thus, with respect to those units sold after assembly of the integrated 
circuits and the printed circuits boards, if S cannot satisfy the 
significant business presence test with respect to all the loaded 
circuit boards (the integrated product), then S must designate a lesser 
product, either the integrated circuit (the component product) or the 
loaded circuit board less the

[[Page 162]]

printed circuit board (the end-product form) as its possession product. 
With respect to the central processing units sold the same rule would 
apply. Thus, if S cannot satisfy the significant business presence test 
with respect to the entire central processing unit for all of the 
central processing units sold, S must designate some lesser product as 
its possession product.
    Example 7. S is a possession corporation. In 1985, S produced 100 
units of product X. Those units were finished into product Y in 1985 by 
affiliates of S. Product X is a component of product Y. In 1985, S 
satisfies the direct labor test with respect to product X but not with 
respect to product Y. S designates the component product X as its 
possession product. In 1986 S produces 100 units of product X and 
finishes those units into product Y. S would have satisfied the 
significant business presence test with respect to product X if S had 
designated product X as its possession product in 1986. In addition, in 
1986 S satisfies the significant business presence test with respect to 
the integrated product Y. In 1986, S sells 150 units of Y. One hundred 
of those units would be deemed to be produced in 1986. With respect to 
those units S may designate the integrated product Y as its possession 
product. Under S's method of inventory accounting the remaining 50 units 
were determined to have been produced in 1985. With respect to those 
units S must define its possession product as it did for the taxable 
year in which those units were produced. Thus, S's possession product 
would be the component product X.

    Q. 6: May an affiliated group establish groupings of possession 
products and treat the groupings as single products?
    A. 6: An affiliated group may establish reasonable groupings of 
possession products based on similarities in the production processes of 
the possession products. Possession products that are grouped shall be 
treated as a single product. The determination of whether the production 
processes involved in producing the products that are to be grouped are 
similar is based on the production processes of the components that are 
included in the possession product. The affiliated group may establish 
new groupings each year. Any grouping which materially distorts a 
taxpayer's income or the application of the significant business 
presence test may be disallowed by the Commissioner. The mere fact that 
a grouping results in an increased allocation of income to the 
possessions corporation does not, of itself, create a material 
distortion of income. If the Commissioner determines that the taxpayer's 
grouping is improper with respect to one or more products in a group, 
then those products shall be excluded from the group. The effect of 
excluding a product or products from the group is that the taxpayer must 
demonstrate that the group without the excluded products (and each 
excluded product itself) satisfies the significant business presence 
test. If the group without the excluded products, or any of the excluded 
products themselves, fails to satisfy the significant business presence 
test, then the possessions corporation's income from those products 
shall be determined under section 936(h)(1) through (4) and the 
regulations thereunder.

    Example 1. The following are examples of possession products the 
processes of production of which are sufficiently similar that they may 
be grouped and treated as a single product:
    (A) Beverage bases or concentrates for different soft drinks or soft 
drink syrups, regardless of whether some include sweeteners and some do 
not:
    (B) Different styles of clothing;
    (C) Different styles of shoes;
    (D) Equipment which relies on gravity to deliver solutions to 
patients intravenously;
    (E) Equipment which relies on machines to deliver solutions to 
patients intravenously;
    (F) Video game cartridges, even though the concept and design of 
each game title is, in part, protected against infringement by separate 
copyrights;
    (G) All integrated circuits;
    (H) All printed circuit boards; and
    (I) Hardware and software if the software is one of several 
alternative types of software offered by the manufacturer and sold only 
with the hardware, and a purchaser of the hardware would ordinarily 
purchase one or more of the manufacturer-provided alternative types of 
software. In all other cases, hardware and software may not be grouped 
and treated as a single product.


Groupings (D) and (E) do not include any solutions which are delivered 
through the equipment described therein.
    Example 2. A possessions corporation produces in Puerto Rico non-
programmable, interactive cathode ray tube computer terminals that vary 
in price. These terminals all interact with a computer or controller to 
perform their functions of data entry, graphics word processing, and 
program development. The terminals can be purchased with

[[Page 163]]

options that include a built-in printer, different language keyboards, 
specialized cathode ray tubes, and different power supply features. All 
terminals are produced in one integrated process requiring the same 
skills and operations. The differences in the production of the 
terminals include differences in the number of printed circuit boards 
incorporated in each terminal, the use of unique keyboards, and the 
installation and testing of the built-in printer. Some difference in 
direct labor time to manufacture the terminals occurs, primarily due to 
the differing number and complexity of printed circuit boards 
incorporated into each terminal. Different model numbers are assigned to 
various computer terminals. A grouping by the taxpayer of all of the 
terminals as one product will be respected by the Service, unless the 
Service establishes that substantial distortion results. This grouping 
is proper because the processes of producing each of the terminals are 
similar.
    Example 3. A possessions corporation, S produces several models of 
serial matrix impact printers and teleprinters. These products have 
differing performance standards based on such factors as speed (in 
characters per second), numbers of columns, and cost. The production 
process for all types of printers involves production of three basic 
elements: electronic circuitry, the printing head, and the mechanical 
parts. The process of producing all the printers is similar. Thus, all 
printers could be grouped and treated as a single product. S purchases 
electronic circuitry and mechanical parts from a U.S. affiliate. S 
performs manufacturing functions relative to the printing head and 
assembles and tests the finished printers. S does not satisfy the 
significant business presence test with respect to the integrated 
products. S therefore specifies on a statement attached to its return 
(Schedule P of Form 5735) that the possession product for both the 
serial matrix printers and the teleprinters is the end-product form. The 
statement identifies the components which are included in each 
possession product. S may group and treat as a single product the serial 
matrix printers and the teleprinters if both end-product forms include 
and exclude similar components. Thus, if the end-product form for both 
the serial matrix printers and the teleprinters includes the mechanical 
parts and excludes the electronic circuitry, then S may group and treat 
as a single product the two end-product forms. If, however, the end-
product forms for the two items of property contain components that are 
not similar and as a result of this definition of the end-product forms 
the production processes involved in producing the two end-product forms 
are not similar, then S may not group the end-product forms.

    Q. 7: Is the affiliated group permitted to include in a group an 
item of property that is not produced in whole or in part in a 
possession?
    A. 7: No.

    Example 1. Possessions corporation S produces 70 units of product A 
in a possession. P, an affiliate of S, produces 30 units of product A 
entirely in the United States. All of the units are sold to unrelated 
parties. The affiliated group is not permitted to group the 30 units of 
product A produced in the United States with the 70 units produced in 
the possession because those units are not produced in whole or in part 
in a possession.
    Example 2. The facts are the same as in example 1 except that the 30 
units of product A are transferred to possessions corporation S. S 
incorporates the 100 units of product A into product B. This 
incorporation takes place in the possession. S may group and treat as a 
single product all of the units of product B even though some of those 
units contain units of product A that were produced in the possession 
and some that were produced in the United States.

    Q. 8: What factors should be disregarded in determining whether a 
particular grouping of similar items of property is reasonable?
    A. 8: In general, differences in the following factors will be 
disregarded in determining whether a particular grouping of items of 
property is reasonable:
    (1) Differences in testing requirements (e.g., some products sold 
for military use may require more extensive or different testing than 
products sold for commercial use);
    (2) Differences in the product specifications that are designed to 
accommodate the product to its area of use or for conditions under which 
used (e.g., electrical products designed for ultimate use in the United 
States differ from electrical products designed for ultimate use in 
Europe);
    (3) Differences in packaging or labeling (e.g., differences in the 
number of units of the items shipped in one package); and
    (4) Minor differences in the operations of the items of property.
    Q. 9: What rules apply for purposes of determining whether 
pharmaceutical products are properly grouped and treated as a single 
product?
    A. 9: The rules contained in questions and answers 6 through 8 of 
this section shall apply. Thus, an affiliated group

[[Page 164]]

may establish reasonable groupings based on similarities in the 
production processes of two or more possession products. In establishing 
a group the affiliated group may only compare the production processes 
involved in producing the possession products. The fact that two 
pharmaceutical products contain different active or inert ingredients is 
not relevant to the determination of whether the pharmaceutical products 
may be grouped. For example, if the possession products are bulk 
chemicals and the production processes involved in producing the bulk 
chemicals are similar, those bulk chemicals may be grouped and treated 
as a single product even though they contain different active or inert 
ingredients. The affiliated group may also group and treat as a single 
product the finished dosage form drug as long as the production 
processes involved in producing the finished dosage forms are similar. 
For these purposes, the production processes involved in producing the 
following classes of items shall be considered to be sufficiently 
similar that possession products delivered in a form described in one of 
the categories may be grouped with other possession products delivered 
in a form described in the same category.
    The categories are:
    (1) Capsules, tablets, and pills;
    (2) Liquids, ointments, and creams; or
    (3) Injectable and intravenous preparations.


No distinctions should be based on packaging, list numbers, or size of 
dosage. The affiliated group may group and treat as a single product the 
integrated product (combination of the bulk and the delivery form) only 
if all the production processes involved in producing the integrated 
products are similar. The rules of this question and answer are 
illustrated by the following examples.

    Example 1. Possessions corporation S produces two chemical active 
ingredients X and Y. Both chemical ingredients are produced through the 
process of fermentation. The affiliated group is permitted to group and 
treat as a single product the two chemical ingredients.
    Example 2. The facts are the same as in example 1 and possessions 
corporation S finishes chemical ingredient X into tablets and chemical 
ingredient Y into capsules. The affiliated group is permitted to group 
and treat as a single product the combination of the bulk pharmaceutical 
and the finishing because the production processes involved in producing 
the integrated products are similar.
    Example 3. Possessions corporation S produces in a possession a bulk 
chemical X by fermentation. A United States affiliate, P, produces in 
the United States a bulk chemical, Y, by fermentation. Both bulk 
chemicals are finished by S in the possession. The finished dosage form 
of X is in pill form. The finished dosage form of Y is in injectable 
form. If S's possession product is the integrated product or the end-
product form then S may not group X and Y because the production 
processes involved in producing the finished dosage form of X and Y are 
not similar. If S's possession product is the component then S may not 
group X and Y because the bulk chemical Y is not produced in whole or in 
part in a possession.

    Q. 10: Will the fact that a manufacturer of a drug must submit a New 
Drug Application (``NDA'') or a supplemental NDA to the Food and Drug 
Administration have any effect on the definition or grouping of a 
product?
    A. 10: No.
    Q. 11: A possessions corporation which produced a product or 
rendered a type of service in a possession on or before September 3, 
1982, is not required to meet the significant business presence test in 
a possession with respect to such product or type of service for its 
taxable years beginning before January 1, 1986 (the interim period). 
During such interim period, how will the term ``product'' be defined for 
purposes of allocating income under the cost sharing or profit split 
methods?
    A. 11: During the interim period the product will be determined 
based on the activities performed by the possessions corporation within 
a possession on September 3, 1982. During the interim period the 
possessions corporation may compute its income under the cost sharing or 
profit split method only with respect to the product that is produced or 
manufactured within the meaning of section 954(d)(1)(A) within the 
possession. If the product is manufactured from a component or 
components produced by an affiliated corporation or a contract 
manufacturer, then the product will not be treated as

[[Page 165]]

including such component or components for purposes of the computation 
of income under the cost sharing or profit split methods. Thus, the 
possessions corporation is not entitled to any return on the intangibles 
associated with the component or components. Notwithstanding the 
preceding sentences, for taxable years beginning before January 1, 1986, 
a possessions corporation may compute its income under the cost sharing 
or profit split method with respect to a product which includes a 
component or components produced by an affiliated corporation or 
contract manufacturer if the possessions corporation satisfies with 
respect to such product the significant business presence test described 
in section 936(h)(5)(B)(ii) and the regulations thereunder.

    Example 1. A possessions corporation, S, was manufacturing (within 
the meaning of section 954(d)(1)(A)) integrated circuits in a possession 
on September 3, 1982. S transferred those integrated circuits to related 
corporation P. P incorporated the integrated circuits into central 
processing units (CPUs in the United States) and sold the CPUs to 
unrelated parties. S continued to manufacture integrated circuits in the 
possession through Juanuary 1, 1986. For taxable years beginning before 
January 1, 1986, S may compute its income under the cost sharing or 
profit split method with respect to the integrated circuits regardless 
of whether S satisfies the significant business presence test. However, 
unless S satisfies the significant business presence test with respect 
to the central processing units, S may not compute its income under the 
cost sharing or profit split methods with respect to the CPUs, and thus, 
S is not entitled to any return on manufacturing intangibles associated 
with CPUs to the extent that they are not related to the integrated 
circuits produced by S, nor (except as provided in the profit split 
methods) to any return on marketing intangibles.
    Example 2. A possessions corporation, S, was engaged on September 3, 
1982, in the manufacture (within the meaning of section 954(d)(1)(A)) of 
a bulk pharmaceutical in Puerto Rico from raw materials. S sold the bulk 
pharmaceutical to its U.S. parent, P, for encapsulation and sale by P to 
customers as the product X. Because S was not engaged in the 
encapsulation of X, S is not considered to have manufactured the 
integrated product, X, in Puerto Rico. During the interim period, S may 
compute its income under the cost sharing or profit split methods with 
respect to the integrated product, X, only if S satisfies the 
significant business presence test with respect to X. S may compute its 
income under the cost sharing or profit split methods with respect to 
the component product (the bulk pharmaceutical).
    Example 3. P is a domestic corporation that is not a possessions 
corporation. P manufactures a bulk pharmaceutical in the United States. 
P transfers the bulk pharmaceutical to its wholly owned subsidiary, S, a 
possessions corporation. On September 3, 1982, S was engaged in the 
encapsulation of the bulk pharmaceutical in Puerto Rico in a manner 
which satisfies the test of section 954(d)(1)(A). For taxable years 
beginning before January 1, 1986, S may compute its income under the 
cost sharing or profit split methods with respect to the end-product 
form the (the encapsulated drug) regardless of whether S meets the 
significant business presence test. However, unless S satisfies the 
significant business presence test with respect to the integrated 
product, S may not compute its income under the cost sharing or profit 
split methods with respect to the integrated product, and thus, S is not 
entitled to any return on the intangibles associated with the bulk 
pharmaceutical.

    Q. 12: On September 3, 1982, a possessions corporation, S was 
engaged in the manufacture (within the meaning of section 954(d)(1)(A)) 
of X in a possession. During the interim period, after September 3, 
1982, but before January 1, 1986, S produced Y, which differs from X in 
terms of minor design features. S did not produce Y in a possession on 
September 3, 1982. Will S be considered to have commenced production of 
a new product after September 3, 1982, for purposes of the application 
of the significant business presence test for the interim period?
    A. 12: No. X and Y will be considered to be a single product, and 
therefore S will not be required to satisfy the business presence test 
separately with respect to Y during the interim period. In all cases in 
which the items of property produced on or before September 3, 1982 and 
the items of property produced after that date could have been grouped 
together under the guidelines provided in Sec. 1.936-5(a) questions and 
answers 6 through 10, the possessions corporation will not be considered 
to manufacture a new product after September 3, 1982.
    Q. 13: May the term ``product'' be defined differently for export 
sales than for domestic sales?

[[Page 166]]

    A. 13: Yes. For rules concerning the application of the separate 
election for export sales see Sec. 1.936-7(b).
    (b) Requirement of significant business presence--(1) General rules.
    Q. 1: In general, a possessions corporation may compute its income 
under the cost sharing or profit split methods with respect to a product 
only if the possessions corporation has a significant business presence 
in a possession with respect to that product. When will a possession 
corporation be considered to have a significant business presence in a 
possession?
    A. 1: For purposes of the cost sharing method, the significant 
business presence test is met if the possessions corporation satisfies 
either a value added test or a direct labor test. For purposes of the 
profit split method, the significant business presence test is met if 
the possessions corporation satisfies either a value added test or a 
direct labor test and also manufactures the product in the possession 
within the meaning of section 954(d)(1)(A).
    Q. 2: How may a possessions corporation satisfy the direct labor 
test with respect to a product?
    A. 2: The possessions corporation will satisfy the direct labor test 
with respect to a product if the direct labor costs incurred by the 
possessions corporation as compensation for services performed in a 
possession are greater than or equal to 65 percent of the direct labor 
costs of the affiliated group for units of the possession product 
produced during the taxable year in whole or in part by the possessions 
corporation.
    Q. 3: How may a possessions corporation satisfy the value added 
test?
    A. 3: In order to satisfy the value added test, the production costs 
of the possessions corporation incurred in the possession with respect 
to units of the possession product produced in whole or in part by the 
possessions corporation in the possession and sold or otherwise disposed 
of during the taxable year by the affiliated group to unrelated parties 
must be greater than or equal to twenty-five percent of the difference 
between gross receipts from such sales or other dispositions and the 
direct material costs of the affilated group for materials purchased for 
such units from unrelated parties.
    Q. 4: Must the significant business presence test be met with 
respect to all units of the product produced during the taxable year by 
the affiliated group?
    A. 4: No. The significant business presence test must be met with 
respect to only those units of the product produced during the taxable 
year in whole or in part by the possessions corporation in a possession.
    Q. 5: For purposes of determining whether a possessions corporation 
satisfies the significant business presence test, how shall the 
possessions corporation treat the cost of components transferred to the 
possessions corporation by a member of the affiliated group?
    A. 5: The treatment of the cost of components transferred from an 
affiliate depends on whether the possession product is treated as 
including the components for purposes of section 936(h). If it is, then 
for purposes of the value added test, the production costs associated 
with the component shall be treated as production costs of the 
affiliated group that are not incurred by the possessions corporation. 
Those production costs, other than the cost of materials, shall not be 
treated as a cost of materials. For purposes of the direct labor test 
and the alternative significant business presence test, the direct labor 
costs associated with such components shall be treated as direct labor 
costs of the affiliated group that are not incurred by the possessions 
corporation. If the possession product is treated as not including such 
component for purposes of section 936(h), then, solely for purposes of 
determining whether the possessions corporation satisfies the value 
added test, the cost of the component shall not be treated as either a 
cost of materials or as a production cost. For purposes of the direct 
labor test and the alternative significant business presence test, the 
direct labor costs associated with such component shall not be treated 
as direct labor costs of the affiliated group. If the possession product 
is treated as not including such component, then the possessions 
corporation shall not be entitled to any return on

[[Page 167]]

the intangibles associated with the manufacturing or marketing of the 
component.
    Q. 6: May two or more related possessions corporations aggregate 
their production or direct labor costs for purposes of determining 
whether they satisfy the significant business presence test with respect 
to a single product?
    A. 6: No.
    Q. 7: A possessions corporation, S, purchases raw materials and 
components from an unrelated corporation which conducts business outside 
of a possession. The unrelated corporation is not a contract 
manufacturer. What is the treatment of such raw materials and components 
for purposes of the significant business presence test?
    A. 7: Where Company S purchases raw materials or components from an 
unrelated corporation which is not a contract manufacturer, the raw 
materials and components are treated as materials, and the costs related 
thereto are treated as a cost of materials.
    (2) Direct labor costs.
    Q. 1: How is the term ``direct labor costs'' to be defined?
    A. 1: The term ``direct labor costs'' has the same meaning which it 
has for purposes of Sec. 1.471-11(b)(2)(i). Thus, direct labor costs 
include the cost of labor which can be identified or associated with 
particular units or groups of units of a specific product. The elements 
of direct labor include such items as basic compensation, overtime pay, 
vacation and holiday pay, sick leave pay (other than payments pursuant 
to a wage continuation plan under section 105(d)), shift differential, 
payroll taxes, and payments to a supplemental unemployment benefit plan 
paid or incurred on behalf of employees engaged in direct labor.
    Q. 2: May a taxpayer treat a cost as a direct labor cost if it is 
not included in inventoriable costs under section 471 and the 
regulations thereunder?
    A. 2: No. A cost may be treated as a direct labor cost only if it is 
included in inventoriable costs. However, a cost may be considered a 
direct labor cost even though the activity to which it relates would not 
constitute manufacturing under section 954(d)(1)(A) as long as the cost 
is included in inventoriable costs.
    Q. 3: May the members of the affiliated group include as direct 
labor costs the labor element in indirect production costs?
    A. 3: No. The labor element of indirect production costs may not be 
considered as part of direct labor costs.
    Q. 4: Do direct labor costs include the costs which can be 
identified or associated with particular units or groups of units of a 
specific product if those costs could also be described as quality 
control and inspection?
    A. 4: Yes. Direct labor costs include costs which can be identified 
or associated with particular units or groups of units of a specific 
product. Thus, if quality control and inspection is an integral part of 
the production process, then the labor associated with that quality 
control and inspection shall be considered direct labor. For example, 
integrated circuits are soldered to printed circuit boards by passing 
the boards over liquid solder. Employees inspect each of the boards and 
repair any imperfectly soldered joints discovered on that inspection. 
The labor associated with this process is direct labor. However, if a 
person performs random inspections on limited numbers of products, then 
that labor associated with those inspections shall be considered quality 
control and therefore indirect labor.
    Q. 5: Do direct labor costs of the possessions corporation include 
only the costs which were actually incurred or do they take into 
account, in addition, any labor savings which result because the 
activities were performed in a possession rather than in the United 
States?
    A. 5: Direct labor costs include only the costs which were actually 
incurred.
    Q. 6: For purposes of determining whether a possessions corporation 
satisfies the significant business presence test for a taxable year with 
respect to a product, how shall the possessions corporation compute its 
direct labor costs of units of the product?
    A. 6: The direct labor test shall be applied separately to products 
produced in whole or in part by the possessions corporation in the 
possession during each taxable year. Sales shall be deemed to be made 
first out of the current year's production. If sales are

[[Page 168]]

made only out of the current year's production, then the direct labor 
costs of producing those units that are sold shall be the pro rata 
portion of the total direct labor costs of producing all the units that 
are produced in whole or in part in the possession by the possessions 
corporation during the current year. If all of the current year's 
production is sold and some inventory is liquidated, then the direct 
labor test shall be applied separately to the current year's production 
and the liquidated inventory. The direct labor costs of producing the 
liquidated inventory shall be the pro rata portion of the total direct 
labor costs that were incurred in producing all the units that were 
produced in whole or in part by the possessions corporation in the 
possessions in the layer of liquidated inventory determined under the 
member's method of inventory accounting.

    Example. S is a cash basis calendar year taxpayer that has made an 
election under section 936(a). In 1985 S produced 100 units of product 
X. Fifty percent of the direct labor costs of the affiliated group were 
incurred by S and were compensation for services performed in the 
possession. Thus, S did not satisfy the significant business presence 
test with respect to product X in taxable year 1985. During 1986 S 
produced 100 units of product X. One hundred percent of the direct labor 
costs of the affiliated group were incurred by S and were compensation 
for services performed in the possession. In 1986 S sells 150 units of 
product X. One hundred of those units are deemed to be from the units 
produced in 1986. With respect to those units S satisfies the 
significant business presence test. Under S's method of inventory 
accounting the remaining 50 units were determined to be produced in 
1985. With respect to those units S does not satisfy the significant 
business presence test because only 50% of the direct labor costs 
incurred in producing those units were incurred by S and were 
compensation for services performed in the possession.

    Q. 7: What is the result if in a particular taxable year the 
possessions corporation satisfies the significant business presence test 
with respect to units of the product produced in one year and fails the 
significant business with respect to units produced in another year?
    A. 7: For those units of the product with respect to which the 
possession corporation satisfies the significant business presence test, 
the possessions corporation may compute its income under the provisions 
of section 936(h)(5). For those units of the product with respect to 
which the possessions corporations fails the significant business 
presence test, the possessions corporation must compute its income under 
section 936(h)(1) through (4).
    Q. 8: Do direct labor costs include costs incurred in a prior 
taxable year with respect to units of the possession product that are 
finished in a later taxable year?
    A. 8: Yes.
    (3) Direct material costs.
    Q. 1: How is the term ``direct material costs'' to be defined?
    A. 1: Direct material costs include the cost of those materials 
which become an integral part of the specific product and those 
materials which are consumed in the ordinary course of manufacturing and 
can be identified or associated with particular units or groups of units 
of that product. See Sec. 1.471-3 for the elements of direct material 
costs.
    Q. 2: May a taxpayer treat a cost as a direct material cost if it is 
not included in inventoriable costs under section 471 and the 
regulations thereunder?
    A. 2: A taxpayer may not treat such costs as direct material costs.
    (4) Production costs.
    Q. 1: How is the term ``production costs'' defined?
    A. 1: The term ``production costs'' has the same meaning which it 
has for purposes of Sec. 1.471-11(b) except that the term does not 
include direct material costs and interest. Thus, production costs 
include direct labor costs and fixed and variable indirect production 
costs (other than interest).
    Q. 2: With respect to indirect production costs described in Sec. 
1.471-11(c)(2) (ii) and (iii), may a possessions corporation include 
these costs in production costs for purposes of section 936, if they are 
not included in inventoriable costs under section 471 and the 
regulations thereunder?
    A. 2: No. A possessions corporation may include these costs only if 
they are included for purposes of section 471 and the regulations 
thereunder. If a possessions corporation and the other

[[Page 169]]

members of the affiliated group include and exclude different indirect 
production costs in their inventoriable costs, then, for purposes of the 
significant business presence test, the possessions corporation shall 
compute its production costs and the production costs of the other 
members of the affiliated group by subtracting from the production costs 
of each member all indirect costs included by that member that are not 
included in production costs by all other members of the affiliated 
group.
    Q. 3: Does a change in a taxpayer's method of accounting for 
purposes of section 471 affect the taxpayer's computation of production 
costs for purposes of section 936?
    A. 3: Yes. If a taxpayer changes its method of accounting for 
purposes of section 471, then the same change shall apply for purposes 
of section 936.
    Q. 4: For purposes of determining whether a possessions corporation 
satisfies the significant business presence test for a taxable year with 
respect to a product, how shall the possessions corporation compute its 
costs of producing units of the product sold or otherwise disposed to 
unrelated parties during the taxable year?
    A. 4: All members of the affiliated group may elect to use their 
current year production costs regardless of whether the members use the 
FIFO or LIFO method of inventory accounting. If some or all of the 
current year's production of a product is sold, then the production 
costs of producing those units sold shall be the pro rata portion of the 
total production costs of producing all the units produced in the 
current year. If all of the current year's production of a product is 
sold and some inventory is liquidated, then the production costs of 
producing the liquidated inventory shall be the pro rata portion of the 
production costs incurred in producing the layer of liquidated inventory 
as determined under the member's method of inventory accounting.
    Q. 5: How should the members of the affiliated group determine the 
portion of their production costs that is allocable to units of the 
product sold or otherwise disposed of during the taxable year?
    A. 5: The members of the affiliated group may use either standard 
production costs (so long as variances are not material), average 
production costs, or FIFO production costs to determine the production 
costs that will be considered to be attributable to units of the product 
sold or otherwise disposed of during the taxable year. However, all 
members of the affiliated group must use the same method.
    Q. 6: When is the quality control and inspection of a product 
considered to be part of the production activity for that product?
    A. 6: Quality control and inspection of a manufactured product 
before its sale or other disposition by the manufacturer, or before its 
incorporation into other products, is considered to be part of the 
indirect production activity for that initial product. Subsequent 
testing of a product to ensure that the product is compatible with other 
products is not a part of the production activity for the initial 
product.


When a component is incorporated into an end-product form and the end-
product form is then tested, the latter testing will be considered to be 
a part of the indirect production activity for the end-product form and 
will not be considered to be a part of the production activity for the 
component.
    Q. 7: For purposes of the significant business presence test and the 
allocation of income to a possessions corporation, what is the treatment 
of the cost of installation of a product?
    A. 7: For purposes of the significant business presence test and the 
allocation of income to a possessions corporation, product installation 
costs need not be taken into account as costs incurred in the 
manufacture of that product, if the taxpayer keeps such permanent books 
of account or records as are sufficient to establish the fair market 
price of the uninstalled product. In such a case, the cost of 
installation materials, the cost of the labor for installation, and a 
reasonable profit for installation will not be included in the costs and 
income associated with the possession product. If the taxpayer does not 
keep such permanent books of account or records, then the cost of 
installation materials and the cost of labor for installation shall be 
treated

[[Page 170]]

as costs associated with the possession product and income will be 
allocated to the possessions corporation and its affiliates under the 
rules provided in these regulations.
    Q. 8: For purposes of the significant business presence test and the 
allocation of income to a product or service, what is the treatment of 
the cost of servicing and maintaining a possession product that is sold 
to an unrelated party?
    A. 8: The cost of servicing and maintaining a possession product 
after it is sold is not associated with the production of that product.
    Q. 9: For purposes of the significant business presence test and the 
allocation of income to a possessions corporation, what is the treatment 
of the cost of samples?
    A. 9: The cost of producing samples will be treated as a marketing 
expense and not as inventoriable costs for these purposes. However, for 
taxable years beginning prior to January 1, 1986, the cost of producing 
samples may be treated as either a marketing expense or as inventoriable 
costs.
    (5) Gross receipts.
    Q. 1: How shall the affiliated group determine gross receipts from 
sales or other dispositions by the affiliated group to unrelated parties 
of the possession product?
    A. 1: Gross receipts shall be determined in the same manner as 
possession sales under the rules contained in Sec. 1.936-6(a)(2).
    (6) Manufacturing within the meaning of section 954(d)(1)(A).
    Q. 1: What is the test for determining, within the meaning of 
section 954(d)(1)(A), whether a product is manufactured or produced by a 
possessions corporation in a possession?
    A. 1: A product is considered to have been manufactured or produced 
by a possessions corporation in a possession within the meaning of 
section 954(d)(1)(A) and Sec. 1.954-3(a)(4) if--
    (i) The property has been substantially transformed by the 
possessions corporation in the possession;
    (ii) The operations conducted by the possessions corporation in the 
possession in connection with the property are substantial in nature and 
are generally considered to constitute the manufacture or production of 
property; or
    (iii) The conversion costs sustained by the possessions corporation 
in the possession, including direct labor, factory burden, testing of 
components before incorporation into an end product and testing of the 
manufactured product before sales account for 20 percent or more of the 
total cost of goods sold of the possessions corporation.


In no event, however, will packaging, repackaging, labeling, or minor 
assembly operations constitute manufacture or production of property. 
See particularly examples 2 and 3 of Sec. 1.954-3(a)(4)(iii).
    Q. 2: Does the requirement that a possession product be produced or 
manufactured in a possession within the meaning of section 954(d)(1)(A) 
apply to taxable years beginning before January 1, 1986?
    A. 2: A possessions corporation must satisfy this requirement for 
taxable years beginning before January 1, 1986, in the following cases:
    (i) If the possessions corporation makes a separate election under 
section 936(h)(5)(F)(iv)(II) with respect to export sales;
    (ii) If the possessions corporation is electing as its possession 
product a product that is subject to the interim period rules of Sec. 
1.936-5(a) question and answer (10); or
    (iii) If the possessions corporation is electing as its possession 
product a product that is not subject to the interim period rules of 
Sec. 1.936-5 (a) question and answer (10) and the possessions 
corporation computes its income under the profit split method with 
respect to that product.


For rules concerning products first produced in a possession after 
September 3, 1982, see Sec. 1.936-5(b)(7) question and answer (2).
    (7) Start-up operations.
    Q. 1: With respect to products not produced (and types of services 
not rendered) in the possession on or before September 3, 1982, when 
must a possessions corporation first satisfy the 25 percent value added 
test or the 65 percent direct labor test?

[[Page 171]]

    A. 1: A transitional period is established such that a possessions 
corporation engaged in start-up operations with respect to a product or 
service need not satisfy the 25 percent value added test or the 65 
percent labor test until the third taxable year following the taxable 
year in which such product is first sold by the possessions corporation 
or such service is first rendered by the possessions corporation. During 
the transitional period, the applicable percentages for these tests will 
be as follows:

------------------------------------------------------------------------
                                                  Any year after 1982
                                              --------------------------
                                                  1        2        3
------------------------------------------------------------------------
Value added test.............................       10       15       20
Labor test...................................       35       45       55
------------------------------------------------------------------------

    Q. 2: Does the requirement that a possession product be produced or 
manufactured in a possessions within the meaning of section 954(d)(1)(A) 
apply to a product if the possessions corporation is engaged in start-up 
operations with respect to that product?
    A. 2: The possessions corporation must produce or manufacture the 
possessions product within the meaning of section 954(d)(1)(A) if the 
possessions corporation computes its income with respect to that product 
under the profit split method.
    Q. 3: When will a possessions corporation be considered to be 
engaged in start-up operations?
    A. 3: A possessions corporation is engaged in start-up operations if 
it begins operations in a possession with respect to a product or type 
of service after September 3, 1982. Subject to the further provisions of 
this answer, a possessions corporation will be considered to begin 
operations with respect to a product if, under the rules of Sec. 1.936-
5(a) questions and answers (6) through (10), such product could not be 
grouped with any other item of property manufactured in whole or in part 
in the possessions by any member of the affiliated group in any 
preceding taxable year. Any improvement or other change in a possession 
product which does not substantially change the production process would 
not be deemed to create a new product. A change in the division of 
manufacturing activity between the possessions corporation and its 
affiliates with respect to an item of property will not give rise to a 
new product. If a possessions corporation was producing a possession 
product that was either a component product or an end-product form and 
the possessions corporation expands its operations in the same 
possession so that it is now producing a product that includes the 
earlier possession product, the possessions corporation will not be 
entitled to use the start-up significant business presence test unless 
the production costs incurred by the possessions corporation in the 
possession in producing a unit of its new possession product are at 
least double the production costs incurred by the possessions 
corporation in the possession in producing a unit of the earlier 
possession product. If any member of an affiliated group actually groups 
two or more items of property then, solely for the purposes of 
determining whether any item of property in that group is a new product, 
that grouping shall be respected. However, the fact that an affiliated 
group does not actually group two or more items of property shall be 
disregarded in determining whether any item of property is a new 
product. Notwithstanding the above, if a possessions corporation is 
producing a possession product in one possession and such corporation or 
a member of its affiliated group begins operations in a different 
possession, regardless of whether the items of property could be 
grouped, the affiliated group may treat the units of the item of 
property produced at the new site of operations in the different 
possession as a new product.
    (8) Alternative significant business presence test.
    Q. 1: Will the Secretary adopt a significant business presence test 
other than those set forth in section 936(h)(5)(B)(ii)?
    A. 1: Yes. The following significant business presence test is 
adopted both for the transitional period and thereafter. A possessions 
corporation will have a significant business presence in a possession 
for a taxable year with respect to a product or type of service if--
    (i) No less than 50 percent of the direct labor costs of the 
affiliated group for units of the product produced, in

[[Page 172]]

whole or in part, during the taxable year by the possessions corporation 
or for the type of service rendered by the possessions corporation 
during the taxable year are incurred by the possessions corporation as 
compensation for services performed in the possession; and
    (ii) The direct labor costs of the possessions corporation for units 
of the product produced or the type of service rendered plus the base 
period construction costs are no less than 70 percent of the sum of such 
base period construction costs and the direct labor costs of the 
affiliated group for such units of the product produced or the type of 
service rendered.


Notwithstanding satisfaction of the above test, for purposes of 
determining whether a possessions corporation may compute its income 
under the profit split method, a possessions corporation will not be 
treated as having a significant business presence in a possession with 
respect to a product unless the possessions corporation manufactures the 
product in the possession within the meaning of section 954(d)(1)(A).
    Q. 2: How is the term ``base period construction costs'' defined?
    A. 2: The term ``base period construction costs'' means the average 
construction costs incurred by or on behalf of the possessions 
corporation for services in the possession during the taxable year and 
the preceding four taxable years for section 1250 property (as defined 
in section 1250(c) and the regulations thereunder) that is used for the 
production of the product or the rendering of the service in the 
possession, and which represents the original use of the section 1250 
property. For purposes of the preceding sentence, if the possessions 
corporation was not in existence during one or more of the four 
preceding taxable years, its construction costs for that year or years 
shall be deemed to be zero. Construction costs include architects' and 
engineers' fees, labor costs, and overhead and profit (if the 
construction is performed by a person that is not a member of the 
affiliated group).
    (c) Definition and treatment of contract manufacturing.
    Q. 1: For purposes of determining whether a possessions corporation 
satisfies the significant business presence test with respect to a 
product, the costs incurred by the possessions corporation or by any of 
its affiliates in connection with contract manufacturing which is 
related to that product and is performed outside the possession shall be 
treated as direct labor costs of the affiliated group and shall not be 
treated as production costs of the possessions corporation or as 
material costs. How is the term ``contract manufacturing'' to be 
defined?
    A. 1: The term ``contract manufacturing'' includes any arrangement 
between a possessions corporation (or another member of the affiliated 
group) and an unrelated person if the unrelated person:
    (1) Performs work on inventory owned by a member of the affiliated 
group for a fee without the passage of title;
    (2) Performs production activities (including manufacturing, 
assembling, finishing, or packaging) under the direct supervision and 
control of a member of the affiliated group; or
    (3) Does not undertake any significant risk in manufacturing its 
product (e.g., it is paid by the hour).
    Q. 2: Does an arrangement between a member of the affiliated group 
and an unrelated party constitute contract manufacturing if the 
unrelated party uses an intangible owned or licensed by a member of the 
affiliated group?
    A. 2: Such an arrangement will be treated as contract manufacturing 
if the unrelated party makes use of a patent owned or licensed by a 
member of the affiliated group in producing the product which becomes 
part of the possession product of the possessions corporation. In 
addition, such use of manufacturing intangibles other than patents may 
be treated as contract manufacturing if it is established that the 
arrangement has the effect of materially distorting the application of 
the significant business presence test. However, the preceding sentence 
shall not apply if the possessions corporation establishes that the 
arrangement was entered into for a substantial business purpose (e.g., 
to obtain the benefit of special expertise of the manufacturer or 
economies of scale). These rules shall not apply to such contract

[[Page 173]]

manufacturing performed in taxable years beginning before January 1, 
1986, nor shall the rules apply to binding contracts for the performance 
of such contract manufacturing entered into before June 13, 1986.
    Q. 3: For purposes of the significant business presence test, how 
shall a possessions corporation treat the cost of contract manufacturing 
performed within a possession?
    A. 3: If the possessions corporation uses the value added test, it 
will be permitted to treat the cost of the contract manufacturing 
performed in a possession, not including material costs, as a production 
cost of the possessions corporation. If it uses the direct labor test or 
the alternative significant business presence test set forth in Sec. 
1.936-5(b)(8), it is permitted to treat the direct labor costs of the 
contract manufacturer associated with such contract manufacturing as a 
cost of direct labor of the possessions corporation. The allowable 
amount of the direct labor cost shall be determined in accordance with 
question and answer 4 below.
    Q. 4: How are the amounts paid by a possessions corporation to a 
contract manufacturer for services rendered in a possession to be 
treated by the possessions corporation in computing the direct labor 
cost of the product to which such contract manufacturing relates?
    A. 4: If the possessions corporation can establish the contract 
manufacturer's direct labor cost which was incurred in the possession, 
such cost will be treated as incurred by the possessions corporation as 
compensation for services performed in the possession. If the 
possessions corporation cannot establish such cost, then 50 percent of 
the amount paid to such contract manufacturer may be treated as incurred 
by the possessions corporation as compensation for services performed in 
the possession: provided, that not more than 50 percent of the fair 
market value of the product manufactured by the contract manufacturer is 
attributable to articles shipped into the possession, and the 
possessions corporation receives a statement from the contract 
manufacturer that this test has been satisfied. If this fair market 
value test is not satisfied, then the cost of contract manufacturing 
performed within a possession shall not be treated as a production cost 
or a direct labor cost of either the possessions corporation or the 
affiliated group.
    Q. 5: For purposes of the significant business presence test, what 
is the treatment of costs which are incurred by a member of the 
affiliated group (including the possessions corporation) for contract 
manufacturing performed outside of the possession with respect to an 
item of property which is a component of the possession product?
    A. 5: If the possession product is treated as including such 
component, the cost of the contract manufacturing shall be treated as a 
direct labor cost of members of the affiliated group other than the 
possessions corporation for purposes of the direct labor test and the 
alternative significant business presence test, and shall not be treated 
as a production cost of the possessions corporation or as a cost of 
materials for purposes of the value added test. If the possession 
product is treated as not including such component, the cost of the 
contract manufacturing shall not be treated as a direct labor cost of 
any member of the affiliated group for purposes of the direct labor test 
and the alternative significant business presence test, and shall not be 
treated as a production cost of the possessions corporation or as a cost 
of materials for purposes of the value added test.

[T.D. 8090, 51 FR 21524, June 13, 1986; 51 FR 27174, July 30, 1986]



Sec. 1.936-6  Intangible property income when an election out is made:
Cost sharing and profit split options; covered intangibles.

    The rules in this section apply for purposes of section 936(h) and 
also for purposes of section 934(e) where applicable.
    (a) Cost sharing option--(1) Product area research.
    Q. 1: Cost sharing payments are based on research undertaken by the 
affiliated group in the ``product area'' which includes the possession 
product. The term ``product area'' is defined by reference to the three-
digit classification

[[Page 174]]

under the Standard Industrial Classification (SIC) code. Which 
governmental agency has jurisdiction to decide the proper SIC category 
for any specfic product?
    A. 1: Solely for the purpose of determining the tax consequences of 
operating in a possession, the Secretary or his delegate has exclusive 
jurisdiction to decide the proper SIC category under which a product is 
classified. For this purpose, the product area under which a product is 
classified will be determined according to the 1972 edition of the SIC 
code. From time to time and in appropriate cases, the Secretary may 
prescribe regulations or issue rulings determining the proper SIC 
category under which a particular product is to be classified, and may 
prescribe regulations for aggregating two or more three-digit 
classifications of the SIC code and for classifying product areas 
according to a system other than under the SIC code.
    Q. 2: How is the term ``affiliated group'' defined for purposes of 
the cost sharing option?
    A. 2: For purposes of the cost sharing option, the term ``affiliated 
group'' means the possessions corporation and all other organizations, 
trades or businesses (whether or not incorporated, whether or not 
organized in the United States, and whether or not affiliated) owned or 
controlled directly or indirectly by the same interests, within the 
meaning of section 482.
    Q. 3: Are research and development expenditures that are included in 
product area research limited to research and development expenditures 
that are deductible under section 174 or that are incurred by U.S. 
affiliates?
    A. 3: No, product area research is not limited to product area 
research expenditures deductible under section 174 or to expenses 
incurred by U.S. affiliates. Product area research also includes 
deductions permitted under section 168 with respect to research property 
which are not deductible under section 174; qualified research expenses 
within the meaning of section 30(b); payments (such as royalities) for 
the use of, or right to use, a patent, invention, formula, process, 
design, pattern or know-how; and a proper allowance for amounts incurred 
in the acquisition of manufacturing intangible property. In the case of 
an acquisition of depreciable or amortizable manufacturing intangible 
property, the annual amount of product area research shall be be equal 
to the allowable depreciation or amortization on the intangible property 
for the taxable year. In the case of an acquisition of nondepreciable or 
nonamortizable manufacturing intangible property, the amount expended 
for the acquisition shall be deemed to be amortized over a five year 
period and included in product area research in the year of the deemed 
amortization. Any contingent payment made with respect to the 
acquisition of nonamortizable manufacturing intangible property shall be 
treated as amounts incurred in the acquisition of nonamortizable 
manufacturing intangible property when paid or accrued.
    Q. 4: Does royalty income from a person outside the affiliated group 
with respect to the manufacturing intangibles within a product area 
reduce the product area research pool within the same product area?
    A. 4: Yes.
    Q. 5: Does income received from a person outside the affiliated 
group from the sale of a manufacturing intangible reduce the product 
area research pool within the same product area?
    A. 5: In determining product area research, the income from the sale 
attributable to noncontingent payments will reduce product area research 
ratably over the remaining useful life of the property in the case of an 
amortizable intangible and ratably over a 5-year period in the case of a 
nonamortizable intangible. Any income attributable to contingent amounts 
received with respect to the sale of manufacturing intangible property 
shall be treated as amounts received from the sale of the manufacturing 
intangible property in the year in which such contingent amounts are 
received or accrued.
    Q. 6: If a member of an affiliated group incurs research and 
development expenses pursuant to a contract with an unrelated person who 
is entitled to

[[Page 175]]

exclusive ownership of all the technology resulting from the 
expenditures, is the amount of product area research reduced by the 
amount of such expenditures?
    A. 6: To the extent that the product area research expenditures can 
be allocated solely to the technology produced for the unrelated person, 
such expenditures will not be included in product area research 
expenditures provided, however, that the unrelated person has exclusive 
ownership of all the technology resulting from these expenditures, and 
further that no member of the affiliated group has a right to use any of 
the technology.
    Q. 7: What is the treatment of product area research expenditures 
attributable to a component where the component and the integrated 
product fall within different product areas?
    A. 7: For purposes of the computation of product area research 
expenditures in the product area by the affiliated group, the product 
area in which the component falls is aggregated with the product area in 
which the integrated product falls. However, if the component product 
and integrated product are in separate SIC codes and if the component 
product is not included in the definition of the possession product, 
then the product area research expenditures are not aggregated. The same 
rule applies where the taxpayer elects a component product which 
encompasses another component product and the two component products 
fall into separate SIC codes. In such case, the product area in which 
the first component falls is aggregated with the product area in which 
the second component falls.
    (2) Possession sales and total sales.
    Q. 1: The cost sharing payment is the same proportion of the total 
cost of product area research which the amount of ``possession sales'' 
of the affiliated group bears to the ``total sales'' of the affiliated 
group within the product area. How are ``possession sales'' defined for 
purposes of the cost sharing fraction?
    A. 1: The term ``possession sales'' means the aggregate sales or 
other dispositions of the possession product, to persons who are not 
members of the affiliated group, less returns and allowances and less 
indirect taxes imposed on the production of the product, for the taxable 
year. Except as otherwise indicated in Sec. 1.936-6(a)(2), the sales 
price to be used is the sales price received by the affiliated group 
from persons who are not members of the affiliated group.
    Q. 2: For purposes of the numerator of the cost sharing fraction, 
how are possession sales computed where the possession product is a 
component product or an end-product form?
    A. 2: (i) The sales price of the component product or end-product 
form is determined as follows. With respect to a component product, an 
independent sales price from comparable uncontrolled transactions must 
be used if such price can be determined in accordance with Sec. 1.482-
2(e)(2). If an independent sales price of the component product from 
comparable uncontrolled transactions cannot be determined, then the 
sales price of the component product shall be deemed to be equal to the 
transfer price, determined under the appropriate section 482 method, 
which the possessions corporation uses under the cost sharing method in 
computing the income it derives from the active conduct of a trade or 
business in the possession with respect to the component product. The 
possessions corporation in lieu of using the transfer price determined 
under the preceding sentence may treat the sales price for the component 
product as equal to the same proportion of the third party sales price 
of the integrated product which the production costs attributable to the 
component product bear to the total production cost for the integrated 
product. Production cost will be the sum of direct and indirect 
production costs as defined in Sec. 1.936-5(b)(4). If the possessions 
corporation determines the sales price of the component product using 
the production cost ratio, the transfer price used by the possessions 
corporation in computing its income from the component product under the 
cost sharing method may not be greater than such sales price.
    (ii) With respect to an end-product form, the sales price of the 
end-product form is equal to the difference between

[[Page 176]]

the third party sales price of the integrated product and the 
independent sales price of the excluded component(s) from comparable 
uncontrolled transactions, if such price can be determined under Sec. 
1.482-2(e)(2). If an independent sales price of the excluded 
component(s) from uncontrolled transactions cannot be determined, then 
the sales price of the end-product form shall be deemed to be equal to 
the transfer price, determined under the appropriate section 482 method, 
which the possessions corporation uses under the cost sharing method in 
computing the income it derives from the active conduct of a trade or 
business in the possession with respect to such end-product form. The 
possessions corporation in lieu of using the transfer price determined 
under the preceding sentence may use the production cost ratio method 
described above to determine the sales price of the end-product form 
(i.e., the same proportion of the third party sales price of the 
integrated product which the production costs attributable to the end-
product form bear to the total production costs for the integrated 
product). If the possessions corporation determines the sales price of 
the end-product form using the production cost ratio, the transfer price 
used by the possessions corporation in computing its income from the 
end-product form under the cost sharing method may not be greater than 
such sales price. For similar rules applicable to the profit split 
option see Sec. 1.936-6(b)(1), question and answer 12.
    Q. 3: For purposes of determining possessions sales in the numerator 
of the cost sharing fraction, will the replacement part price of the 
product be treated as a price from comparable uncontrolled transactions?
    A. 3: Prices for replacement parts are generally higher than prices 
for equipment sold as part of an original system. Thus, prices for 
replacement parts cannot generally be used directly as prices for 
comparable uncontrolled transactions. However, replacement part prices 
may be used for estimating comparable uncontrolled prices where the 
price differential can be reasonably determined and taken into account 
under Sec. 1.482-2(e)(2).
    Q. 4: For purposes of determining possession sales in the cost 
sharing fraction, what is the treatment of components that are purchased 
by one possessions corporation from an affiliated possessions 
corporation and which are incorporated into a possession product where 
the transferor possessions corporation treats the transferred component 
as a possession product?
    A. 4: When one possessions corporation purchases components from a 
second possessions corporation which is an affiliated corporation, the 
purchase price of the components paid to the second possessions 
corporation shall be subtracted from the sales proceeds of the product 
produced in the possession by the first possessions corporation, and 
only the remainder is included in the numerator of the cost sharing 
formula for the first corporation. For example, assume that N 
corporation manufactures a component for sale to O corporation for $100 
(a price which reflects prices in comparable uncontrolled transactions). 
Both N and O are affiliated possessions corporations. N has designated 
that component product as its possession product. O then incorporates 
that product into a second product which is sold to customers for $300 N 
and O must make separate cost sharing payments. The cost sharing payment 
of N corporation is determined by including $100 as possession sales, 
and the payment of O is determined by subtracting that $100 purchase 
price from the $300 received from customers. Thus, the possessions sales 
amount of O is $200. This rule is intended to prevent the double 
counting of the sales of a component produced by one possessions 
corporation and incorporated into another product by an affiliated 
possessions corporation.
    Q. 5: Are pre-TEFRA sales included in the cost sharing fraction?
    A. 5: No. Pre-TEFRA sales are sales of products produced by the 
possessions corporation and transferred to an affiliate prior to a 
possessions corporation's first taxable year beginning after December 
31, 1982. Pre-TEFRA sales are not included in either the numerator or 
denominator of the cost sharing fraction. If the U.S. affiliate uses the 
FIFO method of costing inventory, the pre-TEFRA inventory will be 
treated

[[Page 177]]

as the first inventory sold by the U.S. affiliate during the first year 
in which section 936(h) applies. If the U.S. affiliate uses the LIFO 
method of costing inventory (either dollar-value or specific goods 
LIFO), pre-TEFRA inventor will be treated as inventory sold by the U.S. 
affiliate in the year in which the U.S. afiliate's LIFO layer containing 
pre-TEFRA LIFO inventory is liquidated.
    Q. 6: How are ``possession sales'' determined under the cost sharing 
formula if members of the affiliated group (other than the possessions 
corporation) include purchases of the possession product, X, in a 
dollar-value LIFO inventory pool (as provided under Sec. 1.472-8)?
    A. 6: Possession sales may be determined by applying the revenue 
identification method provided under paragraph (b)(1) Question and 
Answer 18 of this section.
    Q. 7: Do possession sales include excise taxes paid by the 
possessions corporation when the product is sold for ultimate use or 
consumption in the possession?
    A. 7: No. The amount of excise taxes is excluded from both the 
numerator and denominator of the cost sharing fraction.
    Q. 8: How are ``total sales'' defined for purposes of the cost 
sharing fraction?
    A. 8: The term ``total sales'' means aggregate sales or other 
dispositions of products in the same product area as the possession 
product, less returns and allowances and less indirect taxes imposed on 
the production of the product, for the taxable year to persons who are 
not members of the affiliated group. The sales price to be used is the 
sales price received by the affiliated group from persons who are not 
members of the affiliated group.
    Q. 9: In computing that cost sharing payment, how are ``total 
sales'' computed if the dollar-value LIFO inventory pool includes some 
products which are not included in the product area (determined under 
the 3-digit SIC code) on which the denominator of the cost sharing 
fraction is based?
    A. 9: In such case, the amount of the total sales within the product 
area to persons who are not members of the affiliated group by persons 
who are members of the affiliated group is determined by multiplying the 
total sales of the products within the dollar-value LIFO inventory pool 
by a fraction. The numerator of the fraction includes the dollar-value 
of purchases by members of the affiliated group (including the 
possessions corporation) of products within the product area made during 
the year, plus any added production costs (as defined in Sec. 1.471-
11(b), (c), and (d) but not including the costs of materials) incurred 
by the affiliates during the same period. The denominator of the 
fraction includes the dollar-value of purchases by members of the 
affiliated group (including the possessions corporation) of products 
within the dollar-value LIFO inventory pool made during the same period 
(including any production costs, as described above, incurred by the 
affiliate during the same period). For these purposes, purchases of a 
possession product are determined on the basis of the possessions 
corporation's cost for its inventory purposes.
    Q. 10: May a possessions corporation compute its income under the 
cost sharing method with respect to a possession product which the 
possessions corporation sells to a member of its affiliated group and 
which that member then leases to an unrelated person or uses in its own 
trade or business?
    A. 10: Yes, provided that an independent sales price for the 
possession product from comparable uncontrolled transactions can be 
determined in accordance with Sec. 1.482-2(e)(2), and, provided 
further, that such member complies with the requirements of Sec. 1.936-
6(a)(2), question and answer 14. If, however, there is a comparable 
uncontrolled price for an integrated product and the possession product 
is a component product or end-product form thereof, the possessions 
corporation may, if such member complies with the requirements of Sec. 
1.936-6(a)(2), question and answer 14, compute its income under the cost 
sharing method with respect to such possession product. In that case, 
the cost sharing payment shall be computed under the following question 
and answer.

[[Page 178]]

    Q. 11: How are possession sales and total sales to be determined for 
purposes of computing the cost sharing payment with respect to a 
possession product which the possessions corporation sells to a member 
of its affiliated group where that member then leases the possession 
product to unrelated persons or uses it in its own trade or business?
    A. 11: If the possessions corporation is entitled to compute its 
income from such sales of the possession product under the cost sharing 
method, both possession sales and total sales shall be determined as if 
the possession product had been sold by the affiliate to an unrelated 
person at the time the possession product was first leased or otherwise 
placed in service by the affiliate. The sales price on such deemed sale 
shall be equal to the independent sales price from comparable 
uncontrolled transactions determined in accordance with Sec. 1.482-
2(e)(2), if any. If the possession product is a component product or an 
end-product form for which there is no such independent sales price but 
there is a comparable uncontrolled price for the integrated product 
which includes the possession product, the deemed sales price of the 
possession product shall be computed under the rules of Sec. 1.936-
6(a)(2) question and answer 2. The full amount of income received under 
the lease shall be treated as income of (and taxed to) the affiliate and 
not the possessions corporation.
    Q. 12: When may a possessions corporation take into account in 
computing total sales under the cost sharing method products in the same 
product area as the possession product (other than the possession 
product itself) where such products are leased by members of the 
affiliated group to unrelated persons or used by any such member in its 
own trade or business?
    A. 12: For purposes of computing total sales under the cost sharing 
method, the possessions corporation may take into account products in 
the same product area as the possession product itself where such 
products are leased by members of the affiliated group to unrelated 
persons or used in the trade or business of any such member, but only if 
an independent sales price of such products from comparable uncontrolled 
transactions may be determined under Sec. 1.482-2(e)(2). In such cases, 
the units of such products which are leased or otherwise used internally 
by members of the affiliated group may be treated as sold to unrelated 
persons for such independent sales price for purposes of computing total 
sales.
    Q. 13: Assuming that a possessions corporation is entitled to 
compute its income under the cost sharing method with respect to sales 
of a possession product to affiliates in cases where those affiliates 
lease units of the possession product to unrelated persons or use them 
internally, is the possessions corporation's income from the possession 
product any different than if the affiliates had sold the product to 
unrelated parties?
    A. 13: No.
    Q. 14: If a possessions corporation sells units of a possession 
product to a member of its affiliated group and that affiliate then 
leases those units to an unrelated person or uses the units in its own 
trade or business, what requirements must the affilate meet in order for 
the possessions corporation to be entitled to the benefits of the cost 
sharing method with respect to such units?
    A. 14: (i) For taxable years of the possessions corporation 
beginning on or before June 13, 1986, the affiliate need not meet any 
special requirements in order for the possessions corporation to be 
entitled to the beneifts of the cost sharing method with respect to such 
units. Thus, the affiliate's basis in such units shall be equal to the 
transfer price used for computing the possessions corporation's gross 
income with respect to such units under section 936(h)(5)(C)(i)(II), and 
the income derived by the affiliate from such lease or internal use 
shall be reported by the affiliate when and to the extent actually 
derived. The affiliate shall not be deemed to have sold such units to an 
unrelated party at the time they were first leased or otherwise placed 
in service for any purpose other than the computation of possession 
sales and total sales. A similar rule applies to other products in the 
same product area as the possession product which are sold by any member 
in its own trade or

[[Page 179]]

business and which the possessions corporation takes into account in 
computing total sales under the cost sharing method.
    (ii) For taxable years of the possessions corporations beginning 
after June 13, 1986, a possessions corporations will not be entitled to 
the benefits of the cost sharing method with respect to units of the 
possession product which the possessions corporation sells to an 
affiliate where the affiliate then leases such units to an unrelated 
person or uses them in its own trade or business, unless the affiliate 
agrees to be treated for all tax purposes as having sold such units to 
an unrelated party at the time they were first leased or otherwise 
placed in service by such affiliate. The affiliate must demonstrate such 
agreement by reporting its income from such units as if:
    (A) It had sold such units to an unrelated person at such time at a 
price equal to the price used to compute possessions sales under Sec. 
1.936-6(a)(2), question and answer 11;
    (B) It had immediately repurchased such units for the same price; 
and
    (C) Its basis in such units for all subsequent purposes was equal to 
its cost basis from such deemed repurchase.


For treatment of other products in the same product area as the 
possession product see Sec. 1.936-6(a)(2), question and answer 12.
    (iii) The principles contained in questions and answers 11, 12, 13, 
and 14 are illustrated by the following example:

    Example. Possessions corporation S and its affiliate A are calendar 
year taxpayers. In 1985, S manufactures 100 units of possession product 
X. S sells 50 units of X to unrelated persons in arm's length 
transactions for $10 per unit. In applying the cost sharing method to 
determine the portion of its gross income from such sales which 
qualifies for the possessions tax credit, S determines that $8 of the 
$10 sales price may be taken into account. S sells the remaining 50 
units of X to A, and A then leases such units to unrelated persons. In 
1985, A also manufacturers 100 units of product Y, the only other 
product in the same product area as X manufactured or sold by any member 
of the affiliated group. A manufactured the 100 units of Y at a cost of 
$15 per unit, sold 50 units of Y to unrelated persons in arm's length 
transactions for $20 per unit, and leased the remaining 50 units of Y to 
unrelated persons.
    S may compute its income under the cost sharing method with respect 
to the 50 units of X it sold to A because S can determine an independent 
sales price of X from comparable uncontrolled transactions under Sec. 
1.482-2(e)(2). For purposes of computing both possessions sales and 
total sales, the 50 units of X sold to A will be deemed to have been 
sold by A to an unrelated person for $10 per unit. The income of S 
qualifying for the possessions tax credit from the sale of those 50 
units of X to A, and A's basis in those units, will both be determined 
using the $8 transfer price determined under section 936 
(h)(5)(C)(i)(II). For purposes of computing total sales in the 
denominator of the cost sharing fraction, S may also take into account 
the 50 units of Y leased by A to unrelated persons, as if A had sold 
those units for $20 per unit. A's basis in those units of Y will 
continue to be its actual cost basis of $15 per unit.
    If all of the above transactions had occurred in 1987, S would be 
entitled to compute its income under the cost sharing method with 
respect to the 50 units of X it sold to A only if A agreed to be treated 
for all tax purposes as if it had sold such units for $10 per unit, 
realized income on such deemed sale of $2 per unit, repurchased such 
units immediately for $10 per unit, and then leased such units, which 
would then have a $10 per unit basis in A's hands. For purposes of 
computing total sales, S would be entitled to take into account the 50 
units of X leased by A to unrelated persons as if A had sold such units 
for $20 per unit.
    (3) Credits against cost sharing payments.
    Q. 1: Is the cost of product area research paid or accrued by the 
possessions corporation in a taxable year creditable against the cost 
sharing payment?
    A. 1: Yes, if the cost of the product area research is paid or 
accrued solely by the possessions corporation. Thus, payments by the 
possessions corporation under cost sharing arrangements with, or 
royalties paid to, unrelated persons are so creditable. Amounts (such as 
royalties) paid directly or indirectly to, or on behalf of, related 
persons and amounts paid under any cost sharing agreements with related 
persons are not creditable against the cost sharing payment.
    Q. 2: Do royalties or other payments made by an affiliate of the 
possessions corporation to another member of the affiliated group reduce 
the cost sharing

[[Page 180]]

payment if such royalties or other payments are based, in part, on 
activity of the possessions corporation?
    A. 2: No. Payments made between affiliated corporations do not 
reduce the cost sharing payment. Thus, for example, if a possessions 
corporation sells a component to a foreign affiliate for incorporation 
by the foreign affiliate into an integrated product sold to unrelated 
persons, and the foreign affiliate pays a royalty to the U.S. parent of 
the possessions corporation based on the total value of the integrated 
product, the cost sharing payment of the possessions corporation is not 
reduced.
    (4) Computation of cost sharing payment.
    Q. 1: S is a possessions corporation engaged in the manufacture and 
sale of four products (A, B, C, and D) all of which are classified under 
the same three-digit SIC code. S sells its production to a U.S. 
affiliate, P, which resells it to unrelated parties in the United 
States. P's third party sales of each of these products produced in 
whole or in part by S (computed as provided under paragraph (a)(2) of 
Sec. 1.936-6) are $1 million or a total of $4 million for A, B, C, and 
D. P's other sales of products in the same SIC code are $3,000,000; and 
the defined worldwide product area research of the affiliated group is 
$350,000. How should S compute the cost sharing amount for products A, 
B, C, and D?
    A. 1: The cost sharing amount is computed separately for each 
product on Schedule P of Form 5735. S should use the following formula 
for each of the products A, B, C, and D:
[GRAPHIC] [TIFF OMITTED] TC09OC91.006

[GRAPHIC] [TIFF OMITTED] TC09OC91.007

    Q. 2: The facts are the same as in question 1 except that S 
manufactures product D under a license from an unrelated person. S pays 
the unrelated party an annual license fee of $20,000. Thus, the 
worldwide product area research expense of the affiliated group is 
$370,000. How should the cost sharing payment be adjusted?
    A. 2: The cost sharing fee should be reduced by the $20,000 license 
fee made as a direct annual payment to a third party on account of 
product D. The cost sharing payment with respect to product D in this 
example will be adjusted as follows:
[GRAPHIC] [TIFF OMITTED] TC09OC91.008

[GRAPHIC] [TIFF OMITTED] TC09OC91.009

    Q. 3: The facts are the same as in question 1 except that S also 
manufactures and exports product E to a foreign affiliate, which resells 
it to unrelated persons for $1 million. S makes a separate election for 
its export sales. How should S compute the cost sharing amount for 
product E?
    A. 3: The numerator of the cost sharing fraction is the aggregate 
sales or

[[Page 181]]

other dispositions by members of the affiliated group of the units of 
product E produced in whole or in part in the possession to persons who 
are not members of the affiliated group. The cost sharing amount for 
product E would be computed as follows:
[GRAPHIC] [TIFF OMITTED] TC09OC91.010

 or
[GRAPHIC] [TIFF OMITTED] TC09OC91.011

    Q. 4: The facts are the same as in question 1, except that S also 
receives $10,000 in royalty income from unrelated persons for the 
licensing of certain manufacturing intangible property rights. What is 
the amount of the product area research that must be allocated in 
determining the cost sharing amount?
    A. 4: If the affiliated group receives royalty income from unrelated 
persons with respect to manufacturing intangibles in the same product 
area, then the product area research to be considered shall be first 
reduced by such royalty income. In this case, the amount of product area 
research to be used in determining S's cost sharing payment should be 
reduced by the $10,000 royalty payment received to $340,000.
    Q. 5: May a possessions corporation redetermine the amount of its 
required cost sharing payment after filing its tax return?
    A. 5: If after filing its tax return, a possessions corporation 
files an amended return, or if an adjustment is made on audit, either of 
which affects the amount of the cost sharing payment required, then a 
redetermination of the cost sharing payment must be made. See, however, 
section 936(h)(5)(C)(i)(III)(a) with respect to the increase in the cost 
sharing payment due to interest imposed under section 6601(a).
    (5) Effect of election under the cost sharing method.
    Q. 1: What is the effect of the cost sharing method?
    A. 1: The cost sharing payment reduces the amount of deductions (and 
the amount of reductions in earnings and profits) otherwise allowable to 
the U.S. affiliates (other than tax-exempt affiliates) within the 
affiliated group as determined under section 936(h)(5)(C)(i)(I)(b) which 
have incurred research expenditures (as defined in Sec. 1.936-6(a)(1), 
question and answer (3) in the same product area for which the cost 
sharing option is elected, during the taxable year in which the cost 
sharing payment accrues. If there are no such U.S. affiliates, the 
reductions with respect to deductions and earnings and profits, as the 
case may be, are made with respect to foreign affiliates within the same 
affiliated group which have incurred product area research expenditures 
in such product area attributable to a U.S. trade or business. If there 
are no affiliates which have incurred research expenditures in such 
product area, the reductions are then made with respect to any other 
U.S. affiliate and, if there is no such U.S. affiliate, then to any 
other foreign affiliate. The allocations of these reductions in each 
case shall be made in proportion to the gross income of the affiliates. 
In the case of foreign affiliates, the allocation shall be made in 
proportion to gross income attributable to the U.S. trade or business or 
worldwide gross income, as the

[[Page 182]]

case may be. With respect to each group above, the reduction of 
deductions shall be applied first to deductions under section 174, then 
to deductions under section 162, and finally to any other deductions on 
a pro rata basis.
    Q. 2: For purposes of estimated tax payments, when is the cost 
sharing amount deemed to accrue?
    A. 2: The cost sharing amount is deemed to accrue to the appropriate 
affiliate on the last day of the taxable year of each such affiliate in 
which or with which the taxable year of the possessions corporation 
ends.
    Q. 3: If the cost sharing method is elected and the year of accrual 
of the cost sharing payment to the appropriate affiliate (described in 
question and answer 1 of this paragraph (a)(5)) differs from the year of 
actual payment by the possessions corporation, in what year are the 
deductions of the recipients reduced?
    A. 3: In the year the cost sharing payment has accrued.
    Q. 4: What is the treatment of income from intangibles under the 
cost sharing method?
    A. 4: Under the cost sharing method, a possessions corporation is 
treated as the owner, for purposes of obtaining a return thereon, of 
manufacturing intangibles related to a possession product. The term 
``manufacturing intangible'' means any patent, invention, formula, 
process, design, pattern, or know-how. The possessions corporation will 
not be treated as the owner, for purposes of obtaining a return thereon, 
of any manufacturing intangibles related to a component product produced 
by an affiliated corporation and transferred to the possessions 
corporation for incorporation into the possession product, except in the 
case that the possession product is treated as including such component 
product for all purposes of section 936(h)(5). Further, the possessions 
corporation will not be treated as the owner, for purposes of obtaining 
a return thereon, of any marketing intangibles except ``covered 
intangibles.'' (See Sec. 1.936-6(c).)
    Q. 5: If the cost sharing option is elected, is it necessary for the 
possessions corporation to be the legal owner of the manufacturing 
intangibles related to the possession product in order for the 
possessions corporation to receive a full return with respect to such 
intangibles?
    A. 5: No. There is no requirement that manufacturing intangibles be 
owned by the possessions corporation.
    Q. 6: How is income attributable to marketing intangibles treated 
under the cost sharing method?
    A. 6: Except in the case of ``covered intangibles'' (see Sec. 
1.936-6(c)), the possessions corporation is not treated as the owner of 
any marketing intangibles, and income attributable to marketing 
intangible of the possessions corporation will be allocated to the 
possessions corporation's U.S. shareholders with the proration of income 
based on shareholdings. If a shareholder of the possessions corporation 
is a foreign, person or is otherwise tax exempt, the possessions 
corporation is taxable on that shareholder's pro rata amount of the 
intangible property income. If the possessions corporation is a 
corporation any class of the stock of which is regularly traded on an 
established securities market, then the income attributable to marketing 
intangibles will be taxable to the possessions corporation rather than 
the corporation's U.S. shareholders.
    Q. 7: What is the source of the intangible property income described 
in question and answer 6?
    A. 7: The intangible property income is U.S. source whether taxed to 
the U.S. shareholder or taxed to the possessions corporation and section 
863 (b) does not apply for this purpose. However, such intangible 
property income, if treated as income of the possessions corporation, 
does not enter into the calculation of the 80-percent possession source 
test or the 65-percent active trade or business test.
    Q.7a: What is the source of the taxpayer's gross income derived from 
a sale in the United States of a possession product purchased by the 
taxpayer (or an affiliate) from a corporation that has an election in 
effect under section 936, if the income from such sale is taken into 
account to determine benefits under cost sharing for the section 936 
corporation? Is the result different if the taxpayer (or an affiliate) 
derives gross income from a sale in the United

[[Page 183]]

States of an integrated product incorporating a possession product 
purchased by the taxpayer (or an affiliate) from the section 936 
corporation, if the taxpayer (or an affiliate) processes the possession 
product or an excluded component in the United States?
    A.7a: Under either scenario, the income is U.S. source, without 
regard to whether the possession product is a component, end-product, or 
integrated product. Section 863 does not apply in determining the source 
of the taxpayer's income. This Q&A 7a is applicable for taxable years 
beginning on or after November 13, 1998.
    Q. 8: May marketing intangible income, if any, be allocated to the 
possessions corporation with respect to custom-made products?
    A. 8: No. If the cost sharing option is elected, then income 
attributable to marketing intangibles (other than ``covered 
intangibles'' described in Sec. 1.936-6(c)) will be taxed as discussed 
in questions and answers 6 and 7 of paragraph (a)(5) of this section. It 
is immaterial whether the product is custom-made.
    Q. 9: In order to sell a pharmaceutical product in the United 
States, a New Drug Application (``NDA'') for the product must be 
approved by the U.S. Food and Drug Administration. Is an NDA considered 
a manufacturing or marketing intangible for purposes of the allocation 
of income under the cost sharing method?
    A. 9: A manufacturing intangible.
    Q. 10: Can a copyright be, in whole or in part, a manufacturing 
intangible for purposes of the allocation of income under the cost 
sharing method?
    A. 10: In general, a copyright is a marketing intangible. See 
section 936(h)(3)(B)(ii). However, copyrights may be treated either as 
manufacturing intangibles or nonmanufacturing intangibles (or as partly 
each) depending upon the function or the use of the copyright. If the 
copyright is used in manufacturing, it will be treated as a 
manufacturing intangible; but if it is used in marketing, even if it is 
also classified as know-how, it will be treated as a marketing 
intangible.
    Q. 11: If the cost sharing option is elected and a patent is related 
to the product produced by the possessions corporation, does the return 
to the possessions corporation with respect to the manufacturing 
intangible include the make, use, and sell elements of the patent?
    A. 11: Yes. A patent confers an exclusive right for 17 years to sell 
a product covered by the patent. During this period, the return to the 
possessions corporation includes the make, use and sell elements of the 
patent.
    Q. 12: For purposes of the cost sharing option, may a safe haven 
rule be applied to determine the amount of marketing intangible income?
    A. 12: No. The amount of marketing intangible income is determined 
on the basis of all relevant facts and circumstances. The section 482 
regulations will continue to apply except to the extent modified by the 
election. Rev. Proc. 63-10 and Rev. Proc. 68-22 do not apply for this 
purpose.
    Q. 13: If a product covered by the cost sharing election is sold by 
a possessions corporation to an affiliated corporation for resale to an 
unrelated party, may the resale price method under section 482 be used 
to determine the intercompany price of the possessions corporation?
    A. 13: In general, the resale price method may be used if (a) no 
comparable uncontrolled price for the product exists, and (b) the 
affiliated corporation does not add a substantial amount of value to the 
product by manufacturing or by the provision of services which are 
reflected in the sales price of the product to the customer. The 
possessions corporation will not be denied use of the resale price 
method for purposes of such inter-company pricing merely because the 
reseller adds more than an insubstantial amount to the value of the 
product by the use of intangible property.
    Q. 14: If a possessions corporation makes the cost sharing election 
and uses the cost-plus method under section 482 to determine the arm's-
length price of a possession product, will the cost base include the 
cost of materials which are subject to processing or which are 
components in the possession product?
    A. 14: A taxpayer may include the cost of materials in the cost base 
if it

[[Page 184]]

is appropriate under the regulations under Sec. 1.482-2(e)(4).
    Q. 15: If the possessions corporation computes its income with 
respect to a product under the cost sharing method, and the price of the 
product is determined under the cost-plus method under section 482, does 
the cost base used in computing cost-plus under section 482 include the 
amount of the cost sharing payment?
    A. 15: The amount of the cost sharing payment is included in the 
cost base. However, no profit with respect to the cost sharing payment 
will be allowed.
    Q. 16: If a member of the affiliated group transfers to a 
possessions corporation a component which is incorporated into a 
possession product, how will the transfer price for the component be 
determined?
    A. 16: The transfer price for the component will be determined under 
section 482, and as follows. If the possession product is treated as not 
including such component for purposes of section 936(h)(5), the transfer 
price paid for the component will include a return on all intangibles 
related to the component product. If the possession product is treated 
as including such component for purposes of section 936(h)(5), then the 
transfer price paid for the component by the possessions corporation 
will not include a return on any manufacturing intangible related to the 
component product, and the possessions corporation will obtain the 
return on the manufacturing intangibles associated with the component.
    Q. 17: If the possessions corporation computes its income with 
respect to a product under the cost sharing method, with respect to 
which units of the product shall the possessions corporation be treated 
as owning intangible property as a result of having made the cost 
sharing election?
    A. 17: The possessions corporation shall not be treated as owning 
intangible property, as a result of having made the cost sharing 
election, with respect to any units of a possession product which were 
not taken into account by the possessions corporation in applying the 
significant business presence test for the current taxable year or for 
any prior taxable year in which the possessions corporation also had a 
significant business presence in the possession with respect to such 
product.
    (b) Profit split option--(1) Computation of combined taxable income.
    Q. 1: In determining combined taxable income from sales of a 
possession product, how are the allocations and apportionments of 
expenses, losses, and other deductions to be determined?
    A. 1: (i) Expenses, losses, and other deductions are to be allocated 
and apportioned on a ``fully-loaded'' basis under Sec. 1.861-8 to the 
combined gross income of the possessions corporation and other members 
of the affiliated group (other than foreign affiliates). For purposes of 
the profit split option, the term ``affiliated group'' is defined the 
same as under Sec. 1.936-6 (a)(1) question and answer 2. The amount of 
research, development, and experimental expenses allocated and 
apportioned to combined gross income is to be determined under Sec. 
1.861-8(e)(3). The amount of research, development and experimental 
expenses and related deductions (such as royalties paid or accrued with 
respect to manufacturing intangibles by the possessions corporation or 
other domestic members of the affiliated group to unrelated persons or 
to foreign affiliates) allocated and apportioned to combined gross 
income shall in no event be less than the amount of the cost sharing 
payment that would have been required under the rules set forth in 
section 936(h)(5)(C)(i)(II) and paragraph (a) of this section if the 
cost sharing option had been elected. Other expenses which are subject 
to Sec. 1.861-8(e) are to be allocated and apportioned in accordance 
with that section. For example, interest expense (including payments 
made with respect to bonds issued by the Puerto Rican Industrial, 
Medical and Environmental Control Facilities Authority (AFICA)) is to be 
allocated and apportioned under Sec. 1.861-8(e)(2). With the exception 
of marketing and distribution expenses discussed below, the other 
remaining expenses which are definitely related to a class of gross 
income shall be allocated to that class of gross income and shall be 
apportioned on the basis of any reasonable method, as described in Sec. 
1.861-8 (b)(3) and (c)(1). Examples of such

[[Page 185]]

methods may include, but are not limited to, those specified in Sec. 
1.861-8(c)(1)(i) through (vi).
    (ii) The class of gross income to which marketing and distribution 
expenses relate and shall be allocated is generally to be defined by the 
same ``product area'' as is determined for the relevant research, 
development, and experimental expenses (i.e., the appropriate 3-digit 
SIC code), but shall include only gross income generated or reasonably 
expected to be generated from the geographic area or areas to which the 
expenses relate. It shall be presumed that marketing and distribution 
expenses relate to all product sales within the same product area. If, 
however, it can be established that any of these expenses are separately 
identifiable expenses, such as advertising, and relate, directly or 
indirectly, solely to a specific product or a specific group of 
products, such expenses shall be allocated to the class of gross income 
defined by the specific product or group of products. Thus, advertising 
and other separately identifiable marketing expenses which relate 
specifically and exclusively to a particular product must be allocated 
entirely to the gross income from that product, even though the taxpayer 
or other members of an affiliated group which includes the taxpayer 
produce and market other products in the same 3-digit SIC code 
classification. The mere display of a company logo or mention of a 
company name solely in the context of identifying the manufacturer shall 
not prevent an advertisement from relating specifically and exclusively 
to a particular product or group of products.
    (iii) If marketing and distribution expenses are allocated to a 
class of gross income which consists both of income from sales of 
possession products (the statutory grouping) and other income such as 
from sale by U.S. affiliates of products not produced in the possession 
(the residual grouping), then these marketing and distribution expenses 
shall be apportioned on a ``fully loaded'' basis which reflects, to a 
reasonably close extent, the factual relationship between these 
deductions and the statutory and residual groupings of gross income. 
Apportionment methods based upon comparisons of amounts incurred before 
ultimate sale of a product (including apportionment on a comparison of 
costs of goods sold, other expenses incurred, or other comparisons set 
forth in Sec. 1.861-8 (c)(1)(v), such as time spent) are not on a 
``fully-loaded'' basis and do not reflect this required factual 
relationship. These deductions shall be apportioned on a basis of 
comparison of the amount of gross sales or receipts or another method if 
it is established that such method similarly reflects the required 
factual relationship. Thus, for example, a comparison of units sold may 
be used only where the units are of the same or similar value and are, 
thus, in fact comparable.
    (iv) The rules for allocation and apportionment of marketing and 
distribution expenses may be illustrated by the following examples:

    Example 1. Assume that possessions corporation A manufacturers 
prescription pharmaceutical product 1 for resale by P, its U.S. parent 
corporation, in the United States. Additionally, assume that P 
manufactures prescription pharmaceutical products 2 and 3 in the 
United States for sale there. Further, assume that all three products 
are within the same product area, and that marketing and distribution 
expenses are internally divided by P among the three products on the 
basis of time spent by sales persons of P on marketing of the three 
products, as follows:

Product 1.....................................................      50X
Product 2.....................................................      80X
Product 3.....................................................     110X
                                                                --------
    Total......................................................     240X
 


These expenses of 240X are allocated to gross income generated by all 
three products and shall be apportioned on the basis of gross sales or 
receipts of product 1 as compared to products 2 and 3 or another 
method which similarly reflects the factual relationship between these 
expenses and gross income derived from product 1 and products 2 and 
3. Thus, if a sales method were used and sales of product 1 accounted 
for one-third of sales receipts from the three products, 80X (240 / 3) 
of marketing and distribution expenses would be apportioned to the 
combined gross income from product 1.
    Example 2. Corporation B produces and sells Brand W whiskey, in the 
United States. B's subsidiary, S, which is a possessions corporation, 
produces soft drink extract in Puerto Rico which it sells to independent 
bottlers to produce Brand S soft drinks for sale in the United States. 
Corporation B's

[[Page 186]]

advertisements and other promotional materials for Brand W whiskey make 
no reference to Brand S soft drinks (or any other Corporation B 
products), and Brand S soft drink advertisements and other promotional 
materials make no reference to Brand W whiskey (or any other corporation 
B products). For purposes of section 936(h), the advertising and other 
promotional expenses for Brand W whiskey must be allocated entirely to 
the gross income from sales of Brand W whiskey and the advertising and 
other promotional expenses for Brand S soft drink must be allocated 
entirely to the gross income from the sales of soft drink extract, 
notwithstanding the fact that whiskey and soft drink extract are both 
included in SIC code 208. A similar result would apply, for example, to 
separately identifiable advertising and other marketing expenses which 
relate specifically and exclusively to one or the other of the following 
pairs of products: chewing gum and granulated sugar (SIC code 206); 
canned tuna fish and freeze-dried coffee (SIC code 209); children's 
underwear and ladies' brassieres (SIC code 234); aspirin tablets and 
prescription antibiotic tablets (SIC code 283); floor wax and perfume 
(SIC code 284); adhesives and inks (SIC code 289); semi-conductors and 
cathode-ray tubes (SIC code 367); batteries and extension cords (SIC 
code 369); bandages and dental supplies (SIC code 384); stainless steel 
flatware and jewelry parts (SIC code 391); children's toys and sporting 
goods (SIC code 394); hair curlers and zippers (SIC code 396); and paint 
brushes and linoleum tiles (SIC code 399).
    Example 3. Assume the same facts as in Example 1 and that 
possessions corporation A also manufactures aspirin, a non-prescription 
product, for resale by its U.S. parent corporation, P. Further, assume 
that the advertising and separately identifiable marketing expenses 
which relate specifically and exclusively to aspirin sales total $100 
and that these expenses are allocable solely to gross income derived 
from aspirin sales. The sales method continues to be used to apportion 
the marketing and distribution expenses related, directly or indirectly, 
to products 1, 2, and 3, and the apportionment of such expenses to 
product 1 for purposes of determining combined taxable income from 
product 1 will remain as stated in Example 1. None of the advertising 
and other separately identifiable marketing expenses which relate 
specifically and exclusively to aspirin will be taken into account in 
allocating and apportioning the marketing and distribution expenses 
relating to the gross income attributable to products 1, 2, and 3. 
Gross income attributable to aspirin will be considered as a separate 
class of gross income, and all the advertising and separately 
identifiable marketing expenses which relate specifically and 
exclusively to aspirin sales of $100 will be allocated to the class of 
gross income derived from aspirin sales. Similarly, none of the 
marketing and distribution expenses, directly or indirectly, related 
solely to the group of products 1, 2, and 3 will be taken into 
account in determining the combined taxable income from aspirin sales. 
the remaining marketing and distribution expenses which do not, directly 
or indirectly, relate solely to any specific product or group of 
products (e.g., the salaries of a Vice-President of Marketing who has 
responsibility for marketing all products and his staff) shall be 
allocated and apportioned on the basis of the gross receipts from the 
sales of all of the products (or a similar method) in determining 
combined taxable income of any product.

    Q. 2: How may the allocation and apportionment of expenses to 
combined gross income be verified?
    A. 2: Substantiation of the allocation and apportionment of expenses 
will be required upon audit of the possessions corporation and 
affiliates. Detailed substantiation may be necessary, particularly where 
the entities are engaged in multiple lines of business involving 
distinct product areas. Sources of substantiation may include certified 
financial reports. Form 10-K's, annual reports, internal production 
reports, product line assembly work papers, and other relevant 
materials. In this regard, see Sec. 1.861-8(f)(5).
    Q. 3: Does section 936(h) override the moratorium provided by 
section 223 of the Economic Recovery Tax Act of 1981 and any subsequent 
similar moratorium?
    A. 3: Yes. Thus, the allocation and apportionment of product area 
research described in question and answer 1 must be made without regard 
to the moratorium.
    Q. 4: Is the cost of samples treated as a marketing expense?
    A. 4: Yes. The cost of producing samples will be treated as a 
marketing expense and not as inventoriable costs for purposes of 
determining combined taxable income (and compliance with the significant 
business presence test). However, for taxable years beginning prior to 
January 1, 1986, the cost of producing samples may be treated as either 
a marketing expense or as inventoriable costs.
    Q. 5: If a possessions corporation uses the profit split method to 
determine its taxable income from sales of a product, how does it 
determine its gross income

[[Page 187]]

for purposes of the 80-percent possession source test and the 65-percent 
active trade or business test of section 936(a)(2)?
    A. 5: One-half of the deductions of the affiliated group (other than 
foreign affiliates) which are used in determining the combined taxable 
income from sales of the product are added to the portion of the 
combined taxable income allocated to the possessions corporation in 
order to determine the possessions corporation's gross income from sales 
of such product.
    Q. 6: How will income from intangibles related to a possession 
product be treated under the profit split method?
    A. 6: Combined taxable income of the possessions corporation and 
affiliates from the sale of the possession product will include income 
attributable to all intangibles, including both manufacturing and 
marketing intangibles, associated with the product.
    Q. 7: Can a possessions corporation apply the profit split option to 
a possession product if no U.S. affiliates derive income from the sale 
of the possession product?
    A. 7: Yes.
    Q. 8: With respect to the factual situation discussed in question 
and answer 7 how is combined taxable income computed?
    A. 8: The profit split option is applied to the taxable income of 
the possessions corporation from sales of the possession product to 
foreign affiliates and unrelated persons. Fifty percent of that income 
is allocated to the possessions corporation, and the remainder is 
allocated to the appropriate affiliates as described in question and 
answer 13 of this paragraph (b)(1).
    Q. 9: May a possessions corporation compute its income under the 
profit split method with respect to units of a possession product which 
it sells to a U.S. affiliate if the U.S. affiliate leases such units to 
unrelated persons or to foreign affiliates or uses such units in its own 
trade or business?
    A. 9: Yes, provided that an independent sales price for the 
possession product from comparable uncontrolled transactions can be 
determined in accordance with Sec. 1.482-2 (e)(2). If, however, there 
is a comparable uncontrolled price for an integrated product and the 
possession product is a component product or end-product form thereof, 
the possessions corporation may compute its income under the profit 
split method with respect to such units. In either case, the possessions 
corporation shall compute combined taxable income with respect to such 
units under the following question and answer.
    Q. 10: If the possessions corporation is entitled to use the profit 
split method in the situation described in Q. 9 (leasing units of the 
possession product or use of such units in the taxpayer's own trade or 
business), how should it compute combined taxable income with respect to 
such units?
    A. 10: (i) Combined taxable income shall be computed as if the U.S. 
affiliate had sold the units to an unrelated person (or to a foreign 
affiliate) at the time the units were first leased or otherwise placed 
in service by the U.S. affiliate. The sales price on such deemed sale 
shall be equal to the independent sales price from comparable 
uncontrolled transactions determined in accordance with Sec. 1.482-
2(e)(2), if any.
    (ii) If the possession product is a component product or an end-
product form, the combined taxable income with respect to the possession 
product shall be determined under Q&A. 12 of this paragraph (b)(1).
    (iii) For purposes of determining the basis of a component product 
or an end-product form, the deemed sales price of such product must be 
determined. The deemed sales price of the component product shall be 
determined by multiplying the deemed sales price of the integrated 
product that includes the component product by a ratio, the numerator of 
which is the production costs of the component product and the 
denominator of which is the production costs of the integrated product 
that includes the component product. The deemed sales price of an end-
product form shall be determined by multiplying the deemed sales price 
of the integrated product that includes the end-product form by a ratio, 
the numerator of which is the production costs of the end-product form 
and the denominator of which is the production costs of the integrated 
product that includes the end-product form. For the definition of

[[Page 188]]

production costs, see Q&A. 12 of this paragraph (b)(1).
    (iv)(A) If combined taxable income is determined under paragraph (v) 
of A. 12 of this paragraph (b)(1), in the case of a component product, 
the deemed sales price shall be determined by using the actual sales 
price of that product when sold as an integrated product (as adjusted 
under the rules of the fourth sentence of Sec. 1.482-3(b)(2)(ii)(A)).
    (B) If combined taxable income is determined under paragraph (v) of 
A. 12 of this paragraph (b)(1), in the case of an end-product form, the 
deemed sales price shall be determined by subtracting from the deemed 
sales price of the integrated product that includes the end-product form 
(e.g., the leased property) the actual sales price of the excluded 
component when sold as an integrated product to an unrelated person (as 
adjusted under the rules of the fourth sentence of Sec. 1.482-
3(b)(2)(ii)(A)).
    (v) The full amount of income received under the lease shall be 
treated as income of (and be taxed to) the U.S. affiliate and not the 
possessions corporation.
    Q. 11: In the situation described in question 9, how does the U.S. 
affiliate determine its basis in such units for purposes of computing 
depreciation and similar items?
    A. 11: The U.S. affiliate shall be treated, for purposes of 
computing its basis in such units, as if it had repurchased such units 
immediately following the deemed sale and at the deemed sales price as 
provided in Q&A. 10 of this paragraph (b)(1).


The principles of questions and answers 10 and 11 are illustrated by the 
following example:

    Example: Possessions corporation S manufactures 100 units of 
possession product X. S sells 50 units of X to an unrelated person in an 
arm's length transaction for $10 per unit. S sells the remaining 50 
units to its U.S. affiliate, A, which leases such units to unrelated 
persons. The combined taxable income for the 100 units of X is computed 
below on the basis of the given production, sales, and cost data:

Sales:
  1. Total sales by S to unrelated persons (50 x $10)..........     $500
  2. Total deemed sales by A to unrelated persons (50 x $10)...      500
  3. Total gross receipts (line 1 plus line 2).................    1,000
Total costs:
  4. Material costs............................................      200
  5. Production costs..........................................      300
  6. Research expenses.........................................        0
  7. Other expenses............................................      100
  8. Total (add lines 4 through 7).............................      600
Combined taxable income attributable to the 100 units of X:
  9. Combined taxable income (line 3 minus line 8).............      400
  10. Share of combined taxable income apportioned to S (50% of      200
   line 9).....................................................
  11. Share of combined taxable income apportioned to A (line 9      200
   minus line 10)..............................................
A's basis in 50 units of X leased by it to unrelated persons:
  12. 50 units times $10 deemed repurchase price...............      500
 


Subsequent leasing income is entirely taxed to A.

    Q. 12: If the possession product is a component product or an end-
product form, how is the combined taxable income for such product to be 
determined?
    A. 12: (i) Except as provided in paragraph (v) of this A. 12, 
combined taxable income for a component product or an end-product form 
is computed under the production cost ratio (PCR) method.
    (ii) Under the PCR method, the combined taxable income for a 
component product will be the same proportion of the combined taxable 
income for the integrated product that includes the component product 
that the production costs attributable to the component product bear to 
the total production costs (including costs incurred by the U.S. 
affiliates) for the integrated product that includes the component 
product. Production costs will be the sum of the direct and indirect 
production costs as defined under Sec. 1.936-5(b)(4) except that the 
costs will not include any costs of materials. If the possession product 
is a component product that is transformed into an integrated product in 
whole or in part by a contract manufacturer outside of the possession, 
within the meaning of Sec. 1.936-5(c), the denominator of the PCR shall 
be computed by including the same amount paid to the contract 
manufacturer, less the costs of materials of the contract manufacturer, 
as is taken into account for purposes of the significant business 
presence test under Sec. 1.936-5(c) Q&A. 5.
    (iii) Under the PCR method the combined taxable income for an end-
product form will be the same proportion of

[[Page 189]]

the combined taxable income for the integrated product that includes the 
end-product form that the production costs attributable to the end-
product form bear to the total production costs (including costs 
incurred by the U.S. affiliates) for the integrated product that 
includes the end-product form. Production costs will be the sum of the 
direct and indirect production costs as defined under Sec. 1.936-
5(b)(4) except that the costs will not include any costs of materials. 
If the possession product is an end-product form and an excluded 
component is contract manufactured outside of the possession, within the 
meaning of Sec. 1.936-5(c), the denominator shall be computed by 
including the same amount paid to the contract manufacturer, less cost 
of materials of the contract manufacturer, as is also taken into account 
for purposes of the significant business presence test under Sec. 
1.936-5(c) Q&A. 5.
    (iv) This paragraph (iv) of A. 12 illustrates the computation of 
combined taxable income for a component product or end-product form 
under the PCR method. S, a possessions corporation, is engaged in the 
manufacture of microprocessors. S obtains a component from a U.S. 
affiliate, O. S sells its production to another U.S. affiliate, P, which 
incorporates the microprocessors into central processing units (CPUs). P 
transfers the CPUs to a U.S. affiliate, Q, which incorporates the CPUs 
into computers for sale to unrelated persons. S chooses to define the 
possession product as the CPUs. The combined taxable income for the sale 
of the possession product on the basis of the given production, sales, 
and cost data is computed as follows:

Production costs (excluding costs of materials):
    1. O's costs for the component.........................          100
    2. S's costs for the microprocessors...................          500
    3. P's costs for the CPUs (the possession product).....          200
    4. Q's costs for the computers.........................          400
    5. Total production costs for the computer (Add lines 1        1,200
     through 4)............................................
    6. Combined production costs for the CPU (the                    800
     possession product) (Add lines 1 through 3)...........
    7. Ratio of production costs for the CPUs (the                 0.667
     possession product) to the production costs for the
     computer..............................................
Determination of combined taxable income for computers:
  Sales:
    8. Total possession sales of computers to unrelated            7,500
     customers and foreign affiliates......................
  Total costs of O, S, P, and Q incurred in production of a
   computer:
    9. Production costs (enter from line 5)................        1,200
    10. Material costs.....................................          100
    11. Total costs (line 9 plus line 10)..................        1,300
    12. Combined gross income from sale of computers (line         6,200
     8 minus line 11)......................................
  Expenses of the affiliated group (other than foreign
   affiliates) allocable and apportionable to the computers
   or any component thereof under the rules of Sec. Sec.
   1.861-8 through 1.861-14T and 1.936-6 (b)(1), Q&A. 1:
    13. Expenses (other than research expenses)............          980
  Research expenses of the affiliated group allocable and
   apportionable to the computers:
    14. Total sales in the 3-digit SIC Code................       12,500
    15. Possession sales of the computers (enter from line         7,500
     8)....................................................
    16. Cost sharing fraction (divide line 15 by line 14)..          0.6
    17. Research expenses incurred by the affiliated group           700
     in 3-digit SIC Code multiplied by 120 percent.........
    18. Cost sharing amount (multiply line 16 by line 17)..          420
    19. Research of the affiliated group (other than                 300
     foreign affiliates) allocable and apportionable under
     Sec. Sec. 1.861-17 and 1.861-14T(e)(2) to the
     computers.............................................
    20. Enter the greater of line 18 or line 19............          420
Computation of combined taxable income of the computer and
 the CPU:
    21. Combined taxable income attributable to the                4,800
     computer (line 12 minus line 13 and line 20)..........
    22. Combined taxable income attributable to CPUs               3,200
     (multiply line 21 by line 7) (production cost ratio)..
    23. Share of combined taxable income apportioned to S          1,600
     (50 percent of line 22)...............................
Share of combined taxable income apportioned to U.S.
 affiliate(s) of S:
    24. Adjustments for research expenses (line 18 minus              80
     line 19 multiplied by line 7).........................
    25. Adjusted combined taxable income (line 22 plus line        3,280
     24)...................................................
    26. Share of combined taxable income apportioned to            1,680
     affiliates of S (line 25 minus line 23)...............
 

    (v)(A) If a possession product is sold by a taxpayer or its 
affiliate to unrelated persons in covered sales both as an integrated 
product and as a component product and the conditions of paragraph 
(v)(C) of this A. 12 are satisfied, the taxpayer may elect to determine 
the combined taxable income derived from covered sales of the component 
product under this paragraph (v).

[[Page 190]]

In that case, the combined taxable income derived from covered sales of 
the component product shall be determined by using the same per unit 
combined taxable income as is derived from covered sales of the product 
as an integrated product, but subject to the limitation of paragraph 
(v)(D) of this A. 12.
    (B) In the case of a possession product that is an end-product form, 
if all of the excluded components are also separately sold by the 
taxpayer or its affiliate to unrelated persons in uncontrolled 
transactions and the conditions of paragraph (v)(C) of this A. 12 are 
satisfied, the taxpayer may elect to determine the combined taxable 
income of such end-product form under this paragraph (v). In that case, 
the combined taxable income derived from covered sales of the end-
product form shall be determined by reducing the per unit combined 
taxable income from the integrated product that includes the end-product 
form by the per unit combined taxable income for excluded components 
determined under the rules of this paragraph (v), but subject to the 
limitation of paragraph (v)(D) of this A. 12. For this purpose, combined 
taxable income of the excluded components must be determined under 
section 936 as if the excluded components were possession products.
    (C) In the case of component products, this paragraph (v) applies 
only if the sales price of the possession product sold in covered sales 
as an integrated product (i.e., in uncontrolled transactions) would be 
the most direct and reliable measure of an arm's length price within the 
meaning of the fourth sentence of Sec. 1.482-3(b)(2)(ii)(A) for the 
component product. For purposes of applying the fourth sentence of Sec. 
1.482-3(b)(2)(ii)(A), the sale of the integrated product that includes 
the component product is treated as being immediately preceded by a sale 
of the component (i.e. without further processing) in a controlled 
transaction. In the case of end-product forms, this paragraph (v) 
applies only if the sales price of excluded components separately sold 
in uncontrolled transactions would be the most direct and reliable 
measure of an arm's length price within the meaning of the fourth 
sentence of Sec. 1.482-3(b)(2)(ii)(A) for all excluded components of an 
integrated product that includes an end-product form. For purposes of 
applying the fourth sentence of Sec. 1.482-3(b)(2)(ii)(A), the sale of 
the integrated product that includes excluded components is treated as 
being immediately preceded by a sale of the excluded components (i.e. 
without further processing) in a controlled transaction. Under the 
fourth sentence of Sec. 1.482-3(b)(2)(ii)(A), the uncontrolled 
transactions referred to in this paragraph (v)(C) must have no 
differences with the controlled transactions that would affect price, or 
have only minor differences that have a definite and reasonably 
ascertainable effect on price and for which appropriate adjustments are 
made (resulting in appropriate adjustments to the computation of 
combined taxable income). If such adjustments cannot be made, or if 
there are more than minor differences between the controlled and 
uncontrolled transactions, the method provided by this paragraph (v)(C) 
cannot be used. Thus, for example, these uncontrolled transactions must 
involve substantially identical property in the same or a substantially 
identical geographic market, and must be substantially identical to the 
controlled transaction in terms of their volumes, contractual terms, and 
market level. See Sec. 1.482-3(b)(2)(ii)(B).
    (D) In no case can the per unit combined taxable income as 
determined under paragraph (v)(A) or (B) of this A. 12 be greater than 
the per unit combined taxable income of the integrated product that 
includes the component product or end-product form.
    (E) The provisions of this paragraph (v) are illustrated by the 
following example. Taxpayer manufactures product A in a U.S. possession. 
Some portion of product A is sold to unrelated persons as an integrated 
product and the remainder is sold to related persons for transformation 
into product AB. The combined taxable income of integrated product A is 
$400 per unit and the combined taxable income of product AB is $300 per 
unit. The production cost ratio with respect to product A when sold as a 
component of product AB, is 2/3. Unless the taxpayer elects and 
satisfies the conditions of this paragraph (v),

[[Page 191]]

the combined taxable income with respect to A will be $200 per unit 
(combined taxable income for AB of $300 x the production cost ratio of 
2/3). If, however, the comparability standards of paragraph (v)(C) of 
this A. 12 are met, the taxpayer may elect to determine combined taxable 
income of product A when sold as a component of product AB using the 
same per unit combined taxable income as product A when sold as an 
integrated product. However, the per unit combined taxable income from 
sales of product A as a component product may not exceed the per unit 
combined taxable income on the sale of product AB. Therefore, the 
combined taxable income of component product A may not exceed $300 per 
unit.
    (vi) Taxpayers that have not elected the percentage limitation under 
section 936(a)(1) for the first taxable year beginning after December 
31, 1993, may do so if the taxpayer has elected the profit split method 
and computation of combined taxable income is affected by Q&A.12 of this 
paragraph (b)(1).
    (vii) The rules of Q&A. 12 of this paragraph (b)(1) apply for 
taxable years ending after June 9, 1996. If, however, the election under 
paragraph (v) of A. 12 of Sec. 1.936-6(b)(1) is made, this election 
must be made for the taxpayer's first taxable year beginning after 
December 31, 1993, and if not made effective for that year, the election 
cannot be made for any later taxable year. A successor corporation that 
makes the same or substantially similar products as its predecessor 
corporation cannot make an election under paragraph (v) of A.12 of Sec. 
1.936-6(b)(1) unless the election was made by its predecessor 
corporation for its first taxable year beginning after December 31, 
1993.
    Q. 13: If the profit split option is elected, how is the portion of 
combined taxable income not allocated to the possessions corporation to 
be treated?
    A. 13: (i) The income shall be allocated to affiliates in the 
following order, but no allocations will be made to affiliates described 
in a later category if there are any affiliates in a prior category--
    (A) First, to U.S. affiliates (other than tax exempt affiliates) 
within the group (as determined under section 482) that derive income 
with respect to the product produced in whole or in part in the 
possession;
    (B) Second, to U.S. affiliates (other than tax exempt affiliates) 
that derive income from the active conduct of a trade or business in the 
same product area as the possession product;
    (C) Third, to other U.S. affiliates (other than tax-exempt 
affiliates);
    (D) Fourth, to foreign affiliates that derive income from the active 
conduct of a U.S. trade or business in the same product area as the 
possession product (or, if the foreign members are resident in a country 
with which the U.S. has an income tax convention, then to those foreign 
members that have a permanent establishment in the United States that 
derives income in the same product area as the possession product); and
    (E) Fifth, to all other affiliates.
    (ii) The allocations made under paragraph (i)(A) of this A. 13 shall 
be made on the basis of the relative gross income derived by each such 
affiliate with respect to the product produced in whole or in part in 
the possession. For this purpose, gross income must be determined 
consistently for each affiliate and consistently from year to year.
    (iii) The allocations made under paragraphs (i)(B) and (i)(D) of 
this A. 13 shall be made on the basis of the relative gross income 
derived by each such affiliate from the active conduct of the trade or 
business in the same product area.
    (iv) The allocations made under paragraphs (i)(C) and (i)(E) of this 
A. 13 shall be made on the basis of the relative total gross income of 
each such affiliate before allocating income under this section.
    (v) Income allocated to affiliates shall be treated as U.S. source 
and section 863(b) does not apply for this purpose.
    (vi) For purposes of determining an affiliate's estimated tax 
liability for income thus allocated for taxable years beginning prior to 
January 1, 1995, the income shall be deemed to be received on the last 
day of the taxable year of each such affiliate in which or with which 
the taxable year of the possessions corporation ends. For taxable years 
beginning after December 31,

[[Page 192]]

1994, quarterly estimated tax payments will be required as provided 
under section 711 of the Uruguay Round Agreements, Public Law 103-465 
(1994), page 230, and any administrative guidance issued by the Internal 
Revenue Service thereunder.
    Q. 14: What is the source of the portion of combined taxable income 
allocated to the possessions corporation?
    A. 14: Income allocated to the possessions corporation shall be 
treated as possession source income and as derived from the active 
conduct of a trade or business within the possession.
    Q. 15: How is the profit split option to be applied to properly 
account for costs incurred in a year with respect to products which are 
sold by the possessions corporation to a U.S. affiliate during such 
year, but are not resold by the U.S. affiliate to persons who are not 
members of the affiliated group or to foreign affiliates until a later 
year?
    A. 15: The rules under Sec. 1.994-1(c)(5) are to be applied. 
Incomplete transactions will not be taken into consideration in 
computing combined taxable income. Thus, for example, if in 1983, A, a 
possessions corporation, sells units of a product with a cost to A of 
$5000 to B corporation, its U.S. affiliate, which use the dollar-value 
LIFO method of costing inventory, and B sells units with a cost of $4000 
(representing A's cost) to C corporation, a foreign affiliate, only 
$4000 of such costs shall be taken into consideration in computing the 
combined taxable income of the possessions corporation and U.S. 
affiliates for 1983. If a specific goods LIFO inventory method is used 
by B, the determination of whether A's goods remain in B's inventory 
shall be based on whether B's specific goods LIFO grouping has 
experienced an increment or decrement for the year on the specific LIFO 
cost of such units, rather than on an average unit cost of such units. 
If the FIFO method of costing inventory is used by B, transfers may be 
based on the cost of the specific units transferred or on the average 
unit production cost of the units transferred, but in each case a FIFO 
flow assumption shall be used to identify the units transferred. For a 
determination of which goods are sold by taxpayers using the LIFO 
method, see question and answer 19.
    Q. 16: If a possessions corporation purchases materials from an 
affiliate and computes combined taxable income for a possession product 
which includes such materials, how are those materials to be treated in 
the possessions corporation's inventory?
    A. 16: The cost of those materials is considered to be equal to the 
affiliate's cost using the affiliate's method of costing inventory.
    Q. 17: If the possessions corporation uses the FIFO method of 
costing inventory and the U.S. affiliate uses the LIFO method of costing 
inventory, or vice versa, what method of costing inventory should be 
used in computing combined taxable income?
    A. 17: The transferor corporation's method of costing inventory 
determines the cost of inventory for purposes of combined taxable income 
while the transferee corporation's method of costing inventory 
determines the flow. Assume, for example, that X corporation, a 
possessions corporation, using the FIFO method of costing inventory 
purchases materials from Y corporation, U.S. affiliate, also using the 
FIFO method. X corporation produces a product which it transfers to Z 
corporation, another U.S. affiliate using the LIFO method. Assume also 
that the final product satisfies the significant business presence test. 
Under the facts, the cost of the materials purchased by X from Y is Y's 
FIFO cost. The costs of the inventory transferred by X to Z are 
determined under X's FIFO method of accounting as is the flow of the 
inventory from X to Z. The costs added by Z are determined under Z's 
LIFO method of inventory, as is the flow of the inventory from Z to 
unrelated persons or foreign affiliates.
    Q. 18: How are the costs of a possession product and the revenues 
derived from the sale of a possession product determined if the U.S. 
affiliate includes purchases of the possessions product in a dollar-
value LIFO inventory pool (as provided under Sec. 1.472-8)?
    A. 18: The following method will be accepted in determining the 
revenues derived from the sale of a possession product and the costs of 
a possession product if the U.S. affiliate includes

[[Page 193]]

purchases of the possession product in a dollar-value LIFO inventory 
pool. The rules apply solely for the cost sharing and profit split 
options under section 936(h).
    (i) Revenue identification. The identification of revenues derived 
from sales of a possession product must generally be made on a specific 
identification basis. The particular method employed by a taxpayer for 
valuing its inventory will have no impact on the determination of what 
units are sold or how much revenue is derived from such sales. Thus, if 
a U.S. affiliate sells both item A (a possession product) and item B (a 
non-possession product), the actual sales revenues received by the U.S. 
affiliate from item A sales would constitute possession product revenue 
for purposes of the profit split option and possession sales for 
purposes of the cost sharing option regardless of whether the U.S. 
affiliate values its inventories on the FIFO or the LIFO method. In 
instances where sales of item A (i.e., the possession product) cannot be 
determined by use of specific identification (for example, in cases 
where items A and B are identical except that one is produced in the 
possession (item A) and the other (item B) is produced outside of the 
possession and it is not possible to segregate these items in the hands 
of the U.S. affiliate), it will be necessary to identify the portion of 
the combined sales of items A and B (which together can be identified on 
a specific identification basis) which is attributed to item A sales and 
the portion which is attributed to item B sales. The determination of 
the portion of aggregated sales attributable to item A and item B is 
independent of the LIFO method used to determine the cost of such sales 
and may be made under the following approach. A taxpayer may, for 
purposes of this section of the regulations, use the relative purchases 
(in units) of items A and B by the U.S. affiliate during the taxable 
year (or other appropriate measuring period such as the period during 
the taxable year used to determine current-year costs, i.e., earliest 
acquisitions period, latest acquisitions period, etc.) in determining 
the ratio to apply against the combined items A and B sales revenue. If 
the sales exceed current purchases, the taxpayer can use a FIFO unit 
approach which identifies actual unit sales on a first-in, first-out 
basis. Revenue determination where specific identification is not 
possible is illustrated by the following example:

    Example. At the end of year 1, there are 600 units of combined items 
A and B which are to be allocated between A and B on the basis of annual 
purchases of A and B units during year 1. During year 1, 1,000 units of 
item A, a possession product, and 2,000 units of item B, a non-
possession product, were purchased. Thus, the 600 units in year 1 ending 
inventory are allocated 200 (i.e. \1/3\) to item A units and 400 (i.e. 
\2/3\) to item B units based on the relative purchases of A (1,000) and 
B (2,000) in year 1. These units appear as beginning inventory in year 
2.
    In year 2, 1,500 units of item A are purchased and 1,500 units of 
item B are purchased. However, 3,300 units of items A and B in the 
aggregate are sold for $600,000. The relative proportion of the $600,000 
attributable to item A and to item B sales would be determined as 
follows:

------------------------------------------------------------------------
                      Year 2 sales                        Item A  Item B
------------------------------------------------------------------------
Unit sales from opening inventory.......................     200     400
Unit sale from current-year purchases...................   1,350   1,350
                                                         ---------------
    Total unit sales (3,300)............................   1,550   1,750
    Percentage..........................................      47      53
------------------------------------------------------------------------

                                                                  [GRAPHIC] [TIFF OMITTED] TC14NO91.144
                                                                  

------------------------------------------------------------------------
                    Year 2 Closing Inventory                       Units
------------------------------------------------------------------------
Item A..........................................................     150
Item B..........................................................     150
------------------------------------------------------------------------


[[Page 194]]


Thus, revenues from Item A sales for purposes of computing possession 
sales for the cost sharing option and revenues for the profit split 
option are $281,818.
    (ii) Cost identification. The determination of the cost of 
possession product sales by the U.S. affiliate must be based on the LIFO 
inventory method of the U.S. affiliate. The LIFO cost of possession 
product sales will, for purposes of this section of the regulations, be 
determined by maintaining a separate LIFO cost for possession products 
in a taxpayer's opening and closing LIFO inventory and using this cost 
to calculate an independent cost of possession product sales. This 
separate LIFO cost for possession products in the LIFO pool of a 
taxpayer is to be determined as follows:
    (A) Determine the base-year cost of possession products in ending 
inventory in a LIFO pool.
    (B) Determine the percentage of the base-year cost of possession 
products in the pool as compared to the total base-year cost of all 
items in the pool.
    (C) Multiply the percentage determined in step (B) of this 
subdivision (ii) by the ending LIFO inventory value of the pool to 
determine the deemed LIFO cost attributable to possession products in 
the pool.
    (D) Subtract the LIFO cost of possession products in ending 
inventory in the pool (as calculated in step (C) of this subdivision 
(ii)) from the sum of:
    (1) Possession product purchases for the year, plus
    (2) The portion of the opening LIFO inventory value of the pool 
attributed to possession products (i.e., the result obtained in step (C) 
of this subdivision (ii) for the prior year).


The number determined by this calculation is the LIFO cost of possession 
product sales from the taxpayer's LIFO pool.

    Example: Assume that item A is a possession product and item B is a 
non-possession product and also assume the inventory and purchases with 
respect to the LIFO pool as provided below:

                        Year 1--Ending Inventory
------------------------------------------------------------------------
                                No. of   Base-year  Base-year
                                units    cost/unit     cost     Percent
------------------------------------------------------------------------
Item A......................        100      $2.00       $200         20
Item B......................        200       4.00        800         80
------------------------------------------------------------------------


                           Year 1--LIFO Value
------------------------------------------------------------------------
                                         Base-year
                                            cost      Index    LIFO cost
------------------------------------------------------------------------
Increment layer 2......................       $300        3.0       $900
Increment layer 1......................        400        2.0        800
Base layer.............................        300        1.0        300
                                        -----------           ----------
      Pool total.......................     $1,000  .........     $2,000
------------------------------------------------------------------------


                       Year 1--LIFO Value Per Item
------------------------------------------------------------------------
                                                    Base-year     LIFO
                                                       cost      value
------------------------------------------------------------------------
      Total pool..................................     $1,000     $2,000
                                                   ---------------------
Item A............................................        200        400
Item B............................................        800      1,600
------------------------------------------------------------------------


                            Year 2--Purchases
------------------------------------------------------------------------
                                                                 Total
                                                               purchases
------------------------------------------------------------------------
Item A.......................................................     $6,000
Item B.......................................................      4,000
------------------------------------------------------------------------


                        Year 2--Ending Inventory
------------------------------------------------------------------------
                                No. of   Base-year  Base-year
                                units    cost/unit     cost     Percent
------------------------------------------------------------------------
Item A......................        200      $2.00       $400         50
Item B......................        100       4.00        400         50
------------------------------------------------------------------------


                           Year 2--LIFO Value
------------------------------------------------------------------------
                                         Base-year
                                            cost      Index    LIFO cost
------------------------------------------------------------------------
Increment layer 2......................       $100        3.0       $300
Increment layer 1......................        400        2.0        800
Base layer.............................       $300        1.0        300
                                        -----------           ----------
Pool total.............................        800  .........      1,400
------------------------------------------------------------------------
The year 2 LIFO cost of possession product A sales will be calculated as
  follows:
(1) Base-year cost of item in year 2 ending inventory = $400
(2) Percentage of item A base-year cost to total base-year cost ($400 /
  $800) = 50%
(3) LIFO value of item A ($1,400 x 50%) = $700
(4) LIFO cost of item A sales is determined by adding to the beginning
  inventory in year 2 the purchases of item A in year 2 and subtracting
  from this amount the ending inventory in year 2 ($400 + $6000 - $700 =
  $5700). The beginning inventory in year 2 is determined by multiplying
  the LIFO cost of the year 1 ending inventory by a percentage of item A
  base year cost to the total base-year cost in year 1. The ending
  inventory in year 2 is determined under (3) above.



[[Page 195]]

    Q. 19: If a possession product is purchased from a possessions 
corporation by a U.S. affiliate using the dollar-value LIFO method of 
costing its inventory and is included in a LIFO pool of the U.S. 
affiliate which includes products purchased from the possessions 
corporation in pre-TEFRA years, how should the LIFO index computation of 
the U.S. affiliate be made in the first year in which section 936(h) 
applies and in subsequent taxable years?
    A. 19: The U.S. affiliate should treat the first taxable year for 
which section 936(h) applies as a new base year in accordance with 
procedures provided by regulations under section 472. Thus, the opening 
inventory for the first year for which section 936(h) applies (valuing 
possession products purchased from the possessions corporation on the 
basis of the cost of such possession products), would equal the new base 
year cost of the inventory of such pool of the U.S. affiliate. 
Increments and decrements at new base year cost would be valued for LIFO 
purposes pursuant to the procedures provided by regulations under 
section 472.
    Q. 20: If the possessions corporation computes its income with 
respect to a product under the profit split method, with respect to 
which units of the product shall the profit split method apply?
    A. 20: The profit split method shall apply to units of the 
possession product produced in whole or in part by the possessions 
corporation in the possession and sold during the taxable year by 
members of the affiliated group (other than foreign affiliates) to 
unrelated parties or to foreign affiliates. In no event shall the profit 
split method apply to units of the product which were not taken into 
account by the possessions corporation in applying the significant 
business presence test for the current taxable year or for any prior 
taxable year in which the possessions corporation also had a significant 
business presence in the possession with respect to such product.
    (2) Pre-TEFRA inventory.
    Q. 1: How is pre-TEFRA inventory to be determined if the profit 
split option is elected and the FIFO method of costing inventory is used 
by the U.S. affiliate?
    A. 1: Pre-TEFRA inventory is inventory which was produced by the 
possessions corporation and transferred to a U.S. affiliate prior to the 
possessions corporation's first taxable year beginning after December 
31, 1982. Pre-TEFRA inventory will not be included for purposes of the 
profit split option. If the U.S. affiliate uses the FIFO method of 
costing inventory, the pre-TEFRA inventory will be treated as the first 
inventory sold by the U.S. affiliate during the first year in which 
section 936(h) applies and will not be included in the computation of 
combined taxable income for purposes of the profit split option. The 
treatment of pre-TEFRA inventory when FIFO costing is used by both the 
U.S. affiliate and the possessions corporation is illustrated by the 
following example in which FIFO unit costing is used:

    Example. Assume the following:

------------------------------------------------------------------------
                                              X                 Y
                                     -----------------------------------
                                         Possessions     U.S. affiliate
                                         corporation   -----------------
                                     ------------------
                                       Number    Cost    Number    Cost
                                         of      per       of      per
                                       units     unit    units     unit
------------------------------------------------------------------------
Beginning inventory.................      500     $150      200     $225
Units produced during 1983..........    1,000      200
Ending inventory....................      400      200      300  .......
------------------------------------------------------------------------

    In 1983, the beginning inventory of X, a possessions corporation, is 
500 units with a unit cost of $150 and the beginning inventory of Y, the 
U.S. affiliate, is 200 units with a unit cost of $225, which represents 
the section 482 price paid by Y. Y's beginning inventory in 1983 
represents purchases made in 1982 of products produced by X in that 
year. Y sells all the units it purchases from X to Z, a foreign 
affiliate. In 1983, X produces 1000 units at a unit cost of $200 and 
sells 1100 units to Y (the difference between 1500 units, representing 
X's 1983 beginning inventory (500) and the units produced by X in 1983 
(1000), and X's ending inventory of 400 units). Of the 1100 units sold 
by X to Y in 1983 only 800 units (and not 1000 units) which were sold by 
Y to Z are taken into consideration in computing combined taxable income 
for 1983. Since FIFO costing by the possessions corporation is used, the 
cost is $150 per unit for the first 500 units and $200 per unit for the 
remaining 300 units. The 200 units sold by X to Y in 1982 are pre-TEFRA 
inventory and are not included in the computation of combined taxable 
income for 1983. They are also treated as the first units sold by Y to Z 
in 1983. This inventory has a unit cost of $225,

[[Page 196]]

which reflects the section 482 transfer price from X to Y in 1982. Y's 
1983 ending inventory of 300 units will not be taken into consideration 
in computing the combined taxable income of X and Y for 1983 because the 
units have not been sold to a foreign affiliate or to persons who are 
not members of the affiliated group. In a subsequent year when the units 
are sold to Z, the cost to X and selling price to Z of these units will 
enter into the computation of combined taxable income for that year.

    (c) Covered Intangibles.
    Q. 1: What are ``covered intangibles'' under section 
936(h)(5)(C)(i)(II)?
    A. 1: The term ``covered intangibles'' means (1) intangible property 
developed in a possession solely by the possessions corporation and 
owned by it, (2) manufacturing intangible property (described in section 
936(h)(3)(B)(i)) which is acquired by the possessions corporation from 
unrelated persons, and (3) any other intangible property (described in 
section 936(h)(3)(B) (ii) through (v), to the extent not described in 
section 936(h)(3)(B)(i)) which relates to sales of products or services 
to unrelated persons for ultimate consumption or use in the possession 
in which the possessions corporation conducts its business. The 
possessions corporation is treated as the owner of covered intangibles 
for purposes of obtaining a return thereon.
    Q. 2: Do covered intangibles include manufacturing intangible 
property which is acquired by an affiliate and subsequently transferred 
to the possessions corporation?
    A. 2: No. In order for a manufacturing intangible to be treated as a 
covered intangible, the intangible property must be acquired directly by 
the possessions corporation from an unrelated person unless the 
manufacturing intangible was acquired by an affiliate from an unrelated 
person and was transferred to the possessions corporation by the 
affiliate prior to September 3, 1982.
    Q. 3: If a possessions corporation licenses a manufacturing 
intangible from an unrelated party, will the licensed intangible be 
treated as a covered intangible?
    A. 3: No.
    Q. 4: How is ultimate consumption or use determined for purposes of 
the definition of covered intangibles?
    A. 4: A product will be treated as having its ultimate use or 
consumption in a possession if it is sold by the possessions corporation 
to a related or unrelated person in a possession and is not resold or 
used or consumed outside of the possession within one year after the 
date of the sale.
    Q. 5: Are sales of products that relate to covered intangibles 
excluded from the cost sharing fraction?
    A. 5: If no manufacturing intangibles other than covered intangibles 
are associated with the possession product, then sales of such product 
will be excluded from the cost sharing fraction. If both covered and 
non-covered manufacturing intangibles are associated with the possession 
product, then sales of such product will be included in the cost sharing 
fraction.
    Q. 6: If the cost sharing option is elected, is it necessary for the 
possessions corporation to be the legal owner of covered intangibles 
described in section 936(h)(5)(C)(i)(II)(c) related to the product in 
order for the possessions corporation to receive a full return with 
respect to such intangibles?
    A. 6: No. For purposes of section 936(h), it is immaterial whether 
such covered intangibles are owned by the possessions corporation or by 
another member of the affiliated group. Moreover, if the legal owner of 
such covered intangibles which are subject to section 936(h)(5) is an 
affiliate of the possessions corporation, such person will not be 
required to charge an arm's-length royalty under section 482 to the 
possessions corporation.

[T.D. 8090, 51 FR 21532, June 13, 1986; 51 FR 27174, July 30, 1986, as 
amended by T.D. 8669, 61 FR 21367, May 10, 1996; 61 FR 39072, July 26, 
1996; T.D. 8786, 63 FR 55025, Oct. 14, 1998]



Sec. 1.936-7  Manner of making election under section 936 (h)(5);
special election for export sales; revocation of election under
section 936(a).

    (a) The rules in this section apply for purposes of section 936(h) 
and also for purposes of section 934(e), where applicable.
    (b) Manner of making election.
    Q. 1: How does a possessions corporation make an election to use the 
cost sharing method or profit split method?

[[Page 197]]

    A. 1: A possessions corporation makes an election to use the cost 
sharing or profit split method by filing Form 5712-A (``Election and 
Verification of the Cost Sharing or Profit Split Method Under Section 
936(h)(5)'') and attaching it to its tax return. Form 5712-A must be 
filed on or before the due date (including extensions) of the tax return 
of the possessions corporation for its first taxable year beginning 
after December 31, 1982. The electing corporation must set forth on the 
form the name and the taxpayer identification number or address of all 
members of the affiliated group (including foreign affiliates not 
required to file a U.S. tax return). All members of the affiliated group 
must consent to the election. For elections filed with respect to 
taxable years beginning before January 1, 2003, an authorized officer of 
the electing corporation must sign the statement of election and must 
declare that he has received a signed statement of consent from an 
authorized officer, director, or other appropriate official of each 
member of the affiliated group. Elections filed for taxable years 
beginning after December 31, 2002, must incorporate a declaration by the 
electing corporation that it has received a signed consent from an 
authorized officer, director, or other appropriate official of each 
member of the affiliated group and will be verified by signing the 
return. The election is not valid for a taxable year unless all 
affiliates consent. A failure to obtain an affiliate's written consent 
will not invalidate the election out if the possessions corporation made 
a good faith effort to obtain all the necessary consents or the failure 
to obtain the missing consent was inadvertent. Subsequently created or 
acquired affiliates are bound by the election. If an election out is 
revoked under section 936(h)(5)(F)(iii), a new election out with respect 
to that product area cannot be made without the consent of the 
Commissioner. The possessions corporation shall file an amended Form 
5712-A with its timely filed (including extensions) income tax return to 
reflect any changes in the names or number of the members of the 
affiliated group for any taxable year after the first taxable year to 
which the election out applies. By consenting to the election out, all 
affiliates agree to provide information necessary to compute the cost 
sharing payment under the cost sharing method or combined taxable income 
under the profit split method, and failure to provide such information 
shall be treated as a request to revoke the election out under section 
936(h)(5)(F)(iii).
    Q. 2: May the ``election out'' under section 936(h)(5) be made on a 
product-by-product basis, or must it be made on a wide basis?
    A. 2: An electing corporation is required to treat products in the 
same product area in the same manner. Similarly, all possessions 
corporations in the same affiliated group that produce any products or 
render any services in the same product area must make the same election 
for all products that fall within the same product area. However, Sec. 
1.936-7(b) provides that the electing corporation may make a different 
election for export sales than for domestic sales. The electing 
corporation or corporations may also make different elections for 
products that fall within different product areas.
    Q. 3: May the possessions corporation elect to define product area 
more narrowly than the 3-digit SIC code?
    A. 3: No. Certain alternatives, such as the 4-digit SIC code, would 
not be permitted under the statute. However, other methods for defining 
product area may be considered by the Commissioner in the future.
    Q. 4: May a possessions corporation make an election out under the 
cost sharing method with respect to a product area if the affiliated 
group incurs no research, development or experimental costs in the 
product area?
    A. 4: Yes. In that case the cost sharing payment will be zero.
    Q. 5: If the significant business presence test is not satisfied for 
a product or type of service within the product area covered by the 
election out under section 936(h)(5) what rules will apply with respect 
to that product?
    A. 5: With respect to the product which does not satisfy the 
significant business presence test, the provisions of section 936 (h)(1) 
through (h)(4) will apply to the allocation of income. However, if a 
cost sharing or a profit split election has been made with respect to

[[Page 198]]

the product area, the cost sharing payment or the research and 
development floor under section 936(h)(5)(C)(ii)(II) will not be 
reduced.
    Q. 6: Is a taxpayer permitted to make a change of election with 
respect to the cost sharing and profit split methods?
    A. 6: In general, once the election is properly made, it is binding 
for the first year in which it applies and all subsequent years 
(including upon any later created or acquired affiliates), and 
revocation is only permitted with the consent of the Commissioner of 
Internal Revenue. However, a taxpayer will be permitted to change its 
election once from the cost sharing method to the profit split method or 
vice versa, or from the method permitted under section 936 (h)(1) 
through (h)(4) to cost sharing or profit split or vice versa, without 
the consent of the Commissioner if the change is made on the taxpayer's 
return for its first taxable year ending after June 13, 1986. Such 
change will apply to such taxable year and all subsequent taxable years, 
and, at the taxpayer's option, may also apply to all prior taxable years 
for which section 936(h) was in effect. A change of election will be 
treated as an election subject to the procedures set forth above and to 
section 481 of the Internal Revenue Code.
    Q. 7: If the Commissioner determines that a possessions corporation 
does not meet the 80-percent possession source test or the 65-percent 
active trade or business test (the ``qualification tests'') for any 
taxable year beginning after 1982, under what circumstances is the 
possessions corporation permitted to make a distribution of property 
after the close of its taxable year to meet the qualification tests?
    A. 7: A possessions corporation may make a pro rata distribution of 
property to its shareholders after the close of the taxable year if the 
Commissioner determines that the possessions corporation does not 
satisfy the qualification tests (a) by reason of the exclusion from 
gross income of intangible income under section 936(h)(1)(B) or section 
936(h)(5)(C)(i)(II) or (b) by reason of the allocation to the 
shareholders of the possessions corporation of income under section 
936(h)(5)(C)(ii)(III); provided, however, that the determination of the 
Commissioner does not contain a finding that the failure of such 
corporation to satisfy the qualification tests was due, in whole or in 
part, to fraud with intent to evade tax or willful neglect on the part 
of the possessions corporation. The possessions corporation must 
designate the distribution at the time the distribution is made as a 
distribution to meet qualification requirements, and it will be subject 
to the provisions of section 936(h)(4). Such distributions will not 
qualify for the dividends received deduction.
    Q. 8: If a possessions corporation owns stock in a subsidiary 
possessions corporation, any intangible property income allocated to the 
parent possessions corporation under section 936(h) will be treated as 
U.S. source income and taxable to the parent possessions corporation. Is 
the intangible property income taken into consideration in determining 
whether the parent possessions corporation meets the income tests of 
section 936(a)(2)?
    A. 8: While taxable to the parent possessions corporation, the 
intangible property income does not enter into the calculation of the 
80-percent possession source test or the 65-percent active trade or 
business test of section 936(a)(2)(A) and (B). This would also be the 
case if the subsidiary possessions corporation made a qualifying 
distribution under section 936(h)(4).
    (c) Separate election for export sales.
    Q. 1: What methods of computing income can a possessions corporation 
use under the separate election for export sales?
    A. 1: The only two methods which are available under the separate 
election for export sales are the cost sharing method and the profit 
split method.
    Q. 2: What is the definition of export sales for purposes of the 
separate election for export sales?
    A. 2: The determination of export sales is based upon the 
destination of the product, i.e., where it is to be used or consumed. If 
the product is sold to a U.S. affiliate, it will be treated as an export 
sale only if resold or otherwise transferred abroad to a foreign person 
(including a foreign affiliate or foreign branch of a U.S. affiliate) 
within one year from the date of sale to the U.S.

[[Page 199]]

affiliate for ultimate use or consumption outside the United States as 
provided under Sec. 1.954-3(a)(3)(ii).
    Q. 3: Assume that a possessions corporation sells a product to both 
foreign affiliates and foreign branches of U.S. affiliates. In addition, 
it sells the product to its U.S. parent for resale in the U.S. The 
possessions corporation makes a profit split election for domestic sales 
and a cost sharing election of export sales. Will the sales to foreign 
branches of U.S. affiliates be treated as exports subject to the cost 
sharing method or as domestic sales subject to the profit split method?
    A. 3: The sales to a foreign branch of a U.S. corporation are 
exports if for ultimate use or consumption outside of the United States 
as provided under Sec. 1.954-3(a)(3)(ii).
    Q. 4: Under what circumstances may a possessions corporation make 
the separate election under section 936(h)(5)(F)(iv)(II) for computing 
its income from products exported to a foreign person when the income 
derived by such foreign person on the resale of such products is 
included in foreign base company income under section 954(a)?
    A. 4: If the income derived by a foreign person on the resale of 
products manufactured, in whole or in part, by a possessions corporation 
is included in foreign base company income under section 954(a), then 
the possessions corporation may make the separate export election under 
section 936(h)(5)(F)(iv)(II) for computing its income from such products 
only if such foreign person has been formed or is availed of for 
substantial business reasons that are unrelated to an affiliated 
corporation's U.S. tax liability. For purposes of the proceding 
sentence, a foreign person will be considered to be formed or availed of 
for such substantial business reasons if the foreign person in the 
normal course of business purchases substantial quantities of products 
from both the possessions corporation and its affiliates for resale, 
and, in addition provides support services for affiliated companies such 
as centralized testing, marketing of products, management of local 
currency exposures, or other similar services. However, a foreign person 
that purchases and resells products only from a possessions corporation 
is presumed to be formed or availed of for other than such substantial 
business reasons, even if the foreign person provides additional 
services.
    Q. 5: When will the ``manufacturing'' test set forth in subsection 
(d)(1)(A) of section 954 be applicable to the export sales of a product 
of a possessions corporation which makes a separate election for export 
sales?
    A. 5: An electing corporation will be required to meet the 
``manufacturing'' test set forth in subsection (d)(1)(A) of section 954 
with respect to export sales of its product in each taxable year in 
which the separate election for export sales is in effect.
    (d) Revocation of election under section 936(a).
    Q. 1: When may an election under section 936(a) be revoked?
    A. 1: An election under section 936(a) may be revoked during the 
first ten years of section 936 status only with the consent of the 
Commissioner, and without the Commissioner's consent after that time. 
The Commissioner hereby consents to all requests for revocation that are 
made with respect to the taxapayer's first taxable year beginning after 
December 31, 1982 provided that the section 936(a) election was in 
effect for the corporation's last taxable year beginning before January 
1, 1983, if the taxpayer agrees not to re-elect section 936(a) prior to 
its first taxable year beginning after December 31, 1988. A taxpayer 
that wishes to revoke a section 936(a) election under the terms of the 
blanket revocation must attach a ``Statement of Revocation--Section 
936'' to the taxpayer's timely filed return (including extensions) and 
must state that in revoking the election the taxpayer agrees not to re-
elect section 936(a) prior to its first taxable year beginning after 
December 31, 1988. Other requests to revoke not covered by the 
Commissioner's blanket consent should be addressed to the District 
Director having jurisdiction over the taxpayer's tax return.

[T.D. 8090, 51 FR 21545, June 13, 1986, as amended by T.D. 9100, 68 FR 
70705, Dec. 19, 2003; T.D. 9300, 71 FR 71042, Dec. 8, 2006]

[[Page 200]]



Sec. 1.936-8T  Qualified possession source investment income
(temporary). [Reserved]



Sec. 1.936-9T  Source of qualified possession source investment income
(temporary). [Reserved]



Sec. 1.936-10  Qualified investments.

    (a) In general. [Reserved]
    (b) Qualified investments in Puerto Rico. [Reserved]
    (c) Qualified investment in certain Caribbean Basin countries--(1) 
General rule. An investment of qualified funds described in this section 
shall be treated as a qualified investment of funds for use in Puerto 
Rico if the funds are used for a qualified investment in a qualified 
Caribbean Basin country. A qualified investment in a qualified Caribbean 
Basin country is a loan of qualified funds by a qualified financial 
institution (described in paragraph (c)(3) of this section) directly to 
a qualified recipient (described in paragraph (c)(9) of this section) or 
indirectly through a single financial intermediary for investment in 
active busines assets (as defined in paragraph (c)(4) of this section) 
in a qualified Caribbean Basin country (described in paragraph 
(c)(10)(ii) of this section) or for investment in development projects 
(as defined in paragraph (c)(5) of this section) in a qualified 
Caribbean Basin country, provided--
    (i) The investment is authorized, prior to disbursement of the 
funds, by the Commissioner of Financial Institutions of Puerto Rico (or 
his delegate) pursuant to regulations issued by such Commissioner; and
    (ii) The agreement, certification, and due diligency requirements 
under paragraphs (c)(11), (12), and (13) of this section are met.


A loan by a qualified financial institution shall not be disqualified 
merely because the loan transaction is processed by the central bank of 
issue of the country into which the loan is made pursuant to, and solely 
for purposes of complying with, the exchange control laws or regulations 
of such country. Further, a loan by a qualified financial institution 
shall not be disqualified merely because the loan is acquired by another 
person, provided such other person is also a qualified financial 
institution.
    (2) Termination of qualification--(i) In general. An investment 
that, at any time after having met the requirements for a qualified 
investment in a qualified Caribbean Basin country under the terms of 
this paragraph (c), fails to meet any of the conditions enumerated in 
this paragraph (c) shall no longer be considered a qualified investment 
in a qualified Caribbean Basin country from the time of such failure, 
unless the investment satisfies the requirements for a timely cure 
described in paragraph (c)(2)(ii) of this section. Such a failure 
includes, but is not limited to, the occurrence of any of the following 
events:
    (A) Active business assets cease to qualify as such;
    (B) Proceeds from the investment are diverted for the financing of 
assets, projects, or operations that are not active business assets or 
development projects or are not the assets or the project of the 
qualified recipient;
    (C) The holder of the qualified recipient's obligation is not a 
qualified financial institution;
    (D) The qualified recipient's qualified business activity ceases to 
qualify as such; or
    (E) The qualified Caribbean Basin country ceases to be a country 
described in paragraph (c)(10)(ii) of this section.
    (ii) Timely cure--(A) In general. A timely cure shall be considered 
to have been made if the event or events that cause disqualification of 
the investment are corrected within a reasonable period of time. For 
purposes of this section, a reasonable period of time shall not exceed 
60 days after such event or events come to the attention of the 
qualified recipient or the qualified financial institution or should 
have some to their attention by the exercise of reasonable diligence.
    (B) Due diligence requirements. A time cure of a failure to comply 
with the due diligence requirements of paragraphs (c)(11), (12), and 
(13) of this section shall be considered to be made if the failure to 
comply is due to reasonable cause and, upon request of the Commissioner 
of Financial Institutions of Puerto Rico (or his delegate) or of

[[Page 201]]

the Assistant Commissioner (International) (or his authorized 
representative), the qualified financial institution (and its trustee or 
agent), if any), the financial intermediary, or the qualified recipient 
establishes to the satisfaction of the Commissioner of Financial 
Institutions of Puerto Rico (or his delegate) or of the Assistant 
Commissioner (International) (or his authorized representative) that it 
has exercised due diligence in ensuring that the funds were property 
disbursed to a qualified recipient and applied by or on behalf of such 
qualified recipient to uses that qualify the investment as an investment 
in qualified business assets or a development project under the 
provisions of this paragraph (c).
    (iii) Assumption of qualified recipient's obligation. An investment 
shall not cease to qualify merely because the qualified recipient's 
obligation to the qualified financial institution (or to a financial 
intermediary, if any) is assumed by another person, provided such other 
person assumes the qualified recipient's agreement and certification 
requirements under paragraph (c)(11)(i) of this section and is either--
    (A) A qualified recipient on the date of assumption, in which case 
such person shall be treated for purposes of this section as the 
original qualified recipient and shall be subject to all the 
requirements of this section for continued qualification of the loan as 
a qualified investment in a qualified Caribbean Basin country; or
    (B) An international organization, the principal purpose of which is 
to foster economic development in developing countries and which is 
described in section 1 of the International Organizations Immunities Act 
(22 U.S.C. 288), if the assumption of the obligation is pursuant to a 
bona fide guarantee agreement.
    (3) Qualified financial institution--(i) General rule. For purposes 
of section 936(d)(4)(A) and this section, a qualified financial 
institution includes only--
    (A) A banking, financing, or similar business defined in Sec. 
1.864-4(c)(5)(i) that is an eligible institution described in paragraph 
(c)(3)(ii) of this section, but not including branches of such 
institution outside of Puerto Rico;
    (B) A single-purpose entity described in paragraph (c)(3)(iii) of 
this section;
    (C) The Government Development Bank for Puerto Rico;
    (D) The Puerto Rico Economic Development Bank; and
    (E) Such other entity as may be determined by the Commissioner by 
Revenue Procedure or other guidance published in the Internal Revenue 
Bulletin.
    (ii) Eligible institution. An eligible institution means an 
institution--
    (A) That is an entity organized under the laws of the Commonwealth 
of Puerto Rico or is the Puerto Rican branch of an entity organized 
under the laws of another jurisdiction, if such entity is engaged in a 
banking, financing, or similar business defined in Sec. 1.864-
4(c)(5)(i), and
    (B) That is licensed as an eligible institution under Regulation No. 
3582 (or any successor regulation) issued by the Commissioner of 
Financial Institutions of Puerto Rico (hereinafter ``Puerto Rican 
Regulation No. 3582'').
    (iii) Single-purpose entity. A single-purpose entity is an entity 
that meets all of the following conditions:
    (A) The entity is organized under the laws of the Commonwealth of 
Puerto Rico and is a corporation, a partnership or a trust, which 
conducts substantially all of its activities in Puerto Rico.
    (B) The sole purpose of the entity is to use qualified funds from 
possessions corporations to make one or more qualified investments in a 
qualified Caribbean Basin country and the entity actually uses such 
funds only for such purpose.
    (C) In the case of an entity that is a trust, one of the trustees is 
a qualified financial institution described in paragraph (c)(3)(i) of 
this section.
    (D) The entity is licensed as an eligible institution under Puerto 
Rican Regulation No. 3582 (or any successor regulation).
    (E) Any temporary investment by the entity for its own account of 
funds received from a possessions corporation, and the income from the 
investment thereof, and any temporary investment by the entity for its 
own account of principal and interest paid by a borrower to the entity, 
and the income

[[Page 202]]

from the investment thereof, are limited to investments in eligible 
activities, as described in section 6.2.4 of Puerto Rican Regulation No. 
3582, as in effect on September 22, 1989.
    (4) Investments in active business assets--(i) In general. For 
purposes of section 936(d)(4)(A)(i)(I) and this section and subject to 
the provisions of paragraph (c)(8) of this section, a loan qualifies as 
an investment in active business assets if--
    (A) The amounts disbursed to a qualified recipient under the loan or 
bond issue are promptly applied (as defined in paragraphs (c)(6) and (7) 
of this section) by (or on behalf of) the qualified recipient solely for 
capital expenditures for the construction, rehabilitation (including 
demolition associated therewith), improvement, or upgrading of qualified 
assets described in paragraphs (c)(4)(ii)(A), (B), (E), and (F) of this 
section, for the acquisition of qualified assets described in paragraphs 
(c)(4)(ii)(B), (C), (E), and (F) of this section, for the expenditures 
described in paragraphs (c)(4)(ii)(D), (E), and (F) of this section, 
and, if applicable, for the financing of incidental expenditures 
described in paragraph (c)(4)(iii) of this section;
    (B) The qualified recipient owns the assets for United States income 
tax purposes and uses them in a qualified business activity (as defined 
in paragraph (c)(4)(iv)); and
    (C) The requirements of paragraph (c)(6) of this section (regarding 
temporary investments and time periods within which the funds must be 
invested) and of paragraph (c)(7) of this section (regarding the 
refinancing of existing funding and the time periods within which 
funding for investments must be secured) are satisfied.
    (ii) Definition of qualified assets. For purposes of this paragraph 
(c), qualified assets mean--
    (A) Real property;
    (B) Tangible personal property (such as furniture, machinery, or 
equipment) that is not property described in section 1221(1) and that is 
either new property or property which at no time during the period 
specified in paragraph (c)(4)(v) of this section was used in a business 
activity in the qualified Caribbean Basin country in which the property 
is to be used;
    (C) Rights to intangible property that is a patent, invention, 
formula, process, design, pattern, know-how, or similar item, or rights 
under a franchise agreement, provided that such rights--
    (1) Were not at any time during the period specified in paragraph 
(c)(4)(v) of this section used in a business activity in the qualified 
Caribbean Basin country in which the rights are to be used,
    (2) Are not rights the use of which gives rise, or would give rise 
if used, to United States source income, and
    (3) Are not rights acquired by the qualified recipient from a person 
related (within the meaning of section 267(b), using ``10 percent'' 
instead of ``50 percent'' in the places where it appears) to the 
qualified recipient;
    (D) Exploration and development expenditures incurred by a qualified 
recipient for the purpose of ascertaining the existence, location, 
extent or quality of any deposit of ore, oil, gas, or other mineral in a 
qualified Caribbean Basin country, as well as for purposes of developing 
such deposit (within the meaning of section 616 of the Code and the 
regulations thereunder);
    (E) Living plants and animals (other than crops, plants, and animals 
that are acquired primarily to hold as inventory by the qualified 
recipient for resale in the ordinary course of trade or business) 
acquired in connection with a farming business (as defined in Sec. 
1.263-1T(c)(4)(i)), expenditures of a preparatory nature to prepare the 
land or area for farming (such as planting trees, drilling wells, 
clearing brush, leveling land, laying pipes, building roads, 
constructing tanks and reservoirs), expenditures for soil and water 
conservation of a type described in section 175(c)(1), and expenditures 
of a development nature incurred in connection with, and during, the 
preproductive period of property produced in a farming business (as 
defined in Sec. 1.263-1T(c)(4)(ii));
    (F) Other assets or expenditures that are not described in 
paragraphs (c)(4)(ii)(A) through (E) of this section and that the 
Commissioner may, by Revenue Procedure or other guidance

[[Page 203]]

published in the Internal Revenue Bulletin or by ruling issued to a 
qualified financial institution or qualified recipient upon its request, 
determine to be qualified assets.
    (iii) Incidental expenditures. An amount in addition to the loan 
proceeds borrowed to make an investment in active business assets shall 
be considered an investment in active business assets if such amount is 
applied to finance expenditures that are incidental to making the 
investment in active business assets, provided such amount is disbursed 
at or about the same time the proceeds for making the investment in 
active business assets are disbursed. For purposes of this section, 
expenditures incidental to an investment in active business assets 
include only the following items:
    (A) A reasonable amount of costs (other than the cost of credit 
enhancement or bond insurance premiums) associated with arranging the 
financing of an investment in active business assets, not to exceed 3.5 
percent of the proceeds of the loan or bond issue.
    (B) A reasonable amount of installation costs and other reasonable 
costs associated with placing an active business asset in service in the 
qualified business activity.
    (C) An amount not in excess of 10 percent of the total amount of 
investment in qualified assets to finance the acquisition of inventory, 
and other working capital requirements, but if an investment is in 
connection with a manufacturing or farming business, the percentage 
limitation shall be 50 percent rather than 10 percent provided the 
excess over the 10 percent limitation is used to finance inventory 
property. For purposes of this paragraph (c), whether a business is a 
manufacturing business shall be determined under principles similar to 
those described in section 954(d)(1)(A) and the regulations thereunder; 
whether a business is a farming business shall be determined under Sec. 
1.263-1T(c)(4)(i).
    (D) An amount not in excess of 5 percent of the sum of the 
investment in active business assets and the costs described in 
paragraphs (c)(4)(iii)(A), (B), and (C) of this section for the 
refinancing of an existing debt of the qualified recipient if such 
refinancing is incidental to an investment in active business assets. 
For this purpose, the replacement of an existing loan arrangement shall 
not be considered the refinancing of an existing indebtedness to the 
extent that the funds under such loan arrangement have not yet been 
disbursed to the qualified recipient.
    (iv) Qualified business activity. A qualified business activity is a 
lawful industrial or commercial activity that is conducted as an active 
trade or business (under principles similar to those described in Sec. 
1.367(a)-2T(b) (2) and (3)) in a qualified Caribbean Basin country. A 
trade or business for purposes of this paragraph (c)(4)(iv) is any 
business activity meeting the principles of section 367 of the Code and 
described in Divisions A through I (excluding group 43 in Division E 
(relating to the United States Postal Service) and groups 84 (relating 
to museums, art galleries, and botanical and zoological gardens), 86 
(relating to membership organizations), and 88 (relating to private 
households in Division I) of the 1987 Standard Industrial Classification 
Manual issued by the Executive Office of the President, Office of 
Management and Budget, or in the comparable provisions of any successor 
Standard Industrial Classification Manual that is adopted by the 
Commissioner of Internal Revenue in a notice, regulation, or other 
document published in the Internal Revenue Cumulative Bulletin.
    (v) Period of use. The period referred to in paragraphs 
(c)(4)(ii)(B) and (C) of this section shall be a five year period 
preceding the date of acquisition with the loan proceeds, if the date of 
acquisition is on or before May 13, 1991. If the date of acquisition is 
after May 13, 1991, then the period specified in this paragraph 
(c)(4)(v) shall be three years preceding the date of acquisition with 
the loan proceeds.
    (5) Investments in development projects--(i) In general. Subject to 
the provisions of paragraph (c)(8) of this section, this paragraph 
(c)(5)(i) describes the requirements in order for a loan by a qualified 
financial institution to qualify as an investment in a development 
project for purposes of section 936(d)(4)(A)(i)(II) and for this 
section.

[[Page 204]]

    (A) The amounts disbursed under the loan or bond issue must be 
promptly applied (as defined in paragraphs (c)(6) and (7) of this 
section) by (or on behalf of) the qualified recipient solely for one or 
more investments described in paragraph (c)(4)(i)(A) of this section and 
in any land, buildings, or other property functionally related and 
subordinate to a facility described in paragraph (c)(5)(ii) of this 
section (determined under principles similar to those described in Sec. 
1.103-8(a)(3)), for use (under principles similar to those described in 
Sec. 1.367(a)-2T(b)(5)) in connection with one or more activities 
described in paragraph (c)(5)(i)(B) of this section.
    (B) The activities referred to in paragraph (c)(5)(i)(A) of this 
section are--
    (1) A development project described in paragraph (c)(5)(ii) of this 
section in a qualified Caribbean Basin country; or
    (2) The performance in a qualified Caribbean Basin country of a non-
commercial governmental function described in paragraph (c)(5)(iv) of 
this section;
    (C) The qualified recipient must own the assets for United States 
income tax purposes;
    (D) The requirements of paragraph (c)(6) of this section (regarding 
temporary investments and time periods within which the funds must be 
invested) and of paragraph (c)(7) of this section (regarding the 
refinancing of existing funding and time periods within which funding 
for investments must be secured) must be satisfied.
    (ii) Development project. For purposes of this paragraph (c), a 
development project is one or more facilities in a qualified Caribbean 
Basin country that support economic development in that country and that 
satisfy the public use requirement of paragraph (c)(5)(iii) of this 
section. Examples of facilities that may meet the public use requirement 
include, but are not limited to--
    (A) Transportation systems and equipment, including sea, surface, 
and air, such as roads, railways, air terminals, runways, harbor 
facilities, and ships and aircraft;
    (B) Communications facilities;
    (C) Training and education facilities related to qualified business 
activities;
    (D) Industrial parks, including necessary support facilities such as 
roads; transmission lines for water, gas, electricity, and sewage; 
docks; plant sites preparations; power generation; sewage disposal; and 
water treatment;
    (E) Sports facilities;
    (F) Convention or trade show facilities;
    (G) Sewage, solid waste, water, and electric facilities;
    (H) Housing projects pursuant to a government program designed to 
provide affordable housing to low or moderate income families, based 
upon local standards; and
    (I) Hydroelectric generating facilities.
    (iii) Public use requirement. To satisfy the public use requirement 
in paragraph (c)(5)(ii) of this section, a facility must serve or be 
available on a regular basis for general public use, as contrasted with 
similar types of facilities which are constructed for the exclusive use 
of a limited number of persons as determined under principles similar to 
those described in Sec. 1.103-8(a)(2).
    (iv) Non-commercial governmental functions. For purposes of 
paragraph (c)(5)(i)(B) of this section, the term ``non-commercial 
governmental functions'' refers to activities that, under U.S. 
standards, are not customarily attributable to or carried on by private 
enterprises for profit and are performed for the general public with 
respect to the common welfare or which relate to the administration of 
some phase of government. For example, the operation of libraries, toll 
bridges, or local transportation services, and activities substantially 
equivalent to those carried out by the Federal Aviation Authority, 
Interstate Commerce Commission, or United States Postal Service, are 
considered non-commercial governmental functions. For purposes of this 
section, non-commercial government functions shall not include military 
activities.
    (v) [Reserved]
    (6) Prompt application of borrowed proceeds. This paragraph (c)(6) 
provides rules for determining whether amounts disbursed to a qualified 
recipient by a qualified financial institution (or a financial 
intermediary) shall be considered to have been promptly applied for

[[Page 205]]

the purpose of paragraphs (c)(4)(i)(A) and (c)(5)(i)(A) of this section.
    (i) In general. Except as otherwise provided in paragraphs 
(c)(6)(ii) and (c)(7)(iii)(B) of this section, amounts disbursed to a 
qualified recipient by a qualified financial institution (or a financial 
intermediary) shall be considered to have been promptly applied for the 
purpose of paragraphs (c)(4)(i)(A) and (c)(5)(i)(A) of this section if 
the amounts are fully expended for any of the purposes described in 
paragraphs (c)(4)(i)(A) or (c)(5)(i)(A) of this section no later than 
six months from the date of such disbursement and any temporary 
investment of such funds by the qualified recipient during such period 
complies with the rules of paragraph (c)(6)(iii)(A) of this section. 
Where the amounts disbursed are bond proceeds described in paragraph 
(c)(6)(iv)(A) of this section, the six-month period shall begin on the 
date of issuance of the bonds. In the event the qualified financial 
institution (or financial intermediary) invests any part of the bond 
proceeds before disbursement of those proceeds to the qualified 
recipient, all earnings from any such investment shall be paid to the 
qualified recipient or applied for its benefit.
    (ii) Special rules for long term projects financed out of bond 
proceeds. In the case of a long term project described in paragraph 
(c)(6)(iv)(B) of this section that is financed out of bond proceeds, the 
six-month period described in paragraph (c)(6)(i) of this section shall 
be extended with respect to the amount of bond proceeds used to fund the 
project for such reasonable period of time as shall be necessary until 
completion of the project or until beginning of production (in the case 
of a farming business), but, in any event, not to exceed three years 
from the date of issuance of the bonds, and only if--
    (A) The project that is financed out of bond proceeds was identified 
as of the date of issue;
    (B) A construction and expenditure plan certified by an independent 
expert (such as an engineer, an architect, or a farming expert) is filed 
with, and approved by, the Commissioner of Financial Institutions of 
Puerto Rico (or his delegate) prior to the date of issue, which makes a 
reasonable estimate, as of the date of filing of the plan, of the 
amounts and uses of the bond proceeds and the time of completion or 
production, and includes a schedule of progress payments until such 
time;
    (C) The terms of the construction and expenditure plan are disclosed 
in the public offering memorandum, private placement memorandum, or 
similar document prepared for information or disclosure purposes in 
relation to the issuance of bonds; and
    (D) Any temporary investment of the bond proceeds complies with the 
rules of paragraph (c)(6)(iii)(A) and (B) of this section.
    (iii) Temporary investments--(A) During six-month period. During the 
six-month period described in paragraph (c)(6)(i) of this section, 
during the first six months of the period described in paragraph 
(c)(6)(ii) of this section, and during the 30-day period described in 
paragraph (c)(7)(iii)(A) of this section, loan proceeds disbursed to a 
qualified recipient, bond proceeds, and income from the investment 
thereof, may be held in unrestricted yield investments, provided such 
yield reflects normal market yield for such type of investments and 
provided the income from such investments, if any, is or would be 
sourced either in Puerto Rico or in a country in which the investment in 
active business assets or development project is to be made.
    (B) During other periods. During any other period, any temporary 
investment of bond proceeds, and of income from such investments, shall 
be limited to investments in eligible activities. For purposes of this 
paragraph (c)(6)(iii)(B), the term ``eligible activities'' shall mean 
those investments described in section 6.2.4 of Puerto Rican Regulation 
No. 3582, as in effect on September 22, 1989.
    (iv) Definitions--(A) Bond proceeds. For purposes of this paragraph 
(c), bond proceeds shall mean the proceeds from the issuance of 
obligations by way of a public offering or a private placement by a 
qualified financial institution for investment in active business assets 
or a development project that has been identified at the time of issue 
and is described in a public offering memorandum, private placement 
memorandum, or similar document

[[Page 206]]

prepared for information or disclosure purposes in relation to the 
issuance of the bonds.
    (B) Long term project. For purposes of this section, the term long 
term project means--
    (1) A project, whether or not under a contract, for the 
construction, rehabilitation, improvement, upgrading, or production of 
qualified assets, or for expenditures, described in paragraph (c)(4)(ii) 
of this section (other than paragraph (c)(4)(ii)(C) of this section), 
which is reasonably expected to require more than 12 months to complete; 
or
    (2) The production of property in a farming business referred to in 
paragraph (c)(4)(ii)(E) of this section, which is reasonably expected to 
require a preproductive period in excess of 12 months.
    (7) Financing of previously incurred costs. Loan or bond proceeds 
which are disbursed after a qualified recipient has paid or incurred 
part or all of the costs of acquiring active business assets or 
investing in a development project shall be considered to have been 
applied for such purposes only as provided in this paragraph (c)(7).
    (i) Replacement of temporary non-section 936 financing of a 
qualified investment. This paragraph (c)(7)(i) prescribes the maximum 
time limits within which temporary non-section 936 financing of 
qualified investments may be replaced with section 936 funds without 
being considered a prohibited refinancing transaction. This paragraph 
(c)(7)(i) applies to the refinancing of costs incurred with respect to 
investments that, at the time the costs were first incurred, were either 
qualified investments in a qualified Caribbean Basin country or were 
investments by a qualified recipient in active business assets or a 
development project in a qualified Caribbean Basin country. This 
paragraph (c)(7)(i) applies also to the refinancing of costs incurred 
with respect to any other investment. However, in the latter case, the 
amount of costs that may be refinanced with section 936 funds is limited 
to the amount of costs that are incurred with respect to the investment 
after the investment becomes a qualified investment in a qualified 
Caribbean Basin country. For purposes of this paragraph (c)(7)(i), the 
time when costs are incurred shall be determined under principles 
similar to those applicable under section 461(h) dealing with the 
economic performance test for the accrual of deductible liabilities. 
This paragraph (c)(7)(i) applies only to the situations described in 
this paragraph (c)(7)(i).
    (A) In the case of an investment in active business assets or a 
development project, a loan shall be a qualified investment for purposes 
of this paragraph (c) if the loan proceeds are disbursed, or the 
obligations are issued, no later than six months after the date on which 
the qualified recipient takes possession of the asset or the facility 
or, if earlier, places the asset or the facility in service. However, in 
the case of a small project described in paragraph (c)(8)(v) of this 
section, the six-month period shall be one year.
    (B) In the case of an investment in active business assets or a 
development project that is part of a long term project described in 
paragraph (c)(6)(iv)(B) of this section, a loan shall also be a 
qualified investment for purposes of this paragraph (c) if the loan 
proceeds are disbursed, or the obligations are issued, no later than six 
months after completion of the project or, in the case of a farming 
business, after the beginning of production, and in any event, no later 
than three years after the date on which the first payment is made 
toward the eligible costs of the project. The amount of the qualified 
investment may not exceed the sum of--
    (1) The eligible costs relating to investments described in 
paragraph (c)(4)(i)(A) in the case of an investment in active business 
assets, or the eligible costs relating to investments described in 
paragraph (c)(5)(i) of this section in the case of a development 
project, but only to the extent of the costs that are incurred after the 
date described in paragraph (c)(7)(i)(D) of this section, and
    (2) The portion of unpaid interest that would be required to be 
capitalized under U.S. tax rules and that accrued on prior temporary 
non-section 936 financing from the date described in paragraph 
(c)(7)(i)(D) of this section through the date the section 936 loan

[[Page 207]]

proceeds are disbursed or the section 936 obligations are issued.
    (C) In order to qualify for the special rules of this paragraph 
(c)(7)(i), a plan must be filed with the Commissioner of Financial 
Institutions of Puerto Rico (or his delegate) stating the qualified 
recipient's intention to refinance the costs of the long term project 
with section funds.
    (D) The date referred to in paragraph (c)(7)(i)(B) (1) and (2) of 
this section is a date that is the later of--
    (1) The date the plan described in paragraph (c)(7)(i)(C) is filed, 
or
    (2) The date the investment becomes a qualified investment by a 
qualified recipient in active business assets or a development project 
in a qualified Caribbean Basin country.
    (ii) Refinancing of section 936 financing. A section 936 loan or 
bond issue used to finance a qualified investment described in paragraph 
(c)(1) of this section may be refinanced with section 936 funds through 
a new loan or bond issue to the extent of the remaining principal 
balance on such existing qualified financing, increased by the amount of 
unpaid interest accrued through the date the new loan proceeds are 
disbursed or the new obligations are issued and that would be required 
to be capitalized under U.S. tax rules.
    (iii) Prompt application of borrowed proceeds--(A) In general. In 
the case of a loan or bond issue described in paragraph (c)(7)(i) or 
(ii) of this section, the rules of paragraph (c)(6) of this section 
shall apply but the six-month period described in paragraph (c)(6)(i) of 
this section shall be limited to 30 days from the date of disbursement 
of loan proceeds to the qualified recipient or from the date of issuance 
in the case of a bond issue.
    (B) Special rules for long term projects financed out of bond 
proceeds. In the case of a long term project described in paragraph 
(c)(6)(iv)(B) of this section that is financed out of bond proceeds, the 
30-day period described in paragraph (c)(7)(iii)(A) of this section 
shall be extended with respect to the amount of bond proceeds used for 
the permanent financing of the long term project for such reasonable 
period of time as shall be necessary until completion of the project or 
beginning of production (in the case of a farming business), but, in any 
event, not to exceed three years from the date of issuance of the bonds. 
For purposes of this paragraph (c)(7)(iii)(B), the period of time shall 
be considered reasonable only if--
    (1) A construction and expenditure plan certified by an independent 
expert (such as an engineer, an architect, or a farming expert) is filed 
with, and approved by, the Commissioner of Financial Institutions of 
Puerto Rico (or his delegate) prior to the date of issue, which makes a 
reasonable estimate, as of the date of issue, of the amounts and uses of 
the bond proceeds and the time of completion or production, and includes 
a schedule of progress payments until such time; and
    (2) The terms of the construction and expenditure plan are disclosed 
in the public offering memorandum, private placement memorandum, or 
similar document prepared for information or disclosure purposes in 
relation to the bond issue.
    (8) Miscellaneous operating rules--(i) Sale and leaseback. An asset 
that is acquired and leased back to the person from whom acquired does 
not constitute an investment in an active business asset or an 
investment in a development project.
    (ii) Use of asset in qualified business activity. For purposes of 
paragraph (c)(4)(i)(B), an asset shall be considered used or held for 
use in a qualified business activity if it is used or held for use in 
such activity under principles similar to those described in Sec. 
1.367(a)-2T(b)(5), or a successor provision.
    (iii) Definition of capital expenditures. For purposes of this 
paragraph (c), capital expenditures mean those expenditures described in 
section 263(a) of the Code (without regard to paragraphs (A) through (G) 
of section 263(a)(1)), and those costs required to be capitalized under 
section 263A with respect to property described in section 263A(b)(1), 
relating to self-constructed assets.
    (iv) Loans through certain financial intermediaries. A loan by a 
qualified financial institution shall not be disqualified from being an 
investment in

[[Page 208]]

active business assets or in a development project merely because the 
proceeds are first lent to a financial intermediary (as defined in 
paragraph (c)(8)(iv)(H) of this section) which, in turn, on-lends the 
proceeds directly to a qualified recipient, provided the requirements of 
this paragraph (c)(8)(iv) are satisfied.
    (A) The loan to the qualified recipient must satisfy the 
requirements of paragraph (c)(4)(i) of this section in the case of an 
investment in active business assets, or of paragraph (c)(5)(i) of this 
section in the case of an investment in a development project.
    (B) The qualified recipient and the active business assets or 
development project in which the proceeds are to be invested must be 
identified prior to disbursement of any part of the proceeds by the 
qualified financial institution to the financial intermediary.
    (C) The effective interest rate charged by the qualified financial 
institution to the financial intermediary must not exceed the average 
interest rate paid by the qualified financial institution with respect 
to its eligible funds, increased by such number of basis points as is 
required to provide reasonable compensation to the qualified financial 
institution for services performed and risks assumed with respect to the 
loan to the financial intermediary that are not ordinarily required to 
be performed or assumed with respect to a deposit, loan, repurchase 
agreement or other transfer of eligible funds with another qualified 
financial institution. The average interest rate shall be the average 
rate, determined on a daily basis, paid by the qualified financial 
institution on its eligible funds over the most recent quarter preceding 
the date on which the rate on the loan to the financial intermediary is 
committed.
    (D) The effective interest rate charged by the financial 
intermediary to the qualified recipient must not exceed the effective 
interest rate charged to the financial intermediary by the qualified 
financial institution, increased by such number of basis points as is 
required to provide reasonable compensation to the financial 
intermediary for services performed and risks assumed with respect to 
the loan to the qualified recipient.
    (E) The financial intermediary must borrow from the qualified 
financial institution under substantially the same terms as it lends to 
the qualified recipient. In particular, both loans must have 
disbursement terms, repayment schedules and maturity dates for interest 
and principal amounts such that the financial intermediary does not 
retain for more than 48 hours any of the funds disbursed by the 
qualified financial institution nor any of the funds paid by the 
qualified recipient in repayment of principal or interest on the loan.
    (F) The financial institution and the financial intermediary must 
agree to comply with the due diligence requirements described in 
paragraphs (c)(11), (12), and (13) of this section;
    (G) The time periods and temporary investments rules in paragraphs 
(c)(6) and (7) of this section must be complied with; and
    (H) For purposes of this paragraph (c), the financial intermediary 
must be--
    (1) An active trade or business which a person maintains in a 
qualified Caribbean Basin country and which consists of a banking, 
financing or similar business as defined in Sec. 1.864-4(c)(5)(i) 
(other than a central bank of issue); or
    (2) A public international organization, the principal purpose of 
which is to foster economic development in developing countries and 
which is described in section 1 of the International Organizations 
Immunities Act (22 U.S.C. 288).


For purposes of paragraphs (c)(8)(iv)(C) and (D) of this section, the 
determination of whether compensation is reasonable shall be made in 
relation to normal commercial practices for comparable transactions 
carrying a similar degree of commercial, currency and political risk. 
Reasonable credit enhancement fees and other reasonable fees and amounts 
charged to the financial intermediary or the qualified recipient with 
respect to the loan transaction in addition to interest shall be added 
to the interest cost in determining the effective interest rate.
    (v) Small project. For purposes of this paragraph (c), a small 
project shall be

[[Page 209]]

a project (including the acquisition of an asset) for which the total 
amount of section 936 funds used for its financing does not exceed 
$1,000,000 in the aggregate, or such other amount as the Commissioner 
may publish, from time to time, in the Internal Revenue Bulletin.
    (9) Qualified recipient. For purposes of this section, a qualified 
recipient is any person described in paragraph (c)(9)(i) or (ii) of this 
section. The term ``person'' means a person described in section 
7701(a)(1) or a government (within the meaning of Sec. 1.892-2T(a)(1)) 
of a qualified Caribbean Basin country.
    (i) In the case of an investment described in paragraph (c)(4) of 
this section (relating to investments in active business assets), a 
qualified recipient is a person that carries on a qualified business 
activity in a qualified Caribbean Basin country, and complies with the 
agreement and certification requirements described in paragraph 
(c)(11)(i) of this section at all times during the period in which the 
investment remains outstanding.
    (ii) In the case of an investment described in pargraph (c)(5) of 
this section (relating to investments in development projects), a 
qualified recipient is the borrower (including a person empowered by the 
borrower to authorize expenditures for the investment in the development 
project) that has authority to comply, and complies, with the agreement 
and certification requirements described in paragraph (c)(11)(i) of this 
section at all times during the period in which the investment remains 
outstanding.
    (10) Investments in a qualified Caribbean Basin country--(i) Rules 
for determining the place of an investment. The rules of this paragraph 
(c)(10)(i) shall apply to determine the extent to which an investment in 
an active business asset or a development project will be considered 
made in qualified Caribbean Basin Country.
    (A) An investment in real property is considered made in the 
qualified Caribbean Basin country in which the real property is located.
    (B) Except as otherwise provided in this paragraph (c)(10)(i)(B), an 
investment in tangible personal property is considered made in a 
qualified Caribbean Basin Country so long as the tangible personal 
property is predominantly used in that country. Whether property is used 
predominantly in a qualified Caribbean Basin country shall be determined 
under principles similar to those described in Sec. 1.48-1(g)(1), 
(g)(2)(ii), (g)(2)(iv), (g)(2)(vi), (g)(2)(viii), and (g)(2)(x) 
(relating to investment tax credits for property used outside the United 
States) as in effect on December 31, 1985. A vessel, container, or 
aircraft shall be considered for use predominantly in a qualified 
Caribbean Basin country in any year if it is used for transport to and 
from such country with some degree of frequency during that year and at 
least 30 percent of the income from the use of such vessel, container or 
aircraft for that year is sourced in such country under principles 
similar to those described in section 863(c)(1) and (2) (relating to 
source rules for certain transportation income). Cables and pipelines 
which are premanently installed as part of a communication or 
transportation system between a qualified Caribbean Basin country and 
another country or among several countries which include a qualified 
Caribbean Basin country shall be considered used in a qualified 
Caribbean Basin country to the extent of 50 percent of the portion of 
the facility that directly links the qualified country to another 
country or to a hub, unless it is established by notice or other 
guidance published in the Internal Revenue Bulletin or by ruling issued 
to a qualified institution or qualified recipient upon request that it 
is appropriate to attribute a greater portion of the cost of the 
facility to the qualified Caribbean Basin country.
    (C) An investment in rights to intangible property is considered 
made in a qualified Caribbean Basin country to the extent such rights 
are used in that country. Where rights to intangible property are used 
shall be determined under principles similar to those described in Sec. 
1.954-2T(b)(3)(vii) or a successor provision.
    (ii) Qualified Caribbean Basin country. For purposes of this 
section, the term ``qualified Caribbean Basin country'' means any 
beneficiary country (within the meaning of section 212(a)(1)(A) of the 
Caribbean Basin Economic Recovery Act, Public Law 98-67 (Aug. 5, 1983),

[[Page 210]]

97 Stat. 384, 19 U.S.C. 2702(a)(1)(A)), which meets the requirements of 
section 274(h)(6)(A)(i) and (ii) and the U.S. Virgin Islands, and 
includes the territorial waters and continental shelf thereof.
    (11) Agreements and certifications by qualified recipients and 
financial intermediaries--(i) In general. In order for an investment to 
be considered a qualified investment under section 936(d)(4) and 
paragraph (c)(1) of this section, a qualified recipient must certify to 
the qualified financial institution (or to the financial intermediary, 
if the loan is made through a financial intermediary) on the date of 
closing of the loan agreement and on each anniversary date thereof, that 
it is a qualified recipient described in paragraph (c)(9) of this 
section. In addition, the qualified recipient must agree in the loan 
agreement with the qualified financial institution (or with the 
financial intermediary, if the loan is made through a financial 
intermediary)--
    (A) To use the funds at all times during the period the loan is 
outstanding solely for the purposes and in the manner described in 
paragraph (c)(4) of this section (regarding investment in active 
business assets) or in paragraph (c)(5) of this section (regarding 
investment in development projects);
    (B) To comply with the requirements of paragraph (c)(6) of this 
section (regarding temporary investments and time periods within which 
the funds must be invested) and paragraph (c)(7) of this section 
(regarding the refinancing of existing funding and the time periods 
within which funding for investments must be secured);
    (C) To notify the Assistant Commissioner (International), the 
qualified financial institution (or the financial intermediary, if the 
loan is made through a financial intermediary), and the Commissioner of 
Financial Institutions of Puerto Rico (or his delegate) pursuant to 
paragraph (c)(14) of this section if it no longer is a qualified 
recipient or if, for any other reason, the investment has ceased to 
qualify as a qualified investment described in paragraph (c)(1) of this 
section, promptly upon the occurrence of such disqualifying event; and
    (D) To permit examination by the office of the Assistant 
Commissioner (International) (or by the office of any District Director 
authorized by the Assistant Commissioner (International)) and the 
Commissioner of Financial Institutions of Puerto Rico (or his delegate) 
of all necessary books and records that are sufficient to verify that 
the funds were used for investments in active business assets or 
development projects in conformity with the terms of the loan agreement.
    (ii) Certification by a financial intermediary. In the case of a 
loan by a qualified financial institution to a financial intermediary, 
the financial intermediary must certify to the qualified financial 
institution (using the procedures described in paragraph (c)(11)(i) of 
this section) that it is a financial intermediary described in paragraph 
(c)(8)(iv)(H) of this section, and must furnish to the qualified 
financial institution a copy of the qualified recipient's certification 
described in paragraph (c)(11)(i) of this section and of its loan 
agreement with the qualified recipient. In addition, the financial 
intermediary must agree in the loan agreement with the qualified 
financial institution:
    (A) To comply with the requirements of paragraph (c)(8)(iv) of this 
section; and
    (B) To permit examination by the office of the Assistant 
Commissioner (International) (or by the office of any District Director 
authorized by the Assistant Commissioner (International)) and the 
Commissioner of Financial Institutions of Puerto Rico (or his delegate) 
of all its necessary books and records that are sufficient to verify 
that the funds were used in conformity with the terms of the loan 
agreements.
    (12) Certification requirements. In order for an investment to be 
considered a qualified investment under section 936(d)(4), section 
936(d)(4)(C)(i) requires that both the person in whose trade or business 
such investment is made and the financial institution certify to the 
Secretary of the Treasury and the Commissioner of Financial Institutions 
of Puerto Rico that the proceeds of the loan will be promptly used to 
acquire active business assets or to make other

[[Page 211]]

authorized expenditures. This certification requirement is satisfied as 
to the qualified financial institution, the financial intermediary (if 
any), and the qualified recipient if the qualified financial institution 
submits a certificate to both the Assistant Commissioner (International) 
and to the Commissioner of Financial Institutions of Puerto Rico (or his 
delegate) pursuant to paragraph (c)(14) of this section upon 
authorization of the investment by the Commissioner of Financial 
Institutions and, in any event, prior to the first disbursement of the 
loan proceeds to the qualified recipient or to the financial 
intermediary (if any), in which the qualified financial institution--
    (i) Represents that, as of the date of the certification, the 
qualified recipient and the financial intermediary (if any) have 
complied with the requirements described in paragraph (c)(11) of this 
section;
    (ii) Describes the important terms of the loan to the financial 
intermediary (if any) and to the qualified recipient, including the 
amount of the loan, the nature of the investment, the basis for its 
qualification as an investment in active business assets or a 
development project under this section, the identity of the financial 
intermediary (if any) and of the qualified recipient, the qualified 
Caribbean Basin country involved, and the nature of the collateral or 
other security used, including any guarantee;
    (iii) Agrees to permit examination by the Assistant Commissioner 
(International) (or by the office of any District Director authorized by 
the Assistant Commissioner (International)) and the Commissioner of 
Financial Institutions of Puerto Rico (or his delegate) of all its 
necessary books and records that are sufficient to verify that the funds 
were used for investments in active business assets or development 
projects in conformity with the terms of the loan agreement or 
agreements with the financial intermediary (if any) and with the 
qualified recipient; and
    (iv) In the case of a single-purpose entity that is a qualified 
financial institution, discloses the name and address of the entity's 
trustee or agent, if any, that assists the qualified financial 
institution in the performance of its due diligence requirement under 
paragraph (c) of this section, and represents that the trustee or agent 
has agreed with the qualified financial institution to permit 
examination by the Assistant Commissioner (International) (or by the 
office of any District Director authorized by the Assistant Commissioner 
(International)) and the Commissioner of Financial Institutions of 
Puerto Rico (or his delegate) of all necessary books and records of such 
trustee or agent that are sufficient to verify that the funds were used 
for investments in active business assets or development projects in 
conformity with the terms of the loan agreement or agreements with the 
financial intermediary (if any) and with the qualified recipient.
    (13) Continuing due diligence requirements. In order to maintain the 
qualification for an investment under paragraph (c)(1) of this section, 
the continuing due diligence requirements described in this paragraph 
(c)(13) must be satisfied.
    (i) Requirements of qualified recipient. A qualified recipient 
must--
    (A) Submit annually to the qualified financial institution or to the 
financial intermediary from which its qualified funds were obtained a 
copy of its most recent annual financial statement accompanied by an 
opinion of an independent accountant familiar with the financials of the 
qualified recipient disclosing the amount of the loan, the current 
outstanding balance of the loan, describing the assets financed with 
such loan and the qualified business activity in which such assets are 
used or the development project for which the loan is used, and stating 
that there are no reasons to doubt that the loan proceeds have been 
properly used and continue to be properly used, and
    (B) Act in a manner consistent with its representations and 
agreements described in paragraph (c)(11) of this section.
    (ii) Requirements of qualified financial institutions. Except as 
otherwise provided in paragraph (c)(13)(iii) of this section, a 
qualified financial institution described in paragraph (c)(3) of this 
section must maintain in its

[[Page 212]]

records and have available for inspection the documentation described in 
paragraph (c)(13)(ii)(A) or (B) of this section. In addition, the 
qualified financial institution is required to notify the Assistant 
Commissioner (International) and the Commissioner of Financial 
Institutions of Puerto Rico (or his delegate) pursuant to paragraph 
(c)(14) of this section upon becoming aware that a loan has ceased to be 
an investment in active business assets or a development project under 
this section. For purposes of this paragraph (c)(13)(ii), multiple loans 
for investment in a single qualified business activity or development 
project will be aggregated in determining what due diligence 
requirements apply.
    (A) In the case of a small project described in paragraph (c)(8)(v) 
of this section, the following documents must be maintained and 
available for inspection:
    (1) The loan application or other similar document;
    (2) The financial statements of the qualified recipient filed as 
part of the loan application;
    (3) The statement required by section 6.4.3(a)(iii) of Puerto Rican 
Regulation No. 3582 or any successor thereof, signed by the qualified 
recipient (or its duly authorized representative), acknowledging the 
receipt of the loan proceeds, describing the assets financed with such 
loan and the business activity in which such assets are to be used or 
the development project for which the funds will be utilized, the 
collateral to be provided for the transaction including any guarantee, 
and the basis for its qualification as a qualified recipient;
    (4) The loan documents; and
    (5) In the case of a qualified financial institution that is a 
single-purpose entity, a copy of the agreement with the entity's trustee 
or agent, if any, described in paragraph (c)(12)(iv) of this section.
    (B) In the case of a disbursement concerning a project that is not a 
small project described in paragraph (c)(8)(v) of this section, the 
following documents must be maintained and available for inspection, in 
addition to the documents required by paragraph (c)(13)(ii)(A) of this 
section:
    (1) A memorandum of credit prepared by an officer of the qualified 
financial institution (or, in the case of a single purpose entity, an 
agent of the entity or a trustee for the entity, if any) and signed by 
the officer of the qualified financial institution, containing the 
details of the investigation and review that the qualified financial 
institution, or its trustee or agent, if any, conducted in order to 
evaluate whether the investment is qualified under paragraph (c)(1) of 
this section and the opinion of the officer of the qualified financial 
institution, or the opinion of an officer of the agent of, or of the 
trustee for, the qualified financial institution, if any, that there is 
no reasonable ground for belief that the qualified funds will be 
diverted to a use that is not permitted under the provisions of this 
section; in making this investigation and review, factors that must be 
utilized are ones similar to those listed in Puerto Rico Regulation No. 
3582, section 6.4.2;
    (2) The annual financial statement of the qualified recipient; and
    (3) The written report of an officer of the qualified financial 
institution, or of an officer of an agent of, or of the trustee for, the 
qualified financial institution, if any, documenting discussions, both 
before and after the disbursement of the loan proceeds, with each 
recipient's accounting, financial and executive personnel with respect 
to the proposed and actual use of the loan proceeds and his analysis of 
the annual financial statements of the qualified recipient including an 
analysis of the statement of sources and uses of funds. After the loan 
disbursement, such discussions and review shall occur annually during 
the term of the loan. Such report shall include the conclusion that in 
such officer's opinion there is no reasonable ground for belief that the 
qualified recipient is improperly utilizing the funds.
    (iii) Requirements in the case of a financial intermediary. Where a 
qualified financial institution lends funds to a financial intermediary 
which are on-lent to a qualified recipient--
    (A) The obligation to maintain the documentation described in 
paragraph (c)(13)(ii)(A) or (B) of this section shall

[[Page 213]]

apply only to the financial intermediary and not to the qualified 
financial institution and the provisions of paragraph (c)(13)(ii)(A) or 
(B) of this section shall be read so as to impose on the financial 
intermediary any obligation imposed on the qualified financial 
institution.
    (B) The financial intermediary shall forward annually to the 
qualified financial institution a copy of the documentation it is 
required to maintain in its records pursuant to the provisions of this 
paragraph (c)(13)(iii) and shall notify the Assistant Commissioner 
(International), the Commissioner of Financial Institutions of Puerto 
Rico (or his delegate) and the qualified financial institution pursuant 
to paragraph (c)(14) of this section upon becoming aware that a loan has 
ceased to be an investment in active business assets or a development 
project under this section. The qualified financial institution must 
maintain in its records and have available for inspection the 
documentation furnished by the financial intermediary pursuant to this 
paragraph (c)(13)(iii)(B).
    (C) The qualified financial institution shall cause one of its 
officers (or one of the officers of its agent or trustee, if any) to 
prepare a written report documenting his analysis of the documentation 
furnished by the financial intermediary pursuant to paragraph 
(c)(13)(iii)(B) of this section, his discussions, both before and after 
the disbursement of the loan proceeds, with the financial intermediary's 
accounting, financial and executive personnel with respect to the 
proposed and actual use of the loan proceeds, and his analysis of the 
annual financial statements of the qualified recipient including an 
analysis of the statement of sources and uses of funds. After the loan 
disbursement, such discussions and review shall occur annually during 
the term of the loan. Such report shall include the conclusion that in 
such officer's opinion there is no reasonable ground for belief that the 
qualified recipient is improperly utilizing the funds.
    (14) Procedures for notices and certifications. Notices and 
certifications to the Assistant Commissioner (International) required 
under paragraphs (c)(11), (12) and (13) of this section shall be 
addressed to the attention of the Assistant Commissioner 
(International), Office of Taxpayer Service and Compliance, IN:C, 950 
L'Enfant Plaza South, SW., Washington, DC 20024. Notices and 
certifications to the Commissioner of Financial Institutions of Puerto 
Rico required under paragraphs (c)(11), (12), and (13) of this section 
shall be addressed as follows: Commissioner of Financial Institutions, 
GPO Box 70324, San Juan, Puerto Rico 00936.
    (15) Effective date. This paragraph (c) is effective May 13, 1991. 
It is applicable to investments by a possessions corporation in a 
financial institution that are used by a financial institution for 
investments in accordance with a specific authorization granted by the 
Commissioner of Financial Institutions of Puerto Rico (or his delegate) 
after September 22, 1989. However, the taxpayer may choose to apply 
Sec. 1.936-10T(c) for periods before June 12, 1991.

[T.D. 8350, 56 FR 21927, May 13, 1991]



Sec. 1.936-11  New lines of business prohibited.

    (a) In general. A possessions corporation that is an existing credit 
claimant, as defined in section 936(j)(9)(A) and this section, that adds 
a substantial new line of business during a taxable year, or that has a 
new line of business that becomes substantial during the taxable year, 
loses its status as an existing credit claimant for that year and all 
years subsequent.
    (b) New line of business--(1) In general. A new line of business is 
any business activity of the possessions corporation that is not closely 
related to a pre-existing business of the possessions corporation. The 
term closely related is defined in paragraph (b)(2) of this section. The 
term pre-existing business is defined in paragraph (b)(3) of this 
section.
    (2) Closely related. To determine whether a new activity is closely 
related to a pre-existing business of the possessions corporation all 
the facts and circumstances must be considered, including those set 
forth in paragraphs (b)(2)(i)(A) through (G) of this section.
    (i) Factors. The following factors will help to establish that a new 
activity is closely related to a pre-existing business activity of the 
possessions corporation--

[[Page 214]]

    (A) The new activity provides products or services very similar to 
the products or services provided by the pre-existing business;
    (B) The new activity markets products and services to the same class 
of customers;
    (C) The new activity is of a type that is normally conducted in the 
same business location;
    (D) The new activity requires the use of similar operating assets;
    (E) The new activity's economic success depends on the success of 
the pre-existing business;
    (F) The new activity is of a type that would normally be treated as 
a unit with the pre-existing business' in the business accounting 
records; and
    (G) The new activity and the pre-existing business are regulated or 
licensed by the same or similar governmental authority.
    (ii) Safe harbors. An activity is not a new line of business if--
    (A) If the activity is within the same six-digit North American 
Industry Classification System (NAICS) code (or four-digit Standard 
Industrial Classification (SIC) code). The similarity of the NAICS or 
SIC codes may not be relied upon to determine whether the activity is 
closely related to a pre-existing business where the code indicates a 
miscellaneous category;
    (B) If the new activity is within the same five-digit NAICS code (or 
three-digit SIC code) and the facts relating to the new activity also 
satisfy at least three of the factors listed in paragraphs (b)(2)(i)(A) 
through (G) of this section; or
    (C) If the pre-existing business is making a component product or 
end-product form, as defined in Sec. 1.936-5(a)(1),Q&A1, and the new 
business activity is making an integrated product, or an end-product 
form with fewer excluded components, that is not within the same six-
digit NAICS code (or four-digit SIC code) as the pre-existing business 
solely because the component product and the integrated product (or two 
end-product forms) have different end-uses.
    (3) Pre-existing business--(i) In general. Except as provided in 
paragraph (b)(3)(ii) of this section, a business activity is a pre-
existing business of the existing credit claimant if--
    (A) The existing credit claimant was actively engaged in the 
activity within the possession on or before October 13, 1995; and
    (B) The existing credit claimant had elected the benefits of the 
Puerto Rico and possession tax credit pursuant to an election which was 
in effect for the taxable year that included October 13, 1995.
    (ii) Acquisition of an existing credit claimant. (A) If all the 
assets of one or more trades or businesses of a corporation of an 
existing credit claimant are acquired by an affiliated or non-affiliated 
existing credit claimant which carries on the business activity of the 
predecessor existing credit claimant, the acquired business activity 
will be treated as a pre-existing business of the acquiring corporation. 
A non-affiliated acquiring corporation will not be bound by any section 
936(h) election made by the predecessor existing credit claimant with 
respect to that business activity.
    (B) Where all of the assets of one or more trades or businesses of a 
corporation of an existing credit claimant are acquired by a corporation 
that is not an existing credit claimant, the acquiring corporation may 
make a section 936(e) election for the taxable year in which the assets 
are acquired with the following effects--
    (1) The acquiring corporation will be treated as an existing
    (2) The activity will be considered a pre-existing business of the 
acquiring corporation;
    (3) The acquiring corporation will be deemed to satisfy the rules of 
section 936(a)(2) for the year of acquisition; and
    (4) After making an election under section 936(e), a non-affiliated 
acquiring corporation will not be bound by elections under sections 
936(a)(4) and (h) made by the predecessor existing credit claimant.
    (C) For purposes of this section the assets of a trade or business 
are determined at the time of acquisition provided that the transferee 
actively conducts the trade or business acquired.
    (D) A mere change in the stock ownership of a possessions 
corporation will not affect its status as an existing

[[Page 215]]

credit claimant for purposes of this section.
    (4) Leasing of Assets. (i) The leasing of assets (and employees to 
operate leased assets) will not, for purposes of this section, be 
considered a new line of business of the existing credit claimant if--
    (A) The existing credit claimant used the leased assets in an active 
trade or business for at least five years;
    (B) The existing credit claimant does not through its own officers 
or staff of employees perform management or operational functions (but 
not including operational functions performed through leased employees) 
with respect to the leased assets; and
    (C) The existing credit claimant does not perform marketing 
functions with respect to the leasing of the assets.
    (ii) Any income from the leasing of assets not considered a new line 
of business pursuant to paragraph (b)(4)(i) of this section will not be 
income from the active conduct of a trade or business (and, therefore, 
the existing credit claimant may not receive a possession tax credit 
with respect to such income).
    (5) Timing rule. The tests for a new line of business in this 
paragraph (whether the new activity is closely related to a pre-existing 
business) are applied only at the end of the taxable year during which 
the new activity is added.
    (c) Substantial--(1) In general. A new line of business is 
considered to be substantial as of the earlier of--
    (i) The taxable year in which the possessions corporation derives 
more than 15 percent of its gross income from that new line of business 
(gross income test); or
    (ii) The taxable year in which the possessions corporation directly 
uses in that new line of business more than 15 percent of its assets 
(assets test).
    (2) Gross income test. The denominator in the gross income test is 
the amount that is the gross income of the possessions corporation for 
the current taxable year, while the numerator is the amount that is the 
gross income of the new line of business for the current taxable year. 
The gross income test is applied at the end of each taxable year. For 
purposes of this test, if a new line of business is added late in the 
taxable year, the income is not to be annualized in that year. In the 
case of a new line of business acquired through the purchase of assets, 
the gross income of such new line of business for the taxable year of 
the acquiring corporation that includes the date of acquisition is 
determined from the date of acquisition through the end of the taxable 
year. In the case of a consolidated group election made pursuant to 
section 936(i)(5), the test applies on a company by company basis and 
not on a consolidated basis.
    (3) Assets test--(i) Computation. The denominator is the adjusted 
tax basis of the total assets of the possessions corporation for the 
current taxable year. The numerator is the adjusted tax basis of the 
total assets utilized in the new line of business for the current 
taxable year. The assets test is computed annually using all assets 
including cash and receivables.
    (ii) Exception. A new line of business of a possessions corporation 
will not be treated as substantial as a result of meeting the assets 
test if an event that is not reasonably anticipated causes assets used 
in the new line of business of the possessions corporation to exceed 15 
percent of the adjusted tax basis of the possessions corporation's total 
assets. For example, an event that is not reasonably anticipated would 
include the destruction of plant and equipment of the pre-existing 
business due to a hurricane or other natural disaster, or other similar 
circumstances beyond the control of the possessions corporation. The 
expiration of a patent is not such an event and will not permit use of 
this exception.
    (d) Examples. The following examples illustrate the rules described 
in paragraphs (a), (b), and (c) of this section. In the following 
examples, X Corp. is an existing credit claimant unless otherwise 
indicated:

    Example 1. X Corp. is a pharmaceutical corporation which 
manufactured bulk chemicals (a component product). In March 1997, X 
Corp. began to also manufacture pills (e.g., finished dosages or an 
integrated product). The new activity provides products very similar to 
the products provided by the pre-existing business. The new activity is 
of a type that is normally conducted in the same

[[Page 216]]

business location as the pre-existing business. The activity's economic 
success depends on the success of the pre-existing business. The 
manufacture of bulk chemicals is in NAICS code 325411, Medicinal and 
Botanical Manufacturing, while the manufacture of the pills is in NAICS 
code 325412, Pharmaceutical Preparation Manufacturing. Although the 
products have a different end-use, may be marketed to a different class 
of customers, and may not use similar operating assets, they are within 
the same five-digit NAICS code and the activity also satisfies 
paragraphs (b)(2)(i)(A), (C), and (E) of this section. The manufacture 
of the pills by X Corp. will be considered closely related to the 
manufacture of the bulk chemicals. Therefore, X Corp. will not be 
considered to have added a new line of business for purposes of 
paragraph (b) of this section because it falls within the safe harbor 
rule of (b)(2)(ii)(B).
    Example 2. X Corp. currently manufactures printed circuit boards in 
a possession. As a result of a technological breakthrough, X Corp. could 
produce the printed circuit boards more efficiently if it modified its 
existing production methods. Because demand for its products was high, X 
Corp. expanded when it modified its production methods. After these 
modifications to the facilities and production methods, the products 
produced through the new technology were in the same six-digit NAICS 
code as products produced previously by X Corp. See paragraph 
(b)(2)(ii)(A) of this section. Therefore, X Corp. will not be considered 
to have added a new line of business for purposes of paragraph (b) of 
this section because it falls within the safe harbor rule of 
(b)(2)(ii)(A).
    Example 3. X Corp. has manufactured Device A in Puerto Rico for a 
number of years and began to manufacture Device B in Puerto Rico in 
1997. Device A and Device B are both used to conduct electrical current 
to the heart and are both sold to cardiologists. There is no significant 
change in the type of activity conducted in Puerto Rico after the 
transfer of the manufacturing of Device B to Puerto Rico. Similar 
manufacturing equipment, manufacturing processes and skills are used in 
the manufacture of both devices. Both are regulated and licensed by the 
Food and Drug Administration. The economic success of Device B is 
dependent upon the success of Device A only to the extent that the 
liability and manufacturing prowess with respect to one reflects 
favorably on the other. Depending upon the heart abnormality, the 
cardiologist may choose to use Device A, Device B or both on a patient. 
The manufacture of Device B is treated as a unit with the manufacture of 
Device A in X Corp.'s accounting records. The manufacture of Device A is 
in the six-digit NAICS code 339112, Surgical and Medical Instrument 
Manufacturing. The manufacture of Device B is in the six-digit NAICS 
code 334510, Electromedical and Electrotherapeutic Apparatus 
Manufacturing. (The manufacture of Device A is in the four-digit SIC 
code 3845, Electromedical and Electrotherapeutic Apparatus. The 
manufacture of Device B is in the four-digit SIC code 3841, Surgical and 
Medical Instruments and Apparatus.) The safe harbor of paragraph 
(b)(2)(ii)(B) of this section applies because the two activities are 
within the same three-digit SIC code and Corp. X satisfies paragraphs 
(b)(2)(i)(A), (B), (C), (D), (F), and (G) of this section.
    Example 4. X Corp. has been manufacturing house slippers in Puerto 
Rico since 1990. Y Corp. is a U.S. corporation that is not affiliated 
with X Corp. and is not an existing credit claimant. Y Corp. has been 
manufacturing snack food in the United States. In 1997, X Corp. 
purchased the assets of Y Corp. and began to manufacture snack food in 
Puerto Rico. House slipper manufacturing is in the six-digit NAICS code 
316212 (Four-digit SIC code 3142, House Slippers). The manufacture of 
snack foods falls under the six-digit NAICS code 311919, Other Snack 
Food Manufacturing (four-digit SIC code 2052, Cookies and Crackers 
(pretzels)). Because these activities are not within the same five or 
six digit NAICS code (or the same three or four-digit SIC code), and 
because snack food is not an integrated product that contains house 
slippers, the safe harbor of paragraph (b)(2)(ii) of this section cannot 
apply. Considering all the facts and circumstances, including the seven 
factors of paragraph (b)(2)(i) of this section, the snack food 
manufacturing activity is not closely related to the manufacture of 
house slippers, and is a new line of business, within the meaning of 
paragraph (b) of this section.
    Example 5. X Corp., a calendar year taxpayer, is an existing credit 
claimant that has elected the profit-split method for computing taxable 
income. P Corp. was not an existing credit claimant and manufactured a 
product in a different five-digit NAICS code than the product 
manufactured by X Corp. In 1997, X Corp. acquired the stock of P Corp. 
and liquidated P Corp. in a tax-free liquidation under section 332, but 
continued the business activity of P Corp. as a new business segment. 
Assume that this new business segment is a new line of business within 
the meaning of paragraph (c) of this section. In 1997, X Corp. has gross 
income from the active conduct of a trade or business in a possession 
computed under section 936(a)(2) of $500 million and the adjusted tax 
basis of its assets is $200 million. The new business segment had gross 
income of $60 million, or 12 percent of the X Corp. gross income, and 
the adjusted basis of the new segment's assets was $20 million, or 10 
percent of the X Corp. total assets. In 1997, X Corp. does not derive 
more than 15 percent of its gross income, or directly use more that 15 
percent of its total

[[Page 217]]

assets, from the new business segment. Thus, the new line of business 
acquired from P Corp. is not a substantial new line of business within 
the meaning of paragraph (c) of this section, and the new activity will 
not cause X Corp. to lose its status as an existing credit claimant 
during 1997. In 1998, however, the gross income of X Corp. grew to $750 
million while the gross income of the new line of business grew to $150 
million, or 20% of the X Corp. 1998 gross income. Thus, in 1998, the new 
line of business is substantial within the meaning of paragraph (c) of 
this section, and X Corp. loses its status as an existing credit 
claimant for 1998 and all years subsequent.

    (e) Loss of status as existing credit claimant. An existing credit 
claimant that adds a substantial new line of business in a taxable year, 
or that has a new line of business that becomes substantial in a taxable 
year, loses its status as an existing credit claimant for that year and 
all years subsequent.
    (f) Effective date--(1) General rule. This section applies to 
taxable years of a possessions corporation beginning on or after January 
25, 2000.
    (2) Election for retroactive application. Taxpayers may elect to 
apply retroactively all the provisions of this section for any open 
taxable year beginning after December 31, 1995. Such election will be 
effective for the year of the election and all subsequent taxable years. 
This section will not apply to activities of pre-existing businesses for 
taxable years beginning before January 1, 1996.

[T.D. 8868, 65 FR 3815, Jan. 25, 2000]



Sec. 1.937-1  Bona fide residency in a possession.

    (a) Scope--(1) In general. Section 937(a) and this section set forth 
the rules for determining whether an individual qualifies as a bona fide 
resident of a particular possession (the relevant possession) for 
purposes of subpart D, part III, Subchapter N, Chapter 1 of the Internal 
Revenue Code as well as section 865(g)(3), section 876, section 881(b), 
paragraphs (2) and (3) of section 901(b), section 957(c), section 
3401(a)(8)(C), and section 7654(a).
    (2) Definitions. For purposes of this section and Sec. Sec. 1.937-2 
and 1.937-3--
    (i) Possession means one of the following United States possessions: 
American Samoa, Guam, the Northern Mariana Islands, Puerto Rico, or the 
Virgin Islands. When used in a geographical sense, the term comprises 
only the territory of each such possession (without application of 
sections 932(c)(3) and 935(c)(2) (as in effect before the effective date 
of its repeal)).
    (ii) United States, when used in a geographical sense, is defined in 
section 7701(a)(9), and without application of sections 932(a)(3) and 
935(c)(1) (as in effect before the effective date of its repeal).
    (b) Bona fide resident--(1) General rule. An individual qualifies as 
a bona fide resident of the relevant possession if such individual 
satisfies the requirements of paragraphs (c) through (e) of this section 
with respect to such possession.
    (2) Special rule for members of the Armed Forces. A member of the 
Armed Forces of the United States who qualified as a bona fide resident 
of the relevant possession in a prior taxable year is deemed to have 
satisfied the requirements of paragraphs (c) through (e) of this section 
for a subsequent taxable year if such individual otherwise is unable to 
satisfy such requirements by reason of being absent from such possession 
or present in the United States during such year solely in compliance 
with military orders. Conversely, a member of the Armed Forces of the 
United States who did not qualify as a bona fide resident of the 
relevant possession in a prior taxable year is not considered to have 
satisfied the requirements of paragraphs (c) through (e) of this section 
for a subsequent taxable year by reason of being present in such 
possession solely in compliance with military orders. Armed Forces of 
the United States is defined (and members of the Armed Forces are 
described) in section 7701(a)(15).
    (3) Juridical persons. Except as provided in Sec. 1.881-5(f):
    (i) Only natural persons may qualify as bona fide residents of a 
possession; and
    (ii) The rules governing the tax treatment of bona fide residents of 
a possession do not apply to juridical persons (including corporations, 
partnerships, trusts, and estates).
    (4) Transition rule. For taxable years beginning before October 23, 
2004, and

[[Page 218]]

ending after October 22, 2004, an individual is considered to qualify as 
a bona fide resident of the relevant possession if that individual would 
be a bona fide resident of the relevant possession by applying the 
principles of Sec. Sec. 1.871-2 through 1.871-5.
    (5) Special rule for cessation of bona fide residence in Puerto 
Rico. See paragraph (f)(2)(ii) of this section for a special rule 
applicable to a citizen of the United States who ceases to be a bona 
fide resident of Puerto Rico during a taxable year.
    (c) Presence test--(1) In general. A United States citizen or 
resident alien individual (as defined in section 7701(b)(1)(A)) 
satisfies the requirements of this paragraph (c) for a taxable year if 
that individual--
    (i) Was present in the relevant possession for at least 183 days 
during the taxable year;
    (ii) Was present in the relevant possession for at least 549 days 
during the three-year period consisting of the taxable year and the two 
immediately preceding taxable years, provided that the individual was 
also present in the relevant possession for at least 60 days during each 
taxable year of the period;
    (iii) Was present in the United States for no more than 90 days 
during the taxable year;
    (iv) During the taxable year had earned income (as defined in Sec. 
1.911-3(b)) in the United States, if any, not exceeding in the aggregate 
the amount specified in section 861(a)(3)(B) and was present for more 
days in the relevant possession than in the United States; or
    (v) Had no significant connection to the United States during the 
taxable year. See paragraph (c)(5) of this section.
    (2) Special rule for alien individuals. A nonresident alien 
individual (as defined in section 7701(b)(1)(B)) satisfies the 
requirements of this paragraph (c) for a taxable year if during that 
taxable year that individual satisfies the substantial presence test of 
Sec. 301.7701(b)-1(c) of this chapter (except for the substitution of 
the name of the relevant possession for the term United States where 
appropriate).
    (3) Days of presence. For purposes of paragraph (c)(1) of this 
section--
    (i) An individual is considered to be present in the relevant 
possession on:
    (A) Any day that the individual is physically present in that 
possession at any time during the day;
    (B) Any day that an individual is outside of the relevant possession 
to receive, or to accompany on a full-time basis a parent, spouse, or 
child (as defined in section 152(f)(1)) who is receiving, qualifying 
medical treatment as defined in paragraph (c)(4) of this section; and
    (C) Any day that an individual is outside the relevant possession 
because the individual leaves or is unable to return to the relevant 
possession during any--
    (1) 14-day period within which a major disaster occurs in the 
relevant possession for which a Federal Emergency Management Agency 
Notice of a Presidential declaration of a major disaster is issued in 
the Federal Register; or
    (2) Period for which a mandatory evacuation order is in effect for 
the geographic area in the relevant possession in which the individual's 
place of abode is located.
    (ii) An individual is considered to be present in the United States 
on any day that the individual is physically present in the United 
States at any time during the day. Notwithstanding the preceding 
sentence, the following days will not count as days of presence in the 
United States:
    (A) Any day that an individual is temporarily present in the United 
States under circumstances described in paragraph (c)(3)(i)(B) or (C) of 
this section;
    (B) Any day that an individual is in transit between two points 
outside the United States (as described in Sec. 301.7701(b)-3(d) of 
this chapter), and is physically present in the United States for fewer 
than 24 hours;
    (C) Any day that an individual is temporarily present in the United 
States as a professional athlete to compete in a charitable sports event 
(as described in Sec. 301.7701(b)-3(b)(5) of this chapter);
    (D) Any day that an individual is temporarily present in the United 
States as a student (as defined in section 152(f)(2)); and

[[Page 219]]

    (E) In the case of an individual who is an elected representative of 
the relevant possession, or who serves full time as an elected or 
appointed official or employee of the government of the relevant 
possession (or any political subdivision thereof), any day spent serving 
the relevant possession in that role.
    (iii) If, during a single day, an individual is physically present--
    (A) In the United States and in the relevant possession, that day is 
considered a day of presence in the relevant possession;
    (B) In two possessions, that day is considered a day of presence in 
the possession where the individual's tax home is located (applying the 
rules of paragraph (d) of this section).
    (4) Qualifying medical treatment--(i) In general. The term 
qualifying medical treatment means medical treatment provided by (or 
under the supervision of) a physician (as defined in section 213(d)(4)) 
for an illness, injury, impairment, or physical or mental condition that 
satisfies the documentation and production requirements of paragraph 
(c)(4)(iii) of this section and that involves--
    (A) Any period of inpatient care in a hospital or hospice and any 
period immediately before or after that inpatient care to the extent it 
is medically necessary; or
    (B) Any temporary period of inpatient care in a residential medical 
care facility for medically necessary rehabilitation services;
    (ii) Inpatient care. The term inpatient care means care requiring an 
overnight stay in a hospital, hospice, or residential medical care 
facility, as the case may be.
    (iii) Documentation and production requirements. In order to satisfy 
the documentation and production requirements of this paragraph, an 
individual must, with respect to each qualifying medical treatment, 
prepare (or obtain), maintain, and, upon a request by the Commissioner 
(or the person responsible for tax administration in the relevant 
possession), make available within 30 days of such request:
    (A) Records that provide--
    (1) The patient's name and relationship to the individual (if the 
medical treatment is provided to a person other than the individual);
    (2) The name and address of the hospital, hospice, or residential 
medical care facility where the medical treatment was provided;
    (3) The name, address, and telephone number of the physician who 
provided the medical treatment;
    (4) The date(s) on which the medical treatment was provided; and
    (5) Receipt(s) of payment for the medical treatment;
    (B) Signed certification by the providing or supervising physician 
that the medical treatment was qualified medical treatment within the 
meaning of paragraph (c)(4)(i) of this section, and setting forth--
    (1) The patient's name;
    (2) A reasonably detailed description of the medical treatment 
provided by (or under the supervision of) the physician;
    (3) The dates on which the medical treatment was provided; and
    (4) The medical facts that support the physician's certification and 
determination that the treatment was medically necessary; and
    (C) Such other information as the Commissioner may prescribe by 
notice, form, instructions, or other publication (see Sec. 
601.601(d)(2) of this chapter).
    (5) Significant connection. For purposes of paragraph (c)(1)(v) of 
this section--
    (i) The term significant connection to the United States means--
    (A) A permanent home in the United States;
    (B) Current registration to vote in any political subdivision of the 
United States; or
    (C) A spouse or child (as defined in section 152(f)(1)) who has not 
attained the age of 18 whose principal place of abode is in the United 
States other than--
    (1) A child who is in the United States because the child is living 
with a custodial parent under a custodial decree or multiple support 
agreement; or
    (2) A child who is in the United States as a student (as defined in 
section 152(f)(2)).
    (ii) Permanent home--(A) General rule. For purposes of paragraph 
(c)(5)(i)(A) of this section, except as provided in

[[Page 220]]

paragraph (c)(5)(ii)(B) of this section, the term permanent home has the 
same meaning as in Sec. 301.7701(b)-2(d)(2) of this chapter.
    (B) Exception for rental property. If an individual or the 
individual's spouse owns property and rents it to another person at any 
time during the taxable year, then notwithstanding that the rental 
property may constitute a permanent home under Sec. 301.7701(b)-2(d)(2) 
of this chapter, it is not a permanent home under this paragraph 
(c)(5)(ii) unless the taxpayer uses any portion of it as a residence 
during the taxable year under the principles of section 280A(d). In 
applying the principles of section 280A(d) for this purpose, an 
individual is treated as using the rental property for personal purposes 
on any day determined under the principles of section 280A(d)(2) or on 
any day that the rental property (or any portion of it) is not rented to 
another person at fair rental for the entire day. The rental property is 
not used for personal purposes on any day on which the principal purpose 
of the use of the rental property is to perform repair or maintenance 
work on the property. Whether the principal purpose of the use of the 
rental property is to perform repair or maintenance work is determined 
in light of all the facts and circumstances including, but not limited 
to, the following: The amount of time devoted to repair and maintenance 
work, the frequency of the use for repair and maintenance purposes 
during a taxable year, and the presence and activities of companions.
    (iii) For purposes of this paragraph (c)(5), the term spouse does 
not include a spouse from whom the individual is legally separated under 
a decree of divorce or separate maintenance.
    (d) Tax home test--(1) General rule. Except as provided in paragraph 
(d)(2) of this section, an individual satisfies the requirements of this 
paragraph (d) for a taxable year if that individual did not have a tax 
home outside the relevant possession during any part of the taxable 
year. For purposes of section 937 and this section, an individual's tax 
home is determined under the principles of section 911(d)(3) without 
regard to the second sentence thereof. Thus, under section 937, an 
individual's tax home is considered to be located at the individual's 
regular or principal (if more than one regular) place of business. If 
the individual has no regular or principal place of business because of 
the nature of the business, or because the individual is not engaged in 
carrying on any trade or business within the meaning of section 162(a), 
then the individual's tax home is the individual's regular place of 
abode in a real and substantial sense.
    (2) Exceptions--(i) Year of move. See paragraph (f) of this section 
for a special rule applicable to an individual who becomes or ceases to 
be a bona fide resident of the relevant possession during a taxable 
year.
    (ii) Special rule for seafarers. For purposes of section 937 and 
this section, an individual is not considered to have a tax home outside 
the relevant possession solely by reason of employment on a ship or 
other seafaring vessel that is predominantly used in local and 
international waters. For this purpose, a vessel is considered to be 
predominantly used in local and international waters if, during the 
taxable year, the aggregate amount of time it is used in international 
waters and in the waters within three miles of the relevant possession 
exceeds the aggregate amount of time it is used in the territorial 
waters of the United States, another possession, and a foreign country.
    (iii) Special rule for students and government officials. Any days 
described in paragraphs (c)(3)(ii)(D) and (E) of this section are 
disregarded for purposes of determining whether an individual has a tax 
home outside the relevant possession under paragraph (d)(1) of this 
section during any part of the taxable year.
    (e) Closer connection test--(1) General rule. Except as provided in 
paragraph (e)(2) of this section, an individual satisfies the 
requirements of this paragraph (e) for a taxable year if that individual 
did not have a closer connection to the United States or a foreign 
country than to the relevant possession during any part of the taxable 
year. For purposes of this paragraph (e)--
    (i) The principles of section 7701(b)(3)(B)(ii) and Sec. 
301.7701(b)-2(d) of this chapter apply (without regard to the final 
sentence of Sec. 301.7701(b)-2(b) of this chapter); and

[[Page 221]]

    (ii) An individual's connections to the relevant possession are 
compared to the aggregate of the individual's connections with the 
United States and foreign countries.
    (2) Exception for year of move. See paragraph (f) of this section 
for a special rule applicable to an individual who becomes or ceases to 
be a bona fide resident of the relevant possession during a taxable 
year.
    (f) Year of move--(1)Move to a possession. For the taxable year in 
which an individual's residence changes to the relevant possession, the 
individual satisfies the requirements of paragraphs (d)(1) and (e)(1) of 
this section if--
    (i) For each of the 3 taxable years immediately preceding the 
taxable year of the change of residence, the individual is not a bona 
fide resident of the relevant possession;
    (ii) For each of the last 183 days of the taxable year of the change 
of residence, the individual does not have a tax home outside the 
relevant possession or a closer connection to the United States or a 
foreign country than to the relevant possession; and
    (iii) For each of the 3 taxable years immediately following the 
taxable year of the change of residence, the individual is a bona fide 
resident of the relevant possession.
    (2) Move from a possession--(i) General rule. Except for a bona fide 
resident of Puerto Rico to whom Sec. 1.933-1(b) and paragraph 
(f)(2)(ii) of this section apply, for the taxable year in which an 
individual ceases to be a bona fide resident of the relevant possession, 
the individual satisfies the requirements of paragraphs (d)(1) and 
(e)(1) of this section if--
    (A) For each of the 3 taxable years immediately preceding the 
taxable year of the change of residence, the individual is a bona fide 
resident of the relevant possession;
    (B) For each of the first 183 days of the taxable year of the change 
of residence, the individual does not have a tax home outside the 
relevant possession or a closer connection to the United States or a 
foreign country than to the relevant possession; and
    (C) For each of the 3 taxable years immediately following the 
taxable year of the change of residence, the individual is not a bona 
fide resident of the relevant possession.
    (ii) Year of move from Puerto Rico. Notwithstanding an individual's 
failure to satisfy the presence, tax home, or closer connection test 
prescribed under paragraph (b)(1) of this section for the taxable year, 
the individual is a bona fide resident of Puerto Rico for that part of 
the taxable year described in paragraph (f)(2)(ii)(E) of this section if 
the individual--
    (A) Is a citizen of the United States;
    (B) Is a bona fide resident of Puerto Rico for a period of at least 
2 taxable years immediately preceding the taxable year;
    (C) Ceases to be a bona fide resident of Puerto Rico during the 
taxable year;
    (D) Ceases to have a tax home in Puerto Rico during the taxable 
year; and
    (E) Has a closer connection to Puerto Rico than to the United States 
or a foreign country throughout the part of the taxable year preceding 
the date on which the individual ceases to have a tax home in Puerto 
Rico.
    (g) Examples. The principles of this section are illustrated by the 
following examples:

    Example 1. Presence test. H, a U.S. citizen, is engaged in a 
profession that requires frequent travel. H spends 195 days of each of 
the years 2005 and 2006 in Possession N. In 2007, H spends 160 days in 
Possession N. Under paragraph (c)(1)(ii), H satisfies the presence test 
of paragraph (c) of this section with respect to Possession N for 
taxable year 2007. Assuming that in 2007 H does not have a tax home 
outside of Possession N and does not have a closer connection to the 
United States or a foreign country under paragraphs (d) and (e) of this 
section respectively, then regardless of whether H was a bona fide 
resident of Possession N in 2005 and 2006, H is a bona fide resident of 
Possession N for taxable year 2007.
    Example 2. Presence test. W, a U.S. citizen, lives for part of the 
taxable year in a condominium, which she owns, located in Possession P. 
W also owns a house in State N where she lives for 120 days every year 
to be near her grown children and grandchildren. W is retired and her 
income consists solely of pension payments, dividends, interest, and 
Social Security benefits. For 2006, W is only present in Possession P 
for a total of 175 days because of a 70-day vacation to Europe and Asia. 
Thus, for taxable year 2006, W is not present in Possession P for at 
least 183 days, is present in the United States for more than

[[Page 222]]

90 days, and has a significant connection to the United States by reason 
of her permanent home. However, under paragraph (c)(1)(iv) of this 
section, W still satisfies the presence test of paragraph (c) of this 
section with respect to Possession P because she has no earned income in 
the United States and is present for more days in Possession P than in 
the United States.
    Example 3. Presence test. T, a U.S. citizen, was born and raised in 
State A, where his mother still lives in the house in which T grew up. T 
is a sales representative for a company based in Possession V. T lives 
with his wife and minor children in their house in Possession V. T is 
registered to vote in Possession V and not in the United States. In 
2006, T spends 120 days in State A and another 120 days in foreign 
countries. When traveling on business to State A, T often stays at his 
mother's house in the bedroom he used when he was a child. T's stays are 
always of short duration, and T asks for his mother's permission before 
visiting to make sure that no other guests are using the room and that 
she agrees to have him as a guest in her house at that time. Therefore, 
under paragraph (c)(5)(ii) of this section, T's mother's house is not a 
permanent home of T. Assuming that no other accommodations in the United 
States constitute a permanent home with respect to T, then under 
paragraphs (c)(1)(v) and (c)(5) of this section, T has no significant 
connection to the United States. Accordingly, T satisfies the presence 
test of paragraph (c) of this section for taxable year 2006.
    Example 4. Alien resident of possession--presence test. F is a 
citizen of Country G. F's tax home is in Possession C and F has no 
closer connection to the United States or a foreign country than to 
Possession C. F is present in Possession C for 123 days and in the 
United States for 110 days every year. Accordingly, F is a nonresident 
alien with respect to the United States under section 7701(b), and a 
bona fide resident of Possession C under paragraphs (b), (c)(2), (d), 
and (e) of this section.
    Example 5. Seafarers--tax home. S, a U.S. citizen, is employed by a 
fishery and spends 250 days at sea on a fishing vessel in 2006. When not 
at sea, S resides with his wife at a house they own in Possession G. The 
fishing vessel upon which S works departs and arrives at various ports 
in Possession G, other possessions, and foreign countries, but is in 
international and local waters (within the meaning of paragraph (d)(2) 
of this section) for 225 days in 2006. Under paragraph (d)(2) of this 
section, for taxable year 2006, S will not be considered to have a tax 
home outside Possession G for purposes of section 937 and this section 
solely by reason of S's employment on board the fishing vessel.
    Example 6. Seasonal workers--tax home and closer connection. P, a 
U.S. citizen, is a permanent employee of a hotel in Possession I, but 
works only during the tourist season. For the remainder of each year, P 
lives with her husband and children in Possession Q, where she has no 
outside employment. Most of P's personal belongings, including her 
automobile, are located in Possession Q. P is registered to vote in, and 
has a driver's license issued by, Possession Q. P does her personal 
banking in Possession Q and P routinely lists her address in Possession 
Q as her permanent address on forms and documents. P satisfies the 
presence test of paragraph (c) of this section with respect to both 
Possession Q and Possession I, because, among other reasons, under 
paragraph (c)(1)(iii) of this section she does not spend more than 90 
days in the United States during the taxable year. P satisfies the tax 
home test of paragraph (d) of this section only with respect to 
Possession I, because her regular place of business is in Possession I. 
P satisfies the closer connection test of paragraph (e) of this section 
with respect to both Possession Q and Possession I, because she does not 
have a closer connection to the United States or to any foreign country 
(and possessions generally are not treated as foreign countries). 
Therefore, P is a bona fide resident of Possession I for purposes of the 
Internal Revenue Code.
    Example 7. Closer connection to United States than to possession. Z, 
a U.S. citizen, relocates to Possession V in a prior taxable year to 
start an investment consulting and venture capital business. Z's wife 
and two teenage children remain in State C to allow the children to 
complete high school. Z travels back to the United States regularly to 
see his wife and children, to engage in business activities, and to take 
vacations. He has an apartment available for his full-time use in 
Possession V, but he remains a joint owner of the residence in State C 
where his wife and children reside. Z and his family have automobiles 
and personal belongings such as furniture, clothing, and jewelry located 
at both residences. Although Z is a member of the Possession V Chamber 
of Commerce, Z also belongs to and has current relationships with 
social, political, cultural, and religious organizations in State C. Z 
receives mail in State C, including brokerage statements, credit card 
bills, and bank advices. Z conducts his personal banking activities in 
State C. Z holds a State C driver's license and is registered to vote in 
State C. Based on the totality of the particular facts and circumstances 
pertaining to Z, Z is not a bona fide resident of Possession V because 
he has a closer connection to the United States than to Possession V and 
therefore fails to satisfy the requirements of paragraphs (b)(1) and (e) 
of this section.
    Example 8. Year of move to possession. D, a U.S. citizen, files 
returns on a calendar year basis. From January 2003 through May 2006,

[[Page 223]]

D resides in State R. In June 2006, D moves to Possession N, purchases a 
house, and accepts a permanent position with a local employer. D's 
principal place of business from July 1 through December 31, 2006 is in 
Possession N, and during that period (which totals at least 183 days) D 
does not have a closer connection to the United States or a foreign 
country than to Possession N. For the remainder of 2006, and throughout 
years 2007 through 2009, D continues to live and work in Possession N 
and maintains a closer connection to Possession N than to the United 
States or any foreign country. D satisfies the tax home and closer 
connection tests for 2006 under paragraphs (d)(2), (e)(2), and (f)(1) of 
this section. Accordingly, assuming that D also satisfies the presence 
test in paragraph (c) of this section, D is a bona fide resident of 
Possession N for all of taxable year 2006.
    Example 9. Year of move from possession (other than Puerto Rico). J, 
a U.S. citizen, files returns on a calendar year basis. From January 
2007 through December 2009, J is a bona fide resident of Possession C 
because she satisfies the requirements of paragraph (b)(1) of this 
section for each year. J continues to reside in Possession C until 
September 6, 2010, when she accepts new employment and moves to State H. 
J's principal place of business from January 1 through September 5, 2010 
is in Possession C, and during that period (which totals at least 183 
days) J does not have a closer connection to the United States or a 
foreign country than to Possession C. For the remainder of 2010 and 
throughout years 2011 through 2013, D continues to live and work in 
State H and is not a bona fide resident of Possession C. J satisfies the 
tax home and closer connection tests for 2010 with respect to Possession 
C under paragraphs (d)(2)(i), (e)(2), and (f)(2)(i) of this section. 
Accordingly, assuming that J also satisfies the presence test of 
paragraph (c) of this section, J is a bona fide resident of Possession C 
for all of taxable year 2010.
    Example 10. Year of move from Puerto Rico. R, a U.S. citizen who 
files returns on a calendar year basis satisfies the requirements of 
paragraphs (b) through (e) of this section for years 2006 and 2007. From 
January through April 2008, R continues to reside and maintain his 
principal place of business in and closer connection to Puerto Rico. On 
May 5, 2008, R moves and changes his principal place of business (tax 
home) to State N and later that year establishes a closer connection to 
the United States than to Puerto Rico. R does not satisfy the presence 
test of paragraph (c) for 2008 with respect to Puerto Rico. Moreover, 
because R had a tax home outside of Puerto Rico and establishes a closer 
connection to the United States in 2008, R does not satisfy the 
requirements of paragraph (d)(1) or (e)(1) of this section for 2008. 
However, because R was a bona fide resident of Puerto Rico for at least 
two taxable years before his change of residence to State N in 2008, he 
is a bona fide resident of Puerto Rico from January 1 through May 4, 
2008 under paragraphs (b)(5) and (f)(2)(ii) of this section. See section 
933(2) and Sec. 1.933-1(b) for rules on attribution of income.

    (h) Information reporting requirement. The following individuals are 
required to file notice of their new tax status in such time and manner 
as the Commissioner may prescribe by notice, form, instructions, or 
other publication (see Sec. 601.601(d)(2) of this chapter):
    (1) Individuals who take the position for U.S. tax reporting 
purposes that they qualify as bona fide residents of a possession for a 
tax year subsequent to a tax year for which they were required to file 
Federal income tax returns as citizens or residents of the United States 
who did not so qualify.
    (2) Citizens and residents of the United States who take the 
position for U.S. tax reporting purposes that they do not qualify as 
bona fide residents of a possession for a tax year subsequent to a tax 
year for which they were required to file income tax returns (with the 
Internal Revenue Service, the tax authorities of a possession, or both) 
as individuals who did so qualify.
    (3) Bona fide residents of Puerto Rico or a section 931 possession 
(as defined in Sec. 1.931-1(c)(1)) who take a position for U.S. tax 
reporting purposes that they qualify as bona fide residents of that 
possession for a tax year subsequent to a tax year for which they were 
required to file income tax returns as bona fide residents of the U.S. 
Virgin Islands or a section 935 possession (as defined in Sec. 1.935-
1(a)(3)(i)).
    (i) Effective/applicability date. Except as provided in this 
paragraph (i), this section applies to taxable years ending after 
January 31, 2006. Paragraph (h) of this section also applies to a 
taxpayer's 3 taxable years immediately preceding the taxpayer's first 
taxable year ending after October 22, 2004. Taxpayers also may choose to 
apply this section in its entirety to all taxable years ending after 
October 22, 2004 for which the statute of limitations under section 6511 
is open.

[T.D. 9248, 71 FR 5001, Jan. 31, 2006, as amended by T.D. 9297, 71 FR 
66234, Nov. 14, 2006; T.D. 9391, 73 FR 19370, Apr. 9, 2008]

[[Page 224]]



Sec. 1.937-2  Income from sources within a possession.

    (a) Scope. Section 937(b) and this section set forth the rules for 
determining whether income is considered to be from sources within a 
particular possession (the relevant possession) for purposes of the 
Internal Revenue Code, including section 957(c) and Subpart D, Part III, 
Subchapter N, Chapter 1 of the Internal Revenue Code, as well as section 
7654(a) of the 1954 Internal Revenue Code (until the effective date of 
its repeal). Paragraphs (c)(1)(ii) and (c)(2) of this section do not 
apply, however, for purposes of sections 932(a) and (b) and 935(a)(3) 
(as in effect before the effective date of its repeal). In the case of a 
possession or territory that administers income tax laws that are 
identical (except for the substitution of the name of the possession or 
territory for the term ``United States'' where appropriate) to those in 
force in the United States, these rules do not apply for purposes of the 
application of such laws. These rules also do not affect the 
determination of whether income is considered to be from sources without 
the United States for purposes of the Internal Revenue Code.
    (b) In general. Except as provided in paragraphs (c) through (i) of 
this section, the principles of sections 861 through 865 and the 
regulations under those provisions (relating to the determination of the 
gross and the taxable income from sources within and without the United 
States) generally will be applied in determining the gross and the 
taxable income from sources within and without the relevant possession. 
In the application of such principles, it generally will be sufficient 
to substitute, where appropriate, the name of the relevant possession 
for the term ``United States,'' and to substitute, where appropriate, 
the term ``bona fide resident of'' followed by the name of the relevant 
possession for the term ``United States resident.'' Furthermore, the 
term domestic will be construed to mean created or organized in the 
relevant possession. In applying these principles, additional 
substitutions may be necessary to accomplish the intent of section 
937(b) and this section. For example, in applying the principles of 
sections 863(d) and (e) to individuals under this paragraph (b), the 
term ``bona fide resident of a possession'' will be used instead of the 
term ``United States person.'' In no case, however, will a bona fide 
resident or other person have, as a result of the application of these 
principles, more income from sources within the relevant possession than 
the amount of income from sources within the United States that a 
similarly situated U.S. person who is not a bona fide resident would 
have under sections 861 through 865.
    (c) U.S. income--(1) In general. Except as provided in paragraph (d) 
of this section, income from sources within the relevant possession will 
not include any item of income determined under the rules of sections 
861 through 865 and the regulations under those provisions to be--
    (i) From sources within the United States; or
    (ii) Effectively connected with the conduct of a trade or business 
within the United States.
    (2) Conduit arrangements. Income will be considered to be from 
sources within the United States for purposes of paragraph (c)(1) of 
this section if, pursuant to a plan or arrangement--
    (i) The income is received in exchange for consideration provided to 
another person; and
    (ii) Such person (or another person) provides the same consideration 
(or consideration of a like kind) to a third person in exchange for one 
or more payments constituting income from sources within the United 
States.
    (d) Income from certain sales of inventory property. For special 
rules that apply to determine the source of income from certain sales of 
inventory property, see Sec. 1.863-3(f).
    (e) Service in the Armed Forces. In the case of a member of the 
Armed Forces of the United States, the following rules will apply for 
determining the source of compensation for services performed in 
compliance with military orders:
    (1) If the individual is a bona fide resident of a possession and 
such services are performed in the United States or in another 
possession, the compensation constitutes income from sources within the 
possession of which

[[Page 225]]

the individual is a bona fide resident (and not from sources within the 
United States or such other possession).
    (2) If the individual is not a bona fide resident of a possession 
and such services are performed in a possession, the compensation 
constitutes income from sources within the United States (and not from 
sources within such possession).
    (f) Gains from certain dispositions of property--(1) Property of 
former U.S. residents. (i) Except to the extent an election is made 
under paragraph (f)(1)(vi) of this section, income from sources within 
the relevant possession will not include gains from the disposition of 
property described in paragraph (f)(1)(ii) of this section by an 
individual described in paragraph (f)(1)(iii) of this section. See also 
section 1277(e) of the Tax Reform Act of 1986, Public Law 99-514 (100 
Stat. 2085) (providing that gains from the disposition of certain 
property by individuals who acquired residency in certain possessions 
will be considered to be from sources within the United States).
    (ii) Property is described in this paragraph (f)(1)(ii) when the 
following conditions are satisfied--
    (A) The property is of a kind described in section 731(c)(3)(C)(i) 
or 954(c)(1)(B); and
    (B) The property was owned by the individual before such individual 
became a bona fide resident of the relevant possession.
    (iii) An individual is described in this paragraph (f)(1)(iii) when 
the following conditions are satisfied--
    (A) For the taxable year for which the source of the gain must be 
determined, the individual is a bona fide resident of the relevant 
possession; and
    (B) For any of the 10 years preceding such year, the individual was 
a citizen or resident of the United States (other than a bona fide 
resident of the relevant possession).
    (iv) If an individual described in paragraph (f)(1)(iii) of this 
section exchanges property described in paragraph (f)(1)(ii) of this 
section for other property in a transaction in which gain or loss is not 
required to be recognized (in whole or in part) under U.S. income tax 
principles, such other property will also be considered property 
described in paragraph (f)(1)(ii) of this section.
    (v) If an individual described in paragraph (f)(1)(iii) of this 
section owns, directly or indirectly, at least 10 percent (by value) of 
any entity to which property described in paragraph (f)(1)(ii) of this 
section is transferred in a transaction in which gain or loss is not 
required to be recognized (in whole or in part) under U.S. income tax 
principles, any gain recognized upon a disposition of the property by 
such entity will be treated as income from sources outside the relevant 
possession if any gain recognized upon a direct or indirect disposition 
of the individual's interest in such entity would have been so treated 
under paragraph (f)(1)(iv) of this section.
    (vi) Notwithstanding the general rule of paragraph (f)(1)(i) of this 
section and section 1277(e) of the Tax Reform Act of 1986, Public Law 
99-514 (100 Stat. 2085), an individual described in paragraph 
(f)(1)(iii) of this section may elect to treat as gain from sources 
within the relevant possession the portion of the gain attributable to 
the individual's possession holding period. The election under this 
paragraph (f)(1)(vi) will be considered made if the individual's income 
tax return for the year of disposition of the property reports the 
portion of gain attributable to the taxpayer's possession holding period 
as determined in accordance with paragraph (f)(1)(vi)(A) or paragraph 
(f)(1)(vi)(B) of this section, as the case may be.
    (A) In the case of marketable securities, the portion of gain 
attributable to the possession holding period will be determined by 
reference to the fair market value of the marketable security at the 
close of the market on the first day of the individual's possession 
holding period. In the event that the individual is a bona fide resident 
of the relevant possession for more than a single continuous period, the 
portion of gain described in this paragraph (f)(1)(vi)(A) will be the 
aggregate of the portions of gain (or offsetting loss) attributable to 
each possession holding period.
    (B) In the case of property other than marketable securities, the 
portion of gain attributable to the possession

[[Page 226]]

holding period in the relevant possession will be determined by 
multiplying the total gain on disposition of the property by a fraction, 
the numerator of which is the number of days in the possession holding 
period and the denominator of which is the total number of days in the 
individual's holding period for the property. For purposes of the 
preceding sentence, in the event that the individual is a bona fide 
resident of the relevant possession for more than a single continuous 
period, the number of days in the numerator will be the aggregate of the 
number of days in each possession holding period. For purposes of this 
paragraph (f)(1)(vi)(B), the denominator will include days that are 
required to be included in an individual's holding period under section 
735(b), section 1223, and any other applicable holding period rule in 
the Internal Revenue Code.
    (vii) For purposes of paragraph (f)(1)(vi) of this section--
    (A) The term marketable securities means property described in 
paragraph (f)(1)(ii) of this section that is, throughout the 
individual's holding period, actively traded within the meaning of Sec. 
1.1092(d)-1(a); and
    (B) The term possession holding period means the part of the 
individual's holding period for the property during which the individual 
is a bona fide resident of the relevant possession. However, for this 
purpose, the possession holding period will be considered to commence in 
all cases on the first day during such period that the individual does 
not have a tax home outside the relevant possession. In the event that 
the individual is a bona fide resident of the relevant possession for 
more than a single continuous period, each possession holding period 
prior to the one ending on the date of sale or other disposition will be 
considered to end on the first day that the individual has a tax home 
outside the relevant possession. With respect to the determination of 
tax home, see Sec. 1.937-1(d).
    (2) Special rules under section 865 for possessions--(i) Except as 
provided in paragraph (f)(1) of this section--
    (A) Gain that is considered to be derived from sources outside of 
the United States under section 865(g)(3) will be considered income from 
sources within Puerto Rico; and
    (B) Gain that is considered to be derived from sources outside of 
the United States under section 865(h)(2)(B) will be considered income 
from sources within the possession in which the liquidating corporation 
is created or organized.
    (ii) In applying the principles of section 865 and the regulations 
under that section pursuant to paragraph (b) of this section, the rules 
of section 865(g) will not apply, but the special rule of section 
865(h)(2)(B) will apply with respect to gain recognized upon the 
liquidation of corporations created or organized in the United States.
    (g) Dividends--(1) Dividends from certain possessions corporations--
(i) In general. Except as provided in paragraph (g)(1)(ii) of this 
section, with respect to any possessions shareholder, only the 
possessions source ratio of any dividend paid or accrued by a 
corporation created or organized in a possession (possessions 
corporation) will be treated as income from sources within such 
possession. For purposes of this paragraph (g)--
    (A) The possessions source ratio will be a fraction, the numerator 
of which is the gross income of the possessions corporation from sources 
within the possession in which it is created or organized (applying the 
rules of this section) for the testing period and the denominator of 
which is the total gross income of the corporation for the testing 
period; and
    (B) The term possessions shareholder means any individual who is a 
bona fide resident of the possession in which the corporation is created 
or organized and who owns, directly or indirectly, at least 10 percent 
of the total voting stock of the corporation.
    (ii) Dividends from corporations engaged in the active conduct of a 
trade or business in the relevant possession. The entire amount of any 
dividend paid or accrued by a possessions corporation will be treated as 
income from sources within the possession in which it is created or 
organized when the following conditions are met--
    (A) 80 percent or more of the gross income of the corporation for 
the testing period was derived from sources within

[[Page 227]]

such possession (applying the rules of this section) or was effectively 
connected with the conduct of a trade or business in such possession 
(applying the rules of Sec. 1.937-3); and
    (B) 50 percent or more of the gross income of the corporation for 
the testing period was derived from the active conduct of a trade or 
business within such possession.
    (iii) Testing period. For purposes of this paragraph (g)(1), the 
term testing period means the 3-year period ending with the close of the 
taxable year of the payment of the dividend (or for such part of such 
period as the corporation has been in existence).
    (iv) Subsidiary look-through rule. For purposes of this paragraph 
(g)(1), if a possessions corporation owns (directly or indirectly) at 
least 25 percent (by value) of the stock of another corporation, such 
possessions corporation will be treated as if it--
    (A) Directly received its proportionate share of the income of such 
other corporation; and
    (B) Actively conducted any trade or business actively conducted by 
such other corporation.
    (2) Dividends from other corporations. In applying the principles of 
section 861 and the regulations under that section pursuant to paragraph 
(b) of this section, the special rules relating to dividends for which 
deductions are allowable under section 243 or 245 will not apply.
    (h) Income inclusions. For purposes of determining whether an amount 
described in section 904(h)(1)(A) constitutes income from sources within 
the relevant possession--
    (1) If the individual owns (directly or indirectly) at least 10 
percent of the total voting stock of the corporation from which such 
amount is derived, the principles of section 904(h)(2) will apply. In 
the case of an individual who is not a possessions shareholder (as 
defined in paragraph (g)(1)(i)(B) of this section), the preceding 
sentence will apply only if the corporation qualifies as a ``United 
States-owned foreign corporation'' for purposes of section 904(h); and
    (2) In all other cases, the amount will be considered income from 
sources in the jurisdiction in which the corporation is created or 
organized.
    (i) Interest--(1) Interest from certain possessions corporations--
(i) In general. Except as provided in paragraph (i)(1)(ii) of this 
section, with respect to any possessions shareholder (as defined in 
paragraph (g)(1)(i)(B) of this section), interest paid or accrued by a 
possessions corporation will be treated as income from sources within 
the possession in which it is created or organized to the extent that 
such interest is allocable to assets that generate, have generated, or 
could reasonably have been expected to generate income from sources 
within such possession (under the rules of this section) or income 
effectively connected with the conduct of a trade or business within 
such possession (under the rules of Sec. 1.937-3). For purposes of the 
preceding sentence, the principles of Sec. Sec. 1.861-9 through 1.861-
12 will apply.
    (ii) Interest from corporations engaged in the active conduct of a 
trade or business in the relevant possession. The entire amount of any 
interest paid or accrued by a possessions corporation will be treated as 
income from sources within the possession in which it is created or 
organized when the conditions of paragraphs (g)(1)(ii)(A) and (B) of 
this section are met (applying the rules of paragraphs (g)(1)(iii) and 
(iv) of this section).
    (2) Interest from partnerships. Interest paid or accrued by a 
partnership will be treated as income from sources within a possession 
only to the extent that such interest is allocable to income effectively 
connected with the conduct of a trade or business in such possession. 
For purposes of the preceding sentence, the principles of Sec. 1.882-5 
will apply (as if the partnership were a foreign corporation and as if 
the trade or business in the possession were a trade or business in the 
United States).
    (j) Indirect ownership. For purposes of this section, the rules of 
section 318(a)(2) will apply except that the language ``5 percent'' will 
be used instead of ``50 percent'' in section 318(a)(2)(C).
    (k) Examples. The provisions of this section may be illustrated by 
the following examples:

    Example 1. (i) X, a U.S. citizen, resides in State N and acquires 
stock of Corporation C,

[[Page 228]]

a domestic corporation, in 2008 for $10x. X moves to the Northern 
Mariana Islands (NMI) on March 1, 2009 and changes his principal place 
of business to NMI on that same date. Assume for purposes of this 
example that, under Sec. 1.937-1(b) and (f)(1) (year-of-move 
exception), X is considered a bona fide resident of NMI for 2009 through 
2012. On March 1, 2009, the closing value of X's stock in Corporation C, 
a marketable security (within the meaning of paragraph (f)(1)(vii)(A) of 
this section), is $20x. On January 3, 2012, X sells all his Corporation 
C stock for $70x.
    (ii) Pursuant to section 1277(e) of the Tax Reform Act of 1986, and 
absent an election under paragraph (f)(1)(vi) of this section, all of 
X's gain ($60x) will be treated as income from sources within the United 
States for all purposes of the Internal Revenue Code (including section 
7654, as in effect with respect to the NMI), and (under paragraph 
(f)(1)(i) of this section) not as income from sources in the NMI. 
However, pursuant to paragraph (f)(1)(vi) of this section, X may elect 
on his 2012 income tax return filed with NMI to treat the portion of 
this gain attributable to X's possession holding period with respect to 
NMI as gain from sources within NMI. X's possession holding period with 
respect to NMI begins on March 1, 2009, the date his tax home changes to 
the NMI. Under paragraph (f)(1)(vi)(A) of this section, the portion of 
X's gain attributable to this possession holding period is $50x, the 
excess of the sale price of the stock ($70x) over its closing value 
($20x) on the first day of the possession holding period. By reporting 
$50x of gain on his 2012 NMI return, X will elect under paragraph 
(f)(1)(vi) of this section to treat that amount as NMI source income.
    Example 2. (i) R, a U.S. citizen, resides in State F and acquires a 
5 percent interest in Partnership P on January 1, 2009. R moves to 
Puerto Rico on June 1, 2010 and changes her principal place of business 
to Puerto Rico on that same date. Assume for purposes of this example 
that under Sec. 1.937-1(b) and (f)(1) (year-of-move exception), R is 
considered a bona fide resident of Puerto Rico for 2010 through 2012. On 
June 1, 2010, R's interest in Partnership P is not a marketable security 
within the meaning of paragraph (f)(1)(vii)(A) of this section. On 
December 31, 2012, having owned the interest in Partnership P for a 
period of 4 years (1461 days), R sells it, recognizing gain of $100x.
    (ii) Pursuant to paragraph (f)(1) of this section, and absent an 
election under paragraph (f)(1)(vi) of this section, the gain will not 
be treated as income from sources within Puerto Rico for purposes of the 
Internal Revenue Code (including section 933(1)). However, pursuant to 
paragraph (f)(1)(vi) of this section, R may elect on her 2012 return 
filed with the IRS to treat the portion of this gain attributable to R's 
possession holding period with respect to Puerto Rico as gain from 
sources within Puerto Rico. R's possession holding period with respect 
to Puerto Rico is the 945-day period from June 1, 2010, the date her tax 
home changes to Puerto Rico, through December 31, 2012, the date of 
sale. Under paragraph (f)(1)(vi)(B) of this section, the portion of R's 
gain attributable to this possession holding period is $64.68x, computed 
as follows:
[GRAPHIC] [TIFF OMITTED] TR09AP08.000

    (iii) By reporting $64.68x of gain on her 2012 Federal return, R 
will elect under paragraph (f)(1)(vi) of this section to treat that 
amount as Puerto Rico source income.
    Example 3. X, a bona fide resident of Possession S, a section 931 
possession (as defined in Sec. 1.931-1(c)(1)), is engaged in a trade or 
business in the United States through an office in State H. In 2008, 
this office materially participates in the sale of inventory property in 
Possession S, such that the income from these inventory sales is 
considered effectively connected to this trade or business in the United 
States under section 864(c)(4)(B)(iii). This income will not be treated 
as income from sources within Possession S for purposes of section 
931(a)(1) pursuant to paragraph (c)(1)(ii) of this section, but 
nonetheless will continue to be treated as income from sources without 
the United States under section 862 (for example, for purposes of 
section 904).
    Example 4. (i) X, a bona fide resident of Possession I, owns 25 
percent of the outstanding shares of A Corp, a corporation organized 
under the laws of Possession I. In 2010, X receives a dividend of $70x 
from A Corp. During 2008 through 2010, A Corp has gross income from the 
following sources:

------------------------------------------------------------------------
                                                               Sources
                                                 Possession    outside
                                                 I sources    possession
                                                                  I
------------------------------------------------------------------------
2008..........................................         $10x         $20x
2009..........................................          20x          10x
2010..........................................          25x          15x
------------------------------------------------------------------------


[[Page 229]]

    (ii) A Corp owns 50 percent of the outstanding shares of B Corp, a 
corporation organized under the laws of Country FC. During 2008 through 
2010, B Corp has gross income from the following sources:

------------------------------------------------------------------------
                                                               Sources
                                                 Possession    outside
                                                 I sources    possession
                                                                  I
------------------------------------------------------------------------
2008..........................................         $10x          $6x
2009..........................................          14x           8x
2010..........................................          10x           4x
------------------------------------------------------------------------

    (iii) A Corp is treated as having received 50 percent of the gross 
income of B Corp. Therefore, for 2008 through 2010, the gross income of 
A Corp is from the following sources:

------------------------------------------------------------------------
                                                               Sources
                                                 Possession    outside
                                                 I sources    possession
                                                                  I
------------------------------------------------------------------------
2008..........................................         $15x         $23x
2009..........................................          27x          14x
2010..........................................          30x          17x
                                               -------------------------
    Totals....................................         $72x         $54x
------------------------------------------------------------------------

    (iv) Pursuant to paragraph (g) of this section, the portion of the 
dividend of $70x that X receives from Corp A in 2010 that is treated as 
income from sources within Possession I is 72/126 of $70x, or $40x.
    Example 5. X is a U.S. citizen and a bona fide resident of the 
Northern Mariana Islands (NMI). In 2008, X receives compensation for 
services performed as a member of the crew of a fishing boat. Ten 
percent of the services for which X receives compensation are performed 
in the NMI, and 90 percent of X's services are performed in 
international waters. Under the principles of section 861(a)(3) as 
applied pursuant to paragraph (b) of this section, the compensation that 
X receives for services performed in the NMI is treated as income from 
sources within the NMI. Under the principles of section 863(d)(1)(A) as 
applied pursuant to paragraph (b) of this section, the compensation that 
X receives for services performed in international waters is treated as 
income from sources within the NMI for purposes of the Internal Revenue 
Code (including section 7654, as in effect with respect to the NMI). 
Thus, all of X's compensation for services during 2008 is treated as 
income from sources within the NMI.
    Example 6. X, a U.S. citizen, resides in State L and receives $2,500 
of compensation for services performed in Possession J during 2008 for 
Y, X's employer. X is temporarily present in Possession J in 2008 for a 
period (or periods) not exceeding a total of 90 days. Y, a U.S. citizen, 
is not a bona fide resident of Possession J and is not engaged in a 
trade or business within Possession J. Under the principles of section 
861(a)(3) as applied pursuant to paragraph (b) of this section, the 
compensation that X receives for services performed in Possession J 
during 2008 is not treated as income from sources within Possession J.
    Example 7. (i) Company Y, a corporation organized in State C, 
produces, markets, and distributes music products. Y enters into a 
recording contract with Z, a recording artist who is a bona fide 
resident of the U.S. Virgin Islands (USVI). Pursuant to the contract 
between Y and Z, Z agrees to perform services as writer, musician, and 
vocalist on the recording of a new musical composition and related music 
video. Under the contract, all songs, recordings and related artwork, 
packaging copy, and liner notes, together with copyrights and other 
intellectual property in those works, are the sole property of Y, and Z 
obtains no proprietary rights in that property. As compensation for Z's 
services, all of which are performed at a recording studio or other 
locations in the USVI, Y agrees to pay amounts designated as the 
``writer's share'' to Z based on a percentage of the music products 
sold. Y also agrees to make an upfront payment to Z as an advance 
against future portions of Z's writer's share.
    (ii) To the extent that Z performs personal services within the 
USVI, the compensation that Z receives for his services is sourced to 
the USVI under the principles of section 861(a)(3) and Sec. 1.861-4 as 
applied pursuant to Sec. 1.937-2(b). If all of Z's services are 
performed in the USVI, none of the writer's share is derived from 
sources within the United States under section 861(a)(3) and Sec. 
1.861-4, nor is it effectively connected with the conduct of a trade or 
business in the United States under section 864(c)(3). Accordingly, the 
U.S. income rule of section 937(b)(2) and paragraph (c)(1) of this 
section would not operate to prevent Z's services income from being USVI 
source or USVI effectively connected income within the meaning of 
section 937(b)(1). If Z also performs services in the United States, 
however, then the U.S. income rule would apply to the part of Z's 
compensation that is sourced to the United States under section 
861(a)(3) and Sec. 1.861-4. In the event that Y and Z are controlled 
taxpayers within the meaning of Sec. 1.482-1(i)(5), section 482 and the 
regulations under that section, including Sec. 1.482-9T(i), would apply 
to evaluate the arm's length amount charged for Z's controlled services.

    (l) Effective/applicability dates. Except as otherwise provided in 
this paragraph (l), this section applies to income earned in taxable 
years ending after April 9, 2008. Taxpayers may choose to apply 
paragraph (b) of this section to income earned in open taxable years 
ending after October 22, 2004. Taxpayers may choose to apply paragraph

[[Page 230]]

(f)(1) of this section to dispositions made after April 11, 2005.

[T.D. 9391, 73 FR 19370, Apr. 9, 2008, as amended at T.D. 9391, 73 FR 
27728, May 14, 2008; T.D. 9391, 73 FR 36594, June 27, 2008]



Sec. 1.937-3  Income effectively connected with the conduct of a trade
or business in a possession.

    (a) Scope. Section 937(b) and this section set forth the rules for 
determining whether income is effectively connected with the conduct of 
a trade or business within a particular possession (the relevant 
possession) for purposes of the Internal Revenue Code, including 
sections 881(b) and 957(c) and Subpart D, Part III, Subchapter N, 
Chapter 1 of the Internal Revenue Code. Paragraph (c) of this section 
does not apply, however, for purposes of section 881(b). In the case of 
a possession or territory that administers income tax laws that are 
identical (except for the substitution of the name of the possession or 
territory for the term ``United States'' where appropriate) to those in 
force in the United States, these rules do not apply for purposes of the 
application of such laws.
    (b) In general. Except as provided in paragraphs (c) and (d) of this 
section, the principles of section 864(c) and the regulations under that 
section (relating to the determination of income, gain or loss that is 
effectively connected with the conduct of a trade or business within the 
United States) generally will be applied in determining whether income 
is effectively connected with the conduct of a trade or business within 
the relevant possession, without regard to whether the taxpayer 
qualifies as a nonresident alien individual or a foreign corporation 
with respect to such possession. Subject to the rules of this section, 
the principles of section 864(c)(4) will apply for purposes of 
determining whether income from sources without the relevant possession 
is effectively connected with the conduct of a trade or business in the 
relevant possession. For purposes of the preceding sentence, all income 
other than income from sources within the relevant possession (as 
determined under the rules of Sec. 1.937-2) will be considered income 
from sources without the relevant possession in the application of the 
principles of section 864(c) under this paragraph (b), it generally will 
be sufficient to substitute the name of the relevant possession for the 
term ``United States'' where appropriate, but additional substitutions 
may be necessary to accomplish the intent of section 937(b) and this 
section. In no case, however, will a bona fide resident or other person 
have, as a result of the application of these principles, more income 
effectively connected with the conduct of a trade or business in the 
relevant possession than the amount of U.S. effectively connected income 
that a similarly situated U.S. person who is not a bona fide resident 
would have under section 864(c).
    (c) U.S. income--(1) In general. Except as provided in paragraph (d) 
of this section, income considered to be effectively connected with the 
conduct of a trade or business within the relevant possession will not 
include any item of income determined under the rules of sections 861 
through 865 and the regulations under those provisions to be--
    (i) From sources within the United States; or
    (ii) Effectively connected with the conduct of a trade or business 
within the United States.
    (2) Conduit arrangements. Income will be considered to be from 
sources within the United States for purposes of paragraph (c)(1) of 
this section if, pursuant to a plan or arrangement--
    (i) The income is received in exchange for consideration provided to 
another person; and
    (ii) Such person (or another person) provides the same consideration 
(or consideration of a like kind) to a third person in exchange for one 
or more payments constituting income from sources within the United 
States.
    (d) Income from certain sales of inventory property. Paragraph (c) 
of this section will not apply to income from sales of inventory 
property described in Sec. 1.863-3(f).
    (e) Examples. The provisions of this section may be illustrated by 
the following examples:

    Example 1. X is a bona fide resident of Possession I, a section 931 
possession (as defined

[[Page 231]]

in Sec. 1.931-1(c)(1)). X has an office in Possession I from which X 
conducts a business consisting of the development and sale of 
specialized computer software. A purchaser of software will frequently 
pay X an additional amount to install the software on the purchaser's 
operating system and to ensure that the software is functioning 
properly. X performs the installation services at the purchaser's place 
of business, which may be in Possession I, in the United States, or in 
another country. The provision of such services is not de minimis and 
constitutes a separate transaction under the rules of Sec. 1.861-18. 
Under the principles of section 864(c)(4) as applied pursuant to 
paragraph (b) of this section, the compensation that X receives for 
personal services performed outside of Possession I is not considered to 
be effectively connected with the conduct of a trade or business in 
Possession I for purposes of section 931(a)(2).
    Example 2. (i) F Bank is organized under the laws of Country FC and 
operates an active banking business from offices in the U.S. Virgin 
Islands (USVI). In connection with this banking business, F Bank makes 
loans to and receives interest payments from borrowers who reside in the 
USVI, in the United States, and in Country FC.
    (ii) Under the principles of section 861(a)(1) as applied pursuant 
to Sec. 1.937-2(b), interest payments received by F Bank from borrowers 
who reside in the United States or in Country FC constitute income from 
sources outside of the USVI. Under the principles of section 864(c)(4) 
as applied pursuant to paragraph (b) of this section, interest income 
from sources outside of the USVI generally may constitute income that is 
effectively connected with the conduct of a trade or business within the 
USVI for purposes of the Internal Revenue Code. However, interest 
payments received by F Bank from borrowers who reside in the United 
States constitute income from sources within the United States under 
section 861(a)(1). Accordingly, under paragraph (c)(1) of this section, 
such interest income will not be treated as effectively connected with 
the conduct of a trade or business in the USVI for purposes of the 
Internal Revenue Code (for example, for purposes of section 934(b)). 
Interest payments received by F Bank from borrowers who reside in 
Country FC, however, may be treated as effectively connected with the 
conduct of a trade or business in the USVI for purposes of the Internal 
Revenue Code (including section 934(b)).
    (iii) To the extent that, as described in section 934(a), the USVI 
administers income tax laws that are identical (except for the 
substitution of the name of the USVI for the term ``United States'' 
where appropriate) to those in force in the United States, interest 
payments received by F Bank from borrowers who reside in the United 
States or in Country FC may be treated as income that is effectively 
connected with the conduct of a trade or business in the USVI for 
purposes of F Bank's income tax liability to the USVI under mirrored 
section 882.
    Example 3. (i) G is a partnership that is organized under the laws 
of, and that operates an active financing business from offices in, 
Possession I. Interests in G are owned by D, a bona fide resident of 
Possession I, and N, an alien individual who resides in Country FC. 
Pursuant to a pre-arrangement, G loans $x to T, a business entity 
organized under the laws of Country FC, and T in turn loans $y to E, a 
U.S. resident. In accordance with the arrangement, E pays interest to T, 
which in turn pays interest to G.
    (ii) The arrangement constitutes a conduit arrangement under 
paragraph (c)(2) of this section, and the interest payments received by 
G are treated as income from sources within the United States for 
purposes of paragraph (c)(1) of this section. Accordingly, the interest 
received by G will not be treated as effectively connected with the 
conduct of a trade or business in Possession I for purposes of the 
Internal Revenue Code (including sections 931(a)(2) and 934(b), if 
applicable with respect to D). Whether such interest constitutes income 
from sources within the United States for other purposes of the Internal 
Revenue Code under generally applicable conduit principles will depend 
on the facts and circumstances. See, for example, Aiken Indus., Inc. v. 
Commissioner, 56 T.C. 925 (1971).
    (iii) If Possession I administers income tax laws that are identical 
(except for the substitution of the name of the possession for the term 
``United States'' where appropriate) to those in force in the United 
States, the interest received by G may be treated as income effectively 
connected with the conduct of a trade or business in Possession I under 
mirrored section 864(c)(4) for purposes of determining the Possession I 
territorial income tax liability of N under mirrored section 871.
    Example 4. (i) Corporation A, a corporation organized in Possession 
X, is engaged in a business consisting of the development of computer 
software and the sale of that software. Corporation A has its sole place 
of business in Possession X and is not engaged in the conduct of a trade 
or business in the United States. Corporation A receives orders for its 
software from customers in the United States and around the world. After 
orders are accepted, Corporation A's software is either loaded onto 
compact discs at Corporation A's Possession X facility and shipped via 
common carrier, or downloaded from Corporation A's server in Possession 
X. The sales contract provides that the rights, title, and interest in 
the product will pass from Corporation A to the customer either

[[Page 232]]

at Corporation A's place of business in Possession X (if shipped in 
compact disc form) or at Corporation A's server in Possession X (if 
electronically downloaded). Assume for purposes of this example that 
each transaction is classified as a sale of a copyrighted article under 
Sec. 1.861-18(c)(1)(ii) and (f)(2).
    (ii) Under the principles of section 863(a), as applied pursuant to 
Sec. 1.937-2(b), because Corporation A passes the rights, title, and 
interest to the copyrighted articles in Possession X, Corporation A's 
sales income is sourced to Possession X. Corporation A's sales income is 
also effectively connected with the conduct of a trade or business in 
Possession X, under the principles of section 864(c)(3) as applied 
pursuant to Sec. 1.937-3(b). Corporation A's income is not from sources 
within the United States, nor is it effectively connected with the 
conduct of a trade or business in the United States. Accordingly, the 
U.S. income rule of section 937(b)(2), Sec. 1.937-2(c)(1), and 
paragraph (c)(1) of this section does not operate to prevent Corporation 
A's sales income from being Possession X source and Possession X 
effectively connected income under section 937(b)(1).
    Example 5. (i) Corporation B, a corporation organized in Possession 
X, has its sole place of business in Possession X and is not engaged in 
the conduct of a trade or business in the United States. Corporation B 
employs a software business model generally referred to as an 
application service provider. Employees of Corporation B in Possession X 
develop software and maintain it on Corporation B's server in Possession 
X. Corporation B's customers in the United States and around the world 
transmit detailed data about their own customers to Corporation B's 
server and electronic storage facility in Possession X. The customers 
pay a monthly fee to Corporation B under a Subscription Agreement, and 
they can use the software to generate reports analyzing the data at any 
time but do not receive a copy of the software. Corporation B's software 
allows its customers to generate the reports from their location and to 
keep track of their relationships with their own customers. Assume for 
purposes of this example that Corporation B's income from these 
transactions is derived from the provision of services.
    (ii) Under the principles of section 861(a)(3) and Sec. 1.861-4(a), 
as applied pursuant to Sec. 1.937-2(b), because Corporation B performs 
personal services wholly within Possession X, the compensation 
Corporation B receives for services is sourced to Possession X. 
Corporation B's services income is also effectively connected with the 
conduct of a trade or business in Possession X, under the principles of 
section 864(c)(3) as applied pursuant to Sec. 1.937-3(b). Corporation 
B's income is not from sources within the United States, nor is it 
effectively connected with the conduct of a trade or business in the 
United States. Accordingly, the U.S. income rule of section 937(b)(2), 
Sec. 1.937-2(c)(1), and paragraph (c)(1) of this section does not 
operate to prevent Corporation B's services income from being Possession 
X source or Possession X effectively connected income within the meaning 
of section 937(b)(1).

    (f) Effective/applicability date. Except as otherwise provided in 
this paragraph (f), this section applies to income earned in taxable 
years ending after April 9, 2008. Taxpayers may choose to apply 
paragraph (b) of this section to income earned in open taxable years 
ending after October 22, 2004.

[T.D. 9391, 73 FR 19374, Apr. 9, 2008, as amended at T.D. 9391, 73 FR 
27728, May 14, 2008]

                      china trade act corporations



Sec. 1.941-1  Special deduction for China Trade Act corporations.

    In addition to the deductions from taxable income otherwise allowed 
such a corporation, a China Trade Act corporation is, under certain 
conditions, allowed an additional deduction in computing taxable income. 
This special deduction is an amount equal to the proportion of the 
taxable income derived from sources within Formosa and Hong Kong 
(determined without regard to this section and determined in a manner 
similar to that provided in part I (section 861 and following), 
subchapter N, chapter 1 of the Code, and the regulations thereunder) 
which the par value of the shares of stock of the corporation, owned on 
the last day of the taxable year by (a) persons resident in Formosa, 
Hong Kong, the United States, or possessions of the United States, and 
(b) individual citizens of the United States wherever resident, bears to 
the par value of the whole number of shares of stock of the corporation 
outstanding on that date. The decrease, by reason of such deduction, in 
the tax imposed by section 11 must not, however, exceed the amount of 
the special dividend referred to in section 941 (b), and is not 
allowable unless the special dividend has been certified to the 
Commissioner by the Secretary of Commerce.

[[Page 233]]



Sec. 1.941-2  Meaning of terms used in connection with China Trade Act
corporations.

    (a) A China Trade Act corporation is one organized under the 
provisions of the China Trade Act, 1922 (15 U.S.C. chapter 4).
    (b) The term ``special dividend'' means the amount which is 
distributed as a dividend to or for the benefit of such persons as on 
the last day of the taxable year were resident in Formosa, Hong Kong, 
the United States, or possessions of the United States, or were 
individual citizens of the United States, and owned shares of stock of 
the corporation. Such dividend must be distributed prior to or at the 
time fixed by law for filing the return of the corporation, including 
the period of any extension of time granted under rules and regulations 
prescribed by the Commissioner with the approval of the Secretary or his 
delegate. Such special dividend does not include any other amounts 
payable or to be payable to such persons or for their benefit by reason 
of their interest in the corporation and must be made in proportion to 
the par value of the shares of stock of the corporation owned by each.
    (c) For the purposes of section 941, the shares of stock of a China 
Trade Act corporation are considered to be owned by the person in whom 
the equitable right to the income from such shares is in good faith 
vested.
    (d) ``Taxable income derived from sources within Formosa and Hong 
Kong'' is the sum of the taxable income from sources wholly within 
Formosa and Hong Kong and that portion of the taxable income from 
sources partly within and partly without Formosa and Hong Kong which may 
be allocated to sources within Formosa and Hong Kong. The method of 
computing this income is similar to that described in part I (section 
861 and following), subchapter N, chapter 1 of the Code, and the 
regulations thereunder.



Sec. 1.941-3  Illustration of principles.

    The application of section 941 may be illustrated by the following 
example:

    Example. (1) The A Company, a China Trade Act corporation, has 
taxable income (computed without regard to the deduction under section 
941) for the calendar year 1954 of $200,000 and receives no dividends 
from domestic corporations. All of its stock on December 31, 1954, is 
owned on that date by persons resident in Formosa, Hong Kong, the United 
States, or possessions of the United States, or individual citizens of 
the United States. It distributes a special dividend amounting to 
$100,000 on February 15, 1955, which is certified by the Secretary of 
Commerce as provided in section 941(b). For the purpose of the tax 
imposed by section 11, it is necessary in this example to make two 
computations, first, without allowing the special deduction from taxable 
income on account of income derived from sources within Formosa and Hong 
Kong, and, second, allowing such deduction. The computations are as 
follows:
    (2) First computation; without allowing the special deduction from 
taxable income.

Taxable income...............................................   $200,000
Normal tax (section 11 (b))..................................     60,000
Surtax (section 11 (c))......................................     38,500
Total income tax.............................................     98,500
 

    (3) Second computation; allowing the special deduction from taxable 
income.

Taxable income.............................................     $200,000
 


Since the total taxable income is derived from sources within Formosa 
and Hong Kong and since the par value of the shares of stock of the 
corporation owned on the last day of the taxable year by (a) persons 
resident in Formosa, Hong Kong, the United States, or possessions of the 
United States, and (b) individual citizens of the United States wherever 
resident, is 100 percent of the par value of the total number of shares 
of stock of the corporation outstanding on that day, 100 percent of such 
taxable income is deductible.

Special deduction from taxable income......................     $200,000
Amount of income subject to tax under section 11...........         None
 

    (4) Since the special dividend ($100,000) exceeds the diminution of 
the tax ($98,500) on account of the allowance of the special deduction 
from taxable income, the entire amount of the special deduction is 
allowable and the corporation has no income tax liability for 1954.



Sec. 1.943-1  Withholding by a China Trade Act corporation.

    Dividends paid by a China Trade Act corporation to a nonresident 
alien individual, foreign partnership, or foreign corporation are 
subject to withholding of tax at source under Sec. 1.1441-1. However, 
see paragraph (c) of Sec. 1.1441-4 for exemption applicable to 
dividends paid to residents of Formosa or Hong Kong.

[T.D. 6908, 31 FR 16769, Dec. 31, 1966]

[[Page 234]]

                     controlled foreign corporations



Sec. 1.951-1  Amounts included in gross income of United States
shareholders.

    (a) In general. If a foreign corporation is a controlled foreign 
corporation (within the meaning of section 957) for an uninterrupted 
period of 30 days or more (determined under paragraph (f) of this 
section) during any taxable year of such corporation beginning after 
December 31, 1962, every person--
    (1) Who is a United States shareholder (as defined in section 951(b) 
and paragraph (g) of this section) of such corporation at any time 
during such taxable year, and
    (2) Who owns (within the meaning of section 958(a)) stock in such 
corporation on the last day, in such year, on which such corporation is 
a controlled foreign corporation shall include in his gross income for 
his taxable year in which or with which such taxable year of the 
corporation ends, the sum of--
    (i) Such shareholder's pro rata share (determined under paragraph 
(b) of this section) of the corporation's subpart F income (as defined 
in section 952) for such taxable year of the corporation,
    (ii) Such shareholder's pro rata share (determined under paragraph 
(c)(1) of this section) of the corporation's previously excluded subpart 
F income withdrawn from investment in less developed countries for such 
taxable year of the corporation,
    (iii) Such shareholder's pro rata share (determined under paragraph 
(c)(2) of this section) of the corporation's previously excluded subpart 
F income withdrawn from investment in foreign base company shipping 
operations for such taxable year of the corporation, and
    (iv) The amount determined under section 956 with respect to such 
shareholder for such taxable year of the corporation (but only to the 
extent not excluded from gross income under section 959(a)(2)).
    (3) For purposes of determining whether a United States shareholder 
which is a domestic corporation is a personal holding company under 
section 542 and Sec. 1.542-1, the character of the amount includible in 
gross income of such domestic corporation under this paragraph shall be 
determined as if such amount were realized directly by such corporation 
from the source from which it is realized by the controlled foreign 
corporation. See paragraph (a) of Sec. 1.957-2 for special limitation 
on the amount of subpart F income in the case of a controlled foreign 
corporation described in section 957(b). See section 970(a) and Sec. 
1.970-1 which provides for the reduction of subpart F income of export 
trade corporations.
    (b) Limitation on a United States shareholder's pro rata share of 
subpart F income--(1) In general. For purposes of paragraph (a)(2)(i) of 
this section, a United States shareholder's pro rata share (determined 
in accordance with the rules of paragraph (e) of this section) of the 
foreign corporation's subpart F income for the taxable year of such 
corporation is--
    (i) The amount which would have been distributed with respect to the 
stock which such shareholder owns (within the meaning of section 958(a)) 
in such corporation if on the last day, in such corporation's taxable 
year, on which such corporation is a controlled foreign corporation it 
had distributed pro rata to its shareholders an amount which bears the 
same ratio to its subpart F income for such taxable year as the part of 
such year during which such corporation is a controlled foreign 
corporation bears to the entire taxable year, reduced by--
    (ii) The amount of distributions received by any other person during 
such taxable year as a dividend with respect to such stock, but only to 
the extent that such distributions do not exceed the dividend which 
would have been received by such other person if the distributions by 
such corporation to all its shareholders had been the amount which bears 
the same ratio to the subpart F income of such corporation for the 
taxable year as the part of such year during which such shareholder did 
not own (within the meaning of section 958(a)) such stock bears to the 
entire taxable year.
    (2) Illustrations. The application of this paragraph may be 
illustrated by the following examples:

    Example 1. A, a United States shareholder, owns 100 percent of the 
only class of stock of M, a controlled foreign corporation throughout 
1963. Both A and M Corporation use the

[[Page 235]]

calendar year as a taxable year. For 1963, M Corporation derives $100 of 
subpart F income, has $100 of earnings and profits, and makes no 
distributions. A must include $100 in his gross income for 1963 under 
section 951(a)(1)(A)(i).
    Example 2. The facts are the same as in example 1, except that 
instead of holding 100 percent of the stock of M Corporation for the 
entire year, A sells 60 percent of such stock to B, a nonresident alien, 
on May 26, 1963. Thus, M Corporation is a controlled foreign corporation 
for the period January 1, 1963, through May 26, 1963. A must include $40 
($100 x 146/365) in his gross income for 1963 under section 
951(a)(1)(A)(i).
    Example 3. The facts are the same as in example 1, except that 
instead of holding 100 percent of the stock of M Corporation for the 
entire year, A holds 60 percent of such stock on December 31, 1963, 
having acquired such interest on May 26, 1963, from B, a nonresident 
alien, who owned such interest from January 1, 1963. Before A's 
acquisition of such stock, M Corporation had distributed a dividend of 
$15 to B in 1963 with respect to such stock. A must include $21 in his 
gross income for 1963 under section 951(a)(1)(A)(i), such amount being 
determined as follows:

Corporation M's Subpart F income for 1963.......................    $100
Less: Reduction under section 951(a)(2)(A) for period (1-1-63         40
 through 5-26-63) during which M Corporation is not a controlled
 foreign corporation ($100 x 146/365)...........................
                                                         ---------
Subpart F income for 1963 as limited by section 951(a)(2)(A)....      60
A's pro rata share of subpart F income as determined under            36
 section 951 (a)(2)(A) (60 percent of $60)......................
Less: Reduction under section 951(a)(2)(B) for dividends
 received by B during 1963 with respect to the stock acquired by
 A in M Corporation:
  (i) Dividend received by B............................      15
  (ii) B's pro rata share of the amount which bears the       24
   same ratio to M Corporation's subpart F income for
   1963 ($100) as the period during which A did not own
   (within the meaning of section 958(a)) his stock (146
   days) bears to the entire taxable year (365 days) (60
   percent of ($100 x 146/365)).........................
  (iii) Amount of reduction (lesser of (i) or (ii)).....  ......      15
                                                                 -------
A's pro rata share of Subpart F income as determined under            21
 section 951(a)(2)..............................................
 

    Example 4. A, a United States shareholder, owns 100 percent of the 
only class of stock of P, a controlled foreign corporation throughout 
1963, and P owns 100 percent of the only class of stock of R, a 
controlled foreign corporation throughout 1963. A and Corporations P and 
R each use the calendar year as a taxable year. For 1963, R Corporation 
derives $100 of subpart F income, has $100 of earnings and profits, and 
distributes a dividend of $20 to P Corporation. Corporation P has no 
income for 1963 other than the dividend received from R Corporation. A 
must include $100 in his gross income for 1963 under section 
951(a)(1)(A)(i) as subpart F income of R Corporation for such year. Such 
subpart F income is not reduced under section 951(a)(2)(B) for the 
dividend of $20 paid to P Corporation because there was no part of the 
year 1963 during which A did not own (within the meaning of section 
958(a)) the stock of R Corporation. By reason of the application of 
section 959(b), the $20 distribution from R Corporation to P Corporation 
is not again includible in the gross income of A under section 951(a).
    Example 5. The facts are the same as in example 4, except that 
instead of holding the stock of R Corporation for the entire year, P 
Corporation acquires 60 percent of the only class of stock of R 
Corporation on March 14, 1963, from C, a nonresident alien, after R 
Corporation distributes in 1963 a dividend of $35 to C with respect to 
the stock so acquired by P Corporation. The stock interest so acquired 
by P Corporation was owned by C from January 1, 1963, until acquired by 
P Corporation. A must include $36 in his gross income for 1963 under 
section 951(a)(1)(A)(i), such amount being determined as follows:

Corporation R's Subpart F income for 1963......................     $100
Less: Reduction under section 951(a)(2)(A) for period (1-1-63         20
 through 3-14-63) during which R Corporation is not a
 controlled foreign corporation ($100 x 73/365)................
                                                       ----------
Subpart F income for 1963 as limited by section 951(a)(2)(A)...       80
A's pro rata share of subpart F income as determined under            48
 section 951 (a)(2)(A) (60 percent of $80).....................
Less: Reduction under section 951(a)(2)(B) for dividends
 received by C during 1963 with respect to the stock indirectly
 acquired by A in R Corporation:
  (i) Dividend received by C..........................       35
  (ii) C's pro rata share of the amount which bears          12
   the same ratio to R Corporation's Subpart F income
   for 1963 ($100) as the period during which A did
   not indirectly own (within the meaning of section
   958(a)(2)) his stock (73 days) bears to the entire
   taxable year (365 days) (60 percent of ($100 x 73/
   365))..............................................
                                                       ----------
  (iii) Amount of reduction (lesser of (i) or (ii))...  .......       12
                                                                --------
A's pro rata share of Subpart F income as determined under            36
 section 951 (a)(2)............................................
 

    (c) Limitation on a United States shareholder's pro rata share of 
previously excluded subpart F income withdrawn from investments--(1) 
Investments in less developed countries. For purposes of paragraph 
(a)(2)(ii) of this section, a United States shareholder's pro rata share 
(determined in accordance with the rules of paragraph (e) of this 
section) of the

[[Page 236]]

foreign corporation's previously excluded subpart F income withdrawn 
from investment in less developed countries for the taxable year of such 
corporation shall not exceed an amount which bears the same ratio to 
such shareholder's pro rata share of such income withdrawn (as 
determined under section 955(a)(3), as in effect before the enactment of 
the Tax Reduction Act of 1975, and paragraph (c) of Sec. 1.955-1) for 
such taxable year as the part of such year during which such corporation 
is a controlled foreign corporation bears to the entire taxable year. 
See paragraph (c)(2) of Sec. 1.955-1 for a special rule applicable to 
exclusions and withdrawals occurring before the date on which the United 
States shareholder acquires his stock.
    (2) Investments in foreign base company shipping operations. For 
purposes of paragraph (a)(2)(iii) of this section, a United States 
shareholder's pro rata share (determined in accordance with the rules of 
paragraph (e) of this section) of the foreign corporation's previously 
excluded subpart F income withdrawn from investment in foreign base 
company shipping operations for the taxable year of such corporation 
shall not exceed an amount which bears the same ratio to such 
shareholder's pro rata share of such income withdrawn (as determined 
under section 955(a)(3) and paragraph (c) of Sec. 1.955A-1) for such 
taxable year as the part of such year during which such corporation is a 
controlled foreign corporation bears to the entire taxable year. See 
paragraph (c)(2) of Sec. 1.955A-1 for a special rule applicable to 
exclusions and withdrawals occurring before the date on which the United 
States shareholder acquires his stock.
    (d) [Reserved]
    (e) Pro rata share defined--(1) In general. For purposes of 
paragraphs (b) and (c) of this section, a United States shareholder's 
pro rata share of the controlled foreign corporation's subpart F income, 
previously excluded subpart F income withdrawn from investment in less 
developed countries, or previously excluded subpart F income withdrawn 
from investment in foreign base company shipping operations, 
respectively, for any taxable year is his pro rata share determined 
under Sec. 1.952-1(a), Sec. 1.955-1(c), or Sec. 1.955A-1(c), 
respectively.
    (2) One class of stock. If a controlled foreign corporation for a 
taxable year has only one class of stock outstanding, each United States 
shareholder's pro rata share of such corporation's subpart F income or 
withdrawal for the taxable year under paragraph (e)(1) of this section 
shall be determined by allocating the controlled foreign corporation's 
earnings and profits on a per share basis.
    (3) More than one class of stock--(i) In general. Subject to 
paragraphs (e)(3)(ii) through (e)(3)(v) of this section, if a controlled 
foreign corporation for a taxable year has more than one class of stock 
outstanding, the amount of such corporation's subpart F income or 
withdrawal for the taxable year taken into account with respect to any 
one class of stock for purposes of paragraph (e)(1) of this section 
shall be that amount which bears the same ratio to the total of such 
subpart F income or withdrawal for such year as the earnings and profits 
which would be distributed with respect to such class of stock if all 
earnings and profits of such corporation for such year (not reduced by 
actual distributions during the year) were distributed on the last day 
of such corporation's taxable year on which such corporation is a 
controlled foreign corporation (the hypothetical distribution date), 
bear to the total earnings and profits of such corporation for such 
taxable year.
    (ii) Discretionary power to allocate earnings to different classes 
of stock--(A) In general. Subject to paragraph (e)(3)(iii) of this 
section, the rules of this paragraph apply for purposes of paragraph 
(e)(1) of this section if the allocation of a controlled foreign 
corporation's earnings and profits for the taxable year between two or 
more classes of stock depends upon the exercise of discretion by that 
body of persons which exercises with respect to such corporation the 
powers ordinarily exercised by the board of directors of a domestic 
corporation (discretionary distribution rights). First, the earnings and 
profits of the corporation are allocated under paragraph (e)(3)(i) of 
this section to any class or classes of stock with non-discretionary 
distribution

[[Page 237]]

rights (e.g., preferred stock entitled to a fixed return). Second, the 
amount of earnings and profits allocated to a class of stock with 
discretionary distribution rights shall be that amount which bears the 
same ratio to the remaining earnings and profits of such corporation for 
such taxable year as the value of all shares of such class of stock, 
determined on the hypothetical distribution date, bears to the total 
value of all shares of all classes of stock with discretionary 
distribution rights of such corporation, determined on the hypothetical 
distribution date. For purposes of the preceding sentence, in the case 
where the value of each share of two or more classes of stock with 
discretionary distribution rights is substantially the same on the 
hypothetical distribution date, the allocation of earnings and profits 
to such classes shall be made as if such classes constituted one class 
of stock in which each share has the same rights to dividends as any 
other share.
    (B) Special rule for redemption rights. For purposes of paragraph 
(e)(3)(ii)(A) of this section, discretionary distribution rights do not 
include rights to redeem shares of a class of stock (even if such 
redemption would be treated as a distribution of property to which 
section 301 applies pursuant to section 302(d)).
    (iii) Special allocation rule for stock with mixed distribution 
rights. For purposes of paragraphs (e)(3)(i) and (e)(3)(ii) of this 
section, in the case of a class of stock with both discretionary and 
non-discretionary distribution rights, earnings and profits shall be 
allocated to the non-discretionary distribution rights under paragraph 
(e)(3)(i) of this section and to the discretionary distribution rights 
under paragraph (e)(3)(ii) of this section. In such a case, paragraph 
(e)(3)(ii) of this section will be applied such that the value used in 
the ratio will be the value of such class of stock solely attributable 
to the discretionary distribution rights of such class of stock.
    (iv) Dividend arrearages. For purposes of paragraph (e)(3)(i) of 
this section, if an arrearage in dividends for prior taxable years 
exists with respect to a class of preferred stock of such corporation, 
the earnings and profits for the taxable year shall be attributed to 
such arrearage only to the extent such arrearage exceeds the earnings 
and profits of such corporation remaining from prior taxable years 
beginning after December 31, 1962, or the date on which such stock was 
issued, whichever is later.
    (v) Earnings and profits attributable to certain section 304 
transactions. For taxable years of a controlled foreign corporation 
beginning on or after January 1, 2006, if a controlled foreign 
corporation has more than one class of stock outstanding and the 
corporation has earnings and profits and subpart F income for a taxable 
year attributable to a transaction described in section 304, and such 
transaction is part of a plan a principal purpose of which is the 
avoidance of Federal income taxation, the amount of such earnings and 
profits allocated to any one class of stock shall be that amount which 
bears the same ratio to the remainder of such earnings and profits as 
the value of all shares of such class of stock, determined on the 
hypothetical distribution date, bears to the total value of all shares 
of all classes of stock of the corporation, determined on the 
hypothetical distribution date.
    (4) Scope of hypothetical distribution--(i) Redemption rights. 
Notwithstanding the terms of any class of stock of the controlled 
foreign corporation or any agreement or arrangement with respect 
thereto, no amount shall be considered to be distributed as part of the 
hypothetical distribution with respect to a particular class of stock 
for purposes of paragraph (e)(3) of this section to the extent that a 
distribution of such amount would constitute a distribution in 
redemption of stock (even if such redemption would be treated as a 
distribution of property to which section 301 applies pursuant to 
section 302(d)), a distribution in liquidation, or a return of capital.
    (ii) Certain cumulative preferred stock. For taxable years of a 
controlled foreign corporation beginning on or after January 1, 2006, if 
a controlled foreign corporation has one or more classes of preferred 
stock with cumulative dividend rights, such stock shall be considered 
for the purposes of this section as stock with discretionary 
distribution rights. As a result, the provisions of

[[Page 238]]

paragraph (e)(3)(ii) of this section shall apply for purposes of 
allocating earnings and profits to such stock, except that earnings and 
profits shall first be allocated to the stock under paragraph (e)(3)(i) 
of this section to the extent of any dividends paid with respect to the 
stock during the taxable year. Additional earnings and profits will be 
allocated to the stock only in an amount equal to the excess (if any) of 
the amount of earnings and profits allocated to the stock under 
paragraph (e)(3)(ii) of this section over the amount of such dividends. 
Notwithstanding the foregoing, if a class of redeemable preferred stock 
with cumulative dividend rights has a mandatory redemption date, and all 
dividend arrearages with respect to such stock compound at least 
annually at a rate that is not lower than the applicable Federal rate 
(as defined in section 1274(d)(1)) (AFR) that applies on the date the 
stock is issued for the term from such issue date to the mandatory 
redemption date, based on a comparable compounding assumption, such 
stock shall not be considered for purposes of this section as stock with 
discretionary distribution rights.
    (5) Restrictions or other limitations on distributions--(i) In 
general. A restriction or other limitation on distributions of earnings 
and profits by a controlled foreign corporation will not be taken into 
account, for purposes of this section, in determining the amount of 
earnings and profits that shall be allocated to a class of stock of the 
controlled foreign corporation or the amount of the United States 
shareholder's pro rata share of the controlled foreign corporation's 
subpart F income or withdrawal for the taxable year.
    (ii) Definition. For purposes of this section, a restriction or 
other limitation on distributions includes any limitation that has the 
effect of limiting the allocation or distribution of earnings and 
profits by a controlled foreign corporation to a United States 
shareholder, other than currency or other restrictions or limitations 
imposed under the laws of any foreign country as provided in section 
964(b).
    (iii) Exception for certain preferred distributions. The right to 
receive periodically a fixed amount (whether determined by a percentage 
of par value, a reference to a floating coupon rate, a stated return 
expressed in terms of a certain amount of dollars or foreign currency, 
or otherwise) with respect to a class of stock the distribution of which 
is a condition precedent to a further distribution of earnings or 
profits that year with respect to any class of stock (not including a 
distribution in partial or complete liquidation) is not a restriction or 
other limitation on the distribution of earnings and profits by a 
controlled foreign corporation under paragraph (e)(5) of this section.
    (iv) Illustrative list of restrictions and limitations. Except as 
provided in paragraph (e)(5)(iii) of this section, restrictions or other 
limitations on distributions include, but are not limited to--
    (A) An arrangement that restricts the ability of the controlled 
foreign corporation to pay dividends on a class of shares of the 
corporation owned by United States shareholders until a condition or 
conditions are satisfied (e.g., until another class of stock is 
redeemed);
    (B) A loan agreement entered into by a controlled foreign 
corporation that restricts or otherwise affects the ability to make 
distributions on its stock until certain requirements are satisfied; or
    (C) An arrangement that conditions the ability of the controlled 
foreign corporation to pay dividends to its shareholders on the 
financial condition of the controlled foreign corporation.
    (6) Examples. The application of this section may be illustrated by 
the following examples:

    Example 1. (i) Facts. FC1, a controlled foreign corporation within 
the meaning of section 957(a), has outstanding 100 shares of one class 
of stock. Corp E, a domestic corporation and a United States shareholder 
of FC1, within the meaning of section 951(b), owns 60 shares. Corp H, a 
domestic corporation and a United States shareholder of FC1, within the 
meaning of section 951(b), owns 40 shares. FC1, Corp E, and Corp H each 
use the calendar year as a taxable year. Corp E and Corp H are 
shareholders of FC1 for its entire 2005 taxable year. For 2005, FC1 has 
$100x of earnings and profits, and income of $100x with respect to which 
amounts are required to be included in gross income of United States 
shareholders under section 951(a). FC1 makes no distributions during 
that year.

[[Page 239]]

    (ii) Analysis. FC1 has one class of stock. Therefore, under 
paragraph (e)(2) of this section, FC1's earnings and profits are 
allocated on a per share basis. Accordingly, for the taxable year 2005, 
Corp E's pro rata share of FC1's subpart F income is $60x (60 / 100 x 
$100x) and Corp H's pro rata share of FC1's subpart F income is $40x (40 
/ 100 x $100x).
    Example 2. (i) Facts. FC2, a controlled foreign corporation within 
the meaning of section 957(a), has outstanding 70 shares of common stock 
and 30 shares of 4-percent, nonparticipating, voting, preferred stock 
with a par value of $10x per share. The common shareholders are entitled 
to dividends when declared by the board of directors of FC2. Corp A, a 
domestic corporation and a United States shareholder of FC2, within the 
meaning of section 951(b), owns all of the common shares. Individual B, 
a foreign individual, owns all of the preferred shares. FC2 and Corp A 
each use the calendar year as a taxable year. Corp A and Individual B 
are shareholders of FC2 for its entire 2005 taxable year. For 2005, FC2 
has $50x of earnings and profits, and income of $50x with respect to 
which amounts are required to be included in gross income of United 
States shareholders under section 951(a). In 2005, FC2 distributes as a 
dividend $12x to Individual B with respect to Individual B's preferred 
shares. FC2 makes no other distributions during that year.
    (ii) Analysis. FC2 has two classes of stock, and there are no 
restrictions or other limitations on distributions within the meaning of 
paragraph (e)(5) of this section. If the total $50x of earnings were 
distributed on December 31, 2005, $12x would be distributed with respect 
to Individual B's preferred shares and the remainder, $38x, would be 
distributed with respect to Corp A's common shares. Accordingly, under 
paragraph (e)(3)(i) of this section, Corp A's pro rata share of FC1's 
subpart F income is $38x for taxable year 2005.
    Example 3. (i) Facts. The facts are the same as in Example 2, except 
that the shares owned by Individual B are Class B common shares and the 
shares owned by Corp A are Class A common shares and the board of 
directors of FC2 may declare dividends with respect to one class of 
stock without declaring dividends with respect to the other class of 
stock. The value of the Class A common shares on the last day of FC2's 
2005 taxable year is $680x and the value of the Class B common shares on 
that date is $300x. The board of directors of FC2 determines that FC2 
will not make any distributions in 2005 with respect to the Class A and 
B common shares of FC2.
    (ii) Analysis. The allocation of FC2's earnings and profits between 
its Class A and Class B common shares depends solely on the exercise of 
discretion by the board of directors of FC2. Therefore, under paragraph 
(e)(3)(ii)(A) of this section, the allocation of earnings and profits 
between the Class A and Class B common shares will depend on the value 
of each class of stock on the last day of the controlled foreign 
corporation's taxable year. On the last day of FC2's taxable year 2005, 
the Class A common shares had a value of $9.30x/share and the Class B 
common shares had a value of $10x/share. Because each share of the Class 
A and Class B common stock of FC2 has substantially the same value on 
the last day of FC2's taxable year, under paragraph (e)(3)(ii)(A) of 
this section, for purposes of allocating the earnings and profits of 
FC2, the Class A and Class B common shares will be treated as one class 
of stock. Accordingly, for FC2's taxable year 2005, the earnings and 
profits of FC2 are allocated $35x (70 / 100 x $50x) to the Class A 
common shares and $15x (30 / 100 x $50x) to the Class B common shares. 
For its taxable year 2005, Corp A's pro rata share of FC2's subpart F 
income will be $35x.
    Example 4. (i) Facts. FC3, a controlled foreign corporation within 
the meaning of section 957(a), has outstanding 100 shares of Class A 
common stock, 100 shares of Class B common stock and 10 shares of 5-
percent nonparticipating, voting preferred stock with a par value of 
$50x per share. The value of the Class A shares on the last day of FC3's 
2005 taxable year is $800x. The value of the Class B shares on that date 
is $200x. The Class A and Class B shareholders each are entitled to 
dividends when declared by the board of directors of FC3, and the board 
of directors of FC3 may declare dividends with respect to one class of 
stock without declaring dividends with respect to the other class of 
stock. Corp D, a domestic corporation and a United States shareholder of 
FC3, within the meaning of section 951(b), owns all of the Class A 
shares. Corp N, a domestic corporation and a United States shareholder 
of FC3, within the meaning of section 951(b), owns all of the Class B 
shares. Corp S, a domestic corporation and a United States shareholder 
of FC3, within the meaning of section 951(b), owns all of the preferred 
shares. FC3, Corp D, Corp N, and Corp S each use the calendar year as a 
taxable year. Corp D, Corp N, and Corp S are shareholders of FC3 for all 
of 2005. For 2005, FC3 has $100x of earnings and profits, and income of 
$100x with respect to which amounts are required to be included in gross 
income of United States shareholders under section 951(a). In 2005, FC3 
distributes as a dividend $25x to Corp S with respect to the preferred 
shares. The board of directors of FC3 determines that FC3 will make no 
other distributions during that year.
    (ii) Analysis. The distribution rights of the preferred shares are 
not a restriction or other limitation within the meaning of paragraph 
(e)(5) of this section. Pursuant to paragraph (e)(3)(i) of this section, 
if the total $100x of earnings were distributed on December 31, 2005, 
$25x would be distributed with

[[Page 240]]

respect to Corp S's preferred shares and the remainder, $75x would be 
distributed with respect to Corp D's Class A shares and Corp N's Class B 
shares. The allocation of that $75x between its Class A and Class B 
shares depends solely on the exercise of discretion by the board of 
directors of FC3. The value of the Class A shares ($8x/share) and the 
value of the Class B shares ($2x/share) are not substantially the same 
on the last day of FC3's taxable year 2005. Therefore for FC3's taxable 
year 2005, under paragraph (e)(3)(ii)(A) of this section, the earnings 
and profits of FC3 are allocated $60x ($800 / $1,000 x $75x) to the 
Class A shares and $15x ($200 / $1,000 x $75x) to the Class B shares. 
For the 2005 taxable year, Corp D's pro rata share of FC3's subpart F 
income will be $60x, Corp N's pro rata share of FC3's subpart F income 
will be $15x and Corp S's pro rata share of FC3's subpart F income will 
be $25x.
    Example 5. (i) Facts. FC4, a controlled foreign corporation within 
the meaning of section 957(a), has outstanding 40 shares of 
participating, voting, preferred stock and 200 shares of common stock. 
The owner of a share of preferred stock is entitled to an annual 
dividend equal to 0.5-percent of FC4's retained earnings for the taxable 
year and also is entitled to additional dividends when declared by the 
board of directors of FC4. The common shareholders are entitled to 
dividends when declared by the board of directors of FC4. The board of 
directors of FC4 has discretion to pay dividends to the participating 
portion of the preferred shares (after the payment of the preference) 
and the common shares. The value of the preferred shares on the last day 
of FC4's 2005 taxable year is $600x ($100x of this value is attributable 
to the discretionary distribution rights of these shares) and the value 
of the common shares on that date is $400x. Corp E, a domestic 
corporation and United States shareholder of FC4, within the meaning of 
section 951(b), owns all of the preferred shares. FC5, a foreign 
corporation that is not a controlled foreign corporation within the 
meaning of section 957(a), owns all of the common shares. FC 4 and Corp 
E each use the calendar year as a taxable year. Corp E and FC5 are 
shareholders of FC4 for all of 2005. For 2005, FC4 has $100x of earnings 
and profits, and income of $100x with respect to which amounts are 
required to be included in gross income of United States shareholders 
under section 951(a). In 2005, FC4's retained earnings are equal to its 
earnings and profits. FC4 distributes as a dividend $20x to Corp E that 
year with respect to Corp E's preferred shares. The board of directors 
of FC4 determines that FC4 will not make any other distributions during 
that year.
    (ii) Analysis. The non-discretionary distribution rights of the 
preferred shares are not a restriction or other limitation within the 
meaning of paragraph (e)(5) of this section. The allocation of FC4's 
earnings and profits between its preferred shares and common shares 
depends, in part, on the exercise of discretion by the board of 
directors of FC4 because the preferred shares are shares with both 
discretionary distribution rights and non-discretionary distribution 
rights. Paragraph (e)(3)(i) of this section is applied first to 
determine the allocation of earnings and profits of FC4 to the non-
discretionary distribution rights of the preferred shares. If the total 
$100x of earnings were distributed on December 31, 2005, $20x would be 
distributed with respect to the non-discretionary distribution rights of 
Corp E's preferred shares. Accordingly, $20x would be allocated to such 
shares under paragraphs (e)(3)(i) and (iii) of this section. The 
remainder, $80x, would be allocated under paragraph (e)(3)(ii)(A) and 
(e)(3)(iii) of this section between the preferred and common shares by 
reference to the value of the discretionary distribution rights of the 
preferred shares and the value of the common shares. Therefore, the 
remaining $80x of earnings and profits of FC4 are allocated $16x ($100x 
/ $500x x $80x) to the preferred shares and $64x ($400x / $500x x $80) 
to the common shares. For its taxable year 2005, Corp E's pro rata share 
of FC4's subpart F income will be $36x ($20x + $16x).
    Example 6. (i) Facts. FC6, a controlled foreign corporation within 
the meaning of section 957(a), has outstanding 10 shares of common stock 
and 400 shares of 2-percent nonparticipating, voting, preferred stock 
with a par value of $1x per share. The common shareholders are entitled 
to dividends when declared by the board of directors of FC6. Corp M, a 
domestic corporation and a United States shareholder of FC6, within the 
meaning of section 951(b), owns all of the common shares. FC7, a foreign 
corporation that is not a controlled foreign corporation within the 
meaning of section 957(a), owns all of the preferred shares. Corp M and 
FC7 cause the governing documents of FC6 to provide that no dividends 
may be paid to the common shareholders until FC6 cumulatively earns 
$100,000x of income. FC6 and Corp M each use the calendar year as a 
taxable year. Corp M and FC7 are shareholders of FC6 for all of 2005. 
For 2005, FC6 has $50x of earnings and profits, and income of $50x with 
respect to which amounts are required to be included in gross income of 
United States shareholders under section 951(a). In 2005, FC6 
distributes as a dividend $8x to FC7 with respect to FC7's preferred 
shares. FC6 makes no other distributions during that year.
    (ii) Analysis. The agreement restricting FC6's ability to pay 
dividends to common shareholders until FC6 cumulatively earns $100,000x 
of income is a restriction or other limitation, within the meaning of 
paragraph (e)(5) of this section, and will be disregarded for purposes 
of calculating Corp M's pro rata

[[Page 241]]

share of subpart F income. The non-discretionary distribution rights of 
the preferred shares are not a restriction or other limitation within 
the meaning of paragraph (e)(5) of this section. If the total $50x of 
earnings were distributed on December 31, 2005, $8x would be distributed 
with respect to FC7's preferred shares and the remainder, $42x, would be 
distributed with respect to Corp M's common shares. Accordingly, under 
paragraph (e)(3)(i) of this section, Corp M's pro rata share of FC6's 
subpart F income is $42x for taxable year 2005.
    Example 7. (i) Facts. FC8, a controlled foreign corporation within 
the meaning of section 957(a), has outstanding 40 shares of common stock 
and 10 shares of 4-percent voting preferred stock with a par value of 
$50x per share. Pursuant to the terms of the preferred stock, FC8 has 
the right to redeem at any time, in whole or in part, the preferred 
stock. FP, a foreign corporation, owns all of the preferred shares. Corp 
G, a domestic corporation wholly owned by FP and a United States 
shareholder of FC8, within the meaning of section 951(b), owns all of 
the common shares. FC8 and Corp G each use the calendar year as a 
taxable year. FP and Corp G are shareholders of FC8 for all of 2005. For 
2005, FC8 has $100x of earnings and profits, and income of $100x with 
respect to which amounts are required to be included in gross income of 
a United States shareholder under section 951(a). In 2005, FC8 
distributes as a dividend $20x to FP with respect to FP's preferred 
shares. FC8 makes no other distributions during that year.
    (ii) Analysis. Pursuant to paragraph (e)(3)(ii)(B) of this section, 
the redemption rights of the preferred shares will not be treated as a 
discretionary distribution right under paragraph (e)(3)(ii)(A) of this 
section. Further, if FC8 were treated as having redeemed any preferred 
shares under paragraph (e)(3)(i) of this section, the redemption would 
be treated as a distribution to which section 301 applies under section 
302(d) due to FP's constructive ownership of the common shares. However, 
pursuant to paragraph (e)(4) of this section, no amount of earnings and 
profits would be allocated to the preferred shareholders on the 
hypothetical distribution date, under paragraph (e)(3)(i) of this 
section, as a result of FC8's right to redeem, in whole or in part, the 
preferred shares. FC8's redemption rights with respect to the preferred 
shares cannot affect the allocation of earnings and profits between 
FC8's shareholders. Therefore, the redemption rights are not 
restrictions or other limitations within the meaning of paragraph (e)(5) 
of this section. Additionally, the non-discretionary distribution rights 
of the preferred shares are not restrictions or other limitations within 
the meaning of paragraph (e)(5) of this section. Therefore, if the total 
$100x of earnings were distributed on December 31, 2005, $20x would be 
distributed with respect to FP's preferred shares and the remainder, 
$80x, would be distributed with respect to Corp G's common shares. 
Accordingly, under paragraph (e)(3)(i) of this section, Corp G's pro 
rata share of FC8's subpart F income is $80 for taxable year 2005.
    Example 8. (i) Facts. FC9, a controlled foreign corporation within 
the meaning of section 957(a), has outstanding 40 shares of common stock 
and 60 shares of 6-percent, nonparticipating, nonvoting, preferred stock 
with a par value of $100x per share. Individual J, a United States 
shareholder of FC9, within the meaning of section 951(b), who uses the 
calendar year as a taxable year, owns 30 shares of the common stock, and 
15 shares of the preferred stock during tax year 2005. The remaining 10 
common shares and 45 preferred shares of FC9 are owned by Individual N, 
a foreign individual. Individual J and Individual N are shareholders of 
FC9 for all of 2005. For taxable year 2005, FC9 has $1,000x of earnings 
and profits, and income of $500x with respect to which amounts are 
required to be included in gross income of United States shareholders 
under section 951(a).
    (ii) Analysis. The non-discretionary distribution rights of the 
preferred shares are not a restriction or other limitation within the 
meaning of paragraph (e)(5) of this section. If the total $1,000x of 
earnings and profits were distributed on December 31, 2005, $360x (0.06 
x $100x x 60) would be distributed with respect to FC9's preferred stock 
and $640x ($1,000x minus $360x) would be distributed with respect to its 
common stock. Accordingly, of the $500x with respect to which amounts 
are required to be included in gross income of United States 
shareholders under section 951(a), $180x ($360x / $1,000x x $500x) is 
allocated to the outstanding preferred stock and $320x ($640x / $1,000x 
x $500x) is allocated to the outstanding common stock. Therefore, under 
paragraph (e)(3)(i) of this section, Individual J's pro rata share of 
such amounts for 2005 is $285x [($180x x 15 / 60) + ($320x x 30 / 40)].
    Example 9. (i) Facts. In 2006, FC10, a controlled foreign 
corporation within the meaning of section 957(a), has outstanding 100 
shares of common stock and 100 shares of 6-percent, voting, preferred 
stock with a par value of $10x per share. All of the common stock is 
held by Corp H, a foreign corporation, which invested $1000x in FC10 in 
exchange for the common stock. All of the preferred stock is held by 
Corp J, a domestic corporation, which invested $5000x in FC10 in 
exchange for the preferred stock. Corp H is unrelated to Corp J. In 
2006, FC10 borrows $3000x from a bank and invests $5000x in preferred 
stock issued by FC11, a foreign corporation the common stock of which is 
owned by Corp J. Corp J's adjusted basis in its FC 11 common stock is 
$5000x. FC11,

[[Page 242]]

which has no current or accumulated earnings and profits, distributes 
the $5000x to Corp J. Subsequently, in 2007, FC10 sells the FC11 
preferred stock to FC12, a wholly-owned foreign subsidiary of FC11 that 
has $5000x of accumulated earnings and profits, for $5000x in a 
transaction described in section 304. FC10 repays the bank loan in full. 
For 2007, FC10 has $5000x of earnings and profits, all of which is 
subpart F income attributable to a section 304 dividend arising from 
FC10's sale of the FC11 preferred stock to FC12. At all relevant times, 
the value of the common stock of FC10 is $1000x and the value of the 
preferred stock of FC10 is $5000x.
    (ii) Analysis. The acquisition and sale of the FC11 preferred stock 
by FC10 was part of a plan a principal purpose of which was the 
avoidance of Federal income tax by depleting the earnings and profits of 
FC12 and allowing FC11 to make a distribution to Corp J that it 
characterizes entirely as a return of basis. FC10 has $5000x of earnings 
and profits for 2007 attributable to a dividend from a section 304 
transaction which was part of such plan. Under paragraph (e)(3)(v) of 
this section, these earnings and profits are allocated to the common and 
preferred stock of FC10 in accordance with the relative value of each 
class of stock ($1000x and $5000x, respectively). Thus, for taxable year 
2007, $833x (\1/6\ x $5000x = $833x) of these earnings and profits is 
allocated to FC10's common stock and $4167x (\5/6\ x $5000x = $4167x) is 
allocated to its preferred stock.

    (7) Effective dates. Except as provided in paragraphs (e)(3)(v) and 
(e)(4)(ii) of this section, this paragraph (e) applies for taxable years 
of a controlled foreign corporation beginning on or after January 1, 
2005. However, if the application of this paragraph (e) for purposes of 
a related Internal Revenue Code provision, such as section 1248, results 
in an allocation to the stock of such corporation of earnings and 
profits that have already been allocated to the stock for an earlier 
year under the prior rules of Sec. 1.951-1(e), as contained in 26 CFR 
part 1 revised April 1, 2005, then the prior rules will continue to 
apply to the extent necessary to avoid such duplicative allocation.
    (f) Determination of holding period. For purposes of sections 951 
through 964, the holding period of an asset (including stock of a 
controlled foreign corporation) shall be determined by excluding the day 
on which such asset is acquired and including the day on which such 
asset is disposed of. The application of this paragraph may be 
illustrated by the following example:

    Example. On June 30, 1963, United States person E acquires 70 of the 
100 shares of the only class of stock of foreign corporation A from 
nonresident alien B, who until such time owns all such 100 shares. E 
sells 10 shares of stock of such corporation on November 30, 1963, and 
60 shares on December 31, 1963, to nonresident alien F. Corporation A is 
a controlled foreign corporation for the period beginning with July 1, 
1963, and extending through December 31, 1963. As to the 10 shares of 
stock sold on November 30, 1963, E is treated as not owning such shares 
at any time after November 30, 1963, nor before July 1, 1963. As to the 
remaining 60 shares of stock, E is treated as not owning them before 
July 1, 1963, or after December 31, 1963.

    (g) United States shareholder defined--(1) In general. For purposes 
of sections 951 through 964, the term ``United States shareholder'' 
means, with respect to a foreign corporation, a United States person (as 
defined in section 957(d)) who owns within the meaning of section 
958(a), or is considered as owning by applying the rules of ownership of 
section 958(b), 10 percent or more of the total combined voting power of 
all classes of stock entitled to vote of such foreign corporation.
    (2) Percentage of total combined voting power owned by United States 
person--(i) Meaning of combined voting power. In determining for 
purposes of subparagraph (1) of this paragraph whether a United States 
person owns the requisite percentage of voting power of all classes of 
stock entitled to vote, consideration will be given to all the facts and 
circumstances in each case. In any case where--
    (a) A foreign corporation has more than one class of stock 
outstanding, and
    (b) One or more United States persons own (within the meaning of 
section 958) shares of any one class of stock which possesses the power 
to elect, appoint, or replace a person, or persons, who with respect to 
such corporation, exercise the powers ordinarily exercised by a member 
of the board of directors of a domestic corporation,


the percentage of the total combined voting power with respect to such 
corporation owned by any such United States person shall be his 
proportionate share of the percentage of the

[[Page 243]]

persons exercising the powers ordinarily exercised by members of the 
board of directors of a domestic corporation (described in (b) of this 
subdivision) which such class of stock (as a class) possesses the power 
to elect, appoint, or replace. In all cases, however, a United States 
person will be deemed to own 10 percent or more of the total combined 
voting power with respect to a foreign corporation if such person owns 
(within the meaning of section 958) 20 percent or more of the total 
number of shares of a class of stock of such corporation possessing one 
or more powers enumerated in paragraph (b)(1) of Sec. 1.957-1. Whether 
a foreign corporation is a controlled foreign corporation for purposes 
of sections 951 through 964 shall be determined by applying the rules of 
section 957 and Sec. Sec. 1.957-1 through 1.957-4.
    (ii) Illustration. The application of this paragraph may be 
illustrated by the following examples:

    Example 1. Foreign corporation S has two classes of capital stock 
outstanding, consisting of 60 shares of class A stock and 40 shares of 
class B stock. Each class of the outstanding stock is entitled to 
participate on a share for share basis in any dividend distributions by 
S Corporation. The owners of a majority of the class A stock are 
entitled to elect 7 of the 10 corporate directors, and the owners of a 
majority of the class B stock are entitled to elect the other 3 of the 
10 directors. Thus, the class A stock (as a class) possesses 70 percent 
of the total combined voting power of all classes of stock entitled to 
vote of S Corporation, and the class B stock (as a class) possesses 30 
percent of such voting power. D, a United States person, owns 31 shares 
of the class A stock and thus owns 36,167 percent (31/60 x 70 percent) 
of the total combined voting power of all classes of stock entitled to 
vote of S Corporation. By reason of the ownership of such voting power, 
D is a United States shareholder of S Corporation under section 951(b). 
For purposes of section 957, S Corporation is a controlled foreign 
corporation by reason of D's ownership of a majority of the class A 
stock, as illustrated in example 2 of paragraph (c) of Sec. 1.957-1. E, 
a United States person, owns eight shares of the class A stock and thus 
owns 9.333 percent (8/60 x 70 percent) of the total combined voting 
power of all classes of stock entitled to vote of S Corporation. Since E 
owns only 9.333 percent of such voting power and less than 20 percent of 
the number of shares of the class A stock, he is not a United States 
shareholder of S Corporation under section 951(b). F, a United States 
person, owns 14 shares of the class B stock and thus owns 10.5 percent 
(14/40 x 30 percent) of the total combined voting power of all classes 
of stock entitled to vote of S Corporation. By reason of the ownership 
of such voting power, F is a United States shareholder of S Corporation 
under section 951(b).
    Example 2. Foreign corporation R has three classes of stock 
outstanding, consisting of 10 shares of class A stock, 20 shares of 
class B stock, and 300 shares of class C stock. Each class of the 
outstanding stock is entitled to participate on a share for share basis 
in any distribution by R Corporation. The owners of a majority of the 
class A stock are entitled to elect 6 of the 10 corporate directors, and 
the owners of a majority of the class B stock are entitled to elect the 
other 4 of the 10 directors. The class C stock is not entitled to vote. 
D, E, and F, United States persons, each own 2 shares of the class A 
stock and 100 shares of the class C stock. As owners of a majority of 
the class A stock, D, E, and F elect 6 members of the board of 
directors. D, E, and F are United States shareholders of R Corporation 
under section 951(b) since each owns 20 percent of the total number of 
shares of the class A stock which possesses the power to elect a 
majority of the board of directors of R Corporation. For purposes of 
section 957, R Corporation is a controlled foreign corporation by reason 
of the ownership by D, E, and F of a majority of the class A stock, as 
illustrated in example 2 of paragraph (c) of Sec. 1.957-1.

[T.D. 6795, 30 FR 935, Jan. 29, 1965, as amended by T.D. 7893, 48 FR 
22507, May 19, 1983; T.D. 9222, 70 FR 49866, Aug. 25, 2005; 70 FR 67906, 
Nov. 9, 2005; T.D. 9251, 71 FR 8944, Feb. 22, 2006]



Sec. 1.951-2  Coordination of subpart F with election of a foreign
investment company to distribute income.

    A United States shareholder who for his taxable year is a qualified 
shareholder (within the meaning of section 1247(c)) of a foreign 
investment company with respect to which an election under section 
1247(a) and the regulations thereunder is in effect for the taxable year 
of such company which ends with or within such taxable year of such 
shareholder shall not be required to include any amount in his gross 
income for his taxable year under paragraph (a) of Sec. 1.951-1 with 
respect to such company for that taxable year of such company.

[T.D. 6795, 30 FR 937, Jan. 29, 1965]

[[Page 244]]



Sec. 1.951-3  Coordination of subpart F with foreign personal holding
company provisions.

    A United States shareholder (as defined in section 951(b)) who is 
required under section 551(b) to include in his gross income for his 
taxable year his share of the undistributed foreign personal holding 
company income for the taxable year of a foreign personal holding 
company (as defined in section 552) which for that taxable year is a 
controlled foreign corporation (as defined in section 957) shall not be 
required to include in his gross income for his taxable year under 
section 951(a) and paragraph (a) of Sec. 1.951-1 any amount 
attributable to the earnings and profits of such corporation for that 
taxable year of such corporation. If a foreign corporation is both a 
foreign personal holding company and a controlled foreign corporation 
for the same period which is only a part of its taxable year, then, for 
purposes of applying the immediately preceding sentence, such 
corporation shall be deemed to be, for such part of such year, a foreign 
personal holding company and not a controlled foreign corporation and 
the earnings and profits of such corporation for the taxable year shall 
be deemed to be that amount which bears the same ratio to its earnings 
and profits for the taxable year as such part of the taxable year bears 
to the entire taxable year. The application of this section may be 
illustrated by the following examples:

    Example 1. A, a United States shareholder, owns 100 percent of the 
only class of stock of controlled foreign corporation M which, in turn, 
owns 100 percent of the only class of stock of controlled foreign 
corporation N. A and Corporations M and N use the calendar year as a 
taxable year. During 1963, N Corporation derives $40,000 of gross income 
all of which is foreign personal holding company income within the 
meaning of section 553; thus, N Corporation is a foreign personal 
holding company for such year within the meaning of section 552(a). For 
1963, N Corporation has undistributed foreign personal holding company 
income (as defined in section 556(a)) of $30,000, derives $25,000 of 
subpart F income, and has earnings and profits of $32,000. During 1963, 
M Corporation derives $100,000 of gross income (including as a dividend 
under section 555(c)(2) the $30,000 of N Corporation's undistributed 
foreign personal holding company income), 65 percent of which is foreign 
personal holding company income within the meaning of section 553. 
Therefore, M Corporation is a foreign personal holding company for such 
year. For 1963, M Corporation has undistributed foreign personal holding 
company income (as defined in section 556(a)) of $90,000, determined by 
taking into account under section 552(c)(1) N Corporation's $30,000 of 
undistributed foreign personal holding company income for such year; in 
addition, M Corporation derives $50,000 of subpart F income and has 
earnings and profits of $92,000. Neither M Corporation nor N Corporation 
makes any actual distributions during 1963. A is required under section 
551(b) to include in his gross income for 1963 as a dividend the $90,000 
of M Corporation's undistributed foreign personal holding company income 
for such year. For 1963, A is not required to include in his gross 
income under section 951(a) any of the $50,000 subpart F income of M 
Corporation or of the $25,000 subpart F income of N Corporation.
    Example 2. The facts are the same as in example 1, except that only 
45 percent of M Corporation's gross income (determined by including 
under section 555(c)(2) the $30,000 of N Corporation's undistributed 
foreign personal holding company income) is foreign personal holding 
company income within the meaning of section 553; accordingly, M 
Corporation is not a foreign personal holding company for 1963. Since 
for such year M Corporation is not a foreign personal holding company, 
the undistributed foreign personal holding company income ($30,000) of N 
Corporation is not required under section 555(b) to be included in the 
gross income of M Corporation for 1963; as a result, such income is not 
required under section 551(b) to be included in the gross income of A 
for such year even though N Corporation is a foreign personal holding 
company for that year. For 1963, A is required to include $75,000 in his 
gross income under section 951(a)(1)(A)(i) and paragraph (a) of Sec. 
1.951-1, consisting of the $50,000 subpart F income of M Corporation and 
the $25,000 subpart F income of N Corporation.
    Example 3. The facts are the same as in example 1, except that in 
1963 N Corporation actually distributes $30,000 to M Corporation and M 
Corporation, in turn, actually distributes $90,000 to A. Under section 
556 the undistributed foreign personal holding company income of both M 
corporation and N Corporation is thus reduced to zero; accordingly, no 
amount is included in the gross income of A under section 551(b) by 
reason of his interest in corporations M and N. A must include $75,000 
in his gross income for 1963 under section 951(a)(1)(A)(i) and paragraph 
(a) of Sec. 1.951-1, consisting of the $50,000 subpart F income of M 
Corporation and the $25,000 subpart F income of N Corporation. Of the 
$90,000 distribution received by A from M

[[Page 245]]

Corporation, $75,000 is excludable from his gross income under section 
959(a)(1) as previously taxed earnings and profits; the remaining 
$15,000 is includible in his gross income for 1963 as a dividend.
    Example 4. (a) A, a United States shareholder, owns 100 percent of 
the only class of stock of controlled foreign corporation P, organized 
on January 1, 1963. Both A and P Corporation use the calendar year as a 
taxable year. During 1963, 1964, and 1965, P Corporation is not a 
foreign personal holding company as defined in section 552(a); in each 
of such years, P Corporation derives dividend income of $10,000 which 
constitutes foreign personal holding company income (within the meaning 
of Sec. 1.954-2) but under 26 CFR 1.954-1(b)(1) (Revised as of April 1, 
1975) excludes such amounts from foreign base company income as 
dividends received from, and reinvested in, qualified investments in 
less developed countries. Corporation P's earnings and profits 
accumulated for 1963, 1964, and 1965 and determined under paragraph 
(b)(2) of Sec. 1.955-1 are $40,000. For 1966, P Corporation is a 
foreign personal holding company, has predistribution earnings and 
profits of $10,000, derives $10,000 of income which is both foreign 
personal holding company income within the meaning of section 553 and 
subpart F income within the meaning of section 952, distributes $8,000 
to A, and has undistributed foreign personal holding company income of 
$2,000 within the meaning of section 556. In addition, for 1966 P 
Corporation has a withdrawal (determined under section 955(a) as in 
effect before the enactment of the Tax Reduction Act of 1975 but without 
regard to its earnings and profits for such year) of $25,000 of 
previously excluded subpart F income from investment in less developed 
countries. A is required under section 551(b) to include in his gross 
income for 1966 as a dividend the $2,000 undistributed foreign personal 
holding company income. The $8,000 distribution is includible in A's 
gross income for 1966 under sections 61(a)(7) and 301 as a distribution 
to which section 316(a)(2) applies. Corporation P's $25,000 withdrawal 
of previously excluded subpart F income from investment in less 
developed countries is includible in A's gross income for 1966 under 
section 951(a)(1)(A)(ii) and paragraph (a)(2) of Sec. 1.951-1.
    (b) If P Corporation's earnings and profits accumulated for 1963, 
1964, and 1965 were $15,000, instead of $40,000, the result would be the 
same as in paragraph (a) of this example, except that a withdrawal of 
only $15,000 of previously excluded subpart F income from investment in 
less developed countries would be includible in A's gross income for 
1966 under section 951(a)(1)(A)(ii) and paragraph (a)(2) of Sec. 1.951-
1.
    (c) The principles of this example also apply to withdrawals 
(determined under section 955(a), as in effect before the enactment of 
the Tax Reduction Act of 1975) of previously excluded subpart F income 
from investment in less developed countries effected after the effective 
date of such Act, and to withdrawals (determined under section 955(a), 
as amended by such Act) of previously excluded subpart F income from 
investment in foreign base company shipping operations.
    Example 5. (a) The facts are the same as in paragraph (a) of example 
4, except that, instead of having a $25,000 decrease in qualified 
investments in less developed countries for 1966, P Corporation invests 
$20,000 in tangible property (not described in section 956(b)(2)) 
located in the United States and such investment constitutes an increase 
(determined under section 956(a) but without regard to the earnings and 
profits of P Corporation for 1966) in earnings invested in United States 
property. Corporation P's earnings and profits accumulated for 1963, 
1964, and 1965 and determined under paragraph (b)(1) of Sec. 1.956-1 
are $22,000. The result is the same as in paragraph (a) of example 4, 
except that instead of including the $25,000 withdrawal, A must include 
$20,000 in his gross income for 1966 under section 951(a)(1)(B) and 
paragraph (a)(2)(iv) of Sec. 1.951-1 as an investment of earnings in 
United States property.
    (b) If P Corporation's earnings and profits accumulated for 1963, 
1964, and 1965 were $9,000 instead of $22,000, the result would be the 
same as in paragraph (a) of this example, except that only $9,000 would 
be includible in A's gross income for 1966 under section 951(a)(1)(B) 
and paragraph (a)(2)(iv) of Sec. 1.951-1 as an investment of earnings 
in United States property.

[T.D. 6795, 30 FR 937, Jan. 29, 1965, as amended by T.D. 7893, 48 FR 
22508, May 19, 1983]



Sec. 1.952-1  Subpart F income defined.

    (a) In general. For purposes of sections 951 through 964, a 
controlled foreign corporation's subpart F income for any taxable year 
shall, except as provided in paragraph (b) of this section and subject 
to the limitations of paragraphs (c) and (d) of this section, consist of 
the sum of--
    (1) The income derived by such corporation for such year from the 
insurance of United States risks (determined in accordance with the 
provisions of section 953 and Sec. Sec. 1.953-1 through 1.953-6),
    (2) The income derived by such corporation for such year which 
constitutes foreign base company income (determined in accordance with 
the provisions of section 954 and Sec. Sec. 1.954-1 through 1.954-8),

[[Page 246]]

    (3)(i) An amount equal to the product of--
    (A) The income of such corporation other than income which--
    (1) Is attributable to earnings and profits of the foreign 
corporation included in the gross income of a United States person under 
section 951 (other than by reason of this paragraph) (determined in 
accordance with the provisions of section 951 and Sec. 1.951-1), or
    (2) Is described in section 952(b),


multiplied by
    (B) The international boycott factor determined in accordance with 
the provisions of section 999(c)(1), or
    (ii) In lieu of the amount determined under paragraph (a)(3)(i) of 
this section, the amount described under section 999(c)(2) of such 
international boycott income, and
    (4) The sum of the amount of any illegal bribes, kickbacks, or other 
payments paid after November 3, 1976, by or on behalf of the corporation 
during the taxable year of the corporation directly or indirectly to an 
official, employee, or agent in fact of a government. An amount is paid 
by a controlled foreign corporation where it is paid by an officer, 
director, employee, shareholder or agent of such corporation for the 
benefit of such corporation. For purposes of this section, the 
principles of section 162(c) and the regulations thereunder shall apply. 
In the case of payments made after September 3, 1982, a payment is 
illegal if the payment would be unlawful under the Foreign Corrupt 
Practices Act of 1977 if the payor were a United States person. The fair 
market value of an illegal payment made in the form of property or 
services shall be considered the amount of such illegal payment.


Pursuant to section 951(a)(1)(A)(i) and Sec. 1.951-1, a United States 
shareholder of such controlled foreign corporation must include his pro 
rata share of such subpart F income in his gross income for his taxable 
year in which or with which such taxable year of the foreign corporation 
ends. See section 952(a). However, see paragraph (a) of Sec. 1.957-2 
for special rule limiting the subpart F income to the income derived 
from the insurance of United States risks in the case of certain 
controlled foreign corporations described in section 957(b).
    (b) Exclusion of U.S. income--(1) Taxable years beginning before 
January 1, 1967. For rules applicable to taxable years beginning before 
January 1, 1967, see 26 CFR 1.952-1(b)(1) (Revisedof April 1, 1975).
    (2) Taxable years beginning after December 31, 1966. Notwithstanding 
paragraph (a) of this section, a controlled foreign corporation's 
subpart F income for any taxable year beginning after December 31, 1966, 
shall not include any item of income from sources within the United 
States which is effectively connected for that year with the conduct by 
such corporation of a trade or business in the United States unless, 
pursuant to a treaty to which the United States is a party, such item of 
income either is exempt from the income tax imposed by chapter 1 
(relating to normal taxes and surtaxes) of the Code or is subject to 
such tax at a reduced rate.


Thus, for example, dividends received from sources within the United 
States by a foreign corporation engaged in business in the United States 
during the taxable year, which are not effectively connected for that 
year with the conduct of a trade or business in the United States by 
that corporation, shall not be excluded from subpart F income under 
section 952(b) and this subparagraph even though such dividends are 
subject to the tax of 30 percent imposed by section 881 (a). Also, for 
example, if, by reason of an income tax convention to which the United 
States is a party, an amount of interest from sources within the United 
States which is effectively connected for the taxable year with the 
conduct of a business in the United States by a foreign corporation is 
subject to tax under chapter 1 at a flat rate of 15 percent, as provided 
in Sec. 1.871-12, such interest is not excluded from subpart F income 
under section 952(b) and this subparagraph. The deductions attributable 
to items of income which are excluded from subpart F income under this 
subparagraph shall not be taken into account for purposes of section 
952.
    (3) Rule applicable under section 956 (b)(2). For purposes only of 
paragraph

[[Page 247]]

(b)(1))(viii) of Sec. 1.956-2, an item of income derived by a 
controlled foreign corporation from sources within the United States 
with respect to which for the taxable year a tax is imposed in 
accordance with section 882(a) shall be considered described in section 
952(b) whether or not such item of income would have constituted subpart 
F income for such year.
    (c) Limitation on a controlled foreign corporation's subpart F 
income--(1) In general. A United States shareholder's pro rata share 
(determined in accordance with the rules of paragraph (e) of Sec. 
1.951-1) of a controlled foreign corporation's subpart F income for any 
taxable year shall not exceed his pro rata share of the earnings and 
profits (as defined in section 964(a) and Sec. 1.964-1) of such 
corporation for such taxable year, computed as of the close of such 
taxable year without diminution by reason of any distributions made 
during such taxable year, minus the sum of--
    (i) The amount, if any, by which such shareholder's pro rata share 
of--
    (a) The sum of such corporation's deficits in earnings and profits 
for prior taxable years beginning after December 31, 1962, plus
    (b) The sum of such corporation's deficits in earnings and profits 
for taxable years beginning after December 31, 1959, and before January 
1, 1963 (reduced by the sum of the earnings and profits (as so defined) 
of such corporation for any of such taxable years) exceeds
    (c) The sum of such corporation's earnings and profits for prior 
taxable years beginning after December 31, 1962, which, with respect to 
such shareholder, are allocated to other earnings and profits under 
section 959(c)(3) and Sec. 1.959-3; and
    (ii) Such shareholder's pro rata share of any deficits in earnings 
and profits of other foreign corporations for a taxable year beginning 
after December 31, 1962, which are attributable to stock of such other 
foreign corporations owned by such shareholder within the meaning of 
section 958(a) and which, in accordance with section 952(d) and 
paragraph (d) of this section, are taken into account as a reduction in 
the controlled foreign corporation's earnings and profits for such 
taxable year.


For purposes of applying this subparagraph, the reduction (if any) 
provided by subdivision (i) of this subparagraph in a United States 
shareholder's pro rata share of the earnings and profits of a controlled 
foreign corporation shall be taken into account before the reduction 
provided by subdivision (ii) of this subparagraph. See section 952(c).
    (2) Special rules. For purposes only of determining the limitation 
under subparagraph (1) of this paragraph on a United States 
shareholder's pro rata share of a controlled foreign corporation's 
subpart F income for any taxable year--
    (i) Status of foreign corporation. The earnings and profits, or 
deficit in earnings and profits, of a foreign corporation for any 
taxable year shall be taken into account whether or not such foreign 
corporation is a controlled foreign corporation at the time such 
earnings and profits are derived or such deficit in earnings and profits 
is incurred.
    (ii) Deficits in earnings and profits taken into account only once. 
A controlled foreign corporation's deficit in earnings and profits for 
any taxable year preceding the taxable year shall be taken into account 
for the taxable year only to the extent such deficit has not been taken 
into account under this paragraph, paragraph (d) of this section, or 
paragraph (d)(2)(ii) of Sec. 1.963-2 (applied as if section 963 had not 
been repealed by the Tax Reduction Act of 1975) in computing a minimum 
distribution, for any taxable year preceding the taxable year, to reduce 
earnings and profits of such preceding year of such controlled foreign 
corporation or of any other controlled foreign corporation. To the 
extent a controlled foreign corporation's (the ``first corporation'') 
excess foreign base company shipping deductions for any taxable year 
(determined under Sec. 1.955A-3(c)(2)(i)) reduce the foreign base 
company shipping income of another member of a related group (as defined 
in Sec. 1.955A-2(b)), such deductions shall not be taken into account 
in determining the earnings and profits or deficits in

[[Page 248]]

earnings and profits of such first corporation for such taxable year for 
purposes of this paragraph (c) and paragraph (d) of this section. The 
rule of the preceding sentence shall not apply to the extent the excess 
foreign base company shipping deductions of the first corporation reduce 
the foreign base company shipping income of another member of a related 
group below zero.
    (iii) Determination of pro rata share. A United States shareholder's 
pro rata share of a controlled foreign corporation's earnings and 
profits, or deficit in earnings and profits, for any taxable year shall 
be determined in accordance with the principles of paragraph (e) of 
Sec. 1.951-1 and paragraph (d)(2)(ii) of Sec. 1.963-2.
    (3) Illustrations. The application of this paragraph may be 
illustrated by the following examples:

    Example 1. (a) A is a United States shareholder who owns 100 percent 
of the only class of stock of M Corporation, a controlled foreign 
corporation organized on January 1, 1963. Both A and M Corporation use 
the calandar year as a taxable year.
    (b) During 1963, M Corporation derives $20,000 of subpart F income 
and has earnings and profits of $30,000. Corporation M makes no 
distributions to A during such year. The limitation under section 952(c) 
on M Corporation's subpart F income for 1963 is $30,000; and $20,000 is 
includible in A's gross income for such year under section 
951(a)(1)(A)(i).
    (c) On January 1, 1964, M Corporation acquires 100 percent of the 
only class of stock of N Corporation, a controlled foreign corporation 
which uses the calendar year as a taxable year. During 1964, N 
Corporation derives $6,000 of subpart F income, has $7,000 of earnings 
and profits, and distributes $5,000 to M Corporation. The limitation 
under section 952(c) on N Corporation's subpart F income for 1964 is 
$7,000; and $6,000 of subpart F income is includible in A's gross income 
for such year under section 951(a)(1)(A)(i).
    (d) During 1964, M Corporation derives $8,000 of rents which 
constitute subpart F income, makes a $10,000 distribution to A, and has 
earnings and profits of $12,000 (including the $5,000 dividend received 
from N Corporation). The limitation under section 952(c) on M 
Corporation's subpart F income for 1964 is $7,000, determined as 
follows:

Corporation M's earnings and profits for 1964 (determined        $12,000
 under section 964(a) and Sec. 1.964-1 as of the close of
 such year without diminution for any distributions made
 during such year).........................................
Less: Corporation M's earnings and profits for 1964                5,000
 described in section 959(b)...............................
                                                            ------------
Limitation on M Corporation's Subpart F income for 1964....        7,000
 


Thus, for 1964 with respect to A's interest in M Corporation, $7,000 of 
subpart F income is includible in his gross income under section 
951(a)(1)(A)(i). The $10,000 dividend received from M Corporation is 
excludible from A's gross income for 1964 under section 959(a)(1) and 
paragraph (b) of Sec. 1.959-1.
    Example 2. A is a United States shareholder who owns 100 percent of 
the only class of stock of R Corporation which was organized on January 
1, 1961. R Corporation is a controlled foreign corporation for the 
entire period after December 31, 1962, here involved. Both A and R 
Corporation use the calendar year as a taxable year. During 1963, R 
Corporation derives $25,000 of subpart F income and has $50,000 of 
earnings and profits. Corporation R has $15,000 of earnings and profits 
for 1961, and a deficit in earnings and profits of $45,000 for 1962. 
Thus, R Corporation has as of December 31, 1963, a net deficit in 
earnings and profits of $30,000 for the years 1961 and 1962. Corporation 
R makes no distributions to A during 1963. The limitation under section 
952(c) on R Corporation's subpart F income for 1963 is $20,000 ($50,000 
minus $30,000), and $20,000 of subpart F income is includible in A's 
gross income for 1963 under section 951(a)(1)(A)(i). During 1964, R 
Corporation derives $18,000 of subpart F income and has $30,000 of 
earnings and profits. Corporation R makes no distributions to A during 
1964. The entire $18,000 of subpart F income is includible in A's gross 
income for 1964 under section 951(a)(1)(A)(i).

    (d) Treatment of deficits in earnings and profits attributable to 
stock of other foreign corporation indirectly owned by a United States 
shareholder--(1) In general. For purposes of paragraph (c)(1)(ii) of 
this section, if--
    (i) A United States shareholder owns (within the meaning of section 
958(a)) stock in two or more foreign corporations in a chain of foreign 
corporations (as defined in subparagraph (2)(ii) of this paragraph), and
    (ii) Any of the corporations in such chain has a deficit in earnings 
and profits for a taxable year beginning after December 31, 1962,


then, with respect to such shareholder and only for purposes of 
determining the limitation on subpart F income under paragraph (c) of 
this section, the earnings and profits for the taxable year of each such 
foreign corporation

[[Page 249]]

which is a controlled foreign corporation shall, in accordance with the 
rules of subparagraph (2) of this paragraph, be reduced to take into 
account any deficit in earnings and profits referred to in subdivision 
(ii) of this subparagraph. See section 952(d).
    (2) Special rules. For purposes of this paragraph--
    (i) Applicable rules. The special rules set forth in paragraph 
(c)(2) of this section shall apply.
    (ii) ``Chain'' defined. A chain of foreign corporations shall, with 
respect to a United States shareholder, include--
    (a) Any foreign corporation in which such shareholder owns (within 
the meaning of section 958(a)(1)(A)) stock but, only to the extent of 
the stock so owned and
    (b) All foreign corporations in which such shareholder owns (within 
the meaning of section 958(a)(2)) stock, but only to the extent of the 
stock so owned by reason of his ownership of the stock referred to in 
(a) of this subdivision.
    (iii) Allocation of deficit. If one or more foreign corporations 
(whether or not a controlled foreign corporation) includible in a chain 
of foreign corporations has a deficit in earnings and profits 
(determined under section 964(a) and Sec. 1.964-1) for the taxable 
year, the amount of deficit taken into account under section 952(d) with 
respect to a United States shareholder in such chain as a reduction in 
earnings and profits for the taxable year of a controlled foreign 
corporation includible in such chain shall be an amount which bears the 
same ratio to such shareholder's pro rata share of the total deficit in 
earnings and profits for the taxable year of all includible foreign 
corporations as his pro rata share of the earnings and profits 
(determined under paragraph (c) of this section but without regard to 
the provisions of subparagraph (1)(ii) of such paragraph) for the 
taxable year of such includible controlled foreign corporation bears to 
his pro rata share of the total earnings and profits (as so determined 
under paragraph (c) of this section) for the taxable year of all 
includible controlled foreign corporations. The amount of deficit taken 
into account under this subdivision with respect to any controlled 
foreign corporation includible in a chain of foreign corporations shall 
not exceed the United States shareholder's pro rata share of the 
controlled foreign corporation's earnings and profits for the taxable 
year.
    (iv) Taxable year. The taxable year from which a deficit is 
allocated under this paragraph, and the taxable year to which such 
deficit is allocated to reduce earnings and profits, shall be the 
taxable year of the foreign corporation ending with or within the 
taxable year of the United States shareholder described in subparagraph 
(1)(i) of this paragraph.
    (3) Illustration. The application of this paragraph may be 
illustrated by the following examples:

    Example 1. (a) Domestic corporation M owns 100 percent, 20 percent, 
and 100 percent, respectively, of the only class of stock of foreign 
corporations A, B, and F, respectively. Corporation A owns 80 percent of 
the only class of stock of each of foreign corporations B and C, 
respectively. Corporation F owns 20 percent of such stock of C 
Corporation. Corporation B owns 75 percent of the only class of stock of 
foreign corporation D, and 50 percent of the only class of stock of each 
of foreign corporations G and H, respectively. C Corporation owns 75 
percent of the only class of stock of foreign corporation E. All the 
corporations use the calendar year as a taxable year, and all of the 
foreign corporations, except corporations G and H, are controlled 
foreign corporations throughout the period here involved.
    (b) The subpart F income, and the earnings and profits (determined 
under paragraph (c) of this section but without regard to subparagraph 
(1)(ii) of such paragraph) or deficit in earnings and profits 
(determined under section 964(a) and Sec. 1.964-1), of each of the 
foreign corporations for 1963 are as follows, the deficits being set 
forth in parentheses:

------------------------------------------------------------------------
                                                               Earnings
                                                   Subpart F      and
                                                    income      profits
                                                              (deficits)
------------------------------------------------------------------------
A Corporation...................................      $6,000     $18,000
B Corporation...................................  ..........     (7,500)
C Corporation...................................  ..........     (2,500)
D Corporation...................................       4,000       5,000
E Corporation...................................      12,000      15,000
F Corporation...................................       8,000      20,250
G Corporation...................................  ..........    (10,000)
H Corporation...................................  ..........       7,000
------------------------------------------------------------------------

    (c) The chains of foreign corporations (within the meaning of 
subparagraph (2)(ii) of this paragraph) for 1963 are the ``A'' chain, 
consisting of corporations, A, B, C, D, E, G, and H, but only to the 
extent of M Corporation's stock interest in such corporations

[[Page 250]]

under section 958(a) by reason of its ownership of stock in A 
Corporation; the ``B'' chain, consisting of corporations B, D, G, and H, 
but only to the extent of M Corporation's stock interest in such 
corporations under section 958(a) by reason of its ownership of stock in 
B Corporation; and the ``F'' chain, consisting of corporations F, C, and 
E, but only to the extent of M Corporation's stock interest in such 
corporations under section 958(a) by reason of its ownership of stock in 
F Corporation.
    (d) Corporation M's stock interest under section 958(a) in each of 
the chains of foreign corporations is as follows for 1963:

                                                  [In percent]
----------------------------------------------------------------------------------------------------------------
                                                     A       B       C       D       E       F       G       H
----------------------------------------------------------------------------------------------------------------
A chain:
  Direct interest...............................     100
  (100% x 80%)..................................  ......      80
  (100% x 80%)..................................  ......  ......      80
  (80% x 75%)...................................  ......  ......  ......      60
  (80% x 75%)...................................  ......  ......  ......  ......      60
  (80% x 50%)...................................  ......  ......  ......  ......  ......  ......      40
  (80% x 50%)...................................  ......  ......  ......  ......  ......  ......  ......      40
B chain:
  Direct interest...............................  ......      20
  (20% x 75%)...................................  ......  ......  ......      15
  (20% x 50%)...................................  ......  ......  ......  ......  ......  ......      10
  (20% x 50%)...................................  ......  ......  ......  ......  ......  ......  ......      10
F chain:
  Direct interest...............................  ......  ......  ......  ......  ......     100
  (100% x 20%)..................................  ......  ......      20
  (20% x 75%)...................................  ......  ......  ......  ......      15
                                                 ---------------------------------------------------------------
   Total interests..............................     100     100     100      75      75     100      50      50
----------------------------------------------------------------------------------------------------------------

    (e) Corporation M's pro rata share of the earnings and profits 
(determined under paragraph (c) of this section but without regard to 
subparagraph (1)(ii) of such paragraph), or of the deficit, of each 
controlled foreign corporation of each foreign corporation, 
respectively, includible in the respective chains for 1963 is as 
follows:

------------------------------------------------------------------------
                                                  Earnings
                                                and profits    Deficit
------------------------------------------------------------------------
A chain:
  A Corporation (100%)........................      $18,000
  B Corporation (80%).........................  ...........     ($6,000)
  C Corporation (80%).........................  ...........      (2,000)
  D Corporation (60%).........................        3,000
  E Corporation (60%).........................        9,000
  G Corporation (40%).........................  ...........      (4,000)
  H Corporation (40%).........................        (\1\)
                                               -------------------------
   Total......................................       30,000     (12,000)
                                               =========================
B chain:
  B Corporation (20%).........................  ...........     ($1,500)
  D Corporation (15%).........................         $750
  G Corporation (10%).........................  ...........      (1,000)
  H Corporation (10%).........................        (\1\)
                                               -------------------------
   Total......................................         $750     ($2,500)
                                               =========================
F chain:
  F Corporation (100%)........................       20,250
  C Corporation (20%).........................  ...........        (500)
  E Corporation (15%).........................        2,250
                                               -------------------------
   Total......................................      $22,500        (500)
------------------------------------------------------------------------
\1\ The earnings and profits of H Corporation are not included in the
  total earnings and profits for the chain because H Corporation is not
  a controlled foreign corporation.

    (f) The amount by which M Corporation's pro rata share of the 
earnings and profits for 1963 of the controlled foreign corporations in 
each respective chain shall be reduced under section 952(d) by M 
Corporation's pro rata share of the deficits of corporations B, C, and G 
for 1963 is determined as follows:

 
                                                              Amount of
                                                              reduction
 
A chain:
  A Corporation ($12,000 x $18,000/$30,000)................       $7,200
  D Corporation ($12,000 x $3,000/$30,000).................        1,200
  E Corporation ($12,000 x $9,000/$30,000).................        3,600
                                               --------------
   Total...................................................       12,000
                                               ==============
B chain:
  D Corporation ($2,500 x $750/$750)..........       $2,500
  Limitation: M Corporation's pro-rata share            750
   of D Corporation's earnings and profits....

[[Page 251]]

 
  Allocation of used deficit ($750) to M
   Corporation's pro rata share of the
   deficits of corporations B and G:
    B Corporation ($750 x ($1,500/$2,500))....         $450
    G Corporation ($750 x ($1,000/$2,500))....          300
                                               -------------
     Total....................................          750         $750
                                               =========================
F chain:
  F Corporation ($500 x $20,250/$22,500)...................          450
  E Corporation ($500 x $2,250/$22,500)....................           50
                                               --------------
   Total...................................................          500
 

    (g) Corporation M's pro rata share of the earnings and profits 
(determined after reduction for deficits under section 952(d)) for 1963 
of each controlled foreign corporation in the respective chains, 
determined on a chain-by-chain basis, is determined as follows:

------------------------------------------------------------------------
                                          Earnings
                                            and     Reduction   Reduced
                                          profits     (Sec. earnings
                                           before    952(d))      and
                                         reduction              profits
------------------------------------------------------------------------
A chain:
  A Corporation........................    $18,000     $7,200    $10,800
  D Corporation........................      3,000      1,200      1,800
  E Corporation........................      9,000      3,600      5,400
B chain: D Corporation.................        750        750
F chain:
  F Corporation........................     20,250        450     19,800
  E Corporation........................      2,250         50      2,200
------------------------------------------------------------------------

    (h) Corporation M's pro rata share of each controlled foreign 
corporation's subpart F income, limited as provided by section 952(c) 
and paragraph (c) of this section, for 1963 which is includible in its 
gross income for such year under section 951(a)(1)(A)(i) and Sec. 
1.951-1 is determined as follows:

------------------------------------------------------------------------
                                                    Earnings
                                       Subpart F      and       Amount
                                         income      profit   includible
                                        (before    (sec. 952   in income
                                      limitation)     (c))
------------------------------------------------------------------------
A Corporation (100%)................      $6,000     $10,800      $6,000
D Corporation (75%)                        3,000       1,800       1,800
E Corporation (75%)                        9,000       7,600       7,600
F Corporation (100%)                       8,000      19,800       8,000
                                     -----------------------------------
  Total includible under Sec. ...........  .........      23,400
   951(a)(1)(A)(i)..................
------------------------------------------------------------------------

    Example 2. The facts are the same as in example 1 except that, in 
addition, for 1964, foreign corporations C, D, and E have no subpart F 
income and no earnings and profits and foreign corporations G and H have 
no earnings and profits. For 1964, B Corporation has subpart F income of 
$1,000 and earnings and profits (determined in accordance with section 
964(a) and Sec. 1.964-1) of $1,500; A Corporation has subpart F income 
of $800 and earnings and profits of $1,000; and F Corporation has 
subpart F income of $500 and earnings and profits of $1,000. Such 
earnings and profits are determined without regard to distributions for 
1964. Corporation B has an unused deficit in earnings and profits of 
$1,050 for 1963 ($1,500 minus $450) applicable to M Corporation's 
interest in such corporation (paragraph (f) of example 1), and, under 
paragraph (c)(1)(i)(a) of this section, with respect to M Corporation, 
such deficit reduces B Corporation's earnings and profits for 1964 to 
$450. Inasmuch as G Corporation is not a controlled foreign corporation 
for 1964, such corporation's unused deficit in earnings and profits of 
$700 for 1963 ($1,000 minus $300) applicable to M Corporation's interest 
in such corporation (paragraph (f) of example 1) may be used under 
paragraph (c)(1)(i)(a) of this section to reduce M Corporation's 
interest in G Corporation's earnings and profits in a later year or 
years for which G Corporation is a controlled foreign corporation. 
Corporation M's pro rata share of each controlled foreign corporation's 
subpart F income, limited as provided by section 952(c) and paragraph 
(c) of this section, for 1964 which is includible in its gross income 
for such year under section 951(a)(1)(A)(i) and Sec. 1.951-1 is 
determined as follows:

------------------------------------------------------------------------
                                                    Earnings
                                       Subpart F      and       Amount
                                         income     profits   includible
                                        (before      (Sec. in income
                                      limitation)   952(c))
------------------------------------------------------------------------
A Corporation.......................        $800      $1,000        $800
B Corporation.......................       1,000         450         450
F Corporation.......................         500       1,000         500
------------------------------------------------------------------------

    Example 3. The facts are the same as in example 2, except that for 
1964 B Corporation has subpart F income of $550 and earnings and profits 
(determined in accordance with section 964(a) and Sec. 1.964-1) of 
$550; such earnings and profits are determined without regard to 
distributions for 1964. Under paragraph (c)(1)(i)(a) of this section, B 
Corporation's unused deficit of $1,050 for 1963 reduces its earnings and 
profits for 1964 with respect to M Corporation to zero. The remaining 
$500 of the unused deficit for 1963 applicable to M Corporation's 
interest in B Corporation may be used under paragraph (c)(1)(i)(a) of 
this section in later years to reduce M Corporation's interest in B 
Corporation's earnings and profits.

    (e) Application of current earnings and profits limitation--(1) In 
general. If the subpart F income (as defined in section 952(a)) of a 
controlled foreign corporation exceeds the foreign corporation's 
earnings and profits for the taxable year, the subpart F income 
includible in the income of the corporation's United States shareholders 
is reduced under section 952(c)(1)(A) in accordance

[[Page 252]]

with the following rules. The excess of subpart F income over current 
year earnings and profits shall--
    (i) First, proportionately reduce subpart F income in each separate 
category of the controlled foreign corporation, as defined in Sec. 
1.904-5(a)(1), in which current earnings and profits are zero or less 
than zero;
    (ii) Second, proportionately reduce subpart F income in each 
separate category in which subpart F income exceeds current earnings and 
profits; and
    (iii) Third, proportionately reduce subpart F income in other 
separate categories.
    (2) Allocation to a category of subpart F income. An excess amount 
that is allocated under paragraph (e)(1) of this section to a separate 
category must be further allocated to a category of subpart F income if 
the separate category contains more than one category of subpart F 
income described in section 952(a) or, in the case of foreign base 
company income, described in Sec. 1.954-1(c)(1)(iii)(A) (1) or (2). In 
such case, the excess amount that is allocated to the separate category 
must be allocated to the various categories of subpart F income within 
that separate category on a proportionate basis.
    (3) Recapture of subpart F income reduced by operation of earnings 
and profits limitation. Any amount in a category of subpart F income 
described in section 952(a) or, in the case of foreign base company 
income, described in Sec. 1.954-1(c)(1)(iii)(A) (1) or (2) that is 
reduced by operation of the current year earnings and profits limitation 
of section 952(c)(1)(A) and this paragraph (e) shall be subject to 
recapture in a subsequent year under the rules of section 952(c)(2) and 
paragraph (f) of this section.
    (4) Coordination with sections 953 and 954. The rules of this 
paragraph (e) shall be applied after the application of sections 953 and 
954 and the regulations under those sections, except as provided in 
Sec. 1.954-1(d)(4)(ii).
    (5) Earnings and deficits retain separate limitation character. The 
income reduction rules of paragraph (e)(1) of this section shall apply 
only for purposes of determining the amount of an inclusion under 
section 951(a)(1)(A) from each separate category as defined in Sec. 
1.904-5(a)(1) and the separate categories in which recapture accounts 
are established under section 952(c)(2) and paragraph (f) of this 
section. For rules applicable in computing post-1986 undistributed 
earnings, see generally section 902 and the regulations under that 
section. For rules relating to the allocation of deficits for purposes 
of computing foreign taxes deemed paid under section 960 with respect to 
an inclusion under section 951(a)(1)(A), see Sec. 1.960-1(i).
    (f) Recapture of subpart F income in subsequent taxable year--(1) In 
general. If a controlled foreign corporation's subpart F income for a 
taxable year is reduced under the current year earnings and profits 
limitation of section 952(c)(1)(A) and paragraph (e) of this section, 
recapture accounts will be established and subject to recharacterization 
in any subsequent taxable year to the extent the recapture accounts were 
not previously recharacterized or distributed, as provided in paragraphs 
(f)(2) and (3) of this section.
    (2) Rules of recapture--(i) Recapture account. If a category of 
subpart F income described in section 952(a) or, in the case of foreign 
base company income, described in Sec. 1.954-1(c)(1)(iii)(A) (1) or (2) 
is reduced under the current year earnings and profits limitation of 
section 952(c)(1)(A) and paragraph (e) of this section for a taxable 
year, the amount of such reduction shall constitute a recapture account.
    (ii) Recapture. Each recapture account of the controlled foreign 
corporation will be recharacterized, on a proportionate basis, as 
subpart F income in the same separate category (as defined in Sec. 
1.904-5(a)(1)) as the recapture account to the extent that current year 
earnings and profits exceed subpart F income in a taxable year. The 
United States shareholder must include his pro rata share (determined 
under the rules of Sec. 1.951-1(e)) of each recharacterized amount in 
income as subpart F income in such separate category for the taxable 
year.
    (iii) Reduction of recapture account and corresponding earnings. 
Each recapture account, and post-1986 undistributed earnings in the 
separate category containing the recapture account, will be reduced in 
any taxable year by the

[[Page 253]]

amount which is recharacterized under paragraph (f)(2)(ii) of this 
section. In addition, each recapture account, and post-1986 
undistributed earnings in the separate category containing the recapture 
account, will be reduced in the amount of any distribution out of that 
account (as determined under the ordering rules of section 959(c) and 
paragraph (f)(3)(ii) of this section).
    (3) Distribution ordering rules--(i) Coordination of recapture and 
distribution rules. If a controlled foreign corporation distributes an 
amount out of earnings and profits described in section 959(c)(3) in a 
year in which current year earnings and profits exceed subpart F income 
and there is an amount in a recapture account for such year, the 
recapture rules will apply first.
    (ii) Distributions reduce recapture accounts first. Any distribution 
made by a controlled foreign corporation out of earnings and profits 
described in section 959(c)(3) shall be treated as made first on a 
proportionate basis out of the recapture accounts in each separate 
category to the extent thereof (even if the amount in the recapture 
account exceeds post-1986 undistributed earnings in the separate 
category containing the recapture account). Any remaining distribution 
shall be treated as made on a proportionate basis out of the remaining 
earnings and profits of the controlled foreign corporation in each 
separate category. See section 904(d)(3)(D).
    (4) Examples. The application of paragraphs (e) and (f) of this 
section may be illustrated by the following examples:

    Example 1. (i) A, a U.S. person, is the sole shareholder of CFC, a 
controlled foreign corporation formed on January 1, 1998, whose 
functional currency is the u. In 1998, CFC earns 100u of foreign base 
company sales income that is general limitation income described in 
section 904(d)(1)(I) and incurs a (200u) loss attributable to activities 
that would have produced general limitation income that is not subpart F 
income. In 1998 CFC also earns 100u of foreign personal holding company 
income that is passive income described in section 904(d)(1)(A), and 
100u of foreign personal holding company income that is dividend income 
subject to a separate limitation described in section 904(d)(1)(E) for 
dividends from a noncontrolled section 902 corporation. CFC's subpart F 
income for 1998, 300u, exceeds CFC's current earnings and profits, 100u, 
by 200u. Under section 952(c)(1)(A) and paragraph (e) of this section, 
subpart F income is limited to CFC's current earnings and profits of 
100u, all of which is included in A's gross income under section 
951(a)(1)(A). The 200u of CFC's 1998 subpart F income that is not 
included in A's income in 1998 by reason of section 952(c)(1)(A) is 
subject to recapture under section 952(c)(2) and paragraph (f) of this 
section.
    (ii) For purposes of determining the amount and type of income 
included in A's gross income and the amount and type of income in CFC's 
recapture account, the rules of paragraphs (e)(1) and (2) of this 
section apply. Under paragraph (e)(1)(i) of this section, the amount by 
which CFC's subpart F income exceeds its earnings and profits for 1998, 
200u, first reduces from 100u to 0 CFC's subpart F income in the general 
limitation category, which has a current year deficit of (100u) in 
earnings and profits. Next, under paragraph (e)(1)(iii) of this section, 
the remaining 100u by which CFC's 1998 subpart F income exceeds earnings 
and profits is applied proportionately to reduce CFC's subpart F income 
in the separate categories for passive income (100u) and dividends from 
the noncontrolled section 902 corporation (100u). Thus, A includes 50u 
of passive limitation/foreign personal holding company income and 50u of 
dividends from the noncontrolled section 902 corporation/foreign 
personal holding company income in gross income in 1998. CFC has 100u in 
its general limitation/foreign base company sales income recapture 
account attributable to the 100u of foreign base company sales income 
that is not included in A's income by reason of the earnings and profits 
limitation of section 952(c)(1)(A). CFC also has 50u in its passive 
limitation recapture account, all of which is attributable to foreign 
personal holding company income, and 50u in its recapture account for 
dividends from the noncontrolled section 902 corporation, all of which 
is attributable to foreign personal holding company income.
    (iii) For purposes of computing post-1986 undistributed earnings, 
the rules of sections 902 and 960, including the rules of Sec. 1.960-
1(i), apply. Under Sec. 1.960-1(i), the general limitation deficit of 
(100u) is allocated proportionately to reduce passive limitation 
earnings of 100u and noncontrolled section 902 dividend earnings of 
100u. Thus, passive limitation earnings are reduced by 50u to 50u (100u 
passive limitation earnings/200u total earnings in positive separate 
categories x (100u) general limitation deficit = 50u reduction), and the 
noncontrolled section 902 corporation earnings are reduced by 50u to 50u 
(100u noncontrolled section 902 corporation earnings/200u total earnings 
in positive separate categories x (100u) general limitation deficit = 
50u reduction). All of CFC's post-1986 foreign income taxes with respect 
to passive limitation income and dividends from the

[[Page 254]]

noncontrolled section 902 corporation are deemed paid by A under section 
960 with respect to the subpart F inclusions (50u inclusion/50u earnings 
in each separate category). After the inclusion and deemed-paid taxes 
are computed, at the close of 1998 CFC has a (100u) deficit in general 
limitation earnings (100u subpart F earnings + (200u) nonsubpart F 
loss), 50u of passive limitation earnings (100u of earnings attributable 
to foreign personal holding company income -50u inclusion) with a 
corresponding passive limitation/foreign personal holding company income 
recapture account of 50u, and 50u of earnings subject to a separate 
limitation for dividends from the noncontrolled section 902 corporation 
(100u earnings -50u inclusion) with a corresponding noncontrolled 
section 902 corporation/foreign personal holding company income 
recapture account of 50u.
    Example 2. (i) The facts are the same as in Example 1 with the 
addition of the following facts. In 1999, CFC earns 100u of foreign base 
company sales income that is general limitation income and 100u of 
foreign personal holding company income that is passive limitation 
income. In addition, CFC incurs (10u) of expenses that are allocable to 
its separate limitation for dividends from the noncontrolled section 902 
corporation. Thus, CFC's subpart F income for 1999, 200u, exceeds CFC's 
current earnings and profits, 190u, by 10u. Under section 952(c)(1)(A) 
and paragraph (e) of this section, subpart F income is limited to CFC's 
current earnings and profits of 190u, all of which is included in A's 
gross income under section 951(a)(1)(A).
    (ii) For purposes of determining the amount and type of income 
included in A's gross income and the amount and type of income in CFC's 
recapture accounts, the rules of paragraphs (e)(1) and (2) of this 
section apply. While CFC's general limitation post-1986 undistributed 
earnings for 1999 are 0 ((100u) opening balance + 100u subpart F 
income), CFC's general limitation subpart F income (100u) does not 
exceed its general limitation current earnings and profits (100u) for 
1999. Accordingly, under paragraph (e)(1)(iii) of this section, the 
amount by which CFC's subpart F income exceeds its earnings and profits 
for 1999, 10u, is applied proportionately to reduce CFC's subpart F 
income in the separate categories for general limitation income, 100u, 
and passive income, 100u. Thus, A includes 95u of general limitation 
foreign base company sales income and 95u of passive limitation foreign 
personal holding company income in gross income in 1999. At the close of 
1999 CFC has 105u in its general limitation/foreign base company sales 
income recapture account (100u from 1998 + 5u from 1999), 55u in its 
passive limitation/foreign personal holding company income recapture 
account (50u from 1998 + 5u from 1999), and 50u in its dividends from 
the noncontrolled section 902 corporation/foreign personal holding 
company income recapture account (all from 1998).
    (iii) For purposes of computing post-1986 undistributed earnings in 
each separate category, the rules of sections 902 and 960, including the 
rules of Sec. 1.960-1(i), apply. Thus, post-1986 undistributed earnings 
(or an accumulated deficit) in each separate category are increased (or 
reduced) by current earnings and profits or current deficits in each 
separate category. The accumulated deficit in CFC's general limitation 
earnings and profits (100u) is reduced to 0 by the addition of 100u of 
1999 earnings and profits. CFC's passive limitation earnings of 50u are 
increased by 100u to 150u, and CFC's noncontrolled section 902 
corporation earnings of 50u are decreased by (10u) to 40u. After the 
addition of current year earnings and profits and deficits to the 
separate categories there are no deficits remaining in any separate 
category. Thus, the allocation rules of Sec. 1.960-1(i)(4) do not apply 
in 1999. Accordingly, in determining the post-1986 foreign income taxes 
deemed paid by A, post-1986 undistributed earnings in each separate 
category are unaffected by earnings in the other categories. Foreign 
taxes deemed paid under section 960 for 1999 would be determined as 
follows for each separate category: with respect to the inclusion of 95u 
of foreign base company sales income out of general limitation earnings, 
the section 960 fraction is 95u inclusion/0 total earnings; with respect 
to the inclusion of 95u of passive limitation income the section 960 
fraction is 95u inclusion/150u passive earnings. Thus, no general 
limitation taxes would be associated with the inclusion of the general 
limitation earnings because there are no accumulated earnings in the 
general limitation category. After the deemed-paid taxes are computed, 
at the close of 1999 CFC has a (95u) deficit in general limitation 
earnings and profits ((100u) opening balance + 100u current earnings -
95u inclusion), 55u of passive limitation earnings and profits (50u 
opening balance + 100u current foreign personal holding company income -
95u inclusion), and 40u of earnings and profits subject to the separate 
limitation for dividends from the noncontrolled section 902 corporation 
(50u opening balance + (10u) expense).
    Example 3. (i) A, a U.S. person, is the sole shareholder of CFC, a 
controlled foreign corporation whose functional currency is the u. At 
the beginning of 1998, CFC has post-1986 undistributed earnings of 275u, 
all of which are general limitation earnings described in section 
904(d)(1)(I). CFC has no previously-taxed earnings and profits described 
in section 959(c)(1) or (c)(2). In 1998, CFC has a (200u) loss in the 
shipping category described in section 904(d)(1)(D), 100u of foreign 
personal holding company income that is passive income described in 
section 904(d)(1)(A), and 125u of general limitation manufacturing

[[Page 255]]

earnings that are not subpart F income. CFC's subpart F income for 1998, 
100u, exceeds CFC's current earnings and profits, 25u, by 75u. Under 
section 952(c)(1)(A) and paragraph (e) of this section, subpart F income 
is limited to CFC's current earnings and profits of 25u, all of which is 
included in A's gross income under section 951(a)(1)(A). The 75u of 
CFC's 1998 subpart F income that is not included in A's income in 1998 
by reason of section 952(c)(1)(A) is subject to recapture under section 
952(c)(2) and paragraph (f) of this section.
    (ii) For purposes of determining the amount and type of income 
included in A's gross income and the amount and type of income in CFC's 
recapture account, the rules of paragraphs (e)(1) and (2) of this 
section apply. Under paragraph (e)(1) of this section, the amount of 
CFC's subpart F income in excess of earnings and profits for 1998, 75u, 
reduces the 100u of passive limitation foreign personal holding company 
income. Thus, A includes 25u of passive limitation foreign personal 
holding company income in gross income, and CFC has 75u in its passive 
limitation/foreign personal holding company income recapture account.
    (iii) For purposes of computing post-1986 undistributed earnings in 
each separate category the rules of sections 902 and 960, including the 
rules of Sec. 1.960-1(i), apply. Under Sec. 1.960-1(i), the shipping 
limitation deficit of (200u) is allocated proportionately to reduce 
general limitation earnings of 400u and passive limitation earnings of 
100u. Thus, general limitation earnings are reduced by 160u to 240u 
(400u general limitation earnings/500u total earnings in positive 
separate categories x (200u) shipping deficit = 160u reduction), and 
passive limitation earnings are reduced by 40u to 60u (100u passive 
earnings/500u total earnings in positive separate categories x (200u) 
shipping deficit = 40u reduction). Five-twelfths of CFC's post-1986 
foreign income taxes with respect to passive limitation earnings are 
deemed paid by A under section 960 with respect to the subpart F 
inclusion (25u inclusion/60u passive earnings). After the inclusion and 
deemed-paid taxes are computed, at the close of 1998 CFC has 400u of 
general limitation earnings (275u opening balance + 125u current 
earnings), 75u of passive limitation earnings (100u of foreign personal 
holding company income -25u inclusion), and a (200u) deficit in shipping 
limitation earnings.
    Example 4. (i) The facts are the same as in Example 3 with the 
addition of the following facts. In 1999, CFC earns 50u of general 
limitation earnings that are not subpart F income and 75u of passive 
limitation income that is foreign personal holding company income. Thus, 
CFC has 125u of current earnings and profits. CFC distributes 200u to A. 
Under paragraph (f)(3)(i) of this section, the recapture rules are 
applied first. Thus, the amount by which 1999 current earnings and 
profits exceed subpart F income, 50u, is recharacterized as passive 
limitation foreign personal holding company income. CFC's total subpart 
F income for 1999 is 125u of passive limitation foreign personal holding 
company income (75u current earnings plus 50u recapture account), and 
the passive limitation/foreign personal holding company income recapture 
account is reduced from 75u to 25u.
    (ii) CFC has 150u of previously-taxed earnings and profits described 
in section 959(c)(2) (25u attributable to 1998 and 125u attributable to 
1999), all of which is passive limitation earnings and profits. Under 
section 959(c), 150u of the 200u distribution is deemed to be made from 
earnings and profits described in section 959(c)(2). The remaining 50u 
is deemed to be made from earnings and profits described in section 
959(c)(3). Under paragraph (f)(3)(ii) of this section, the dividend 
distribution is deemed to be made first out of the passive limitation 
recapture account to the extent thereof (25u). Under paragraph 
(f)(2)(iii) of this section, the passive limitation recapture account is 
reduced from 25u to 0. The remaining distribution of 25u is treated as 
made out of CFC's general limitation earnings and profits.
    (iii) For purposes of computing post-1986 undistributed earnings, 
the rules of section 902 and 960, including the rules of Sec. 1.960-
1(i), apply. Thus, the shipping limitation accumulated deficit of (200u) 
reduces general limitation earnings and profits of 450u and passive 
limitation earnings and profits of 150u on a proportionate basis. Thus, 
100% of CFC's post-1986 foreign income taxes with respect to passive 
limitation earnings are deemed paid by A under section 960 with respect 
to the 1999 subpart F inclusion of 125u (100u inclusion (numerator 
limited to denominator)/100u passive earnings). No post-1986 foreign 
income taxes remain to be deemed paid under section 902 in connection 
with the 25u distribution from the passive limitation/foreign personal 
holding company income recapture account. One-twelfth of CFC's post-1986 
foreign income taxes with respect to general limitation earnings are 
deemed paid by A under section 902 with respect to the distribution of 
25u general limitation earnings and profits described in section 
959(c)(3) (25u inclusion/300u general limitation earnings). After the 
deemed-paid taxes are computed, at the close of 1999 CFC has 425u of 
general limitation earnings and profits (400u opening balance + 50u 
current earnings--25u distribution), 0 of passive limitation earnings 
(75u recapture account + 75u current foreign personal holding company 
income--125u inclusion--25u distribution), and a (200u) deficit in 
shipping limitation earnings.

    (5) Effective date. Paragraph (e) of this section and this paragraph 
(f) apply to

[[Page 256]]

taxable years of a controlled foreign corporation beginning after March 
3, 1997.
    (g) Treatment of distributive share of partnership income--(1) In 
general. A controlled foreign corporation's distributive share of any 
item of income of a partnership is income that falls within a category 
of subpart F income described in section 952(a) to the extent the item 
of income would have been income in such category if received by the 
controlled foreign corporation directly. For specific rules regarding 
the treatment of a distributive share of partnership income under 
certain provisions of subpart F, see Sec. Sec. 1.954-1(g), 1.954-
2(a)(5), 1.954-3(a)(6), and 1.954-4(b)(2)(iii).
    (2) Example. The application of this paragraph (g) may be 
illustrated by the following example:

    Example. CFC, a controlled foreign corporation, is an 80-percent 
partner in PRS, a foreign partnership. PRS earns $100 of interest income 
that is not export financing interest as defined in section 
954(c)(2)(B), or qualified banking or financing income as defined in 
section 954(h)(3)(A), from a person unrelated to CFC. This interest 
income would have been foreign personal holding company income to CFC, 
under section 954(c), if it had received this income directly. 
Accordingly, CFC's distributive share of this interest income, $80, is 
foreign personal holding company income.

    (3) Effective date. This paragraph (g) applies to taxable years of a 
controlled foreign corporation beginning on or after July 23, 2002.

[T.D. 6795, 30 FR 938, Jan. 29, 1965, as amended by T.D. 6892, 31 FR 
11144, Aug. 23, 1966; T.D. 7293, 38 FR 32802, Nov. 28, 1973; T.D. 7545, 
43 FR 19652, May 8, 1978; T.D. 7862, 47 FR 56490, Dec. 17, 1982; T.D. 
7893, 48 FR 22508, May 19, 1983; T.D. 7894, 48 FR 22516, May 19, 1983; 
T.D. 8331, 56 FR 2846, Jan. 25, 1991; T.D. 8704, 62 FR 18, Jan. 2, 1997; 
T.D. 9008, 67 FR 48023, July 23, 2002]



Sec. 1.952-2  Determination of gross income and taxable income 
of a foreign corporation.

    (a) Determination of gross income--(1) In general. Except as 
provided in subparagraph (2) of this paragraph, the gross income of a 
foreign corporation for any taxable year shall, subject to the special 
rules of paragraph (c) of this section, be determined by treating such 
foreign corporation as a domestic corporation taxable under section 11 
and by applying the principles of section 61 and the regulations 
thereunder.
    (2) Insurance gross income--(i) Life insurance gross income. The 
gross income for any taxable year of a controlled foreign corporation 
which is engaged in the business of reinsuring or issuing insurance or 
annuity contracts and which, if it were a domestic corporation engaged 
only in such business, would be taxable as a life insurance company to 
which part I (sections 801 through 820) of subchapter L of chapter 1 of 
the Code applies, shall, subject to the special rules of paragraph (c) 
of this section, be the sum of--
    (a) The gross investment income, as defined under section 804(b), 
except that interest which is excluded from gross income under section 
103 shall not be taken into account;
    (b) The sum of the items taken into account under section 809(c), 
except that advance premiums shall not be taken into account; and
    (c) The amount by which the net long-term capital gain exceeds the 
net short-term capital loss.
    (ii) Mutual and other insurance gross income. The gross income for 
any taxable year of a controlled foreign corporation which is engaged in 
the business of reinsuring or issuing insurance or annuity contracts and 
which, if it were a domestic corporation engaged only in such business, 
would be taxable as a mutual insurance company to which part II 
(sections 821 through 826) of subchapter L of chapter 1 of the Code 
applies or as a mutual marine insurance or other insurance company to 
which part III (sections 831 and 832) of subchapter L of chapter 1 of 
the Code applies, shall, subject to the special rules of paragraph (c) 
of this section, be--
    (a) The sum of--
    (1) The gross income, as defined in section 832(b)(1);
    (2) The amount of losses incurred, as defined in section 832(b)(5); 
and
    (3) The amount of expenses incurred, as defined in section 
832(b)(6); reduced by
    (b) The amount of interest which under section 103 is excluded from 
gross income.

[[Page 257]]

    (b) Determination of taxable income--(1) In general. Except as 
provided in subparagraph (2) of this paragraph, the taxable income of a 
foreign corporation for any taxable year shall, subject to the special 
rules of paragraph (c) of this section, be determined by treating such 
foreign corporation as a domestic corporation taxable under section 11 
and by applying the principles of section 63.
    (2) Insurance taxable income. The taxable income for any taxable 
year of a controlled foreign corporation which is engaged in the 
business of reinsuring or issuing insurance or annuity contracts and 
which, if it were a domestic corporation engaged only in such business, 
would be taxable as an insurance company to which subchapter L of 
chapter 1 of the Code applies shall, subject to the special rules of 
paragraph (c) of this section, be determined by treating such 
corporation as a domestic corporation taxable under subchapter L of 
chapter 1 of the Code and by applying the principles of Sec. Sec. 
1.953-4 and 1.953-5 for determining taxable income.
    (c) Special rules for purposes of this section--(1) Nonapplication 
of certain provisions. Except where otherwise distinctly expressed, the 
provisions of subchapters F, G, H, L, M, N, S, and T of chapter 1 of the 
Internal Revenue Code shall not apply and, for taxable years of a 
controlled foreign corporation beginning after March 3, 1997, the 
provisions of section 103 of the Internal Revenue Code shall not apply.
    (2) Application of principles of Sec. 1.964-1. The determinations 
with respect to a foreign corporation shall be made as follows:
    (i) Books of account. The books of account to be used shall be those 
regularly maintained by the corporation for the purpose of accounting to 
its shareholders.
    (ii) Accounting principles. Except as provided in subparagraphs (3) 
and (4) of this paragraph, the accounting principles to be employed are 
those described in paragraph (b) of Sec. 1.964-1. Thus, in applying 
accounting principles generally accepted in the United States for 
purposes of reflecting in the financial statements of a domestic 
corporation the operations of foreign affiliates, no adjustment need be 
made unless such adjustment will have a material effect, within the 
meaning of paragraph (a) of Sec. 1.964-1.
    (iii) Translation into United States dollars--(a) In general. Except 
as provided in (b) of this subdivision, the amounts determined in 
accordance with subdivision (ii) of this subparagraph shall be 
translated into United States dollars in accordance with the principles 
of paragraph (d) of Sec. 1.964-1.
    (b) Special rule. In any case in which the value of the foreign 
currency in relation to the United States dollar fluctuates more than 10 
percent during any translation period (within the meaning of paragraph 
(d)(6) of Sec. 1.964-1), the subpart F income and non-subpart F income 
shall be separately translated as if each constituted all the income of 
the controlled foreign corporation for the translation period.
    (iv) Tax accounting methods. The tax accounting methods to be 
employed are those established or adopted by or on behalf of the foreign 
corporation under paragraph (c) of Sec. 1.964-1. Thus, such accounting 
methods must be consistent with the manner of treating inventories, 
depreciation, and elections referred to in subdivisions (ii), (iii), and 
(iv) of paragraph (c)(1) of Sec. 1.964-1 and used for purposes of such 
paragraph; however, if, in accordance with paragraph (c)(6) of Sec. 
1.964-1, a foreign corporation receives foreign base company income 
before any elections are made or before an accounting method is adopted 
by or on behalf of such corporation under paragraph (c)(3) of Sec. 
1.964-1, the determinations of whether an exclusion set forth in section 
954(b) applies shall be made as if no elections had been made and no 
accounting method had been adopted.
    (v) Exchange gain or loss--(a) Exchange gain or loss, determined in 
accordance with the principles of Sec. 1.964-1(e), shall be taken into 
account for purposes of determining gross income and taxable income.
    (b) Exchange gain or loss shall be treated as foreign base company 
shipping income (or as a deduction allocable thereto) to the extent that 
it is attributable to foreign base company shipping operations. The 
extent to

[[Page 258]]

which exchange gain or loss is attributable to foreign base company 
shipping operations may be determined under any reasonable method which 
is consistently applied from year to year. For example, the extent to 
which the exchange gain or loss is attributable to foreign base company 
shipping operations may be determined on the basis of the ratio which 
the foreign based company shipping income of the corporation for the 
taxable year bears to its total gross income for the taxable year, such 
ratio to be determined without regard to this subdivision (v).
    (c) The remainder of the exchange gain or loss shall be allocated 
between subpart F income and non-subpart F income under any reasonable 
method which is consistently applied from year to year. For example, 
such remainder may be allocated to subpart F income in the same ratio 
that the gross subpart F income (exclusive of foreign base company 
shipping income) of the corporation for the taxable year bears to its 
total gross income (exclusive of foreign base company shipping income) 
for the taxable year, such ratio to be determined without regard to this 
subdivision (v).
    (3) Necessity for recognition of gain or loss. Gross income of a 
foreign corporation (including an insurance company) includes gain or 
loss only if such gain or loss would be recognized under the provisions 
of the Internal Revenue Code if the foreign corporation were a domestic 
corporation taxable under section 11 (subject to the modifications of 
subparagraph (1) of this paragraph). See section 1002. However, a 
foreign corporation shall not be treated as a domestic corporation for 
purposes of determining whether section 367 applies.
    (4) Gross income and gross receipts. The term ``gross income'' may 
not have the same meaning as the term ``gross receipts''. For example, 
in a manufacturing, merchandising, or mining business, gross income 
means the total sales less the cost of goods sold, plus any income from 
investments and from incidental or outside operations or sources.
    (5) Treatment of capital loss and net operating loss. In determining 
taxable income of a foreign corporation for any taxable year--
    (i) Capital loss carryback and carryover. The capital loss carryback 
and carryover provided by section 1212(a) shall not be allowed.
    (ii) Net operating loss deduction. The net operating loss deduction 
under section 172(a) or the operations loss deduction under section 812 
shall not be allowed.
    (6) Corporations which have insurance income. For purposes of 
paragraphs (a)(2) and (b)(2) of this section, in determining whether a 
controlled foreign corporation which is engaged in the business of 
reinsuring or issuing insurance or annuity contracts and which, if it 
were a domestic corporation engaged only in such business, would be 
taxable as an insurance company to which subchapter L of chapter 1 of 
the Code applies, it is immaterial that--
    (i) The corporation would be exempt from taxation as an organization 
described in section 501(a),
    (ii) The corporation would not be taxable as an insurance company to 
which subchapter L of the Code applies, or
    (iii) The corporation would be subject to the alternative tax for 
small mutual insurance companies provided by section 821(c).

[T.D. 6795, 30 FR 941, Jan. 29, 1965, as amended by T.D. 7893, 48 FR 
22508, May 19, 1983; T.D. 7894, 48 FR 22516, May 19, 1983; T.D. 8704, 62 
FR 20, Jan. 2, 1997]



Sec. 1.953-1  Income from insurance of United States risks.

    (a) In general. The subpart F income of a controlled foreign 
corporation for any taxable year includes its income derived from the 
insurance of United States risks for such taxable year. See section 
952(a)(1). A controlled foreign corporation shall have income derived 
from the insurance of United States risks for such purpose of it has 
taxable income, as determined under Sec. 1.953-4 or Sec. 1.953-5, 
which is attributable to the reinsuring or the issuing of any insurance 
or annuity contract in connection with United States risks, as defined 
in Sec. 1.953-2 or Sec. 1.953-3, and if it satisfies the 5-percent 
minimum premium requirement prescribed in paragraph (b) of this section. 
It is immaterial for purposes of this section whether the

[[Page 259]]

person insured or the beneficiary of any insurance, annuity, or 
reinsurance contract is, as to such corporation, a related person or a 
United States shareholder. For definition of the term ``controlled 
foreign corporation'' for purposes of taking into account income derived 
from the insurance of United States risks under section 953, see section 
957 (a) and (b) and Sec. Sec. 1.957-1 and 1.957-2.
    (b) 5-percent minimum premium requirement. A controlled foreign 
corporation shall not have income derived from the insurance of United 
States risks for purposes of this section unless the premiums received 
by such corporation during the taxable year which are attributable to 
the reinsuring and the issuing of insurance and annuity contracts in 
connection with the United States risks exceed 5 percent of the total 
premiums which are received by such corporation during such taxable year 
and which are attributable to the reinsuring and the issuing of 
insurance and annuity contracts in connection with all risks.
    (c) General definitions. For purposes of Sec. Sec. 1.953-1 to 
1.953-6, inclusive--
    (1) Reinsurance, etc. The terms ``reinsurance'', ``insurance'', and 
``annuity contract'' have the same meaning which they have for purposes 
of applying section 809(c)(1) or section 832(b)(4), as the case may be.
    (2) Premiums. The term ``premiums'' means the items taken into 
account for the taxable year under section 809(c)(1), or the amount 
computed for the taxable year under section 832(b)(4) without the 
application of subparagraph (B) thereof, as the case may be; except 
that, for purposes of determining the amount of premiums received in 
applying paragraph (b) of this section or paragraph (a) of Sec. 1.953-
3, advance premiums and deposits shall not be taken into account.
    (3) Insurance company. The term ``insurance company'' has the same 
meaning which it has for purposes of applying section 801(a), determined 
by applying the principles of paragraph (a) of Sec. 1.801-3.
    (4) Related person. The term ``related person'', when used with 
respect to a controlled foreign corporation, shall have the meaning 
assigned to it by paragraph (e) of Sec. 1.954-1.
    (5) Policy period. With respect to any insurance or annuity contract 
under which a corporation is potentially liable at any time during its 
taxable year, the term ``policy period'' means with respect to such year 
each period of coverage under the contract if such period begins or ends 
with or within the taxable year, except that, if such period of coverage 
is more than one year, such term means such of the following periods as 
are applicable, each one of which is a policy period with respect to the 
taxable year:
    (i) The one-year period which begins with the effective date of the 
contract and begins or ends with or within the taxable year,
    (ii) The one-year period which begins with an anniversary of the 
contract and begins or ends with or within the taxable year, and
    (iii) The period of less than one year if such period begins with an 
anniversary of the contract, ends with the date on which coverage under 
the contract terminates, and begins or ends with or within the taxable 
year.


For such purposes, the effective date of the contract is the date on 
which coverage under the contract begins, and the anniversary of the 
contract is the annual return of the effective date. The period of 
coverage under a contract is the period beginning with the effective 
date of the contract and ending with the date on which the coverage 
under the contract expires; except that, if the risk under the contract 
has been transferred by assumption reinsurance, the period of coverage 
shall end with the effective date of such transfer or, if the contract 
is canceled, with the effective date of cancellation. For this purpose, 
the term ``assumption reinsurance'' shall have the meaning provided by 
paragraph (a)(7)(ii) of Sec. 1.809-5. The application of this 
subparagraph may be illustrated by the following examples:

    Example 1. Controlled foreign corporation A issues to domestic 
corporation M an insurance contract which provides coverage for the 2\1/
2\ year period beginning on July 1, 1963. Corporation A uses the 
calendar year as the taxable year. For 1963, the policy period under 
such contract as to A Corporation is July 1, 1963, to June 30, 1964. For 
1964, the

[[Page 260]]

policy periods under such contract as to A Corporation are July 1, 1963, 
to June 30, 1964, and July 1, 1964, to June 30, 1965. For 1965, the 
policy periods under such contract as to A Corporation are July 1, 1964, 
to June 30, 1965, and July 1, 1965, to December 31, 1965.
    Example 2. The facts are the same as in example 1 except that M 
Corporation cancels the contract on August 31, 1963. For 1963, the 
policy period under such contract as to A Corporation is July 1, 1963, 
to August 31, 1963.
    Example 3. The facts are the same as in example 1 except that on 
January 15, 1965, A Corporation cedes insurance under the contract to 
controlled foreign corporation B, which also uses the calendar year as 
the taxable year. For 1964, the policy periods under such contract as to 
A Corporation are July 1, 1963, to June 30, 1964, and July 1, 1964, to 
June 30, 1965. For 1965, the policy periods under such contract as to 
both A Corporation and B Corporation are July 1, 1964, to June 30, 1965, 
and July 1, 1965, to December 31, 1965.
    Example 4. Controlled foreign corporation C, which uses the calendar 
year as the taxable year, issues to domestic corporation N an insurance 
contract which covers the marine risks in connection with shipping a 
machine to Europe. The contract does not specify the dates during which 
the machine is covered, but provides coverage from the time the machine 
is delivered alongside a named vessel in Hoboken, New Jersey, until the 
machine is delivered alongside such vessel in Liverpool, England. Such 
deliveries in New Jersey and England take place on February 1, and 
February 28, 1963, respectively. For 1963, the policy period under such 
contract as to C Corporation is February 1, to February 28, 1963.

    (6) Foreign country. The term ``foreign country'' includes, where 
not otherwise expressly provided, a possession of the United States.

[T.D. 6781, 29 FR 18201, Dec. 23, 1964]



Sec. 1.953-2  Actual United States risks.

    (a) In general. For purposes of paragraph (a) of Sec. 1.953-1, the 
term ``United States risks'' means risks described in section 
953(a)(1)(A)--
    (1) In connection with property in the United States (as defined in 
paragraph (b) of this section),
    (2) In connection with liability arising out of activity in the 
United States (as defined in paragraph (c) of this section), or
    (3) In connection with the lives or health of residents of the 
United States (as defined in paragraph (d) of this section).


For purposes of section 953(a), the term ``United States'' is used in a 
geographical sense and includes only the States and the District of 
Columbia. Therefore, the reinsuring or the issuing of insurance or 
annuity contracts by a controlled foreign corporation in connection with 
property located in a foreign country or a possession of the United 
States, in connection with activity in a foreign country or a 
possession, or in connection with the lives or health of citizens of the 
United States who are not residents of the United States will not give 
rise to income to which paragraph (a) of Sec. 1.953-1 applies, unless 
the income derived by the controlled foreign corporation from such 
contracts constitutes income derived in connection with risks which are 
deemed to be United States risks, as defined in Sec. 1.953-3.
    (b) Property in the United States. The term ``property in the United 
States'' means property, as defined in subparagraph (1) of this 
paragraph, which is in the United States, within the meaning of 
subparagraph (2) of this paragraph.
    (1) Property defined. The term ``property'' means any interest of an 
insured in tangible (including real and personal) or intangible 
property. Such interests include, but are not limited to, those of an 
owner, landlord, tenant, mortgagor, mortgagee, trustee, beneficiary, or 
partner. Thus, for example, if insurance is issued against loss from 
fire and theft with respect to an insured's home and its contents, such 
risks are risks in connection with property, whether the insured is the 
owner or lessee and whether the contents include furniture or cash and 
securities. Furthermore, if insurance is issued against all risks of 
damage or loss with respect to the automobile of an insured, such risks 
are risks in connection with property, whether the risks insured against 
may be caused by the insured, another person, or natural forces.
    (2) United States location--(i) In general. Property will be 
considered property in the United States when it is exclusively located 
in the United States. Conversely, property will be considered property 
not in the United States when it is exclusively located outside the 
United States. In addition, property

[[Page 261]]

which is ordinarily located in, but temporarily located outside, the 
United States will be considered property in the United States both when 
it is ordinarily located in, and when it is temporarily located outside, 
the United States if the premium which is attributable to the reinsuring 
or issuing of any insurance contract in connection with such property 
cannot be allocated to, or apportioned between, risks incurred when such 
property is actually located in the United States and risks incurred 
when it is actually located outside the United States. If such premium 
can be so allocated or apportioned on a reasonable basis, however, such 
property will be considered property not in the United States when it is 
actually located outside the United States. However, property will not 
be considered property in the United States if it is neither property 
which is exclusively located in the United States nor property which is 
ordinarily located in, but temporarily located outside, the United 
States. The rules prescribed in subdivision (ii) of this subparagraph 
shall apply in determining whether a premium can be allocated or 
apportioned on a reasonable basis to or between risks incurred when 
property is actually located in the United States and risks incurred 
when such property is actually located outside the United States. The 
rules prescribed in subdivisions (iii) through (x) of this subparagraph 
shall apply in determining whether property is, or will be considered, 
exclusively located in or outside the United States and whether property 
is, or will be considered, ordinarily located in the United States; such 
rules also limit the rule of premium allocation and apportionment 
prescribed in this subdivision and subdivision (ii) of this 
subparagraph. The determinations required by this subparagraph shall be 
made with respect to the location of property during the policy period 
applicable to the taxable year of the insuring or reinsuring 
corporation, or, if more than one policy period exists with respect to 
such taxable year, such determinations shall be made separately with 
respect to the location of property during each such policy period.
    (ii) Premium allocation or apportionment. Whether a premium can be 
allocated or apportioned on a reasonable basis to or between risks 
incurred when property is actually located in the United States and 
risks incurred when such property is actually located outside the United 
States shall depend on the intention of the parties to the insurance 
contract, as determined from its provisions and the facts and 
circumstances preceding its execution. Contract provisions on the basis 
of which the premium reasonably may be so allocated or apportioned 
include, but are not limited to, provisions which separately describe 
each risk covered, the period of coverage of each risk, the special 
warranties for each risk, the premium for each risk (or the basis for 
determining such premium), and the conditions of paying the premium for 
each risk. For purposes of this subdivision, it shall be unnecessary 
formally to make a separate policy with respect to each risk covered or 
with respect to each clause attached to the policy, provided that the 
intention of the parties to the contract is reasonably clear. For 
example, if in the ordinary course of carrying on an insurance business 
an insurance policy is issued which covers fire, theft, and water damage 
risks incurred when property is actually located in the United States 
and marine risks incurred when such property is actually located outside 
the United States and which, pursuant to accepted insurance principles, 
properly describes the premium rates as percentages of the amount of 
coverage as ``.825% plus .3% fire, etc. risks plus .12% water risks = 
1.245%'', a reasonable basis exists to allocate a $124.50 premium paid 
for $10,000 of such coverage to $82.50 for foreign risks and $42.00 
($30.00 + $12.00) to United States risks.
    (iii) Property in general--(a) Ordinary and temporary location. 
Except as otherwise provided in subdivisions (iv) through (x) of this 
subparagraph, the determination of whether property is ordinarily 
located in the United States will depend on all the facts and 
circumstances in each case. Property is ordinarily located in the United 
States if its location in the United States is

[[Page 262]]

regular, usual, or often occurring. However, in all cases property will 
be considered ordinarily located in the United States if it is actually 
located in the United States for an aggregate of more than 50 percent of 
the days in the applicable policy period whereas property will, under no 
circumstances, be considered ordinarily located in the United States if 
it is actually located in the United States for an aggregate of not more 
than 30 percent of the days in the applicable policy period. Property 
which is ordinarily located in the United States is temporarily located 
outside the United States when it is actually located outside the United 
States. For purposes of determining the number and percent of the days 
in an applicable policy period, the term ``day'' means, not any 24-
consecutive-hour period, but a continuous period of twenty-four hours 
commencing from midnight and ending with the following midnight; in 
determining the location of property for such purposes, an amount of 
time which is at least one-half of such a day, but less than the entire 
day, shall be considered a day, and an amount of time which is less than 
one-half of such a day shall not be considered a day.
    (b) Illustrations. The application of this subdivision may be 
illustrated by the following examples:

    Example 1. Controlled foreign corporation A issues to domestic 
corporation M a comprehensive blanket or floater insurance policy which, 
for one year, covers inventory samples which M Corporation regularly 
ships from the United States in order to encourage sales. Such shipments 
are made on the condition that they be returned to the United States 
within 5 days after they are received. During the one-year policy 
period, such samples are sent from, and returned to, the United States 
50 times, and during such one-year period are actually located in the 
United States for an aggregate of 120 days. Since the location of the 
samples in the United States during such one-year period is often 
recurring, they are property ordinarily located in, but temporarily 
located outside, the United States. Therefore, they will be considered 
property in the United States even though for such one-year period their 
location in the United States is not regular or usual and is not for an 
aggregate of more than 50 percent of the days in the policy period. 
However, if, by considering such factors as the terms and premium 
schedule of the insurance contract as well as the number, value, and 
duration of the location in and outside the United States, of such 
samples, the premium which is attributable to the issuing of such 
contract can be allocated to, or apportioned between, risks occurring 
when such samples are actually located in the United States and risks 
occurring when they are actually located outside the United States, such 
samples will be considered property not in the United States when they 
are actually located outside the United States.
    Example 2. A machine, located for several years in a foreign branch 
of a United States manufacturer, is permanently transferred to the home 
office of such manufacturer, where it arrives on January 1, 1963, and 
remains for the remainder of 1963. Under a separate insurance contract 
issued by a controlled foreign corporation, which uses the calendar year 
as the taxable year, such machine is insured against damage for the 
three-year period commencing on May 1, 1962. Because of the change in 
location of the machine, the premiums are increased as of January 1, 
1963. Since the machine is in the United States from January 1, 1963, to 
April 30, 1963, its location in the United States is regular and usual 
during the policy period of May 1, 1962, to April 30, 1963. Accordingly, 
the machine is ordinarily located in the United States for such policy 
period. However, since the premium which is attributable to the issuing 
of such contract is allocable to risks occurring when the machine is 
actually located in, and when it is actually located outside, the United 
States, such machine will be considered property not in the United 
States from May 1, 1962, through December 31, 1962.

    (iv) Commercial motor vehicles, ships, aircraft, railroad rolling 
stock, and containers. Any motor vehicle, ship, aircraft, railroad 
rolling stock, or any container transported thereby, which is used 
exclusively in the commercial transportation of persons or property to 
or from the United States (including such transportation from one place 
to another in the United States) and is ordinarily located in the United 
States will be considered property in the United States both when such 
property is ordinarily located in, and when such property is temporarily 
located outside, the United States. Whether such property is used in the 
transportation of persons or property to or from the United States and 
is ordinarily located in the United States are issues to be determined 
from all the facts and circumstances in each case. However, in all cases 
such transportation property will be considered ordinarily located in 
the United States if either more than

[[Page 263]]

50 percent of the miles traversed during the applicable policy period in 
the use of such property are traversed within the United States or such 
property is located in the United States more than 50 percent of the 
time during such period. Further, such transportation property will not 
at any time be considered property in the United States if either not 
more than 30 percent of the miles traversed during the applicable policy 
period in the use of such property are traversed within the United 
States or such property is located in the United States for not more 
than 30 percent of the time during such period. Nevertheless, if not 
more than 30 percent of the miles traversed during the applicable policy 
period in the use of such transportation property are traversed within 
the United States, such property will be considered ordinarily located 
in the United States if it is located in the United States more than 50 
percent of the time during such period Moreover, if such transportation 
property is located in the United States for not more than 30 percent of 
the time during the applicable policy period, such property will be 
considered ordinarily located in the United States if more than 50 
percent of the miles traversed during such period in the use of such 
property are traversed within the United States. If such transportation 
property is considered property in the United States because more than 
50 percent of the miles traversed during the applicable policy period in 
the use of such property are traversed within the United States, the 
apportionment of premium provided in subdivision (i) of this 
subparagraph shall be made on a mileage basis. If, however, such 
property is considered property in the United States because such 
property is located in the United States more than 50 percent of the 
time during the applicable policy period, the apportionment of premium 
provided in subdivision (i) of this subparagraph shall be made on a time 
basis.
    (v) Noncommercial motor vehicles, ships, aircraft, and railroad 
rolling stock. Except as provided in subdivision (iv) of this 
subparagraph, any motor vehicle, ship or boat, aircraft, or railroad 
rolling stock which at any time is actually located in the United States 
and which either (a) is registered with the United States, a State 
(including any political subdivision thereof), or any agency thereof or 
(b), if not so registered, is owned by a citizen, resident, or 
corporation of the United States will be considered property which is 
ordinarily located in the United States. Unless the premium which is 
attributable to the reinsuring or issuing of any insurance contract in 
connection with such property considered ordinarily located in the 
United States is specifically allocated under the contract to risks 
incurred when such property is actually located in the United States and 
to risks incurred when it is actually located outside the United States, 
such property will be considered property in the United States both when 
it is ordinarily located in, and when it is temporarily located outside, 
the United States; under no circumstances will such property be 
considered outside the United States on the basis of any apportionment 
of such premium.
    (vi) Property exported or imported by railroad or motor vehicle. Any 
property which is exported from, or imported to, the United States by 
railroad or motor vehicle will be considered property ordinarily located 
in the United States which, when such property is not actually located 
in the United States, is temporarily located outside the United States. 
For example, if an insurance contract reinsured or issued in connection 
with property exported from the United States by motor vehicle covers 
risks commencing when such property is loaded on the motor vehicle at 
the United States warehouse and terminating when such property is 
unloaded at the foreign warehouse, and if the premium payable with 
respect to risks incurred when the property is in the United States and 
risks incurred when the property is in the foreign country is not 
separately stated, such property will be considered property in the 
United States only until such property is actually located outside the 
United States, provided that the premium can be properly apportioned 
(for example) on the basis of time or mileage, between risks incurred 
when the property is actually located in the United States

[[Page 264]]

and risks incurred when it is actually located outside the United 
States. If in such case the premium is not so apportionable, such 
property will be considered property in the United States both when such 
property is ordinarily located in, and when it is temporarily located 
outside, the United States.
    (vii) Property exported by ship or aircraft. If an insurance 
contract which is reinsured or issued in connection with property which 
is exported from the United States by ship or aircraft covers risks all 
of which terminate when such property is placed aboard a ship or 
aircraft at the United States port of exit for shipment from the United 
States, such property will be considered property in the United States. 
If such insurance contract covers risks all of which commence when such 
property is placed aboard a ship or aircraft at the United States port 
of exit for shipment from the United States, such property will be 
considered property not in the United States. If such insurance contract 
covers risks commencing before, and terminating after, such property is 
placed aboard a ship or aircraft at the United States port of exit for 
shipment from the United States, such property will be considered 
property ordinarily located in the United States which, after such 
property is placed aboard such ship or aircraft at the United States 
port of exit, is temporarily located outside the United States. The 
application of this subdivision may be illustrated by the following 
example:

    Example. A controlled foreign corporation issues an insurance 
contract in connection with property exported from the United States by 
ship. The contract covers risks commencing after such property is 
removed from the United States warehouse and terminating when such 
property is unloaded at the foreign port of entry. Assuming that the 
premium payable with respect to the risks incurred before and the risks 
incurred after the property is placed aboard the ship at the United 
States port of exit for shipment from the United States or with respect 
to the steps in handling such property during such coverage, such as 
transporting the property to the United States port of exit, unloading 
the property there, placing the property aboard the ship, holding the 
property aboard the ship in port, the actual voyage, and unloading the 
property at the foreign port of entry, is separately stated in, or is 
determinable from, such contract, the property will be considered 
property in the United States only until such property is placed aboard 
the ship at the United States port of exit for shipment from the United 
States. Assuming, however, that the premiums payable with respect to 
such steps, or with respect to the risks incurred before and the risks 
incurred after the property is placed aboard the ship at the United 
States port of exit, are not allocable or apportionable under the 
contract, such property will be considered property in the United States 
both before and after such property is placed aboard the ship at the 
United States port of exit.

    (viii) Property imported by ship or aircraft. If an insurance 
contract which is reinsured or issued in connection with property which 
is imported to the United States by ship or aircraft covers risks all of 
which terminate when such property is unloaded at the United States port 
of entry, such property will be considered property not in the United 
States. If such insurance contract covers risks all of which commence 
after such property is unloaded at the United States port of entry, such 
property will be considered property in the United States. If such 
insurance contract covers risks commencing before, and terminating 
after, such property is unloaded at the United States port of entry, 
such property will be considered property ordinarily located in the 
United States which, before such property is unloaded at the United 
States port of entry, is temporarily located outside the United States. 
For an illustration pertaining to the allocation or apportionment of the 
premium, see the example in subdivision (vii) of this subparagraph.
    (ix) Shipments originating and terminating in the United States. Any 
property which is shipped from one place in the United States to another 
place in the United States, on or over a foreign country, the high seas, 
or the coastal waters of the United States will be considered property 
actually located at all times in the United States. For example, 
property which is shipped from New York City to Los Angeles via the 
Panama Canal or from San Francisco to Hawaii or Alaska will be 
considered property actually located at all times in the United States.

[[Page 265]]

    (x) Shipments originating and terminating in a foreign country. Any 
property which is shipped by any means, or a combination of means, of 
transportation from one foreign country to another foreign country, or 
from a contiguous foreign country to the same contiguous foreign 
country, on or over the United States will be considered property 
exclusively located outside the United States. Notwithstanding the 
foregoing, any property which is shipped by any means, or a combination 
of means, of transportation from one contiguous foreign country to 
another contiguous foreign country on or over the United States will be 
considered property ordinarily located in the United States which, when 
such property is not actually located in the United States, is 
temporarily located outside the United States.
    (c) Liability from United States activity. The term ``liability 
arising out of activity in the United States'' means a loss, as 
described in subparagraph (1) of this paragraph, or a liability, as 
described in subparagraph (2) of this paragraph, which could arise from 
activity performed in the United States, as defined in subparagraph (3) 
of this paragraph.
    (1) Loss described. The term ``loss'' includes all loss of an 
insured which could arise from the occurrence of the event insured 
against except that such term does not include any loss in connection 
with property described in paragraph (b) of this section. For example, 
such term includes, in the case of a promoter of outdoor sporting 
events, the loss which could arise from the cancellation of such an 
event because of inclement weather.
    (2) Liability described. The term ``liability'' includes all 
liability of an insured in tort, contract, property, or otherwise. It 
includes, for example, the liability of a principal for the acts of his 
agent, of a husband for the acts of his spouse, and of a parent for the 
acts of his child. The term not only includes the direct liability which 
may be incurred, for example, by a tortfeasor to the person harmed, but 
also the indirect liability which may be incurred, for example, by a 
manufacturer to the purchaser at retail for a breach of warranty.
    (3) Activity in the United States--(i) In general. A loss or 
liability will be considered a loss or liability which could arise from 
activity performed in the United States if the loss or liability would 
result, if at all, from an activity exclusively carried on in the United 
States. Conversely, a loss or liability will be considered a loss or 
liability which could not arise from activity performed in the United 
States if the loss or liability would result, if at all, from an 
activity exclusively carried on outside the United States. In addition, 
a loss or liability will be considered a loss or liability which could 
arise from activity performed in the United States if the loss or 
liability would result, if at all, from an activity ordinarily carried 
on in, but partly carried on outside, the United States. If the premium 
which is attributable to the reinsuring or issuing of any insurance 
contract in connection with an activity ordinarily carried on in, but 
partly carried on outside, the United States can, on a reasonable basis, 
be allocated to, or apportioned between, the risks incurred with respect 
to the activity carried on in, and the risks incurred with respect to 
the activity carried on outside, the United States, such loss or 
liability will be considered a loss or liability which could not arise 
from activity performed in the United States to the extent the loss or 
liability would result, if at all, from that activity carried on outside 
the United States. However, a loss or liability will not be considered a 
loss or liability which could arise from an activity performed in the 
United States if such loss or liability would result, if at all, from an 
activity which is neither exclusively carried on in the United States 
nor ordinarily carried on in, but partly carried on outside, the United 
States. The principles of paragraph (b)(2)(ii) of this section for 
allocating or apportioning a premium on a reasonable basis to or between 
risks incurred when property is actually located in the United States 
and risks incurred when such property is actually located outside the 
United States shall apply for allocating or apportioning a premium on a 
reasonable basis to or between the risks incurred with respect to the 
activity carried on in, and the risks incurred with respect

[[Page 266]]

to the activity carried on outside, the United States. The rules 
prescribed in subdivisions (ii) through (vi) of this subparagraph shall 
apply in determining whether an activity is, or will be considered, 
exclusively carried on in or outside the United States and whether an 
activity is, or will be considered, ordinarily carried on in the United 
States and in determining what is the activity which is performed by the 
insured from which a loss or liability results or could result; such 
rules also limit the rule of premium allocation and apportionment 
prescribed in this subdivision. The determinations required by this 
subparagraph shall be made with respect to the location of an activity 
of the insured performed during the policy period applicable to the 
taxable year of the insuring or reinsuring corporation, or, if more than 
one policy period exists with respect to such taxable year, such 
determinations shall be made separately with respect to the location of 
the activity during each such policy period.
    (ii) Substantial activity carried on in the United States. The term 
``activity'' is used in its broadest sense and includes the performance 
of an act unlawfully undertaken, the wrongful performance of an act 
lawfully undertaken, and the wrongful failure to perform an act lawfully 
required to be undertaken. With respect to a loss described in 
subparagraph (1) of this paragraph, the term ``activity'' includes the 
occurrence of the event insured against. The determination of whether an 
activity ordinarily is carried on in, but is partly carried on outside, 
the United States will depend on all the facts and circumstances in each 
case. An activity ordinarily is carried on in the United States if a 
substantial amount of such activity is carried on in the United States. 
Factors which will be taken into account in determining whether a 
substantial amount of activity is carried on in the United States are 
those which are connected with the activity and include, but are not 
limited to, the location of the insured's assets, the place where 
personal services are performed, and the place where sales occur, but 
only if such assets, services, and sales are connected with the 
activity. In all cases an activity will be considered substantially 
carried on in the United States if more than 50 percent of the insured's 
total assets, personal services, and sales, if any, connected with such 
activity are located, performed, or occur in the United States. On the 
other hand, an activity will, under no circumstances, be considered 
substantially carried on in the United States if not more than 30 
percent of the insured's total assets, personal services, and sales, if 
any, connected with such activity are located, performed, or occur in 
the United States. For this purpose, the mean of the value of the total 
assets at the beginning and end of the policy period shall be used, 
determined by taking assets into account at their actual value (not 
reduced by liabilities), which, in the absence of affirmative evidence 
to the contrary, shall be deemed to be (a) face value in the case of 
bills receivable, accounts receivable, notes receivable, and open 
accounts held by an insured using the cash receipts and disbursements 
method of accounting and (b) adjusted basis in the case of all other 
assets. Personal services shall be measured by the amount of 
compensation paid or accrued for such services, and sales shall be 
measured by the volume of gross sales. An activity is carried on partly 
outside the United States if it is carried on, whether substantially or 
in substantially, outside the United States.
    (iii) Manufacturing, producing, constructing, or assembling 
activity. If a person who manufactures, produces, constructs, or 
assembles property is liable with regard to the consumption or use of 
such property, such liability will be considered to result from the 
activity performed of manufacturing, producing, constructing, or 
assembling such property. If such person manufactures, produces, 
constructs, or assembles more than one type of product, the liability 
with regard to the consumption or use of one of such products will be 
considered to result from the activity performed of manufacturing, 
producing, constructing, or assembling that particular product. For 
example, the liability of a building contractor, which constructs 
apartment buildings only in the United States, for the improper 
construction of, or the failure to

[[Page 267]]

construct, an apartment building, will be considered to result from an 
activity exclusively carried on in the United States and will be 
considered a liability which could arise from activity performed in the 
United States. In further illustration, the liability (which is covered 
by a single policy of insurance) of a domestic corporation, which 
assembles refrigerators exclusively in the United States and 
manufactures automobiles both in a foreign country and in the United 
States through substantial activity carried on in each of such 
countries, for the negligent manufacturing of a part for one of the 
automobiles by the foreign branch, will be considered to result from an 
activity ordinarily carried on in, but partly carried on outside, the 
United States and will be considered a liability which could arise from 
activity performed in the United States.
    (iv) Selling activity. If a person is liable with regard to selling 
activity performed, such liability will be considered, except as 
provided in subdivisions (iii), (v), and (vi) of this subparagraph, to 
result from such selling activity. A person will be considered to be 
engaged in selling activity if such person engages in an activity 
resulting in the sale of property. Thus, it is immaterial that, under 
the Code, such activity would not constitute engaging in or carrying on 
a trade or business in the country in which such activity is carried on, 
the property in the goods does not pass in such country, or delivery of 
the property is not made in such country. For example, if a foreign 
wholesale distributor, which manages its entire business operations in a 
foreign country and sells its inventory exclusively in the United 
States--its only contact in the United States being the promotion of 
such sales to United States retail outlets by advertising in trade 
publications and distributing sales catalogues--is liable for a breach 
of warranty with regard to the sale of property to a United States 
retail outlet, such liability will be considered to result from an 
activity exclusively carried on in the United States and will be 
considered a liability which could arise from activity performed in the 
United States.
    (v) Liability from service or driving activity--(a) In general. If a 
person is liable with regard to any service activity performed, or is 
liable with regard to driving activity performed in connection with a 
motor vehicle, ship or boat, aircraft, or railroad rolling stock, 
whether or not exclusively used in the commercial transportation of 
persons or property, such liability will be considered to result from 
such service or driving activity. For example, if an oil company which 
drills for oil exclusively in a foreign country is liable with regard to 
the negligent handling by its employees of explosives in the course of 
such drilling there, such liability will be considered to result from an 
activity exclusively carried on outside the United States and will be 
considered a liability which could not arise from activity performed in 
the United States. In further illustration, if a corporation which 
services machinery exclusively in a foreign country under servicing 
contracts is liable with regard to the negligent repairing of a machine 
under such a contract, such liability will be considered to result from 
an activity exclusively carried on outside the United States and will be 
considered a liability which could not arise from activity performed in 
the United States.
    (b) Location of activities in connection with transportation 
property. For purposes of (a) of this subdivision, service or driving 
activity performed in connection with a motor vehicle, ship or boat, 
aircraft, or railroad rolling stock, whether or not exclusively used in 
the commercial transportation of persons or property, will be considered 
activity performed in the United States if the activity is carried on at 
a time when such property is or will be considered, in accordance with 
subdivision (iv) or (v) of paragraph (b)(2) of this section, actually in 
the United States or ordinarily located in the United States. However, 
if the premium which is attributable to the reinsuring or issuing of any 
insurance contract in connection with such service or driving activity 
which is carried on at a time when such property is, or will be 
considered, ordinarily located in the United States can be allocated to, 
or apportioned between, the risks incurred when such

[[Page 268]]

property is actually located in the United States and risks incurred 
when it is actually located outside the United States, such liability 
will be considered a liability which could arise from activity performed 
in the United States only when such property is actually located in the 
United States. Any allocation or apportionment of premium under the 
preceding sentence shall be made in accordance with the rules of 
allocation and apportionment provided in subdivision (iv) or (v) of 
paragraph (b)(2) of this section. For example, if a person is liable 
with regard to the performance of services outside the United States in 
the operation of a motor vehicle which is used exclusively in the 
commercial transportation of persons to and from the United States and 
which, because more than 50 percent of the miles traversed during the 
applicable policy period in the use of such property are traversed 
within the United States, is considered ordinarily located in the United 
States, such liability will be considered to be a liability which could 
not arise from activity performed in the United States only to the 
extent that the premium which is attributable to the reinsuring or 
issuing of any insurance contract in connection with such service 
activity is apportioned on a mileage basis between the risks incurred 
when such motor vehicle is actually located in the United States and 
when such vehicle is actually located outside the United States. See 
paragraph (b)(2)(iv) of this section. In further illustration, if a 
person is liable with regard to his negligent driving of a motor vehicle 
which is not used exclusively in the commercial transportation of 
persons or property, which is registered with any State, and which is 
driven both in the United States and a foreign country, such liability 
will be considered a liability which could arise from activity performed 
in the United States, unless the premium which is attributable to the 
reinsuring or issuing of an insurance contract in connection with such 
driving performed in such motor vehicle ordinarily located in the United 
States is specifically allocated under the contract to risks incurred 
with respect to driving performed in, and to risks incurred with respect 
to driving performed outside, the United States. See paragraph (b)(2)(v) 
of this section.
    (c) Illustration. The application of this subdivision may be further 
illustrated by the following example:

    Example. Controlled foreign corporation A is a wholly owned 
subsidiary of domestic corporation M. Both corporations are insurance 
companies and use the calendar year as the taxable year. Corporation M 
is exclusively engaged in issuing to owners of commercial rental 
property which is located in the United States insurance contracts which 
cover any harm which may be caused in 1963 by the tortious conduct of 
the owners' employees in managing and maintaining such property. The 
owners insured under such contracts include both residents and 
nonresidents of the United States. In 1963, M Corporation cedes to A 
Corporation one-half of the insurance contracts issued by M Corporation 
in that year, including the contracts issued to nonresidents. Income of 
A Corporation derived in 1963 from reinsuring the risks of M Corporation 
is income from the insurance of United States risks since all the 
insurance contracts reinsured by it are in connection with a liability 
which could arise from service activity performed in the United States.

    (vi) Liability from delivery of property. If the person who is 
obligated to deliver property is liable with regard to such delivery, 
such liability will be considered to result from the activity performed 
of delivering such property. For example, if a corporation which exports 
all of its inventory from the United States to foreign countries or 
possessions of the United States is liable with regard to its failure to 
make delivery outside the United States of inventory it has sold, such 
liability will be considered to result from an activity exclusively 
carried on outside the United States and will be considered a liability 
which could not arise from activity performed in the United States. In 
further illustration, if a corporation which exports all of its 
inventory from a foreign country to the United States is liable with 
regard to its improper delivery in the United States of inventory it has 
sold, such liability will be considered to result from an activity 
exclusively carried on in the United States and will be considered a 
liability which could arise from activity performed in the United 
States.

[[Page 269]]

    (d) Lives or health of United States residents. Risks in connection 
with the lives or health of residents of the United States include those 
risks which are the subject of insurance contracts referred to in 
section 801(a), relating to the definition of a life insurance company. 
If the insured is a resident of the United States at the time the 
insurance contract is approved, the risk is in connection with the life 
or health of a resident of the United States for the period of coverage 
under the contract. However, if during such period of coverage the 
insured notifies the insurer, or circumstances known to the insurer 
indicate, that the insured is no longer a resident of the United States, 
the risk shall cease to be a risk in connection with the life or health 
of a resident of the United States for the policy period in which the 
insured gives such notice or such circumstances are known to the 
insurer, and for each subsequent policy period. Conversely, if the 
insured is a resident of a particular foreign country at the time the 
insurance contract is approved, the risk is in connection with the life 
or health of a resident of such foreign country for the period of 
coverage under the contract. However, if during such period of coverage 
the insured notifies the insurer, or circumstances known to the insurer 
indicate, that the insured is no longer a resident of such foreign 
country, the risk shall cease to be a risk in connection with the life 
or health of a resident of such particular foreign country for the 
policy period in which the insured gives such notice or such 
circumstances are known to the insurer, and for each subsequent policy 
period. In determining the country of residence of an insured, the 
principles of Sec. Sec. 301.7701(b)-1 through 301.7701(b)-9 of this 
chapter, relating to the determination of residence and nonresidence in 
the United States and of foreign residence, shall apply. Citizens of the 
United States are not residents of the United States merely because of 
their citizenship. The application of this paragraph may be illustrated 
by the following example:

    Example. Controlled foreign corporation A is a wholly owned 
subsidiary of domestic corporation M. Corporation A uses the calendar 
year as the taxable year and is engaged in the life insurance business 
in foreign country X. In 1963, A Corporation issues ordinary life 
insurance contracts on the lives of residents of the United States, 
including one issued on February 1, 1963, to R, a citizen of foreign 
country Y and a resident of the United States on such date. All activity 
in connection with the issuing of such contracts is transacted by mail. 
On May 1, 1963, R abandons his United States residence and establishes 
residence in foreign country Z. There are no circumstances known to A 
Corporation that R has changed his residence until R, on March 1, 1964, 
actually notifies A Corporation of that change. Income of A Corporation 
for the policy period of February 1, 1963, to January 31, 1964, from 
issuing such insurance contracts is income derived from the insurance of 
United States risks. However, income of A Corporation derived for the 
policy period of February 1, 1964, to January 31, 1965, from R's 
insurance contract is not income derived from the insurance of United 
States risks.

(Secs. 913(m) (92 Stat. 3106; 26 U.S.C. 913(m)), and 7805 (68A Stat. 
917; 26 U.S.C. 7805), Internal Revenue Code of 1954)

[T.D. 6781, 29 FR 18202, Dec. 23, 1964, as amended by T.D. 7736, 45 FR 
76143, Nov. 18, 1980; T.D. 8411, 57 FR 15241, Apr. 27, 1992]



Sec. 1.953-3  Risks deemed to be United States risks.

    (a) Artificial arrangements. For purposes of paragraph (a) of Sec. 
1.953-1, the term ``United States risks'' also includes under section 
953(a)(1)(B) risks which are deemed to be United States risks. They are 
risks (other than United States risks described in section 953(a)(1)(A) 
and Sec. 1.953-2) which a controlled foreign corporation reinsures 
under an insurance or annuity contract, or with respect to which a 
controlled foreign corporation issues any insurance or annuity contract, 
in accordance with any arrangement whereby another corporation which is 
not a controlled foreign corporation receives an amount of premiums (for 
reinsuring or issuing any insurance or annuity contract in connection 
with the United States risks described in section 953(a)(1)(A) and Sec. 
1.953-2) which is substantially equal to the amount of premiums which 
the controlled foreign corporation receives under its contracts. 
Arrangements to which this rule applies include those entered into by 
the controlled foreign corporation,

[[Page 270]]

by its United States shareholders, or by a related person.
    (b) Evidence of arrangements. The determination of the existence of 
an arrangement referred to in paragraph (a) of this section shall depend 
on all the facts and circumstances in each case. In making this 
determination, it will be recognized that arrangements of this type 
generally are orally entered into outside the United States and that 
direct evidence of such an arrangement is not ordinarily available. 
Therefore, in determining the existence of such an arrangement, 
consideration will be given to whether or not there is substantial 
similarity between the type, location, profit margin expected, and loss 
experience of the risks which the corporation which is not a controlled 
foreign corporation insures or reinsures and the risks which the 
controlled foreign corporation insures or reinsures. Further, 
consideration will be given to the existence of prior similar 
arrangements between, and the identity of the directors or shareholders 
of, the corporation which is not a controlled foreign corporation, its 
shareholders, or related persons and the controlled foreign corporation, 
its shareholders, or related persons. However, the absence of such prior 
arrangements or identity of directors or shareholders will not of itself 
establish the nonexistence of an arrangement referred to in paragraph 
(a) of this section. In determining whether the amounts received by the 
controlled foreign corporation and the corporation which is not a 
controlled foreign corporation are substantially equal, the period in 
which the controlled foreign corporation receives premiums need not be 
the same as, or identical in length with, that of the corporation which 
is not a controlled foreign corporation nor limited to a taxable year of 
the controlled foreign corporation.
    (c) Illustrations. The application of this section may be 
illustrated by the following examples:

    Example 1. Controlled foreign corporation A is a wholly owned 
subsidiary of domestic corporation M. Foreign corporation B is a wholly 
owned subsidiary of foreign corporation R. All corporations use the 
calendar year as the taxable year. Corporations M and R, which are not 
related persons, agree that from July 1, 1963, through December 31, 
1963, B Corporation will reinsure all risks of M Corporation which are 
United States risks described in section 953(a)(1)(A), and that from 
January 1, 1964, through June 30, 1964, A Corporation will reinsure all 
risks of R Corporation which are not United States risks described in 
section 953(a)(1)(A). The amount of premiums received by A Corporation 
and B Corporation, respectively, as a result of the agreement are 
substantially equal. The income of A Corporation derived in 1964 from 
reinsuring the risks of R Corporation is income derived from the 
insurance of United States risks described in section 953(a)(1)(B).
    Example 2. Assume the same facts as in example 1, except that M and 
R Corporations also agree, as part of their arrangement, that from July 
1, 1964, through December 31, 1964, B Corporation will reinsure all 
risks of M Corporation which are United States risks described in 
section 953(a)(1)(A), and that from January 1, 1965, through June 30, 
1965, A Corporation will reinsure all risks of R Corporation which are 
not United States risks described in section 953(a)(1)(A). The amount of 
premiums derived by B Corporation from July 1, 1963, through December 
31, 1963, under the agreement is not substantially equal to the amount 
of premiums derived by A Corporation from January 1, 1964, through June 
30, 1964, and the amount of premiums derived by B Corporation from July 
1, 1964, through December 31, 1964, is not substantially equal to the 
amount of premiums derived by A Corporation from January 1, 1965, 
through June 30, 1965. However, the aggregate amount of premiums 
received by B Corporation under the arrangement is substantially equal 
to the aggregate amount of premiums received by A Corporation. The 
income of A Corporation derived in 1964 and 1965 from reinsuring the 
risks of R Corporation is income derived from the insurance of United 
States risks described in section 953(a)(1)(B).
    Example 3. Assume the same facts as in example 1, except that 
foreign corporation C is also a wholly owned subsidiary of R 
Corporation. Assume that C Corporation uses the calendar year as its 
taxable year. Assume further that M Corporation and R Corporation agree 
that from July 1, 1963, through December 31, 1963, B Corporation and C 
Corporation together will reinsure the United States risks described in 
section 953(a)(1)(A) of M Corporation. The amount of premiums received 
by B Corporation in respect of such United States risks is equal to one-
third of the amount received by A Corporation in respect of the risks 
which are not United States risks described in section 953(a)(1)(A), and 
the amount of premiums received by C Corporation in respect of such 
United States risks is equal to two-thirds of the amount so received by 
A Corporation. The income of A Corporation derived in 1964 from 
reinsuring the risks of R Corporation is income derived

[[Page 271]]

from the insurance of United States risks described in section 
953(a)(1)(B).
    Example 4. Assume the same facts as in example 3, except that 
controlled foreign corporation D is also a wholly owned subsidiary of M 
Corporation and uses the calendar year as its taxable year. Assume 
further that M Corporation and R Corporation agree that in 1964 R 
Corporation will pay premiums of $300,000 to A Corporation and $700,000 
to D Corporation to reinsure all risks of R Corporation which are not 
United States risks described in section 953(a)(1)(A), and that in 1963 
M Corporation will pay premiums of $400,000 to B Corporation and 
$600,000 to C Corporation to reinsure all risks of M Corporation which 
are United States risks described in section 953(a)(1)(A). The income of 
A Corporation and D Corporation derived in 1964 from reinsuring the 
risks of R Corporation is income derived from the insurance of United 
States risks described in section 953(a)(1)(B).
    Example 5. Controlled foreign corporation A is a wholly owned 
subsidiary of domestic insurance corporation M. Controlled foreign 
corporation B is a wholly owned subsidiary of domestic insurance 
corporation N. All corporations use the calendar year as the taxable 
year. As a result of an arrangement between M Corporation and N 
Corporation, in 1963 A Corporation reinsures all the United States risks 
described in section 953(a)(1)(A) of N Corporation, and B Corporation 
reinsures all the United States risks described in section 953(a)(1)(A) 
of M Corporation. The premiums and other consideration received by A 
Corporation and B Corporation in respect of such reinsurance are not 
substantially equal. The income of A Corporation and B Corporation in 
1962 from reinsuring the risks of N Corporation and M Corporation, 
respectively, is income derived from the insurance of United States 
risks described in section 953(a)(1)(A) and is not income derived from 
the insurance or United States risks described in section 953(a)(1)(B).
    Example 6. Assume the same facts as in example 5, except that B 
Corporation is not a controlled foreign corporation. The income of A 
Corporation in 1963 from reinsuring the risks of N Corporation is income 
derived from the insurance of United States risks described in section 
953(a)(1)(A) and is not income derived from the insurance of United 
States risks described in section 953(a)(1)(B).

[T.D. 6781, 29 FR 18207, Dec. 23, 1964]



Sec. 1.953-4  Taxable income to which section 953 applies.

    (a) Taxable income defined--(1) Life insurance taxable income. For a 
controlled foreign corporation which is engaged in the business of 
reinsuring or issuing insurance or annuity contracts and which, if it 
were a domestic corporation engaged only in such business, would be 
taxable as a life insurance company to which part I (sections 801 
through 820) of subchapter L of the Code applies, the term ``taxable 
income'' means for purposes of paragraph (a) of Sec. 1.953-1 the gain 
from operations, as defined in section 809(b) and as modified by this 
section, derived from, and attributable to, the insurance of United 
States risks. For purposes of determining such taxable income, the 
provisions of section 802(b) (relating to the definition of life 
insurance company taxable income) shall not apply. Determinations for 
purposes of this subparagraph shall be made without regard to section 
501(a).
    (2) Mutual and other insurance taxable income. For a controlled 
foreign corporation which is engaged in the business of reinsuring or 
issuing insurance or annuity contracts and which, if it were a domestic 
corporation engaged only in such business, would be taxable as a mutual 
insurance company to which part II (sections 821 through 826) of 
subchapter L of the Code applies or a mutual marine insurance or other 
insurance company to which part III (sections 831 and 832) of subchapter 
L of the Code applies, the term ``taxable income'' means for purposes of 
paragraph (a) of Sec. 1.953-1 taxable income, as defined in section 
832(a) and as modified by this section, derived from, and attributable 
to, the insurance of United States risks. Determinations for purposes of 
this subparagraph shall be made without regard to section 501(a).
    (3) Corporations not qualifying as insurance companies. For special 
rules applicable under this section in the case of a controlled foreign 
corporation which, if it were a domestic corporation, would not qualify 
as an insurance company, see Sec. 1.953-5.
    (b) Certain provisions inapplicable. In determining taxable income 
under this section, the following provisions of subchapter L of the Code 
shall not apply:
    (1) Section 809(d)(4), relating to the operations loss deduction;
    (2) Section 809(d)(5), relating to certain nonparticipating 
contracts;

[[Page 272]]

    (3) Section 809(d)(6), relating to certain accident and health 
insurance and group life insurance;
    (4) Section 809(d)(10), relating to small business deduction;
    (5) Section 817(b), relating to gain on property held on December 
31, 1958, and certain substituted property acquired after 1958; and
    (6) Section 832(c)(5), relating to capital losses.
    (c) Computation of reserves required by law--(1) Law applicable in 
determining reserves. The reserves which will be taken into account as 
reserves required by law under section 801(b)(2), both in determining 
for any taxable year whether a controlled foreign corporation is a 
controlled foreign corporation described in paragraph (a)(1) or (2) of 
this section and in determining taxable income of such corporation for 
the taxable year under paragraph (a) of this section, shall be the 
following reserves:
    (i) Reserves required by the law of a State. The reserves which are 
required by the law of the State or States to which the insurance 
business of the controlled foreign corporation is subject, but only with 
respect to its United States business, if any, which is taxable under 
section 819(a).
    (ii) Reserves deemed to be required. To the extent of such 
controlled foreign corporation's insurance business not taxable under 
section 819(a)--
    (a) Except as provided in (b) of this subdivision (ii), the reserves 
which would result if such reserves were determined by applying the 
minimum standards of the law of New York as if such controlled foreign 
corporation were an insurance company transacting all of its insurance 
business (other than its United States business which is taxable under 
section 819(a)) for such taxable year in such State, and
    (b) With respect to all risks covered by insurance ceded to such 
controlled foreign corporation by an insurance company to which apply 
the provisions of subchapter L of the Code (determined without regard to 
section 501(a)) and in respect of which an election is made by or on 
behalf of such controlled foreign corporation to determine its reserves 
in accordance with this subdivision (b), the amount of reserves against 
such risks which would result if all of such reserves were determined by 
applying the law of the State, to which the risks in the hands of such 
insurance company are subject, as if such controlled foreign corporation 
were an insurance company engaged in reinsuring such risks in such 
State.
    (2) Rules of application. For purposes of subparagraph (1) of this 
paragraph, the following rules shall apply:
    (i) Life insurance reserves computed on preliminary term basis. For 
purposes of determining under paragraph (a) of this section the taxable 
income of a controlled foreign corporation, an election may be made by 
or on behalf of such corporation that the amount of reserves which are 
taken into account as life insurance reserves with respect to contracts 
for which reserves are computed on a preliminary term basis shall be 
determined as provided in section 818(c). This election shall apply, 
subject to section 818(c), to all life insurance reserves of the 
controlled foreign corporation, whether or not reserves applicable to 
the United States business taxable under section 819(a). However, 
reserves determined as provided in section 818(c) shall not be taken 
into account in determining whether a controlled foreign corporation is 
a controlled foreign corporation described in paragraph (a)(1) or (2) of 
this section.
    (ii) Actual reserves required. (a) A controlled foreign corporation 
will be considered to have a reserve only to the extent the reserve has 
been actually held during the taxable year for which such reserve is 
claimed.
    (b) For determining when reserves are required by the law of a 
State, see paragraph (b) of Sec. 1.801-5 of this chapter.
    (iii) Total reserves to be taken into account. The total reserves of 
a controlled foreign corporation shall be taken into account in 
determining whether such corporation is a controlled foreign corporation 
described in paragraph (a)(1) or (2) of this section. Therefore, in 
making such determination, the reserves which, under subparagraph (1)(i) 
of this paragraph, are required by the law of any State shall be taken 
into account together with the reserves which, under subparagraph 
(1)(ii) of this paragraph, are deemed to

[[Page 273]]

be required. Moreover, reserves applicable to the reinsuring or the 
issuing of insurance or annuity contracts of both United States risks 
and foreign risks shall be taken into account. Finally, except as 
provided in subdivision (i) of this subparagraph, the reserves which are 
taken into account in determining whether a controlled foreign 
corporation is a controlled foreign corporation described in paragraph 
(a)(1) or (2) of this section shall be the same reserves which are taken 
into account in determining under paragraph (a) of this section the 
taxable income of such corporation.
    (iv) Method of comparing reserves when subject to more than one 
State. If the insurance business of a controlled foreign corporation is 
subject to the law of more than one State, the amount of reserves taken 
into account under subparagraph (1)(i) of this paragraph shall be the 
amount of the highest aggregate reserve required by any State, 
determined as provided in paragraph (a) of Sec. 1.801-5 of this 
chapter.
    (d) Domestic corporation tax attributes. In determining taxable 
income of a controlled foreign corporation under this section there 
shall be allowed, except as provided in section 953(b), this section, 
and Sec. 1.953-5, the exclusions and deductions from gross income which 
would be allowed if such corporation were a domestic insurance company 
engaged in the business of only reinsuring or issuing the insurance or 
annuity contracts which have been reinsured or issued by such 
corporation. For this purpose, the provisions of sections 819, 821(e), 
822(e), 831(b), and 832(d), relating to foreign insurance companies, 
shall not apply; however, for the exclusion from the taxable income 
determined under section 953 of amounts derived from sources within the 
United States, see section 952(b) and paragraph (b) of Sec. 1.952-1. 
Furthermore, taxable income shall be determined under this section 
without regard to section 882 (b) and (c), relating to gross income and 
deductions of a foreign corporation, and without regard to whether the 
controlled foreign corporation is carrying on an insurance business in 
the United States. For other rules relating to the determination of 
gross income and taxable income of a foreign corporation for purposes of 
subpart F, see Sec. 1.952-2.
    (e) Limitation on certain amounts in respect of United States risks. 
In determining taxable income under this section the following amounts 
shall not, in accordance with section 953(b)(4), be taken into account 
except to the extent they are attributable to the reinsuring or issuing 
of any insurance or annuity contract in connection with United States 
risks described in Sec. 1.953-2 or Sec. 1.953-3:
    (1) The amount of premiums determined under section 809(c)(1);
    (2) The net decrease in reserves determined under section 809(c)(2);
    (3) The net increase in reserves determined under section 809(d)(2); 
and
    (4) The premiums earned on insurance contracts during the taxable 
year, as determined under section 832(b)(4). For the allocation and 
apportionment of such amounts to income from the insurance of United 
States risks, see paragraphs (f) and (g) of this section.
    (f) Items allocated or apportioned--(1) Rules of allocation or 
apportionment. In determining taxable income under this section, first 
determine all items of income, expenses, losses, and other deductions 
which directly relate to the premiums received for the reinsuring or the 
issuing of any insurance or annuity contract in connection with United 
States risks, as defined in Sec. Sec. 1.953-2 and 1.953-3, and allocate 
such items to the insurance of United States risks. For example, the 
deductions allowed by section 809(d)(1), relating to death benefits, 
section 809(d)(3), relating to dividends to policyholders, and section 
809(d)(7), relating to the assumption by another person of liabilities 
under insurance contracts, shall be allocated to the insurance of United 
States risks to the extent they relate directly to the premiums received 
for reinsuring or issuing insurance or annuity contracts in connection 
with United States risks. Next, determine all items of income, expenses, 
losses, and other deductions which directly relate to the premiums 
received for the reinsuring or the issuing of any insurance or annuity 
contract in connection with foreign risks and allocate such items to the 
reinsuring of foreign risks. Finally, determine all items of income,

[[Page 274]]

expenses, losses, and other deductions which relate to the premiums 
received for the reinsuring or the issuing of any insurance or annuity 
contract in connection with both United States risks and foreign risks, 
and, except as provided in paragraph (g) of this section, apportion such 
items between the insurance of United States risks and the insurance of 
foreign risks in the manner prescribed in subparagraph (2) or (3) of 
this paragraph, as the case may be. As used in this section, the term 
``foreign risks'' means risks which are not United States risks as 
defined in Sec. 1.953-2 or Sec. 1.953-3.
    (2) Method of apportionment in determination of life insurance 
taxable income--(i) Investment yield and net long-term capital gain. 
Unless they can be allocated to the insurance of United States risks, as 
provided in subparagraph (1) of this paragraph, in determining a 
controlled foreign corporation's taxable income for any taxable year 
under paragraph (a)(1) of this section--
    (a) The investment yield under section 804(c),
    (b) The amount (if any) under section 809(b)(1)(B) by which the net 
long-term capital gain exceeds the net short-term capital loss, and
    (c) Those deductions allowed under section 809(d)(8), (9), and (12) 
which relate to gross investment income shall be apportioned to the 
reinsuring and issuing of insurance and annuity contracts in connection 
with United States risks in an amount which bears the same ratio to each 
of such amounts of investment yield, excess gain, and deductions as the 
sum of the mean of each of the items described in section 810(c) at the 
beginning and end of the taxable year attributable to reinsuring and 
issuing any insurance and annuity contracts in connection with United 
States risks bears to the sum of the mean of each of the items described 
in section 810(c) at the beginning and end of the taxable year 
attributable to reinsuring and issuing all insurance and annuity 
contracts. Thus, for example, if the ratio which the sum of the mean of 
each of the items described in section 810(c) at the beginning and end 
of the taxable year attributable to reinsuring and issuing insurance and 
annuity contracts in connection with United States risks bears to the 
sum of the mean of each of the items described in section 810(c) at the 
beginning and end of the taxable year attributable to reinsuring and 
issuing all insurance and annuity contracts in one to three, then, 
unless an allocation to the insurance of United States risks can be made 
as provided in subparagraph (1) of this paragraph, one-third of each of 
such amounts of investment yield, excess gain, and deductions shall be 
apportioned to the reinsuring and issuing of insurance and annuity 
contracts in connection with United States risks, and two-thirds of each 
of such amounts shall be apportioned to the reinsuring and issuing of 
insurance and annuity contracts in connection with foreign risks.
    (ii) Other income and deductions--(a) Amount taken into account. In 
determining a controlled foreign corporation's taxable income for any 
taxable year under paragraph (a)(1) of this section, all items of income 
taken into account under section 809(c)(3), relating to other amounts of 
gross income, and the other deductions allowed under section 809(d)(12) 
to the extent that such other deductions do not relate to gross 
investment income shall be apportioned to the reinsuring and issuing of 
insurance and annuity contracts in connection with United States risks 
in an amount which bears the same ratio to each of such items of income 
or of such other deductions as the numerator determined under (b) of 
this subdivision bears to the denominator determined under (c) of this 
subdivision.
    (b) Numerator. The numerator used for purposes of the apportionment 
under (a) of this subdivision shall be an amount which equals the amount 
determined under (c) of this subdivision, but only to the extent that 
the amount so determined is taken into account under paragraph (e) of 
this section in determining taxable income for the taxable year.
    (c) Denominator. The denominator used for purposes of the 
apportionment under (a) of this subdivision shall be an amount which 
equals--
    (1) The amount of premiums determined under section 809(c)(1) for 
the taxable year, plus

[[Page 275]]

    (2) The net decrease in reserves determined under section 809(c)(2) 
for such year, minus
    (3) The net increase in reserves determined under section 809(d)(2) 
for such year.
    (iii) Reserves used in apportionment formula. The rules for 
determining which reserves are taken into account in determining the 
taxable income of a controlled foreign corporation under paragraph (a) 
of this section shall also apply under subdivision (ii) (b) and (c) of 
this subparagraph in determining the net decrease in reserves under 
section 809(c)(2) or the net increase in reserves under section 
809(d)(2). See paragraph (c) of this section.
    (3) Method of apportionment in determination of mutual and other 
insurance income--(i) In general. In determining a controlled foreign 
corporation's taxable income for any taxable year under paragraph (a)(2) 
of this section, any item which is required to be apportioned under 
subparagraph (1) of this paragraph shall be apportioned to the 
reinsuring and issuing of insurance and annuity contracts in connection 
with United States risks in an amount which bears the same ratio to the 
total amount of such item as the amount of premiums earned on insurance 
contracts during the taxable year which is required to be taken into 
account by such corporation under paragraph (e)(4) of this section in 
determining such taxable income bears to the total amount of all its 
premiums earned (as determined under section 832(b)(4)) on insurance 
contracts during the taxable year.
    (ii) Reserves used in apportionment formula. The principles of 
subparagraph (2)(iii) of this paragraph shall apply in determining the 
reserves included in premiums earned on insurance contracts during the 
taxable year for purposes of subdivision (i) of this subparagraph.
    (g) Separate accounting. The methods of apportionment prescribed in 
subparagraphs (2) and (3) of paragraph (f) of this section for 
determining taxable income under this section shall not apply if the 
district director determines that the controlled foreign corporation, in 
good faith and unaffected by considerations of tax liability, regularly 
employs in its books of account a detailed segregation of receipts, 
expenditures, assets, liabilities, and net worth which clearly reflects 
the income derived from the reinsuring or issuing of insurance or 
annuity contracts in connection with United States risks. The district 
director, in making such determination, shall give effect to any foreign 
law, satisfactory evidence of which is presented by the United States 
shareholder to the district, director, which requires a reasonable 
segregation of those items of income, expense, losses, and other 
deductions which relate to determining such taxable income.
    (h) Illustration. The application of paragraphs (e) and (f) of this 
section may be illustrated by the following example:

    Example. Controlled foreign corporation A, incorporated under, and 
engaged in an insurance business subject to, the laws of foreign country 
X, is a wholly owned subsidiary of domestic corporation M. Both 
corporations use the calendar year as the taxable year. Corporation M is 
a life insurance company as defined in section 801(a); A Corporation 
would, if it were a domestic corporation, be taxable under part I of 
subchapter L of the Code. In 1963, A Corporation derives income from the 
insurance of United States risks as a result of reinsuring the life 
insurance policies issued by M Corporation on lives of residents of the 
United States. In 1963, A Corporation also issues policies of life 
insurance on individuals who are not residents of the United States, but 
its premiums from the reinsuring of United States risks exceed he 5-
percent minimum premium requirement prescribed in paragraph (b) of Sec. 
1.953-1. Based upon the facts set forth in paragraph (a) of this 
example, A Corporation for 1963 has taxable income under this section of 
$40,200, which is attributable to the reinsuring of life insurance 
contracts in connection with United States risks, determined in the 
manner provided in paragraphs (b), (c), and (d) of this example.
    (a) A summary of the entire operations of A Corporation for 1963, 
determined under this section as though such corporation were a domestic 
life insurance company but without applying paragraph (f) of this 
section, is as follows:

[[Page 276]]



------------------------------------------------------------------------
                                              Attributable  Attributable
                                Attributable       to        to insuring
             Item                  to all      reinsuring      foreign
                                  insurance    U.S. risks       risks
------------------------------------------------------------------------
Investment Income:
  (1) Investment yield under         $90,000   Unallocable   Unallocable
   section 804(c).............
  (2) Sum of the mean of each      2,500,000    $1,000,000    $1,500,000
   of the items described in
   section 810(c) at beginning
   and end of 1963............
  (3) Required interest under         60,000        25,000        35,000
   section 809(a)(2)..........
  (4) Deductions allowed under        10,000   Unallocable   Unallocable
   section 809(d)(8), (9), and
   (12) which relate to gross
   investment income..........
Underwriting Income:
  (5) Premiums under section         600,000       200,000       400,000
   809(c)(1)..................
  (6) Net decrease in reserves        10,000          None        10,000
   under section 809(c)(2)....
  (7) Net increase in reserves        40,000        40,000          None
   under section 809(d)(2)....
  (8) Deductions allowed under
   section 809(d) (other than
   deduction allowed under
   section 809(d)(2) and other
   than those deductions
   allowed under section
   809(d)(8), (9), and (12)
   which relate to gross
   investment income):
    (i) Allocable.............       330,000       110,000       220,000
    (ii) Unallocable..........        60,000   Unallocable   Unallocable
------------------------------------------------------------------------

    (b) The unallocable investment yield ($90,000) under paragraph 
(a)(1) of this example and the unallocable deductions ($10,000) under 
paragraph (a)(4) relating to gross investment income are apportioned to 
the reinsuring of United States risks under paragraph (f)(1)(i) of this 
section in the amounts of $36,000, and $4,000, respectively, determined 
as follows:

(1) Sum of the mean of each of the items described in         $1,000,000
 section 810(c) at beginning and end of 1963, attributable
 to reinsuring U.S. risks (paragraph (a)(2))................
(2) Sum of the mean of each of the items described in         $2,500,000
 section 810(c) at beginning and end of 1963, attributable
 to all insurance (paragraph (a)(2))........................
(3) Ratio of amount under subparagraph (1) to amount under           40%
 subparagraph (2) ($1,000,000/$2,500,000)...................
(4) Amount of investment yield attributable to reinsuring of     $36,000
 U.S. risks (40% of $90,000)................................
(5) Amount of such deductions attributable to reinsuring of       $4,000
 U.S. risks (40% of $10,000)................................
 

    (c) The unallocable deductions ($60,000) under paragraph (a)(8)(ii) 
of this example which do not relate to gross investment income are 
apportioned to the reinsuring of United States risks under paragraph 
(f)(2)(ii) of this section in the amount of $16,800, determined as 
follows:
    (1) The numerator determined under paragraph (f)(2)(ii)(b) of this 
section is $160,000, determined as follows:

(i) Premiums under section 809(c)(1)               $200,000
 attributable to reinsuring U.S. risks
 (paragraph (a)(5))...........................
(ii) Plus: Net decrease in reserves under       ...........     $200,000
 section 809(c)(2) attributable to reinsuring
 U.S. risks (paragraph (a)(6))................
                                                            ------------
(iii) Less: Net increase in reserves under section               $40,000
 809(d)(2) attributable to reinsuring U.S. risks (paragraph
 (a)(7))...................................................
                                                            ------------
                                                ...........     $160,000
 

    (2) The denominator determined under paragraph (f)(2)(ii)(c) of this 
section is $570,000, determined as follows:

(i) Premiums under section 809(c)(1)               $600,000
 attributable to all insurance (paragraph
 (a)(5))......................................
(ii) Plus: Net decrease in reserves under            10,000
 section 809(c)(2) attributable to all
 insurance (paragraph (a)(6)).................
                                               --------------
                                                ...........     $610,000
(iii) Less: Net increase in reserves under section                40,000
 809(d)(2) attributable to all insurance (paragraph (a)(7))
                                                            ------------
                                                ...........     $570,000
 

    (3) Ratio which the numerator determined under subparagraph (1) 
bears to the denominator determined under subparagraph (2) ($160,000/
$570,000)--28%.
    (4) Amount of deductions attributable to reinsuring of U.S. risks 
(28% of $60,000)--$16,800.
    (d) The taxable income of A Corporation for 1963 which constitutes 
its income derived from the insurance of United States risks for 
purposes of paragraph (a) of Sec. 1.953-1 is $40,200, determined as 
follows:

----------------------------------------------------------------------------------------------------------------
                                                 Attributable to all     Attributable to       Attributable to
                                                      insurance          reinsuring U.S.      insuring foreign
                                               ----------------------         risks                 risks
                                                                     -------------------------------------------
 
----------------------------------------------------------------------------------------------------------------
Item:
  (1) Investment yield under section 804(c)       $90,000  .........    $36,000  .........    $54,000
   (paragraph (a)(1), unallocable but as
   apportioned under paragraph (b)(4).........

[[Page 277]]

 
  (2) Less: Required interest under section        60,000  .........     25,000  .........     35,000
   809(a)(2) (paragraph (a)(3))...............
                                               -----------           -----------           -----------
  (3) Life insurance company's share of         .........    $30,000  .........    $11,000  .........    $19,000
   investment yield under section 809(b)(1)(A)
Plus sum of:
  (4) Premiums under section 809(c)(1)            600,000  .........    200,000  .........    400,000
   (paragraph (a)(5)).........................
  (5) Net decrease in reserves under section       10,000    610,000       None    200,000     10,000    410,000
   809(c)(2) (paragraph (a)(6))...............
                                               -----------------------------------------------------------------
     Sum determined under section 809(b)(1)...  .........    640,000  .........    211,000  .........    429,000
Less sum of:
  (6) Net increase in reserves under section       40,000  .........     40,000  .........       None
   809(d)(2) (paragraph (a)(7))...............
  (7) Deductions allowed under section             10,000  .........      4,000  .........      6,000
   809(d)(8), (9), and (12) which relate to
   gross investment income (paragraph (a)(4)),
   unallocable but as apportioned under
   paragraph (b)(5)...........................
  (8) Deductions allowed under section 809(d)
   (other than deduction allowed under section
   809(d)(2) and other than those deductions
   allowed under section 809(d)(8), (9), and
   (12) which relate to gross investment
   income) (paragraph (a)(8)):................
    (i) Allocable.............................    330,000  .........    110,000  .........    220,000
    (ii) Unallocable, but as apportioned under     60,000    440,000     16,800    170,800     43,200    269,200
     paragraph (c)(4).........................
                                               -----------------------------------------------------------------
     Gain from operations.....................  .........    200,000  .........     40,200  .........    159,800
----------------------------------------------------------------------------------------------------------------


[T.D. 6781, 29 FR 18207, Dec. 23, 1964]



Sec. 1.953-5  Corporations not qualifying as insurance companies.

    (a) In general. A controlled foreign corporation is not excluded 
from the application of paragraph (a) of Sec. 1.953-1 because such 
corporation, if it were a domestic corporation, would not be taxable as 
an insurance company to which subchapter L of the Code applies. Thus, if 
a controlled foreign corporation reinsures or issues insurance or 
annuity contracts in connection with United States risks, as defined in 
Sec. 1.953-2 or Sec. 1.953-3, and satisfies the 5-percent minimum 
premium requirement prescribed in paragraph (b) of Sec. 1.953-1, such 
corporation may derive income from the insurance of United States risks 
even though the primary and predominant business activity of such 
corporation during the taxable year is not the issuing of insurance or 
annuity contracts or the reinsuring of risks underwritten by insurance 
companies.
    (b) Income from insurance of United States risks by noninsurance 
company. For purposes of paragraph (a) of Sec. 1.953-1, the taxable 
income derived from the reinsuring or the issuing of any insurance or 
annuity contract in connection with United States risks by a controlled 
foreign corporation which, if it were a domestic corporation, would not 
be taxable as an insurance company to which subchapter L of the Code 
applies shall be determined under Sec. 1.953-4, subject to, and to the 
extent not inconsistent with, the special rules prescribed in paragraph 
(c) or (d) of this section, whichever applies.
    (c) Special rules in determining taxable income--(1) In general. The 
rules prescribed in this paragraph apply in order to exclude from the 
determination under Sec. 1.953-4 of the taxable income described in 
paragraph (b) of this section those items of the controlled foreign 
corporation's gross income and deductions which are not attributable to 
the reinsuring and issuing of insurance and annuity contracts.
    (2) Life insurance taxable income--(i) Amount of investment yield 
taken into account. For purposes of determining the

[[Page 278]]

taxable income of a controlled foreign corporation which would not be 
taxable as an insurance company to which subchapter L of the Code 
applies if it were a domestic corporation but would be taxable as an 
insurance company to which part I of such subchapter applies if it were 
a domestic insurance company engaged in the business of only reinsuring 
or issuing the insurance or annuity contracts which have been reinsured 
or issued by such corporation, the investment yield under section 
804(c), the amount (if any) by which the net long-term capital gain 
exceeds the net short-term capital loss, and all items of income taken 
into account under section 809(c)(3) shall be taken into account, 
subject to the provisions of paragraphs (e) and (f) of Sec. 1.953-4, in 
an amount which bears the same ratio to each of such amounts of 
investment yield, excess gain, and income items, as the case may be, as 
the numerator determined under subdivision (ii) of this subparagraph 
bears to the denominator determined under subdivision (iii) of this 
subparagraph.
    (ii) Numerator. The numerator used for purposes of the apportionment 
under subdivision (i) of this subparagraph shall be the sum of--
    (a) The mean of each of the items described in section 810(c) at the 
beginning and end of the taxable year, determined in accordance with the 
rules prescribed in paragraph (c) of Sec. 1.953-4 for purposes of 
determining taxable income of a controlled foreign corporation under 
paragraph (a) of Sec. 1.953-4,
    (b) The mean of other liabilities at the beginning and end of the 
taxable year which are attributable to the reinsuring and issuing of 
insurance and annuity contracts, and
    (c) The mean of the earnings and profits accumulated by the 
controlled foreign corporation at the beginning and end of the taxable 
year (determined without diminution by reason of any distributions made 
during the taxable year) which are attributable to the reinsuring and 
issuing of insurance and annuity contracts.
    (iii) Denominator. The denominator used for purposes of the 
apportionment under subdivision (i) of this subparagraph shall be the 
mean of the value of the total assets held by the controlled foreign 
corporation at the beginning and end of the taxable year, determined by 
taking assets into account at their actual value (not reduced by 
liabilities), which, in the absence of affirmative evidence to the 
contrary, shall be deemed to be (a) face value in the case of bills 
receivable, accounts receivable, notes receivable, and open accounts 
held by a controlled foreign corporation using the cash receipts and 
disbursements method of accounting and (b) adjusted basis in the case of 
all other assets.
    (3) Mutual and other insurance taxable income--(i) Amount of 
insurance income taken into account. For purposes of determining the 
taxable income of a controlled foreign corporation which, if it were a 
domestic corporation, would not be taxable as an insurance company to 
which subchapter L of the Code applies but which if it were a domestic 
insurance company engaged in the business of only reinsuring or issuing 
the insurance or annuity contracts which have been reinsured or issued 
by such corporation, would be taxable as a mutual insurance company to 
which part II of subchapter L of the Code applies, or would be taxable 
as a mutual marine insurance or other insurance company to which part 
III of subchapter L of the Code applies, the sum of the items of gross 
income referred to in section 832(b)(1) (except the gross amount earned 
during the taxable year from underwriting income described in section 
832(b)(1)(A)) reduced by the deductions allowable under section 832(c) 
which are related to such items of gross income shall be taken into 
account, subject to the provisions of paragraphs (e) and (f) of Sec. 
1.953-4, in an amount which bears the same proportion to the sum of such 
items of gross income reduced by such deductions as the numerator 
determined under subdivision (ii) of this subparagraph bears to the 
denominator determined under subdivision (iii) of this subparagraph.
    (ii) Numerator. The numerator used for purposes of the apportionment 
under subdivision (i) of this subparagraph shall be the sum of--
    (a) The mean of the controlled foreign corporation's unearned 
premiums at the beginning and end of the taxable year, determined under 
section

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832(b)(4)(B) and in accordance with the rules prescribed in paragraph 
(c) of Sec. 1.953-4 for purposes of determining taxable income of a 
controlled foreign corporation under paragraph (a) of Sec. 1.953-4,
    (b) The mean of such corporation's unpaid losses at the beginning 
and end of the taxable year, determined under section 832(b)(5)(B),
    (c) The mean of the items described in section 810(c)(4) at the 
beginning and end of the taxable year, to the extent allowable to such 
corporation under section 832(c)(11),
    (d) The mean of other liabilities at the beginning and end of the 
taxable year which are attributable to the reinsuring and issuing of 
insurance and annuity contracts, and
    (e) The mean of the earnings and profits accumulated by such 
corporation at the beginning and end of the taxable year (determined 
without diminution by reason of any distributions made during the 
taxable year) which are attributable to the reinsuring and issuing of 
insurance and annuity contracts.
    (iii) Denominator. The denominator used for purposes of the 
apportionment under subdivision (i) of this subparagraph shall be the 
mean of the value of the total assets held by the controlled foreign 
corporation at the beginning and end of the taxable year, determined in 
the manner prescribed in subparagraph (2)(iii) of this paragraph.
    (d) Separate accounting. The special rules prescribed in paragraph 
(c) of this section shall not apply if the district director determines 
that the controlled foreign corporation, in good faith and unaffected by 
considerations of tax liability, regularly employs in its books of 
account a detailed segregation of receipts, expenditures, assets, 
liabilities, and net worth which clearly reflects the income derived 
from the reinsuring or issuing of insurance or annuity contracts. The 
district director, in making such determination, shall give effect to 
any foreign law, satisfactory evidence of which is presented by the 
United States shareholder to the district director, which requires a 
reasonable segregation of the insurance assets of the controlled foreign 
corporation.

[T.D. 6781, 29 FR 18211, Dec. 23, 1964]



Sec. 1.953-6  Relationship of sections 953 and 954.

    (a) Priority of application. For purposes of determining the subpart 
F income of a controlled foreign corporation under section 952 for any 
taxable year, the provisions of section 954, relating to foreign base 
company income, shall be applied, after first applying section 953, only 
with respect to income which is not income derived from the insurance of 
United States risks under section 953. For example, the provisions of 
section 954 may be applied with respect to the income of a controlled 
foreign corporation which is not income derived from the insurance of 
United States risks under section 953 because such corporation does not 
satisfy the 5-percent minimum premium requirement prescribed in 
paragraph (b) of Sec. 1.953-1, even though such corporation has taxable 
income, as determined under Sec. 1.953-4, which is attributable to the 
reinsuring or the issuing of any insurance or annuity contracts in 
connection with United States risks. In addition, the provisions of 
section 954 may apply with respect to the income of a controlled foreign 
corporation to the extent such income is not allocated or apportioned 
under Sec. 1.953-4 to the insurance of United States risks.
    (b) Decrease in income not material. It is not material that the 
income of a controlled foreign corporation is decreased as a result of 
the application of paragraph (a) of this section. Thus, in applying 
Sec. 1.953-4 to the income of a controlled foreign corporation 
described in paragraph (c)(2) of Sec. 1.953-5 which would, but for 
paragraph (a) of this section, be subject to the provisions of section 
954, there shall be allowed, in determining the taxable income derived 
from the insurance of United States risks under Sec. 1.953-4, a 
deduction under section 809(a)(1) for the share of each and every item 
of investment yield set aside for policyholders; it is not material that 
in determining foreign base company income such deduction would not be 
allowed under section 954(b)(5). Further, income of a controlled foreign 
corporation which is required to be taken into account under section 953 
in determining income derived from the insurance of United States risks 
and would,

[[Page 280]]

but for the provisions of paragraph (a) of this section, constitute 
foreign base company income under section 954 shall not be taken into 
account under section 954(b)(3)(B) in determining whether foreign base 
company income exceeds 70 percent of gross income for the taxable year.
    (c) Increase in income not material. It is not material that the 
income of a controlled foreign corporation is increased as a result of 
the application of paragraph (a) of this section. Thus, in applying 
Sec. 1.953-4 to income of a controlled foreign corporation which would, 
but for paragraph (a) of this section, be subject to the provisions of 
section 954, it is not material that the dividends, interest, and gains 
from the sale or exchange of stock or securities derived from certain 
investments which would not be included in foreign personal holding 
company income under section 954(c)(3)(B) are included under section 953 
in income derived from the insurance of United States risks. Further, 
income of a controlled foreign corporation which is required to be taken 
into account under section 953 in determining income derived from the 
insurance of United States risks and would, but for paragraph (a) of 
this section, constitute foreign base company income shall not be 
excluded under section 954(b)(3)(A) for the taxable year.

[T.D. 6781, 29 FR 18212, Dec. 23, 1964]



Sec. 1.954-0  Introduction.

    (a) Effective dates--(1) Final regulations--(i) In general. Except 
as otherwise specifically provided, the provisions of Sec. Sec. 1.954-1 
and 1.954-2 apply to taxable years of a controlled foreign corporation 
beginning after November 6, 1995. If any of the rules described in 
Sec. Sec. 1.954-1 and 1.954-2 are inconsistent with provisions of other 
regulations under subpart F, these final regulations are intended to 
apply instead of such other regulations.
    (ii) Election to apply final regulations retroactively--(A) Scope of 
election. An election may be made to apply the final regulations 
retroactively with respect to any taxable year of the controlled foreign 
corporation beginning on or after January 1, 1987. If such an election 
is made, these final regulations must be applied in their entirety for 
such taxable year and all subsequent taxable years. All references to 
section 11 in the final regulations shall be deemed to include section 
15, where applicable.
    (B) Manner of making election. An election under this paragraph 
(a)(1)(ii) is binding on all United States shareholders of the 
controlled foreign corporation and must be made--
    (1) By the controlling United States shareholders, as defined in 
Sec. 1.964-1(c)(5), by attaching a statement to such effect with their 
original or amended income tax returns for the taxable year of such 
United States shareholders in which or with which the taxable year of 
the CFC ends, and including any additional information required by 
applicable administrative pronouncements, or
    (2) In such other manner as may be prescribed in applicable 
administrative pronouncements.
    (C) Time for making election. An election may be made under this 
paragraph (a)(1)(ii) with respect to a taxable year of the controlled 
foreign corporation beginning on or after January 1, 1987 only if the 
time for filing a return or claim for refund has not expired for the 
taxable year of any United States shareholder of the controlled foreign 
corporation in which or with which such taxable year of the controlled 
foreign corporation ends.
    (D) Revocation of election. An election made under this paragraph 
(a)(1)(ii) may not be revoked.
    (2) Temporary regulations. The provisions of Sec. Sec. 4.954-1 and 
4.954-2 of this chapter apply to taxable years of a controlled foreign 
corporation beginning after December 31, 1986 and on or before November 
6, 1995. However, the provisions of Sec. 4.954-2(b)(6) of this chapter 
continue to apply. For transactions entered into on or before October 
10, 1995, taxpayers may rely on Notice 89-90, 1989-2 C.B. 407, in 
applying the temporary regulations.
    (3) Sec. Sec. 1.954A-1 and 1.954A-2. The provisions of Sec. Sec. 
1.954A-1 and 1.954A-2 (as contained in 26 CFR part 1 edition revised 
April 1, 1995) apply to taxable years of a controlled foreign 
corporation beginning before January 1, 1987. All references therein to 
sections of the Code

[[Page 281]]

are to the Internal Revenue Code of 1954 prior to the amendments made by 
the Tax Reform Act of 1986.
    (b) Outline of Sec. Sec. 1.954-0, 1.954-1 and 1.954-2.

                       Sec. 1.954-0 Introduction.

    (a) Effective dates.
    (1) Final regulations.
    (i) In general.
    (ii) Election to apply final regulations retroactively.
    (A) Scope of election.
    (B) Manner of making election.
    (C) Time for making election.
    (D) Revocation of election.
    (2) Temporary regulations.
    (3) Sec. Sec. 1.954A-1 and 1.954A-2.
    (b) Outline of Sec. Sec. 1.954-0, 1.954-1, and 1.954-2.

               Sec. 1.954-1 Foreign base company income.

    (a) In general.
    (1) Purpose and scope.
    (2) Gross foreign base company income.
    (3) Adjusted gross foreign base company income.
    (4) Net foreign base company income.
    (5) Adjusted net foreign base company income.
    (6) Insurance income.
    (7) Additional items of adjusted net foreign base company income or 
adjusted net insurance income by reason of section 952(c).
    (b) Computation of adjusted gross foreign base company income and 
adjusted gross insurance income.
    (1) De minimis and full inclusion tests.
    (i) De minimis test.
    (A) In general.
    (B) Currency translation.
    (C) Coordination with sections 864(d) and 881(c).
    (ii) Seventy percent full inclusion test.
    (2) Character of gross income included in adjusted gross foreign 
base company income.
    (3) Coordination with section 952(c).
    (4) Anti-abuse rule.
    (i) In general.
    (ii) Presumption.
    (iii) Related persons.
    (iv) Example.
    (c) Computation of net foreign base company income.
    (1) General rule.
    (i) Deductions against gross foreign base company income.
    (ii) Losses reduce subpart F income by operation of earnings and 
profits limitation.
    (iii) Items of income.
    (A) Income other than passive foreign personal holding company 
income.
    (B) Passive foreign personal holding company income.
    (2) Computation of net foreign base company income derived from same 
country insurance income.
    (d) Computation of adjusted net foreign base company income or 
adjusted net insurance income.
    (1) Application of high tax exception.
    (2) Effective rate at which taxes are imposed.
    (3) Taxes paid or accrued with respect to an item of income.
    (i) Income other than passive foreign personal holding company 
income.
    (ii) Passive foreign personal holding company income.
    (4) Special rules.
    (i) Consistency rule.
    (ii) Coordination with earnings and profits limitation.
    (iii) Example.
    (5) Procedure.
    (6) Coordination of full inclusion and high tax exception rules.
    (7) Examples.
    (e) Character of income.
    (1) Substance of the transaction.
    (2) Separable character.
    (3) Predominant character.
    (4) Coordination of categories of gross foreign base company income 
or gross insurance income.
    (i) In general.
    (ii) Income excluded from other categories of gross foreign base 
company income.
    (f) Definition of related person.
    (1) Persons related to controlled foreign corporation.
    (i) Individuals.
    (ii) Other persons.
    (2) Control.
    (i) Corporations.
    (ii) Partnerships.
    (iii) Trusts and estates.
    (iv) Direct or indirect ownership.

         Sec. 1.954-2 Foreign personal holding company income.

    (a) Computation of foreign personal holding company income.
    (1) Categories of foreign personal holding company income.
    (2) Coordination of overlapping categories under foreign personal 
holding company provisions.
    (i) In general.
    (ii) Priority of categories.
    (3) Changes in the use or purpose for which property is held.
    (i) In general.
    (ii) Special rules.
    (A) Anti-abuse rule.
    (B) Hedging transactions.
    (iii) Example.
    (4) Definitions and special rules.
    (i) Interest.
    (ii) Bona fide hedging transaction.
    (A) Definition.
    (B) Identification.
    (C) Effect of identification and non-identification.

[[Page 282]]

    (1) Transactions identified.
    (2) Inadvertent identification.
    (3) Transactions not identified.
    (4) Inadvertent error.
    (5) Anti-abuse rule.
    (iii) Inventory and similar property.
    (A) Definition.
    (B) Hedging transactions.
    (iv) Regular dealer.
    (v) Dealer property.
    (A) Definition.
    (B) Securities dealers.
    (C) Hedging transactions.
    (vi) Examples.
    (vii) Debt instrument.
    (b) Dividends, interest, rents, royalties and annuities.
    (1) In general.
    (2) Exclusion of certain export financing interest.
    (i) In general.
    (ii) Exceptions.
    (iii) Conduct of a banking business.
    (iv) Examples.
    (3) Treatment of tax-exempt interest. [Reserved]
    (4) Exclusion of dividends or interest from related persons.
    (i) In general.
    (A) Corporate payor.
    (B) Payment by a partnership.
    (ii) Exceptions.
    (A) Dividends.
    (B) Interest paid out of adjusted foreign base company income or 
insurance income.
    (1) In general.
    (2) Rule for corporations that are both recipients and payors of 
interest.
    (C) Coordination with sections 864(d) and 881(c).
    (iii) Trade or business requirement.
    (iv) Substantial assets test.
    (v) Valuation of assets.
    (vi) Location of tangible property.
    (A) In general.
    (B) Exception.
    (vii) Location of intangible property.
    (A) In general.
    (B) Exception for property located in part in the payor's country of 
incorporation.
    (viii) Location of inventory and dealer property.
    (A) In general.
    (B) Inventory and dealer property located in part in the payor's 
country of incorporation.
    (ix) Location of debt instruments.
    (x) Treatment of certain stock interests.
    (xi) Treatment of banks and insurance companies. [Reserved]
    (5) Exclusion of rents and royalties derived from related persons.
    (i) In general.
    (A) Corporate payor.
    (B) Payment by a partnership.
    (ii) Exceptions.
    (A) Rents or royalties paid out of adjusted foreign base company 
income or insurance income.
    (B) Property used in part in the controlled foreign corporation's 
country of incorporation.
    (6) Exclusion of rents and royalties derived in the active conduct 
of a trade or business.
    (c) Excluded rents.
    (1) Active conduct of a trade or business.
    (2) Special rules.
    (i) Adding substantial value.
    (ii) Substantiality of foreign organization.
    (iii) Active leasing expenses.
    (iv) Adjusted leasing profit.
    (3) Examples.
    (d) Excluded royalties.
    (1) Active conduct of a trade or business.
    (2) Special rules.
    (i) Adding substantial value.
    (ii) Substantiality of foreign organization.
    (iii) Active licensing expenses.
    (iv) Adjusted licensing profit.
    (3) Examples.
    (e) Certain property transactions.
    (1) In general.
    (i) Inclusions.
    (ii) Exceptions.
    (iii) Treatment of losses.
    (iv) Dual character property.
    (2) Property that gives rise to certain income.
    (i) In general.
    (ii) Gain or loss from the disposition of a debt instrument.
    (3) Property that does not give rise to income.
    (f) Commodities transactions.
    (1) In general.
    (i) Inclusion in foreign personal holding company income.
    (ii) Exception.
    (iii) Treatment of losses.
    (2) Definitions.
    (i) Commodity.
    (ii) Commodities transaction.
    (iii) Qualified active sale.
    (A) In general.
    (B) Active conduct of a commodities business.
    (C) Substantially all.
    (D) Activities of employees of a related entity.
    (iv) Qualified hedging transaction entered into prior to January 31, 
2003.
    (A) In general.
    (B) Exception.
    (C) Effective date.
    (v) Qualified hedging transaction entered into on or after January 
31, 2003.
    (A) In general.
    (B) Exception.
    (C) Examples.
    (D) Effective date.
    (vi) Financial institutions not a producer, etc.
    (g) Foreign currency gain or loss.

[[Page 283]]

    (1) Scope and purpose.
    (2) In general.
    (i) Inclusion.
    (ii) Exclusion for business needs.
    (A) General rule.
    (B) Business needs.
    (C) Regular dealers.
    (1) General rule.
    (2) Certain interest-bearing liabilities treated as dealer property.
    (i) In general.
    (ii) Failure to identify certain liabilities.
    (iii) Effective date.
    (D) Example.
    (iii) Special rule for foreign currency gain or loss from an 
interest-bearing liability.
    (3) Election to characterize foreign currency gain or loss that 
arises from a specific category of subpart F income as gain or loss in 
that category.
    (i) In general.
    (ii) Time and manner of election.
    (iii) Revocation of election.
    (iv) Example.
    (4) Election to treat all foreign currency gains or losses as 
foreign personal holding company income.
    (i) In general.
    (ii) Time and manner of election.
    (iii) Revocation of election.
    (5) Gains and losses not subject to this paragraph.
    (i) Capital gains and losses.
    (ii) Income not subject to section 988.
    (iii) Qualified business units using the dollar approximate separate 
transactions method.
    (iv) Gain or loss allocated under Sec. 1.861-9. [Reserved]
    (h) Income equivalent to interest.
    (1) In general.
    (i) Inclusion in foreign personal holding company income.
    (ii) Exceptions.
    (A) Liability hedging transactions.
    (B) Interest.
    (2) Definition of income equivalent to interest.
    (i) In general.
    (ii) Income from the sale of property.
    (3) Notional principal contracts.
    (i) In general.
    (ii) Regular dealers.
    (4) Income equivalent to interest from factoring.
    (i) General rule.
    (ii) Exceptions.
    (iii) Factored receivable.
    (iv) Examples.
    (5) Receivables arising from performance of services.
    (6) Examples.

[T.D. 8618, 60 FR 46508, Sept. 7, 1995; T.D. 8618, 60 FR 62024, Dec. 4, 
1995; T.D. 8767, 63 FR 14615, Mar. 26, 1998; T.D. 9039, 68 FR 4917, Jan. 
31, 2003]



Sec. 1.954-1  Foreign base company income.

    (a) In general--(1) Purpose and scope. Section 954 and Sec. Sec. 
1.954-1 and 1.954-2 provide rules for computing the foreign base company 
income of a controlled foreign corporation. Foreign base company income 
is included in the subpart F income of a controlled foreign corporation 
under the rules of section 952. Subpart F income is included in the 
gross income of a United States shareholder of a controlled foreign 
corporation under the rules of section 951 and thus is subject to 
current taxation under section 1, 11 or 55 of the Internal Revenue Code. 
The determination of whether a foreign corporation is a controlled 
foreign corporation, the subpart F income of which is included currently 
in the gross income of its United States shareholders, is made under the 
rules of section 957.
    (2) Gross foreign base company income. The gross foreign base 
company income of a controlled foreign corporation consists of the 
following categories of gross income (determined after the application 
of section 952(b))--
    (i) Foreign personal holding company income, as defined in section 
954(c);
    (ii) Foreign base company sales income, as defined in section 
954(d);
    (iii) Foreign base company services income, as defined in section 
954(e);
    (iv) Foreign base company shipping income, as defined in section 
954(f); and
    (v) Foreign base company oil related income, as defined in section 
954(g).
    (3) Adjusted gross foreign base company income. The term adjusted 
gross foreign base company income means the gross foreign base company 
income of a controlled foreign corporation as adjusted by the de minimis 
and full inclusion rules of paragraph (b) of this section.
    (4) Net foreign base company income. The term net foreign base 
company income means the adjusted gross foreign base company income of a 
controlled foreign corporation reduced so as to take account of 
deductions (including taxes) properly allocable or apportionable to such 
income under the rules of section 954(b)(5) and paragraph (c) of this 
section.
    (5) Adjusted net foreign base company income. The term adjusted net 
foreign

[[Page 284]]

base company income means the net foreign base company income of a 
controlled foreign corporation reduced, first, by any items of net 
foreign base company income excluded from subpart F income pursuant to 
section 952(c) and, second, by any items excluded from subpart F income 
pursuant to the high tax exception of section 954(b). See paragraph 
(d)(4)(ii) of this section. The term foreign base company income as used 
in the Internal Revenue Code and elsewhere in the Income Tax Regulations 
means adjusted net foreign base company income, unless otherwise 
provided.
    (6) Insurance income. The term gross insurance income includes all 
gross income taken into account in determining insurance income under 
section 953. The term adjusted gross insurance income means gross 
insurance income as adjusted by the de minimis and full inclusion rules 
of paragraph (b) of this section. The term net insurance income means 
adjusted gross insurance income reduced under section 953 so as to take 
into account deductions (including taxes) properly allocable or 
apportionable to such income. The term adjusted net insurance income 
means net insurance income reduced by any items of net insurance income 
that are excluded from subpart F income pursuant to section 952(b) or 
pursuant to the high tax exception of section 954(b). The term insurance 
income as used in subpart F of the Internal Revenue Code and in the 
regulations under that subpart means adjusted net insurance income, 
unless otherwise provided.
    (7) Additional items of adjusted net foreign base company income or 
adjusted net insurance income by reason of section 952(c). Earnings and 
profits of the controlled foreign corporation that are recharacterized 
as foreign base company income or insurance income under section 952(c) 
are items of adjusted net foreign base company income or adjusted net 
insurance income, respectively. Amounts subject to recharacterization 
under section 952(c) are determined after adjusted net foreign base 
company income and adjusted net insurance income are otherwise 
determined under subpart F and are not again subject to any exceptions 
or special rules that would affect the amount of subpart F income. Thus, 
for example, items of gross foreign base company income or gross 
insurance income that are excluded from adjusted gross foreign base 
company income or adjusted gross insurance income because the de minimis 
test is met are subject to recharacterization under section 952(c). 
Further, the de minimis and full inclusion tests of paragraph (b) of 
this section, and the high tax exception of paragraph (d) of this 
section, for example, do not apply to such amounts.
    (b) Computation of adjusted gross foreign base company income and 
adjusted gross insurance income--(1) De minimis and full inclusion 
tests--(i) De minimis test--(A) In general. Except as provided in 
paragraph (b)(1)(i)(C) of this section, adjusted gross foreign base 
company income and adjusted gross insurance income are equal to zero if 
the sum of the gross foreign base company income and the gross insurance 
income of a controlled foreign corporation is less than the lesser of--
    (1) 5 percent of gross income; or
    (2) $1,000,000.
    (B) Currency translation. Controlled foreign corporations having a 
functional currency other than the United States dollar shall translate 
the $1,000,000 threshold using the exchange rate provided under section 
989(b)(3) for amounts included in income under section 951(a).
    (C) Coordination with sections 864(d) and 881(c). Adjusted gross 
foreign base company income or adjusted gross insurance income of a 
controlled foreign corporation always includes income from trade or 
service receivables described in section 864(d)(1) or (6), and portfolio 
interest described in section 881(c), even if the de minimis test of 
this paragraph (b)(1)(i) is otherwise satisfied.
    (ii) Seventy percent full inclusion test. Except as provided in 
section 953, adjusted gross foreign base company income consists of all 
gross income of the controlled foreign corporation other than gross 
insurance income and amounts described in section 952(b), and adjusted 
gross insurance income consists of all gross insurance income

[[Page 285]]

other than amounts described in section 952(b), if the sum of the gross 
foreign base company income and the gross insurance income for the 
taxable year exceeds 70 percent of gross income. See paragraph (d)(6) of 
this section, under which certain items of full inclusion foreign base 
company income may nevertheless be excluded from subpart F income.
    (2) Character of gross income included in adjusted gross foreign 
base company income. The gross income included in the adjusted gross 
foreign base company income of a controlled foreign corporation 
generally retains its character as foreign personal holding company 
income, foreign base company sales income, foreign base company services 
income, foreign base company shipping income, or foreign base company 
oil related income. However, gross income included in adjusted gross 
foreign base company income because the full inclusion test of paragraph 
(b)(1)(ii) of this section is met is termed full inclusion foreign base 
company income, and constitutes a separate category of adjusted gross 
foreign base company income for purposes of allocating and apportioning 
deductions under paragraph (c) of this section.
    (3) Coordination with section 952(c). Income that is included in 
subpart F income because the full inclusion test of paragraph (b)(1)(ii) 
of this section is met does not reduce amounts that, under section 
952(c), are subject to recharacterization.
    (4) Anti-abuse rule--(i) In general. For purposes of applying the de 
minimis test of paragraph (b)(1)(i) of this section, the income of two 
or more controlled foreign corporations shall be aggregated and treated 
as the income of a single corporation if a principal purpose for 
separately organizing, acquiring, or maintaining such multiple 
corporations is to prevent income from being treated as foreign base 
company income or insurance income under the de minimis test. A purpose 
may be a principal purpose even though it is outweighed by other 
purposes (taken together or separately).
    (ii) Presumption. Two or more controlled foreign corporations are 
presumed to have been organized, acquired or maintained to prevent 
income from being treated as foreign base company income or insurance 
income under the de minimis test of paragraph (b)(1)(i) of this section 
if the corporations are related persons, as defined in paragraph 
(b)(4)(iii) of this section, and the corporations are described in 
paragraph (b)(4)(ii)(A), (B), or (C) of this section. This presumption 
may be rebutted by proof to the contrary.
    (A) The activities carried on by the controlled foreign 
corporations, or the assets used in those activities, are substantially 
the same activities that were previously carried on, or assets that were 
previously held, by a single controlled foreign corporation. Further, 
the United States shareholders of the controlled foreign corporations or 
related persons (as determined under paragraph (b)(4)(iii) of this 
section) are substantially the same as the United States shareholders of 
the one controlled foreign corporation in a prior taxable year. A 
presumption made in connection with the requirements of this paragraph 
(b)(4)(ii)(A) may be rebutted by proof that the activities carried on by 
each controlled foreign corporation would constitute a separate branch 
under the principles of Sec. 1.367(a)-6T(g)(2) if carried on directly 
by a United States person.
    (B) The controlled foreign corporations carry on a business, 
financial operation, or venture as partners directly or indirectly in a 
partnership (as defined in section 7701(a)(2) and Sec. 301.7701-3 of 
this chapter) that is a related person (as defined in paragraph 
(b)(4)(iii) of this section) with respect to each such controlled 
foreign corporation.
    (C) The activities carried on by the controlled foreign corporations 
would constitute a single branch operation under Sec. 1.367(a)-6T(g)(2) 
if carried on directly by a United States person.
    (iii) Related persons. For purposes of this paragraph (b), two or 
more persons are related persons if they are in a relationship described 
in section 267(b). In determining for purposes of this paragraph (b) 
whether two or more corporations are members of the same controlled 
group under section 267(b)(3), a person is considered to own stock owned 
directly by such person, stock owned with the application of section 
1563(e)(1), and stock owned with

[[Page 286]]

the application of section 267(c). In determining for purposes of this 
paragraph (b) whether a corporation is related to a partnership under 
section 267(b)(10), a person is considered to own the partnership 
interest owned directly by such person and the partnership interest 
owned with the application of section 267(e)(3).
    (iv) Example. The following example illustrates the application of 
this paragraph (b)(4).

    Example. (i)(1) USP is the sole United States shareholder of three 
controlled foreign corporations: CFC1, CFC2 and CFC3. The three 
controlled foreign corporations all have the same taxable year. The 
three controlled foreign corporations are partners in FP, a foreign 
entity classified as a partnership under section 7701(a)(2) and Sec. 
301.7701-3 of the regulations. For their current taxable years, each of 
the controlled foreign corporations derives all of its income other than 
foreign base company income from activities conducted through FP, and 
its foreign base company income from activities conducted both jointly 
through FP and separately without FP. Based on the facts in the table 
below, the foreign base company income derived by each controlled 
foreign corporation for its current taxable year, including income 
derived from FP, is less than five percent of the gross income of each 
controlled foreign corporation and is less than $1,000,000:

----------------------------------------------------------------------------------------------------------------
                                                                       CFC1            CFC2            CFC3
----------------------------------------------------------------------------------------------------------------
Gross income....................................................      $4,000,000      $8,000,000     $12,000,000
Five percent of gross income....................................         200,000         400,000         600,000
Foreign base company income.....................................         199,000         398,000         597,000
----------------------------------------------------------------------------------------------------------------

    (2) Thus, without the application of the anti-abuse rule of this 
paragraph (b)(4), each controlled foreign corporation would be treated 
as having no foreign base company income after the application of the de 
minimis test of section 954(b)(3)(A) and paragraph (b)(1)(i) of this 
section.
    (ii) However, under these facts, the requirements of paragraph 
(b)(4)(i) of this section are met unless the presumption of paragraph 
(b)(4)(ii) of this section is successfully rebutted. The sum of the 
foreign base company income of the controlled foreign corporations is 
$1,194,000. Thus, the amount of gross foreign base company income of 
each controlled foreign corporation will not be reduced by reason of the 
de minimis rule of section 954(b)(3)(A) and this paragraph (b).

    (c) Computation of net foreign base company income--(1) General 
rule. The net foreign base company income of a controlled foreign 
corporation (as defined in paragraph (a)(4) of this section) is computed 
under the rules of this paragraph (c)(1). The principles of Sec. 1.904-
5(k) shall apply where payments are made between controlled foreign 
corporations that are related persons (within the meaning of section 
954(d)(3)). Consistent with these principles, only payments described in 
Sec. 1.954-2(b)(4)(ii)(B)(2) may be offset as provided in Sec. 1.904-
5(k)(2).
    (i) Deductions against gross foreign base company income. The net 
foreign base company income of a controlled foreign corporation is 
computed first by taking into account deductions in the following 
manner:
    (A) First, the gross amount of each item of income described in 
paragraph (c)(1)(iii) of this section is determined.
    (B) Second, any expenses definitely related to less than all gross 
income as a class shall be allocated and apportioned under the 
principles of sections 861, 864 and 904(d) to the gross income described 
in paragraph (c)(1)(i)(A) of this section.
    (C) Third, foreign personal holding company income that is passive 
within the meaning of section 904 (determined before the application of 
the high-taxed income rule of Sec. 1.904-4(c)) is reduced by related 
person interest expense allocable to passive income under Sec. 1.904-
5(c)(2); such interest must be further allocated and apportioned to 
items described in paragraph (c)(1)(iii)(B) of this section.
    (D) Fourth, the amount of each item of income described in paragraph 
(c)(1)(iii) of this section is reduced by other expenses allocable and 
apportionable to such income under the principles of sections 861, 864 
and 904(d).
    (ii) Losses reduce subpart F income by operation of earnings and 
profits limitation. Except as otherwise provided in Sec. 1.954-2(g)(4), 
if after applying the rules of paragraph (c)(1)(i) of this section,

[[Page 287]]

the amount remaining in any category of foreign base company income or 
foreign personal holding company income is less than zero, the loss in 
that category may not reduce any other category of foreign base company 
income or foreign personal holding company income except by operation of 
the earnings and profits limitation of section 952(c)(1).
    (iii) Items of income--(A) Income other than passive foreign 
personal holding company income. A single item of income (other than 
foreign personal holding company income that is passive) is the 
aggregate amount from all transactions that falls within a single 
separate category (as defined in Sec. 1.904-5(a)(1)), and either--
    (1) Falls within a single category of foreign personal holding 
company income as--
    (i) Dividends, interest, rents, royalties and annuities;
    (ii) Gain from certain property transactions;
    (iii) Gain from commodities transactions;
    (iv) Foreign currency gain; or
    (v) Income equivalent to interest; or
    (2) Falls within a single category of foreign base company income, 
other than foreign personal holding company income, as--
    (i) Foreign base company sales income;
    (ii) Foreign base company services income;
    (iii) Foreign base company shipping income;
    (iv) Foreign base company oil related income; or
    (v) Full inclusion foreign base company income.
    (B) Passive foreign personal holding company income. A single item 
of foreign personal holding company income that is passive is an amount 
of income that falls within a single group of passive income under the 
grouping rules of Sec. 1.904-4(c)(3), (4) and (5) and a single category 
of foreign personal holding company income described in paragraphs 
(c)(1)(iii)(A)(1) (i) through (v).
    (2) Computation of net foreign base company income derived from same 
country insurance income. Deductions relating to foreign base company 
income attributable to the issuing (or reinsuring) of any insurance or 
annuity contract in connection with risks located in the country under 
the laws of which the controlled foreign corporation is created or 
organized shall be allocated and apportioned in accordance with the 
rules set forth in section 953.
    (d) Computation of adjusted net foreign base company income or 
adjusted net insurance income--(1) Application of high tax exception. 
Adjusted net foreign base company income (or adjusted net insurance 
income) equals the net foreign base company income (or net insurance 
income) of a controlled foreign corporation, reduced by any net item of 
such income that qualifies for the high tax exception provided by 
section 954(b)(4) and this paragraph (d). Any item of income that is 
foreign base company oil related income, as defined in section 954(g), 
or portfolio interest, as described in section 881(c), does not qualify 
for the high tax exception. See paragraph (c)(1)(iii) of this section 
for the definition of the term item of income. For rules concerning the 
treatment for foreign tax credit purposes of amounts excluded from 
subpart F under section 954(b)(4), see Sec. 1.904-4(c). A net item of 
income qualifies for the high tax exception only if--
    (i) An election is made under section 954(b)(4) and paragraph (d)(5) 
of this section to exclude the income from the computation of subpart F 
income; and
    (ii) It is established that the net item of income was subject to 
foreign income taxes imposed by a foreign country or countries at an 
effective rate that is greater than 90 percent of the maximum rate of 
tax specified in section 11 for the taxable year of the controlled 
foreign corporation.
    (2) Effective rate at which taxes are imposed. The effective rate 
with respect to a net item of income shall be determined separately for 
each controlled foreign corporation in a chain of corporations through 
which a distribution is made. The effective rate at which taxes are 
imposed on a net item of income is--
    (i) The United States dollar amount of foreign income taxes paid or 
accrued (or deemed paid or accrued) with respect to the net item of 
income, determined under paragraph (d)(3) of this section; divided by

[[Page 288]]

    (ii) The United States dollar amount of the net item of foreign base 
company income or insurance income, described in paragraph (c)(1)(iii) 
of this section, increased by the amount of foreign income taxes 
referred to in paragraph (d)(2)(i) of this section.
    (3) Taxes paid or accrued with respect to an item of income--(i) 
Income other than passive foreign personal holding company income. The 
amount of foreign income taxes paid or accrued with respect to a net 
item of income (other than an item of foreign personal holding company 
income that is passive) for purposes of section 954(b)(4) and this 
paragraph (d) is the United States dollar amount of foreign income taxes 
that would be deemed paid under section 960 with respect to that item if 
that item were included in the gross income of a United States 
shareholder under section 951(a)(1)(A) (determined, in the case of a 
United States shareholder that is an individual, as if an election under 
section 962 has been made, whether or not such election is actually 
made). For this purpose, in accordance with the regulations under 
section 960, the amounts that would be deemed paid under section 960 
shall be determined separately with respect to each controlled foreign 
corporation and without regard to the limitation applicable under 
section 904(a). The amount of foreign income taxes paid or accrued with 
respect to a net item of income, determined in the manner provided in 
this paragraph (d), will not be affected by a subsequent reduction in 
foreign income taxes attributable to a distribution to shareholders of 
all or part of such income.
    (ii) Passive foreign personal holding company income. The amount of 
income taxes paid or accrued with respect to a net item of foreign 
personal holding company income that is passive for purposes of section 
954(b)(4) and this paragraph (d) is the United States dollar amount of 
foreign income taxes that would be deemed paid under section 960 and 
that would be taken into account for purposes applying the provisions of 
Sec. 1.904-4(c) with respect to that net item of income.
    (4) Special rules--(i) Consistency rule. An election to exclude 
income from the computation of subpart F income for a taxable year must 
be made consistently with respect to all items of passive foreign 
personal holding company income eligible to be excluded for the taxable 
year. Thus, high-taxed passive foreign personal holding company income 
of a controlled foreign corporation must either be excluded in its 
entirety, or remain subject to subpart F in its entirety.
    (ii) Coordination with earnings and profits limitation. If the 
amount of income included in subpart F income for the taxable year is 
reduced by the earnings and profits limitation of section 952(c)(1), the 
amount of income that is a net item of income, within the meaning of 
paragraph (c)(1)(iii) of this section, is determined after the 
application of the rules of section 952(c)(1).
    (iii) Example. The following example illustrates the provisions of 
paragraph (d)(4)(ii) of this section. All of the taxes referred to in 
the following example are foreign income taxes. For simplicity, this 
example assumes that the amount of taxes that are taken into account as 
a deduction under section 954(b)(5) and the amount of the gross-up 
required under sections 960 and 78 are equal. Therefore, this example 
does not separately illustrate the deduction for taxes and gross-up.

    Example. During its 1995 taxable year, CFC, a controlled foreign 
corporation, earns royalty income, net of taxes, of $100 that is foreign 
personal holding company income. CFC has no expenses associated with 
this royalty income. CFC pays $50 of foreign income taxes with respect 
to the royalty income. For 1995, CFC has current earnings and profits of 
$50. CFC's subpart F income, as determined prior to the application of 
this paragraph (d), exceeds its current earnings and profits. Thus, 
under paragraph (d)(4)(ii) of this section, the amount of CFC's only net 
item of income, the royalty income, will be limited to $50. The 
remaining $50 will be subject to recharacterization in a subsequent 
taxable year under section 952(c)(2). Because the amount of foreign 
income taxes paid with respect to this net item of income is $50, the 
effective rate of tax on the item, for purposes of this paragraph (d), 
is 50 percent ($50 of taxes/$50 net item + $50 of taxes). Accordingly, 
an election under paragraph (d)(5) of this section may be made to 
exclude the item of income from the computation of subpart F income.


[[Page 289]]


    (5) Procedure. An election made under the procedure provided by this 
paragraph (d)(5) is binding on all United States shareholders of the 
controlled foreign corporation and must be made--
    (i) By the controlling United States shareholders, as defined in 
Sec. 1.964-1(c)(5), by attaching a statement to such effect with their 
original or amended income tax returns, and including any additional 
information required by applicable administrative pronouncements; or
    (ii) In such other manner as may be prescribed in applicable 
administrative pronouncements.
    (6) Coordination of full inclusion and high tax exception rules. 
Notwithstanding paragraph (b)(1)(ii) of this section, full inclusion 
foreign base company income will be excluded from subpart F income if 
more than 90 percent of the adjusted gross foreign base company income 
and adjusted gross insurance company income of a controlled foreign 
corporation (determined without regard to the full inclusion test of 
paragraph (b)(1) of this section) is attributable to net amounts 
excluded from subpart F income pursuant to an election to have the high 
tax exception described in section 954(b)(4) and this paragraph (d) 
apply.
    (7) Examples. (i) The following examples illustrate the rules of 
this paragraph (d). All of the taxes referred to in the following 
examples are foreign income taxes. For simplicity, these examples assume 
that the amount of taxes that are taken into account as a deduction 
under section 954(b)(5) and the amount of the gross-up required under 
sections 960 and 78 are equal. Therefore, these examples do not 
separately illustrate the deduction for taxes and gross-up. Except as 
otherwise stated, these examples assume there are no earnings, deficits, 
or foreign income taxes in the post-1986 pools of earnings and profits 
or foreign income taxes.

    Example 1. (i) Items of income. During its 1995 taxable year, 
controlled foreign corporation CFC earns from outside its country of 
operation portfolio dividend income of $100 and interest income, net of 
taxes, of $100 (consisting of a gross payment of $150 reduced by a 
third-country withholding tax of $50). For purposes of illustration, 
assume that CFC incurs no expenses. None of the income is taxed in CFC's 
country of operation. The dividend income was not subject to third-
country withholding taxes. Pursuant to the operation of section 904, the 
interest income is high withholding tax interest and the dividend income 
is passive income. Accordingly, pursuant to paragraph (c)(1)(iii) of 
this section, CFC has two net items of income--
    (1) $100 of foreign personal holding company (FPHC)/passive income 
(the dividends); and
    (2) $100 of FPHC/high withholding tax income (the interest).
    (ii) Effective rates of tax. No foreign tax would be deemed paid 
under section 960 with respect to the net item of income described in 
paragraph (i)(1) of this Example 1. Therefore, the effective rate of 
foreign tax is 0, and the item may not be excluded from subpart F income 
under the rules of this paragraph (d). Foreign tax of $50 would be 
deemed paid under section 960 with respect to the net item of income 
described in paragraph (i)(2) of this Example 1. Therefore, the 
effective rate of foreign tax is 33 percent ($50 of creditable taxes 
paid, divided by $150, consisting of the net item of foreign base 
company income ($100) plus creditable taxes paid thereon ($50)). The 
highest rate of tax specified in section 11 for the 1995 taxable year is 
35 percent. Accordingly, the net item of income described in paragraph 
(i)(2) of this Example 1 may be excluded from subpart F income if an 
election under paragraph (d)(5) of this section is made, since it is 
subject to foreign tax at an effective rate that is greater than 31.5 
percent (90 percent of 35 percent). However, for purposes of section 
904(d), it remains high withholding tax interest.
    Example 2. (i) The facts are the same as in Example 1, except that 
CFC's country of operation imposes a tax of $50 with respect to CFC's 
dividend income (and thus CFC earns portfolio dividend income, net of 
taxes, of only $50). The interest income is still high withholding tax 
interest. The dividend income is still passive income (without regard to 
the possible applicability of the high tax exception of section 
904(d)(2)). Accordingly, CFC has two items of income for purposes of 
this paragraph (d)--
    (1) $50 of FPHC/passive income (net of the $50 foreign tax); and
    (2) $100 of FPHC/high withholding tax interest income.
    (ii) Each item is taxed at an effective rate greater than 31.5 
percent. The net item of income described in paragraph (i)(1) of this 
Example 2: foreign tax ($50) divided by sum ($100) of net item of income 
($50) plus creditable tax thereon ($50) equals 50 percent. The net item 
of income described in paragraph (i)(2) of this Example 2: foreign tax 
($50) divided by sum ($150) of income item ($100) plus creditable tax 
thereon ($50) equals 33

[[Page 290]]

percent. Accordingly, an election may be made under paragraph (d)(5) of 
this section to exclude either or both of the net items of income 
described in paragraphs (i)(1) and (2) of this Example 2 from subpart F 
income. If no election is made the items would be included in the 
subpart F income of CFC.
    Example 3. (i) The facts are the same as in Example 1, except that 
the $100 of portfolio dividend income is subject to a third-country 
withholding tax of $50, and the $150 of interest income is from sources 
within CFC's country of operation, is subject to a $10 income tax 
therein, and is not subject to a withholding tax. Although the interest 
income and the dividend income are both passive income, under paragraph 
(c)(1)(iii)(B) of this section they constitute separate items of income 
pursuant to the application of the grouping rules of Sec. 1.904-4(c). 
Accordingly, CFC has two net items of income for purposes of this 
paragraph (d)--
    (1) $50 (net of $50 tax) of FPHC/non-country of operation/greater 
than 15 percent withholding tax income; and
    (2) $140 (net of $10 tax) of FPHC/country of operation income.
    (ii) The item described in paragraph (i)(1) of this Example 3 is 
taxed at an effective rate greater than 31.5 percent, but Item 2 is not. 
The net item of income described in paragraph (i)(1) of this Example 3: 
foreign tax ($50) divided by sum ($100) of net item of income ($50) plus 
creditable tax thereon ($50) equals 50 percent. The net item of income 
described in paragraph (i)(2) of this Example 3: foreign tax ($10) 
divided by sum ($150) of net item of income ($140) plus creditable tax 
thereon ($10) equals 6.67 percent. Therefore, an election may be made 
under paragraph (d)(5) of this section to exclude the net item of income 
described in paragraph (i)(1) of this Example 3 but not the net item of 
income described in paragraph (i)(2) of this Example 3 from subpart F 
income.
    Example 4. The facts are the same as in Example 3, except that the 
$150 of interest income is subject to an income tax of $50 in CFC's 
country of operation. Accordingly, CFC's items of income are the same as 
in Example 3, but both items are taxed at an effective rate greater than 
31.5 percent. The net item of income described in paragraph (i)(1) of 
Example 3: foreign tax ($50) divided by sum ($100) of net item of income 
($50) plus creditable tax thereon ($50) equals 50 percent. The net item 
of income described in paragraph (i)(2) of Example 3: foreign tax ($50) 
divided by sum ($150) of net item of income ($100) plus creditable tax 
thereon ($50) equals 33 percent. Pursuant to the consistency rule of 
paragraph (d)(4)(i) of this section, an election made by CFC's 
controlling United States shareholders must exclude from subpart F 
income both items of FPHC income under the high tax exception of section 
954(b)(4) and this paragraph (d). The election may not be made only with 
respect to one item.
    Example 5. The facts are the same as in Example 1, except that CFC 
earns $5 of portfolio dividend income and $150 of interest income. In 
addition, CFC earns $45 for performing consulting services within its 
country of operation for unrelated persons. CFC's gross foreign base 
company income for 1995 of $155 ($150 of gross interest income and $5 of 
portfolio dividend income) is greater than 70 percent of its gross 
income of $200. Therefore, under the full inclusion test of paragraph 
(b)(1)(ii) of this section, CFC's adjusted gross foreign base company 
income is $200, and under paragraph (b)(2) of this section, the $45 of 
consulting income is full inclusion foreign base company income. If CFC 
elects, under paragraph (d)(5) of this section, to exclude the interest 
income from subpart F income pursuant to the high tax exception, the $45 
of full inclusion foreign base company income will be excluded from 
subpart F income under paragraph (d)(6) of this section because the $150 
of gross interest income excluded under the high tax exception is more 
than 90 percent of CFC's adjusted gross foreign base company income of 
$155.

    (ii) The following examples generally illustrate the application of 
paragraph (c) of this section and this paragraph (d). Example 1 
illustrates the order of computations. Example 2 illustrates the 
computations required by sections 952 and 954 and this Sec. 1.954-1 if 
the full inclusion test of paragraph (b)(1)(ii) of this section is met 
and the income is not excluded from subpart F income under section 
952(b). Computations in these examples involving the operation of 
section 952(c) are included for purposes of illustration only and do not 
provide substantive rules concerning the operation of that section. For 
simplicity, these examples assume that the amount of taxes that are 
taken into account as a deduction under section 954(b)(5) and the amount 
of the gross-up required under sections 960 and 78 are equal. Therefore, 
these examples do not separately illustrate the deduction for taxes and 
gross-up.

    Example 1. (i) Gross income. CFC, a controlled foreign corporation, 
has gross income of $1000 for the current taxable year. Of that $1000 of 
income, $100 is interest income that is included in the definition of 
foreign personal holding company income under section 954(c)(1)(A) and 
Sec. 1.954-2(b)(1)(ii), is not income from a trade or service 
receivable described in section 864(d)(1) or (6), or portfolio interest 
described in section 881(c), and is not excluded from foreign personal 
holding

[[Page 291]]

company income under any provision of section 952(b) or section 954(c). 
Another $50 is foreign base company sales income under section 954(d). 
The remaining $850 of gross income is not included in the definition of 
foreign base company income or insurance income under sections 954 (c), 
(d), (e), (f) or (g) or 953, and is foreign source general limitation 
income described in section 904(d)(1)(I).
    (ii) Expenses. For the current taxable year, CFC has expenses of 
$500. This amount includes $8 of interest paid to a related person that 
is allocable to foreign personal holding company income under section 
904, and $2 of other expense that is directly related to foreign 
personal holding company income. Another $20 of expense is directly 
related to foreign base company sales. The remaining $470 of expenses is 
allocable to general limitation income that is not foreign base company 
income or insurance income.
    (iii) Earnings and losses. CFC has earnings and profits for the 
current taxable year of $500. In the prior taxable year, CFC had losses 
with respect to income other than gross foreign base company income or 
gross insurance income. By reason of the limitation provided under 
section 952(c)(1)(A), those losses reduced the subpart F income 
(consisting entirely of foreign source general limitation income) of CFC 
by $600 for the prior taxable year.
    (iv) Taxes. Foreign income tax of $30 is considered imposed on the 
interest income under the rules of section 954(b)(4), this paragraph 
(d), and Sec. 1.904-6. Foreign income tax of $14 is considered imposed 
on the foreign base company sales income under the rules of section 
954(b)(4), paragraph (d) of this section, and Sec. 1.904-6. Foreign 
income tax of $177 is considered imposed on the remaining foreign source 
general limitation income under the rules of section 954(b)(4), this 
paragraph (d), and Sec. 1.904-6. For the taxable year of CFC, the 
maximum United States rate of taxation under section 11 is 35 percent.
    (v) Conclusion. Based on these facts, if CFC elects to exclude all 
items of income subject to a high foreign tax under section 954(b)(4) 
and this paragraph (d), it will have $500 of subpart F income as defined 
in section 952(a) (consisting entirely of foreign source general 
limitation income) determined as follows:

Step 1--Determine gross income:
  (1) Gross income.............................................    $1000
Step 2--Determine gross foreign base company income and gross
 insurance income:
  (2) Interest income included in gross foreign personal             100
   holding company income under section 954(c).................
  (3) Gross foreign base company sales income under section           50
   954(d)......................................................
  (4) Total gross foreign base company income and gross              150
   insurance income as defined in sections 954 (c), (d), (e),
   (f) and (g) and 953 (line (2) plus line (3))................
Step 3--Compute adjusted gross foreign base company income and
 adjusted gross insurance income:
  (5) Five percent of gross income (.05 x line (1))............       50
  (6) Seventy percent of gross income (.70 x line (1)).........      700
  (7) Adjusted gross foreign base company income and adjusted        150
   gross insurance income after the application of the de
   minimis test of paragraph (b) (line (4), or zero if line (4)
   is less than the lesser of line (5) or $1,000,000) (if the
   amount on this line 7 is zero, proceed to Step 8)...........
  (8) Adjusted gross foreign base company income and adjusted        150
   gross insurance income after the application of the full
   inclusion test of paragraph (b) (line (4), or line (1) if
   line (4) is greater than line (6))..........................
Step 4--Compute net foreign base company income:
  (9) Expenses directly related to adjusted gross foreign base        20
   company sales income........................................
  (10) Expenses (other than related person interest expense)           2
   directly related to adjusted gross foreign personal holding
   company income..............................................
  (11) Related person interest expense allocable to adjusted           8
   gross foreign personal holding company income under section
   904.........................................................
  (12) Net foreign personal holding company income after              90
   allocating deductions under section 954(b)(5) and paragraph
   (c) of this section (line (2) reduced by lines (10) and
   (11)).......................................................
  (13) Net foreign base company sales income after allocating         30
   deductions under section 954(b)(5) and paragraph (c) of this
   section (line (3) reduced by line (9))......................
  (14) Total net foreign base company income after allocating        120
   deductions under section 954(b)(5) and paragraph (c) of this
   section (line (12) plus line (13))..........................
Step 5--Compute net insurance income:
  (15) Net insurance income under section 953..................        0
Step 6--Compute adjusted net foreign base company income:
  (16) Foreign income tax imposed on net foreign personal             30
   holding company income (as determined under section
   954(b)(4) and this paragraph (d))...........................
  (17) Foreign income tax imposed on net foreign base company         14
   sales income (as determined under section 954(b)(4) and this
   paragraph (d))..............................................
  (18) Ninety percent of the maximum United States corporate       31.5%
   tax rate....................................................
  (19) Effective rate of foreign income tax imposed on net           33%
   foreign personal holding company income ($90 of interest)
   under section 954(b)(4) and this paragraph (d) (line (16)
   divided by line (12)).......................................
  (20) Effective rate of foreign income tax imposed on $30 of        47%
   net foreign base company sales income under section
   954(b)(4) and this paragraph (d) (line (17) divided by line
   (13)).......................................................
  (21) Net foreign personal holding company income subject to a       90
   high foreign tax under section 954(b)(4) and this paragraph
   (d) (zero, or line (12) if line (19) is greater than line
   (18)).......................................................
  (22) Net foreign base company sales income subject to a high        30
   foreign tax under section 954(b)(4) and this paragraph (d)
   (zero, or line (13) if line (20) is greater than line (18)).
  (23) Adjusted net foreign base company income after applying         0
   section 954(b)(4) and this paragraph (d) (line (14), reduced
   by the sum of line (21) and line (22))......................
Step 7--Compute adjusted net insurance income:
  (24) Adjusted net insurance income...........................        0

[[Page 292]]

 
Step 8--Additions to or reduction of adjusted net foreign base
 company income by reason of section 952(c):
  (25) Earnings and profits for the current year...............      500
  (26) Amount subject to being recharacterized as subpart F          500
   income under section 952(c)(2) (excess of line (25) over the
   sum of lines (23) and (24)); if there is a deficit, then the
   limitation of section 952(c)(1) may apply for the current
   year........................................................
  (27) Amount of reduction in subpart F income for prior             600
   taxable years by reason of the limitation of section
   952(c)(1)...................................................
  (28) Subpart F income as defined in section 952(a), assuming       500
   section 952(a)(3), (4), and (5) do not apply (the sum of
   line (23), line (24), and the lesser of line (26) or line
   (27)).......................................................
  (29) Amount of prior year's deficit to be recharacterized as       100
   subpart F income in later years under section 952(c) (excess
   of line (27) over line (26))................................
 

    Example 2. (i) Gross income. CFC, a controlled foreign corporation, 
has gross income of $1000 for the current taxable year. Of that $1000 of 
income, $720 is interest income that is included in the definition of 
foreign personal holding company income under section 954(c)(1)(A) and 
Sec. 1.954-2(b)(1)(ii), is not income from trade or service receivables 
described in section 864(d)(1) or (6), or portfolio interest described 
in section 881(c), and is not excluded from foreign personal holding 
company income under any provision of section 954(c) and Sec. 1.954-2 
or section 952(b). The remaining $280 is services income that is not 
included in the definition of foreign base company income or insurance 
income under sections 954 (c), (d), (e), (f), or (g) or 953, and is 
foreign source general limitation income for purposes of section 
904(d)(1)(I).
    (ii) Expenses. For the current taxable year, CFC has expenses of 
$650. This amount includes $350 of interest paid to related persons that 
is allocable to foreign personal holding company income under section 
904, and $50 of other expense that is directly related to foreign 
personal holding company income. The remaining $250 of expenses is 
allocable to services income other than foreign base company income or 
insurance income.
    (iii) Earnings and losses. CFC has earnings and profits for the 
current taxable year of $350. In the prior taxable year, CFC had losses 
with respect to income other than foreign base company income or 
insurance income. By reason of the limitation provided under section 
952(c)(1)(A), those losses reduced the subpart F income of CFC 
(consisting entirely of foreign source general limitation income) by 
$600 for the prior taxable year.
    (iv) Taxes. Foreign income tax of $120 is considered imposed on the 
$720 of interest income under the rules of section 954(b)(4), paragraph 
(d) of this section, and Sec. 1.904-6. Foreign income tax of $2 is 
considered imposed on the services income under the rules of section 
954(b)(4), paragraph (d) of this section, and Sec. 1.904-6. For the 
taxable year of CFC, the maximum United States rate of taxation under 
section 11 is 35 percent.
    (v) Conclusion. Based on these facts, if CFC elects to exclude all 
items of income subject to a high foreign tax under section 954(b)(4) 
and this paragraph (d), it will have $350 of subpart F income as defined 
in section 952(a), determined as follows.

Step 1--Determine gross income:
  (1) Gross income.............................................    $1000
Step 2--Determine gross foreign base company income and gross
 insurance income:
  (2) Gross foreign base company income and gross insurance          720
   income as defined in sections 954 (c), (d), (e), (f) and (g)
   and 953 (interest income)...................................
Step 3--Compute adjusted gross foreign base company income and
 adjusted gross insurance income:
  (3) Seventy percent of gross income (.70 x line (1)).........      700
  (4) Adjusted gross foreign base company income and adjusted       1000
   gross insurance income after the application of the full
   inclusion rule of this paragraph (b)(1) (line (2), or line
   (1) if line (2) is greater than line (3))...................
  (5) Full inclusion foreign base company income under               280
   paragraph (b)(1)(ii) (line (4) minus line (2))..............
Step 4--Compute net foreign base company income:
  (6) Expenses (other than related person interest expense)           50
   directly related to adjusted gross foreign personal holding
   company income..............................................
  (7) Related person interest expense allocable to adjusted          350
   gross foreign personal holding company income under section
   904.........................................................
  (8) Deductions allocable to full inclusion foreign base            250
   company income under section 954(b)(5) and paragraph (c) of
   this section................................................
  (9) Net foreign personal holding company income after              320
   allocating deductions under section 954(b)(5) and paragraph
   (c) of this section (line (2) reduced by line (6) and line
   (7))........................................................
  (10) Full inclusion foreign base company income after               30
   allocating deductions under section 954(b)(5) and paragraph
   (c) of this section (line (5) reduced by line (8))..........
  (11) Total net foreign base company income after allocating        350
   deductions under section 954(b)(5) and paragraph (c) of this
   section (line (9) plus line (10))...........................
Step 5--Compute net insurance income:
  (12) Net insurance income under section 953..................        0
Step 6--Compute adjusted net foreign base company income:
  (13) Foreign income tax imposed on net foreign personal            120
   holding company income (interest)...........................
  (14) Foreign income tax imposed on net full inclusion foreign        2
   base company income.........................................
  (15) Ninety percent of the maximum United States corporate       31.5%
   tax rate....................................................
  (16) Effective rate of foreign income tax imposed on $320 of       38%
   net foreign personal holding company income under section
   954(b)(4) and this paragraph (d) (line (13) divided by line
   (9))........................................................
  (17) Effective rate of foreign income tax imposed on $30 of         7%
   net full inclusion foreign base company income under section
   954(b)(4) and this paragraph (d) (line (14) divided by line
   (10)).......................................................

[[Page 293]]

 
  (18) Net foreign personal holding company income subject to a      320
   high foreign tax under section 954(b)(4) and this paragraph
   (d) (zero, or line (9) if line (16) is greater than line
   (15)).......................................................
  (19) Net full inclusion foreign base company income subject          0
   to a high foreign tax under section 954(b)(4) and this
   paragraph (d) (zero, or line (10) if line (17) is greater
   than line (15)).............................................
  (20) Adjusted net foreign base company income after applying        30
   section 954(b)(4) and this paragraph (d) (line (11) reduced
   by the sum of line (18) and line (19))......................
Step 7--Compute adjusted net insurance income:
  (21) Adjusted net insurance income...........................        0
Step 8--Reduction of adjusted net foreign base company income
 or adjusted net insurance income by reason of paragraph (d)(6)
 of this section:
  (22) Adjusted gross foreign base company income and adjusted       720
   gross insurance income (determined without regard to the
   full inclusion test of paragraph (b)(1) of this section)
   (line (4) reduced by line (5))..............................
  (23) Ninety percent of adjusted gross foreign base company         648
   income and adjusted gross insurance income (determined
   without regard to the full inclusion test of paragraph
   (b)(1)(ii) of this section) (90% of the amount on line (22))
  (24) Net foreign base company income and net insurance income      720
   excluded from subpart F income under section 954(b)(4),
   increased by the amount of expenses that reduced this income
   under section 954(b)(5) and paragraph (c) of this section
   (line (18) increased by the sum of line (6) and line (7))...
  (25) Adjusted net full inclusion foreign base company income        30
   excluded from subpart F income under paragraph (d)(6) of
   this section (zero, or line (10) reduced by line (19) if
   line (24) is greater than line (23))........................
  (26) Adjusted net foreign base company income after                  0
   application of paragraph (d)(6) of this section (line (20)
   reduced by line (25)).......................................
Step 9--Additions to or reduction of subpart F income by reason
 of section 952(c):
  (27) Earnings and profits for the current year...............      350
  (28) Amount subject to being recharacterized as subpart F          350
   income under section 952(c)(2) (excess of line (27) over the
   sum of line (21) and line (26)); if there is a deficit, then
   the limitation of 952(c)(1) may apply for the current year..
  (29) Amount of reduction in subpart F income for prior             600
   taxable years by reason of the limitation of section
   952(c)(1)...................................................
  (30) Subpart F income as defined in section 952(a), assuming       350
   section 952(a)(3), (4), and (5) do not apply (the sum of
   line (21) and line (26) plus the lesser of line (28) or line
   (29)).......................................................
  (31) Amount of prior years' deficit remaining to be                250
   recharacterized as subpart F income in later years under
   section 952(c) (excess of line (29) over line (28)).........
 


    (e) Character of income--(1) Substance of the transaction. For 
purposes of section 954, income shall be characterized in accordance 
with the substance of the transaction, and not in accordance with the 
designation applied by the parties to the transaction. For example, an 
amount that is designated as rent by the taxpayer but actually 
constitutes income from the sale of property, royalties, or income from 
services shall not be characterized as rent but shall be characterized 
as income from the sale of property, royalties or income from services, 
as the case may be. Local law shall not be controlling in characterizing 
income.
    (2) Separable character. To the extent the definitional provisions 
of section 953 or 954 describe the income or gain derived from a 
transaction, or any portion or portions thereof, that income or gain, or 
portion or portions thereof, is so characterized for purposes of subpart 
F. Thus, a single transaction may give rise to income in more than one 
category of foreign base company income described in paragraph (a)(2) of 
this section. For example, if a controlled foreign corporation, in its 
business of purchasing personal property and selling it to related 
persons outside its country of incorporation, also performs services 
outside its country of incorporation with respect to the property it 
sells, the sales income will be treated as foreign base company sales 
income and the services income will be treated as foreign base company 
services income for purposes of these rules.
    (3) Predominant character. The portion of income or gain derived 
from a transaction that is included in the computation of foreign 
personal holding company income is always separately determinable and 
thus must always be segregated from other income and separately 
classified under paragraph (e)(2) of this section. However, the portion 
of income or gain derived from a transaction that would meet a 
particular definitional provision under section 954 or 953 (other than 
the definition of foreign personal holding company income) in unusual 
circumstances may not be separately determinable. If such portion is not 
separately determinable, it must be classified in accordance with the 
predominant character of the transaction. For example, if a controlled 
foreign corporation engineers, fabricates, and installs a fixed offshore 
drilling platform as part of an integrated transaction, and the portion 
of income that relates to services is not accounted for separately from 
the portion that relates to sales, and is

[[Page 294]]

otherwise not separately determinable, then the classification of income 
from the transaction shall be made in accordance with the predominant 
character of the arrangement.
    (4) Coordination of categories of gross foreign base company income 
or gross insurance income--(i) In general. The computations of gross 
foreign base company income and gross insurance income are limited by 
the following rules:
    (A) If income is foreign base company shipping income, pursuant to 
section 954(f), it shall not be considered insurance income or income in 
any other category of foreign base company income.
    (B) If income is foreign base company oil related income, pursuant 
to section 954(g), it shall not be considered insurance income or income 
in any other category of foreign base company income, except as provided 
in paragraph (e)(4)(i)(A) of this section.
    (C) If income is insurance income, pursuant to section 953, it shall 
not be considered income in any category of foreign base company income 
except as provided in paragraph (e)(4)(i)(A) or (B) of this section.
    (D) If income is foreign personal holding company income, pursuant 
to section 954(c), it shall not be considered income in any other 
category of foreign base company income, other than as provided in 
paragraph (e)(4)(i)(A), (B) or (C) of this section.
    (ii) Income excluded from other categories of gross foreign base 
company income. Income shall not be excluded from a category of gross 
foreign base company income or gross insurance income under this 
paragraph (e)(4) by reason of being included in another category of 
gross foreign base company income or gross insurance income, if the 
income is excluded from that other category by a more specific provision 
of section 953 or 954. For example, income derived from a commodity 
transaction that is excluded from foreign personal holding company 
income under Sec. 1.954-2(f) as income from a qualified active sale may 
be included in gross foreign base company income if it also meets the 
definition of foreign base company sales income. See Sec. 1.954-2(a)(2) 
for the coordination of overlapping categories within the definition of 
foreign personal holding company income.
    (f) Definition of related person--(1) Persons related to controlled 
foreign corporation. Unless otherwise provided, for purposes of section 
954 and Sec. Sec. 1.954-1 through 1.954-8 inclusive, the following 
persons are considered under section 954(d)(3) to be related persons 
with respect to a controlled foreign corporation:
    (i) Individuals. An individual, whether or not a citizen or resident 
of the United States, who controls the controlled foreign corporation.
    (ii) Other persons. A foreign or domestic corporation, partnership, 
trust or estate that controls or is controlled by the controlled foreign 
corporation, or is controlled by the same person or persons that control 
the controlled foreign corporation.
    (2) Control--(i) Corporations. With respect to a corporation, 
control means the ownership, directly or indirectly, of stock possessing 
more than 50 percent of the total voting power of all classes of stock 
entitled to vote or of the total value of the stock of the corporation.
    (ii) Partnerships. With respect to a partnership, control means the 
ownership, directly or indirectly, of more than 50 percent (by value) of 
the capital or profits interest in the partnership.
    (iii) Trusts and estates. With respect to a trust or estate, control 
means the ownership, directly or indirectly, of more than 50 percent (by 
value) of the beneficial interest in the trust or estate.
    (iv) Direct or indirect ownership. For purposes of this paragraph 
(f), to determine direct or indirect ownership, the principles of 
section 958 shall be applied without regard to whether a corporation, 
partnership, trust or estate is foreign or domestic or whether or not an 
individual is a citizen or resident of the United States.
    (g) Distributive share of partnership income--(1) Application of 
related person and country of organization tests. Unless otherwise 
provided, to determine the extent to which a controlled foreign 
corporation's distributive share of any item of gross income of a 
partnership would have been subpart F income if

[[Page 295]]

received by it directly, under Sec. 1.952-1(g), if a provision of 
subpart F requires a determination of whether an entity is a related 
person, within the meaning of section 954(d)(3), or whether an activity 
occurred within or outside the country under the laws of which the 
controlled foreign corporation is created or organized, this 
determination shall be made by reference to such controlled foreign 
corporation and not by reference to the partnership.
    (2) Application of related person test for sales and purchase 
transactions between a partnership and its controlled foreign 
corporation partner. For purposes of determining whether a controlled 
foreign corporation's distributive share of any item of gross income of 
a partnership is foreign base company sales income under section 
954(d)(1) when the item of income is derived from the sale by the 
partnership of personal property purchased by the partnership from (or 
sold by the partnership on behalf of) the controlled foreign 
corporation; or the sale by the partnership of personal property to (or 
the purchase of personal property by the partnership on behalf of) the 
controlled foreign corporation (CFC-partnership transaction), the CFC-
partnership transaction will be treated as a transaction with an entity 
that is a related person, within the meaning of section 954(d)(3), under 
paragraph (g)(1) of this section, if--
    (i) The controlled foreign corporation purchased such personal 
property from (or sold it to the partnership on behalf of), or sells 
such personal property to (or purchases it from the partnership on 
behalf of), a related person with respect to the controlled foreign 
corporation (other than the partnership), within the meaning of section 
954(d)(3); or
    (ii) The branch rule of section 954(d)(2) applies to treat as 
foreign base company sales income the income of the controlled foreign 
corporation from selling to the partnership (or a third party) personal 
property that the controlled foreign corporation has manufactured, in 
the case where the partnership purchases personal property from (or 
sells personal property on behalf of) the controlled foreign 
corporation.
    (3) Examples. The application of this paragraph (g) is illustrated 
by the following examples:

    Example 1. CFC, a controlled foreign corporation organized in 
Country A, is an 80-percent partner in Partnership, a partnership 
organized in Country A. All of the stock of CFC is owned by USP, a U.S. 
corporation. Partnership earns commission income from purchasing Product 
O on behalf of USP, from unrelated manufacturers in Country B, for sale 
in the United States. To determine whether CFC's distributive share of 
Partnership's commission income is foreign base company sales income 
under section 954(d), CFC is treated as if it purchased Product O on 
behalf of USP. Under section 954(d)(3), USP is a related person with 
respect to CFC. Thus, with respect to CFC, the sales income is deemed to 
be derived from the purchase of personal property on behalf of a related 
person. Because the property purchased is both manufactured and sold for 
use outside of Country A, CFC's country of organization, CFC's 
distributive share of the sales income is foreign base company sales 
income.
    Example 2. (i) CFC1, a controlled foreign corporation organized in 
Country A, is an 80-percent partner in Partnership, a partnership 
organized in Country B. CFC2, a controlled foreign corporation organized 
in Country B, owns the remaining 20 percent interest in Partnership. 
CFC1 and CFC2 are owned by a common U.S. parent, USP. CFC2 manufactures 
Product A in Country B. Partnership earns sales income from purchasing 
Product A from CFC2 and selling it to third parties located in Country B 
that are not related persons with respect to CFC1 or CFC2. To determine 
whether CFC1's distributive share of Partnership's sales income is 
foreign base company sales income under section 954(d), CFC1 is treated 
as if it purchased Product A from CFC2 and sold it to third parties in 
Country B. Under section 954(d)(3), CFC2 is a related person with 
respect to CFC1. Thus, with respect to CFC1, the sales income is deemed 
to be derived from the purchase of personal property from a related 
person. Because the property purchased is both manufactured and sold for 
use outside of Country A, CFC1's country of organization, CFC1's 
distributive share of the sales income is foreign base company sales 
income.
    (ii) Because Product A is both manufactured and sold for use within 
CFC2's country of organization, CFC2's distributive share of 
Partnership's sales income is not foreign base company sales income.
    Example 3. CFC, a controlled foreign corporation organized in 
Country A, is an 80 percent partner in MJK Partnership, a Country B 
partnership. CFC purchased goods from J Corp, a Country C corporation 
that is a related person with respect to CFC. CFC sold

[[Page 296]]

the goods to MJK Partnership. In turn, MJK Partnership sold the goods to 
P Corp, a Country D corporation that is unrelated to CFC. P Corp sold 
the goods to unrelated customers in Country D. The goods were 
manufactured in Country C by persons unrelated to J Corp . CFC's 
distributive share of the income of MJK Partnership from the sale of 
goods to P Corp will be treated as income from the sale of goods 
purchased from a related person for purposes of section 954(d)(1) 
because CFC purchased the goods from J Corp, a related person. Because 
the goods were both manufactured and sold for use outside of Country A, 
CFC's distributive share of the income attributable to the sale of the 
goods is foreign base company sales income. Further, CFC's income from 
the sale of the goods to MJK Partnership will also be foreign base 
company sales income.
    Example 4. The facts are the same as Example 3, except that MJK 
Partnership purchased the goods from P Corp and sold those goods to CFC. 
CFC sold the goods to J Corp. J Corp sold the goods to unrelated 
customers in Country C. CFC's distributive share of the income of MJK 
Partnership from the sale of the goods by the partnership to itself will 
be treated as income from the sale of goods to a related person, for 
purposes of section 954(d)(1). Because the goods were both manufactured 
and sold for use outside of Country A, CFC's distributive share of 
income attributable to the sale of the goods is foreign base company 
sales income. Further, CFC's income from the sale of the goods to J Corp 
is also foreign base company sales income.

    (4) Effective date. This paragraph (g) applies to taxable years of a 
controlled foreign corporation beginning on or after July 23, 2002.

[T.D. 8618, 60 FR 46509, Sept. 7, 1995; 60 FR 62024, 62025, Dec. 4, 
1995, as amended by T.D. 8704, 62 FR 20, Jan. 2, 1997; T.D. 8767, 63 FR 
14615, Mar. 26, 1998; T.D. 8827, 64 FR 37677, July 13, 1999; T.D. 9008, 
67 FR 48023, July 23, 2002]



Sec. 1.954-2  Foreign personal holding company income.

    (a) Computation of foreign personal holding company income--(1) 
Categories of foreign personal holding company income. For purposes of 
subpart F and the regulations under that subpart, foreign personal 
holding company income consists of the following categories of income--
    (i) Dividends, interest, rents, royalties, and annuities as 
described in paragraph (b) of this section;
    (ii) Gain from certain property transactions as described in 
paragraph (e) of this section;
    (iii) Gain from commodities transactions as described in paragraph 
(f) of this section;
    (iv) Foreign currency gain as described in paragraph (g) of this 
section; and
    (v) Income equivalent to interest as described in paragraph (h) of 
this section.
    (2) Coordination of overlapping categories under foreign personal 
holding company provisions--(i) In general. If any portion of income, 
gain or loss from a transaction is described in more than one category 
of foreign personal holding company income (as described in paragraph 
(a)(2)(ii) of this section), that portion of income, gain or loss is 
treated solely as income, gain or loss from the category of foreign 
personal holding company income with the highest priority.
    (ii) Priority of categories. The categories of foreign personal 
holding company income, listed from highest priority (paragraph 
(a)(2)(ii)(A) of this section) to lowest priority (paragraph 
(a)(2)(ii)(E) of this section), are--
    (A) Dividends, interest, rents, royalties, and annuities, as 
described in paragraph (b) of this section;
    (B) Income equivalent to interest, as described in paragraph (h) of 
this section without regard to the exceptions in paragraph (h)(1)(ii)(A) 
of this section;
    (C) Foreign currency gain or loss, as described in paragraph (g) of 
this section without regard to the exclusion in paragraph (g)(2)(ii) of 
this section;
    (D) Gain or loss from commodities transactions, as described in 
paragraph (f) of this section without regard to the exclusion in 
paragraph (f)(1)(ii) of this section; and
    (E) Gain or loss from certain property transactions, as described in 
paragraph (e) of this section without regard to the exceptions in 
paragraph (e)(1)(ii) of this section.
    (3) Changes in the use or purpose for which property is held--(i) In 
general. Under paragraphs (e), (f), (g) and (h) of this section, 
transactions in certain property give rise to gain or loss included in 
the computation of foreign

[[Page 297]]

personal holding company income if the controlled foreign corporation 
holds that property for a particular use or purpose. The use or purpose 
for which property is held is that use or purpose for which it was held 
for more than one- half of the period during which the controlled 
foreign corporation held the property prior to the disposition.
    (ii) Special rules--(A) Anti-abuse rule. If a principal purpose of a 
change in use or purpose of property was to avoid including gain or loss 
in the computation of foreign personal holding company income, all the 
gain or loss from the disposition of the property is treated as foreign 
personal holding company income. A purpose may be a principal purpose 
even though it is outweighed by other purposes (taken together or 
separately).
    (B) Hedging transactions. The provisions of paragraph (a)(3)(i) of 
this section shall not apply to bona fide hedging transactions, as 
defined in paragraph (a)(4)(ii) of this section. A transaction will be 
treated as a bona fide hedging transaction only so long as it satisfies 
the requirements of paragraph (a)(4)(ii) of this section.
    (iii) Example. The following example illustrates the application of 
this paragraph (a)(3).

    Example. At the beginning of taxable year 1, CFC, a controlled 
foreign corporation, purchases a building for investment. During taxable 
years 1 and 2, CFC derives rents from the building that are included in 
the computation of foreign personal holding company income under 
paragraph (b)(1)(iii) of this section. At the beginning of taxable year 
3, CFC changes the use of the building by terminating all leases and 
using it in an active trade or business. At the beginning of taxable 
year 4, CFC sells the building at a gain. The building was not used in 
an active trade or business of CFC for more than one-half of the period 
during which it was held by CFC. Therefore, the building is considered 
to be property that gives rise to rents, as described in paragraph 
(e)(2) of this section, and gain from the sale is included in the 
computation of CFC's foreign personal holding company income under 
paragraph (e) of this section.

    (4) Definitions and special rules. The following definitions and 
special rules apply for purposes of computing foreign personal holding 
company income under this section.
    (i) Interest. The term interest includes all amounts that are 
treated as interest income (including interest on a tax-exempt 
obligation) by reason of the Internal Revenue Code or Income Tax 
Regulations or any other provision of law. For example, interest 
includes stated interest, acquisition discount, original issue discount, 
de minimis original issue discount, market discount, de minimis market 
discount, and unstated interest, as adjusted by any amortizable bond 
premium or acquisition premium.
    (ii) Bona fide hedging transaction--(A) Definition. The term bona 
fide hedging transaction means a transaction that meets the requirements 
of Sec. 1.1221-2 (a) through (d) and that is identified in accordance 
with the requirements of paragraph (a)(4)(ii)(B) of this section, except 
that in applying Sec. 1.1221-2(b)(1), the risk being hedged may be with 
respect to ordinary property, section 1231 property, or a section 988 
transaction. A transaction that hedges the liabilities, inventory or 
other assets of a related person (as defined in section 954(d)(3)), that 
is entered into to assume or reduce risks of a related person, or that 
is entered into by a person other than a person acting in its capacity 
as a regular dealer (as defined in paragraph (a)(4)(iv) of this section) 
to reduce risks assumed from a related person, will not be treated as a 
bona fide hedging transaction. For an illustration of how this rule 
applies with respect to foreign currency transactions, see paragraph 
(g)(2)(ii)(D) of this section.
    (B) Identification. The identification requirements of this section 
shall be satisfied if the taxpayer meets the identification and 
recordkeeping requirements of Sec. 1.1221-2(f). However, for bona fide 
hedging transactions entered into prior to March 7, 1996 the 
identification and recordkeeping requirements of Sec. 1.1221-2 shall 
not apply. Rather, for bona fide hedging transactions entered into on or 
after July 22, 1988 and prior to March 7, 1996 the identification and 
recordkeeping requirements shall be satisfied if such transactions are 
identified by the close of the fifth day after the day on which they are 
entered into. For bona fide hedging transactions entered into prior

[[Page 298]]

to July 22, 1988, the identification and recordkeeping requirements 
shall be satisfied if such transactions are identified reasonably 
contemporaneously with the date they are entered into, but no later than 
within the normal period prescribed under the method of accounting of 
the controlled foreign corporation used for financial reporting 
purposes.
    (C) Effect of identification and non-identification--(1) 
Transactions identified. If a taxpayer identifies a transaction as a 
bona fide hedging transaction for purposes of this section, the 
identification is binding with respect to any loss arising from such 
transaction whether or not all of the requirements of paragraph 
(a)(4)(ii)(A) of this section are satisfied. Accordingly, such loss will 
be allocated against income that is not subpart F income (or, in the 
case of an election under paragraph (g)(3) of this section, against the 
category of subpart F income to which it relates) and apportioned among 
the categories of income described in section 904(d)(1). If the 
transaction is not in fact a bona fide hedging transaction described in 
paragraph (a)(4)(ii)(A) of this section, however, then any gain realized 
with respect to such transaction shall not be considered as gain from a 
bona fide hedging transaction. Accordingly, such gain shall be treated 
as gain from the appropriate category of foreign personal holding 
company income. Thus, the taxpayer's identification of the transaction 
as a hedging transaction does not itself operate to exclude gain from 
the appropriate category of foreign personal holding company income.
    (2) Inadvertent identification. Notwithstanding paragraph 
(a)(4)(ii)(C)(1) of this section, if the taxpayer identifies a 
transaction as a bona fide hedging transaction for purposes of this 
section, the characterization of the loss is determined as if the 
transaction had not been identified as a bona fide hedging transaction 
if--
    (i) The transaction is not a bona fide hedging transaction (as 
defined in paragraph (a)(4)(ii)(A) of this section);
    (ii) The identification of the transaction as a bona fide hedging 
transaction was due to inadvertent error; and
    (iii) All of the taxpayer's transactions in all open years are being 
treated on either original or, if necessary, amended returns in a manner 
consistent with the principles of this section.
    (3) Transactions not identified. Except as provided in paragraphs 
(a)(4)(ii)(C)(4) and (5) of this section, the absence of an 
identification that satisfies the requirements of paragraph 
(a)(4)(ii)(B) of this section is binding and establishes that a 
transaction is not a bona fide hedging transaction. Thus, subject to the 
exceptions, the characterization of gain or loss is determined without 
reference to whether the transaction is a bona fide hedging transaction.
    (4) Inadvertent error. If a taxpayer does not make an identification 
that satisfies the requirements of paragraph (a)(4)(ii)(B) of this 
section, the taxpayer may treat gain or loss from the transaction as 
gain or loss from a bona fide hedging transaction if--
    (i) The transaction is a bona fide hedging transaction (as defined 
in paragraph (a)(4)(ii)(A) of this section);
    (ii) The failure to identify the transaction was due to inadvertent 
error; and
    (iii) All of the taxpayer's bona fide hedging transactions in all 
open years are being treated on either original or, if necessary, 
amended returns as bona fide hedging transactions in accordance with the 
rules of this section.
    (5) Anti-abuse rule. If a taxpayer does not make an identification 
that satisfies all the requirements of paragraph (a)(4)(ii)(B) of this 
section but the taxpayer has no reasonable grounds for treating the 
transaction as other than a bona fide hedging transaction, then loss 
from the transaction shall be treated as realized with respect to a bona 
fide hedging transaction. Thus, a taxpayer may not elect to exclude loss 
from its proper characterization as a bona fide hedging transaction. The 
reasonableness of the taxpayer's failure to identify a transaction is 
determined by taking into consideration not only the requirements of 
paragraph (a)(4)(ii)(A) of this section but also the taxpayer's 
treatment of the transaction for financial accounting or other purposes 
and the taxpayer's identification of similar transactions as hedging 
transactions.

[[Page 299]]

    (iii) Inventory and similar property--(A) Definition. The term 
inventory and similar property (or inventory or similar property) means 
property that is stock in trade of the controlled foreign corporation or 
other property of a kind that would properly be included in the 
inventory of the controlled foreign corporation if on hand at the close 
of the taxable year (if the controlled foreign corporation were a 
domestic corporation), or property held by the controlled foreign 
corporation primarily for sale to customers in the ordinary course of 
its trade or business.
    (B) Hedging transactions. A bona fide hedging transaction with 
respect to inventory or similar property (other than a transaction 
described in section 988(c)(1) without regard to section 
988(c)(1)(D)(i)) shall be treated as a transaction in inventory or 
similar property.
    (iv) Regular dealer. The term regular dealer means a controlled 
foreign corporation that--
    (A) Regularly and actively offers to, and in fact does, purchase 
property from and sell property to customers who are not related persons 
(as defined in section 954(d)(3)) with respect to the controlled foreign 
corporation in the ordinary course of a trade or business; or
    (B) Regularly and actively offers to, and in fact does, enter into, 
assume, offset, assign or otherwise terminate positions in property with 
customers who are not related persons (as defined in section 954(d)(3)) 
with respect to the controlled foreign corporation in the ordinary 
course of a trade or business.
    (v) Dealer property--(A) Definition. Property held by a controlled 
foreign corporation is dealer property if--
    (1) The controlled foreign corporation is a regular dealer in 
property of such kind (determined under paragraph (a)(4)(iv) of this 
section); and
    (2) The property is held by the controlled foreign corporation in 
its capacity as a dealer in property of such kind without regard to 
whether the property arises from a transaction with a related person (as 
defined in section 954(d)(3)) with respect to the controlled foreign 
corporation. The property is not held by the controlled foreign 
corporation in its capacity as a dealer if the property is held for 
investment or speculation on its own behalf or on behalf of a related 
person (as defined in section 954(d)(3)).
    (B) Securities dealers. If a controlled foreign corporation is a 
licensed securities dealer, only the securities that it has identified 
as held for investment in accordance with the provisions of section 
475(b) or section 1236 will be considered to be property held for 
investment or speculation under this section. A licensed securities 
dealer is a controlled foreign corporation that is both a securities 
dealer, as defined in section 475, and a regular dealer, as defined in 
paragraph (a)(4)(iv) of this section, and that is either--
    (1) Registered as a securities dealer under section 15(a) of the 
Securities Exchange Act of 1934 or as a Government securities dealer 
under section 15C(a) of such Act; or
    (2) Licensed or authorized in the country in which it is chartered, 
incorporated, or organized to purchase and sell securities from or to 
customers who are residents of that country. The conduct of such 
securities activities must be subject to bona fide regulation, including 
appropriate reporting, monitoring, and prudential (including capital 
adequacy) requirements, by a securities regulatory authority in that 
country that regularly enforces compliance with such requirements and 
prudential standards.
    (C) Hedging transactions. A bona fide hedging transaction with 
respect to dealer property shall be treated as a transaction in dealer 
property.
    (vi) Examples. The following examples illustrate the application of 
paragraphs (a)(4)(ii), (iv) and (v) of this section.

    Example 1. (i) CFC1 and CFC2 are related controlled foreign 
corporations (within the meaning of section 954(d)(3)) located in 
Countries F and G, respectively. CFC1 and CFC2 regularly purchase 
securities from and sell securities to customers who are not related 
persons with respect to CFC1 or CFC2 (within the meaning of section 
954(d)(3)) in the ordinary course of their businesses and regularly and 
actively hold themselves out as being willing to, and in fact do, enter 
into either side of options, forward contracts, or other financial 
instruments. CFC1 uses securities that are traded in securities markets 
in Country G to hedge positions that it enters into with customers 
located in Country F.

[[Page 300]]

CFC1 is not a member of a securities exchange in Country G, so it 
purchases such securities from CFC2 and unrelated persons that are 
registered as securities dealers in Country G and that are members of 
Country G securities exchanges. Such hedging transactions qualify as 
bona fide hedging transactions under paragraph (a)(4)(ii) of this 
section.
    (ii) Transactions that CFC1 and CFC2 enter into with each other do 
not affect the determination of whether they are regular dealers. 
Because CFC1 and CFC2 regularly purchase securities from and sell 
securities to customers who are not related persons within the meaning 
of section 954(d)(3) in the ordinary course of their businesses and 
regularly and actively hold themselves out as being willing to, and in 
fact do, enter into either side of options, forward contracts, or other 
financial instruments, however, they qualify as regular dealers in such 
property within the meaning of paragraph (a)(4)(iv) of this section. 
Moreover, because CFC1 purchases securities from CFC2 as bona fide 
hedging transactions with respect to dealer property, the securities are 
dealer property under paragraph (a)(4)(v)(C) of this section. Similarly, 
because CFC2 sells securities to CFC1 in the ordinary course of its 
business as a dealer, the securities are dealer property under paragraph 
(a)(4)(v)(A) of this section.
    Example 2. (i) CFC is a controlled foreign corporation located in 
Country B. CFC serves as the currency coordination center for the 
controlled group, aggregating currency risks incurred by the group and 
entering into hedging transactions that transfer those risks outside of 
the group. CFC regularly and actively holds itself out as being willing 
to, and in fact does, enter into either side of options, forward 
contracts, or other financial instruments with other members of the same 
controlled group. CFC hedges risks arising from such transactions by 
entering into transactions with persons who are not related persons 
(within the meaning of section 954(d)(3)) with respect to CFC. However, 
CFC does not regularly and actively hold itself out as being willing to, 
and does not, enter into either side of transactions with unrelated 
persons.
    (ii) CFC is not a regular dealer in property under paragraph 
(a)(4)(iv) of this section and its options, forwards, and other 
financial instruments are not dealer property within the meaning of 
paragraph (a)(4)(v) of this section.

    (vii) Debt instrument. The term debt instrument includes bonds, 
debentures, notes, certificates, accounts receivable, and other 
evidences of indebtedness.
    (5) Special rules applicable to distributive share of partnership 
income--(i) [Reserved]
    (ii) Certain other exceptions applicable to foreign personal holding 
company income. To determine the extent to which a controlled foreign 
corporation's distributive share of an item of income of a partnership 
is foreign personal holding company income--
    (A) The exceptions contained in section 954(c) that are based on 
whether the controlled foreign corporation is engaged in the active 
conduct of a trade or business, including section 954(c)(2) and 
paragraphs (b)(2) and (6), (e)(1)(ii) and (3)(ii), (iii) and (iv), 
(f)(1)(ii), (g)(2)(ii), and (h)(3)(ii) of this section, shall apply only 
if any such exception would have applied to exclude the income from 
foreign personal holding company income if the controlled foreign 
corporation had earned the income directly, determined by taking into 
account only the activities of, and property owned by, the partnership 
and not the separate activities or property of the controlled foreign 
corporation or any other person;
    (B) A controlled foreign corporation's distributive share of 
partnership income will not be excluded from foreign personal holding 
company income under the exception contained in section 954(h) unless 
the controlled foreign corporation is an eligible controlled foreign 
corporation within the meaning of section 954(h)(2) (taking into account 
the income of the controlled foreign corporation and any partnerships or 
other qualified business units, within the meaning of section 989(a), of 
the controlled foreign corporation, including the controlled foreign 
corporation's distributive share of partnership income) and the 
partnership, of which the controlled foreign corporation is a partner, 
generates qualified banking or financing income within the meaning of 
section 954(h)(3) (taking into account only the income of the 
partnership);
    (C) A controlled foreign corporation's distributive share of 
partnership income will not be excluded from foreign personal holding 
company income under the exception contained in section 954(i) unless 
the controlled foreign corporation is a qualifying insurance company, as 
defined in section 953(e)(3), and the income of the partnership would 
have been qualified insurance income, as defined in section

[[Page 301]]

954(i)(2), if received by the controlled foreign corporation directly. 
See Sec. 1.952-1(g)(1).
    (iii) Examples. The application of paragraph (a)(5)(ii) is 
demonstrated by the following examples:

    Example 1. B Corp, a Country C corporation, is a controlled foreign 
corporation within the meaning of section 957(a). B Corp is an 80 
percent partner of RKS Partnership, a Country D partnership whose 
principal office is located in Country D. RKS Partnership is a qualified 
business unit of B Corp, within the meaning of section 989(a). B Corp, 
including income earned through RKS Partnership, derives more than 70 
percent of its gross income directly from the active and regular conduct 
of a lending or finance business, within the meaning of section 
954(h)(4), from transactions in various countries with customers which 
are not related persons. Thus, B Corp is predominantly engaged in the 
active conduct of a banking, financing, or similar business within the 
meaning of section 954(h)(2)(A)(i). B Corp conducts substantial activity 
with respect to such business within the meaning of section 
954(h)(2)(A)(ii). RKS Partnership derives more than 30 percent of its 
income from the active and regular conduct of a lending or finance 
business, within the meaning of section 954(h)(4), from transactions 
with customers which are not related persons and which are located 
solely within the home country of RKS Partnership, Country D. B Corp's 
distributive share of RKS Partnership's income from its lending or 
finance business will satisfy the special rule for income derived in the 
active conduct of banking, financing, or similar business of section 
954(h). B Corp is an eligible controlled foreign corporation within the 
meaning of section 954(h)(2) and RKS Partnership generates qualified 
banking or financing income within the meaning of section 954(h)(3). B 
Corp does not have any foreign personal holding company income with 
respect to its distributive share of RKS Partnership income attributable 
to its lending or finance business income earned in Country D.
    Example 2. D Corp, a Country F corporation, is a controlled foreign 
corporation within the meaning of section 957(a). D Corp is a qualifying 
insurance company, within the meaning of section 953(e)(3), that is 
engaged in the business of issuing life insurance contracts. D Corp has 
reserves of $100x, all of which are allocable to exempt contracts, and 
$10x of surplus, which is equal to 10 percent of the reserves allocable 
to exempt contracts. D Corp contributed the $100x of reserves and $10x 
of surplus to DJ Partnership in exchange for a 40-percent partnership 
interest. DJ Partnership is an entity organized under the laws of 
Country G and is treated as a partnership under the laws of Country G 
and Country F. DJ Partnership earns $30x of investment income during the 
taxable year that is received from persons who are not related persons 
with respect to D Corp, within the meaning of section 954(d)(3). D 
Corp's distributive share of this investment income is $12x. This income 
is treated as earned by D Corp in Country F under the tax laws of 
Country F and meets the definition of exempt insurance income in section 
953(e)(1). This $12x of investment income would be qualified insurance 
income, under section 954(i)(2), if D Corp had received the income 
directly, because the $110x invested by D Corp in DJ Partnership is 
equal to D Corp's reserves allocable to exempt contracts under section 
954(i)(2)(A) and allowable surplus under section 954(i)(2)(B)(ii). Thus, 
D Corp's distributive share of DJ Partnership's income will be excluded 
from foreign personal holding company income under section 954(i).

    (iv) [Reserved]
    (v) Effective date. This paragraph (a)(5) applies to taxable years 
of a controlled foreign corporation beginning on or after July 23, 2002.
    (b) Dividends, interest, rents, royalties, and annuities--(1) In 
general. Foreign personal holding company income includes--
    (i) Dividends, except certain dividends from related persons as 
described in paragraph (b)(4) of this section and distributions of 
previously taxed income under section 959(b);
    (ii) Interest, except export financing interest as defined in 
paragraph (b)(2) of this section and certain interest received from 
related persons as described in paragraph (b)(4) of this section;
    (iii) Rents and royalties, except certain rents and royalties 
received from related persons as described in paragraph (b)(5) of this 
section and rents and royalties derived in the active conduct of a trade 
or business as defined in paragraph (b)(6) of this section; and
    (iv) Annuities.
    (2) Exclusion of certain export financing interest--(i) In general. 
Foreign personal holding company income does not include interest that 
is export financing interest. The term export financing interest means 
interest that is derived in the conduct of a banking business and is 
export financing interest as defined in section 904(d)(2)(G). Solely for 
purposes of determining whether interest

[[Page 302]]

is export financing interest, property is treated as manufactured, 
produced, grown, or extracted in the United States if it is so treated 
under Sec. 1.927(a)-1T(c).
    (ii) Exceptions. Export financing interest does not include income 
from related party factoring that is treated as interest under section 
864(d)(1) or (6) after the application of section 864(d)(7).
    (iii) Conduct of a banking business. For purposes of this section, 
export financing interest is considered derived in the conduct of a 
banking business if, in connection with the financing from which the 
interest is derived, the corporation, through its own officers or staff 
of employees, engages in all the activities in which banks customarily 
engage in issuing and servicing a loan.
    (iv) Examples. The following examples illustrate the application of 
this paragraph (b)(2).

    Example 1. (i) DS, a domestic corporation, manufactures property in 
the United States. In addition to selling inventory (property described 
in section 1221(1)), DS occasionally sells depreciable equipment it 
manufactures for use in its trade or business, which is property 
described in section 1221(2). Less than 50 percent of the fair market 
value, determined in accordance with section 904(d)(2)(G), of each item 
of inventory or equipment sold by DS is attributable to products 
imported into the United States. CFC, a controlled foreign corporation 
with respect to which DS is a related person (within the meaning of 
section 954(d)(3)), provides loans described in section 864(d)(6) to 
unrelated persons for the purchase of property from DS. This property is 
purchased exclusively for use or consumption outside the United States 
and outside CFC's country of incorporation.
    (ii) If, in issuing and servicing loans made with respect to 
purchases from DS of depreciable equipment used in its trade or 
business, which is property described in section 1221(2) in the hands of 
DS, CFC engages in all the activities in which banks customarily engage 
in issuing and servicing loans, the interest accrued from these loans 
would be export financing interest meeting the requirements of this 
paragraph (b)(2) and, thus, not included in foreign personal holding 
company income. However, interest from the loans made with respect to 
purchases from DS of property that is inventory in the hands of DS 
cannot be export financing interest because it is treated as income from 
a trade or service receivable under section 864(d)(6) and the exception 
under section 864(d)(7) does not apply. Thus the interest from loans 
made with respect to this inventory is included in foreign personal 
holding company income under paragraph (b)(1)(ii) of this section.
    Example 2. (i) DS, a domestic corporation, wholly owns two 
controlled foreign corporations organized in Country A, CFC1 and CFC2. 
CFC1 purchases from DS property that DS manufactures in the United 
States. CFC1 uses the purchased property as a component part of property 
that CFC1 manufactures in Country A within the meaning of Sec. 1.954-
3(a)(4). CFC2 provides loans described in section 864(d)(6) to unrelated 
persons in Country A for the purchase of the property that CFC1 
manufactures in Country A.
    (ii) The interest accrued from the loans by CFC2 is not export 
financing interest as defined in section 904(d)(2)(G) because the 
property sold by CFC1 is not manufactured in the United States under 
Sec. 1.927(a)-1T(c). No portion of the interest is export financing 
interest as defined in this paragraph (b)(2). The full amount of the 
interest is, therefore, included in foreign personal holding company 
income under paragraph (b)(1)(ii) of this section.

    (3) Treatment of tax exempt interest. For taxable years of a 
controlled foreign corporation beginning after March 3, 1997, foreign 
personal holding company income includes all interest income, including 
interest that is described in section 103 (see Sec. 1.952-2(c)(1)).
    (4) Exclusion of dividends or interest from related persons--(i) In 
general--(A) Corporate payor. Foreign personal holding company income 
received by a controlled foreign corporation does not include dividends 
or interest if the payor--
    (1) Is a corporation that is a related person with respect to the 
controlled foreign corporation, as defined in section 954(d)(3);
    (2) Is created or organized under the laws of the same foreign 
country (the country of incorporation) as is the controlled foreign 
corporation; and
    (3) Uses a substantial part of its assets in a trade or business in 
its country of incorporation, as determined under this paragraph (b)(4).
    (B) Payment by a partnership. For purposes of this paragraph (b)(4), 
if a partnership with one or more corporate partners makes a payment of 
interest, a corporate partner will be treated as the payor of the 
interest--
    (1) If the interest payment gives rise to a partnership item of 
deduction

[[Page 303]]

under the Internal Revenue Code or Income Tax Regulations, to the extent 
that the item of deduction is allocable to the corporate partner under 
section 704(b); or
    (2) If the interest payment does not give rise to a partnership item 
of deduction under the Internal Revenue Code or Income Tax Regulations, 
to the extent that a partnership item reasonably related to the payment 
would be allocated to that partner under an existing allocation under 
the partnership agreement (made pursuant to section 704(b)).
    (ii) Exceptions--(A) Dividends. Dividends are excluded from foreign 
personal holding company income under this paragraph (b)(4) only to the 
extent that they are paid out of earnings and profits that are earned or 
accumulated during a period in which--
    (1) The stock on which dividends are paid with respect to which the 
exclusion is claimed was owned by the recipient controlled foreign 
corporation directly, or indirectly through a chain of one or more 
subsidiaries each of which meets the requirements of paragraph 
(b)(4)(i)(A) of this section; and
    (2) Each of the requirements of paragraph (b)(4)(i)(A) of this 
section is satisfied or, to the extent earned or accumulated during a 
taxable year of the related foreign corporation ending on or before 
December 31, 1962, during a period in which the payor was a related 
corporation as to the controlled foreign corporation and the other 
requirements of paragraph (b)(4)(i)(A) of this section were 
substantially satisfied.
    (3) This paragraph (b)(4)(ii)(A) is illustrated by the following 
example:

    Example. A, a domestic corporation, owns all of the stock of B, a 
corporation created and organized under the laws of Country Y, and C, a 
corporation created and organized under the laws of Country X. The 
taxable year of each of the corporations is the calendar year. In Year 
1, B earns $100 of income from the sale of products in Country Y that it 
manufactured in Country Y. C had no earnings and profits in Year 1. On 
January 1 of Year 2, A contributes all of the stock of B and C to Newco, 
a Country Y corporation, in exchange for all of the stock of Newco. 
Neither B nor C earns any income in Year 2, but at the end of Year 2 B 
distributes the $100 accumulated earnings and profits to Newco. Newco's 
income from the distribution, $100, is foreign personal holding company 
income because the earnings and profits distributed by B were not earned 
or accumulated during a period in which the stock of B was owned by 
Newco and in which each of the requirements of paragraph (b)(4)(i)(A) of 
this section was satisfied.

    (B) Interest paid out of adjusted foreign base company income or 
insurance income--(1) In general. Interest may not be excluded from the 
foreign personal holding company income of the recipient under this 
paragraph (b)(4) to the extent that the deduction for the interest is 
allocated under Sec. 1.954-1(a)(4) and (c) to the payor's adjusted 
gross foreign base company income (as defined in Sec. 1.954-1(a)(3)), 
adjusted gross insurance income (as defined in Sec. 1.954-1(a)(6)), or 
any other category of income included in the computation of subpart F 
income under section 952(a).
    (2) Rule for corporations that are both recipients and payors of 
interest. If a controlled foreign corporation is both a recipient and 
payor of interest, the interest that is received will be characterized 
before the interest that is paid. In addition, the amount of interest 
paid or accrued, directly or indirectly, by the controlled foreign 
corporation to a related person (as defined in section 954(d)(3)) shall 
be offset against and eliminate any interest received or accrued, 
directly or indirectly, by the controlled foreign corporation from that 
related person. In a case in which the controlled foreign corporation 
pays or accrues interest to a related person, as defined in section 
954(d)(3), and also receives or accrues interest indirectly from the 
related person, the smallest interest payment is eliminated and the 
amounts of all other interest payments are reduced by the amount of the 
smallest interest payment.
    (C) Coordination with sections 864(d) and 881(c). Income of a 
controlled foreign corporation that is treated as interest under section 
864(d)(1) or (6), or that is portfolio interest, as defined by section 
881(c), is not excluded from foreign personal holding company income 
under section 954(c)(3)(A)(i) and this paragraph (b)(4).
    (iii) Trade or business requirement. Except as otherwise provided 
under this paragraph (b)(4), the principles of section 367(a) apply for 
purposes of determining whether the payor has a trade

[[Page 304]]

or business in its country of incorporation and whether its assets are 
used in that trade or business. Property purchased or produced for use 
in a trade or business is not considered used in a trade or business 
before it is placed in service or after it is retired from service as 
determined in accordance with the principles of sections 167 and 168.
    (iv) Substantial assets test. A substantial part of the assets of 
the payor will be considered to be used in a trade or business located 
in the payor's country of incorporation for a taxable year only if the 
average value of the payor's assets for such year that are used in the 
trade or business and are located in such country equals more than 50 
percent of the average value of all the assets of the payor (including 
assets not used in a trade or business). The average value of assets for 
the taxable year is determined by averaging the values of assets at the 
close of each quarter of the taxable year. The value of assets is 
determined under paragraph (b)(4)(v) of this section, and the location 
of assets used in a trade or business of the payor is determined under 
paragraphs (b)(4)(vi) through (xi) of this section.
    (v) Valuation of assets. For purposes of determining whether a 
substantial part of the assets of the payor are used in a trade or 
business in its country of incorporation, the value of assets shall be 
their fair market value (not reduced by liabilities), which, in the 
absence of affirmative evidence to the contrary, shall be deemed to be 
their adjusted basis.
    (vi) Location of tangible property--(A) In general. Tangible 
property (other than inventory and similar property as defined in 
paragraph (a)(4)(iii) of this section, and dealer property as defined in 
paragraph (a)(4)(v) of this section) used in a trade or business is 
considered located in the country in which it is physically located.
    (B) Exception. An item of tangible personal property that is used in 
the trade or business of a payor in the payor's country of incorporation 
is considered located within the payor's country of incorporation while 
it is temporarily located elsewhere for inspection or repair if the 
property is not placed in service in a country other than the payor's 
country of incorporation and is not to be so placed in service following 
the inspection or repair.
    (vii) Location of intangible property--(A) In general. Intangible 
property (other than inventory and similar property as defined in 
paragraph (a)(4)(iii) of this section, dealer property as defined in 
paragraph (a)(4)(v) of this section, and debt instruments) is considered 
located entirely in the payor's country of incorporation for a quarter 
of the taxable year only if the payor conducts all of its activities in 
connection with the use or exploitation of the property in that country 
during that entire quarter. For this purpose, the country in which the 
activities connected to the use or exploitation of the property are 
conducted is the country in which the expenses associated with these 
activities are incurred. Expenses incurred in connection with the use or 
exploitation of an item of intangible property are included in the 
computation provided by this paragraph (b)(4) if they would be 
deductible under section 162 or includible in inventory costs or the 
cost of goods sold if the payor were a domestic corporation. If the 
payor conducts such activities through an agent or independent 
contractor, then the expenses incurred by the payor with respect to the 
agent or independent contractor shall be deemed to be incurred by the 
payor in the country in which the expenses of the agent or independent 
contractor were incurred by the agent or independent contractor.
    (B) Exception for property located in part in the payor's country of 
incorporation. If the payor conducts its activities in connection with 
the use or exploitation of an item of intangible property, including 
goodwill (other than inventory and similar property, dealer property and 
debt instruments) during a quarter of the taxable year both in its 
country of incorporation and elsewhere, then the value of the intangible 
considered located in the payor's country of incorporation during that 
quarter is a percentage of the value of the item as of the close of the 
quarter. That percentage equals the ratio that the expenses incurred by 
the payor (described in paragraph (b)(4)(vii)(A) of this section) during 
the entire quarter

[[Page 305]]

by reason of activities that are connected with the use or exploitation 
of the item of intangible property and are conducted in the payor's 
country of incorporation bear to all expenses incurred by the payor 
during the entire quarter by reason of all such activities worldwide.
    (viii) Location of inventory and dealer property--(A) In general. 
Inventory and similar property, as defined in paragraph (a)(4)(iii) of 
this section, and dealer property, as defined in paragraph (a)(4)(v) of 
this section, are considered located entirely in the payor's country of 
incorporation for a quarter of the taxable year only if the payor 
conducts all of its activities in connection with the production and 
sale, or purchase and resale, of such property in its country of 
incorporation during that entire quarter. If the payor conducts such 
activities through an agent or independent contractor, then the location 
of such activities is the place in which they are conducted by the agent 
or independent contractor.
    (B) Inventory and dealer property located in part in the payor's 
country of incorporation. If the payor conducts its activities in 
connection with the production and sale, or purchase and resale, of 
inventory or similar property or dealer property during a quarter of the 
taxable year both in its country of incorporation and elsewhere, then 
the value of the inventory or similar property or dealer property 
considered located in the payor's country of incorporation during each 
quarter is a percentage of the value of the inventory or similar 
property or dealer property as of the close of the quarter. That 
percentage equals the ratio that the costs and expenses incurred by the 
payor during the entire quarter by reason of activities connected with 
the production and sale, or purchase and resale, of inventory or similar 
property or dealer property that are conducted in the payor's country of 
incorporation bear to all costs or expenses incurred by the payor during 
the entire quarter by reason of all such activities worldwide. A cost 
incurred in connection with the production and sale or purchase and 
resale of inventory or similar property or dealer property is included 
in this computation if it--
    (1) Would be included in inventory costs or otherwise capitalized 
with respect to inventory or similar property or dealer property under 
section 61, 263A, 471, or 472 if the payor were a domestic corporation; 
or
    (2) Would be deductible under section 162 if the payor were a 
domestic corporation and is definitely related to gross income derived 
from such property (but not to all classes of gross income derived by 
the payor) under the principles of Sec. 1.861-8.
    (ix) Location of debt instruments. For purposes of this paragraph 
(b)(4), debt instruments, other than debt instruments that are inventory 
or similar property (as defined in paragraph (a)(4)(iii) of this 
section) or dealer property (as defined in paragraph (a)(4)(v) of this 
section) are considered to be used in a trade or business only if they 
arise from the sale of inventory or similar property or dealer property 
by the payor or from the rendition of services by the payor in the 
ordinary course of a trade or business of the payor, and only until such 
time as interest is required to be charged under section 482. Debt 
instruments that arise from the sale of inventory or similar property or 
dealer property during a quarter are treated as having the same 
location, proportionately, as the inventory or similar property or 
dealer property held during that quarter. Debt instruments arising from 
the rendition of services in the ordinary course of a trade or business 
are considered located on a proportionate basis in the countries in 
which the services to which they relate are performed.
    (x) Treatment of certain stock interests. Stock in a controlled 
foreign corporation (lower-tier corporation) that is incorporated in the 
same country as the payor and that is more than 50-percent owned, 
directly or indirectly, by the payor within the meaning of section 
958(a) shall be considered located in the payor's country of 
incorporation and, solely for purposes of section 954(c)(3), used in a 
trade or business of the payor in proportion to the value of the assets 
of the lower-tier corporation that are used in a trade or business in 
the country of incorporation. The location of assets used in a trade or 
business of the

[[Page 306]]

lower-tier corporation shall be determined under the rules of this 
paragraph (b)(4).
    (xi) Treatment of banks and insurance companies. [Reserved]
    (5) Exclusion of rents and royalties derived from related persons--
(i) In general--(A) Corporate payor. Foreign personal holding company 
income received by a controlled foreign corporation does not include 
rents or royalties if--
    (1) The payor is a corporation that is a related person with respect 
to the controlled foreign corporation, as defined in section 954(d)(3); 
and
    (2) The rents or royalties are for the use of, or the privilege of 
using, property within the country under the laws of which the 
controlled foreign corporation receiving the payments is created or 
organized (the country of incorporation).
    (B) Payment by a partnership. For purposes of this paragraph (b)(5), 
if a partnership with one or more corporate partners makes a payment of 
rents or royalties, a corporate partner will be treated as the payor of 
the rents or royalties--
    (1) If the rent or royalty payment gives rise to a partnership item 
of deduction under the Internal Revenue Code or Income Tax Regulations, 
to the extent the item of deduction is allocable to the corporate 
partner under section 704(b); or
    (2) If the rent or royalty payment does not give rise to a 
partnership item of deduction under the Internal Revenue Code or Income 
Tax Regulations, to the extent that a partnership item reasonably 
related to the payment would be allocated to that partner under an 
existing allocation under the partnership agreement (made pursuant to 
section 704(b)).
    (ii) Exceptions--(A) Rents or royalties paid out of adjusted foreign 
base company income or insurance income. Rents or royalties may not be 
excluded from the foreign personal holding company income of the 
recipient under this paragraph (b)(5) to the extent that deductions for 
the payments are allocated under section 954(b)(5) and Sec. 1.954-
1(a)(4) and (c) to the payor's adjusted gross foreign base company 
income (as defined in Sec. 1.954-1(a)(3)), adjusted gross insurance 
income (as defined in Sec. 1.954-1(a)(6)), or any other category of 
income included in the computation of subpart F income under section 
952(a).
    (B) Property used in part in the controlled foreign corporation's 
country of incorporation. If the payor uses the property both in the 
controlled foreign corporation's country of incorporation and elsewhere, 
the part of the rent or royalty attributable (determined under the 
principles of section 482) to the use of, or the privilege of using, the 
property outside such country of incorporation is included in the 
computation of foreign personal holding company income under this 
paragraph (b).
    (6) Exclusion of rents and royalties derived in the active conduct 
of a trade or business. Foreign personal holding company income shall 
not include rents or royalties that are derived in the active conduct of 
a trade or business and received from a person that is not a related 
person (as defined in section 954(d)(3)) with respect to the controlled 
foreign corporation. For purposes of this section, rents or royalties 
are derived in the active conduct of a trade or business only if the 
provisions of paragraph (c) or (d) of this section are satisfied.
    (c) Excluded rents--(1) Active conduct of a trade or business. Rents 
will be considered for purposes of paragraph (b)(6) of this section to 
be derived in the active conduct of a trade or business if such rents 
are derived by the controlled foreign corporation (the lessor) from 
leasing any of the following--
    (i) [Reserved]. For further guidance, see Sec. 1.954-2T(c)(1)(i).
    (ii) Real property with respect to which the lessor, through its own 
officers or staff of employees, regularly performs active and 
substantial management and operational functions while the property is 
leased;
    (iii) Personal property ordinarily used by the lessor in the active 
conduct of a trade or business, leased temporarily during a period when 
the property would, but for such leasing, be idle; or
    (iv) [Reserved]. For further guidance, see Sec. 1.954-2T(c)(1)(iv).
    (2) Special rules--(i) Adding substantial value. For purposes of 
paragraph

[[Page 307]]

(c)(1)(i) of this section, the performance of marketing functions will 
not be considered to add substantial value to property.
    (ii) [Reserved]. For further guidance, see Sec. 1.954-2T(c)(2)(ii).
    (iii) Active leasing expenses. The term active leasing expenses 
means the deductions incurred by an organization of the lessor in a 
foreign country that are properly allocable to rental income and that 
would be allowable under section 162 to the lessor if it were a domestic 
corporation, other than--
    (A) Deductions for compensation for personal services rendered by 
shareholders of, or related persons (as defined in section 954(d)(3)) 
with respect to, the lessor;
    (B) Deductions for rents paid or accrued;
    (C) Deductions that, although generally allowable under section 162, 
would be specifically allowable to the lessor (if the lessor were a 
domestic corporation) under any section of the Internal Revenue Code 
other than section 162; and
    (D) Deductions for payments made to agents or independent 
contractors with respect to the leased property other than payments for 
insurance, utilities and other expenses for like services, or for 
capitalized repairs.
    (E) [Reserved]. For further guidance, see Sec. 1.954-
2T(c)(2)(iii)(E).
    (iv) Adjusted leasing profit. The term adjusted leasing profit means 
the gross income of the lessor from rents, reduced by the sum of--
    (A) The rents paid or incurred by the lessor with respect to such 
rental income;
    (B) The amounts that would be allowable to such lessor (if the 
lessor were a domestic corporation) as deductions under sections 167 or 
168 with respect to such rental income; and
    (C) The amounts paid by the lessor to agents or independent 
contractors with respect to such rental income other than payments for 
insurance, utilities and other expenses for like services, or for 
capitalized repairs.
    (v) Leased in foreign commerce. For purposes of paragraphs 
(c)(1)(iv) and (c)(2)(ii) of this section, an aircraft or vessel is 
considered to be leased in foreign commerce if the aircraft or vessel is 
used in foreign commerce and is used predominantly outside the United 
States. An aircraft or vessel is considered to be used in foreign 
commerce if it is used for the transportation of property or passengers 
between a port (or airport) in the United States and a port (or airport) 
in a foreign country or between foreign ports (or airports). An aircraft 
or vessel will be considered to be used predominantly outside the United 
States if more than 50 percent of the miles traversed during the taxable 
year in the use of the aircraft or vessel are traversed outside the 
United States or if the aircraft or vessel is located outside the United 
States more than 50 percent of the time during the taxable year.
    (vi) Leases acquired by the CFC lessor. Except as provided in this 
paragraph (c)(2)(vi), the exception in paragraph (c)(1)(iv) of this 
section will also apply to rents from leases acquired from any person, 
if following the acquisition the lessor performs active and substantial 
management, operational, and remarketing (including remarketing for 
purposes of re-leasing or selling the property) functions with respect 
to the leased property. However, if any person is claiming a benefit 
with respect to an acquired lease pursuant to section 921 or 114 of the 
Internal Revenue Code or section 101(d) of the American Jobs Creation 
Act of 2004, (Pub. L. 108-357 (118 Stat. 1418) (2004)), the rents from 
such lease, notwithstanding paragraphs (b)(6) and (c) of this section, 
are ineligible for the exception in section 954(c)(2)(A).
    (vii) Marketing of leases. Paragraph (c)(1)(iv) of this section can 
apply whether a lessor is engaged in the marketing of leases as a form 
of financing or is engaged in marketing the property as such, and 
regardless of whether the lease is classified as a finance lease or an 
operating lease for financial accounting purposes, so long as such lease 
is treated as a lease for Federal income tax purposes.
    (viii) [Reserved]. For further guidance, see Sec. 1.954-
2T(c)(2)(viii).
    (3) Examples. The application of this paragraph (c) is illustrated 
by the following examples.


[[Page 308]]


    Example 1. Controlled foreign corporation A is regularly engaged in 
the production of office machines which it sells or leases to others and 
services. Under paragraph (c)(1)(i) of this section, the rental income 
of Corporation A from these leases is derived in the active conduct of a 
trade or business for purposes of section 954(c)(2)(A).
    Example 2. Controlled foreign corporation D purchases motor vehicles 
which it leases to others. In the conduct of its short-term leasing of 
such vehicles in foreign country X, Corporation D owns a large number of 
motor vehicles in country X which it services and repairs, leases motor 
vehicles to customers on an hourly, daily, or weekly basis, maintains 
offices and service facilities in country X from which to lease and 
service such vehicles, and maintains therein a sizable staff of its own 
administrative, sales, and service personnel. Corporation D also leases 
in country X on a long-term basis, generally for a term of one year, 
motor vehicles that it owns. Under the terms of the long-term leases, 
Corporation D is required to repair and service, during the term of the 
lease, the leased motor vehicles without cost to the lessee. By the 
maintenance in country X of office, sales, and service facilities and 
its complete staff of administrative, sales, and service personnel, 
Corporation D maintains and operates an organization therein that is 
regularly engaged in the business of marketing and servicing the motor 
vehicles that are leased. The deductions incurred by such organization 
satisfy the 25-percent test of paragraph (c)(2)(ii) of this section; 
thus, such organization is substantial in relation to the rents 
Corporation D receives from leasing the motor vehicles. Therefore, under 
paragraph (c)(1)(iv) of this section, such rents are derived in the 
active conduct of a trade or business for purposes of section 
954(c)(2)(A).
    Example 3. Controlled foreign corporation E owns a complex of 
apartment buildings that it has acquired by purchase. Corporation E 
engages a real estate management firm to lease the apartments, manage 
the buildings and pay over the net rents to Corporation E. The rental 
income of Corporation E from such leases is not derived in the active 
conduct of a trade or business for purposes of section 954(c)(2)(A).
    Example 4. Controlled foreign corporation F acquired by purchase a 
twenty-story office building in a foreign country, three floors of which 
it occupies and the rest of which it leases. Corporation F acts as 
rental agent for the leasing of offices in the building and employs a 
substantial staff to perform other management and maintenance functions. 
Under paragraph (c)(1)(ii) of this section, the rents received by 
Corporation F from such leasing operations are derived in the active 
conduct of a trade or business for purposes of section 954(c)(2)(A).
    Example 5. Controlled foreign corporation G owns equipment that it 
ordinarily uses to perform contracts in foreign countries to drill oil 
wells. For occasional brief and irregular periods it is unable to obtain 
contracts requiring immediate performance sufficient to employ all such 
equipment. During such a period it sometimes leases such idle equipment 
temporarily. After the expiration of such temporary leasing of the 
property, Corporation G continues the use of such equipment in the 
performance of its own drilling contracts. Under paragraph (c)(1)(iii) 
of this section, rents Corporation G receives from such leasing of idle 
equipment are derived in the active conduct of a trade or business for 
purposes of section 954(c)(2)(A).
    Example 6. The facts are the same as in Example 2, except that 
controlled foreign corporation D purchases aircraft which it leases to 
others. If Corporation D incurs active leasing expenses, as defined in 
paragraph (c)(2)(iii) of this section, equal to or in excess of 10 
percent of its adjusted leasing profit, as defined in paragraph 
(c)(2)(iv) of this section, the organization maintained and operated by 
Corporation D in country X is substantial in relation to the amount of 
rents Corporation D receives from leasing the aircraft. Therefore, under 
paragraph (c)(1)(iv) of this section, such rents are derived in the 
active conduct of a trade or business for purposes of section 
954(c)(2)(A). If a particular aircraft subject to lease was not leased 
by the lessee corporation in foreign commerce, for example, because 50 
percent or less of the miles during the taxable year were traversed 
outside the United States and the aircraft was located in the United 
States for 50 percent or more of the taxable year, Corporation D is not 
prevented from otherwise showing that it actively carries on a trade or 
business with regard to the rents derived from that aircraft under 
paragraph (c)(2)(ii) of this section, based on its facts and 
circumstances or a showing that active leasing expenses equal or exceed 
25 percent of the adjusted leasing profit.

    (d) Excluded royalties--(1) Active conduct of a trade or business. 
Royalties will be considered for purposes of paragraph (b)(6) of this 
section to be derived in the active conduct of a trade or business if 
such royalties are derived by the controlled foreign corporation (the 
licensor) from licensing--
    (i) [Reserved]. For further guidance, see Sec. 1.954-2T(d)(1)(i).
    (ii) [Reserved]. For further guidance, see Sec. 1.954-2T(d)(1)(ii).
    (2) Special rules--(i) Adding substantial value. For purposes of 
paragraph (d)(1)(i) of this section, the performance of marketing 
functions will not be

[[Page 309]]

considered to add substantial value to property.
    (ii) [Reserved]. For further guidance, see Sec. 1.954-2T(d)(2)(ii).
    (iii) Active licensing expenses. The term active licensing expenses 
means the deductions incurred by an organization of the licensor in a 
foreign country that are properly allocable to royalty income and that 
would be allowable under section 162 to the licensor if it were a 
domestic corporation, other than--
    (A) Deductions for compensation for personal services rendered by 
shareholders of, or related persons (as defined in section 954(d)(3)) 
with respect to, the licensor;
    (B) Deductions for royalties paid or incurred;
    (C) Deductions that, although generally allowable under section 162, 
would be specifically allowable to the licensor (if the controlled 
foreign corporation were a domestic corporation) under any section of 
the Internal Revenue Code other than section 162; and
    (D) Deductions for payments made to agents or independent 
contractors with respect to the licensed property.
    (E) [Reserved]. For further guidance, see Sec. 1.954-
2T(d)(2)(iii)(E).
    (iv) Adjusted licensing profit. The term adjusted licensing profit 
means the gross income of the licensor from royalties, reduced by the 
sum of--
    (A) The royalties paid or incurred by the licensor with respect to 
such royalty income;
    (B) The amounts that would be allowable to such licensor as 
deductions under section 167 or 197 (if the licensor were a domestic 
corporation) with respect to such royalty income; and
    (C) The amounts paid by the licensor to agents or independent 
contractors with respect to such royalty income.
    (v) [Reserved]. For further guidance, see sect; 1.954-2T(d)(2)(v).
    (3) Examples. The application of this paragraph (d) is illustrated 
by the following examples.

    Example 1. Controlled foreign corporation A, through its own staff 
of employees, owns and operates a research facility in foreign country 
X. At the research facility, employees of Corporation A who are 
scientists, engineers, and technicians regularly perform experiments, 
tests, and other technical activities, that ultimately result in the 
issuance of patents that it sells or licenses. Under paragraph (d)(1)(i) 
of this section, royalties received by Corporation A for the privilege 
of using patented rights that it develops as a result of such research 
activity are derived in the active conduct of a trade or business for 
purposes of section 954(c)(2)(A), but only so long as the licensor is 
regularly engaged in the development, creation or production of, or in 
the acquisition of and addition of substantial value to, property of 
such kind.
    Example 2. Assume that Corporation A in Example 1, in addition to 
receiving royalties for the use of patents that it develops, receives 
royalties for the use of patents that it acquires by purchase and 
licenses to others without adding any value thereto. Corporation A 
generally consummates royalty agreements on such purchased patents as 
the result of inquiries received by it from prospective licensees when 
the fact becomes known in the business community, as a result of the 
filing of a patent, advertisements in trade journals, announcements, and 
contacts by employees of Corporation A, that Corporation A has acquired 
rights under a patent and is interested in licensing its rights. 
Corporation A does not, however, maintain and operate an organization in 
a foreign country that is regularly engaged in the business of marketing 
the purchased patents. The royalties received by Corporation A for the 
use of the purchased patents are not derived in the active conduct of a 
trade or business for purposes of section 954(c)(2)(A).
    Example 3. Controlled foreign corporation B receives royalties for 
the use of patents that it acquires by purchase. The primary business of 
Corporation B, operated on a regular basis, consists of licensing 
patents that it has purchased raw from inventors and, through the 
efforts of a substantial staff of employees consisting of scientists, 
engineers, and technicians, made susceptible to commercial application. 
For example, Corporation B, after purchasing patent rights covering a 
chemical process, designs specialized production equipment required for 
the commercial adaptation of the process and, by so doing, substantially 
increases the value of the patent. Under paragraph (d)(1)(i) of this 
section, royalties received by Corporation B from the use of such patent 
are derived in the active conduct of a trade or business for purposes of 
section 954(c)(2)(A).
    Example 4. Controlled foreign corporation C receives royalties for 
the use of a patent that it developed through its own staff of employees 
at its facility in country X. Corporation C has developed no other 
patents. It does not regularly employ a staff of scientists, engineers 
or technicians to create new products to be patented. Further, it does 
not purchase and license patents developed by others to which it has 
added substantial value. The royalties received by Corporation C are not

[[Page 310]]

derived from the active conduct of a trade or business for purposes of 
section 954(c)(2)(A).
    Example 5. Controlled foreign corporation D finances independent 
persons in the development of patented items in return for an ownership 
interest in such items from which it derives a percentage of royalty 
income, if any, subsequently derived from the use by others of the 
protected right. Corporation D also attempts to increase its royalty 
income from such patents by contacting prospective licensees and 
rendering to licensees advice that is intended to promote the use of the 
patented property. Corporation D does not, however, maintain and operate 
an organization in a foreign country that is regularly engaged in the 
business of marketing the patents. Royalties received by Corporation D 
for the use of such patents are not derived in the active conduct of a 
trade or business for purposes of section 954(c)(2)(A).

    (e) Certain property transactions--(1) In general--(i) Inclusions. 
Gain from certain property transactions described in section 
954(c)(1)(B) includes the excess of gains over losses from the sale or 
exchange of--
    (A) Property that gives rise to dividends, interest, rents, 
royalties or annuities, as described in paragraph (e)(2) of this 
section;
    (B) Property that is an interest in a partnership, trust or REMIC; 
and
    (C) Property that does not give rise to income, as described in 
paragraph (e)(3) of this section.
    (ii) Exceptions. Gain or loss from certain property transactions 
described in section 954(c)(1)(B) and paragraph (e)(1)(i) of this 
section does not include gain or loss from the sale or exchange of--
    (A) Inventory or similar property, as defined in paragraph 
(a)(4)(iii) of this section;
    (B) Dealer property, as defined in paragraph (a)(4)(v) of this 
section; or
    (C) Property that gives rise to rents or royalties described in 
paragraph (b)(6) of this section that are derived in the active conduct 
of a trade or business from persons that are not related persons (as 
defined in section 954(d)(3)) with respect to the controlled foreign 
corporation.
    (iii) Treatment of losses. Section 1.954-1(c)(1)(ii) provides for 
the treatment of losses in excess of gains from the sale or exchange of 
property described in paragraph (e)(1)(i) of this section.
    (iv) Dual character property. Property may, in part, constitute 
property that gives rise to certain income as described in paragraph 
(e)(2) of this section or, in part, constitute property that does not 
give rise to any income as described in paragraph (e)(3) of this 
section. However, property that is described in paragraph (e)(1)(i)(B) 
of this section cannot be dual character property. Dual character 
property must be treated as two separate properties for purposes of 
paragraph (e)(2) or (3) of this section. Accordingly, the sale or 
exchange of such dual character property will give rise to gain or loss 
that in part must be included in the computation of foreign personal 
holding company income under paragraph (e)(2) or (3) of this section, 
and in part is excluded from such computation. Gain or loss from the 
disposition of dual character property must be bifurcated under this 
paragraph (e)(1)(iv) pursuant to the method that most reasonably 
reflects the relative uses of the property. Reasonable methods may 
include comparisons in terms of gross income generated or the physical 
division of the property. In the case of real property, the physical 
division of the property will in most cases be the most reasonable 
method available. For example, if a controlled foreign corporation owns 
an office building, uses 60 percent of the building in its trade or 
business, and rents out the other 40 percent, then 40 percent of the 
gain recognized on the disposition of the property would reasonably be 
treated as gain that is included in the computation of foreign personal 
holding company income under this paragraph (e)(1). This paragraph 
(e)(1)(iv) addresses the contemporaneous use of property for dual 
purposes. For rules concerning changes in the use of property affecting 
its classification for purposes of this paragraph (e), see paragraph 
(a)(3) of this section.
    (2) Property that gives rise to certain income--(i) In general. 
Property the sale or exchange of which gives rise to foreign personal 
holding company income under this paragraph (e)(2) includes property 
that gives rise to dividends, interest, rents, royalties or annuities 
described in paragraph (b) of this section, including--

[[Page 311]]

    (A) Property that gives rise to export financing interest described 
in paragraph (b)(2) of this section; and
    (B) Property that gives rise to income from related persons 
described in paragraph (b)(4) or (5) of this section.
    (ii) Gain or loss from the disposition of a debt instrument. Gain or 
loss from the sale, exchange or retirement of a debt instrument is 
included in the computation of foreign personal holding company income 
under this paragraph (e) unless--
    (A) In the case of gain--
    (1) It is interest (as defined in paragraph (a)(4)(i) of this 
section); or
    (2) It is income equivalent to interest (as described in paragraph 
(h) of this section); and
    (B) In the case of loss--
    (1) It is directly allocated to, or treated as an adjustment to, 
interest income (as described in paragraph (a)(4)(i) of this section) or 
income equivalent to interest (as defined in paragraph (h) of this 
section) under any provision of the Internal Revenue Code or Income Tax 
Regulations; or
    (2) It is required to be apportioned in the same manner as interest 
expense under section 864(e) or any other provision of the Internal 
Revenue Code or Income Tax Regulations.
    (3) Property that does not give rise to income. Except as otherwise 
provided in this paragraph (e)(3), for purposes of this section, the 
term property that does not give rise to income includes all rights and 
interests in property (whether or not a capital asset) including, for 
example, forwards, futures and options. Property that does not give rise 
to income shall not include--
    (i) Property that gives rise to dividends, interest, rents, 
royalties or annuities described in paragraph (e)(2) of this section;
    (ii) Tangible property (other than real property) used or held for 
use in the controlled foreign corporation's trade or business that is of 
a character that would be subject to the allowance for depreciation 
under section 167 or 168 and the regulations under those sections 
(including tangible property described in Sec. 1.167(a)-2);
    (iii) Real property that does not give rise to rental or similar 
income, to the extent used or held for use in the controlled foreign 
corporation's trade or business;
    (iv) Intangible property (as defined in section 936(h)(3)(B)), 
goodwill or going concern value, to the extent used or held for use in 
the controlled foreign corporation's trade or business;
    (v) Notional principal contracts (but see paragraphs (f)(2), (g)(2) 
and (h)(3) of this section for rules that include income from certain 
notional principal contracts in gains from commodities transactions, 
foreign currency gains and income equivalent to interest, respectively); 
or
    (vi) Other property that is excepted from the general rule of this 
paragraph (e)(3) by the Commissioner in published guidance. See Sec. 
601.601(d)(2) of this chapter.
    (f) Commodities transactions--(1) In general--(i) Inclusion in 
foreign personal holding company income. Foreign personal holding 
company income includes the excess of gains over losses from commodities 
transactions.
    (ii) Exception. Gains and losses from qualified active sales and 
qualified hedging transactions are excluded from the computation of 
foreign personal holding company income under this paragraph (f).
    (iii) Treatment of losses. Section 1.954-1(c)(1)(ii) provides for 
the treatment of losses in excess of gains from commodities 
transactions.
    (2) Definitions--(i) Commodity. For purposes of this section, the 
term commodity includes tangible personal property of a kind that is 
actively traded or with respect to which contractual interests are 
actively traded.
    (ii) Commodities transaction. The term commodities transaction means 
the purchase or sale of a commodity for immediate (spot) delivery or 
deferred (forward) delivery, or the right to purchase, sell, receive, or 
transfer a commodity, or any other right or obligation with respect to a 
commodity accomplished through a cash or off-exchange market, an 
interbank market, an organized exchange or board of trade, or an over-
the-counter market, or in a transaction effected between private parties 
outside of any market. Commodities transactions include, but are not 
limited to--

[[Page 312]]

    (A) A futures or forward contract in a commodity;
    (B) A leverage contract in a commodity purchased from a leverage 
transaction merchant;
    (C) An exchange of futures for physical transaction;
    (D) A transaction, including a notional principal contract, in which 
the income or loss to the parties is measured by reference to the price 
of a commodity, a pool of commodities, or an index of commodities;
    (E) The purchase or sale of an option or other right to acquire or 
transfer a commodity, a futures contract in a commodity, or an index of 
commodities; and
    (F) The delivery of one commodity in exchange for the delivery of 
another commodity, the same commodity at another time, cash, or 
nonfunctional currency.
    (iii) Qualified active sale--(A) In general. The term qualified 
active sale means the sale of commodities in the active conduct of a 
commodities business as a producer, processor, merchant or handler of 
commodities if substantially all of the controlled foreign corporation's 
business is as an active producer, processor, merchant or handler of 
commodities. The sale of commodities held by a controlled foreign 
corporation other than in its capacity as an active producer, processor, 
merchant or handler of commodities is not a qualified active sale. For 
example, the sale by a controlled foreign corporation of commodities 
that were held for investment or speculation would not be a qualified 
active sale.
    (B) Active conduct of a commodities business. For purposes of this 
paragraph, a controlled foreign corporation is engaged in the active 
conduct of a commodities business as a producer, processor, merchant or 
handler of commodities only with respect to commodities for which each 
of the following conditions is satisfied--
    (1) It holds the commodities directly, and not through an agent or 
independent contractor, as inventory or similar property (as defined in 
paragraph (a)(4)(iii) of this section) or as dealer property (as defined 
in paragraph (a)(4)(v) of this section); and
    (2) With respect to such commodities, it incurs substantial expenses 
in the ordinary course of a commodities business from engaging in one or 
more of the following activities directly, and not through an 
independent contractor--
    (i) Substantial activities in the production of the commodities, 
including planting, tending or harvesting crops, raising or slaughtering 
livestock, or extracting minerals;
    (ii) Substantial processing activities prior to the sale of the 
commodities, including the blending and drying of agricultural 
commodities, or the concentrating, refining, mixing, crushing, aerating 
or milling of commodities; or
    (iii) Significant activities as described in paragraph 
(f)(2)(iii)(B)(3) of this section.
    (3) For purposes of paragraph (f)(2)(iii)(B)(2)(iii) of this 
section, the significant activities must relate to--
    (i) The physical movement, handling and storage of the commodities, 
including preparation of contracts and invoices, arranging freight, 
insurance and credit, arranging for receipt, transfer or negotiation of 
shipping documents, arranging storage or warehousing, and dealing with 
quality claims;
    (ii) Owning and operating facilities for storage or warehousing; or
    (iii) Owning or chartering vessels or vehicles for the 
transportation of the commodities.
    (C) Substantially all. Substantially all of the controlled foreign 
corporation's business is as an active producer, processor, merchant or 
handler of commodities if the sum of its gross receipts from all of its 
qualified active sales (as defined in this paragraph (f)(2)(iii) without 
regard to the substantially all requirement) of commodities and its 
gross receipts from all of its qualified hedging transactions (as 
defined in paragraph (f)(2)(iv) of this section, applied without regard 
to the substantially all requirement of this paragraph (f)(2)(iii)(C)) 
equals or exceeds 85 percent of its total gross receipts for the taxable 
year (computed as though the corporation were a domestic corporation). 
In computing gross receipts, the District Director may disregard any 
sale or hedging transaction that has as

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a principal purpose manipulation of the 85 percent gross receipts test. 
A purpose may be a principal purpose even though it is outweighed by 
other purposes (taken together or separately).
    (D) Activities of employees of a related entity. For purposes of 
this paragraph (f), activities of employees of an entity related to the 
controlled foreign corporation, who are made available to and supervised 
on a day-to-day basis by, and whose salaries are paid by (or reimbursed 
to the related entity by), the controlled foreign corporation, are 
treated as activities engaged in directly by the controlled foreign 
corporation.
    (iv) Qualified hedging transaction entered into prior to January 31, 
2003--(A) In general. The term qualified hedging transaction means a 
bona fide hedging transaction, as defined in paragraph (a)(4)(ii) of 
this section, with respect to qualified active sales (other than 
transactions described in section 988(c)(1) without regard to section 
988(c)(1)(D)(i)).
    (B) Exception. The term qualified hedging transaction does not 
include transactions that are not reasonably necessary to the conduct of 
business of the controlled foreign corporation as a producer, processor, 
merchant or handler of a commodity in the manner in which such business 
is customarily and usually conducted by others.
    (C) Effective date. This paragraph (f)(2)(iv) applies to gain or 
loss realized by a controlled foreign corporation with respect to a 
qualified hedging transaction entered into prior to January 31, 2003.
    (v) Qualified hedging transaction entered into on or after January 
31, 2003--(A) In general. The term qualified hedging transaction means a 
bona fide hedging transaction, as defined in paragraph (a)(4)(ii) of 
this section, with respect to one or more commodities transactions 
reasonably necessary to the conduct of any business by a producer, 
processor, merchant or handler of commodities in a manner in which such 
business is customarily and usually conducted by others. For purposes of 
this paragraph (f)(2)(v), a producer, processor, merchant or handler of 
commodities includes a controlled foreign corporation that regularly 
uses commodities in a manufacturing, construction, utilities, or 
transportation business.
    (B) Exception. The term qualified hedging transaction does not 
include a transaction described in section 988(c)(1) (without regard to 
section 988(c)(1)(D)(i)).
    (C) Examples. The following examples illustrate the provisions of 
this paragraph (f)(2)(v):

    Example 1. CFC1 is a controlled foreign corporation located in 
country A. CFC1 manufactures and sells machinery in country B using 
aluminum and component parts purchased from third parties that contain 
significant amounts of aluminum. CFC1 conducts its manufacturing 
business in a manner in which such business is customarily and usually 
conducted by others. To protect itself against increases in the price of 
aluminum used in the machinery it manufactures, CFC1 enters into futures 
purchase contracts for the delivery of aluminum. These futures purchase 
contracts are bona fide hedging transactions. As CFC1 purchases aluminum 
and component parts containing significant amounts of aluminum in the 
spot market for use in its business, it closes out an equivalent amount 
of aluminum futures purchase contracts by entering into offsetting 
aluminum futures sales contracts. The aluminum futures purchase 
contracts are qualified hedging transactions as defined in paragraph 
(f)(2)(v)(A) of this section. Accordingly, any gain or loss on such 
aluminum futures purchase contracts is excluded from the computation of 
foreign personal holding company income.
    Example 2. CFC2 is a controlled foreign corporation located in 
country B. CFC2 operates an airline business within country B in a 
manner in which such business is customarily and usually conducted by 
others. To protect itself against increases in the price of aviation 
fuel, CFC2 enters into forward contracts for the purchase of aviation 
fuel. These forward purchase contracts are bona fide hedging 
transactions. As CFC2 purchases aviation fuel in the spot market for use 
in its business, it closes out an equivalent amount of its forward 
purchase contracts for cash pursuant to a contractual provision that 
permits CFC2 to terminate the contract and make or receive a one-time 
payment representing the contract's fair market value. The aviation fuel 
forward purchase contracts are qualified hedging transactions as defined 
in paragraph (f)(2)(v)(A) of this section. Accordingly, any gain or loss 
on such aviation fuel forward purchase contracts is excluded from the 
computation of foreign personal holding company income.


[[Page 314]]


    (D) Effective date. This paragraph (f)(2)(v) applies to gain or loss 
realized by a controlled foreign corporation with respect to a qualified 
hedging transaction entered into on or after January 31, 2003.
    (vi) Financial institutions not a producer, etc. For purposes of 
this paragraph (f), a corporation is not a producer, processor, merchant 
or handler of commodities if its business is primarily financial. For 
example, the business of a controlled foreign corporation is primarily 
financial if its principal business is making a market in notional 
principal contracts based on a commodities index.
    (g) Foreign currency gain or loss--(1) Scope and purpose. This 
paragraph (g) provides rules for the treatment of foreign currency gains 
and losses. Paragraph (g)(2) of this section provides the general rule. 
Paragraph (g)(3) of this section provides an election to include foreign 
currency gains or losses that would otherwise be treated as foreign 
personal holding company income under this paragraph (g) in the 
computation of another category of subpart F income. Paragraph (g)(4) of 
this section provides an alternative election to treat any net foreign 
currency gain or loss as foreign personal holding company income. 
Paragraph (g)(5) of this section provides rules for certain gains and 
losses not subject to this paragraph (g).
    (2) In general--(i) Inclusion. Except as otherwise provided in this 
paragraph (g), foreign personal holding company income includes the 
excess of foreign currency gains over foreign currency losses 
attributable to any section 988 transactions (foreign currency gain or 
loss). Section 1.954-1(c)(1)(ii) provides rules for the treatment of 
foreign currency losses in excess of foreign currency gains. However, if 
an election is made under paragraph (g)(4) of this section, the excess 
of foreign currency losses over foreign currency gains to which the 
election would apply may be apportioned to, and offset, other categories 
of foreign personal holding company income.
    (ii) Exclusion for business needs--(A) General rule. Foreign 
currency gain or loss directly related to the business needs of the 
controlled foreign corporation is excluded from foreign personal holding 
company income.
    (B) Business needs. Foreign currency gain or loss is directly 
related to the business needs of a controlled foreign corporation if--
    (1) The foreign currency gain or loss--
    (i) Arises from a transaction (other than a hedging transaction) 
entered into, or property used or held for use, in the normal course of 
the controlled foreign corporation's trade or business, other than the 
trade or business of trading foreign currency;
    (ii) Arises from a transaction or property that does not itself (and 
could not reasonably be expected to) give rise to subpart F income other 
than foreign currency gain or loss;
    (iii) Does not arise from a transaction described in section 
988(c)(1)(B)(iii); and
    (iv) Is clearly determinable from the records of the controlled 
foreign corporation as being derived from such transaction or property; 
or
    (2) The foreign currency gain or loss arises from a bona fide 
hedging transaction, as defined in paragraph (a)(4)(ii) of this section, 
with respect to a transaction or property that satisfies the 
requirements of paragraphs (g)(2)(ii)(B)(1) (i) through (iii) of this 
section, provided that any gain or loss arising from such transaction or 
property that is attributable to changes in exchange rates is clearly 
determinable from the records of the CFC as being derived from such 
transaction or property. For purposes of this paragraph 
(g)(2)(ii)(B)(2), a hedging transaction will satisfy the aggregate 
hedging rules of Sec. 1.1221-2(c)(3) only if all (or all but a de 
minimis amount) of the aggregate risk being hedged arises in connection 
with transactions or property that satisfy the requirements of 
paragraphs (g)(2)(ii)(B)(1) (i) through (iii) of this section, provided 
that any gain or loss arising from such transactions or property that is 
attributable to changes in exchange rates is clearly determinable from 
the records of the CFC as being derived from such transactions or 
property.
    (C) Regular dealers--(1) General rule. Transactions in dealer 
property (as defined in paragraph (a)(4)(v) of this section) described 
in section 988(c)(1)(B) or

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(C) that are entered into by a controlled foreign corporation that is a 
regular dealer (as defined in paragraph (a)(4)(iv) of this section) in 
such property in its capacity as a dealer will be treated as directly 
related to the business needs of the controlled foreign corporation 
under paragraph (g)(2)(ii)(A) of this section.
    (2) Certain interest-bearing liabilities treated as dealer 
property--(i) In general. For purposes of this paragraph (g)(2)(ii)(C), 
an interest-bearing liability incurred by a controlled foreign 
corporation that is denominated in (or determined by reference to) a 
non-functional currency shall be treated as dealer property of the type 
described in paragraph (g)(2)(ii)(C)(1) of this section if the 
liability, by being denominated in such currency, reduces the controlled 
foreign corporation's currency risk with respect to dealer property, and 
the liability is identified on the controlled foreign corporation's 
records as a liability treated as dealer property before the close of 
the day on which the liability is incurred.
    (ii) Failure to identify certain liabilities. If a controlled 
foreign corporation identifies certain interest-bearing liabilities as 
liabilities treated as dealer property under paragraph 
(g)(2)(ii)(C)(2)(i) of this section but fails to so identify other 
interest-bearing liabilities that manage its currency risk with respect 
to assets held that constitute dealer property, the Commissioner may 
treat such other liabilities as properly identified as dealer property 
under paragraph (g)(2)(ii)(C)(2)(i) of this section if the Commissioner 
determines that the failure to identify such other liabilities had as 
one of its principal purposes the avoidance of Federal income tax.
    (iii) Effective date. This paragraph (g)(2)(ii)(C)(2) applies only 
to gain or loss from an interest-bearing liability entered into by a 
controlled foreign corporation on or after January 31, 2003.
    (D) Example. The following example illustrates the provisions of 
this paragraph (g)(2).

    Example. (i) CFC1 and CFC2 are controlled foreign corporations 
located in Country B, and are members of the same controlled group. CFC1 
is engaged in the active conduct of a trade or business that does not 
produce any subpart F income. CFC2 serves as the currency coordination 
center for the controlled group, aggregating currency risks incurred by 
the group and entering into hedging transactions that transfer those 
risks outside of the group. Pursuant to this arrangement, and to hedge 
the currency risk on a non-interest bearing receivable incurred by CFC1 
in the normal course of its business, on Day 1 CFC1 enters into a 
forward contract to sell Japanese Yen to CFC2 in 30 days. Also on Day 1, 
CFC2 enters into a forward contract to sell Yen to unrelated Bank X on 
Day 30. CFC2 is not a regular dealer in Yen spot and forward contracts, 
and the Yen is not the functional currency for either CFC1 or CFC2.
    (ii) Because the forward contract entered into by CFC1 to sell Yen 
hedges a transaction entered into in the normal course of CFC1's 
business that does not give rise to subpart F income, it qualifies as a 
bona fide hedging transaction as defined in paragraph (a)(4)(ii) of this 
section. Therefore, CFC1's foreign exchange gain or loss from that 
forward contract will not be treated as foreign personal holding company 
income or loss under this paragraph (g).
    (iii) Because the forward contract to purchase Yen was entered into 
by CFC2 in order to assume currency risks incurred by CFC1 it does not 
qualify as a bona fide hedging transaction, as defined in paragraph 
(a)(4)(ii) of this section. Thus, foreign exchange gain or loss 
recognized by CFC2 from that forward contract will be foreign personal 
holding company income. Because CFC2 entered into the forward contract 
to sell Yen in order to hedge currency risks of CFC1, that forward 
contract also does not qualify as a bona fide hedging transaction. Thus, 
CFC2's foreign currency gain or loss arising from that forward contract 
will be foreign personal holding company income.

    (iii) Special rule for foreign currency gain or loss from an 
interest-bearing liability. Except as provided in paragraph 
(g)(2)(ii)(C)(2) or (g)(5)(iv) of this section, foreign currency gain or 
loss arising from an interest-bearing liability is characterized as 
subpart F income and non-subpart F income in the same manner that 
interest expense associated with the liability would be allocated and 
apportioned between subpart F income and non-subpart F income under 
Sec. Sec. 1.861-9T and 1.861-12T.
    (3) Election to characterize foreign currency gain or loss that 
arises from a specific category of subpart F income as gain or loss in 
that category--(i) In general. For taxable years of a controlled foreign 
corporation beginning on or after

[[Page 316]]

November 6, 1995, the controlling United States shareholders of the 
controlled foreign corporation may elect, under this paragraph (g)(3), 
to exclude foreign currency gain or loss otherwise includible in the 
computation of foreign personal holding company income under this 
paragraph (g) from the computation of foreign personal holding company 
income under this paragraph (g) and include such foreign currency gain 
or loss in the category (or categories) of subpart F income (described 
in section 952(a), or, in the case of foreign base company income, 
described in Sec. 1.954-1(c)(1)(iii)(A) (1) or (2)) to which such gain 
or loss relates. If an election is made under this paragraph (g)(3) with 
respect to a category (or categories) of subpart F income described in 
section 952(a), or, in the case of foreign base company income, 
described in Sec. 1.954-1(c)(1)(iii)(A) (1) or (2), the election shall 
apply to all foreign currency gain or loss that arises from--
    (A) A transaction (other than a hedging transaction) entered into, 
or property used or held for use, in the normal course of the controlled 
foreign corporation's trade or business that gives rise to income in 
that category (or categories) and that is clearly determinable from the 
records of the controlled foreign corporation as being derived from such 
transaction or property; and
    (B) A bona fide hedging transaction, as defined in paragraph 
(a)(4)(ii) of this section, with respect to a transaction or property 
described in paragraph (g)(3)(i)(A) of this section. For purposes of 
this paragraph (g)(3)(i)(B), a hedging transaction will satisfy the 
aggregate hedging rules of Sec. 1.1221-2(c)(3) only if all (or all but 
a de minimis amount) of the aggregate risk being hedged arises in 
connection with transactions or property that generate the same category 
of subpart F income described in section 952(a), or, in the case of 
foreign base company income, described in Sec. 1.954-1(c)(1)(iii)(A) 
(1) or (2).
    (ii) Time and manner of election. The controlling United States 
shareholders, as defined in Sec. 1.964-1(c)(5), make the election on 
behalf of the controlled foreign corporation by filing a statement with 
their original income tax returns for the taxable year of such United 
States shareholders ending with or within the taxable year of the 
controlled foreign corporation for which the election is made, clearly 
indicating that such election has been made. If the controlling United 
States shareholders elect to apply these regulations retroactively, 
under Sec. 1.954-0(a)(1)(ii), the election under this paragraph (g)(3) 
may be made by the amended return filed pursuant to the election under 
Sec. 1.954-0(a)(1)(ii). The controlling United States shareholders 
filing the election statement described in this paragraph (g)(3)(ii) 
must provide copies of the election statement to all other United States 
shareholders of the electing controlled foreign corporation. Failure to 
provide copies of such statement will not cause an election under this 
paragraph (g)(3) to be voidable by the controlled foreign corporation or 
the controlling United States shareholders. However, the District 
Director has discretion to void the election if it is determined that 
three was no reasonable cause for the failure to provide copies of such 
statement. The statement shall include the following information--
    (A) The name, address, taxpayer identification number, and taxable 
year of such United States shareholder;
    (B) The name, address, and taxable year of the controlled foreign 
corporation for which the election is effective; and
    (C) Any additional information required by the Commission by 
administrative pronouncement.
    (iii) Revocation of election. This election is effective for the 
taxable year of the controlled foreign corporation for which it is made 
and all subsequent taxable years of such corporation unless revoked by 
or with the consent of the Commissioner.
    (iv) Example. The following example illustrates the provisions of 
this paragraph (g)(3).

    Example. (i) CFC, a controlled foreign corporation, is a sales 
company that earns foreign base company sales income under section 
954(d). CFC makes an election under this paragraph (g)(3) to treat 
foreign currency gains or losses that arise from a specific category (or 
categories) of subpart F income (as described in section 952(a), or, in 
the case of foreign base company income, as described in Sec. 1.954-
1(c)(1)(iii)(A) (1) or (2)) as that type

[[Page 317]]

of income. CFC aggregates the currency risk on all of its transactions 
that generate foreign base company sales income and hedges this net 
currency exposure.
    (ii) Assuming no more than a de minimis amount of risk in the pool 
of risks being hedged arises from transactions or property that generate 
income other than foreign base company sales income, pursuant to its 
election under (g)(3), CFC's net foreign currency gain from the pool and 
the hedging transactions will be treated as foreign base company sales 
income under section 954(d), rather than as foreign personal holding 
company income under section 954(c)(1)(D). If the pool of risks and the 
hedging transactions generate a net foreign base company sales loss, 
however, CFC must apply the rules of Sec. 1.954-1(c)(1)(ii).

    (4) Election to treat all foreign currency gains or losses as 
foreign personal holding company income--(i) In general. If the 
controlling United States shareholders make an election under this 
paragraph (g)(4), the controlled foreign corporation shall include in 
its computation of foreign personal holding company income the excess of 
foreign currency gains over losses or the excess of foreign currency 
losses over gains attributable to any section 988 transaction (except 
those described in paragraph (g)(5) of this section) and any section 
1256 contract that would be a section 988 transaction but for section 
988(c)(1)(D). Separate elections for section 1256 contracts and section 
988 transactions are not permitted. An election under this paragraph 
(g)(4) supersedes an election under paragraph (g)(3) of this section.
    (ii) Time and manner of election. The controlling United States 
shareholders, as defined in Sec. 1.964-1(c)(5), make the election on 
behalf of the controlled foreign corporation in the same time and manner 
as provided in paragraph (g)(3)(ii) of this section.
    (iii) Revocation of election. This election is effective for the 
taxable year of the controlled foreign corporation for which it is made 
and all subsequent taxable years of such corporation unless revoked by 
or with the consent of the Commissioner.
    (5) Gains and losses not subject to this paragraph--(i) Capital 
gains and losses. Gain or loss that is treated as capital gain or loss 
under section 988(a)(1)(B) is not foreign currency gain or loss for 
purposes of this paragraph (g). Such gain or loss is treated as gain or 
loss from the sale or exchange of property that is included in the 
computation of foreign personal holding company income under paragraph 
(e)(1) of this section. Paragraph (a)(2) of this section provides other 
rules concerning income described in more than one category of foreign 
personal holding company income.
    (ii) Income not subject to section 988. Gain or loss that is not 
treated as foreign currency gain or loss by reason of section 988 (a)(2) 
or (d) is not foreign currency gain or loss for purposes of this 
paragraph (g). However, such gain or loss may be included in the 
computation of other categories of foreign personal holding company 
income in accordance with its characterization under section 988 (a)(2) 
or (d) (for example, foreign currency gain that is treated as interest 
income under section 988(a)(2) will be included in the computation of 
foreign personal holding company income under paragraph (b)(ii) of this 
section).
    (iii) Qualified business units using the dollar approximate separate 
transactions method. This paragraph (g) does not apply to any DASTM gain 
or loss computed under Sec. 1.985-3(d). Such gain or loss is allocated 
under the rules of Sec. 1.985-3 (e)(2)(iv) or (e)(3). However, the 
provisions of this paragraph (g) do apply to section 988 transactions 
denominated in a currency other than the United States dollar or the 
currency that would be the qualified business unit's functional currency 
were it not hyperinflationary.
    (iv) Gain or loss allocated under Sec. 1.861-9. [Reserved]
    (h) Income equivalent to interest--(1) In general--(i) Inclusion in 
foreign personal holding company income. Except as provided in this 
paragraph (h), foreign personal holding company income includes income 
equivalent to interest as defined in paragraph (h)(2) of this section.
    (ii) Exceptions--(A) Liability hedging transactions. Income, gain, 
deduction or loss that is allocated and apportioned in the same manner 
as interest expense under the provisions of Sec. 1.861-9T is not income 
equivalent to interest for purposes of this paragraph (h).

[[Page 318]]

    (B) Interest. Amounts treated as interest under section 954(c)(1)(A) 
and paragraph (b) of this section are not income equivalent to interest 
for purposes of this paragraph (h).
    (2) Definition of income equivalent to interest--(i) In general. The 
term income equivalent to interest includes income that is derived 
from--
    (A) A transaction or series of related transactions in which the 
payments, net payments, cash flows or return predominantly reflect the 
time value of money;
    (B) Transactions in which the payments (or a predominant portion 
thereof) are, in substance, for the use or forbearance of money;
    (C) Notional principal contracts, to the extent provided in 
paragraph (h)(3) of this section;
    (D) Factoring, to the extent provided in paragraph (h)(4) of this 
section;
    (E) Conversion transactions, but only to the extent that gain 
realized with respect to such a transaction is treated as ordinary 
income under section 1258;
    (F) The performance of services, to the extent provided in paragraph 
(h)(5) of this section;
    (G) The commitment by a lender to provide financing, if any portion 
of such financing is actually provided;
    (H) Transfers of debt securities subject to section 1058; and
    (I) Other transactions, as provided by the Commissioner in published 
guidance. See Sec. 601.601(d)(2) of this chapter.
    (ii) Income from the sale of property. Income from the sale of 
property will not be treated as income equivalent to interest by reason 
of paragraph (h)(2)(i)(A) or (B) of this section. Income derived by a 
controlled foreign corporation will be treated as arising from the sale 
of property only if the corporation in substance carries out sales 
activities. Accordingly, an arrangement that is designed to lend the 
form of a sales transaction to a transaction that in substance 
constitutes an advance of funds will be disregarded. For example, if a 
controlled foreign corporation acquires property on 30-day payment terms 
from one person and sells that property to another person on 90-day 
payment terms and at prearranged prices and terms such that the foreign 
corporation bears no substantial economic risk with respect to the 
purchase and sale other than the risk of non-payment, the foreign 
corporation has not in substance derived income from the sale of 
property.
    (3) Notional principal contracts--(i) In general. Income equivalent 
to interest includes income from notional principal contracts 
denominated in the functional currency of the taxpayer (or a qualified 
business unit of the taxpayer, as defined in section 989(a)), the value 
of which is determined solely by reference to interest rates or interest 
rate indices, to the extent that the income from such transactions 
accrues on or after August 14, 1989.
    (ii) Regular dealers. Income equivalent to interest does not include 
income earned by a regular dealer (as defined in paragraph (a)(4)(iv) of 
this section) from notional principal contracts that are dealer property 
(as defined in paragraph (a)(4)(v) of this section).
    (4) Income equivalent to interest from factoring--(i) General rule. 
Income equivalent to interest includes factoring income. Except as 
provided in paragraph (h)(4)(ii) of this section, the term factoring 
income includes any income (including any discount income or service 
fee, but excluding any stated interest) derived from the acquisition and 
collection or disposition of a factored receivable. The amount of income 
equivalent to interest realized with respect to a factored receivable is 
the difference (if a positive number) between the amount paid for the 
receivable by the foreign corporation and the amount that it collects on 
the receivable (or realizes upon its sale of the receivable). The rules 
of this paragraph (h)(4) apply only with respect to the tax treatment of 
factoring income derived from the acquisition and collection or 
disposition of a factored receivable and shall not affect the 
characterization of an expense or loss of either the person whose goods 
or services gave rise to a factored receivable or the obligor under a 
receivable.
    (ii) Exceptions. Factoring income shall not include--
    (A) Income treated as interest under section 864(d)(1) or (6) 
(relating to income derived from trade or service receivables of related 
persons), even if such income is treated as not described

[[Page 319]]

in section 864(d)(1) by reason of the same-country exception of section 
864(d)(7);
    (B) Income derived from a factored receivable if payment for the 
acquisition of the receivable is made on or after the date on which 
stated interest begins to accrue, but only if the rate of stated 
interest equals or exceeds 120 percent of the Federal short-term rate 
(as defined under section 1274) (or the analogous rate for a currency 
other than the dollar) as of the date on which the receivable is 
acquired by the foreign corporation; or
    (C) Income derived from a factored receivable if payment for the 
acquisition of the receivable by the foreign corporation is made only on 
or after the anticipated date of payment of all principal by the obligor 
(or the anticipated weighted average date of payment of a pool of 
purchased receivables).
    (iii) Factored receivable. For purposes of this paragraph (h)(4), 
the term factored receivable includes any account receivable or other 
evidence of indebtedness, whether or not issued at a discount and 
whether or not bearing stated interest, arising out of the disposition 
of property or the performance of services by any person, if such 
account receivable or evidence of indebtedness is acquired by a person 
other than the person who disposed of the property or provided the 
services that gave rise to the account receivable or evidence of 
indebtedness. For purposes of this paragraph (h)(4), it is immaterial 
whether the person providing the property or services agrees to transfer 
the receivable at the time of sale (as by accepting a third-party charge 
or credit card) or at a later time.
    (iv) Examples. The following examples illustrate the application of 
this paragraph (h)(4).

    Example 1. DP, a domestic corporation, owns all of the outstanding 
stock of FS, a controlled foreign corporation. FS acquires accounts 
receivable arising from the sale of property by unrelated corporation X. 
The receivables have a face amount of $100, and after 30 days bear 
stated interest equal to at least 120 percent of the applicable Federal 
short-term rate (determined as of the date the receivables are acquired 
by FS). FS purchases the receivables from X for $95 on Day 1 and 
collects $100 plus stated interest from the obligor under the 
receivables on Day 40. Income (other than stated interest) derived by FS 
from the factored receivables is factoring income within the meaning of 
paragraph (h)(4)(i) of this section and, therefore, is income equivalent 
to interest.
    Example 2. The facts are the same as in Example 1, except that, 
rather than collecting $100 plus stated interest from the obligor under 
the factored receivables on Day 40, FS sells the receivables to 
controlled foreign corporation Y on Day 15 for $97. Both the income 
derived by FS on the factored receivables and the income derived by Y 
(other than stated interest) on the receivables are factoring income 
within the meaning of paragraph (h)(4)(i) of this section, and 
therefore, constitute income equivalent to interest.
    Example 3. The facts are the same as in Example 1, except that FS 
purchases the receivables from X for $98 on Day 30. Income derived by FS 
from the factored receivables is excluded from factoring income under 
paragraph (h)(4)(ii)(B) of this section and, therefore, does not give 
rise to income equivalent to interest.
    Example 4. The facts are the same as in Example 3, except that it is 
anticipated that all principal will be paid by the obligor of the 
receivables by Day 30. Income derived by FS from this maturity factoring 
of the receivables is excluded from factoring income under paragraph 
(h)(4)(ii)(C) of this section and, therefore, does not give rise to 
income equivalent to interest.
    Example 5. The facts are the same as in Example 4, except that FS 
sells the factored receivables to Y for $99 on Day 45, at which time 
stated interest is accruing on the unpaid balance of $100. Because 
interest was accruing at the time Y acquired the receivables at a rate 
equal to at least 120 percent of the applicable Federal short-term rate, 
income derived by Y from the factored receivables is excluded from 
factoring income under paragraph (h)(4)(ii)(B) of this section and, 
therefore, does not give rise to income equivalent to interest.
    Example 6. DP, a domestic corporation engaged in an integrated 
credit card business, owns all of the outstanding stock of FS, a 
controlled foreign corporation. On Day 1, individual A uses a credit 
card issued by DP to purchase shoes priced at $100 from X, a foreign 
corporation unrelated to DP, FS, or A. On Day 7, X transfers the 
receivable (which does not bear stated interest) arising from A's 
purchase to FS in exchange for $95. FS collects $100 from A on Day 45. 
Income derived by FS on the factored receivable is factoring income 
within the meaning of paragraph (h)(4)(i) of this section and, 
therefore, is income equivalent to interest.


[[Page 320]]


    (5) Receivables arising from performance of services. If payment for 
services performed by a controlled foreign corporation is not made until 
more than 120 days after the date on which such services are performed, 
then the income derived by the controlled foreign corporation 
constitutes income equivalent to interest to the extent that interest 
income would be imputed under the principles of section 483 or the 
original issue discount provisions (sections 1271 through 1275), if--
    (i) Such provisions applied to contracts for the performance of 
services;
    (ii) The time period referred to in sections 483(c)(1) and 
1274(c)(1)(B) were 120 days rather than six months; and
    (iii) The time period referred to in section 483(c)(1)(A) were 120 
days rather than one year.
    (6) Examples. The following examples illustrate the application of 
this paragraph (h).

    Example 1. CFC, a controlled foreign corporation, promises that 
Corporation A may borrow up to $500 in principal for one year beginning 
at any time during the next three months at an interest rate of 10 
percent. In exchange, Corporation A pays CFC a commitment fee of $2. 
Pursuant to this agreement, CFC lends $80 to Corporation A. As a result, 
the entire $2 fee is included in the computation of CFC's foreign 
personal holding company income under paragraph (h)(2)(i)(G) of this 
section.
    Example 2. (i) At the beginning of its current taxable year, CFC, a 
controlled foreign corporation, purchases at face value a one-year debt 
instrument issued by Corporation A having a $100 principal amount and 
bearing a floating rate of interest set at the London Interbank Offered 
Rate (LIBOR) plus one percentage point. Contemporaneously, CFC borrows 
$100 from Corporation B for one year at a fixed interest rate of 10 
percent, using the debt instrument as security.
    (ii) During its current taxable year, CFC accrues $11 of interest 
from Corporation A on the bond. Because interest is excluded from the 
definition of income equivalent to interest under paragraph 
(h)(1)(ii)(B) of this section, the $11 is not income equivalent to 
interest.
    (iii) During its current taxable year, CFC incurs $10 of interest 
expense with respect to the borrowing from Corporation B. That expense 
is allocated and apportioned to, and reduces, subpart F income to the 
extent provided in section 954(b)(5) and Sec. Sec. 1.861-9T through 
1.861-12T and 1.954-1(c).
    Example 3. (i) On January 1, 1994, CFC, a controlled foreign 
corporation with the United States dollar as its functional currency, 
purchases at face value a 10-year debt instrument issued by Corporation 
A having a $100 principal amount and bearing a floating rate of interest 
set at LIBOR plus one percentage point payable on December 31st of each 
year. CFC subsequently determines that it would prefer receiving a fixed 
rate of return. Accordingly, on January 1, 1995, CFC enters into a 9-
year interest rate swap agreement with Corporation B whereby Corporation 
B promises to pay CFC on December 31st of each year an amount equal to 
10 percent on a notional principal amount of $100. In exchange, CFC 
promises to pay Corporation B an amount equal to LIBOR plus one 
percentage point on the notional principal amount.
    (ii) On December 31, 1995, CFC receives $9 of interest income from 
Corporation A with respect to the debt instrument. On the same day, CFC 
receives a total of $10 from Corporation B and pays $9 to Corporation B 
with respect to the interest rate swap.
    (iii) The $9 of interest income is foreign personal holding income 
under section 954(c)(1). Pursuant to Sec. 1.446-3(d), CFC recognizes $1 
of swap income for its 1995 taxable year that is also foreign personal 
holding company income because it is income equivalent to interest under 
paragraph (h)(2)(i)(C) of this section.
    Example 4. (i) CFC, a controlled foreign corporation, purchases 
commodity X on the spot market for $100 and, contemporaneously, enter 
into a 3-month forward contract to sell commodity X for $104, a price 
set by the forward market.
    (ii) Assuming that substantially all of CFC's expected return is 
attributable to the time value of the net investment, as described in 
section 1258(c)(1), the transaction is a conversion transaction under 
section 1258(c). Accordingly, any gain treated as ordinary income under 
section 1258(a) will be foreign personal holding company income because 
it is income equivalent to interest under paragraph (h)(2)(i)(E) of this 
section.
    (i) Effective/applicability date. The last two sentences of 
paragraph (c)(2)(ii), and paragraphs (c)(2)(v) through (vii) and (c)(3) 
Example 6 of this section apply to taxable years of controlled foreign 
corporations beginning on or after May 2, 2006, and for taxable years of 
United States shareholders with or within which such taxable years of 
the controlled foreign corporations end. Taxpayers may elect to apply 
the last two sentences of paragraph (c)(2)(ii) and paragraphs (c)(2)(v) 
through (vii) to taxable years of controlled foreign corporations 
beginning after December 31, 2004, and for taxable years of United 
States shareholders with or within

[[Page 321]]

which such taxable years of the controlled foreign corporations end. If 
an election is made to apply Sec. 1.956-2(b)(1)(vi) to taxable years 
beginning after December 31, 2004, then the election must also be made 
for paragraphs (c)(2)(ii) and (c)(2)(v) through (vii) of this section.
    (j) [Reserved]. For further guidance, see Sec. 1.954-2T(j).

[T.D. 8618, 60 FR 46517, Sept. 7, 1995]

    Editorial Note: For Federal Register citations affecting Sec. 
1.954-2, see the List of CFR Sections Affected, which appears in the 
Finding Aids section of the printed volume and at www.fdsys.gov.



Sec. 1.954-2T  Foreign personal holding company income (temporary).

    (a)(1) through (c)(1) introductory text [Reserved]. For further 
guidance, see Sec. 1.954-2(a)(1) through (c)(1) introductory text.
    (i) Property that the lessor, through its own officers or staff of 
employees, has manufactured or produced, or property that the lessor has 
acquired and, through its own officers or staff of employees, added 
substantial value to, but only if the lessor, through its officers or 
staff of employees, is regularly engaged in the manufacture or 
production of, or in the acquisition and addition of substantial value 
to, property of such kind;
    (c)(1)(ii) and (iii) [Reserved]. For further guidance, see Sec. 
1.954-2(c)(1)(ii) and (c)(1)(iii).
    (iv) Property that is leased as a result of the performance of 
marketing functions by such lessor through its own officers or staff of 
employees located in a foreign country or countries, if the lessor, 
through its officers or staff of employees, maintains and operates an 
organization either in such country or in such countries (collectively), 
as applicable, that is regularly engaged in the business of marketing, 
or of marketing and servicing, the leased property and that is 
substantial in relation to the amount of rents derived from the leasing 
of such property.
    (c)(2)(i) [Reserved]. For further guidance, see Sec. 1.954-
2(c)(2)(i).
    (ii) Substantiality of foreign organization. For purposes of 
paragraph (c)(1)(iv) of this section, whether an organization either in 
a foreign country or in foreign countries (collectively) is substantial 
in relation to the amount of rents is determined based on all the facts 
and circumstances. However, such an organization will be considered 
substantial in relation to the amount of rents if active leasing 
expenses, as defined in paragraph (c)(2)(iii) of this section, equal or 
exceed 25 percent of the adjusted leasing profit, as defined in 
paragraph (c)(2)(iv) of this section. In addition, for purposes of 
aircraft or vessels leased in foreign commerce, an organization will be 
considered substantial if active leasing expenses, as defined in 
paragraph (c)(2)(iii) of this section, equal or exceed 10 percent of the 
adjusted leasing profit, as defined in paragraph (c)(2)(iv) of this 
section. For purposes of paragraphs (c)(1)(iv) and (c)(2) of this 
section and Sec. 1.956-2(b)(1)(vi), the term aircraft or vessels 
includes component parts, such as engines that are leased separately 
from an aircraft or vessel.
    (c)(2)(iii) introductory text through (c)(2)(iii)(D) [Reserved]. For 
further guidance, see Sec. 1.954-2(c)(2)(iii) introductory text through 
(c)(2)(iii)(D).
    (E) Deductions for CST Payments or PCT Payments (as defined in Sec. 
1.482-7(b)).
    (c)(2)(iv) through (c)(2)(vii) [Reserved]. For further guidance, see 
Sec. 1.954-2(c)(2)(iv) through (c)(2)(vii).
    (viii) Cost sharing arrangements (CSAs). For purposes of paragraphs 
(c)(1)(i) and (iv) of this section, CST Payments or PCT Payments (as 
defined in Sec. 1.482-7(b)(1)) made by the lessor to another controlled 
participant (as defined in Sec. 1.482-7(j)(1)(i)) pursuant to a CSA (as 
defined in Sec. 1.482-7(a)) do not cause the activities undertaken by 
that other controlled participant to be considered to be undertaken by 
the lessor's own officers or staff of employees.
    (c)(3) and (d)(1) introductory text [Reserved]. For further 
guidance, see Sec. 1.954-2(c)(3) and (d)(1) introductory text.
    (i) Property that the licensor, through its own officers or staff of 
employees, has developed, created, or produced, or property that the 
licensor has acquired and, through its own officers or staff of 
employees, added substantial value to, but only so long as the licensor, 
through its officers or

[[Page 322]]

staff of employees, is regularly engaged in the development, creation, 
or production of, or in the acquisition and addition of substantial 
value to, property of such kind; or
    (ii) Property that is licensed as a result of the performance of 
marketing functions by such licensor through its own officers or staff 
of employees located in a foreign country or countries, if the licensor, 
through its officers or staff of employees, maintains and operates an 
organization either in such foreign country or in such foreign countries 
(collectively), as applicable, that is regularly engaged in the business 
of marketing, or of marketing and servicing, the licensed property and 
that is substantial in relation to the amount of royalties derived from 
the licensing of such property.
    (d)(2)(i) [Reserved]. For further guidance, see Sec. 1.954-
2(d)(2)(i).
    (ii) Substantiality of foreign organization. For purposes of 
paragraph (d)(1)(ii) of this section, whether an organization either in 
a foreign country or in foreign countries (collectively) is substantial 
in relation to the amount of royalties is determined based on all of the 
facts and circumstances. However, such an organization will be 
considered substantial in relation to the amount of royalties if active 
licensing expenses, as defined in paragraph (d)(2)(iii) of this section, 
equal or exceed 25 percent of the adjusted licensing profit, as defined 
in paragraph (d)(2)(iv) of this section.
    (d)(2)(iii) introductory text through (d)(2)(iii)(D) [Reserved]. For 
further guidance, see Sec. 1.954-2(d)(2)(iii) introductory text through 
(d)(2)(iii)(D).
    (E) Deductions for CST Payments or PCT Payments (as defined in Sec. 
1.482-7(b)).
    (d)(2)(iv) [Reserved]. For further guidance, see Sec. 1.954-
2(d)(2)(iv).
    (v) Cost sharing arrangements (CSAs). For purposes of paragraphs 
(d)(1)(i) and (ii) of this section, CST Payments or PCT Payments (as 
defined in Sec. 1.482-7(b)(1)) made by the licensor to another 
controlled participant (as defined in Sec. 1.482-7(j)(1)(i)) pursuant 
to a CSA (as defined in Sec. 1.482-7(a)) do not cause the activities 
undertaken by that other controlled participant to be considered to be 
undertaken by the licensor's own officers or staff of employees.
    (d)(3) through (i) [Reserved]. For further guidance, see Sec. 
1.954-2(d)(3) through (i).
    (j) Effective/applicability date. Paragraphs (c)(1)(i) and (d)(1)(i) 
of this section apply to rents or royalties, as applicable, received or 
accrued during taxable years of controlled foreign corporations ending 
on or after September 1, 2015, and to taxable years of United States 
shareholders in which or with which such taxable years end, but only 
with respect to property manufactured, produced, developed, or created, 
or in the case of acquired property, property to which substantial value 
has been added, on or after September 1, 2015. Paragraphs (c)(1)(iv), 
(c)(2)(ii), (c)(2)(iii)(E), (c)(2)(viii), (d)(1)(ii), (d)(2)(ii), 
(d)(2)(iii)(E), and (d)(2)(v) of this section apply to rents or 
royalties, as applicable, received or accrued during taxable years of 
controlled foreign corporations ending on or after September 1, 2015, 
and to taxable years of United States shareholders in which or with 
which such taxable years end, to the extent that such rents or royalties 
are received or accrued on or after September 1, 2015. See Sec. 1.954-
2(c)(1)(i), (c)(1)(iv), (c)(2)(ii), (c)(2)(iii), (d)(1)(i), (d)(1)(ii), 
(d)(2)(ii), and (d)(2)(iii), as contained in 26 CFR part 1 revised as of 
April 1, 2015, for rules applicable to rents or royalties, as 
applicable, received or accrued before September 1, 2015.
    (k) Expiration date. The applicability of paragraphs (c)(1)(i), 
(c)(1)(iv), (c)(2)(ii), (c)(2)(iii)(E), (c)(2)(viii), (d)(1)(i), 
(d)(1)(ii), (d)(2)(ii), (d)(2)(iii)(E), and (d)(2)(v) of this section 
expires on or before August 31, 2018.

[T.D. 9733, 80 FR 52980, Sept. 2, 2015; 80 FR 66416, Oct. 29, 2015]



Sec. 1.954-3  Foreign base company sales income.

    (a) Income included--(1) In general--(i) General rules. Foreign base 
company sales income of a controlled foreign corporation shall, except 
as provided in paragraphs (a)(2), (a)(3) and (a)(4) of this section, 
consist of gross income (whether in the form of profits, commissions, 
fees or otherwise) derived in

[[Page 323]]

connection with the purchase of personal property from a related person 
and its sale to any person, the sale of personal property to any person 
on behalf of a related person, the purchase of personal property from 
any person and its sale to a related person, or the purchase of personal 
property from any person on behalf of a related person. See section 
954(d)(1). For purposes of the preceding sentence, except as provided in 
paragraphs (a)(2) and (a)(4) of this section, personal property sold by 
a controlled foreign corporation will be considered to be the same 
property that was purchased by the controlled foreign corporation 
regardless of whether the personal property is sold in the same form in 
which it was purchased, in a different form than the form in which it 
was purchased, or as a component part of a manufactured product. This 
section shall apply to the purchase and/or sale of personal property, 
whether or not such property was purchased and/or sold in the ordinary 
course of trade or business, except that income derived in connection 
with the sale of tangible personal property will not be considered to be 
foreign base company sales income if such property is sold to a person 
that is not a related person, as defined in Sec. 1.954-1(f), after 
substantial use has been made of the property by the controlled foreign 
corporation in its trade or business. This section shall not apply to 
the excess of gains over losses from sales or exchanges of securities or 
from futures transactions, to the extent such excess gains are 
includible in foreign personal holding company income of the controlled 
foreign corporation under Sec. 1.954-2; nor shall it apply to the sale 
of the controlled foreign corporation's property (other than its stock 
in trade or other property of a kind which would properly be included in 
its inventory if on hand at the close of the taxable year, or property 
held primarily for sale to customers in the ordinary course of its 
business) if substantially all the property of such corporation is sold 
pursuant to the discontinuation of the trade or business previously 
carried on by such corporation. The term ``any person'' as used in this 
paragraph (a)(1)(i) includes a related person as defined in Sec. 1.954-
1(f).
    (ii) Special rule--(a) In general. The term ``personal property'' as 
used in section 954(d) and this section shall not include agricultural 
commodities which are not grown in the United States (within the meaning 
of section 7701(a)(9)) in commercially marketable quantities. All of the 
agricultural commodities listed in table I shall be considered grown in 
the United States in commercially marketable quantities. Bananas, black 
pepper, cocoa, coconut, coffee, crude rubber, and tea shall not be 
considered grown in the United States in commercially marketable 
quantities. All other agricultural commodities shall not be considered 
grown in the United States in commercially marketable quantities when, 
in consideration of all of the facts and circumstances of the individual 
case, such commodities are shown to be produced in the United States in 
insufficient quantity and quality to be marketed commercially. The term 
``agricultural commodities'' includes, but is not limited to, livestock, 
poultry, fish produced in fish farms, fruit, furbearing animals as well 
as the products of truck farms, ranches, nurseries, ranges, and 
orchards. A fish farm is an area where fish are grown or raised 
(artificially protected and cared for), as opposed to merely caught or 
harvested. However, the term ``agricultural commodities'' shall not 
include timber (either standing or felled), or any commodity at least 50 
percent of the fair market value of which is attributable to 
manufacturing or processing, determined in a manner consistent with the 
regulations under section 993(c) (relating to the definition of export 
property). For purposes of applying such regulations, the term 
``processing'' shall be deemed not to include handling, packing, 
packaging, grading, storing, transporting, slaughtering, and harvesting. 
Subdivision (ii) shall apply in the computation of foreign base company 
sales income for taxable years of controlled foreign corporations 
beginning after December 31, 1975, and to taxable years of U.S. 
shareholders (within the meaning of section 951(b)) within which or with 
which such taxable years of such foreign corporations end.
    (b) Table.

[[Page 324]]



     Table I--Agricultural Commodities Grown in the United States in
                   Commercially Marketable Quantities
                         Livestock and Products
 
Beeswax                              Horses
Cattle and calves                    Milk
Chickens                             Mink
Chicken eggs                         Mohair
Ducks                                Rabbits
Geese                                Sheep and lambs
Goats                                Turkeys
Hogs                                 Wool
Honey
 
                                  Crops
 
Alfalfa                              Lettuce
Almonds                              Lime
Apples                               Macadamia nuts
Apricots                             Maple syrup and
Artichokes                            sugar
Asparagus                            Mint
Avocadoes                            Mushrooms
Barley                               Nectarines
Beans                                Oats
Beets                                Olives
Blackberries                         Onions
Blueberries                          Oranges
Brussel sprouts                      Papayas
Broccoli                             Pecans
Bulbs                                Peaches
Cabbage                              Peanuts
Cantaloupes                          Pears
Carrots                              Peas
Cauliflower                          Peppers
Celery                               Plums and prunes
Cherries                             Potatoes
Corn                                 Potted plants
Cotton                               Raspberries
Cranberries                          Rice
Cucumbers                            Rhubarb
Cut flowers                          Rye
Dates                                Sorghum grain
Eggplant                             Soybeans
Escarole                             Spinach
Figs                                 Strawberries
Filberts                             Sugar beets
Flaxseed                             Sugarcane
Garlic                               Sweet potatoes
Grapes                               Tangelos
Grapefruit                           Tangerines
Grass seed                           Tobacco
Hay                                  Tomatoes
Honeydew melons                      Walnuts
Hops                                 Watermelons
Lemons                               Wheat
 

    (iii) The application of this subparagraph may be illustrated by the 
following examples:

    Example 1. Controlled foreign corporation A, incorporated under the 
laws of foreign country X, is a wholly owned subsidiary of domestic 
corporation M. Corporation A purchases from M Corporation, a related 
person, articles manufactured in the United States and sells the 
articles to P, an unrelated person, for delivery and use in foreign 
country Y. Gross income of A Corporation derived from the purchase and 
sale of the personal property is foreign base company sales income.
    Example 2. Corporation A in Example 1 also purchases from P, an 
unrelated person, articles manufactured in country Y and sells the 
articles to foreign corporation B, a related person, for use in foreign 
country Z. Gross income of A Corporation derived from the purchase and 
sale of the personal property is foreign base company sales income.
    Example 3. Controlled foreign corporation C, incorporated under the 
laws of foreign country X, is a wholly owned subsidiary of domestic 
corporation N. By contract, N Corporation agrees to pay C Corporation, a 
related person, a commission equal to 6 percent of the gross selling 
price of all personal property shipped by N Corporation as the result of 
orders solicited by C Corporation in foreign countries Y and Z. In 
fulfillment of such orders, N Corporation ships products manufactured by 
it in the United States. Corporation C does not assume title to the 
property sold. Gross commissions received by C Corporation from N 
Corporation in connection with the sale of such property for use in 
countries Y and Z constitute foreign base company sales income.
    Example 4. Controlled foreign corporation D, incorporated under the 
laws of foreign country Y, is a wholly owned subsidiary of domestic 
corporation R. In 1964, D Corporation acquires a United States 
manufactured lathe from R Corporation. In 1972, after having made 
substantial use of the lathe in its manufacturing business, D 
Corporation sells the lathe to an unrelated person for use in foreign 
country Z. Gross income from the sale of the lathe is not foreign base 
company sales income since it is sold to an unrelated person after 
substantial use has been made of it by D Corporation in its business.
    Example 5. Controlled foreign corporation E, incorporated under the 
laws of foreign country Y, is a wholly owned subsidiary of domestic 
corporation P. Corporation E purchases from P Corporation articles 
manufactured by P Corporation outside of country Y and sells the 
articles to F Corporation, an unrelated person, for use in foreign 
country Z. Corporation E finances the purchase of the articles by F 
Corporation by agreeing to accept payment over an extended period of 
time and receives not only the purchase price but also interest and 
service fees. All gross income of E Corporation derived in connection 
with the purchase and sale of the personal property, including interest 
and service fees derived from financing the sale to F Corporation, 
constitutes foreign base company sales income.

    (2) Property manufactured, produced, constructed, grown, or 
extracted within the country in which the controlled foreign corporation 
is created or organized. Foreign base company sales income

[[Page 325]]

does not include income derived in connection with the purchase and sale 
of personal property (or purchase or sale of personal property on behalf 
of a related person) in a transaction described in paragraph (a)(1) of 
this section if the property is manufactured, produced, constructed, 
grown, or extracted in the country under the laws of which the 
controlled foreign corporation which purchases and sells the property 
(or acts on behalf of a related person) is created or organized. See 
section 954(d)(1)(A). The principles set forth in paragraphs (a)(4)(ii) 
and (a)(4)(iii) of this section apply under this paragraph (a)(2) in 
determining what constitutes the manufacture, production, or 
construction of personal property, excluding the requirement set forth 
in paragraph (a)(4)(i) of this section that the provisions of paragraphs 
(a)(4)(ii) and (a)(4)(iii) of this section may only be satisfied through 
the activities of employees of the corporation manufacturing, producing, 
or constructing the personal property. The principles of paragraph 
(a)(4)(iv) of this section apply under this paragraph (a)(2) in 
determining what constitutes the manufacture, production, or 
construction of personal property but only when the personal property is 
manufactured, produced, or constructed by a person related to the 
controlled foreign corporation within the meaning of Sec. 1.954-1(f). 
The application of this paragraph (a)(2) may be illustrated by the 
following examples:

    Example 1. Controlled foreign corporation A, incorporated under the 
laws of foreign country X, is a wholly owned subsidiary of domestic 
corporation M. Corporation A purchases coffee beans grown in country X 
from foreign corporation P, a related person, and sells the beans to M 
Corporation, a related person, for use in the United States. Income from 
the purchase and sale of the coffee beans by A Corporation is not 
foreign base company sales income since the beans were grown in country 
X.
    Example 2. Controlled foreign corporation B, incorporated under the 
laws of foreign country X, is a wholly owned subsidiary of controlled 
foreign corporation C, also incorporated under the laws of country X. 
Corporation B purchases and imports into country X rough diamonds mined 
in foreign country Y; in country X it cuts, polishes, and shapes the 
diamonds in a process which constitutes manufacturing within the meaning 
of subparagraph (4) of this paragraph. Corporation B sells the finished 
diamonds to C Corporation, a related person, which in turn sells them 
for use in foreign country Z. Since for purposes of this subparagraph 
the finished diamonds are manufactured in country X, gross income 
derived by C Corporation from their sale is not foreign base company 
sales income.

    (3) Property sold for use, consumption, or disposition within the 
country in which the controlled foreign corporation is created or 
organized--(i) In general. Foreign base company sales income does not 
include income derived in connection with the purchase and sale of 
personal property (or purchase or sale of personal property on behalf of 
a related person) in a transaction described in subparagraph (1) of this 
paragraph, (a) if the property is sold for use, consumption, or 
disposition in the country under the laws of which the controlled 
foreign corporation which purchases and sells the property (or sells on 
behalf of a related person) is created or organized or (b), where the 
property is purchased by the controlled foreign corporation on behalf of 
a related person, if such property is purchased for use, consumption, or 
disposition in the country under the laws of which such controlled 
foreign corporation is created or organized. See section 954(d)(1)(B).
    (ii) Rules for determining country of use, consumption, or 
disposition. As a general rule, personal property which is sold to an 
unrelated person will be presumed for purposes of this subparagraph to 
have been sold for use, consumption, or disposition in the country of 
destination of the property sold; for such purpose, the occurrence in a 
country of a temporary interruption in shipment of goods shall not 
constitute such country the country of destination. However, if at the 
time of a sale of personal property to an unrelated person the 
controlled foreign corporation knew, or should have known from the facts 
and circumstances surrounding the transaction, that the property 
probably would not be used, consumed, or disposed of in the country of 
destination, the controlled foreign corporation must determine the 
country of ultimate use, consumption, or disposition of the property or 
the property will be presumed to have been

[[Page 326]]

used, consumed, or disposed of outside the country under the laws of 
which the controlled foreign corporation is created or organized. A 
controlled foreign corporation which sells personal property to a 
related person is presumed to sell such property for use, consumption, 
or disposition outside the country under the laws of which the 
controlled foreign corporation is created or organized unless such 
corporation establishes the use made of the property by the related 
person; once it has established that the related person has disposed of 
the property, the rules in the two preceding sentences relating to sales 
by a controlled foreign corporation to an unrelated person will apply at 
the first stage in the chain of distribution at which a sale is made by 
a related person to an unrelated person. Notwithstanding the preceding 
provisions of this subdivision, a controlled foreign corporation which 
sells personal property to any person all of whose business except for 
an insubstantial part consists of selling from inventory to retail 
customers at retail outlets all within one country may assume at the 
time of such sale to such person that such property will be used, 
consumed, or disposed of within such country.
    (iii) Fungible goods. For purposes of this subparagraph, a 
controlled foreign corporation which sells to a purchaser personal 
property which because of its fungible nature cannot reasonable be 
specifically traced to other purchasers and to the countries of ultimate 
use, consumption, or disposition shall, unless such corporation 
establishes a different disposition as being proper, treat such property 
as being sold, for ultimate use, consumption, or disposition in those 
countries, and to those other purchasers, in the same proportions in 
which property from the fungible mass of the first purchaser is sold in 
the regular course of business by such first purchaser. No apportionment 
need be made, however, on the basis of sporadic sales by the first 
purchaser. This subdivision shall apply only in a case where the 
controlled foreign corporation knew, or should have known from the facts 
and circumstances surrounding the transaction, the manner in which the 
first purchaser disposes of goods from the fungible mass.
    (iv) Illustrations. The application of this subparagraph may be 
illustrated by the following examples:

    Example 1. Controlled foreign corporation A, incorporated under the 
laws of foreign country X, and controlled foreign corporation B, 
incorporated under the laws of foreign country Y, are related persons. 
Corporation A purchases from B Corporation electric transformers 
produced by B Corporation in country Y and sells the transformers to D 
Corporation, an unrelated person, for installation in a factory building 
being constructed in country X. Since the personal property purchased 
and sold by A Corporation is to be used within the country in which A 
Corporation is incorporated, income of A Corporation derived from the 
purchase and sale of the electric transformers is not foreign base 
company sales income.
    Example 2. Controlled foreign corporation C, incorporated under the 
laws of foreign country X, is a wholly owned subsidiary of domestic 
corporation N. Corporation C purchases from N Corporation sewing 
machines manufactured in the United States by N Corporation and sells 
the sewing machines to retail department stores, unrelated persons, 
located in foreign country X. The entire activities of the department 
stores to which C Corporation sells the machines consist of selling 
goods from inventory to retail customers at retail outlets in country X. 
Under these circumstances, at the time of sale C Corporation may assume 
the sewing machines will be used, consumed, or disposed of in country X, 
and no attempt need be made by C Corporation to determine where the 
sewing machines will ultimately be used by the customers of the retail 
department stores. Gross income of C Corporation derived from the sales 
to the department stores located in country X is not foreign base 
company sales income.
    Example 3. Controlled foreign corporation D, incorporated under the 
laws of foreign country Y, and controlled foreign corporation E, 
incorporated under the laws of foreign country X, are related persons. 
Corporation D purchases from E Corporation sulphur extracted by E 
Corporation from deposits located in country X. Corporation D sells the 
sulphur to F Corporation, an unrelated person, for delivery to F 
Corporation's storage facilities located in country Y. At the time of 
the sale of the sulphur from D Corporation to F Corporation, D 
Corporation knows that F Corporation is actively engaged in the business 
of selling a large amount of sulphur in country Y but also that F 
Corporation sells, in the normal course of its business, 25

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percent of its sulphur for ultimate consumption in foreign country Z. 
However, D Corporation has no knowledge at the time of sale whether any 
portion of the particular shipment it sells to F Corporation will be 
resold by F Corporation for ultimate use, consumption, or disposition 
outside country Y. Moreover, delivery of the sulphur to F Corporation's 
storage facilities constitutes more than a temporary interruption in the 
shipment of the sulphur. Under such circumstances, D Corporation may, 
but is not required to, trace the ultimate disposition by F Corporation 
of the personal property sold to F Corporation; however, if D 
Corporation does not trace the ultimate disposition and if it does not 
establish a different disposition as being proper, 25 percent of the 
sulphur sold by D Corporation to F Corporation will be treated as being 
sold for consumption in country Z and 25 percent of the gross income 
from the sale of sulphur by D Corporation to F Corporation will be 
treated as foreign base company sales income.
    Example 4. Controlled foreign corporation G, incorporated under the 
laws of foreign country X, is a wholly owned subsidiary of domestic 
corporation P. Corporation G purchases from P Corporation toys 
manufactured in the United States by P Corporation and sells the toys to 
R, an unrelated person, for delivery to a duty-free port in country X. 
Instructions for the assembly and operation of the toys are printed in a 
language which is not commonly used in country X. From the facts and 
circumstances surrounding the sales to R, G Corporation knows, or should 
know, that the toys will probably not be used, consumed, or disposed of 
within country X. Therefore, unless G Corporation determines the use to 
be made of the toys by R, such property will be presumed to have been 
sold by R for use, consumption, or disposition outside of country X, and 
the entire gross income of G Corporation derived from the sales will be 
considered foreign base company sales income.

    (4) Property manufactured, produced, or constructed by the 
controlled foreign corporation--(i) In general. Foreign base company 
sales income does not include income of a controlled foreign corporation 
derived in connection with the sale of personal property manufactured, 
produced, or constructed by such corporation. A controlled foreign 
corporation will have manufactured, produced, or constructed personal 
property which the corporation sells only if such corporation satisfies 
the provisions of paragraph (a)(4)(ii), (a)(4)(iii), or (a)(4)(iv) of 
this section through the activities of its employees (as defined in 
Sec. 31.3121(d)-1(c) of this chapter) with respect to such property. A 
controlled foreign corporation will not be treated as having 
manufactured, produced, or constructed personal property which the 
corporation sells merely because the property is sold in a different 
form than the form in which it was purchased. For rules of apportionment 
in determining foreign base company sales income derived from the sale 
of personal property purchased and used as a component part of property 
which is not manufactured, produced, or constructed, see paragraph 
(a)(5) of this section.
    (ii) Substantial transformation of property. If personal property 
purchased by a foreign corporation is substantially transformed by such 
foreign corporation prior to sale, the property sold by the selling 
corporation is manufactured, produced, or constructed by such selling 
corporation. The application of this paragraph (a)(4)(ii) may be 
illustrated by the following examples:

    Example 1. Controlled foreign corporation A, incorporated under the 
laws of foreign country X, operates a paper factory in foreign country 
Y. Corporation A purchases from a related person wood pulp grown in 
country Y. Corporation A, by a series of processes, converts the wood 
pulp to paper which it sells for use in foreign country Z. The 
transformation of wood pulp to paper constitutes the manufacture or 
production of property for purposes of this subparagraph.
    Example 2. Controlled foreign corporation B, incorporated under the 
laws of foreign country X, purchases steel rods from a related person 
which produces the steel in foreign country Y. Corporation B operates a 
machining plant in country X in which it utilizes the purchased steel 
rods to make screws and bolts. The transformation of steel rods to 
screws and bolts constitutes the manufacture or production of property 
for purposes of this subparagraph.
    Example 3. Controlled foreign corporation C, incorporated under the 
laws of foreign country X, purchases tuna fish from unrelated persons 
who own fishing boats which catch such fish on the high seas. 
Corporation C receives such fish in country X in the condition in which 
taken from the fishing boats and in such country processes, cans, and 
sells the fish to related person D, incorporated under the laws of 
foreign country Y, for consumption in foreign country Z. The 
transformation of such fish into canned fish constitutes the manufacture 
or production of property for purposes of this subparagraph.


[[Page 328]]


    (iii) Manufacture of a product when purchased components constitute 
part of the property sold. If purchased property is used as a component 
part of personal property which is sold, the sale of the property will 
be treated as the sale of a manufactured product, rather than the sale 
of component parts, if the assembly or conversion of the component parts 
into the final product by the selling corporation involves activities 
that are substantial in nature and generally considered to constitute 
the manufacture, production, or construction of property. Without 
limiting this substantive test, which is dependent on the facts and 
circumstances of each case, the operations of the selling corporation in 
connection with the use of the purchased property as a component part of 
the personal property which is sold will be considered to constitute the 
manufacture of a product if in connection with such property conversion 
costs (direct labor and factory burden) of such corporation account for 
20 percent or more of the total cost of goods sold. In no event, 
however, will packaging, repackaging, labeling, or minor assembly 
operations constitute the manufacture, production, or construction of 
property for purposes of section 954(d)(1). The application of this 
paragraph (a)(4)(iii) may be illustrated by the following examples:

    Example 1. Controlled foreign corporation A, incorporated under the 
laws of foreign country X, sells industrial engines for use, 
consumption, and disposition outside country X. Corporation A, in 
connection with the assembly of such engines, performs machining and 
assembly operations. In addition, A Corporation purchases, from related 
and unrelated persons, components manufactured in foreign country Y. On 
a per unit basis, A Corporation's selling price and costs of such 
engines are as follows:

Selling price...................................  ......  ......    $400
Cost of goods sold:
  Material--
    Acquired from related persons...............    $100
    Acquired from others........................      40
                                                 --------
     Total material.............................  ......    $140
Conversion costs (direct labor and factory burden)......      70
                                                 --------
Total cost of goods sold........................  ......     210
                                                         ---------
Gross profit....................................  ......     190
Administrative and selling expenses.............  ......      50
                                                         =========
Taxable income..................................  ......     140
 


The conversion costs incurred by A Corporation are more than 20 percent 
of total costs of goods sold ($70/$210 or 33 percent). Although the 
product sold, an engine, is not sufficiently distinguishable from the 
components to constitute a substantial transformation of the purchased 
parts within the meaning of subdivision (ii) of this subparagraph, A 
Corporation will be considered under this subdivision to have 
manufactured the product it sells.
    Example 2. Controlled foreign corporation B, incorporated under the 
laws of foreign country X, operates an automobile assembly plant. In 
connection with such activity, B Corporation purchases from related 
persons assembled engines, transmissions, and certain other components, 
all of which are manufactured outside of country X; purchases additional 
components from unrelated persons; conducts stamping, machining, and 
subassembly operations; and has a substantial investment in tools, jigs, 
welding equipment, and other machinery and equipment used in the 
assembly of an automobile. On a per unit basis, B Corporation's selling 
price and costs of such automobiles are as follows:

Selling price..........................  .........  .........     $2,500
Cost of goods sold:
  Material--
    Acquired from related persons......     $1,200
    Acquired from others...............        275
                                        -----------
     Total material....................  .........     $1,475
Conversion costs (direct labor and factory burden)         25
                                        -----------
     Total cost of goods sold.....................  .........      1,800
                                                   ------------
Gross profit......................................  .........        700
Administrative and selling expenses...............  .........        300
                                                   ------------
     Taxable income...............................  .........        400
                                                   ============
 


The product sold, an automobile, is not sufficiently distinguishable 
from the components purchased (the engine, transmission, etc.) to 
constitute a substantial transformation of purchased parts within the 
meaning of subdivision (ii) of this subparagraph. Although conversion 
costs of B Corporation are less than 20 percent of total cost of goods 
sold ($325/$1800 or 18 percent), the operations conducted by B 
Corporation in connection with the property purchased and sold are 
substantial in nature and are generally considered to constitute the 
manufacture of a product. Corporation B will be considered under this 
subdivision to have manufactured the product it sells.
    Example 3. Controlled foreign corporation C, incorporated under the 
laws of foreign country X, purchases from related persons radio parts 
manufactured in foreign country Y. Corporation C designs radio kits, 
packages component parts required for assembly

[[Page 329]]

of such kits, and sells the parts in a knocked-down condition to 
unrelated persons for use outside country X. These packaging operations 
of C Corporation do not constitute the manufacture, production, or 
construction of personal property for purposes of section 954(d)(1).

    (iv) Substantial contribution to manufacturing of personal 
property--(a) In general. If an item of personal property would be 
considered manufactured, produced, or constructed (under the principles 
of paragraph (a)(4)(ii) or (a)(4)(iii) of this section) prior to sale by 
the controlled foreign corporation had all of the manufacturing, 
producing, and constructing activities undertaken with respect to that 
property prior to sale been undertaken by the controlled foreign 
corporation through the activities of its employees, then this paragraph 
(a)(4)(iv) applies. If this paragraph (a)(4)(iv) applies and if the 
facts and circumstances evince that the controlled foreign corporation 
makes a substantial contribution through the activities of its employees 
to the manufacture, production, or construction of the personal property 
sold, then the personal property sold by the controlled foreign 
corporation is manufactured, produced, or constructed by such controlled 
foreign corporation.
    (b) Activities. The determination of whether a controlled foreign 
corporation makes a substantial contribution through the activities of 
its employees to the manufacture, production, or construction of the 
personal property sold involves, but will not necessarily be limited to, 
consideration of the following activities:
    (1) Oversight and direction of the activities or process pursuant to 
which the property is manufactured, produced, or constructed (under the 
principles of paragraph (a)(4)(ii) or (a)(4)(iii) of this section).
    (2) Activities that are considered in, but that are insufficient to 
satisfy, the tests provided in paragraphs (a)(4)(ii) and (a)(4)(iii) of 
this section.
    (3) Material selection, vendor selection, or control of the raw 
materials, work-in-process or finished goods.
    (4) Management of manufacturing costs or capacities (for example, 
managing the risk of loss, cost reduction or efficiency initiatives 
associated with the manufacturing process, demand planning, production 
scheduling, or hedging raw material costs).
    (5) Control of manufacturing related logistics.
    (6) Quality control (for example, sample testing or establishment of 
quality control standards).
    (7) Developing, or directing the use or development of, product 
design and design specifications, as well as trade secrets, technology, 
or other intellectual property for the purpose of manufacturing, 
producing, or constructing the personal property.
    (c) Application of substantial contribution test. When considering 
whether a controlled foreign corporation makes a substantial 
contribution to the manufacture, production, or construction of the 
personal property, the performance of any activity in paragraph 
(a)(4)(iv)(b) of this section will be taken into account. The 
performance or lack of performance of any particular activity in 
paragraph (a)(4)(iv)(b) of this section, or of a particular number of 
activities in (a)(4)(iv)(b) of this section, is not determinative. The 
weight accorded to the performance of any quantum of any activity 
(whether or not specified in paragraph (a)(4)(iv)(b) of this section) 
will vary with the facts and circumstances of the particular business. 
See paragraph (a)(4)(iv)(d) Examples 8, 10 and 11 of this section. In 
determining whether the activities of the controlled foreign corporation 
constitute a substantial contribution, there is no minimum performance 
threshold before an activity can be considered. The fact that other 
persons make a substantial contribution to the manufacture, production, 
or construction of the personal property prior to sale does not preclude 
the controlled foreign corporation from making a substantial 
contribution to the manufacture, construction, or production of that 
property through the activities of its employees. See paragraph 
(a)(4)(iv)(d) Example 9 of this section.
    (d) Examples. The rules of this paragraph (a)(4)(iv) are illustrated 
by the following examples:

    Example 1. No substantial contribution to manufacturing. (i) Facts. 
FS, a controlled foreign corporation, purchases raw materials from a 
related person. The raw materials are

[[Page 330]]

manufactured (under the principles of paragraph (a)(4)(ii) or 
(a)(4)(iii) of this section) into Product X by CM, an unrelated 
corporation, pursuant to a contract manufacturing arrangement. CM 
physically performs the substantial transformation, assembly, or 
conversion outside of FS's country of organization. Product X is sold by 
FS for use outside of FS's country of organization. Under the terms of 
the contract, FS retains the right to control the raw materials, work-
in-process, and finished goods, and the right to oversee and direct the 
activities or process pursuant to which Product X is manufactured by CM. 
FS owns the intellectual property used in the manufacturing process. 
However, FS does not exercise, through its employees, its powers to 
control the raw materials, work-in-process, or finished goods, and FS 
does not exercise its powers of oversight and direction. Likewise, FS 
does not, through its employees, develop or direct the use or 
development of the intellectual property for the purpose of 
manufacturing Product X.
    (ii) Result. If the manufacturing activities undertaken with respect 
to Product X prior to sale had been undertaken by FS through the 
activities of its employees, FS would have satisfied the manufacturing 
exception contained in paragraph (a)(4)(ii) or (a)(4)(iii) of this 
section with respect to Product X. Therefore, this paragraph (a)(4)(iv) 
applies. FS does not satisfy the test under this paragraph (a)(4)(iv) 
because it does not make a substantial contribution through the 
activities of its employees to the manufacture of Product X. Mere 
contractual rights to control materials, contractual rights to oversee 
and direct the manufacturing activities or process pursuant to which the 
property is manufactured, and ownership of intellectual property are not 
sufficient to satisfy this paragraph (a)(4)(iv). Therefore, under the 
facts and circumstances of the business, FS is not considered to have 
manufactured Product X under paragraph (a)(4)(i) of this section.
    Example 2. Substantial contribution to manufacturing. (i) Facts. 
Assume the same facts as in Example 1, except for the following. FS, 
through its employees, engages in product design and quality control and 
controls manufacturing related logistics. Employees of FS exercise the 
right to oversee and direct the activities of CM in the manufacture of 
Product X.
    (ii) Result. If the manufacturing activities undertaken with respect 
to Product X prior to sale had been undertaken by FS through the 
activities of its employees, FS would have satisfied the manufacturing 
exception contained in paragraph (a)(4)(ii) or (a)(4)(iii) of this 
section with respect to Product X. Therefore, this paragraph (a)(4)(iv) 
applies. Under the facts and circumstances of the business, FS satisfies 
the test under this paragraph (a)(4)(iv) because it makes a substantial 
contribution through the activities of its employees to the manufacture 
of Product X. Therefore, FS is considered to have manufactured Product X 
under paragraph (a)(4)(i) of this section. The analysis and conclusion 
would be the same if CM were related to FS because the relationship 
between CM and FS is irrelevant for purposes of applying paragraph 
(a)(4) of this section.
    Example 3. Raw materials procured by contract manufacturer. (i) 
Facts. FS, a controlled foreign corporation, enters into a contract with 
CM to manufacture (under the principles of paragraph (a)(4)(ii) or 
(a)(4)(iii) of this section) Product X. CM physically performs the 
substantial transformation, assembly, or conversion required to 
manufacture Product X outside of FS's country of organization. Product X 
is sold by FS to a related person for use outside of FS's country of 
organization. Employees of FS select the materials that will be used to 
manufacture Product X. FS does not own the materials or work-in-process 
during the manufacturing process. FS, through its employees, exercises 
oversight and direction of the manufacturing process and provides 
quality control. FS manages the manufacturing costs and capacities with 
respect to Product X by managing the risk of loss and engaging in demand 
planning and production scheduling.
    (ii) Result. If the manufacturing activities undertaken with respect 
to Product X prior to sale had been undertaken by FS through the 
activities of its employees, FS would have satisfied the manufacturing 
exception contained in paragraph (a)(4)(ii) or (a)(4)(iii) of this 
section with respect to Product X. Therefore, this paragraph (a)(4)(iv) 
applies. Under the facts and circumstances of the business, FS satisfies 
the test under this paragraph (a)(4)(iv) because it makes a substantial 
contribution through the activities of its employees to the manufacture 
of Product X. Therefore, FS is considered to have manufactured Product X 
under paragraph (a)(4)(i) of this section.
    Example 4. Physical conversion by employees of a person other than 
the contract manufacturer. (i) Facts. FS, a controlled foreign 
corporation organized in Country M, purchases raw materials from a 
related person. The raw materials are manufactured (under the principles 
of paragraph (a)(4)(ii) or (a)(4)(iii) of this section) into Product X 
by CM, an unrelated corporation, pursuant to a contract manufacturing 
arrangement. CM physically performs the substantial transformation, 
assembly, or conversion required to manufacture Product X outside of 
FS's country of organization. Product X is sold by FS for use outside of 
FS's country of organization. CM contracts with another corporation for 
its employees in order to operate CM's manufacturing plant and 
transform, assemble, or convert the raw materials into Product X.

[[Page 331]]

Apart from the physical performance of the substantial transformation, 
assembly, or conversion of the raw materials into Product X, employees 
of FS perform all of the other manufacturing activities required in 
connection with the manufacture of Product X (for example, oversight and 
direction of the manufacturing process; vendor selection; control of raw 
materials, work-in-process, and finished goods; control of manufacturing 
related logistics; and quality control).
    (ii) Result. If the manufacturing activities undertaken with respect 
to Product X prior to sale had been undertaken by FS through the 
activities of its employees, FS would have satisfied the manufacturing 
exception contained in paragraph (a)(4)(ii) or (a)(4)(iii) of this 
section with respect to Product X. Therefore, this paragraph (a)(4)(iv) 
applies. Under the facts and circumstances of the business, FS satisfies 
the test under this paragraph (a)(4)(iv) because it makes a substantial 
contribution through the activities of its employees to the manufacture 
of Product X. Therefore, FS is considered to have manufactured Product X 
under paragraph (a)(4)(i) of this section.
    Example 5. Automated manufacturing supervised by another person. (i) 
Facts. FS, a controlled foreign corporation, purchases raw materials 
from a related person. The raw materials are manufactured (under the 
principles of paragraph (a)(4)(ii) or (a)(4)(iii) of this section) into 
Product X by CM, an unrelated corporation selected by FS, pursuant to a 
contract manufacturing arrangement. CM physically performs the 
substantial transformation, assembly, or conversion outside of FS's 
country of organization. Product X is sold by FS to related and 
unrelated persons for use outside of FS's country of organization. At 
all times, FS retains ownership of the raw materials, work-in-process, 
and finished goods. FS retains the right to oversee and direct the 
activities or process pursuant to which Product X is manufactured by CM, 
but does not exercise, through its employees, its powers of oversight 
and direction. FS is the owner of sophisticated software and network 
systems that remotely and automatically (without human involvement) take 
orders, route them to CM, order raw materials, and perform quality 
control. FS has a small number of computer technicians who monitor the 
software and network systems to ensure that they are running smoothly 
and apply any necessary patches or fixes. The software and network 
systems were developed by employees of DP, the U.S. corporate parent of 
FS. DP's employees supervise the computer technicians, evaluate the 
results of the automated manufacturing business, and make ongoing 
operational decisions, including decisions related to acceptable 
performance of the manufacturing process, stoppages of that process, and 
decisions related to product and manufacturing process design. DP's 
employees develop and provide to FS all of the upgrades to the software 
and network systems. DP also has employees who direct and control other 
aspects of the manufacturing process such as vendor and material 
selection, management of the manufacturing costs and capacities, and the 
selection of CM. The need for DP's employees to direct the activities of 
the FS employees and otherwise contribute to the manufacturing process 
evinces that substantial operational responsibilities and decision 
making are required to be exercised by parties other than CM in order to 
manufacture Product X.
    (ii) Result. If the manufacturing activities undertaken with respect 
to Product X prior to sale had been undertaken by FS through the 
activities of its employees, FS would have satisfied the manufacturing 
exception contained in paragraph (a)(4)(ii) or (a)(4)(iii) of this 
section with respect to Product X. Therefore, this paragraph (a)(4)(iv) 
applies. Under the facts and circumstance of the business, FS does not 
satisfy the test under this paragraph (a)(4)(iv) because it does not 
make a substantial contribution through the activities of its employees 
to the manufacture of Product X. Mere ownership of materials and 
intellectual property along with contractual rights to exercise powers 
of direction and control are not sufficient to satisfy this paragraph 
(a)(4)(iv). The employees of FS do not perform the amount of activity 
necessary to constitute a substantial contribution. FS is not considered 
to have manufactured Product X under paragraph (a)(4)(i) of this 
section.
    Example 6. Automated manufacturing supervised by FS. (i) Facts. 
Assume the same facts as in Example 5, except for the following. FS, 
through its employees, engages in the activities undertaken by DP's 
employees in Example 5. DP's employees also contribute to product and 
manufacturing process design, and provide support and oversight to FS in 
connection with functions performed by FS through its employees.
    (ii) Result. If the manufacturing activities undertaken with respect 
to Product X prior to sale had been undertaken by FS through the 
activities of its employees, FS would have satisfied the manufacturing 
exception contained in paragraph (a)(4)(ii) or (a)(4)(iii) of this 
section with respect to Product X. Therefore, this paragraph (a)(4)(iv) 
applies. Under the facts and circumstances of the business, FS satisfies 
the test under this paragraph (a)(4)(iv) because it makes a substantial 
contribution through the activities of its employees to the manufacture 
of Product X. This determination does not require a comparison between 
the activities of FS and the activities of DP. Selection of the contract 
manufacturer, even though not specifically identified in paragraph 
(a)(4)(iv)(b) of this section, is considered under paragraph 
(a)(4)(iv)(c) of this section in determining

[[Page 332]]

whether FS makes a substantial contribution to the manufacture of 
Product X through its employees. FS is considered to have manufactured 
Product X under paragraph (a)(4)(i) of this section.
    Example 7. Automated manufacturing supervised by FS with purchased 
intellectual property. (i) Facts. Assume the same facts as in Example 6, 
except for the following. The software and network systems, and the 
upgrades to those systems, were purchased by FS rather than developed by 
employees of FS.
    (ii) Result. If the manufacturing activities undertaken with respect 
to Product X prior to sale had been undertaken by FS through the 
activities of its employees, FS would have satisfied the manufacturing 
exception contained in paragraph (a)(4)(ii) or (a)(4)(iii) of this 
section with respect to Product X. Therefore, this paragraph (a)(4)(iv) 
applies. The lack of performance of software and network system 
development activities is not determinative under the facts and 
circumstances of the business. Therefore, FS satisfies the test under 
this paragraph (a)(4)(iv) because it makes a substantial contribution 
through the activities of its employees to the manufacture of Product X. 
This determination does not require a comparison between the activities 
of FS and the activities of DP. FS is considered to have manufactured 
Product X under paragraph (a)(4)(i) of this section.
    Example 8. Manufacture without intellectual property. (i) Facts. FS, 
a controlled foreign corporation, purchases raw materials from a related 
person. The raw materials are manufactured (under the principles of 
paragraph (a)(4)(ii) or (a)(4)(iii) of this section) into Product X by 
CM, an unrelated corporation, pursuant to a contract manufacturing 
arrangement. CM physically performs the substantial transformation, 
assembly, or conversion outside of FS's country of organization. Product 
X is sold by FS for use outside of FS's country of organization. At all 
times, FS controls the raw materials, work-in-process, and finished 
goods. FS controls the manufacturing related logistics, manages the 
manufacturing costs and capacities, and provides quality control with 
respect to CM's manufacturing process and product. No intellectual 
property of significant value is required to manufacture Product X. FS 
does not own any intellectual property underlying Product X, or hold an 
exclusive or non-exclusive right to manufacture Product X.
    (ii) Result. If the manufacturing activities undertaken with respect 
to Product X prior to sale had been undertaken by FS through the 
activities of its employees, FS would have satisfied the manufacturing 
exception contained in paragraph (a)(4)(ii) or (a)(4)(iii) of this 
section with respect to Product X. Therefore, this paragraph (a)(4)(iv) 
applies. Because use of intellectual property plays little or no role in 
the manufacture of Product X, it is not important to the substantial 
contribution analysis under paragraph (a)(4)(iv) of this section. Under 
the facts and circumstances of the business, FS satisfies the test under 
this paragraph (a)(4)(iv) because it makes a substantial contribution 
through the activities of its employees to the manufacture of Product X. 
Therefore, FS is considered to have manufactured Product X under 
paragraph (a)(4)(i) of this section.
    Example 9. Substantial contribution by more than one CFC. (i) Facts. 
FS1 and FS2, unrelated controlled foreign corporations, contract with 
CM, an unrelated corporation, to manufacture (under the principles of 
paragraph (a)(4)(ii) or (a)(4)(iii) of this section) Product X. CM 
physically performs the substantial transformation, assembly, or 
conversion required to manufacture Product X outside of FS1's and FS2's 
respective countries of organization. Neither FS1 nor FS2 owns the 
materials or work-in-process during the manufacturing process. Product X 
is sold by FS1 and FS2 to persons related to FS1 and FS2, respectively, 
for disposition outside of FS1's and FS2's respective countries of 
organization. FS1, through its employees, designs Product X. FS1 directs 
the use of the product design and design specifications, and other 
intellectual property, for the purpose of manufacturing Product X. 
Employees of FS1 also select the materials that will be used to 
manufacture Product X, and the vendors that provide those materials. 
FS2, through its employees, designs the process for manufacturing 
Product X. FS2, through its employees, manages the manufacturing costs 
and capacities with respect to Product X. FS1 and FS2 each provide 
quality control and oversight and direction of CM's manufacturing 
activities with respect to different aspects of the manufacture of 
Product X.
    (ii) Result. If the manufacturing activities undertaken with respect 
to Product X prior to sale had been undertaken by FS1 or FS2 through the 
activities of their employees, FS1 or FS2 would have satisfied the 
manufacturing exception contained in paragraph (a)(4)(ii) or (a)(4)(iii) 
of this section with respect to Product X. Therefore, this paragraph 
(a)(4)(iv) applies. The fact that other persons make a substantial 
contribution to the manufacture of personal property does not preclude a 
controlled foreign corporation from making a substantial contribution to 
the manufacture of personal property through the activities of its 
employees. In the analysis of whether FS1 or FS2 make a substantial 
contribution to the manufacture of Product X, each company takes into 
account its individual activities, including those of providing quality 
control and oversight and direction of the manufacture of Product X. In 
addition, no threshold level of activity is required, including with 
respect to providing quality control or oversight and

[[Page 333]]

direction of the activities or process pursuant to which Product X is 
manufactured, before FS1 and FS2 can take into account their respective 
activities. Under the facts and circumstances of the business, both FS1 
and FS2 satisfy the test under this paragraph (a)(4)(iv) because each 
independently makes a substantial contribution through the activities of 
its employees to the manufacture of Product X. Therefore, FS1 and FS2 
are each considered to have manufactured Product X under paragraph 
(a)(4)(i) of this section.
    Example 10. Manufacture of products designed by CFC. (i) Facts. FS, 
a controlled foreign corporation, purchases raw materials from a related 
person. The raw materials are manufactured (under the principles of 
paragraph (a)(4)(ii) or (a)(4)(iii) of this section) into Product X by 
CM, an unrelated corporation, pursuant to a contract manufacturing 
arrangement. CM physically performs the substantial transformation, 
assembly, or conversion outside of FS's country of organization. Product 
X is sold by FS for use outside of FS's country of organization. 
Products in the X industry are distinguished (and vary widely in value) 
based on the raw materials used to make the product and the product 
design. FS designs the product and selects the materials that CM will 
use to manufacture Product X. FS also manages the manufacturing costs 
and capacities. Product X can be manufactured from the raw materials to 
FS's design specifications without significant oversight and direction, 
quality control, or control of manufacturing related logistics. The 
activities most relevant to the substantial contribution analysis under 
these facts are material selection, product design and management of the 
manufacturing costs and capacities.
    (ii) Result. If the manufacturing activities undertaken with respect 
to Product X prior to sale had been undertaken by FS through the 
activities of its employees, FS would have satisfied the manufacturing 
exception contained in paragraph (a)(4)(ii) or (a)(4)(iii) of this 
section with respect to Product X. Therefore, this paragraph (a)(4)(iv) 
applies. Under the facts and circumstances of the business, FS makes a 
substantial contribution through the activities of its employees to the 
manufacture of Product X. FS satisfies the test under this paragraph 
(a)(4)(iv) because it makes a substantial contribution through the 
activities of its employees to the manufacture of Product X. Therefore, 
FS is considered to have manufactured Product X under paragraph 
(a)(4)(i) of this section.
    Example 11. Direction and oversight of manufacturing and quality 
control through periodic visits. (i) Facts. FS, a controlled foreign 
corporation, purchases raw materials from a related person. The raw 
materials are manufactured (under the principles of paragraph (a)(4)(ii) 
or (a)(4)(iii) of this section) into Product X by CM, an unrelated 
corporation, pursuant to a contract manufacturing arrangement. CM 
physically performs the substantial transformation, assembly, or 
conversion outside of FS's country of organization. Product X is sold by 
FS for use outside of FS's country of organization. FS controls the raw 
material, work-in-process, and finished goods, manages the manufacturing 
costs and capacities, and provides oversight and direction of the 
manufacture of Product X. Employees of FS visit CM's manufacturing 
facility for one week each quarter and perform quality control tests on 
a random sample of the units of Product X produced during the week. In 
the X industry, quarterly visits to a manufacturing facility by 
qualified persons are sufficient to control the quality of 
manufacturing.
    (ii) Result. If the manufacturing activities undertaken with respect 
to Product X prior to sale had been undertaken by FS through the 
activities of its employees, FS would have satisfied the manufacturing 
exception contained in paragraph (a)(4)(ii) or (a)(4)(iii) of this 
section with respect to Product X. Therefore, this paragraph (a)(4)(iv) 
applies. Under the facts and circumstances of the business, FS satisfies 
the test under this paragraph (a)(4)(iv) with respect to Product X 
because it makes a substantial contribution through the activities of 
its employees to the manufacture of Product X. Therefore, FS is 
considered to have manufactured Product X under paragraph (a)(4)(i) of 
this section.

    (5) Rules for apportionment of income derived from the sale of 
purchased components used in property not manufactured, produced, or 
constructed. The foreign base company sales income derived by a 
controlled foreign corporation for the taxable year from sales of 
personal property purchased and used as a component part of property 
which is not manufactured, produced, or constructed by such corporation 
within the meaning of subparagraph (4) of this paragraph shall, unless 
the records of the controlled foreign corporation show that a different 
apportionment of income is proper or unless all the income from such 
sales is treated as foreign base company sales income, be determined by 
first making for such year the following separate classifications and 
subclassifications with respect to the property which is sold and then 
by apportioning the income for such year from such sales in accordance 
with the rules of this subparagraph:
    (i) A classification of the cost of components used in the property 
which is

[[Page 334]]

sold into two classes consisting of the cost of components manufactured, 
produced, constructed, grown, or extracted--
    (a) Within the country under the laws of which the controlled 
foreign corporation is created or organized, and
    (b) Outside such country;
    (ii) A subclassification of the class described in subdivision (i) 
(b) of this subparagraph into--
    (a) The cost of such components purchased from unrelated persons, 
and
    (b) The cost of such components purchased from related persons;
    (iii) A classification of the income derived from such sales into 
two classes consisting of income derived from sales for use, 
consumption, or disposition--
    (a) Within the country under the laws of which the controlled 
foreign corporation is created or organized, and
    (b) Outside such country; and
    (iv) A subclassification of the class described in subdivision (iii) 
(b) of this subparagraph into income from--
    (a) Sales to unrelated persons, and
    (b) Sales to related persons.


The foreign base company sales income for the taxable year from 
purchases of the property from related persons and sales to unrelated 
persons shall be the amount which bears to the amount described in 
subdivision (iv) (a) of this subparagraph the same ratio that the amount 
described in subdivision (ii) (b) of this subparagraph bears to the 
total cost of components used in the product which is sold. The foreign 
base company sales income for the taxable year from purchases of the 
property from related persons and sales to related persons is the amount 
which bears to the amount described in subdivision (iv) (b) of this 
subparagraph the same ratio that the amount described in subdivision 
(ii) (b) of this subparagraph bears to the total cost of components used 
in the product which is sold.


The foreign base company sales income for the taxable year from 
purchases of the property from unrelated persons and sales to related 
persons is the amount which bears to the amount described in subdivision 
(iv) (b) of this subparagraph the same ratio that the amount described 
in subdivision (ii) (a) of this subparagraph bears to the total cost of 
components used in the product which is sold. The application of this 
subparagraph may be illustrated by the following examples:

    Example 1. Controlled foreign corporation C, which is incorporated 
under the laws of foreign country X, uses the calendar year as the 
taxable year. For 1964, C Corporation purchases radio parts of which 
some are manufactured in foreign country Y; and others, in country X. 
Some of the parts manufactured in country Y are purchased from related 
persons. Corporation C uses the purchased parts in radio kits which it 
designs and sells for assembly by its customers, unrelated persons, some 
of whom use the kits outside country X. Unless the records of C 
Corporation show that a different apportionment of income is proper, the 
foreign base company sales income for 1964 is determined in the 
following manner upon the basis of the following factual classifications 
for such year:

Cost of components purchased from all persons:
  Manufactured within country X..................................    $20
  Manufactured outside country X.................................     40
                                                           --------
   Total cost....................................................     60
                                                           ========
Cost of components manufactured outside country X:
  Purchased from unrelated persons...............................     10
  Purchased from related persons.................................     30
                                                           --------
   Total cost....................................................     40
                                                           ========
Gross income from sales:
  Gross receipts from sales......................................    120
  Cost of goods sold:
    Components............................................    $60
    Direct labor and factory burden.......................     10     70
                                                           -------------
     Gross income................................................     50
                                                           ========
Gross income from sales:
  For use within country X.......................................     26
  For use outside country X......................................     24
                                                           --------
   Gross income..................................................     50
                                                           ========
Foreign base company sales income from purchases from related         12
 persons and sales to unrelated persons ($24 x $30/$60)..........
                                                           ========
 

    Example 2. The facts are the same as in example 1 except that none 
of the purchases are from related persons and some of the sales for use 
outside country X are to related persons. Unless the records of C 
Corporation show that a different apportionment of income is proper, the 
foreign base company sales income for 1964 is determined in the 
following manner upon the basis of the following additional factual 
classification for such year:

[[Page 335]]



Gross income from sales for use outside country X--
  To unrelated persons........................................        $8
  To related persons..........................................        16
                                                               ---------
   Total gross income.........................................        24
                                                               =========
Foreign base company sales income from purchases from              10.67
 unrelated persons and sales to related persons ($16 x $40/
 $60).........................................................
                                                               =========
 

    Example 3. The facts are the same as in example 1 except that some 
of the sales for use outside country X are to related persons as in 
example 2. Unless the records of C Corporation show that a different 
apportionment of income is proper, the foreign base company sales income 
for 1964 is determined in the following manner:

Foreign base company sales income from purchases from related      $4.00
 persons and sales to unrelated persons ($8 x $30/$60)........
Foreign base company sales income from purchases from related       8.00
 persons and sales to related persons ($16 x $30/$60).........
Foreign base company sales income from purchases from               2.67
 unrelated persons and sales to related persons ($16 x $10/
 $60).........................................................
                                                               ---------
  Total foreign base company sales income.....................     14.67
                                                               =========
 


    (6) Special rule applicable to distributive share of partnership 
income--(i) In general. To determine the extent to which a controlled 
foreign corporation's distributive share of any item of gross income of 
a partnership would have been foreign base company sales income if 
received by it directly, under Sec. 1.952-1(g), the property sold will 
be considered to be manufactured, produced, or constructed by the 
controlled foreign corporation, within the meaning of paragraph 
(a)(4)(i) of this section, only if the manufacturing exception of 
paragraph (a)(4)(i) of this section would have applied to exclude the 
income from foreign base company sales income if the controlled foreign 
corporation had earned the income directly, determined by taking into 
account only the activities of the employees of, and property owned by, 
the partnership.
    (ii) Example. The application of paragraph (a)(6)(i) of this section 
is illustrated by the following example:

    Example. CFC, a controlled foreign corporation organized under the 
laws of Country A, is an 80 percent partner in Partnership X, a 
partnership organized under the laws of Country B. Partnership X 
performs activities in Country B that would constitute the manufacture 
of Product O, within the meaning of paragraph (a)(4) of this section, if 
performed directly by CFC. Partnership X, through its sales offices in 
Country B, then sells Product O to Corp D, a corporation that is a 
related person with respect to CFC, within the meaning of section 
954(d)(3), for use within Country B. CFC's distributive share of 
Partnership X's sales income is not foreign base company sales income 
because the manufacturing exception of paragraph (a)(4) of this section 
would have applied to exclude the income from foreign base company sales 
income if CFC had earned the income directly.

    (iii) Effective date. This paragraph (a)(6) applies to taxable years 
of a controlled foreign corporation beginning on or after July 23, 2002.
    (b) Branches of controlled foreign corporation treated as separate 
corporations--(1) General rules for determining when to apply separate 
treatment--(i) Sales or purchase branch--(a) In general. If a controlled 
foreign corporation carries on purchasing or selling activities by or 
through a branch or similar establishment located outside the country 
under the laws of which such corporation is created or organized and the 
use of the branch or similar establishment for such activities has 
substantially the same tax effect as if the branch or similar 
establishment were a wholly owned subsidiary corporation of such 
controlled foreign corporation, the branch or similar establishment and 
the remainder of the controlled foreign corporation will be treated as 
separate corporations for purposes of determining foreign base company 
sales income of such corporation. See section 954(d)(2).
    (b) Allocation of income and comparison of effective rates of tax. 
The determination as to whether such use of the branch or similar 
establishment has the same tax effect as if it were a wholly owned 
subsidiary corporation of the controlled foreign corporation shall be 
made by allocating to such branch or similar establishment only that 
income derived by the branch or establishment which, when the special 
rules of subparagraph (2)(i) of this paragraph are applied, is described 
in paragraph (a) of this section (but determined without applying 
subparagraphs (2), (3), and (4) of such paragraph). The use of the 
branch or similar establishment for such activities will be considered 
to have substantially the same tax effect

[[Page 336]]

as if it were a wholly owned subsidiary corporation of the controlled 
foreign corporation if the income allocated to the branch or similar 
establishment under the immediately preceding sentence is, by statute, 
treaty obligation, or otherwise, taxed in the year when earned at an 
effective rate of tax that is less than 90 percent of, and at least 5 
percentage points less than, the effective rate of tax which would apply 
to such income under the laws of the country in which the controlled 
foreign corporation is created or organized, if, under the laws of such 
country, the entire income of the controlled foreign corporation were 
considered derived by the corporation from sources within such country 
from doing business through a permanent establishment therein, received 
in such country, and allocable to such permanent establishment, and the 
corporation were managed and controlled in such country.
    (c) Use of more than one branch. If a controlled foreign corporation 
carries on purchasing or selling activities by or through more than one 
branch or similar establishment located outside the country under the 
laws of which such corporation is created or organized, then paragraph 
(b)(1)(i)(b) of this section shall be applied separately to the income 
derived by each such branch or similar establishment (by treating such 
purchasing or selling branch or similar establishment as if it were the 
only branch or similar establishment of the controlled foreign 
corporation and as if any such other branches or similar establishments 
were separate corporations) in determining whether the use of such 
branch or similar establishment has substantially the same tax effect as 
if such branch or similar establishment were a wholly owned subsidiary 
corporation of the controlled foreign corporation. See paragraph 
(b)(1)(ii)(c)(1) of this section for rules applicable to a controlled 
foreign corporation that carries on purchase or sales activities by or 
through one or more branches or similar establishments in addition to 
carrying on manufacturing activities by or through one or more branches 
or similar establishments.
    (ii) Manufacturing branch--(a) In general. If a controlled foreign 
corporation carries on manufacturing, producing, constructing, growing, 
or extracting activities by or through a branch or similar establishment 
located outside the country under the laws of which such corporation is 
created or organized and the use of the branch or similar establishment 
for such activities with respect to personal property purchased or sold 
by or through the remainder of the controlled foreign corporation has 
substantially the same tax effect as if the branch or similar 
establishment were a wholly owned subsidiary corporation of such 
controlled foreign corporation, the branch or similar establishment and 
the remainder of the controlled foreign corporation will be treated as 
separate corporations for purposes of determining the foreign base 
company sales income of such corporation. See section 954(d)(2). The 
provisions of this paragraph (b)(1)(ii) will apply only if the 
controlled foreign corporation (including any branches or similar 
establishments of such controlled foreign corporation) manufactures, 
produces, or constructs such personal property within the meaning of 
paragraph (a)(4)(i) of this section, or carries on growing or extracting 
activities with respect to such personal property.
    (b) Allocation of income and comparison of effective rates of tax. 
The determination as to whether such use of the branch or similar 
establishment has substantially the same tax effect as if the branch or 
similar establishment were a wholly owned subsidiary corporation of the 
controlled foreign corporation shall be made by allocating to the 
remainder of such controlled foreign corporation only that income 
derived by the remainder of such corporation, which, when the special 
rules of subparagraph (2)(i) of this paragraph are applied, is described 
in paragraph (a) of this section (but determined without applying 
subparagraphs (2), (3), and (4) of such paragraph). The use of the 
branch or similar establishment for such activities will be considered 
to have substantially the same tax effect as if it were a wholly owned 
subsidiary corporation of the controlled foreign corporation if income 
allocated to the remainder of the controlled foreign corporation under 
the immediately

[[Page 337]]

preceding sentence is, by statute, treaty obligation, or otherwise, 
taxed in the year when earned at an effective rate of tax that is less 
than 90 percent of, and at least 5 percentage points less than, the 
effective rate of tax which would apply to such income under the laws of 
the country in which the branch or similar establishment is located, if, 
under the laws of such country, the entire income of the controlled 
foreign corporation were considered derived by such corporation from 
sources within such country from doing business through a permanent 
establishment therein, received in such country, and allocable to such 
permanent establishment, and the corporation were created or organized 
under the laws of, and managed and controlled in, such country.
    (c) Use of more than one branch--(1) Use of one or more sales or 
purchase branches in addition to a manufacturing branch. If, with 
respect to personal property manufactured, produced, constructed, grown, 
or extracted by or through a branch or similar establishment located 
outside the country under the laws of which the controlled foreign 
corporation is created or organized, purchasing or selling activities 
are carried on by or through more than one branch or similar 
establishment, or by or through one or more branches or similar 
establishments located outside such country, of such corporation, then 
paragraph (b)(1)(ii)(b) of this section shall be applied separately to 
the income derived by each such purchasing or selling branch or similar 
establishment (by treating such purchasing or selling branch or similar 
establishment as though it alone were the remainder of the controlled 
foreign corporation) for purposes of determining whether the use of such 
manufacturing, producing, constructing, growing, or extracting branch or 
similar establishment has substantially the same tax effect as if such 
branch or similar establishment were a wholly owned subsidiary 
corporation of the controlled foreign corporation. If this rule applies, 
the sales or purchase branch rules contained in paragraph (b)(1)(i) of 
this section do not apply. The application of this paragraph 
(b)(1)(ii)(c)(1) is illustrated by the following example:

    Example. All activities of controlled foreign corporation conducted 
through sales branches and manufacturing branch. (i) Facts. FS, a 
controlled foreign corporation organized under the laws of country M, 
operates three branches. Branch A, located in country A, manufactures 
Product X under the principles of paragraph (a)(4)(i) of this section. 
Branch B, located in Country B, sells Product X manufactured by Branch A 
to customers for use outside of Country B. Branch C, located in Country 
C sells Product X manufactured by Branch A to customers for use outside 
of Country C. FS does not conduct any manufacturing or selling 
activities apart from the activities of Branches A, B and C. Country M 
imposes an effective rate of tax on sales income of 0%. Country A 
imposes an effective rate of tax on sales income of 20%. Country B 
imposes an effective rate of tax on sales income of 20%. Country C 
imposes an effective rate of tax on sales income of 18%.
    (ii) Result. Pursuant to this paragraph (b)(1)(ii)(c)(1), paragraph 
(b)(1)(ii)(b) of this section is applied to the sales income derived by 
Branch B by treating Branch B as though it alone were the remainder of 
the controlled foreign corporation. The use of Branch B does not have 
the same tax effect as if Branch B were a wholly owned subsidiary of FS 
because the tax rate applicable to the income allocated to Branch B 
under paragraph (b)(1)(ii)(b) of this section (20%) is not less than 90% 
of, and at least 5 percentage points less than, the effective rate of 
tax which would apply to such income under the laws of Country A (20%), 
the country in which Branch A is located. In addition, paragraph 
(b)(1)(ii)(b) of this section is applied separately to the sales income 
derived by Branch C by treating Branch C as though it alone were the 
remainder of the controlled foreign corporation. The use of Branch C 
does not have the same tax effect as if Branch C were a wholly owned 
subsidiary of FS because the tax rate applicable to the income allocated 
to Branch C under paragraph (b)(1)(ii)(b) of this section (18%) is not 
less than 90% of, and at least 5 percentage points less than, the 
effective rate of tax which would apply to such income under the laws of 
Country A (20%), the country in which Branch A is located. Pursuant to 
this paragraph (b)(1)(ii)(c)(1), the rules under paragraph (b)(1)(i) of 
this section for determining whether a sales or purchase branch is 
treated as a separate corporation from the remainder of the controlled 
foreign corporation do not apply.

    (2) Use of more than one branch to manufacture, produce, construct, 
grow, or extract separate items of personal property. If a controlled 
foreign corporation carries on manufacturing, producing, constructing, 
growing, or extracting activities with respect to separate

[[Page 338]]

items of personal property by or through more than one branch or similar 
establishment located outside the country under the laws of which such 
corporation is created or organized, then paragraphs (b)(1)(ii)(b) and 
(c) of this section will be applied separately to each such branch or 
similar establishment (by treating such manufacturing branch or similar 
establishment as if it were the only such branch or similar 
establishment of the controlled foreign corporation and as if any other 
such branches or similar establishments were separate corporations) for 
purposes of determining whether the use of such branch or similar 
establishment has substantially the same tax effect as if such branch or 
similar establishment were a wholly owned subsidiary corporation of the 
controlled foreign corporation. The application of this paragraph 
(b)(1)(ii)(c)(2) is illustrated by the following example:

    Example. Multiple branches that satisfy paragraph (a)(4)(i). (i) 
Facts. FS is a controlled foreign corporation organized in Country M. FS 
operates two branches, Branch A and Branch B located in Country A and 
Country B, respectively. Branch A and Branch B each manufacture separate 
items of personal property (Product X and Product Y, respectively) 
within the meaning of paragraph (a)(4)(ii) or (iii) of this section. Raw 
materials used in the manufacture of Product X and Product Y are 
purchased by FS from an unrelated person. FS engages in activities in 
Country M to sell Product X and Product Y to a related person for use, 
disposition or consumption outside of Country M. Employees of FS located 
in Country M perform only sales functions. The effective rate of tax 
imposed in Country M on the income from the sales of Product X and 
Product Y is 10%. Country A imposes an effective rate of tax on sales 
income of 20%. Country B imposes an effective rate of tax on sales 
income of 12%.
    (ii) Result. Pursuant to this paragraph (b)(1)(ii)(c)(2), paragraph 
(b)(1)(ii)(b) of this section is applied separately to Branch A and 
Branch B with respect to the sales income of FS attributable to Product 
X (manufactured by Branch A) and Product Y (manufactured by Branch B). 
Because the effective rate of tax on FS's sales income from the sale of 
Product X in Country M (10%) is less than 90% of, and at least 5 
percentage points less than, the effective rate of tax that would apply 
to such income in the country in which Branch A is located (20%), the 
use of Branch A to manufacture Product X has substantially the same tax 
effect as if Branch A were a wholly owned subsidiary corporation of FS. 
Because the effective rate of tax on FS's sales income from the sale of 
Product Y in Country M (10%) is not less than 90% of, and at least 5 
percentage points less than, the effective rate of tax that would apply 
to such income in the country in which Branch B is located (12%), the 
use of Branch B to manufacture Product Y does not have substantially the 
same tax effect as if Branch B were a wholly owned subsidiary 
corporation of FS. Consequently, only Branch A is treated as a separate 
corporation apart from the remainder of FS for purposes of determining 
foreign base company sales income from the sales of Product X.

    (3) Use of more than one manufacturing branch, or one or more 
manufacturing branches and the remainder of the controlled foreign 
corporation, to manufacture, produce, or construct the same item of 
personal property--(i) In general. This paragraph (b)(1)(ii)(c)(3) 
applies to determine the location of manufacture, production, or 
construction of personal property for purposes of applying paragraph 
(b)(1)(i)(b) or (b)(1)(ii)(b) of this section where more than one branch 
or similar establishment of a controlled foreign corporation, or one or 
more branches or similar establishments of a controlled foreign 
corporation and the remainder of the controlled foreign corporation, 
each engage in manufacturing, producing, or constructing activities with 
respect to the same item of personal property which is then sold by the 
controlled foreign corporation. This paragraph (b)(1)(ii)(c)(3) is 
applied separately with respect to the income derived by each purchasing 
or selling branch or similar establishment or purchasing or selling 
remainder of the controlled foreign corporation as provided under 
paragraphs (b)(1)(i) and (b)(1)(ii) of this section. The location of 
manufacture, production, or construction is determined under paragraph 
(b)(1)(ii)(c)(3)(ii) of this section if one or more branches or similar 
establishments or the remainder of the controlled foreign corporation 
independently satisfies paragraph (a)(4)(i) of this section with respect 
to an item of personal property. The location of manufacture, 
production, or construction is determined under paragraph 
(b)(1)(ii)(c)(3)(iii) of this section if none

[[Page 339]]

of the branches or similar establishments or the remainder of the 
controlled foreign corporation independently satisfies paragraph 
(a)(4)(i) of this section with respect to an item of personal property, 
but the controlled foreign corporation as a whole makes a substantial 
contribution to the manufacture, production or construction of that 
property within the meaning of paragraph (a)(4)(iv) of this section. For 
purposes of this paragraph (b)(1)(ii)(c)(3), the location of any 
activity with respect to the manufacture, production, or construction of 
an item of personal property is determined under paragraph 
(b)(1)(ii)(c)(3)(iv) of this section. For purposes of this paragraph 
(b)(1)(ii)(c)(3), if multiple branches or similar establishments are 
located in a single jurisdiction, then the activities of those branches 
will be aggregated for purposes of determining whether a branch or 
remainder of the controlled foreign corporation satisfies paragraph 
(a)(4)(i) of this section.
    (ii) Manufacture, production, or construction in one or more 
locations. If only one branch or similar establishment or only the 
remainder of a controlled foreign corporation independently satisfies 
paragraph (a)(4)(i) of this section with respect to an item of personal 
property, then that branch or similar establishment or the remainder of 
the controlled foreign corporation will be the location of manufacture, 
production, or construction of that property for purposes of applying 
paragraph (b)(1)(i)(b) or (b)(1)(ii)(b) of this section to the income 
from the sale of that property. See paragraph (b)(1)(ii)(c)(3)(v) 
Example 1 of this section. If more than one branch or similar 
establishment or one or more branches or similar establishments and the 
remainder of the controlled foreign corporation, each independently 
satisfy paragraph (a)(4)(i) of this section with respect to an item of 
personal property, then the location of manufacture, production, or 
construction of that property for purposes of applying paragraph 
(b)(1)(i)(b) or (b)(1)(ii)(b) of this section will be the location of 
that branch or similar establishment or the jurisdiction under the laws 
of which the remainder of the controlled foreign corporation is 
organized that satisfies paragraph (a)(4)(i) of this section and that 
would, after applying paragraph (b)(1)(ii)(b) of this section to such 
branch or similar establishment or paragraph (b)(1)(i)(b) of this 
section to the remainder of the controlled foreign corporation, impose 
the lowest effective rate of tax on the income allocated to such branch 
or the remainder of the controlled foreign corporation under such 
section (that is, either paragraph (b)(1)(i)(b) or (b)(1)(ii)(b) of this 
section). See paragraph (b)(1)(ii)(c)(3)(v) Example 2 of this section.
    (iii) No location independently satisfies manufacturing test. If no 
branch or similar establishment or the remainder of the controlled 
foreign corporation independently satisfies paragraph (a)(4)(i) of this 
section with respect to an item of personal property but the controlled 
foreign corporation as a whole makes a substantial contribution to the 
manufacture, production, or construction of that property within the 
meaning of paragraph (a)(4)(iv) of this section, then for purposes of 
applying paragraph (b)(1)(i)(b) or (b)(1)(ii)(b) of this section, the 
location of manufacture, production, or construction with respect to the 
income derived by a purchasing or selling branch or similar 
establishment or the purchasing or selling remainder of the controlled 
foreign corporation in connection with the purchase or sale of that 
property will be the ``tested manufacturing location'' unless the 
``tested sales location'' provides a greater contribution to the 
manufacture, production, or construction of the property. The tested 
manufacturing location is the location of any branch or similar 
establishment or remainder of the controlled foreign corporation that 
contributes to the manufacture, production, or construction of the 
personal property, if any, that would, after applying paragraph 
(b)(1)(ii)(b) of this section to such branch or similar establishment or 
paragraph (b)(1)(i)(b) of this section to the remainder of the 
controlled foreign corporation, be treated as a separate corporation and 
would impose the lowest effective rate of tax on the income allocated to 
such branch or similar establishment or to the remainder of the 
controlled foreign corporation under such section (that is, either

[[Page 340]]

paragraph (b)(1)(i)(b) or (b)(1)(ii)(b) of this section). The tested 
sales location is the location of the purchasing or selling branch or 
similar establishment or the remainder of the controlled foreign 
corporation by or through which the purchasing or selling activities are 
carried on with respect to the personal property. For purposes of this 
paragraph (b)(1)(ii)(c)(3)(iii), the contribution to the manufacture, 
production, or construction of the personal property by the tested sales 
location will be deemed to include the activities of any branch or 
similar establishment or remainder of the controlled foreign corporation 
that would not be treated as a corporation separate from the tested 
sales location after the application of paragraph (b)(1)(i)(b) or 
(b)(1)(ii)(b) of this section. For purposes of this paragraph 
(b)(1)(ii)(c)(3)(iii), the contribution of the tested manufacturing 
location to the manufacture, production, or construction of the personal 
property will be deemed to include any activities of any branch or 
similar establishment or remainder of the controlled foreign corporation 
that would be treated as a corporation separate from the tested sales 
location after the application of paragraph (b)(1)(i)(b) or 
(b)(1)(ii)(b) of this section. Whether the tested sales location 
provides a greater contribution to the manufacture, production, or 
construction of the personal property is determined by weighing the 
relative contributions to the manufacture, production, or construction 
of that property by the tested sales location and the tested 
manufacturing location under the facts and circumstances test provided 
in paragraph (a)(4)(iv) of this section. See paragraph 
(b)(1)(ii)(c)(3)(v) Examples 3, 4, 5, and 6 of this section. If the 
tested sales location provides a greater contribution to the 
manufacture, production, or construction of the personal property than 
the tested manufacturing location or if there is no tested manufacturing 
location, then the tested sales location is the location of manufacture, 
production, or construction of that property and the rules of paragraphs 
(b)(1)(i)(a) and (b)(1)(ii)(a) of this section will not apply with 
respect to the income derived by the tested sales location in connection 
with the purchase or sale of that property and the use of that 
purchasing or selling branch or similar establishment or the purchasing 
or selling remainder will not result in a branch being treated as a 
separate corporation for purposes of paragraph (b)(2)(ii) of this 
section.
    (iv) Location of activity. For purposes of paragraph 
(b)(1)(ii)(c)(3) of this section, the location of any activity with 
respect to the manufacture, production, or construction of an item of 
personal property is the location where the employees of the controlled 
foreign corporation perform such activity. For example, the location of 
any activity concerning intellectual property is determined based on 
where employees of the controlled foreign corporation develop or direct 
the use or development of the intellectual property, not on the formal 
assignment of that intellectual property.
    (v) Examples. The following examples illustrate the application of 
this paragraph (b)(1)(ii)(c)(3):

    Example 1. Multiple branches contribute to the manufacture of a 
single product only one branch satisfies paragraph (a)(4)(i). (i) Facts. 
FS is a controlled foreign corporation organized in Country M. FS 
operates three branches, Branch A, Branch B, and Branch C, located 
respectively in Country A, Country B, and Country C. Branch A, Branch B, 
and Branch C each performs different manufacturing activities with 
respect to the manufacture of Product X. Branch A, through the 
activities of employees of FS located in Country A, designs Product X. 
Branch B, through the activities of employees of FS located in Country 
B, provides quality control and oversight and direction. Branch C, 
through the activities of employees of FS located in Country C, 
manufactures Product X (within the meaning of paragraph (a)(4)(ii) or 
(a)(4)(iii) of this section) using the designs developed by Branch A and 
under the oversight of the quality control personnel of Branch B. The 
activities of Branch A and Branch B do not independently satisfy 
paragraph (a)(4)(i) of this section. Employees of FS located in Country 
M purchase the raw materials used in the manufacture of Product X from a 
related person and control the work-in-process and finished goods 
throughout the manufacturing process. Employees of FS located in Country 
M also manage the manufacturing costs and capacities related to Product 
X. Further, employees of FS located in Country M oversee the 
coordination between the branches. The activities of the remainder of FS 
in Country M do not independently satisfy paragraph (a)(4)(i) of this

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section. Employees of FS located in Country M sell Product X to 
unrelated persons for use outside of Country M. The sales income from 
the sale of Product X is taxed in Country M at an effective rate of tax 
of 10%. Country C imposes an effective rate of tax of 20% on sales 
income.
    (ii) Result. Country C is the location of manufacture for purposes 
of applying paragraph (b)(1)(ii)(b) of this section because only the 
activities of Branch C independently satisfy paragraph (a)(4)(i) of this 
section. The use of Branch C has substantially the same tax effect as if 
Branch C were a wholly owned subsidiary corporation of FS because the 
effective rate of tax on the sales income (10%) is less than 90% of, and 
at least 5 percentage points less than, the effective rate of tax that 
would apply to such income in the country in which Branch C is located 
(20%). Therefore, sales of Product X by the remainder of FS are treated 
as sales on behalf of Branch C. In determining whether the remainder of 
FS will qualify for the manufacturing exception under paragraph 
(a)(4)(iv) of this section, the activities of FS will include the 
activities of Branch A or Branch B, respectively, if each of those 
branches would not be treated as a separate corporation under paragraph 
(b)(1)(ii)(b) of this section, if that paragraph were applied 
independently to each of Branch A and Branch B. See paragraph 
(b)(2)(ii)(a) of this section.
    Example 2. Multiple branches satisfy paragraph (a)(4)(i) with 
respect to the same product sold by the controlled foreign corporation. 
(i) Facts. Assume the same facts as in Example 1, except for the 
following. In addition to the design of Product X, Branch A also 
performs in Country A other manufacturing activities, including those 
ascribed to FS in Example 1, that are sufficient to qualify as 
manufacturing under paragraph (a)(4)(iv) of this section with respect to 
Product X. Country A imposes an effective rate of tax of 12% on sales 
income.
    (ii) Result. Branch A and Branch C through their activities each 
independently satisfy the requirements of paragraph (a)(4)(i) of this 
section. Therefore, paragraph (b)(1)(ii)(b) of this section is applied 
by comparing the effective rate of tax imposed on the income from the 
sales of Product X against the lowest effective rate of tax that would 
apply to the sales income in either Country A or Country C if paragraph 
(b)(1)(ii)(b) of this section were applied separately to Branch A and 
Branch C. Country A imposes the lower effective rate of tax, and 
therefore, Branch A is treated as the location of manufacture for 
purposes of applying paragraph (b)(1)(ii)(b) of this section. The 
effective rate of tax in Country B is not considered because Branch B 
does not satisfy paragraph (a)(4)(i) of this section. Neither Branch A 
nor Branch C is treated as a separate corporation because the effective 
rate of tax on the sales income of FS from the sale of Product X (10%) 
is not less than 90% of, and at least 5 percentage points less than, the 
effective rate of tax that would apply to such income in the country in 
which Branch A is located (12%). Sales of Product X by the remainder of 
the controlled foreign corporation are not treated as made on behalf of 
any branch.
    Example 3. Determining the location of manufacture when 
manufacturing activities performed by multiple branches and no branch 
independently satisfies paragraph (a)(4)(i). (i) Facts. FS, a controlled 
foreign corporation organized in Country M, purchases raw materials from 
a related person. The raw materials are manufactured (under the 
principles of paragraph (a)(4)(ii) or (a)(4)(iii) of this section) into 
Product X by CM, an unrelated corporation, pursuant to a contract 
manufacturing arrangement. CM physically performs the substantial 
transformation, assembly, or conversion of the raw materials in Country 
C. FS has two branches, Branch A and Branch B, located in Country A and 
Country B respectively. Branch A, through the activities of employees of 
FS located in Country A, designs Product X. Branch B, through the 
activities of employees of FS located in Country B, controls 
manufacturing related logistics, provides oversight and direction during 
the manufacturing process, and controls the raw materials and work-in-
process. FS manages the manufacturing costs and capacities related to 
the manufacture of Product X through employees located in Country M. 
Further, employees of FS located in Country M oversee the coordination 
between the branches. Employees of FS located in Country M also sell 
Product X to unrelated persons for use outside of Country M. Country M 
imposes an effective rate of tax on sales income of 10%. Country A 
imposes an effective rate of tax on sales income of 20%, and Country B 
imposes an effective rate of tax on sales income of 24%. Neither the 
remainder of FS, nor any branch of FS independently satisfies paragraph 
(a)(4)(i) of this section. However, under the facts and circumstances of 
the business, FS as a whole provides a substantial contribution to the 
manufacture of Product X within the meaning of paragraph (a)(4)(iv) of 
this section.
    (ii) Result. Based on the facts, neither the remainder of FS 
(through the activities of its employees in Country M) nor any branch of 
FS independently satisfies paragraph (a)(4)(i) of this section with 
respect to Product X, but FS, as a whole, provides a substantial 
contribution through the activities of its employees to the manufacture 
of Product X. The remainder of FS, Branch A, and Branch B each provides 
a contribution through the activities of employees to the manufacture of 
Product X. Therefore, FS must determine the location of manufacture 
under paragraph (b)(1)(ii)(c)(3)(iii) of this section. The tested sales 
location is Country M

[[Page 342]]

because the selling activities with respect to Product X are carried on 
by the remainder of FS. The location of Branch A is the tested 
manufacturing location because the effective rate of tax imposed on FS's 
sales income by Country M (10%) is less than 90% of, and at least 5 
percentage points less than, the effective rate of tax that would apply 
to such income in Country A (20%), and Country A has the lowest 
effective rate of tax among the manufacturing branches that would, after 
applying paragraph (b)(1)(ii)(b) of this section, be treated as a 
separate corporation. The activities of Branch B will be included in the 
contribution of Branch A for purposes of determining the location of 
manufacture of Product X because the effective rate of tax imposed on 
the sales income by Country M (10%) is less than 90% of, and at least 5 
percentage points less than, the effective rate of tax that would apply 
to such income in Country B (24%). Under the facts and circumstances of 
the business, the activities of the remainder of FS would not provide a 
greater contribution to the manufacture of Product X than the activities 
of Branch A and Branch B, considered together. Therefore, the location 
of manufacture is Country A, the location of Branch A.
    Example 4. Manufacturing activities performed by multiple branches, 
no branch independently satisfies paragraph (a)(4)(i), selling 
activities carried on by remainder of the controlled foreign 
corporation, remainder contribution includes branch manufacturing 
activities. (i) Facts. The facts are the same as Example 3, except that 
the effective rate of tax on sales income in Country B is 12%. In 
addition, under the facts of the particular business, the activities of 
employees of FS located in Country B and Country M, if considered 
together, would provide a greater contribution to the manufacture of 
Product X than the activities of employees of FS located in Country A.
    (ii) Result. Based on the facts, neither the remainder of FS 
(through activities of its employees in Country M) nor any branch of FS 
independently satisfies paragraph (a)(4)(i) of this section with respect 
to Product X, but FS, as a whole, provides a substantial contribution 
through the activities of its employees to the manufacture of Product X. 
The remainder of FS, Branch A, and Branch B each provide a contribution 
through the activities of their employees to the manufacture of Product 
X. Therefore, FS must determine the location of manufacture under 
paragraph (b)(1)(ii)(c)(3)(iii) of this section. The tested sales 
location is Country M because the selling activities with respect to 
Product X are carried on by the remainder of FS. The location of Branch 
A is the tested manufacturing location because the effective rate of tax 
imposed on FS's sales income by Country M (10%) is less than 90% of, and 
at least 5 percentage points less than, the effective rate of tax that 
would apply to such income in Country A (20%), and Branch A is the only 
branch that would, after applying paragraph (b)(1)(ii)(b) of this 
section, be treated as a separate corporation. The activities of Branch 
B will be included in the contribution of the remainder of FS for 
purposes of determining the location of manufacture of Product X because 
the effective rate of tax imposed on the sales income by Country M (10%) 
is not less than 90% of, and at least 5 percentage points less than, the 
effective rate of tax that would apply to such income in Country B 
(12%). Under a facts and circumstances analysis, considered together, 
the activities of Branch B and the remainder of FS would provide a 
greater contribution to the manufacture of Product X than the activities 
of Branch A. Therefore, the rules of paragraph (b)(1)(ii)(a) of this 
section will not apply with respect to the income derived by the 
remainder of FS in connection with the sale of Product X, and neither 
Branch A nor Branch B will be treated as a separate corporation for 
purposes of paragraph (b)(2)(ii) of this section.
    Example 5. Manufacturing activities performed by multiple branches, 
no branch independently satisfies paragraph (a)(4)(i), sales carried on 
by remainder of the controlled foreign corporation and a sales branch. 
(i) Facts. The facts are the same as Example 3, except that sales of 
Product X are also carried on through Branch D in Country D, and Country 
D imposes a 16% effective rate of tax on sales income. In addition, 
under the facts and circumstances of the business, the activities of 
employees of FS located in Country A and Country M, considered together, 
would provide a greater contribution to the manufacture of Product X 
than the activities of employees of FS located in Country B.
    (ii) Result. Based on the facts, neither the remainder of FS nor any 
branch of FS independently satisfies paragraph (a)(4)(i) of this section 
with respect to Product X, but FS, as a whole, provides a substantial 
contribution through the activities of its employees to the manufacture 
of Product X. The remainder of FS, Branch A, and Branch B each provide a 
contribution through the activities of their employees to the 
manufacture of Product X. Therefore, FS must determine the location of 
manufacture under paragraph (b)(1)(ii)(c)(3)(iii) of this section. 
Further, pursuant to paragraph (b)(1)(ii)(c)(1) of this section, 
paragraph (b)(1)(ii)(c)(3)(iii) of this section must be applied 
separately to the sales income derived by the remainder of FS and Branch 
D respectively. The results with respect to the income derived by the 
remainder of FS in connection with the sale of Product X in this Example 
5 are the same as in Example 3. However, paragraph (b)(1)(ii)(c)(3)(iii) 
of this section must also be applied with respect to Branch D because 
the sale of Product X is also carried on through

[[Page 343]]

Branch D. Thus, for purposes of that sales income, the location of 
Branch D is the tested sales location. The location of Branch B is the 
tested manufacturing location because the effective rate of tax imposed 
on Branch D's sales income by Country D (16%) is less than 90% of, and 
at least 5 percentage points less than, the effective rate of tax that 
would apply to such income in Country B (24%), and Branch B is the only 
branch that would, after applying paragraph (b)(1)(ii)(b) of this 
section, be treated as a separate corporation. The manufacturing 
activities performed in Country M by the remainder of FS and the 
manufacturing activities performed in Country A by Branch A will be 
included in Branch D's contribution to the manufacture of Product X for 
purposes of determining the location of manufacture of Product X with 
respect to Branch D's sales income because the effective rate of tax 
imposed on the sales income by Country D (16%) is not less than 90% of, 
and at least 5 percentage points less than, the effective rate of tax 
that would apply to such income in Country M (10%) and Country A (20%). 
Under the facts and circumstances of the business, the activities of 
Branch D, Branch A, and the remainder of FS, considered together, would 
provide a greater contribution to the manufacture of Product X than the 
activities of Branch B. Therefore, the rules of paragraph (b)(1)(ii)(a) 
of this section will not apply with respect to the income derived by 
Branch D in connection with the sale of Product X and the use of Branch 
D to sell Product X will not result in a branch being treated as a 
separate corporation for purposes of paragraph (b)(2)(ii) of this 
section.
    Example 6. Determining the location of manufacture when employees of 
remainder of controlled foreign corporation travel to location of 
unrelated contract manufacturer to perform manufacturing activities. (i) 
Facts. FS, a controlled foreign corporation organized in Country M, 
purchases raw materials from a related person. The raw materials are 
manufactured (under the principles of paragraph (a)(4)(ii) or 
(a)(4)(iii) of this section) into Product X by CM, an unrelated 
corporation, pursuant to a contract manufacturing arrangement. CM 
physically performs the substantial transformation, assembly, or 
conversion of the raw materials in Country C. Employees of FS located in 
Country M sell Product X to unrelated persons for use outside of Country 
M. Employees of FS located in Country M engage in product design, manage 
the manufacturing costs and capacities with respect to Product X, and 
direct the use of intellectual property for the purpose of manufacturing 
Product X. Quality control and oversight and direction of the 
manufacturing process are conducted in Country C by employees of FS who 
are employed in Country M but who regularly travel to Country C. Branch 
A, located in Country A, is the only branch of FS. Product design with 
respect to Product X conducted by employees of FS located in Country A 
is supplemental to the bulk of the design work, which is done by 
employees of FS located in Country M. At all times, employees of Branch 
A control the raw materials, work-in-process and finished goods. 
Employees of FS located in Country A also control manufacturing related 
logistics with respect to Product X. Country M imposes an effective rate 
of tax on sales income of 10%. Country A imposes an effective rate of 
tax on sales income of 20%. Neither the remainder of FS nor Branch A 
independently satisfies paragraph (a)(4)(i) of this section. However, 
under the facts and circumstance of the business, FS as a whole 
(including Branch A) provides a substantial contribution to the 
manufacture of Product X within the meaning of paragraph (a)(4)(iv) of 
this section.
    (ii) Result. Based on the facts, neither the remainder of FS nor 
Branch A independently satisfies paragraph (a)(4)(i) of this section 
with respect to Product X, but FS, as a whole, provides a substantial 
contribution through the activities of its employees to the manufacture 
of Product X. The remainder of FS and Branch A each provide a 
contribution through the activities of employees to the manufacture of 
Product X. Therefore, FS must determine the location of manufacture 
under paragraph (b)(1)(ii)(c)(3)(iii) of this section. The tested sales 
location is Country M because the selling activities with respect to 
Product X are carried on by the remainder of FS. The tested 
manufacturing location is the location of Branch A because the effective 
rate of tax imposed on the remainder of FS's sales income by Country M 
(10%) is less than 90% of, and at least 5 percentage points less than, 
the effective rate of tax that would apply to such income in Country A 
(20%), and Branch A is the only branch that would, after applying 
paragraph (b)(1)(ii)(b) of this section, be treated as a separate 
corporation. Although the activities of traveling employees are 
considered in determining whether FS, as a whole, makes a substantial 
contribution to the manufacture of Product X under paragraph (a)(4)(iv) 
of this section, the activities of the employees of FS that are 
performed in Country C are not taken into consideration in determining 
whether Country M, the jurisdiction under the laws of which FS is 
organized, is the location of manufacture under paragraph 
(b)(1)(ii)(c)(3)(iii) of this section. Activities of employees performed 
outside the jurisdiction in which the controlled foreign corporation is 
organized and outside a location in which the controlled foreign 
corporation maintains a branch or similar establishment, are not 
considered in determining the location of manufacture. Under the facts 
and circumstances of the business, the activities of employees of FS 
performed in Country M do

[[Page 344]]

not provide a greater contribution to the manufacture of Product X than 
the activities of employees of FS performed in Country A. Therefore, the 
location of manufacture is Country A, the location of Branch A.

    (4) Use of more than one branch to manufacture, produce, construct, 
grow, or extract separate items of personal property. For purposes of 
paragraphs (b)(1)(ii)(c)(2) and (b)(1)(ii)(c)(3) of this section, an 
item of personal property refers to an individual unit of personal 
property rather than a type or class of personal property.
    (2) Special rules--(i) Determination of treatment as a wholly owned 
subsidiary corporation. For purposes of determining under this paragraph 
whether the use of a branch or similar establishment which is treated as 
a separate corporation has substantially the same tax effect as if the 
branch or similar establishment were a wholly owned subsidiary 
corporation of a controlled foreign corporation--
    (a) Treatment as separate corporations. The branch or similar 
establishment will be treated as a wholly owned subsidiary corporation 
of the controlled foreign corporation, and such branch or similar 
establishment will be deemed to be incorporated in the country in which 
it is located.
    (b) Activities treated as performed on behalf of the remainder of 
corporation. (1) With respect to purchasing or selling activities 
performed by or through the branch or similar establishment, such 
purchasing or selling activities will, with respect to personal property 
manufactured, produced, constructed, grown, or extracted by the 
remainder of the controlled foreign corporation, be treated as performed 
on behalf of the remainder of the controlled foreign corporation.
    (2) With respect to purchasing or selling activities performed by or 
through the branch or similar establishment, such purchasing or selling 
activities will, with respect to personal property (other than property 
described in paragraph (b)(2)(i)(b)(1) of this section) purchased or 
sold, or purchased and sold, by the remainder of the controlled foreign 
corporation (or any branch treated as the remainder of the controlled 
foreign corporation), be treated as performed on behalf of the remainder 
of the controlled foreign corporation.
    (c) Activities treated as performed on behalf of branch. With 
respect to manufacturing, producing, constructing, growing, or 
extracting activities performed by or through the branch or similar 
establishment, purchasing or selling activities performed by or through 
the remainder of the controlled foreign corporation with respect to the 
personal property manufactured, produced, constructed, grown, or 
extracted by or through the branch or similar establishment shall be 
treated as performed on behalf of the branch or similar establishment.
    (d) [Reserved] For further guidance, see Sec. 1.954-3T(b)(2)(i)(d).
    (e) Tax laws to be taken into account. Tax determinations shall be 
made by taking into account only the income, war profits, excess 
profits, or similar tax laws (or the absence of such laws) of the 
countries involved.
    (ii) Determination of foreign base company sales income. Once it has 
been determined under subparagraph (1) of this paragraph that a branch 
or similar establishment and the remainder of the controlled foreign 
corporation are to be treated as separate corporations, the 
determination of whether such branch or similar establishment, or the 
remainder of the controlled foreign corporation, as the case may be, has 
foreign base company sales income shall be made by applying the 
following rules:
    (a) Treatment as separate corporations. The branch or similar 
establishment will be treated as a wholly owned subsidiary corporation 
of the controlled foreign corporation, and such branch or similar 
establishment will be deemed to be incorporated in the country in which 
it is located. For purposes of applying the rules of this paragraph 
(b)(2)(ii), a branch or similar establishment of a controlled foreign 
corporation treated as a separate corporation purchasing or selling on 
behalf of the remainder of the controlled foreign corporation under 
paragraph (b)(2)(ii)(b) of this section, or the remainder of the 
controlled foreign corporation treated as a separate corporation 
purchasing or selling on behalf of a branch or similar establishment of

[[Page 345]]

the controlled foreign corporation under paragraph (b)(2)(ii)(c) of this 
section, will include the activities of any other branch or similar 
establishment or remainder of the controlled foreign corporation that 
would not be treated as a separate corporation (apart from the branch or 
similar establishment of a controlled foreign corporation that is 
treated as performing purchasing or selling activities on behalf of the 
remainder of the controlled foreign corporation under paragraph 
(b)(2)(ii)(b) of this section or the remainder of the controlled foreign 
corporation that is treated as performing purchasing or selling 
activities on behalf of the branch or similar establishment under 
paragraph (b)(2)(ii)(c) of this section) if the effective rate of tax 
imposed on the income of the purchasing or selling branch or similar 
establishment, or purchasing or selling remainder of the controlled 
foreign corporation, were tested under the principles of paragraph 
(b)(1)(i)(b) or (b)(1)(ii)(b) of this section against the effective rate 
of tax that would apply to such income if it were considered derived by 
such other branch or similar establishment or the remainder of the 
controlled foreign corporation.
    (b) Activities treated as performed on behalf of the remainder of 
corporation. (1) With respect to purchasing or selling activities 
performed by or through the branch or similar establishment, such 
purchasing or selling activities will, with respect to personal property 
manufactured, produced, constructed, grown, or extracted by the 
remainder of the controlled foreign corporation, be treated as performed 
on behalf of the remainder of the controlled foreign corporation.
    (2) With respect to purchasing or selling activities performed by or 
through the branch or similar establishment, such purchasing or selling 
activities will, with respect to personal property (other than property 
described in paragraph (b)(2)(ii)(b)(1) of this section) purchased or 
sold, or purchased and sold, by the remainder of the controlled foreign 
corporation (or any branch treated as the remainder of the controlled 
foreign corporation), be treated as performed on behalf of the remainder 
of the controlled foreign corporation.
    (c) Activities treated as performed on behalf of branch. With 
respect to manufacturing, producing, constructing, growing, or 
extracting activities performed by or through the branch or similar 
establishment, purchasing or selling activities performed by or through 
the remainder of the controlled foreign corporation with respect to the 
personal property manufactured, produced, constructed, grown, or 
extracted by or through the branch or similar establishment shall be 
treated as performed on behalf of the branch or similar establishment.
    (d) [Reserved]
    (e) Comparison with ordinary treatment. Income derived by a branch 
or similar establishment, or by the remainder of the controlled foreign 
corporation, will not be foreign base company sales income under 
paragraph (b) of this section if the income would not be foreign base 
company sales income if it were derived by a separate controlled foreign 
corporation under like circumstances.
    (f) Priority of application. If income derived by the branch or 
similar establishment, or by the remainder of the controlled foreign 
corporation, from a transaction would be classified as foreign base 
company sales income of such controlled foreign corporation under 
section 954(d)(1) and paragraph (a) of this section, the income shall, 
notwithstanding this paragraph, be treated as foreign base company sales 
income under paragraph (a) of this section and the branch or similar 
establishment shall not be treated as a separate corporation with 
respect to such income.
    (3) Inclusion of amounts in gross income of United States 
shareholders. A branch or similar establishment of a controlled foreign 
corporation and the remainder of such corporation shall be treated as 
separate corporations under this paragraph solely for purposes of 
determining the foreign base company sales income of each such 
corporation and for purposes of including an amount in subpart F income 
of the controlled foreign corporation under section 953(a). See section 
954(b)(3) and

[[Page 346]]

paragraph (d)(4) of Sec. 1.954-1 for rules relating to the treatment of 
a branch or similar establishment of a controlled foreign corporation 
and the remainder of such corporation as separate corporations for 
purposes of independently determining if the foreign base company income 
of each such corporation is less than 10 percent, or more than 70 
percent, of its gross income. For all other purposes, however, a branch 
or similar establishment of a controlled foreign corporation and the 
remainder of such corporation shall not be treated as separate 
corporations. For example, if the controlled foreign corporation has a 
deficit in earnings and profits to which section 952(c) applies, the 
limitation of such section on the amount includable in the subpart F 
income of such corporation will apply. Moreover, income, war profits, or 
excess profits taxes paid by a branch or similar establishment to a 
foreign country will be treated as having been paid by the controlled 
foreign corporation for purposes of section 960 (relating to special 
rules for foreign tax credit) and the regulations thereunder. Also, 
income of a branch or similar establishment, treated as a separate 
corporation under this paragraph, will not be treated as dividend income 
of the controlled foreign corporation of which it is a branch or similar 
establishment.
    (4) Illustrations. The application of this paragraph (b) may be 
illustrated by the following examples:

    Example 1. Controlled foreign corporation A, incorporated under the 
laws of foreign country X, is engaged in the manufacturing business in 
such country. Corporation A negotiates sales of its products for use 
outside of country X through a sales office, branch B, maintained in 
foreign country Y. These activities constitute the only activities of A 
Corporation. Country X levies an income tax at an effective rate of 50 
percent on the income of A Corporation derived by the manufacturing 
plant in country X but does not tax the sales income of A Corporation 
derived by branch B in country Y. Country Y levies an income tax at an 
effective rate of 10 percent on the sales income derived by branch B but 
does not tax the income of A Corporation derived by the manufacturing 
plant in country X. If the sales income derived by branch B were, under 
the laws of country X, derived from sources within country X by A 
Corporation, such income would be taxed by such country at an effective 
rate of 50 percent. In determining foreign base company sales income of 
A Corporation, branch B is treated as a separate wholly owned subsidiary 
corporation of A Corporation, the 10 percent rate of tax on branch B's 
income being less than 90 percent of, and at least 5 percentage points 
less than, the 50 percent rate. Income derived by branch B, treated as a 
separate corporation, from the sale by or through it for use, 
consumption, or disposition outside country Y of the personal property 
produced in country X is treated as income from the sale of personal 
property on behalf of A Corporation, a related person, and constitutes 
foreign base company sales income. The remainder of A Corporation, 
treated as a separate corporation, derives no foreign base company sales 
income since it produces the product which is sold.
    Example 2. Controlled foreign corporation C is incorporated under 
the laws of foreign country X. Corporation C maintains branch B in 
foreign country Y. Branch B manufactures articles in country Y which are 
sold through the sales offices of C Corporation located in country X. 
These activities constitute the only activities of C Corporation. 
Country Y levies an income tax at an effective rate of 30 percent on the 
manufacturing profit of C Corporation derived by branch B but does not 
tax the sales income of C Corporation derived by the sales offices in 
country X. Country X does not impose an income, war profits, excess 
profits, or similar tax, and no tax is paid to any foreign country with 
respect to income of C Corporation which is not derived by branch B. If 
C Corporation were incorporated under the laws of country Y, the sales 
income of the sales offices in country X would be taxed by country Y at 
an effective rate of 30 percent. In determining foreign base company 
sales income of C Corporation, branch B is treated as a separate wholly 
owned subsidiary corporation of C Corporation, the zero rate of tax on 
the income derived by the remainder of C Corporation being less than 90 
percent of, and at least 5 percentage points less than, the 30 percent 
rate. Branch B, treated as a separate corporation, derives no foreign 
base company sales income since it produces the product which is sold. 
Income derived by the remainder of C Corporation, treated as a separate 
corporation, from the sale by or through it for use, consumption, or 
disposition outside country X of the personal property produced in 
country Y is treated as income from the sale of personal property on 
behalf of branch B, a related person, and constitutes foreign base 
company sales income.
    Example 3. (i) Facts. Corporation E, a controlled foreign 
corporation incorporated under the laws of foreign Country X, is a 
wholly owned subsidiary of Corporation D, also a controlled foreign 
corporation incorporated under the laws of Country X. Corporation E 
maintains Branch B in foreign

[[Page 347]]

Country Y. Both corporations use the calendar year as the taxable year. 
In 1964, Corporation E's sole activity, carried on through Branch B, 
consists of the purchase of articles manufactured in Country X by 
Corporation D, a related person, and the sale of the articles through 
Branch B to unrelated persons. One hundred percent of the articles sold 
through Branch B are sold for use outside Country X and 90% are also 
sold for use outside of Country Y. The income of Corporation E derived 
by Branch B from such transactions is taxed to Corporation E by Country 
X only at the time Corporation E distributes such income to Corporation 
D and is taxed on the basis of what the tax (a 40% effective rate) would 
have been if the income had been derived in 1964 by Corporation E from 
sources within Country X from doing business through a permanent 
establishment therein. Country Y levies an income tax at an effective 
rate of 50% on income derived from sources within such country, but the 
income of Branch B for 1964 is effectively taxed by Country Y at a 5% 
rate since under the laws of such country, only 10% of Branch B's income 
is derived from sources within such country. Corporation E makes no 
distributions to Corporation D in 1964.
    (ii) Result. In determining foreign base company sales income of 
Corporation E for 1964, Branch B is treated as a separate wholly owned 
subsidiary corporation of Corporation E, the 5% rate of tax being less 
than 90% of, and at least 5 percentage points less than the 40% rate. 
Income derived by Branch B, treated as a separate corporation, from the 
purchase from a related person (Corporation D), of personal property 
manufactured outside of Country Y and sold for use, disposition, or 
consumption outside of Country Y constitutes foreign base company sales 
income. If, instead, Corporation D were unrelated to Corporation E, none 
of the income would be foreign base company sales income because 
Corporation E would be purchasing from and selling to unrelated persons 
and if Branch B were treated as a separate corporation it would likewise 
be purchasing from and selling to unrelated persons. Alternatively, if 
Corporation D were related to Corporation E, but Branch B manufactured 
the articles prior to sale under the principles of paragraph (a)(4)(iv) 
of this section, the income would not be foreign base company sales 
income because Branch B, treated as a separate corporation, would 
qualify for the manufacturing exception under paragraph (a)(4) of this 
section.
    Example 4. Controlled foreign corporation F, incorporated under the 
laws of foreign country X, is a wholly owned subsidiary of domestic 
corporation M. Corporation F, through its branch B in foreign country Y, 
purchases from controlled foreign corporation G, a wholly owned 
subsidiary of M Corporation incorporated under the laws of foreign 
country Z, personal property which G Corporation manufactures in country 
Z. Corporation F sells such property for use in foreign country W. Since 
the income of F Corporation from such purchases and sales is classified 
as foreign base company sales income under section 954(d)(1) and 
paragraph (a) of this section, branch B will not be treated as a 
separate corporation with respect to such income even if the tax 
differential between countries X and Y would otherwise justify such 
treatment.
    Example 5. Controlled foreign corporation A, incorporated under the 
laws of foreign country X, is engaged in manufacturing articles through 
its home office, located in country X, and selling such articles through 
branch B, located in foreign country Y, and through branch C, located in 
foreign country Z, for use outside country X. These activities 
constitute the only activities of A Corporation for its taxable year 
1963. Each such country levies an income tax on only the income derived 
from sources within such country, and all income derived in 1963 by the 
home office, branch B, and branch C, respectively, is derived from 
sources within countries X, Y, and Z, respectively. The income and 
income taxes of A Corporation for 1963 are as follows:

------------------------------------------------------------------------
                                    X Country    Y Country    Z Country
------------------------------------------------------------------------
Income of:
  Home office....................     $200,000
  Branch B.......................  ...........     $100,000
  Branch C.......................  ...........  ...........     $100,000
Income tax.......................     $100,000      $20,000      $20,000
Effective rate of tax............          50%          20%          20%
------------------------------------------------------------------------


By applying subparagraph (1)(i) of this paragraph and by treating branch 
B as though it were the only branch of A Corporation, branch B is 
treated as a separate wholly owned subsidiary corporation of A 
Corporation in determining foreign base company sales income of A 
Corporation for 1963, the 20 percent rate of tax on the income of such 
branch being less than 90 percent of, and at least 5 percentage points 
less than, the 50 percent rate of tax which would apply to the income of 
branch B under the laws of country X if, under the laws of such country, 
all the income of A Corporation for 1963 derived through the home office 
and branch B were derived from sources within country X. Moreover, by 
applying subparagraph (1)(i) of this paragraph and by treating branch C 
as though it were the only branch of A Corporation, branch C is treated 
as a separate wholly owned subsidiary corporation of A Corporation, the 
20 percent rate of tax on the income of such branch being less than 90 
percent of, and at least 5 percentage points less than, the 50 percent 
rate of tax which would apply to the income of branch C under the laws 
of country X if, under the laws of such

[[Page 348]]

country, all the income of A Corporation for 1963 derived through the 
home office and branch C were derived from sources within country X. The 
income derived by branch B and branch C, respectively, each treated as a 
separate corporation, from the sale by or through each of them for use, 
consumption, or disposition outside country Y and country Z, 
respectively, is treated as income from the sale of personal property on 
behalf of A Corporation, a related person, and constitutes foreign base 
company sales income for 1963. The home office of A Corporation, treated 
as a separate corporation, derives no foreign base company sales income 
for 1963 since it produces the articles which are sold.
    Examples 6-7 [Reserved]
    Example 8. Uniformly applicable incentive tax rate in one country. 
(i) Facts. FS is a controlled foreign corporation organized in Country 
M. FS operates one branch, Branch A, located in Country A. Branch A 
manufactures Product X within the meaning of paragraph (a)(4)(ii) or 
(a)(4)(iii) of this section. Raw materials used in the manufacture of 
Product X are purchased by FS from an unrelated person. FS engages in 
activities in Country M to sell Product X to a related person for use 
outside of Country M. Employees of FS located in Country M carry on only 
sales functions. The effective rate imposed in Country M on the income 
from the sale of Product X is 10%. Country A generally imposes an 
effective rate of tax on income of 20%, but imposes a uniformly 
applicable incentive rate of tax of 10% on manufacturing income and 
related sales income.
    (ii) Result. The use of Branch A to manufacture Product X does not 
have substantially the same tax effect as if Branch A were a wholly 
owned subsidiary corporation of FS because the effective rate of tax on 
FS's sales income from the sale of Product X in Country M (10%) is not 
less than 90% of, and at least 5 percentage points less than, the 
effective rate of tax that would apply to such income in the country in 
which Branch A is located (10%). Consequently, pursuant to paragraph 
(b)(1)(ii)(b) of this section, Branch A is not treated as a separate 
corporation apart from the remainder of FS for purposes of determining 
foreign base company sales income.
    Example 9. Manufacturing activities performed by multiple branches, 
no branch independently satisfies paragraph (a)(4)(i), selling 
activities carried on by remainder of the controlled foreign 
corporation, some branch manufacturing activities included in remainder 
contribution. (i) Facts. FS, a controlled foreign corporation organized 
in Country M, has three branches, Branch A, Branch B, and Branch C, 
located in Country A, Country B, and Country C respectively. FS 
purchases raw materials from a related person. The raw materials are 
manufactured (under the principles of paragraph (a)(4)(ii) or 
(a)(4)(iii) of this section) into Product X by CM, an unrelated 
corporation, pursuant to a contract manufacturing arrangement. CM 
physically performs the substantial transformation, assembly, or 
conversion required to manufacture Product X outside of FS's country of 
organization. FS manages the manufacturing costs and capacities with 
respect to the manufacture of Product X through employees located in 
Country M. Further, employees of FS located in Country M oversee the 
coordination between the branches. Branch A, through the activities of 
employees of FS located in Country A, designs Product X, controls 
manufacturing related logistics, and controls the raw materials and 
work-in-process during the manufacturing process. Branch B, through the 
activities of employees of FS located in Country B, provides quality 
control. Branch C, through the activities of employees of FS located in 
Country C, provides oversight and direction during the manufacturing 
process. Employees of FS located in Country M sell Product X to 
unrelated persons for use outside of Country M. Country M imposes an 
effective rate of tax on sales income of 10%. Country A imposes an 
effective rate of tax on sales income of 12%, Country B imposes an 
effective rate of tax on sales income of 24%, and Country C imposes an 
effective rate of tax on sales income of 25%. None of the remainder of 
FS, Branch A, Branch B, or Branch C independently satisfies paragraph 
(a)(4)(i) of this section. However, under the facts and circumstances of 
the business, FS, as a whole, provides a substantial contribution to the 
manufacture of Product X within the meaning of paragraph (a)(4)(iv) of 
this section. Under the facts and circumstances of the business, the 
activities of the remainder of FS and Branch A, if considered together, 
would not provide a greater contribution to the manufacture of Product X 
than the activities of Branch B and Branch C, if considered together. 
Under the facts and circumstances of the business, however, the 
activities of the employees of the remainder of FS and Branch A, if 
considered together, would constitute a substantial contribution to the 
manufacture of Product X.
    (ii) Result. Based on the facts, neither the remainder of FS 
(through activities of its employees in Country M) nor any branch of FS 
independently satisfies paragraph (a)(4)(i) of this section with respect 
to Product X, but FS, as a whole, provides a substantial contribution 
through the activities of its employees to the manufacture of Product X. 
The remainder of FS, Branch A, Branch B, and Branch C each provide a 
contribution through the activities of employees to the manufacture of 
Product X. Therefore, FS must determine the location of manufacture 
under paragraph (b)(1)(ii)(c)(3)(iii) of this section. The tested sales 
location is Country M because the selling activities with respect to

[[Page 349]]

Product X are carried on by the remainder of FS. The location of Branch 
B is the tested manufacturing location because the effective rate of tax 
imposed on FS's sales income by Country M (10%) is less than 90% of, and 
at least 5 percentage points less than, the effective rate of tax that 
would apply to such income in Country B (24%), and Country B has the 
lowest effective rate of tax among the manufacturing branches that 
would, after applying paragraph (b)(1)(ii)(b) of this section, be 
treated as a separate corporation. The manufacturing activities 
performed in Country A by Branch A will be included in the contribution 
of the remainder of FS for purposes of determining the location of 
manufacture of Product X because the effective rate of tax imposed on 
the sales income by Country M (10%) is not less than 90% of, and at 
least 5 percentage points less than, the effective rate of tax that 
would apply to such income in Country A (12%). The manufacturing 
activities performed in Country C by Branch C will be included in the 
contribution of Branch B for purposes of determining the location of 
manufacture of Product X because the effective rate of tax imposed on 
the sales income by Country M (10%) is less than 90% of, and at least 5 
percentage points less than, the effective rate of tax that would apply 
to such income in Country C (25%). Under the facts and circumstances of 
the business, the manufacturing activities of the remainder of FS and 
Branch A, considered together, would not provide a greater contribution 
to the manufacture of Product X than the activities of Branch B and 
Branch C, considered together. Therefore, the location of manufacture is 
Country B, the location of Branch B. In determining that Country B is 
the location of manufacture, it was determined that after applying 
paragraph (b)(1)(ii)(b) of this section Branch B would be treated as a 
separate corporation under paragraph (b)(1)(ii)(a) of this section for 
purposes of determining foreign base company sales income. To determine 
whether income from the sale of Product X is foreign base company sales 
income, the remainder of FS takes into account the activities of Branch 
A because, under paragraph (b)(2)(ii)(a) of this section, Branch A would 
not be treated as a separate corporation apart from FS. The remainder of 
FS is considered to have manufactured Product X under paragraph 
(a)(4)(i) of this section because the manufacturing activities of the 
remainder of FS and Branch A, considered together, would make a 
substantial contribution to the manufacture of Product X within the 
meaning of paragraph (a)(4)(iv) of this section. Therefore, income 
derived from the sale of Product X by the remainder of FS does not 
constitute foreign base company sales income.

    (c) Effective/applicability date. Paragraphs (a)(1)(i), (a)(1)(iii) 
Example 1, (a)(1)(iii) Example 2, (a)(2), (a)(4)(i), (a)(4)(ii), 
(a)(4)(iii), (a)(4)(iv), (a)(6)(i), (b)(1)(i)(c), (b)(1)(ii)(a), 
(b)(1)(ii)(c), (b)(2)(i)(b), (b)(2)(ii)(a), (b)(2)(ii)(b), 
(b)(2)(ii)(e), and (b)(4) Example 3, (b)(4) Example 8, and (b)(4) 
Example 9 of this section shall apply to taxable years of controlled 
foreign corporations beginning after June 30, 2009, and for taxable 
years of United States shareholders in which or with which such taxable 
years of the controlled foreign corporations end.
    (d) Application of regulations to earlier taxable years. A taxpayer 
may choose to apply these regulations retroactively with respect to its 
open taxable years that began prior to July 1, 2009. The taxpayer may so 
choose if and only if the taxpayer and all members of the taxpayer's 
affiliated group (within the meaning of section 1504(a)) apply these 
regulations, in their entirety, to the earliest taxable year of each 
controlled foreign corporation that ends with or within an open taxable 
year of the taxpayer and to all subsequent taxable years.

[T.D. 6734, 29 FR 6392, May 15, 1964, as amended by T.D. 7545, 43 FR 
32754, May 8, 1978; T.D. 7893, 48 FR 22508, May 19, 1983; T.D. 7894, 48 
FR 22523, May 19, 1983; T.D. 9008, 67 FR 48025, July 23, 2002; T.D. 
9438, 73 FR 79344, T.D. 9438, Dec. 29, 2008; 74 FR 11844, Mar. 20, 2009; 
T.D. 9563, 76 FR 78546, Dec. 19, 2011]



Sec. 1.954-4  Foreign base company services income.

    (a) Items included. Except as provided in paragraph (d) of this 
section, foreign base company services income means income of a 
controlled foreign corporation, whether in the form of compensation, 
commissions, fees, or otherwise, derived in connection with the 
performance of technical, managerial, engineering, architectural, 
scientific, skilled, industrial, commercial, or like services which--
    (1) Are performed for, or on behalf of a related person, as defined 
in paragraph (e)(1) of Sec. 1.954-1, and
    (2) Are performed outside the country under the laws of which the 
controlled foreign corporation is created or organized.
    (b) Services performed for, or on behalf of, a related person--(1) 
Specific cases. For purposes of paragraph (a)(1) of this

[[Page 350]]

section, ``services which are performed for, or on behalf of, a related 
person'' include (but are not limited to) services performed by a 
controlled foreign corporation in a case where--
    (i) The controlled foreign corporation is paid or reimbursed by, is 
released from an obligation to, or otherwise receives substantial 
financial benefit from, a related person for performing such services;
    (ii) The controlled foreign corporation performs services (whether 
or not with respect to property sold by a related person) which a 
related person is, or has been, obligated to perform;
    (iii) The controlled foreign corporation performs services with 
respect to property sold by a related person and the performance of such 
services constitutes a condition or a material term of such sale; or
    (iv) Substantial assistance contributing to the performance of such 
services has been furnished by a related person or persons.
    (2) Special rules--(i) Guaranty of performance. Subparagraph (1)(ii) 
of this paragraph shall not apply with respect to services performed by 
a controlled foreign corporation pursuant to a contract the performance 
of which is guaranteed by a related person, if (a) the related person's 
sole obligation with respect to the contract is to guarantee performance 
of such services, (b) the controlled foreign corporation is fully 
obligated to perform the services under the contract, and (c) the 
related person (or any other person related to the controlled foreign 
corporation) does not in fact (1) pay for performance of, or perform, 
any of such services the performance of which is so guaranteed or (2) 
pay for performance of, or perform, any significant services related to 
such services. If the related person (or any other person related to the 
controlled foreign corporation) does in fact pay for performance of, or 
perform, any of such services or any significant services related to 
such services, subparagraph (1)(ii) of this paragraph shall apply with 
respect to the services performed by the controlled foreign corporation 
pursuant to the contract the performance of which is guaranteed by the 
related person, even though such payment or performance is not 
considered to be substantial assistance for purposes of subparagraph 
(1)(iv) of this paragraph. For purposes of this subdivision, a related 
person shall be considered to guarantee performance of the services by 
the controlled foreign corporation whether it guarantees performance of 
such services by a separate contract of guaranty or enters into a 
service contract solely for purposes of guaranteeing performance of such 
services and immediately thereafter assigns the entire contract to the 
controlled foreign corporation for execution.
    (ii) Application of substantial assistance test. For purposes of 
subparagraph (1)(iv) of this paragraph--
    (a) Assistance furnished by a related person or persons to the 
controlled foreign corporation shall include, but shall not be limited 
to, direction, supervision, services, know-how, financial assistance 
(other than contributions to capital), and equipment, material, or 
supplies.
    (b) Assistance furnished by a related person or persons to a 
controlled foreign corporation in the form of direction, supervision, 
services, or know-how shall not be considered substantial unless either 
(1) the assistance so furnished provides the controlled foreign 
corporation with skills which are a principal element in producing the 
income from the performance of such services by such corporation or (2) 
the cost to the controlled foreign corporation of the assistance so 
furnished equals 50 percent or more of the total cost to the controlled 
foreign corporation of performing the services performed by such 
corporation. The term ``cost'', as used in this subdivision (b), shall 
be determined after taking into account adjustments, if any, made under 
section 482.
    (c) Financial assistance (other than contributions to capital), 
equipment, material, or supplies furnished by a related person to a 
controlled foreign corporation shall be considered assistance only in 
that amount by which the consideration actually paid by the controlled 
foreign corporation for the purchase or use of such item is less than 
the arm's length charge for such purchase or use. The total of such 
amounts so considered to be assistance

[[Page 351]]

in the case of financial assistance, equipment, material, and supplies 
furnished by all related persons shall be compared with the profits 
derived by the controlled foreign corporation from the performance of 
the services to determine whether the financial assistance, equipment, 
material, and supplies furnished by a related person or persons are by 
themselves substantial assistance contributing to the performance of 
such services. For purposes of this subdivision (c), determinations 
shall be made after taking into account adjustments, if any, made under 
section 482 and the term ``consideration actually paid'' shall include 
any amount which is deemed paid by the controlled foreign corporation 
pursuant to such an adjustment.
    (d) Even though assistance furnished by a related person or persons 
to a controlled foreign corporation in the form of direction, 
supervision, services, or know-how is not considered to be substantial 
under (b) of this subdivision and assistance furnished by a related 
person or persons in the form of financial assistance (other than 
contributions to capital), equipment, material, or supplies is not 
considered to be substantial under (c) of this subdivision, such 
assistance may nevertheless constitute substantial assistance when taken 
together or in combination with other assistance furnished by a related 
person or persons which in itself is not considered to be substantial.
    (e) Assistance furnished by a related person or persons to a 
controlled foreign corporation in the form of direction, supervision, 
services, or know-how shall not be taken into account under (b) or (d) 
of this subdivision unless the assistance so furnished assists the 
controlled foreign corporation directly in the performance of the 
services performed by such corporation.
    (iii) Special rule applicable to distributive share of partnership 
income. A controlled foreign corporation's distributive share of a 
partnership's services income will be deemed to be derived from services 
performed for or on behalf of a related person, within the meaning of 
section 954(e)(1)(A), if the partnership is a related person with 
respect to the controlled foreign corporation, under section 954(d)(3), 
and, in connection with the services performed by the partnership, the 
controlled foreign corporation, or a person that is a related person 
with respect to the controlled foreign corporation, provided assistance 
that would have constituted substantial assistance contributing to the 
performance of such services, under paragraph (b)(2)(ii) of this 
section, if furnished to the controlled foreign corporation by a related 
person. This paragraph (b)(2)(iii) applies to taxable years of a 
controlled foreign corporation beginning on or after July 23, 2002.
    (3) Illustrations. The application of this paragraph may be 
illustrated by the following examples:

    Example 1. Controlled foreign corporation A is paid by related 
corporation M for the installation and maintenance of industrial 
machines which M Corporation manufactures and sells to B Corporation. 
Such installation and maintenance services by A Corporation are 
performed for, or on behalf of, M Corporation for purposes of section 
954(e).
    Example 2. Controlled foreign corporation B enters into a contract 
with an unrelated person to drill an oil well in a foreign country. 
Domestic corporation M owns all the outstanding stock of B Corporation. 
Corporation B employs a relatively small clerical and administrative 
staff and owns the necessary well-drilling equipment. Most of the 
technical and supervisory personnel who oversee the drilling of the oil 
well by B Corporation are regular employees of M Corporation who are 
temporarily employed by B Corporation. In addition, B Corporation hires 
on the open market unskilled and semiskilled laborers to work on the 
drilling project. The services performed by B Corporation under the 
well-drilling contract are performed for, or on behalf of, a related 
person for purposes of section 954(e) because the services of the 
technical and supervisory personnel which are provided by M Corporation 
are of substantial assistance in the performance of such contract in 
that they assist B Corporation directly in the execution of the contract 
and provide B Corporation with skills which are a principal element in 
producing the income from the performance of such contract.
    Example 3. Controlled foreign corporation F enters into a contract 
with an unrelated person to construct a dam in a foreign country. 
Domestic corporation M owns all the outstanding stock of F Corporation. 
Corporation F leases or buys from M Corporation, on an arm's length 
basis, the equipment and material necessary for the construction of the 
dam. The technical and supervisory personnel who design and oversee the 
construction of the dam are regular full-time employees of F Corporation 
who are not on loan

[[Page 352]]

from any related person. The principal clerical work, and the financial 
accounting, required in connection with the construction of the dam by F 
Corporation are performed, on a remunerated basis, by full-time 
employees of M Corporation. All other assistance F Corporation requires 
in completing the construction of the dam is paid for by that 
corporation and furnished by unrelated persons. The services performed 
by F Corporation under the contract for the construction of the dam are 
not performed for, or on behalf of, a related person for purposes of 
section 954(e) because the clerical and accounting services furnished by 
M Corporation do not assist F Corporation directly in the performance of 
the contract.
    Example 4. Controlled foreign corporation D, a wholly owned 
subsidiary of domestic corporation M, procures and enters a contract 
with an unrelated person to construct a superhighway in a foreign 
country, but such person enters the contract only on the condition that 
M Corporation agrees to perform, or to pay for the performance by some 
person other than D Corporation of, the services called for by the 
contract if D Corporation should fail to complete their performance. 
Corporation D is capable of performing such contract. No related person 
as to D Corporation pays for, or performs, any services called for by 
the contract, or pays for, or performs, any significant services related 
to such services. The construction of the superhighway by D Corporation 
is not considered for purposes of section 954(e) to be the performance 
of services for, or on behalf of M Corporation.
    Example 5. Domestic corporation M is obligated under a contract with 
an unrelated person to construct a superhighway in a foreign country. At 
a later date M Corporation assigns the entire contract to its wholly 
owned subsidiary, controlled foreign corporation C, and the unrelated 
person releases M Corporation from any obligation under the contract. 
The construction of such highway by C Corporation is considered for 
purposes of section 954(e) to be the performance of services for, or on 
behalf of, M Corporation.
    Example 6. Domestic corporation M enters a contract with an 
unrelated person to construct a superhighway in a foreign country. 
Corporation M immediately assigns the entire contract to its wholly 
owned subsidiary, controlled foreign corporation C. The unrelated person 
does not release M Corporation of its obligation under the contract, the 
sole purpose of these arrangements being to have M Corporation guarantee 
performance of the contract by C Corporation. Corporation C is capable 
of performing the construction contract. Neither M Corporation nor any 
other person related to C Corporation pays for, or performs, any 
services called for by the construction contract or at any time pays 
for, or performs, any significant services related to the services 
performed under such contract. The construction of the superhighway by C 
Corporation is not considered for purposes of section 954(e) to be the 
performance of services for, or on behalf of, M Corporation.
    Example 7. The facts are the same as in example 6 except that M 
Corporation, preparatory to entering the construction contract, prepares 
plans and specifications which enable the submission of bids for the 
contract. Since M Corporation has performed significant services related 
to the services the performance of which it has guaranteed, the 
construction of such highway by C Corporation is considered for purposes 
of section 954(e) to be the performance of services for, or on behalf 
of, M Corporation.
    Example 8. Domestic corporation M manufactures an industrial machine 
which requires specialized installation. Corporation M sells the 
machines for a basic price if the contract of sale contains no provision 
for installation. If, however, the customer agrees to employ controlled 
foreign corporation E, a wholly owned subsidiary of M Corporation, to 
install the machine and to pay E Corporation a specified installation 
charge, M Corporation sells the machine at a price which is less than 
the basic price. The installation services performed by E Corporation 
for customers of M Corporation purchasing the machine at the reduced 
price are considered for purposes of section 954(e) to be performed for, 
or on behalf of, M Corporation.
    Example 9. Domestic corporation M manufactures and sells industrial 
machines with a warranty as to their performance conditional upon their 
installation and maintenance by a factory-authorized service agency. 
Controlled foreign corporation F, a wholly owned subsidiary of M 
Corporation, is the only authorized service agency. Any installation or 
maintenance services performed by F Corporation on such machines are 
considered for purposes of section 954(e) to be performed for, or on 
behalf of, M Corporation.
    Example 10. Domestic corporation M manufactures electric office 
machines which it sells at a basic price without any provision for, or 
understanding as to, adjustment or maintenance of the machines. The 
machines require constant adjustment and maintenance services which M 
Corporation, certain wholly owned subsidiaries of M Corporation, and 
certain unrelated persons throughout the world are qualified to perform. 
From among the numerous persons qualified and available to perform 
adjustment and maintenance services with respect to such office 
machines, foreign corporation B, a customer of M Corporation, employs 
controlled foreign corporation G, a wholly owned subsidiary of M 
Corporation, to adjust and maintain the office machines which B 
Corporation purchases from M Corporation. The adjustment and maintenance 
services performed by G

[[Page 353]]

Corporation for B Corporation are not considered for purposes of section 
954(e) to be performed for, or on behalf of, M Corporation.

    (c) Place where services are performed. The place where services 
will be considered to have been performed for purposes of paragraph 
(a)(2) of this section will depend on the facts and circumstances of 
each case. As a general rule, services will be considered performed 
where the persons performing services for the controlled foreign 
corporation which derives income in connection with the performance of 
technical, managerial, architectural, engineering, scientific, skilled, 
industrial, commercial, or like services are physically located when 
they perform their duties in the execution of the service activity 
resulting in such income. Therefore, in many cases, total gross income 
of a controlled foreign corporation derived in connection with each 
service contract or arrangement performed for or on behalf of a related 
person must be apportioned, between income which is not foreign base 
company services income and that which is foreign base company services 
income, on a basis of employee-time spent within the foreign country 
under the laws of which the controlled foreign corporation is created or 
organized and employee-time spent without the foreign country under the 
laws of which such corporation is created or organized. In allocating 
time spent within and without the foreign country under the laws of 
which the controlled foreign corporation is created or organized, 
relative weight must also be given to the value of the various functions 
performed by persons in fulfillment of the service contract or 
arrangement. For example, clerical work will ordinarily be assigned 
little value, while services performed by technical, highly skilled, and 
managerial personnel will be assigned greater values in relation to the 
type of function performed by each individual.
    (d) Items excluded. Foreign base company services income does not 
include--
    (1) Income derived in connection with the performance of services by 
a controlled foreign corporation if--
    (i) The services directly relate to the sale or exchange of personal 
property by the controlled foreign corporation,
    (ii) The property sold or exchanged was manufactured, produced, 
grown, or extracted by such controlled foreign corporation, and
    (iii) The services were performed before the sale or exchange of 
such property by the controlled foreign corporation;
    (2) Income derived in connection with the performance of services by 
a controlled foreign corporation if the services directly relate to an 
offer or effort to sell or exchange personal property which was, or 
would have been, manufactured, produced, grown, or extracted by such 
controlled foreign corporation whether or not a sale or exchange of such 
property was in fact consummated; or
    (3) For taxable years beginning after December 31, 1975, foreign 
base company shipping income (as determined under Sec. 1.954-6).

[T.D. 6734, 29 FR 6399, May 15, 1964, as amended by T.D. 6981, 33 FR 
16497, Nov. 13, 1968; T.D. 7893, 48 FR 22523, May 19, 1983; T.D. 9008, 
67 FR 48025, July 23, 2002]



Sec. 1.954-5  Increase in qualified investments in less developed
countries; taxable years of controlled foreign corporations beginning
before January 1, 1976.

    For rules applicable to taxable years of controlled foreign 
corporations beginning before January 1, 1976, see section 954(b)(1) (as 
in effect before the enactment of the Tax Reduction Act of 1975) and 26 
CFR 1.954-5 (Revised as of April 1, 1975).

[T.D. 7893, 48 FR 22508, May 19, 1983]



Sec. 1.954-6  Foreign base company shipping income.

    (a) Scope--(1) In general. This section prescribes rules for 
determining foreign base company shipping income under the provisions of 
section 954(f), as amended by the Tax Reduction Act of 1975.
    (2) Effective date. (i) The rules prescribed in this section apply 
to taxable years of foreign corporations beginning after December 31, 
1975, and to taxable years of United States shareholders (as defined in 
section 951 (b)) within which

[[Page 354]]

or with which such taxable years of such foreign corporations end.
    (ii) Except as described in paragraph (b)(1)(viii) of this section, 
foreign base company shipping income does not include amounts earned by 
a foreign corporation in a taxable year of such corporation beginning 
before January 1, 1976. See example 1 of paragraph (g)(2) of this 
section for an illustration of the effect of this subparagraph on 
partnership income. See example 3 of paragraph (f)(4)(ii) of this 
section for an illustration of the effect of this subparagraph on 
certain dividend income. See paragraph (f)(5)(iii) of this section for 
the effect of this subparagraph on certain interest and gains.
    (b) Definitions--(1) Foreign base company shipping income. The term 
``foreign base company shipping income'' means--
    (i) Gross income derived from, or in connection with, the use (or 
hiring or leasing for use) of any aircraft or vessel in foreign commerce 
(see paragraph (c) of this section),
    (ii) Gross income derived from, or in connection with, the 
performance of services directly related to the use of any aircraft or 
vessel in foreign commerce (see paragraph (d) of this section),
    (iii) Gross income incidental to income described in subdivisions 
(i) and (ii) of this subparagraph, as provided in paragraph (e) of this 
section,
    (iv) Gross income derived from the sale, exchange, or other 
disposition of any aircraft or vessel used or held for use (by the 
seller or by a person related to the seller) in foreign commerce,
    (v) In the case of a controlled foreign corporation, dividends, 
interest, and gains described in paragraph (f) of this section,
    (vi) Income described in paragraph (g) of this section (relating to 
partnerships, trusts, etc.),
    (vii) Exchange gain, to the extent allocable to foreign base company 
shipping income (see Sec. 1.952-2(c)(2)(v)(b), and
    (viii) In the case of a controlled foreign corporation and at its 
option, dividends, interest, and gains attributable to income derived 
from aircraft and vessels (as defined in 26 CFR 1.954-1(b)(2) (Revised 
as of April 1, 1975)) by a less developed country shipping company 
(described in Sec. 1.955-5(b)) in taxable years beginning after 
December 31, 1962, and before January 1, 1976. The portion of a 
dividend, interest, or gain attributable to such income shall be 
determined by the same method as that for determining the portion of a 
dividend, interest, or gain attributable to foreign base company 
shipping income under paragraphs (f)(4), (5), and (6) of this section, 
but without regard to paragraphs (f)(6)(ii) and (iv)(B).
    (2) Foreign base company shipping operations. For purposes of 
sections 951 through 964, the term ``foreign base company shipping 
operations'' means the trade or business from which gross income 
described in subparagraph (1)(i) and (ii) of this paragraph is derived.
    (3) Foreign commerce. For purposes of sections 951 through 964--
    (i) An aircraft or vessel is used in foreign commerce to the extent 
it is used in transportation of property or passengers--
    (A) Between a port (or airport) in the United States or possession 
of the United States and a port (or airport) in a foreign country, or
    (B) Between a port (or airport) in a foreign country and another in 
the same country or between a port (or airport) in a foreign country and 
one in another foreign country.


Thus, for example, a trawler, a factory ship, and an oil drilling ship 
are not considered to be used in foreign commerce. On the other hand, a 
cruise ship which visits one or more foreign ports is considered to be 
so used. Notwithstanding subdivision (i)(B) of this paragraph (b)(3), 
foreign base company income does not include income derived from, or in 
connection with, the use of an aircraft or vessel in transportation of 
property or passengers between a port (or airport) in a foreign country 
and another port (or airport) in the same country if both the foreign 
corporation is created or organized and the aircraft or vessel is 
registered in that country.
    (ii) The term vessel includes all water craft and other artificial 
contrivances of whatever description and at whatever stage of 
construction, whether on the stocks or launched, which are used

[[Page 355]]

or are capable of being used or are intended to be used as a means of 
transportation on water. This definition does not apply for purposes of 
section 956(b)(2)(G) and Sec. 1.956-2(b)(1)(ix).
    (iii) The term port means any place (whether on or off shore) where 
aircraft or vessels are accustomed to load or unload goods or to take on 
or let off passengers.
    (iv) Any vessel (such as a lighter or beacon lightship) which serves 
other vessels used in foreign commerce (within the meaning of 
subdivision (i) of this subparagraph) shall, to the extent so used, also 
be considered to be used in foreign commerce.
    (v) For the meaning of the term ``foreign country'', see section 
638(2).
    (4) Use in foreign commerce. For purposes of sections 951 through 
964, the use of an aircraft or vessel in foreign commerce includes the 
hiring or leasing (or subleasing) of an aircraft or vessel to another 
for use in foreign commerce. Thus, for example, an aircraft or vessel is 
``used in foreign commerce'' within the meaning of section 955(b)(1)(A) 
if such aircraft or vessel is chartered (whether pursuant to a bareboat 
charter, time charter, or otherwise) to another for use in foreign 
commerce.
    (5) Related person. With respect to a controlled foreign 
corporation, the term ``related person'' means a related person as 
defined in Sec. 1.954-1(e)(1), and the term ``unrelated person'' means 
an unrelated person as defined in Sec. 1.954-1(e)(2).
    (c) Aircraft or vessel income--(1) In general. The term ``income 
derived from, or in connection with, the use (or hiring or leasing for 
use) of any aircraft or vessel in foreign commerce'' as used in 
paragraph (b)(1)(i) of this section means--
    (i) Income derived from transporting passengers or property by 
aircraft or vessel in foreign commerce and
    (ii) Income derived from hiring or leasing an aircraft or vessel to 
another for use in foreign commerce.
    (2) Illustrations. The application of this paragraph may be 
illustrated by the following examples:

    Example 1. Foreign corporation C owns a foreign flag vessel which it 
charters under a long-term charter to foreign corporation D. The vessel 
is used by D as a tramp which has no fixed or regular schedule. The 
vessel carries bulk and packaged cargoes, as well as occasional 
passengers, under charter parties, contracts of affreightment, or other 
contracts of carriage. The carriage of cargoes and passengers is between 
a port in the United States and a port in a foreign country or between a 
port in one foreign country and another port in the same or a different 
foreign country. The charter hire paid to C by D constitutes income 
derived from the use of the vessel in foreign commerce, but is not 
foreign base company income to the extent the charter hire is allocable 
to income derived from the use of the vessel between ports in the same 
foreign country in which both C is incorporated and the vessel is 
registered. The charter hire and freight and passenger revenue 
(including demurrage and dead freight) derived by D also constitute 
income derived from the use of the vessel in foreign commerce, but is 
not foreign base company income to the extent the charter hire and 
freight and passenger revenue are allocable to the use of the vessel 
between ports in the same foreign country in which both D is 
incorporated and the vessel is registered.
    Example 2. (a) Foreign corporation E owns a foreign flag tanker 
which it charters under a long-term bareboat charter to foreign 
corporation F for use in foreign commerce. F produces oil in a foreign 
country and ships the oil to other foreign countries and to the United 
States. The vessel, when not engaged in carrying F's oil, is used to 
carry bulk cargoes for unrelated persons in foreign commerce as 
opportunity offers. The charger hire received by E constitutes income 
derived from the use of the vessel in foreign commerce. The income 
derived by F from carrying bulk cargoes for unrelated persons also 
constitutes income derived from the use of the vessel in foreign 
commerce.
    (b) F is forced to lay up the vessel as a result of adverse market 
developments. Pursuant to the terms of the charter, F continues to pay 
charter hire to E during the period of lay-up. The charter hire received 
by E during the period of lay-up constitutes income derived from the use 
of the vessel in foreign commerce.
    Example 3. (a) A shipment of cheese is loaded into a container owned 
by controlled foreign corporation S at the consignor's place of business 
in Hamar, Norway. The cheese is transported to Milan, Italy, by the 
following routings:
    (1) Overland by road from Hamar, Norway, to Gothenburg, Sweden, by 
unrelated motor carriers via Oslo, Norway,
    (2) By sea from Gothenburg to Rotterdam, Netherlands, by feeder 
vessel under foreign flag, time chartered to S by unrelated owner,

[[Page 356]]

    (3) By sea from Rotterdam to Algeciras, Spain, by feeder vessel 
under foreign flag, time chartered to S by unrelated owner.
    (4) By sea from Algeciras to Genoa, Italy, by line-haul vessel under 
U.S. flag, chartered by S from related company, and
    (5) Overland from Genoa to Milan, Italy, by unrelated motor carrier.
    (b) The consignor pays S total charges of $1,710, and S pays $676 to 
unrelated third parties, which amounts may be broken down as follows:

------------------------------------------------------------------------
                                                     Revenue     Costs
                                           Amount   collected   paid to
                                         billed to   by S on   unrelated
         Description of charges           customer  behalf of   3d party
                                            and         an        and
                                         collected  unrelated   absorbed
                                            by S      party       by S
------------------------------------------------------------------------
Ocean freight..........................     $1,420
Trucking charge of empty equipment to           50        $50
 shipper's facility....................
Trucking charges Hamar to Oslo.........         60         60
Trucking charges Oslo to Gothenburg....  .........  .........       $315
Trucking charges Genoa to Milan........        180        180
Brokerage Commission in Europe.........  .........  .........         71
                                        --------------------------------
    Total..............................      1,710        290        386
------------------------------------------------------------------------

    (c) Of the $1,710 amount billed to the consignor and collected by S, 
$290 is collected by S on behalf of unrelated third parties. This $290 
amount is not includable in S's gross income, and is therefore not 
includable in S's foreign base company shipping income. The remaining 
$1,420 amount (i.e., $1,710-$290) is includable in S's foreign base 
company shipping income. The $386 amount paid by S to unrelated third 
parties and absorbed by S is deductible from foreign base company 
shipping income under Sec. 1.954-1(c).

    (d) Services directly related--(1) In general. The term ``income 
derived from, or in connection with, the performance of services 
directly related to the use of an aircraft or vessel in foreign 
commerce'', as used in paragraph (b)(1)(ii) of this section, means--
    (i) Income derived from, or in connection with, the performance of 
services described in subparagraph (2) or (3) of this paragraph, and
    (ii) Income treated as foreign base company shipping income under 
subparagraph (4) of this paragraph.
    (2) Intragroup services. The services described in this subparagraph 
are services performed for a person who is the owner, lessor, lessee or 
operator of an aircraft or vessel used in foreign commerce, by such 
person or by a person related to such person, and which fall into one or 
more of the following categories:
    (i) Terminal services, such as dockage, wharfage, storage, lights, 
water, refrigeration, and similar services;
    (ii) Stevedoring and other cargo handling services;
    (iii) Container related services (including the rental of containers 
and related equipment) performed either in connection with the local 
drayage or inland haulage of cargo or in the course of transportation in 
foreign commerce;
    (iv) Services performed by tugs, lighters, barges, scows, launches, 
floating cranes, and other similar equipment;
    (v) Maintenance and repairs;
    (vi) Training of pilots and crews;
    (vii) Licensing of patents, know-how, and similar intangible 
property developed and used in the course of foreign base company 
shipping operations;
    (viii) Services performed by a booking, operating, or managing 
agent; and
    (ix) Any service performed in the course of the actual 
transportation of passengers or property.
    (3) Services for passenger, consignor, or consignee. The services 
described in this subparagraph are services provided by the operator (or 
person related to the operator) of an aircraft or vessel in foreign 
commerce for the passenger, consignor, or consignee, such as--
    (i) Services described in one or more of the categories set out in 
subparagraphs (2)(i) through (iv) and (ix) of this paragraph,
    (ii) The rental of staterooms, berths, or living accommodations and 
the furnishing of meals,
    (iii) Barber shop and other services to passengers aboard vessels,
    (iv) Excess baggage, and
    (v) Demurrage, dispatch, and dead freight.
    (4) The 70-percent test. At the option of the foreign corporation 
all the gross income for a taxable year derived by a foreign corporation 
from any facility used in connection with the performance of services 
described in one or more of the categories set out in subparagraph 
(2)(i) through (ix) of this paragraph is foreign base company

[[Page 357]]

shipping income if more than 70 percent of such gross income for 
either--
    (i) Such taxable year, or
    (ii) Such taxable year and the two preceding taxable years,


is foreign base company shipping income (determined without regard to 
this subparagraph). Thus, for example, if 80 percent of the gross income 
derived by a controlled foreign corporation at a stevedoring facility is 
treated as foreign base company shipping income under subparagraph (2) 
of this paragraph, then the remaining 20 percent is treated as foreign 
base company shipping income under this subparagraph.
    (5) Rules for applying subparagraph (4). (i) Solely for purposes of 
applying subparagraphs (4) of this paragraph, foreign base company 
shipping income and gross income shall be deemed to include an arm's 
length charge (see paragraph (h)(5) of this section) for services 
performed by the foreign corporation for itself.
    (ii) In determining whether services performed by a foreign 
corporation are performed at a single facility or at two or more 
different facilities, all of the facts and circumstances involved will 
be taken into account. Ordinarily, all services performed by a foreign 
corporation within a single port area will be considered performed at a 
single facility.
    (iii) The application of this subparagraph and subparagraph (4) of 
this paragraph may be illustrated by the following example in which it 
is assumed that the foreign corporation has chosen to apply the 70-
percent test of subparagraph (4):

    Example. (a) Controlled foreign corporation X uses the calendar year 
as the taxable year. For 1976, X is divided into two operating 
divisions, A and B. Division A operates a number of vessels in foreign 
commerce. Division B operates a terminal facility at which it performs 
services described in subparagraph (2)(i) of this paragraph for vessels 
some of which are operated by division A, some of which are operated by 
persons related to X, and some of which are operated by persons 
unrelated to X. For 1976, X includes under subparagraph (5) as foreign 
base company shipping income and gross income, for purposes of 
subparagraph (4), an arm's length charge for services performed for 
itself. For 1976, the gross income derived by division B is 
reconstructed for purposes of subparagraph (4) of this paragraph as 
follows, based on the facts shown in the following table:

(1) Gross income derived from persons unrelated to X...........      $20
(2) Gross income derived from persons related to X.............       10
                                                                --------
(3) Actual gross income (line (1) plus line (2))...............       30
(4) Hypothetical gross income derived from division A                 70
 (determined by the application of subdivision (i) of this
 subparagraph).................................................
                                                                --------
(5) Total reconstructed gross income (line (3) plus line (4))..      100
                                                                ========
 

    (b) Since 80 percent of the reconstructed gross income derived by 
division B would be treated as foreign base company shipping income 
under subparagraph (2) of this paragraph, the entire $30 amount of the 
gross income actually derived by division B is treated as foreign base 
company shipping income under subparagraph (4) of this paragraph.

    (6) Arm's length charge. For purposes of this section, the arm's 
length charge for services performed by a foreign corporation for itself 
shall be determined by applying the principles of section 482 and the 
regulations thereunder as if the party for whom the services are 
performed and the party by whom the services are performed were not the 
same person, but were controlled taxpayers within the meaning of Sec. 
1.482-1(a)(4).
    (7) Illustrations. The application of this paragraph may be 
illustrated by the following examples:

    Example 1. Controlled foreign corporation A acts as a managing agent 
for foreign corporation B, a related person which contracts to construct 
and charter a foreign flag vessel for use in foreign commerce. As 
managing agent for B, A performs a broad range of services relating to 
the use of the vessel, including arranging for, and supervising of, 
construction and chartering of the vessel, and handling of operating 
services after construction is completed. The income derived by A from 
its management and operating services constitutes income derived in 
connection with the performance of services directly related to the use 
of the vessel in foreign commerce.
    Example 2. Controlled foreign corporation C uses the calendar year 
as the taxable year. During 1976, C is engaged in the trade or business 
of acting as a steamship agent solely for unrelated persons. C's 
activities as steamship agent range from ``husbanding'' (i.e., arranging 
for fuel, supplies and port services, and attending to crew and customs 
matters) to the solicitation and booking of cargo at a number of foreign 
ports. None of C's other gross income for 1976 is foreign

[[Page 358]]

base company shipping income. Under these circumstances, C's gross 
income derived from its steamship agency does not constitute foreign 
base company shipping income.

    (e) Incidental income--(1) In general. Foreign base company shipping 
income includes all incidental income derived by a foreign corporation 
in the course of its active conduct of foreign base company shipping 
operations.
    (2) Examples. Examples of incidental income derived in the course of 
the active conduct of foreign base company shipping operations include--
    (i) Gain from the sale, exchange or other disposition of assets 
which are related shipping assets within the meaning of Sec. 1.955A-
2(b),
    (ii) Income derived from temporary investments described in Sec. 
1.955A-2(b)(2)(i) and (iii),
    (iii) Interest on accounts receivable and evidences of indebtedness 
described in Sec. 1.955A-2(b)(2)(ii),
    (iv) Income derived from granting concessions to others aboard 
aircraft or vessels used in foreign commerce,
    (v) Income derived from stock and currency futures described in 
Sec. 1.955A-2(b)(2)(vii) and (viii),
    (vi) Income derived by the lessor of an aircraft or vessel used in 
foreign commerce from additional rentals for the use of related 
equipment (such as a complement of containers), and
    (vii) Interest derived by the seller from a purchase money mortgage 
loan in respect of the sale of an aircraft or vessel described in Sec. 
1.955A-2(a)(1)(i).
    (f) Certain dividends, interest, and gain--(1) In general. (i) The 
foreign base company shipping income of a controlled foreign corporation 
(referred to in subdivision (ii)(A) of this paragraph (f)(1) as ``first 
corporation'') includes--
    (A) Dividends and interest received from foreign corporations listed 
in subdivision (ii) of this paragraph (f)(1), and
    (B) Gain recognized from the sale, exchange, or other disposition of 
stock or obligations of foreign corporations listed in subdivision (ii) 
of this paragraph (f)(1),


but only to the extent that such dividends, interest, and gains are 
attributable to foreign base company shipping income of the foreign 
corporations listed in subdivision (ii) of this paragraph (f)(1).
    (ii) The foreign corporations referred to in subdivision (i) of this 
paragraph (f)(1) are--
    (A) Foreign corporations with respect to which the first corporation 
(see subdivision (i) of this paragraph (f)(1)) would be deemed under 
section 902(b) to pay taxes,
    (B) Controlled foreign corporations which are related persons 
(within the meaning of section 954(d)(3)), and
    (C) Less developed country shipping companies described in Sec. 
1.955-5(b).
    (2) Corporation deemed to pay taxes. (i) For purposes of this 
paragraph, a controlled foreign corporation would be deemed under 
section 902(b) to pay taxes in respect of any other foreign corporation 
if such controlled foreign corporation would be deemed, for purposes of 
applying section 902(a) to any United States shareholder of such 
controlled foreign corporation, to pay taxes in respect of dividends 
which were received from such other foreign corporation (whether or not 
such other foreign corporation actually pays any taxes or dividends). 
Solely for purposes of this subdivision, each United States shareholder 
(within the meaning of section 951(b)) shall be deemed to be a domestic 
corporation.
    (ii) The application of subdivision (i) of this subparagraph may be 
illustrated by the following examples:

    Example 1. Domestic corporation M owns 100 percent of the one class 
of stock of controlled foreign corporation X, which in turn owns 40 
percent of the one class of stock of foreign corporation Y. Y is not a 
controlled foreign corporation. For purposes of subdivision (1) of this 
subparagraph, X is deemed to pay taxes in respect of Y.
    Example 2. The facts are the same as in example 1, except that 
United States shareholder A, an individual, owns 80 percent of the stock 
of corporation X, and United States shareholders B and C, parent and 
child, own the other 20 percent in equal shares. For purposes of 
applying this paragraph to all three United States shareholders (A, B, 
and C), X is deemed to pay taxes in respect of Y.

    (3) Obligation defined. For purposes of this section, the term 
``obligation'' means any bond, note, debenture, certificate, or other 
evidence of indebtedness, and a debt recorded in the books

[[Page 359]]

of account of both the creditor and the debtor. In the absence of legal, 
governmental, or business reasons to the contrary, the indebtedness must 
bear interest or be issued at a discount.
    (4) Dividends. (i) For purposes of this paragraph and Sec. 1.954-
1(b)(2), the portion of a dividend which is attributable to foreign base 
company shipping income is that amount which bears the same ratio to the 
total dividend received as the earnings and profits out of which such 
dividend is paid that are attributable to foreign base company shipping 
income bears to the total earnings and profits out of which such 
dividend is paid. For purposes of this subdivision, the source of the 
earnings and profits out of which a distribution is made shall be 
determined under section 316(a), except that the source of the earnings 
and profits out of which a distribution is made by a controlled foreign 
corporation with respect to stock owned (within the meaning of section 
958(a)) by a United States shareholder of such controlled foreign 
corporation shall be determined under Sec. 1.959-3.
    (ii) The application of this subparagraph may be illustrated by the 
following examples:

    Example 1. Domestic corporation M owns 100 percent of the one class 
of stock of controlled foreign corporation X, which in turn owns 40 
percent of the one class of stock of foreign corporation Y. Y, which is 
not (and has not been) either a controlled foreign corporation or a less 
developed country shipping company, makes a distribution of $100 to X. 
Under section 316(a), such distribution is made out of Y's earnings and 
profits for 1978. Sixty percent of Y's earnings and profits for 1978 are 
attributable to foreign base company shipping income. As a result, $60 
of the $100 distribution constitutes foreign base company shipping 
income to X under subdivision (i) of this subparagraph.
    Example 2. The facts are the same as in example 1, except that under 
section 316(a) $20 of the $100 dividend is paid out of Y's earnings and 
profits for 1979, and the other $80 is paid out of Y's earnings and 
profits for 1978. Thirty percent of Y's earnings and profits for 1979 
are attributable to foreign base company shipping income. Since 60 
percent of Y's earnings and profits for 1978 are also attributable to 
foreign base company shipping income, $54, i.e. (.60 x $80) + (.30 x 
$20), of the $100 distribution constitutes foreign base company shipping 
income to X under subdivision (i) of this subparagraph.
    Example 3. The facts are the same as in example 1 except that under 
section 316(a) the $100 dividend is made out of Y's earnings and profits 
for 1972. Since under paragraph (a)(2)(ii) of this section foreign base 
company shipping income does not include amounts earned by a foreign 
corporation (not a less developed country shipping company) in a taxable 
year beginning before January 1, 1978, no amount of such $100 
distribution constitutes foreign base company shipping income to X under 
subdivision (i) of this subparagraph.
    Example 4. Domestic corporation N owns 100 percent of the one class 
of stock of controlled foreign corporation S, which in turn owns 100 
percent of the one class of stock of controlled foreign corporation T. T 
makes a distribution of $100 to S, of which $80 is allocable under Sec. 
1.959-3 to earnings and profits for 1977 which are described in Sec. 
1.959-3(b)(2), and $20 is allocable to earnings and profits for 1978 
which are described in Sec. 1.959-3(b)(3). The $80 amount is excluded 
from S's gross income under section 959(b) and therefore is not included 
in S's foreign base company shipping income. One hundred percent of T's 
earnings and profits for 1978 described in Sec. 1.959-3(b)(3) were 
attributable to reinvested foreign base company shipping income. As a 
result, the entire $20 amount is included in S's foreign base company 
shipping income under this paragraph. See Sec. 1.954-1(b)(2) for the 
rule that such $20 amount may be excluded from the foreign base company 
income of S.

    (5) Interest and gain. (i) Except as provided in subdivisions (ii) 
and (iii) of this subparagraph, the portion of any interest paid by a 
foreign corporation, or gain recognized from the sale, exchange, or 
other disposition of stock or obligations of a foreign corporation, 
which is attributable to the foreign base company shipping income of 
such foreign corporation is that amount which bears the same ratio to 
such interest or gain as the foreign base company shipping income of 
such corporation for the period described in subparagraph (6) of this 
paragraph bears to its gross income for such period.
    (ii) Interest which is paid by a controlled foreign corporation is 
attributable to such corporation's foreign base company shipping income 
to the same extent that such interest is allocable (under the principles 
of Sec. 1.954-1(c)) to its foreign base company shipping income.
    (iii) If interest is paid by a foreign corporation, or if stock 
obligations of a

[[Page 360]]

foreign corporation are sold, exchanged, or otherwise disposed of, 
during a taxable year of such foreign corporation beginning before 
January 1, 1976, then no portion of such interest or gain is 
attributable to foreign base company shipping income.
    (iv) Solely for purposes of subdivision (i) of this subparagraph, if 
a controlled foreign corporation (the ``first corporation'') owns more 
than 10 percent of the stock of another controlled foreign corporation 
(the ``second corporation''), then
    (A) The gross income of the first corporation for any taxable year 
shall be--
    (1) Increased by its pro rata share of the gross income of the 
second corporation for the taxable year which ends with or within such 
taxable year of the first corporation, and
    (2) Decreased by the amount of any dividends received from the 
second corporation; and
    (B) The foreign base company shipping income of the first 
corporation for any taxable year shall be--
    (1) Increased by its pro rata share of the foreign base company 
shipping income of the second corporation for the taxable year which 
ends with or within such taxable year of the first corporation, and
    (2) Decreased by the amount of any dividends received from the 
second corporation which constitute foreign base company income.
    (v) Solely for purposes of applying subdivision (i) of this 
subparagraph, the district director shall make such other adjustments to 
the gross income and the foreign base company shipping income of any 
foreign corporation as are necessary to properly determine the extent to 
which any interest or gain is attributable to foreign base company 
shipping income, including proper adjustments to reflect any transaction 
during the test period described in subparagraph (6) of this paragraph 
to which section 332, 351, 354, 355, 356, or 361 applies.
    (6) Test period. (i) Except as provided in subdivisions (ii) and 
(iii) of this subparagraph the period described in this subparagraph 
with respect to any foreign corporation is the 3-year period ending with 
the close of such corporation's taxable year preceding the year during 
which interest was paid or stock or obligations were sold, exchanged, or 
otherwise disposed of, or such part of such period as such corporation 
was in existence.
    (ii) The period described in this paragraph shall not include any 
part of a taxable year beginning before January 1, 1976.
    (iii) If interest is paid by a foreign corporation, or if stock or 
obligations of a foreign corporation are sold, exchanged, or otherwise 
disposed of during its first taxable year, then the period described in 
this paragraph shall be such first taxable year.
    (iv) For purposes of subdivision (iii) of this subparagraph, the 
first taxable year of a foreign corporation is the later of--
    (A) The first taxable year of its existence, or
    (B) Its first taxable year beginning after December 31, 1975.
    (g) Income from partnerships, trusts, etc--(1) In general. The 
foreign base company shipping income of any foreign corporation 
includes--
    (i) Its distributive share of the gross income of any partnership, 
and
    (ii) Any amounts includible in its gross income under section 
652(a), 662(a), 671, or 691(a),


to the extent that such items would have been includible in its foreign 
base company shipping income had they been realized by it directly.
    (2) Illustrations. The application of subparagraph (1) of this 
paragraph may be illustrated by the following examples:

    Example 1. Controlled foreign corporations X and Y are equal 
partners in partnership P. The taxable years end on December 31 for X, 
June 30 for Y, and March 31 for P. In the fiscal year ending March 31, 
1976, P's sole business activity is the use of a vessel in foreign 
commerce. P derives gross income of $200 from the use of the vessel, and 
incurs expenses, taxes, and other deductions of $160. Assume X's 
distributive share of such

$200 of P's gross income is $100, all of which is includible in X's 
gross income. If X had realized its distributive share of $100 directly, 
then the amount which would have been includible in X's foreign base 
company shipping income under this paragraph is the portion allocable to 
the months of January, February, and March of 1976. Such amount,

[[Page 361]]

$25 (i.e., \1/2\ x $200 x 3 months/12 months), is included in X's 
foreign base company shipping income for its taxable year ending 
December 31, 1976. Similarly, X is entitled under this paragraph to a 
deduction from foreign base company shipping income of $20 (i.e., \1/2\ 
x $160 x 3 months/12 months). Since foreign base company shipping income 
does not include amounts earned by a foreign corporation (not a less 
developed country shipping corporation) in a taxable year beginning 
before January 1, 1976, Y has no foreign base company shipping income 
(under this paragraph or otherwise) for its taxable year beginning on 
July 1, 1975.
    Example 2. The facts are the same as in example 1, except that P 
incurs expenses, taxes, and deductions of $240 in its taxable year 
ending on March 31, 1976. Accordingly, $25 is includible in X's foreign 
base company shipping income, and the amount deductible therefrom under 
this paragraph is $30 (i.e., \1/2\ x $240 x 3 months/12 months).

    (3) Other income. Except as expressly provided in subparagraph (1) 
of this paragraph, foreign base company shipping income does not include 
any amount includible in the gross income of a controlled foreign 
corporation under part I of subchapter J (section 641 and following, 
relating to estates, trusts, and beneficiaries), and gains from the sale 
or other disposition of any interest in an estate or trust.
    (h) Additional rules--(1) Gross income. For purposes of this section 
and Sec. 1.955A-2, the gross income of a foreign corporation (whether 
or not a controlled foreign corporation) shall be determined in 
accordance with the provisions of section 952 and Sec. 1.952-2. Thus, 
for example, section 883 (relating to exclusions from gross income of 
foreign corporations) is inapplicable under Sec. 1.952-2 (a)(1) and 
(c)(1). In addition, the gross income of a controlled foreign 
corporation shall be determined, with respect to a United States 
shareholder of such controlled foreign corporation, by excluding 
distributions received by such corporation which are excluded from gross 
income under section 959(b) with respect to such shareholder.
    (2) Earnings and profits. For purposes of this section, the earnings 
and profits of a foreign corporation (whether or not a controlled 
foreign corporation) shall be determined in accordance with the 
provisions of section 964 and the regulations thereunder.
    (3) No double counting. No item of gross income shall be counted as 
foreign base company shipping income under more than one provision of 
this section. For example, If $200 of gross income derived from the use 
of a lighter is treated as foreign base company shipping income under 
both paragraphs (b)(1)(i) and (ii) of this section, then such $200 is 
counted only once as foreign base company shipping income. A taxpayer 
may choose under which provision to include an item of income.
    (4) Losses. (i) Generally, if a controlled foreign corporation has 
losses which are properly allocable to foreign base company shipping 
income, the extent to which such losses are deductible from such income 
shall be determined by treating such foreign corporation as a domestic 
corporation and applying the principles of section 63. See Sec. Sec. 
1.954-1(c) and 1.952-2(b). Thus for example, losses from sales or 
exchanges of capital assets are allowable only to the extent of gains 
from such sales or exchanges.
    (ii) If gain from the sale, exchange, or other disposition of any 
stock or obligation would be treated (to any extent) as foreign base 
company shipping income, then loss from such sale, exchange, or other 
disposition is properly allocable to foreign base company shipping 
income (to the same extent).
    (iii) In determining the extent to which any loss on the disposition 
of a qualified investment in foreign base company shipping operations is 
deductible from foreign base company shipping income, it is immaterial 
that such loss is taken into account under Sec. 1.955A-1(b)(1)(ii) as a 
reduction in the amount of the decrease in (withdrawal from) qualified 
investments in foreign base company shipping operations.
    (5) Hypothetical charges. Under paragraph (d)(5)(i) of this section 
and Sec. 1.955A-2(a)(4)(ii)(A), gross income may be deemed to include 
hypothetical arm's length charges for services performed by a controlled 
foreign corporation for itself. Under paragraph (d)(2) of this section, 
certain of these hypothetical charges may be treated as foreign based 
company shipping income. Such hypothetical charges are deemed

[[Page 362]]

to be income solely for purposes of applying the ``extent of use'' tests 
prescribed by paragraph (d)(4) of this section and Sec. 1.955A-2(a)(4). 
Charges for services performed by a controlled foreign corporation for 
itself shall in no event be included in income for any other purposes.

[T.D. 7894, 48 FR 22523, May 19, 1983]



Sec. 1.954-7  Increase in qualified investments in foreign base
company shipping operations.

    (a) Determination of investments at close of taxable year--(1) In 
general. Under section 954(g), the increase in qualified investments in 
foreign base company shipping operations, for purposes of section 
954(b)(2) and paragraph (b)(1) of Sec. 1.954-1, of any controlled 
foreign corporation for any taxable year is, except as provided in 
paragraph (b) of this section, the amount by which--
    (i) The controlled foreign corporation's qualified investments in 
foreign base company shipping operations at the close of the taxable 
year, exceed
    (ii) Its qualified investments in foreign base company shipping 
operations at the close of the preceding taxable year.
    (2) Preceding taxable year. For purposes of this section, a taxable 
year which begins before January 1, 1976, may be a preceding taxable 
year.
    (3) Cross-reference. See section 955 (b) and Sec. 1.955A-2 for the 
definition of the term ``qualified investments in foreign base company 
shipping operations''.
    (b) Election to determine investments at close of following taxable 
year--(1) General rule. In lieu of determining an increase in qualified 
investments in foreign base company shipping operations for a taxable 
year in the manner provided in paragraph (a) of this section, a United 
States shareholder of a controlled foreign corporation may make an 
election under section 955(b)(3) to determine the increase for the 
corporation's taxable year by ascertaining the amount by which--
    (i) Such corporation's qualified investments in foreign base company 
shipping operations at the close of the taxable year immediately 
following such taxable year, exceed
    (ii) Its qualified investments in foreign base company shipping 
operations at the close of the taxable year immediately preceding such 
following taxable year.
    (2) Election with respect to first taxable year. Notwithstanding 
subparagraph (1) of this paragraph, if an election is made without 
consent by a United States shareholder under Sec. 1.955A-4 (b)(1) with 
respect to a controlled foreign corporation, the increase in such 
controlled foreign corporation's qualified investments in foreign base 
company shipping operations for the first taxable year to which such 
election applies shall be the amount by which--
    (i) Such corporation's qualified investments in foreign base company 
shipping operations at the close of the taxable year immediately 
following such first taxable year, exceed
    (ii) Its qualified investments in foreign base company shipping 
operations at the close of the taxable year immediately preceding such 
first taxable year.
    (3) Manner of making election. For the manner of making an election 
under section 955(b)(3), and for rules pertaining to the revocation of 
such an election, see Sec. 1.955A-4.
    (4) Coordination with prior law. If a United States shareholder 
makes an election without consent under Sec. 1.955A-4(b)(1) with 
respect to a controlled foreign corporation, then such corporation's 
increase in qualified investments in foreign base company shipping 
operations for the first taxable year to which such election applies 
shall be determined by disregarding any change which occurs during such 
taxable year in the amount of such corporation's investments in stock or 
obligations of a less developed country shipping company described in 
Sec. 1.955-5 (b) if both of the following conditions exist:
    (i) Such taxable year is the first taxable year of such corporation 
which begins after December 31, 1975, and
    (ii) Such United States shareholder has elected to determine the 
change in such corporation's qualified investments in less developed 
countries for its last taxable year beginning before January 1, 1976, 
under Sec. 1.954-5(b) or Sec. 1.955-3.

[[Page 363]]

    (5) Illustrations. The application of this paragraph may be 
illustrated by the following examples:

    Example 1. (a) Controlled foreign corporation X is a wholly owned 
subsidiary of domestic corporation M. X uses the calendar year as the 
taxable year. The amounts of X's qualified investments in foreign base 
company shipping operations at the close of 1975 through 1979 are as 
follows:

Qualified investments at December 31, 1975.................      $16,000
Qualified investments at December 31, 1976.................       17,000
Qualified investments at December 31, 1977.................       23,000
Qualified investments at December 31, 1978.................       28,000
Qualified investments at December 31, 1979.................       30,000
 

    (b) Assume that M properly files without consent a timely election 
under Sec. 1.955A-4(b)(1) to determine X's increase for 1976 in 
qualified investments in foreign base company shipping operations 
pursuant to this paragraph, and that the election remains in force 
through 1978. Then X's increases for 1976 through 1978 in qualified 
investments in foreign base company shipping operations are as follows:

Increase for 1976 ($23,000 minus $16,000).....................    $7,000
Increase for 1977 ($28,000 minus $23,000).....................     5,000
Increase for 1978 ($30,000 minus $28,000).....................     2,000
 

    Example 2. Assume the same facts as in example 1, except that M 
never files an election under Sec. 1.955A-4(b)(1). X's increases for 
1976 through 1978 in qualified investments in foreign base company 
shipping operations are as follows:

Increase for 1976 ($17,000 minus $16,000).....................    $1,000
Increase for 1977 ($23,000 minus $17,000).....................     6,000
Increase for 1978 ($28,000 minus $23,000).....................     5,000
 

    Example 3. The facts are the same as in example 1, except that X's 
qualified investments in foreign base company shipping operations 
include an investment in less developed country shipping companies 
described in Sec. 1.955-5(b) of $500 on December 31, 1975, and $750 on 
December 31, 1976. Assume further that M has made an election under 
section 955(b)(3) (as in effect before the enactment of the Tax 
Reduction Act of 1975) with respect to X's taxable year 1975. Then X's 
increase in qualified investments in foreign base company shipping 
operations for 1976 is $6,750 (i.e., $7,000-$250).

    (c) Illustration. The application of this section may be illustrated 
by the following example:

    Example. (a) Controlled foreign corporation X uses the calendar year 
as the taxable year. On December 31, 1975, X's qualified investments in 
foreign base company shipping operations (determined as provided in 
Sec. 1.955A-2(g)) consist of the following amounts:

Cash.........................................................     $6,000
Readily marketable securities................................      1,000
Stock of related controlled foreign corporations.............      4,000
Traffic and other receivables................................     14,000
Marine insurance claims receivables..........................      1,000
Foreign income tax refunds receivable........................      1,000
Prepaid shipping expenses and shipping inventories ashore....      1,000
Vessel construction funds....................................          0
Vessels......................................................    123,000
Vessel plans and construction in progress....................      3,000
Containers and chassis.......................................          0
Terminal property and equipment..............................      2,000
Shipping office (land and building)..........................      1,000
Vessel spare parts ashore....................................      1,000
Performance deposits.........................................      2,000
Deferred charges.............................................      2,000
Stock of less developed country shipping company described in     10,000
 Sec. 1-955-5(b)...........................................
                                                              ----------
                                                                 172,000
                                                              ==========
 

    (b) On December 31, 1976, X's qualified investments in foreign base 
company shipping operations (determined as provided in Sec. 1.955A-
2(g)) consists of the following amounts:

Cash.........................................................     $5,000
Readily marketable securities................................      2,000
Stock of related controlled foreign corporations.............      4,000
Traffic and other receivables................................     16,000
Foreign income tax refunds receivable........................      3,000
Prepaid shipping expenses and shipping inventories ashore....      2,000
Vessel construction funds....................................      1,000
Vessels......................................................    117,000
Vessel plans and construction in progress....................     12,000
Containers and chassis.......................................      4,000
Terminal property and equipment..............................      2,000
Shipping office (land and building)..........................      1,000
Vessel spare parts ashore....................................      1,000
Performance deposits.........................................      2,000
Deferred charges.............................................      2,000
Stock of less developed country shipping company described in          0
 Sec. 1.955-5(b)...........................................
                                                              ----------
                                                                 174,000
                                                              ==========
 

    (c) For 1976, X's increase in qualified investments in foreign base 
company shipping operations is $2,000, which amount is determined as 
follows:

Qualified investments at Dec. 31, 1976.......................   $174,000
Qualified investments at Dec. 31, 1975.......................    172,000
                                                              ----------
    Increase for 1976........................................      2,000
 


[T.D. 7894, 48 FR 22528, May 19, 1983]



Sec. 1.954-8  Foreign base company oil related income.

    (a) Foreign base company oil related income--(1) In general. Under 
section 954(g), the foreign base company oil related income of a 
controlled foreign corporation (except as provided under paragraph (b) 
of this section) consists of the items of foreign oil related income 
(``FORI'') described in section 907(c)(2) and (3), other than such 
income derived from a source within a foreign country in connection 
with--

[[Page 364]]

    (i) Oil or gas which was extracted from an oil or gas well located 
in that foreign country (``extraction exception''), or
    (ii) Oil, gas, or a primary product of oil or gas which is sold by 
the controlled foreign corporation or a related person for use or 
consumption within that country or is loaded in that country on a vessel 
or aircraft as fuel for the vessel or aircraft (``use or consumption 
exception'').


A taxpayer claiming the use or consumption exception must establish its 
applicability on the basis of facts and circumstances. For special rules 
for applying the extraction exception, see paragraph (c) of this 
section.
    (2) Source of income. The source of foreign base company oil related 
income is determined generally under the principles of Sec. Sec. 1.861-
1 to 1.863-5. See Sec. 1.863-6. Thus, income from the performance of a 
service generally is sourced in the country where the service is 
performed. See Sec. 1.861-4. Underwriting income from insuring a 
foreign oil related activity is sourced at the location of the risk. See 
section 861(a)(7) and Sec. 1.953-2.
    (3) Primary product. The term ``primary product'' of oil or gas has 
the meaning given this term by Sec. 1.907(c)-1(d)(5) and (6).
    (4) Vessel. For the definition of the term ``vessel'', see Sec. 
1.954-6(b)(3)(ii).
    (5) Foreign country. For purposes of this section, the term 
``foreign country'' has the same meaning as in section 638 (relating to 
continental shelf areas). Thus, for example, oil or gas extracted from a 
sea area will be deemed to be extracted in the country which has 
exclusive rights of exploitation of natural resources with respect to 
that area if the other conditions of section 638 are met.
    (6) Country of use or consumption. For rules for determining the 
country of use or consumption, see Sec. 1.954-3(a)(3)(ii).
    (7) Insurance income. For purposes of this section, income derived 
from or attributable to insurance of section 907(c)(2) activities means 
taxable income as defined in section 832(a) and as modified by the 
principles of Sec. 1.953-4 (other than as the section is applied to 
life insurance).
    (8) Fuel product. For purposes of this section, the term ``fuel 
product'' means oil, gas or a primary product of oil or gas.
    (9) Effective date. The provisions of section 954(g) and this 
section are applicable to taxable years of foreign corporations 
beginning on or after January 1, 1983, and to taxable years of United 
States shareholders in which or with which those taxable years of 
foreign corporations end.
    (b) Exemption for small oil producers--(1) In general. Foreign base 
company oil related income does not include any income of a foreign 
corporation which is not a large oil producer.
    (2) Large oil producer. A corporation is a large oil producer 
(within the meaning of section 954(g)(2)) if the average daily 
production (extraction) of foreign crude oil and natural gas by the 
related group which includes the corporation and related persons (within 
the meaning of section 954(d)(3)) for the taxable year or immediately 
preceding taxable year is 1,000 or more barrels. The average daily 
production of foreign crude oil or natural gas for any taxable year (and 
the conversion of cubic feet of natural gas into barrels) is determined 
under rules similar to the rules of section 613A, except that only crude 
oil or natural gas from a well located outside the United States is 
taken into account.
    (c) Special rules for applying the extraction exception of paragraph 
(a)(1)(i) of this section--(1) Refining income described in section 
907(c)(2)(A). With regard to a controlled foreign corporation's refining 
income from the processing of minerals extracted (by the taxpayer or by 
any other person) from oil or gas wells into their primary products, as 
described in section 907(c)(2)(A), a pro rata method will be applied for 
purposes of determining the part of the refining income that qualifies 
for the extraction exception of paragraph (a)(1)(i) of this section. The 
pro rata method will be based on the proportion that the barrels of the 
fuel product extracted in the country of processing bears to the total 
barrels of the fuel product processed in that country and will apply 
regardless of the country of sale of the primary product.

[[Page 365]]

    (2) Marketing income described in section 907(c)(2)(C). With regard 
to a controlled foreign corporation's marketing income from the 
distribution or sale of minerals extracted from oil or gas wells or of 
primary products, as described in section 907(c)(2)(C), a pro rata 
method will be applied for purposes of determining the part of the 
marketing income that qualifies for the extraction exception of 
paragraph (a)(1)(i) of this section. When applying the pro rata method 
to the sale of a fuel product other than a primary product, the pro rata 
method will be based on the proportion that the barrels of the fuel 
product extracted in the country of sale bears to the total barrels of 
the fuel product sold in that country. When applying the pro rata method 
to the sale of primary products, the method will be based on the 
proportion that the barrels of the fuel product extracted in the country 
of sale bears to the total barrels of the fuel product processed. For 
purposes of applying the pro rata method, data of the controlled foreign 
corporation's related group (as defined in section 954(g)(2)(C)) will be 
taken into account. The pro rata method will not apply, however, if the 
mineral or primary product is purchased by the controlled foreign 
corporation from a person not within the controlled foreign 
corporation's related group. In that situation, the marketing income 
will be presumed to qualify for the extraction exception if the country 
of the source of the marketing income is a net exporter of crude oil or 
gas, whichever is relevant. If the country of the source of the 
marketing income is not a net exporter of crude oil or gas, whichever is 
relevant, the marketing income will be presumed not to qualify for the 
extraction exception. The controlled foreign corporation may, however, 
rebut this latter presumption by demonstrating on the basis of all the 
facts and circumstances that its marketing income does qualify for the 
extraction exception. If a primary product that is acquired from a 
person within the controlled foreign corporation's related group is 
commingled with like products acquired from persons not within that 
related group, the pro rata method based on the proportion that the 
barrels of the fuel product extracted in the country of sale bears to 
the total barrels of the fuel product processed will be applied to that 
portion of the total products sold that was purchased from persons 
within the related group, to the extent that that person did not sell 
product purchased from an unrelated person, and either the presumption 
or facts and circumstances will determine the characterization of the 
remainder.
    (3) Transportation income described in section 907(c)(2)(B). With 
regard to a controlled foreign corporation's income from the 
transportation of minerals from oil and gas wells or of primary 
products, as described in section 907(c)(2)(B), the rules set forth in 
paragraph (c)(2) of this section will apply for purposes of determining 
the part of the transportation income that qualifies for the extraction 
exception of paragraph (a)(1)(i) of this section.
    (4) Illustrations. The following examples illustrate the application 
of this paragraph.

    Example 1. Controlled foreign corporation M has a refinery in 
foreign country A that refines 250x barrels of oil during its taxable 
year beginning in 1984. It is determined that 125x barrels of its 250x 
barrels were extracted in country A. M sold 150x barrels of its 250x 
barrels in country A for consumption in country A which resulted in 
$225x of income from refining and $225x of marketing income, as 
described in section 907(c)(2)(C). M also sold within foreign country B, 
for consumption in country B, 100x barrels of its 250x barrels which 
resulted in an additional $150x of income from refining for M and $170x 
of marketing income for M. The 100x barrels sold by M within country B, 
a contiguous country, were transported from M's refinery in country A to 
country B by a pipeline which is owned by M, and M recognized a total of 
$10x of income from the transportation of the 100x barrels. Of this 
$10x, $8x was recognized in country A and $2x was recognized in country 
B. Under the source of income rules of paragraph (a)(2) of this section, 
income from refining is considered derived from the country in which the 
refining occurs and not from the country where the sale of the refined 
product occurs.
    (i) M's refining income. M has $75x of foreign base company oil 
related income with respect to its refining of the 250x barrels, 
determined as follows:
(A) Total amount of income from refining attributable to oil refined in 
country A by M.....................................................$375x
(B) Amount of income from refining

[[Page 366]]

with respect to oil sold for consumption ($225x) in country A (use or 
consumption exception under paragraph (a)(1)(ii) of this section 
                                                                  (225x)
(C) Pro rate amount of income from refining attributable to sales in 
country B considered extracted from country A ($150x times 125x barrels/
250x barrels) (extraction exception under paragraph (a)(1)(i) of this 
section..........................................................(75x)..
(D) Foreign base company oil related income.......................$75x..
    (ii) M's marketing income. M does not have foreign base company oil 
related income with respect to its sale of the 100x barrels in country B 
and 150x barrels in country A because the $170x and $225x, respectively, 
of marketing income was derived from the country in which the oil was 
sold for consumption (an exception under paragraph (a)(1)(ii) of this 
section).
    (iii) M's transportation income. M does not have foreign base 
company oil related income with respect to its $2x of pipeline 
transportation income recognized in country B because the income was 
derived from the country in which the 100x barrels were sold for 
consumption, an exception under paragraph (a)(1)(ii) of this section. 
With regard to the $8x of pipeline transportation income recognized in 
country A, however, M has $4x of foreign base company oil related income 
since of the total barrels refined in country A (250x) only one-half 
were extracted in that country. Therefore, only one-half of the 
transportation income qualifies for the extraction exception of 
paragraph (a)(1)(i) of this section.
    (iv) M's extraction income. M does not have foreign base company oil 
related income for its extraction activity because extraction income is 
excluded in all events. See section 954(g)(1)(A).
    Example 2. Assume the same facts as in Example 1 except that M sold 
all of the 250x barrels of refined oil in country A. In addition, assume 
that country A is a net exporter of crude oil. As in Example 1, M sold 
150x barrels for consumption in country A with the same resulting 
income. M sold in country A the remaining 100x barrels to unrelated 
controlled foreign corporation N which resulted in an additional $150x 
of income from refining for M and $170x of marketing income for M. N 
immediately resold in country A for export those 100x barrels. N did not 
commingle the 100x barrels with any other refined oil. N earned $10x of 
marketing income on that sale.
    (i) M's refining income. M has $75x foreign base company oil related 
income with respect to its refining of the 250x barrels determined as 
follows:
(A) Total amount of income from refining attributable to oil refined in 
country A by M.....................................................$375x
(B) Amount of income from refining with respect to oil sold for 
consumption ($225x) in country A (use or consumption exception under 
paragraph (a)(1)(ii) of this section).............................(225x)
(C) Pro rata amount of income from refining attributable to sales in 
country A (for consumption outside of country A) considered extracted 
from country A ($150x times 125x barrels/250x barrels) (extraction 
exception under paragraph (a)(1)(i) of this section).............(75x)..
(D) Foreign base company oil related income.......................$75x..
    (ii) M's marketing income. M does not have foreign base company oil 
related income with respect to its marketing income from the sale of the 
150x barrels in country A because the $225x of marketing income was 
derived from the country in which the oil was sold for consumption (an 
exception under paragraph (a)(1)(ii) of this section). M has $85x of 
foreign base company oil related income with respect to its marketing 
income from sale to N of the 100x barrels, determined as follows:
(A) Total amount of marketing income from the sale.................$170x
(B) Pro rata amount of marketing income attributable to oil product 
considered extracted in country A ($170x times 125x barrels/250x 
barrels) (extraction exception under paragraph (a)(1)(i) of this 
section).........................................................(85x)..
(C) Foreign base company oil related income.......................$85x..
    (iii) N's marketing income. N is not related to M. Therefore, since 
N sold the 100x barrels in country A, a net exporter of crude oil, and 
since N did not commingle the 100x barrels with other refined products, 
it is presumed that all of the 100x barrels were extracted in country A. 
Accordingly, all of N's $10x of marketing income is excepted under 
paragraph (a)(1)(i) of this section.
    Example 3. Assume the same facts as in Example 2 except that N is 
related to M. Characterization of M's income remains the same as in 
Example 2. N will have, however, $5x of foreign base company oil related 
income with regard to its marketing income, determined as follows:
(i) Total amount of marketing income from the sale..................$10x
(ii) Pro rata amount of marketing income considered extracted from 
country A ($10x times 125x barrels/250x barrels) (extraction exception 
under paragraph (a)(1)(i) of this section)..........................5x..
(iii) Foreign base company oil related income......................$5x..

[[Page 367]]

    Example 4. Assume that controlled foreign corporation M has a 
refinery in foreign country A that refines 200x barrels of oil during 
its taxable year beginning in 1984. It is determined that 100x barrels 
of that oil were extracted in country A and that the other 100x barrels 
were extracted in country B. Neither country A nor country B is a net 
exporter of crude oil. In addition, M purchased from an unrelated 
country A refiner 100x barrels of already refined oil. M does not know 
where this oil was extracted. These 100x barrels of purchased refined 
oil were commingled with the 200x barrels of refined oil from M's 
refinery. M sold 225x barrels of refined oil in country A for 
consumption in country A which resulted in $250x of income from refining 
and $225x of marketing income. M sold within foreign country B for 
consumption outside of country B 75x barrels of refined oil which 
resulted in $100x of income from refining and $75x of marketing income. 
The refined product was transported between country A and country B by 
an unrelated person.
    (i) M's refining income. With regard to the sales in country A, M 
has $50x of foreign base company oil related income with respect to its 
refining of the 100x barrels, determined as follows:
(A) Total amount of income from refining attributable to oil refined in 
country A by M.....................................................$350x
(B) Amount of income from refining with respect to oil sold for 
consumption in country A ($250x) (use or consumption exception under 
paragraph (a)(1)(ii) of this section).............................(250x)
(C) Pro rata amount of income from refining attributable to sales in 
country B considered extracted from country A ($100x times 100x barrels/
200x barrels) (extraction exception under paragraph (a)(1)(i) of this 
section).........................................................(50x)..
(D) Foreign base company oil related income.......................$50x..
    (ii) M's marketing income. Since the barrels from M's refinery and 
those that M purchased were commingled, a portion, as follows, of the 
marketing income is deemed to derive from both purchased and refined 
products. Since M refined 200x barrels and purchased 100x barrels, its 
marketing income of $225x from the sale of the 225x barrels in country A 
for consumption in country A will be deemed to consist of $150x (200x/
300x x $225x) from the sale of products refined by M and $75x (100x/300x 
x $225x) from the sale of purchased products. Likewise, its marketing 
income of $75x from the sale of the 75x barrels in country B for 
consumption outside of country B will be deemed to consist of $50x 
(200x/300x x $75x) from the sale of products refined by M and $25x 
(100x/300x x $75x) from the sale of purchased products.
    (A) Purchased products. M is considered as having $75x of marketing 
income from the sale of purchased products in country A for consumption 
in country A. None of this marketing income is foreign base company oil 
related income since the marketing income is earned in country A, the 
country of consumption. See paragraph (a)(1)(ii) of this section. All of 
the $25x of M's marketing income from the sale of purchased products in 
country B will be foreign base company oil related income. The exception 
at paragraph (a)(1)(ii) of this section does not apply since the refined 
oil is not sold for use or consumption in country B. Likewise, the 
extraction exception under paragraph (a)(1)(i) of this section does not 
apply. The purchased product cannot be presumed to be extracted in 
country B since country B is not a net exporter of crude oil. In 
addition, M cannot show, on a facts and circumstances basis, that 
purchased products were refined from crude oil extracted in country B.
    (B) Products refined by M. With regard to M's marketing income 
attributable to the sale of products refined by M, M does not have any 
foreign base company oil related income with regard to its $150x of 
marketing income in country A since that income was derived from the 
country in which the oil was sold for consumption (the use or 
consumption exception under paragraph (a)(1)(ii) of this section). M has 
$25x of foreign base company oil related income with regard to its $50x 
of marketing income in country B determined as follows:
(1) Total amount of income from marketing attributable to oil refined by 
M and sold in country B.............................................$50x
(2) Pro rata amount of income from marketing attributable to sales in 
country B considered extracted from country B ($50x times 100x barrels/
200x barrels) (extraction exception under paragraph (a)(1)(i) of this 
section).........................................................(25x)..
(3) Foreign base company oil related income.......................$25x..

[T.D. 8331, 56 FR 2847, Jan. 25, 1991; 56 FR 11511, Mar. 19, 1991]



Sec. 1.955-0  Effective dates.

    (a) Section 955 as in effect before the enactment of the Tax 
Reduction Act of 1975--(1) In general. In general, Sec. Sec. 1.955-1 
through 1.955-6 are applicable with respect to withdrawals of previously 
excluded subpart F income from qualified investment in less developed 
countries for taxable years of foreign corporations beginning after 
December 31, 1962, and to taxable years of United States shareholders 
(as defined in section 951(b)) within which or with which such

[[Page 368]]

taxable years of such foreign corporations end. However, such sections 
are effective with respect to withdrawals of amounts invested in less 
developed country shipping companies described in section 955(c)(2) (as 
in effect before the enactment of the Tax Reduction Act of 1975) only 
for taxable years of foreign corporations beginning before January 1, 
1976, and for taxable years of United States shareholders (as defined in 
section 951(b)) within which or with which such taxable years of such 
foreign corporations end. For rules applicable to withdrawals of amounts 
invested in less developed country shipping companies described in 
section 955(c)(2) (as in effect before such enactment), in taxable years 
of foreign corporations beginning after December 31, 1975, see section 
955(b)(5) (as amended by such Act) and Sec. Sec. 1.955A-1 through 
1.955A-4.
    (2) References. Except as otherwise provided therein, all references 
contained in Sec. Sec. 1.955-1 through 1.955-6 to section 954 or 955 or 
to the regulations under section 954 are to those sections and 
regulations as in effect before the enactment of the Tax Reduction Act 
of 1975. For regulations under section 954 (as in effect before such 
enactment), see 26 CFR Sec. 1.954-1 through 1.954-5 (Revised as of 
April 1, 1975). For taxable years of foreign corporations beginning 
after December 31, 1975, and for taxable years of United States 
shareholders (as described in section 951(b)) within which or with which 
such taxable years of such foreign corporations end, the definitions of 
less developed countries and less developed country corporations 
contained in section 902(d) (as amended by such Act) and Sec. 1.902-2 
apply for purposes of determining the credit for corporate stockholders 
in foreign corporations under section 902.
    (b) Section 955 as amended by the Tax Reduction Act of 1975. Except 
as otherwise provided therein, Sec. Sec. 1.955A-1 through 1.955A-4 are 
applicable to taxable years of foreign corporations beginning after 
December 31, 1975, and to taxable years of United States shareholders 
(as defined in section 951(b)) within which or with which such taxable 
years of such foreign corporations end.

[T.D. 7893, 48 FR 22508, May 19, 1983, as amended by T.D. 7894, 48 FR 
22529, May 19, 1983]



Sec. 1.955-1  Shareholder's pro rata share of amount of previously
excluded subpart F income withdrawn from investment in less
developed countries.

    (a) In general. Pursuant to section 951(a)(1)(A)(ii) and the 
regulations thereunder, a United States shareholder of a controlled 
foreign corporation must include in its gross income its pro rata share 
(as determined in accordance with paragraph (c) of this section) of the 
amount of such controlled foreign corporation's previously excluded 
subpart F income which is withdrawn for any taxable year from investment 
in less developed countries. Section 955 provides rules for determining 
the amount of a controlled foreign corporation's previously excluded 
subpart F income for any taxable year of the corporation beginning after 
December 31, 1962, that is withdrawn from investment in less developed 
countries for any taxable year of the corporation beginning before 
January 1, 1976. Except for investment in less developed country 
shipping companies, section 955 also provides rules for determining the 
amount of a controlled foreign corporation's previously excluded subpart 
F income for any taxable year of the corporation beginning after 
December 31, 1962, which is withdrawn from investment in less developed 
countries in taxable years of the corporation beginning after December 
31, 1975. To determine the amount of a controlled foreign corporation's 
previously excluded subpart F income withdrawn from investment in less 
developed country shipping companies described in section 955(c)(2) in 
taxable years of a controlled foreign corporation beginning after 
December 31, 1975, see section 955(b)(5) (as in effect after amendment 
by the Tax Reduction Act of 1975) and Sec. Sec. 1.955A-1 through 
1.955A-4. For effective dates, see Sec. 1.955-0.
    (b) Amount withdrawn by controlled foreign corporation--(1) In 
general. For purposes of sections 951 through 964,

[[Page 369]]

the amount of a controlled foreign corporation's previously excluded 
subpart F income which is withdrawn for any taxable year from investment 
in less developed countries is an amount equal to the decrease for such 
year in such corporation's qualified investments in less developed 
countries. Such decrease is, except as provided in Sec. 1.955-3--
    (i) An amount equal to the excess of the amount of its qualified 
investments in less developed countries at the close of the preceding 
taxable year over the amount of its qualified investments in less 
developed countries at the close of the taxable year, minus
    (ii) The amount (if any) by which recognized losses on sales or 
exchanges by such corporation during the taxable year of qualified 
investments in less developed countries exceed its recognized gains on 
sales or exchanges during such year of qualified investments in less 
developed countries,


but only to the extent that the net amount so determined does not exceed 
the limitation determined under subparagraph (2) of this paragraph. See 
Sec. 1.955-2 for determining the amount of qualified investments in 
less developed countries.
    (2) Limitations applicable in determining decreases--(i) General. 
The limitation referred to in subparagraph (1) of this paragraph for any 
taxable year of a controlled foreign corporation shall be the lesser of 
the following two limitations:
    (a) The sum of the controlled foreign corporation's earnings and 
profits (or deficit in earnings and profits) for the taxable year, 
computed as of the close of the taxable year without diminution by 
reason of any distributions made during the taxable year, plus the sum 
of its earnings and profits (or deficits in earnings and profits) 
accumulated for prior taxable years beginning after December 31, 1962, 
(including prior taxable years beginning after December 31, 1975) or,
    (b) The sum of the amounts excluded under section 954(b)(1) and 
paragraph (b)(1) of Sec. 1.954-1 from the foreign base company income 
of such corporation for all prior taxable years, minus the sum of the 
amounts (determined under this paragraph) of its previously excluded 
subpart F income withdrawn from investment in less developed countries 
for all prior taxable years.
    (ii) Treatment of earnings and profits. For purposes of determining 
earnings and profits of a controlled foreign corporation under 
subdivision (i)(a) of this subparagraph, such earnings and profits shall 
be considered not to include any amounts which are attributable to--
    (a)(1) Amounts which, for the current taxable year, are included in 
the gross income of a United States shareholder of such controlled 
foreign corporation under section 951(a)(1)(A)(i) or (iii), or
    (2) Amounts which, for any prior taxable year, have been included in 
the gross income of a United States shareholder of such controlled 
foreign corporation under section 951(a) and have not been distributed; 
or
    (b)(1) Amounts which, for the current taxable year, are included in 
the gross income of a United States shareholder of such controlled 
foreign corporation under section 551(b) or would be so included under 
such section but for the fact that such amounts were distributed to such 
shareholder during the taxable year, or
    (2) Amounts which, for any prior taxable year, have been included in 
the gross income of a United States shareholder of such controlled 
foreign corporation under section 551(b) and have not been distributed.


The rules of this subdivision apply only in determining the limitation 
on a controlled foreign corporation's decrease in qualified investments 
in less developed countries. See section 959 and the regulations 
thereunder for limitations on the exclusion from gross income of 
previously taxed earnings and profits.
    (3) Taxable years beginning after December 31, 1975. (i) In the case 
of a taxable year of a controlled foreign corporation beginning after 
December 31, 1975, Sec. 1.955-2(b)(5) must be applied in determining 
the amount of its qualified investments in less developed countries on 
both of the determination dates applicable to such taxable year.
    (ii) The application of this subparagraph may be illustrated by the 
following examples:

    Example 1. (a) Controlled foreign corporation M uses the calendar 
year as the taxable year. Throughout 1974 through 1976, M owns

[[Page 370]]

100 percent of the only class of stock of foreign corporation N, a less 
developed country shipping company described in Sec. 1.955-5(b), and M 
owns no other stock or obligations. The amount taken into account under 
Sec. 1.955-2(d) with respect to the stock of N is $10,000 at the close 
of 1974, 1975, and 1976. The amount of M's previously excluded subpart F 
income which is withdrawn for 1975 (a year to which Sec. 1.955-2(b)(5) 
does not apply) from investment in less developed countries is zero, 
determined as follows:

(1) Qualified investments in less developed countries at the     $10,000
 close of 1974...............................................
(2) Less: qualified investments in less developed countries       10,000
 at the close of 1975........................................
                                                              ----------
(3) Balance..................................................          0
                                                              ==========
 


(Further computations similar to those set out in lines (iv) through 
(ix) of example 1 of paragraph (d) of this section are unnecessary 
because the balance in line (3) of this example is zero.)
    (b) As a result of Sec. 1.955-2(b)(5)(ii), the amount of M's 
previously excluded subpart F income which is withdrawn for 1976 from 
investment in less developed countries is zero, determined as follows:

(1) Qualified investments in less developed countries at the close    $0
 of 1975...........................................................
(2) Less: qualified investments in less developed countries at the     0
 close of 1976.....................................................
                                                                    ----
(3) Balance........................................................    0
                                                                    ====
 

    Example 2. The facts are the same as in example 1, except that 
foreign corporation N is a less developed country corporation described 
in Sec. 1.955-5(a). The amount of M's previously excluded subpart F 
income withdrawn for 1976 from investment in less developed countries is 
zero, determined as follows:

(1) Qualified investments in less developed countries at the     $10,000
 close of 1975...............................................
(2) Less: qualified investments in less developed countries       10,000
 at the close of 1976........................................
                                                              ----------
(3) Balance..................................................          0
                                                              ==========
 

    (c) Shareholder's pro rata share of amount withdrawn by controlled 
foreign corporation--(1) In general. A United States shareholder's pro 
rata share of a controlled foreign corporation's previously excluded 
subpart F income withdrawn for any taxable year from investment in less 
developed countries is his pro rata share of the amount withdrawn for 
such year by such corporation, as determined under paragraph (b) of this 
section. See section 955(a)(3).
    (2) Special rule. A United States shareholder's pro rata share of 
the net amount determined under paragraph (b)(2)(i)(b) of this section 
with respect to any stock of the controlled foreign corporation owned by 
such shareholder shall be determined without taking into account any 
amount attributable to a period prior to the date on which such 
shareholder acquired such stock. See section 1248 and the regulations 
thereunder for rules governing treatment of gain from sales or exchanges 
of stock in certain foreign corporations.
    (d) Illustrations. The application of this section may be 
illustrated by the following examples:

    Example 1. A, a United States shareholder, owns 60 percent of the 
only class of stock of M Corporation, a controlled foreign corporation 
throughout the entire period here involved. Both A and M Corporation use 
the calendar year as a taxable year. Corporation M's qualified 
investments in less developed countries at the close of 1964 amount to 
$125,000; and, at the close of 1965, to $75,000. During 1965, M 
Corporation realizes recognized gains of $5,000 and recognized losses of 
$15,000, on sales of qualified investments in less developed countries. 
Corporation M's earnings and profits for 1965 and its accumulated 
earnings and profits for 1963 and 1964 amount to $45,000, as determined 
under paragraph (b)(2) of this section. The amount excluded under 
section 954(b)(1) for 1963 from its foreign base company income is 
$75,000, and the amount of its previously excluded subpart F income 
withdrawn for 1964 from investment in less developed countries is 
$25,000. The amount of M Corporation's previously excluded subpart F 
income withdrawn for 1965 from investment in less developed countries is 
$40,000, and A's pro rata share of such amount is $24,000, determined as 
follows:

(i) Qualified investments in less developed countries at the    $125,000
 close of 1964...............................................
(ii) Less: Qualified investments in less developed countries      75,000
 at the close of 1965........................................
                                                              ----------
(iii) Balance................................................     50,000
(iv) Less: Excess of recognized losses over recognized gains      10,000
 on sales during 1965 of qualified investments in less
 developed countries ($15,000 less $5,000)...................
                                                              ----------
(v) Tentative decrease in qualified investments in less           40,000
 developed countries for 1965................................
                                                              ==========
(vi) Earnings and profits for 1963, 1964, and 1965...........     45,000
                                                              ----------
(vii) Excess of amount excluded under section 954(b)(1) from      50,000
 foreign base company income for 1963 ($75,000 over amount of
 previously excluded subpart F income withdrawn for 1964 from
 investment in less developed countries ($25,000)............
                                                              ----------

[[Page 371]]

 
(viii) M Corporation's amount of previously excluded subpart      40,000
 F income withdrawn for 1965 from investment in less
 developed countries (item (v), but not to exceed the lesser
 of item (vi) or item (vii)).................................
                                                              ----------
(ix) A's pro rata share of M Corporation's amount of             $24,000
 previously excluded subpart F income withdrawn for 1965 from
 investment in less developed countries (60 percent of
 $40,000)....................................................
                                                              ==========
 

    Example 2. The facts are the same as in example 1, except that M 
Corporation's earnings and profits (determined under paragraph (b)(2) of 
this section) for 1963, 1964, and 1965 (item (vi)) are $30,000 instead 
of $45,000. Corporation M's amount of previously excluded subpart F 
income withdrawn for 1965 from investment in less developed countries is 
$30,000. A's pro rata share of such amount is $18,000 (60 percent of 
$30,000).
    Example 3. The facts are the same as in example 1, except that the 
excess of the amount excluded under section 954(b)(1) for 1963 from M 
Corporation's foreign base company income over the amount of its 
previously excluded subpart F income withdrawn for 1964 from investment 
in less developed countries (item (vii)) is $20,000 instead of $50,000. 
Corporation M's amount of previously excluded subpart F income withdrawn 
for 1965 from investment in less developed countries is $20,000. A's pro 
rata share of such amount is $12,000 (60 percent of $20,000).

[T.D. 6683, 28 FR 11178, Oct. 18, 1963, as amended by T.D. 6795, 30 FR 
942, Jan. 29, 1965; T.D. 7893, 48 FR 22509, May 19, 1983; T.D. 7894, 48 
FR 22529, May 19, 1983]



Sec. 1.955-2  Amount of a controlled foreign corporation's qualified
investments in less developed countries.

    (a) Included property. For purposes of sections 951 through 964, a 
controlled foreign corporation's ``qualified investments in less 
developed countries'' are items of property (other than property 
excluded under paragraph (b)(1) of this section) owned directly by such 
corporation on the applicable determination date for purposes of section 
954(f) or section 955(a)(2) and consisting of one or more of the 
following:
    (1) Stock of a less developed country corporation if the controlled 
foreign corporation owns (within the meaning of paragraph (b)(2) of this 
section) on the applicable determination date 10 percent or more of the 
total combined voting power of all classes of stock of such less 
developed country corporation;
    (2) An obligation (as defined in paragraph (b)(3) of this section) 
of a less developed country corporation which, at the time of 
acquisition (as defined in paragraph (b)(4) of this section) of such 
obligation by the controlled foreign corporation, has a maturity of one 
year or more, but only if the controlled foreign corporation owns 
(within the meaning of paragraph (b)(2) of this section) on the 
applicable determination date 10 percent or more of the total combined 
voting power of all classes of stock of such less developed country 
corporation; and
    (3) An obligation (as defined in paragraph (b)(3) of this section) 
of a less developed country, including obligations issued or guaranteed 
by the government of such country or of a political subdivision thereof 
and obligations of any agency or instrumentality of such country, in 
which such country is financially committed. The application of this 
subparagraph may be illustrated by the following example:

    Example. A, a political subdivision of foreign country X, constructs 
and operates a toll bridge. Country X is a less developed country 
throughout the period here involved. A issues bonds under an indenture 
which provides for amortization of the principal and interest of such 
bonds only out of the net revenues derived from operation of the bridge. 
The bonds of A are obligations in which X country is financially 
committed and, in the hands of a controlled foreign corporation, are 
qualified investments in less developed countries.

    (b) Special rules--(1) Excluded property. For purposes of paragraph 
(a) of this section, property which is disposed of within 6 months after 
the date of its acquisition shall be excluded from a controlled foreign 
corporation's qualified investments in less developed countries. 
However, the fact that property acquired by a controlled foreign 
corporation has not been held on an applicable determination date for 
more than 6 months after the date of its acquisition shall not prevent 
such property from being included in the controlled foreign 
corporation's qualified investments in less developed countries on such 
date. Proper adjustments shall be made subsequently, however, to exclude 
any item of property so included, if the property is in fact disposed of

[[Page 372]]

within 6 months after the date of its acquisition. See section 
955(b)(4).
    (2) Determination of stock ownership. In determining for purposes of 
paragraphs (a)(1) and (2) of this section whether a controlled foreign 
corporation owns 10 percent or more of the total combined voting power 
of all classes of stock of a less developed country corporation, only 
stock owned directly by such controlled foreign corporation shall be 
taken into account and the provisions of section 958 and the regulations 
thereunder shall not apply. See section 958(a)(1).
    (3) Obligation defined. For purposes of paragraphs (a)(2) and (3) of 
this section, the term ``obligation'' means any bond, note, debenture, 
certificate, or other evidence of indebtedness. In the absence of legal, 
governmental, or business reasons to the contrary, the indebtedness must 
bear interest or be issued at a discount.
    (4) Date of acquisition. For purposes of paragraphs (a)(2) and 
(b)(5)(i) of this section, stock or an obligation shall be considered 
acquired by a foreign corporation as of the date such corporation 
acquires an adjusted basis in the stock or obligation. For this purpose, 
in a case in which a foreign corporation acquires stock or an obligation 
in a transaction (other than a reorganization of the type described in 
section 368(a)(1)(E) or (F)) in which no gain or loss would be 
recognized had the transaction been between two domestic corporations, 
such corporation will be considered to have acquired an adjusted basis 
in such stock or obligation as of the date such transaction occurs.
    (5) Taxable years beginning after December 31, 1975. For taxable 
years beginning after December 31, 1975, qualified investments in less 
developed countries do not include--
    (i) Any property acquired after the latest determination date 
applicable to a taxable year beginning before December 31, 1975,
    (ii) Stock or obligations of a less developed country shipping 
company described in Sec. 1.955-5(b), and
    (iii) Stock or obligations which were not treated as qualified 
investments in less developed countries on the later of the two 
determination dates applicable to the preceding taxable year.


See Sec. 1.955-1(b)(3) for rules relating to the application of this 
subparagraph. See Sec. 1.955A-2(h) for rules relating to the treatment 
of investments in stock or obligations described in subdivision (ii) of 
this subparagraph as qualified investments in foreign base company 
shipping operations.
    (6) Determination dates. For purposes of subparagraph (5) of this 
paragraph and Sec. 1.955-1(b)(3), the determination dates applicable to 
a taxable year of a controlled foreign corporation are--
    (i) Except as provided in subdivision (ii) of this subparagraph, the 
close of such taxable year and the close of the preceding taxable year, 
and
    (ii) With respect to a United States shareholder who has made an 
election under section 955(b)(3) to determine such corporation's 
increase in qualified investments in less developed countries at the 
close of the following taxable year, the close of such taxable year and 
the close of the taxable year immediately following such taxable year.
    (c) Termination of designation as a less developed country. For 
purposes of sections 951 through 964, property which would constitute a 
qualified investment in a less developed country but for the fact that a 
foreign country or United States possession has, after the acquisition 
of such property by the controlled foreign corporation, ceased to be a 
less developed country shall be treated as a qualified investment in a 
less developed country. The application of this paragraph may be 
illustrated by the following example:

    Example. On December 31, 1969, in accordance with the provisions of 
Sec. 1.955-4, the designation of the foreign country X as an 
economically less developed country is terminated. Corporation M, a 
controlled foreign corporation, has $50,000 of qualified investments in 
country X acquired before December 31, 1969. After 1969 such investments 
are treated as qualified investments in a less developed country 
notwithstanding the termination of the status of X Country as an 
economically less developed country. However, if such qualified 
investments of M Corporation are reduced to $40,000, each United States 
shareholder of M Corporation is required, subject to the provisions of 
Sec. 1.955-1, to include his pro rata share of the $10,000 decrease in 
his gross income under section 951(a)(1)(A)(ii) and the regulations 
thereunder.


[[Page 373]]


    (d) Amount attributable to property--(1) General rule. For purposes 
of this section, the amount taken into account with respect to any 
property which constitutes a qualified investment in a less developed 
country shall be its adjusted basis as of the applicable determination 
date, reduced by any liability (other than a liability described in 
subparagraph (2) of this paragraph) to which such property is subject on 
such date. To be taken into account under this subparagraph, a liability 
must constitute a specific charge against the property involved. Thus, a 
liability evidenced by an open account or a liability secured only by 
the general credit of the controlled foreign corporation will not be 
taken into account. On the other hand, if a liability constitutes a 
specific charge against several items of property and cannot definitely 
be allocated to any single item of property, the liability shall be 
apportioned against each of such items of property in that ratio which 
the adjusted basis of such item on the applicable determination date 
bears to the adjusted basis of all such items at such time. A liability 
in excess of the adjusted basis of the property which is subject to such 
liability shall not be taken into account for the purpose of reducing 
the adjusted basis of other property which is not subject to such 
liability.
    (2) Excluded charges. For purposes of subparagraph (1) of this 
paragraph, a specific charge created with respect to any item of 
property principally for the purpose of artificially increasing or 
decreasing the amount of a controlled foreign corporation's qualified 
investments in less developed countries will not be recognized; whether 
a specific charge is created principally for such purpose will depend 
upon all the facts and circumstances of each case. One of the factors 
that will be considered in making such a determination with respect to a 
loan is whether the loan is from a related person, as defined in section 
954(d)(3) and paragraph (e) of Sec. 1.954-1.
    (3) Statement required. If for purposes of this section a United 
States shareholder of a controlled foreign corporation reduces the 
adjusted basis of property which constitutes a qualified investment in a 
less developed country on the ground that such property is subject to a 
liability, he shall attach to his return a statement setting forth the 
adjusted basis of the property before the reduction and the amount and 
nature of the reduction.
    (4) Taxable years beginning after December 31, 1975. For taxable 
years beginning after December 31, 1975, the amount taken into account 
under subparagraph (1) of this paragraph with respect to any property 
which constitutes a qualified investment in less developed countries 
shall not exceed the amount taken into account with respect to such 
property at the close of the preceding taxable year.

[T.D. 6683, 28 FR 11179, Oct. 18, 1963, as amended by T.D. 7894, 48 FR 
22529, May 19, 1983]



Sec. 1.955-3  Election as to date of determining qualified investments
in less developed countries.

    (a) Nature of election. In lieu of determining the increase for a 
taxable year of a foreign corporation beginning before January 1, 1976, 
under the provisions of section 954(f) and paragraph (a) of Sec. 1.954-
5, or the decrease under the provisions of section 955(a)(2) and 
paragraph (b) of Sec. 1.955-1, in a controlled foreign corporation's 
qualified investments in less developed countries for a taxable year in 
the manner provided in such provisions, a United States shareholder of 
such controlled foreign corporation may elect, under the provisions of 
section 955(b)(3) and this section, to determine such increase in 
accordance with the provisions of paragraph (b) of Sec. 1.954-5 and to 
determine such decrease by ascertaining the amount by which--
    (1) Such controlled foreign corporation's qualified investments in 
less developed countries at the close of such taxable year exceed its 
qualified investments in less developed countries at the close of the 
taxable year immediately following such taxable year, and reducing such 
excess by
    (2) The amount determined under paragraph (b)(1)(ii) of Sec. 1.955-
1 for such taxable year,


subject to the limitation provided in paragraph (b)(2) of Sec. 1.955-1 
for such taxable year. An election under this section may be made with 
respect to

[[Page 374]]

each controlled foreign corporation with respect to which a person is a 
United States shareholder within the meaning of section 951(b), but the 
election may not be exercised separately with respect to the increases 
and the decreases of such controlled foreign corporation. If an election 
is made under this section to determine the increase of a controlled 
foreign corporation in accordance with the provisions of paragraph (b) 
of Sec. 1.954-5, subsequent decreases of such controlled foreign 
corporation shall be determined in accordance with this paragraph and 
not in accordance with paragraph (b) of Sec. 1.955-1.
    (b) Time and manner of making election--(1) Without consent. An 
election under this section with respect to a controlled foreign 
corporation shall be made without the consent of the Commissioner by a 
United States shareholder's filing a statement to such effect with his 
return for his taxable year in which or with which ends the first 
taxable year of such controlled foreign corporation in which--
    (i) Such shareholder owns, within the meaning of section 958(a), or 
is considered as owning by applying the rules of ownership of section 
958(b), 10 percent or more of the total combined voting power of all 
classes of stock entitled to vote of such controlled foreign 
corporation, and
    (ii) Such controlled foreign corporation realizes foreign base 
company income from which amounts are excluded under section 954(b)(1) 
and paragraph (b)(1) of Sec. 1.954-1.


The statement shall contain the name and address of the controlled 
foreign corporation and identification of such first taxable year of 
such corporation. For taxable years of a foreign corporation beginning 
after December 31, 1975, no election under this section with respect to 
a controlled foreign corporation may be made without the consent of the 
Commissioner.
    (2) With consent. An election under this section with respect to a 
controlled foreign corporation may be made by a United States 
shareholder at any time with the consent of the Commissioner. Consent 
will not be granted unless the United States shareholder and the 
Commissioner agree to the terms, conditions, and adjustments under which 
the election will be effected. Consent will not be granted if the first 
taxable year of the controlled foreign corporation with respect to which 
the shareholder desires to compute an amount described in section 
954(b)(1) in accordance with the election provided in this section 
begins after December 31, 1975. The application for consent to elect 
shall be made by the United States shareholder's mailing a letter for 
such purpose to the Commissioner of Internal Revenue, Washington, DC 
20224. The application shall be mailed before the close of the first 
taxable year of the controlled foreign corporation with respect to which 
the shareholder desires to compute an amount described in section 
954(b)(1) in accordance with the election provided in this section. The 
application shall include the following information:
    (i) The name, address, and taxable year of the United States 
shareholder;
    (ii) The name and address of the controlled foreign corporation;
    (iii) The first taxable year of the controlled foreign corporation 
for which income is to be computed under the election;
    (iv) The amount of the controlled foreign corporation's qualified 
investments in less developed countries at the close of its preceding 
taxable year; and
    (v) The sum of the amounts excluded under section 954(b)(1) and 
paragraph (b)(1) of Sec. 1.954-1 from the foreign base company income 
of the controlled foreign corporation for all prior taxable years during 
which such shareholder was a United States shareholder of such 
corporation and the sum of the amounts of its previously excluded 
subpart F income withdrawn from investment in less developed countries 
for all prior taxable years during which such shareholder was a United 
States shareholder of such corporation.
    (c) Effect of election--(1) General. Except as provided in 
subparagraphs (3) and (4) of this paragraph, an election under this 
section with respect to a controlled foreign corporation shall be 
binding on the United States shareholder and shall apply to all 
qualified investments in less developed countries

[[Page 375]]

acquired, or disposed of, by such controlled foreign corporation during 
the taxable year following its taxable year for which income is first 
computed under the election and during all succeeding taxable years of 
such corporation.
    (2) Returns. Any return of a United States shareholder required to 
be filed before the completion of a period with respect to which 
determinations are to be made as to a controlled foreign corporation's 
qualified investments in less developed countries for purposes of 
computing such shareholder's taxable income shall be filed on the basis 
of an estimate of the amount of the controlled foreign corporation's 
qualified investments in less developed countries at the close of the 
period. If the actual amount of such investments is not the same as the 
amount of the estimate, the United States shareholder shall immediately 
notify the Commissioner. The Commissioner will thereupon redetermine the 
amount of tax of such United States shareholder for the year or years 
with respect to which the incorrect amount was taken into account. The 
amount of tax, if any, due upon such redetermination shall be paid by 
the United States shareholder upon notice and demand by the district 
director. The amount of tax, if any, shown by such redetermination to 
have been overpaid shall be credited or refunded to the United States 
shareholder in accordance with the provisions of sections 6402 and 6511 
and the regulations thereunder.
    (3) Revocation. Upon application by the United States shareholder, 
the election made under this section may, subject to the approval of the 
Commissioner, be revoked. Approval will not be granted unless the United 
States shareholder and the Commissioner agree to the terms, conditions, 
and adjustments under which the rev- ocation will be effected. Unless 
such agreement provides otherwise, the change in the controlled foreign 
corporation's qualified investments in less developed countries for its 
first taxable year for which income is computed without regard to the 
election previously made will be considered to be zero for purposes of 
effectuating the revocation. The application for consent to revocation 
shall be made by the United States shareholder's mailing a letter for 
such purpose to the Commissioner of Internal Revenue, Washington, DC 
20224. The application shall be mailed before the close of the first 
taxable year of the controlled foreign corporation with respect to which 
the shareholder desires to compute the amounts described in section 
954(b)(1) or 955(a) without regard to the election provided in this 
section. The application may also be filed in a taxable year beginning 
after December 31, 1975. The application shall include the following 
information:
    (i) The name, address, and taxpayer identification number of the 
United States shareholder;
    (ii) The name and address of the controlled foreign corporation;
    (iii) The taxable year of the controlled foreign corporation for 
which such amounts are to be so computed;
    (iv) The amount of the controlled foreign corporation's qualified 
investments in less developed countries at the close of its preceding 
taxable year;
    (v) The sum of the amounts excluded under section 954(b)(1) and 
paragraph (b)(1) of Sec. 1.954-1 from the foreign base company income 
of the controlled foreign corporation for all prior taxable years during 
which such shareholder was a United States shareholder of such 
corporation and the sum of the amounts of its previously excluded 
subpart F income withdrawn from investment in less developed countries 
for all prior taxable years during which such shareholder was a United 
States shareholder of such corporation; and
    (vi) The reasons for the request for consent to revocation.
    (4) Transfer of stock. If during any taxable year of a controlled 
foreign corporation--
    (i) A United States shareholder who has made an election under this 
section with respect to such controlled foreign corporation sells, 
exchanges, or otherwise disposes of all or part of his stock in such 
controlled foreign corporation, and
    (ii) The foreign corporation is a controlled foreign corporation 
immediately after the sale, exchange, or other disposition,


[[Page 376]]



then, with respect to the stock so sold, exchanged, or disposed of, the 
controlled foreign corporation's acquisitions and dispositions of 
qualified investments in less developed countries for such taxable year 
shall be considered to be zero. If the United States shareholder's 
successor in interest is entitled to and does make an election under 
paragraph (b)(1) of this section to determine the controlled foreign 
corporation's increase in qualified investments in less developed 
countries for the taxable year in which he acquires such stock, such 
increase with respect to the stock so acquired shall be determined in 
accordance with the provisions of paragraph (b)(1) of Sec. 1.954-5. If 
the controlled foreign corporation realizes no foreign base company 
income from which amounts are excluded under section 954(b)(1) and 
paragraph (b)(1) of Sec. 1.954-1 for the taxable year in which the 
United States shareholder's successor in interest acquires such stock 
and such successor in interest makes an election under paragraph (b)(1) 
of this section with respect to a subsequent taxable year of such 
controlled foreign corporation, the increase in the controlled foreign 
corporation's qualified investments in less developed countries for such 
subsequent taxable year shall be determined in accordance with the 
provisions of paragraph (b)(2) of Sec. 1.954-5.
    (d) Illustrations. The application of this section may be 
illustrated by the following examples:

    Example 1. Foreign corporation A is a wholly owned subsidiary of 
domestic corporation M. Both corporations use the calendar year as a 
taxable year. In a statement filed with its return for 1963, M 
Corporation makes an election under section 955(b)(3) and the election 
remains in force for the taxable year 1964. At December 31, 1964, A 
Corporation's qualified investments in less developed countries amount 
to $100,000; and, at December 31, 1965, to $80,000. For purposes of 
paragraph (a)(1) of this section, A Corporation's decrease in qualified 
investments in less developed countries for the taxable year 1964 is 
$20,000 and is determined by ascertaining the amount by which A 
Corporation's qualified investments in less developed countries at 
December 31, 1964 ($100,000) exceed its qualified investments in less 
developed countries at December 31, 1965 ($80,000).
    Example 2. The facts are the same as in example 1 except that A 
Corporation experiences no changes in qualified investments in less 
developed countries during its taxable years 1966 and 1967. If M 
Corporation's election were to remain in force, A Corporation's 
acquisitions and dispositions of qualified investments in less developed 
countries during A Corporation's taxable year 1968 would be taken into 
account in determining whether A Corporation has experienced an increase 
or a decrease in qualified investments in less developed countries for 
its taxable year 1967. However, M Corporation duly files before the 
close of A Corporation's taxable year 1967 an application for consent to 
revocation of M Corporation's election under section 955(b)(3), and, 
pursuant to an agreement between the Commissioner and M Corporation, 
consent is granted by the Commissioner. Assuming such agreement does not 
provide otherwise, A Corporation's change in qualified investments in 
less developed countries for its taxable year 1967 is zero because the 
effect of the revocation of the election is to treat acquisitions and 
dispositions of qualified investments in less developed countries 
actually occurring in 1968 as having occurred in such year rather than 
in 1967.
    Example 3. The facts are the same as in example 2 except that A 
Corporation's qualified investments in less developed countries at 
December 31, 1968, amount to $70,000. For purposes of paragraph 
(b)(1)(i) of Sec. 1.955-1, the decrease in A Corporation's qualified 
investments in less developed countries for the taxable year 1968 is 
$10,000 and is determined by ascertaining the amount by which A 
Corporation's qualified investments in less developed countries at 
December 31, 1967 ($80,000) exceed its qualified investments in less 
developed countries at December 31, 1968 ($70,000).
    Example 4. The facts are the same as in example 1 except that on 
September 30, 1965, M Corporation sells 40 percent of the only class of 
stock of A Corporation to N Corporation, a domestic corporation. 
Corporation N uses the calendar year as a taxable year. Corporation A 
remains a controlled foreign corporation immediately after such sale of 
its stock. Corporation A's qualified investments in less developed 
countries at December 31, 1966, amount to $90,000. The changes in A 
Corporation's qualified investments in less developed countries 
occurring in its taxable year 1965 are considered to be zero with 
respect to the 40-percent stock interest acquired by N Corporation. The 
entire $20,000 reduction in A Corporation's qualified investments in 
less developed countries which occurs during the taxable year 1965 is 
taken into account by M Corporation for purposes of paragraph (a)(1) of 
this section in determining its tax liability for the taxable year 1964. 
Corporation A's increase in qualified investments in less developed 
countries for the taxable year 1965 with respect to the 60-percent stock 
interest

[[Page 377]]

retained by M Corporation is $6,000 and is determined by ascertaining M 
Corporation's pro rata share (60 percent) of the amount by which A 
Corporation's qualified investments in less developed countries at 
December 31, 1968 ($90,000) exceed its qualified investments in less 
developed countries at December 31, 1965 ($80,000). Corporation N does 
not make an election under section 955(b)(3) in its return for its 
taxable year 1966. Corporation A's increase in qualified investments in 
less developed countries for the taxable year 1966 with respect to the 
40-percent stock interest acquired by N Corporation is $4,000.

[T.D. 6683, 28 FR 11180, Oct. 18, 1963, as amended by T.D. 7893, 48 FR 
22509, May 19, 1983; T.D. 7894, 48 FR 22530, May 19, 1983]



Sec. 1.955-4  Definition of less developed country.

    (a) Designation by Executive order. For purposes of sections 951 
through 964, the term ``less developed country'' means any foreign 
country (other than an area within the Sino-Soviet bloc) or any 
possession of the United States with respect to which, on the first day 
of the foreign corporation's taxable year, there is in effect an 
Executive order by the President of the United States designating such 
country or possession as an economically less developed country for 
purposes of such sections. Each territory, department, province, or 
possession of any foreign country other than a country within the Sino-
Soviet bloc may be treated as a separate foreign country for purposes of 
such designation if the territory, department, province, or possession 
is overseas from the country of which it is a territory, department, 
province, or possession. Thus, for example, an overseas possession of a 
foreign country may be designated by Executive order as an economically 
less developed country even though the foreign country itself has not 
been designated as an economically less developed country; or the 
foreign country may be so designated even though the overseas 
possessions of such country have not been designated as economically 
less developed countries. The term ``possession of the United States'', 
for purposes of section 955(c)(3) and this section, shall be construed 
to have the same meaning as that contained in paragraph (b)(2) of Sec. 
1.957-3.
    (b) Countries not eligible for designation. Section 955(c)(3) 
provides that no designation by Executive order may be made under 
section 955(c)(3) and paragraph (a) of this section with respect to--

Australia
Austria
Belgium
CanadaDenmark
France
Germany (Federal Republic)
Hong Kong
Italy
Japan
Liechtenstein
Luxembourg
Monaco
Netherlands
New Zealand
Norway
Union of South Africa
San Marino
Sweden
Switzerland
United Kingdom.

    (c) Termination of designation. Section 955(c)(3) provides that, 
after the President has designated any foreign country or possession of 
the United States as an economically less developed country for purposes 
of sections 951 through 964, he may not terminate such designation 
(either by issuing an Executive order for the purpose of terminating 
such designation or by issuing an Executive order which has the effect 
of terminating such designation) unless, at least 30 days prior to such 
termination, he has notified the Senate and the House of Representatives 
of his intention to terminate such designation. If such 30-day notice is 
given, no action by the Congress of the United States is necessary to 
effectuate the termination. The requirement for giving 30-day notice to 
the Senate and House of Representatives applies also to the termination 
of a designation with respect to an overseas territory, department, 
province, or possession of a foreign country. See paragraph (c) of Sec. 
1.955-2 for the effect of a termination of a Presidential designation 
upon property which would be a qualified investment in a less developed 
country but for the fact of such termination.

[T.D. 6683, 28 FR 11182, Oct. 18, 1963]



Sec. 1.955-5  Definition of less developed country corporation.

    (a) Less developed country corporation--(1) In general. For purposes 
of sections 951 through 964, the term ``less developed country 
corporation'' means a foreign corporation described in paragraph (b) of 
this section and also any foreign corporation--

[[Page 378]]

    (i) Which is engaged in the active conduct of one or more trades or 
businesses during the entire taxable year;
    (ii) Which derives 80 percent or more of its gross income, if any, 
for such taxable year from sources within less developed countries, as 
determined under the provisions of Sec. 1.955-6; and
    (iii) Which has 80 percent or more in value (within the meaning of 
paragraph (d) of this section) of its assets on each day of such taxable 
year consisting of one or more of the following items of property:
    (a) Property (other than property described in (b) through (h) of 
this subdivision) which is used, or held for use, in such trades or 
businesses and is located in one or more less developed countries;
    (b) Money;
    (c) Deposits with persons carrying on the banking business;
    (d) Stock of any other less developed country corporation;
    (e) Obligations (within the meaning of paragraph (b)(3) of Sec. 
1.955-2) of another less developed country corporation which at the time 
of their acquisition (within the meaning of paragraph (b)(4) of Sec. 
1.955-2) by the foreign corporation have a maturity of one year or more;
    (f) Obligations (within the meaning of paragraph (b)(3) of Sec. 
1.955-2) of any less developed country;
    (g) Investments which are required to be made or held because of 
restrictions imposed by the government of any less developed country; 
and
    (h) Property described in section 956(b)(2).


For purposes of this subparagraph, if a foreign corporation is a partner 
in a foreign partnership, as defined in section 7701(a)(2) and (5) and 
the regulations thereunder, such corporation will be considered to be 
engaged in the active conduct of a trade or business to the extent and 
in the manner in which the partnership is so engaged and to own directly 
its proportionate share of each of the assets of the partnership. For 
purposes of subdivision (i) of this subparagraph, a newly-organized 
foreign corporation will be considered engaged in the active conduct of 
a trade or business from the date of its organization if such 
corporation commences business operations as soon as practicable after 
such organization. In the absence of affirmative evidence showing that 
the 80-percent requirement of subdivision (iii) of this subparagraph has 
not been satisfied on each day of the taxable year, such requirement 
will be considered satisfied if it is established to the satisfaction of 
the district director that such requirement has been satisfied on the 
last day of each quarter of the taxable year of the foreign corporation. 
For purposes of subdivision (iii) of this subparagraph, property (other 
than stock in trade or other property of a kind which would properly be 
included in inventory of the foreign corporation if on hand at the close 
of the taxable year, or property held primarily for sale to customers in 
the ordinary course of the trade or business of the foreign corporation) 
purchased for use in a trade or business and temporarily located outside 
less developed countries will be considered located in less developed 
countries if, but only if, such property is shipped to and received in 
less developed countries promptly after such purchase.
    (2) Special rules. For purposes of subparagraph (1)(iii)(a) of this 
paragraph--
    (i) Treatment of receivables. Bills receivable, accounts receivable, 
notes receivable and open accounts shall be considered to be used in the 
trade or business and located in less developed countries if, but only 
if--
    (a) Such obligations arise out of the rental of property located in 
less developed countries, the performance of services within less 
developed countries, or the sale of property manufactured, produced, 
grown, or extracted in less developed countries, but only to the extent 
that the aggregate amount of such obligations at any time during the 
taxable year does not exceed an amount which is ordinary and necessary 
to carry on the business of both parties to the transactions if such 
transactions are between unrelated persons or, if such transactions are 
between related persons, an amount which would be ordinary and necessary 
to carry on the business of both parties to the transactions if such 
transactions were between unrelated persons;

[[Page 379]]

    (b) In the case of bills receivable, accounts receivable, notes 
receivable, and open accounts arising out of transactions other than 
those referred to in (a) of this subdivision--
    (1) If the obligor is an individual such individual is a resident of 
one or more less developed countries and of no other country which is 
not a less developed country;
    (2) If the obligor is a corporation which as to the foreign 
corporation is a related person as defined in section 954(d)(3) and 
paragraph (e) of Sec. 1.954-1, such obligor meets, with respect to the 
period ending with the close of its annual accounting period in which 
occurs the date on which the obligation is incurred, the 80-percent 
gross income requirement of paragraph (b)(1)(ii) of Sec. 1.955-6.
    (3) If the obligor is a corporation which as to the foreign 
corporation is not a related person as defined in section 954(d)(3) and 
paragraph (e) of Sec. 1.954-1, it is reasonable, on the basis of 
ascertainable facts, for the obligee to believe that the obligor meets, 
with respect to such period, the 80-percent gross income requirement of 
paragraph (b)(1)(ii) of Sec. 1.955-6.
    (ii) Location of interests in real estate. Interests in real estate 
such as leaseholds of land or improvements thereon, mortgages on real 
property (including interests in mortgages on leaseholds of land or 
improvements thereon), and mineral, oil, or gas interests shall be 
considered located in less developed countries if, but only if, the 
underlying real estate is located in less developed countries.
    (iii) Location of certain other intangibles. Intangible property 
(other than any such property described in subdivision (i) or (ii) of 
this subparagraph) used in the trade or business of the foreign 
corporation shall be considered to be located in less developed 
countries in the same ratio that the amount of the foreign corporation's 
tangible property and property described in subdivision (i) or (ii) of 
this subparagraph used in its trades or businesses and located or deemed 
located in less developed countries bears to the total amount of its 
tangible property and property described in subdivision (i) or (ii) of 
this subparagraph used in its trades or businesses.
    (3) Illustration. The provisions of subparagraph (1) of this 
paragraph may be illustrated by the following example:

    Example. Foreign corporation A is formed on November 1, 1963, to 
engage in the business of manufacturing and selling radios in Brazil, a 
less developed country as of November 1, 1963. Corporation A uses the 
calendar year as a taxable year. Shortly after it is formed, A 
Corporation acquires a plant site and begins construction of a plant 
which is completed on August 1, 1964. Corporation A commences business 
operations as soon as practicable and continues such operations through 
December 31, 1964, and thereafter. Corporation A will be considered for 
purposes of subparagraph (1)(i) of this paragraph to be engaged in the 
active conduct of a trade or business for its entire taxable years 
ending on December 31, 1963, and 1964. The plant site and the plant 
(while under construction and after completion) will be considered to be 
property held during such taxable years for use in A Corporation's trade 
or business.

    (b) Shipping companies. For purposes of sections 951 through 964, 
the term ``less developed country corporation'' also means any foreign 
corporation--
    (1) Which has 80 percent or more of its gross income, if any, for 
the taxable year consisting of one or more of--
    (i) Gross income derived--
    (a) From, or in connection with, the using (or hiring or leasing for 
use) in foreign commerce of aircraft or vessels registered under the 
laws of a less developed country,
    (b) From, or in connection with, the performance of services 
directly related to the use in foreign commerce of aircraft or vessels 
registered under the laws of a less developed country, or
    (c) From the sale or exchange of aircraft or vessels registered 
under the laws of a less developed country and used in foreign commerce 
by such foreign corporation;
    (ii) Dividends and interest received or accrued from other foreign 
corporations which are less developed country corporations within the 
meaning of this paragraph and 10 percent or more of the total combined 
voting power of all classes of stock of which is owned at the time such 
dividends and interest are so received or accrued by such foreign 
corporation; and

[[Page 380]]

    (iii) Gain from the sale or exchange of stock or obligations of 
other foreign corporations which are less developed country corporations 
within the meaning of this paragraph and 10 percent or more of the total 
combined voting power of all classes of stock of which is owned by such 
foreign corporation immediately before such sale or exchange; and
    (2) Which has 80 percent or more in value (within the meaning of 
paragraph (d) of this section) of its assets on each day of the taxable 
year consisting of--
    (i) Assets used, or held for use, for the production of income 
described in subparagraph (1) of this paragraph, or in connection with 
the production of such income, whether or not such income is received 
during the taxable year, and
    (ii) Property described in section 956(b)(2).


In the absence of affirmative evidence showing that the 80-percent 
requirement of this subparagraph has not been satisfied on each day of 
the taxable year such requirement will be considered satisfied if it is 
established to the satisfaction of the district director that such 
requirement has been satisfied on the last day of each quarter of the 
taxable year of the foreign corporation. The provisions of this 
subparagraph may be illustrated by the following example:

    Example. Foreign corporation A is formed on November 1, 1963, for 
the purpose of constructing and operating a vessel and, on that date, 
enters a charter agreement which provides that such vessel will be 
registered under the laws of Liberia, a less developed country as of 
November 1, 1963, and operated between South American and European 
ports. Corporation A uses the calendar year as a taxable year. 
Construction of the vessel is completed on September 1, 1965, and the 
vessel is registered under the laws of Liberia and operated between 
South American and European ports through December 31, 1965, and 
thereafter. The charter and the vessel (while under construction and 
after completion), or any interest of A Corporation in such assets, will 
be considered assets which are held by A Corporation during its taxable 
years ending on December 31, 1963, 1964, and 1965, for use in the 
production of income described in subparagraph (1) of this paragraph.

    (c) Determination of stock ownership. In determining for purposes of 
paragraph (b)(1)(ii) and (iii) of this section whether a foreign 
corporation owns 10 percent or more of the total combined voting power 
of all classes of stock of a less developed country corporation, only 
stock owned directly by such foreign corporation shall be taken into 
account and the provisions of section 958 and the regulations thereunder 
shall not apply. See section 958(a)(1).
    (d) Determination of value. For purposes of paragraphs (a)(1)(iii) 
and (b)(2) of this section--
    (1) General. Except as provided in subparagraph (2) of this 
paragraph, the value at which property shall be taken into account is 
its actual value (not reduced by liabilities) which, in the absence of 
affirmative evidence to the contrary, shall be deemed to be its adjusted 
basis.
    (2) Treatment of certain receivables. The value at which receivables 
described in paragraph (a)(2)(i) of this section and held by a foreign 
corporation using the cash receipts and disbursements method of 
accounting shall be taken into account is their actual value (not 
reduced by liabilities) which, in the absence of affirmative evidence to 
the contrary, shall be deemed to be their face value.

[T.D. 6683, 28 FR 11182, Oct. 18, 1963]



Sec. 1.955-6  Gross income from sources within less developed 
countries.

    (a) General. For purposes of paragraph (a)(1)(ii) of Sec. 1.955.5, 
the determination whether a foreign corporation has derived 80 percent 
or more of its gross income from sources within less developed countries 
for any taxable year shall be made by the application of the provisions 
of sections 861 through 864, and Sec. Sec. 1.861-1 through 1.863-5, in 
application of which the name of a less developed country shall be 
substituted for ``the United States'', except that if income is derived 
by the foreign corporation from--
    (1) Interest (other than interest to which subparagraph (3) of this 
paragraph applies), the rules set forth in paragraph (b) of this section 
shall apply;
    (2) Dividends, the rules set forth in paragraph (c) of this section 
shall apply; or

[[Page 381]]

    (3) Income (including interest) derived in connection with the sale 
of tangible personal property, the rules set forth in paragraph (d) of 
this section shall apply.


The source of income described in subparagraph (1), (2), or (3) of this 
paragraph shall be determined solely under the rules of this section and 
without regard to the rules of sections 861 through 864, and the 
regulations thereunder.
    (b) Interest--(1) In general. Except as provided in subparagraph (2) 
of this paragraph and paragraph (d) of this section, gross income 
derived by the foreign corporation from interest on any indebtedness--
    (i) Of an individual shall be treated as income from sources within 
a less developed country if, but only if, such individual is a resident 
of one or more less developed countries and of no other country which is 
not a less developed country.
    (ii) Of a corporation shall be treated as income from sources within 
less developed countries if, but only if, 80 percent or more of the 
gross income of the payer corporation for the 3-year period ending with 
the close of its annual accounting period in which such interest is 
paid, or for such part of such 3-year period as such corporation has 
been in existence, or for such part of such 3-year period as occurs on 
and after the beginning of such corporation's first annual accounting 
period beginning after December 31, 1962, whichever period is shortest, 
was derived from sources within less developed countries as determined 
in accordance with the principles of this section; or
    (iii) Of a less developed country, including obligations issued or 
guaranteed by the government of such country or of a political 
subdivision thereof and obligations of any agency or instrumentality of 
such country, in which such country is financially committed shall be 
treated as income from sources within such country.
    (2) Special rule. Gross income derived by the foreign corporation 
from interest on obligations of the United States shall be treated as 
income from sources within less developed countries without regard to 
the provisions of subparagraph (1) of this paragraph.
    (3) Payers other than related persons. For purposes of subparagraph 
(1)(ii) of this paragraph, a payer corporation which as to the recipient 
corporation is not a related person as defined in section 954(d)(3) and 
paragraph (e) of Sec. 1.954-1 shall be deemed to have satisfied the 80-
percent gross income requirement if, on the basis of ascertainable 
facts, it is reasonable for the recipient corporation to believe that 
such requirement is satisfied.
    (c) Dividends--(1) In general. Gross income derived by the foreign 
corporation from dividends, as defined in section 316 and the 
regulations thereunder, shall be treated as income from sources within 
less developed countries if, but only if, 80 percent or more of the 
gross income of the payer corporation for the 3-year period ending with 
the close of its annual accounting period in which such dividends are 
distributed, or for such part of such 3-year period as such corporation 
has been in existence, or for such part of such 3-year period as occurs 
on and after the beginning of such corporation's first annual accounting 
period beginning after December 31, 1962, whichever period is shortest, 
was derived from sources within less developed countries as determined 
in accordance with the principles of this section.
    (2) Payers other than related persons. See paragraph (b)(3) of this 
section for rule governing satisfaction of the 80-percent gross income 
requirement by payers other than related persons.
    (d) Sale of tangible personal property--(1) In general. Income 
(whether in the form of profits, commissions, fees, interest, or 
otherwise) derived by the foreign corporation in connection with the 
sale of tangible personal property shall be treated as income from 
sources within less developed countries if, but only if--
    (i) Such property is produced (within the meaning of subparagraph 
(2) of this paragraph) within less developed countries; or
    (ii) Such property is sold for use, consumption, or disposition 
within less developed countries even though produced outside less 
developed countries and the selling corporation is engaged within less 
developed countries, in connection with sales of such property, in

[[Page 382]]

continuous operational activities which are substantial in relation to 
such sales, as evidenced, for example, by the maintenance within less 
developed countries of a substantial sales or service organization or 
substantial facilities for the storage, handling, transportation, 
assembly, packaging, or servicing of such property.
    (2) Production defined. For purposes of this paragraph, the term 
``produced'' means manufactured, grown, extracted, or constructed and 
includes a substantial transformation of property purchased for resale 
or the manufacture of a product when purchased components constitute 
part of the property which is sold. See paragraph (a)(4)(ii) and (iii) 
of Sec. 1.954-3 for a statement and illustration of the principles set 
forth in the preceding sentence.

[T.D. 6683, 28 FR 11183, Oct. 18, 1963, as amended by T.D. 6688, 28 FR 
11632, Oct. 31, 1963]



Sec. 1.955A-1  Shareholder's pro rata share of amount of previously
excluded subpart F income withdrawn from investment in foreign base
company shipping operations.

    (a) In general. Section 955 provides rules for determining the 
amount of a controlled foreign corporation's previously excluded subpart 
F income which is withdrawn for any taxable year beginning after 
December 31, 1975, from investment in foreign base company shipping 
operations. Pursuant to section 951(a)(1)(A)(iii) and the regulations 
thereunder, a United States shareholder of such controlled foreign 
corporation must include in his gross income his pro rata share of such 
amount as determined in accordance with paragraph (c) of this section.
    (b) Amount withdrawn by controlled foreign corporation--(1) In 
general. For purposes of sections 951 through 964, the amount of a 
controlled foreign corporation's previously excluded subpart F income 
which is withdrawn for any taxable year from investment in foreign base 
company shipping operations is an amount equal to the decrease for such 
year in such corporation's qualified investments in foreign base company 
shipping operations. Such decrease is, except as provided in Sec. 
1.955A-4--
    (i) An amount equal to the excess of the amount of its qualified 
investments in foreign base company shipping operations at the close of 
the preceding taxable year over the amount of its qualified investments 
in foreign base company shipping operations at the close of the taxable 
year, minus
    (ii) The amount (if any) by which recognized losses on sales or 
exchanges by such corporation during the taxable year of qualified 
investments in foreign base company shipping operations exceed its 
recognized gains on sales or exchanges during such year of qualified 
investments in foreign base company shipping operations,


but only to the extent that the net amount so determined does not exceed 
the limitation determined under subparagraph (2) of this paragraph. See 
Sec. 1.955A-2 for determining the amount of qualified investments in 
foreign base company shipping operations.
    (2) Limitation applicable in determining decreases--(i) In general. 
The limitation referred to in subparagraph (i) of this paragraph for any 
taxable year of a controlled foreign corporation shall be the lesser of 
the following two limitations:
    (A) The sum of (1) the controlled foreign corporation's earnings and 
profits (or deficit in earnings and profits) for the taxable year, 
computed as of the close of the taxable year without diminution by 
reason of any distribution made during the taxable year, (2) the sum of 
its earnings and profits (or deficits in earnings and profits) 
accumulated for prior taxable years beginning after December 31, 1975, 
and (3) the amount described in subparagraph (3) of this paragraph; or
    (B) The sum of the amounts excluded under section 954(b)(2) (see 
subparagraph (4) of this paragraph) from the foreign base company income 
of such corporation for all prior taxable years beginning after December 
31, 1975, minus the sum of the amounts (determined under this paragraph) 
of its previously excluded subpart F income withdrawn from investment in 
foreign base company shipping operations for all such prior taxable 
years.
    (C) For purposes of the immediately preceding subparagrah (B), the 
amount excluded under section 954(b)(2) for a

[[Page 383]]

taxable year of a controlled foreign corporation (the ``first 
corporation'') includes (1) an amount excluded under section 954(b)(2) 
by another corporation which is a member of a related group (as defined 
in Sec. 1.955A-3(b)(1)) attributable to the first corporation's excess 
investment (see Sec. 1.955A-3(c)(4)) for a taxable year beginning after 
December 31, 1983, (2) an amount excluded by a corporation under Sec. 
1.954-1(b)(4)(ii)(b) by reason of the application of the carryover rule 
there set forth, and (3) an amount equal to the first corporation's pro 
rata share of a group excess deduction (see Sec. 1.955A-3(c)(2)) of a 
related group for a taxable year beginning after December 31, 1983 (but 
not in excess of that portion of such pro rata share which would reduce 
the first corporation's foreign base company shipping income to zero). 
Such amounts will not be treated as excluded under section 954(b)(2) by 
any other corporation.
    (ii) Certain exclusions from earnings and profits. For purposes of 
determining the earnings and profits of a controlled foreign corporation 
under subdivision (i)(A)(1) and (2) of this subparagraph, such earnings 
and profits shall be considered not to include any amounts which are 
attributable to--
    (A)(1) Amounts which, for the current taxable year, are included in 
the gross income of a United States shareholder of such controlled 
foreign corporation under section 951(a)(1)(A)(i), or
    (2) Amounts which, for any prior taxable year, have been included in 
the gross income of a United States shareholder of such controlled 
foreign corporation under section 951(a) and have not been distributed; 
or
    (B)(1) Amounts which, for the current taxable year, are included in 
the gross income of a United States shareholder of such controlled 
foreign corporation under section 551(b) or would be so included under 
such section but for the fact that such amounts were distributed to such 
shareholder during the taxable year, or
    (2) Amounts which, for any prior taxable year, have been included in 
the gross income of a United States shareholder of such controlled 
foreign corporation under section 551(b) and have not been distributed.


The rules of this subdivision apply only in determining the limitation 
on a controlled foreign corporation's decrease in qualified investments 
in foreign base company shipping operations. See section 959 and the 
regulations thereunder for rules relating to the exclusion from gross 
income of previously taxed earnings and profits.
    (3) Carryover of amounts relating to investments in less developed 
country shipping companies--(i) In general. The amount described in this 
subparagraph for any taxable year of a controlled foreign corporation 
beginning after December 31, 1975, is the lesser of--
    (A) The excess of the amount described in subdivision (ii) of this 
subparagraph, over the amount described in subdivision (iii) of this 
subparagraph, or
    (B) The limitation determined under subdivision (iv) of this 
subparagraph.
    (ii) Previously excluded subpart F income invested in less developed 
country shipping companies. The amount described in this subdivision for 
all taxable years of a controlled foreign corporation beginning after 
December 31, 1975, is the lesser of--
    (A) The amount of such corporation's qualified investments 
(determined under Sec. 1.955-2 other than paragraph (b)(5) thereof) in 
less developed country shipping companies described in Sec. 1.955-5(b) 
at the close of the last taxable year of such corporation beginning 
before January 1, 1976, or
    (B) The limitation determined under Sec. 1.955-1(b)(2)(i)(b) 
(relating to previously excluded subpart F income) for the first taxable 
year of such corporation beginning after January 1, 1976.
    (iii) Amounts previously carried over. The amount described in this 
subdivision for any taxable year of a controlled foreign corporation 
shall be the sum of the excesses determined for each prior taxable year 
beginning after December 31, 1976, of--
    (A) The amount (determined under this paragraph) of such 
corporation's previously excluded subpart F income withdrawn from 
investment in foreign base company shipping operations, over

[[Page 384]]

    (B) The sum of the earnings and profits determined under 
subparagraph (2)(i)(A)(1) and (2) of this paragraph.
    (iv) Extent attributable to accumulated earnings and profits. The 
limitation determined under this subdivision for any taxable year of a 
controlled foreign corporation is the sum of such controlled foreign 
corporation's earnings and profits (or deficits in earnings and profits) 
accumulated for taxable years beginning after December 31, 1962, and 
before January 1, 1976. For purposes of the preceding sentence, earnings 
and profits shall be determined by excluding the amounts described in 
subparagraph (2)(ii)(A) and (B) of this paragraph.
    (v) Illustration. The application of this subparagraph may be 
illustrated by the following example:

    Example. (a) Throughout the period here involved, A is a United 
States shareholder of controlled foreign corporation M. M is not a 
foreign personal holding company, and M uses the calendar year as the 
taxable year.
    (b) The amount described in this subparagraph for M's taxable year 
1978 with respect to A is determined as follows, based on the facts 
shown in the following table:

(1) Investment in less developed country shipping companies      $10,000
 on December 31, 1975 (subdivision (ii)(A) amount).........
(2) Sec. 1.955-1(b)(2)(i)(b) limitation for 1976                50,000
 (previously excluded subpart F income not withdrawn from
 investment in less developed countries) (subdivision
 (ii)(B) amount)...........................................
(3) Subdivision (ii) amount (lesser of lines (1) and (2))..       10,000
(4) Subdivision (iii) amount: Excess for 1977 of M's               2,000
 previously excluded subpart F income withdrawn from
 investment in foreign base country shipping operations,
 $3,000, over the sum of the amounts determined under
 subparagraphs (2)(i)(A)(1) and (2) of this paragraph,
 $1,000....................................................
                                                            ------------
(5) Excess of line (3) over line (4).......................        8,000
                                                            ============
(6) Sum of M's earnings and profits accumulated for 1962          26,000
 through 1975, determined on December 31, 1978.............
(7) Amount described in this subparagraph for 1978 (lesser         8,000
 of line (5) and line (6)).................................
                                                            ============
 

    (c) For 1978, M's earnings and profits (reduced as provided in Sec. 
1.955-1(b)(2)(ii)(a)(1)) are $19,000, and the amount of M's previously 
excluded subpart F income withdrawn from investment in less developed 
countries determined under Sec. 1.955-1(b)) is $42,000. Consequently, 
$23,000 of M's earnings and profits accumulated for 1962 through 1975 
are attributable to such $42,000 amount, and will therefore be excluded 
under subparagraph (2)(ii))(A)(2) of this paragraph from M's earnings 
and profits accumulated for 1962 through 1975, determined as of December 
31, 1979. No other portion of M's earnings and profits accumulated for 
1962 through 1975 is distributed or included in the gross income of a 
United States shareholder in 1978.
    (d) The amount described in this subparagraph for M's taxable year 
1979 with respect to A is determined as follows, based on the additional 
facts shown in the following table:

(1) Subdivision (ii) amount (line (3) from paragraph (b) of      $10,000
 this example).............................................
(2) Subdivision (iii) amount: (i) Excess for 1977 from line        2,000
 (4) of paragraph (b) of this example......................
 


  (ii) Plus: excess for 1978 of M's previously excluded       0
   subpart F income withdrawn from investment in foreign
   base country shipping operations, $6,000, over the
   sum of the amounts determined under subparagraphs
   (2)(i)(A)(1) and (2) of this paragraph, $25,000......
                                                         -------
 


  (iii) Subdivision (iii) amount...........................        2,000
                                                            ------------
(3) Excess of line (1) over line (2)(iii)..................        8,000
                                                            ============
(4) Sum of M's earnings and profits accumulated for 1962           3,000
 through 1975, determined on December 31, 1979 ($26,000
 minus $23,000)............................................
(5) Amount described in this subparagraph for 1979 (lesser         3,000
 of line (3) and line (4)).................................
                                                            ============
 

    (4) Amount excluded. For purposes of subparagraph (2)(i)(B) of this 
paragraph, the amount excluded under section 954(b)(2) from the foreign 
base company income of a controlled foreign corporation for any taxable 
year beginning after December 31, 1975, is the excess of--
    (i) The amount which would have been equal to the subpart F income 
of such corporation for such taxable year if such corporation had had no 
increase in qualified investments in foreign base company shipping 
operations for such taxable year, over
    (ii) The subpart F income of such corporation for such taxable year.
    (c) Shareholder's pro rata share of amount withdrawn by controlled 
foreign corporation--(1) In general. A United States shareholder's pro 
rata share of a controlled foreign corporation's previously excluded 
subpart F income withdrawn for any taxable year from investment in 
foreign base company shipping operations is his pro rata share of the 
amount withdrawn for such year by such corporation, as determined under 
paragraph (b) of this section. See section 955(a)(3). Such pro

[[Page 385]]

rata share shall be determined in accordance with the principles of 
Sec. 1.195-1(e).
    (2) Special rule. A United States shareholder's pro rata share of 
the net amount determined under paragraph (b)(2)(i)(B) of this section 
with respect to any stock of the controlled foreign corporation owned by 
such shareholder shall be determined without taking into account any 
amount attributable to a period prior to the date on which such 
shareholder acquired such stock. See section 1248 and the regulations 
thereunder for rules governing treatment of gain from sales or exchanges 
of stock in certain foreign corporations.
    (d) Illustrations. The application of this section may be 
illustrated by the following examples:

    Example 1. A, a United States shareholder, owns 60 percent of the 
only class of stock of M Corporation, a controlled foreign coporation 
throughout the entire period here involved. Both A and M use the 
calendar year as a taxable year. The amount of M's previously excluded 
subpart F income withdrawn for 1978 from investment in foreign base 
company shipping operations is $40,000, and A's pro rata share of such 
amount is $24,000 determined as follows based on the facts shown in the 
following table:

(a) Qualified investments in foreign base company shipping      $125,000
 operations at the close of 1977...........................
(b) Less: qualified investments in foreign base company           75,000
 shipping operations at the close of 1978..................
                                                            ------------
(c) Balance................................................       50,000
(d) Less: excess of recognized losses ($15,000) over              10,000
 recognized gains ($5,000) on sales during 1978 of
 qualified investments in foreign base company shipping
 operations................................................
                                                            ------------
(e) Tentative decrease in qualified investment in foreign         40,000
 base company shipping operations for 1978.................
                                                            ============
(f) Earnings and profits for 1976, 1977, and 1978..........       45,000
(g) Plus: amount determined under paragraph (b)(3) of this             0
 section...................................................
                                                            ------------
(h) Earnings and profits limitation........................       45,000
                                                            ============
(i) Excess of amount excluded under section 954(b)(2) from        50,000
 foreign base company income for 1976 ($75,000) over amount
 of previously excluded subpart F income withdrawn for 1977
 from investment in foreign base company shipping
 operations ($25,000)......................................
(j) M's amount of previously excluded subpart F income            40,000
 withdrawn for 1978 from investment in foreign base company
 shipping operations (item (e), but not to exceed the
 lesser of item (h) or item (i)............................
(k) A's pro rata share of M Corporation's amount of               24,000
 previously excluded subpart F in come withdrawn for 1978
 from investment in foreign base company shipping
 operations (60 percent of $40,000)........................
                                                            ============
 

    Example 2. The facts are the same as in example 1, except that M's 
earnings and profits (determined under paragraph (b)(2) of this section) 
for 1976, 1977, and 1978 (item (f)) are $30,000 instead of $45,000. M's 
amount of previously excluded subpart F income withdrawn for 1978 from 
investment in foreign base company shipping operations is $30,000. A's 
pro rata share of such amount is $18,000 (60 percent of $30,000).
    Example 3. The facts are the same as in example 1, except that the 
excess of the amount excluded under section 954(b)(2) for 1976 from M 
Corporation's foreign base company income over the amount of its 
previously excluded subpart F income withdrawn for 1977 from investment 
in foreign base company shipping operations (item (i)) is $20,000 
instead of $50,000. M's amount of previously excluded subpart F income 
withdrawn for 1978 from investment in foreign base company shipping 
operations is $20,000. A's pro rata share of such amount is $12,000 (60 
percent of $20,000).

[T.D. 7894, 48 FR 22530, May 19, 1983; 48 FR 40888, Sept. 12, 1983]



Sec. 1.955A-2  Amount of a controlled foreign corporation's qualified
investments in foreign base company shipping operations.

    (a) Qualified investments--(1) In general. Under section 955(b), for 
purposes of sections 951 through 964, a controlled foreign corporation's 
``qualified investments in foreign base company shipping operations'' 
are investments in--
    (i) Any aircraft or vessel, to the extent that such aircraft or 
vessel is used (or hired or leased for use) in foreign commerce,
    (ii) Related shipping assets (within the meaning of paragraph (b) of 
this section),
    (iii) Stock or obligations of a related controlled foreign 
corporation, to the extent provided in paragraph (c) of this section,
    (iv) A partnership, to the extent provided in paragraph (d) of this 
section, and
    (v) Stock or obligations of a less developed country shipping 
company described in Sec. 1.955-5(b), as provided in paragraph (h) of 
this section.
    (2) Coordination of provisions. No amount shall be counted as a 
qualified

[[Page 386]]

investment in foreign base company shipping operations under more than 
one provision of this section. Thus, for example, if a $10,000 
investment in stock of a controlled foreign corporation is treated as a 
qualified investment in foreign base company shipping operations under 
both subparagraphs (1)(iii) and (v) of this paragraph, then such $10,000 
is counted only once as a qualified investment in foreign base company 
shipping operations.
    (3) Definitions. If the meaning of any term is defined or explained 
in Sec. 1.954-6, then such term shall have the same meaning when used 
in this section.
    (4) Extent of use. (i) For purposes of subparagraph (1)(i) of this 
paragraph and paragraph (b)(1) of this section, the extent to which an 
asset of a controlled foreign corporation is used during a taxable year 
in foreign base company shipping operations shall be determined on the 
basis of the proportion for such year which the foreign base company 
shipping income derived from the use of such asset bears to the total 
gross income derived from the use of such asset.
    (ii) For purposes of determining under subdivision (i) of this 
subparagraph the amounts of foreign base company shipping income and 
gross income of a controlled foreign corporation--
    (A) Such amounts shall be deemed to include an arm's length charge 
(see Sec. 1.954-6(h)(5)) for services performed by such corporation for 
itself,
    (B) Such amounts shall be deemed to include an arm's length charge 
for the use of an asset (such as a vessel under construction or laid up 
for repairs) which is held for use in foreign base company shipping 
operations, but is not actually so used,
    (C) Foreign base company shipping income shall be deemed to include 
amounts earned in taxable years beginning before January 1, 1976, and
    (D) The district director shall make such other adjustments to such 
amounts as are necessary to properly determine the extent to which any 
asset is used in foreign base company shipping operations.
    (b) Related shipping assets--(1) In general. For purposes of this 
section, the term ``related shipping asset'' means any asset which is 
used (or held for use) for or in connection with the production of 
income described in Sec. 1.954-6(b)(1)(i) or (ii), but only to the 
extent that such asset is so used (or is so held for use).
    (2) Examples. Examples of assets of a controlled foreign corporation 
which are used (or held for use) for or in connection with the 
production of income described in subparagraph (1) of this paragraph 
include--
    (i) Money, bank deposits, and other temporary investments which are 
reasonably necessary to meet the working capital requirements of such 
corporation in its conduct of foreign base company shipping operations,
    (ii) Accounts receivable and evidences of indebtedness which arise 
from the conduct of foreign base company shipping operations by such 
corporation or by a related person,
    (iii) Amounts (other than amounts described in subdivision (i) of 
this subparagraph) deposited in bank accounts or invested in readily 
marketable securities pursuant to a specific, definite, and feasible 
plan to purchase any tangible asset for use in foreign base company 
shipping operations,
    (iv) Amounts paid into escrow to secure the payment of (A) charter 
hire for an aircraft, vessel, or other asset used in foreign base 
company shipping operations or (B) a debt which constitutes a specific 
charge against such an asset,
    (v) Capitalized expenditures (such as progress payments) made under 
a contract to purchase any asset for use in foreign base company 
shipping operations,
    (vi) Prepaid expense and deferred charges incurred in the course of 
foreign base company shipping operations,
    (vii) Stock acquired and retained to insure a source of supplies or 
services used in the conduct of foreign base company shipping 
operations, and
    (viii) Currency futures acquired and retained as a hedge against 
international currency fluctuations in connection with foreign base 
company shipping operations.
    (3) Limitations--(i) Vessels generally. Notwithstanding any other 
provision of this paragraph, the term ``related shipping assets'' does 
not include any money or other intangible assets of a

[[Page 387]]

controlled foreign corporation, to the extent that such assets are 
permitted to accumulate in excess of the reasonably anticipated needs of 
the business.
    (ii) Safe harbor. If a controlled foreign corporation accumulates 
money or other intangible assets pursuant to a plan to purchase one or 
more vessels for use in foreign commerce, and if--
    (A) The amount so accumulated, plus
    (B) The sum of the amounts accumulated by other controlled foreign 
corporations which are related persons (within the meaning of section 
954(d)(3)) pursuant to similar plans, does not exceed 110 percent of a 
reasonable down payment on each vessel planned to be purchased within a 
reasonable period, then such plan will be considered to be feasible. For 
purposes of the preceding sentence, a reasonable down payment shall not 
exceed 28 percent of the total cost of acquisition. The determination 
dates applicable to the taxable year of a controlled foreign corporation 
are those set forth in paragraph (c)(2)(ii) of this section. In the case 
of accumulation of assets which do not come within the safe harbor 
limitation of this subdivision (ii), in determining whether such assets 
have accumulated beyond the reasonably anticipated needs of the 
business, factors to be taken into account include, but are not limited 
to, the availability of financing to purchase a vessel and the 
availability of a vessel suitable for the purposes to which the vessel 
is to be put.
    (iii) Other assets. In determining whether a plan to purchase any 
asset other than a vessel for use in foreign base company shipping 
operations is feasible, principles similar to those stated in 
subdivision (ii) of this subparagraph shall be applied.
    (4) Cross-reference. See Sec. 1.954-7(c) for additional 
illustrations bearing on the application of this paragraph.
    (c) Stock and obligations--(1) In general. Investments by a 
controlled foreign corporation (the ``first corporation'') in stock or 
obligations of a second controlled foreign corporation which is a 
related person (within the meaning of section 954(d)(3) are considered 
to be qualified investments in foreign base company shipping operations 
to the extent that the assets of such second corporation are used (or 
held for use) in foreign base company shipping operations. See 
subparagraph (2) of this paragraph. However, an investment in an 
obligation of the second corporation will not be considered a qualified 
investment in foreign base company shipping operations if the obligation 
represents a liability which constitutes a specific charge (nonrecourse 
or otherwise) against an asset of the second corporation which is not 
either--
    (i) An aircraft or vessel used (or held for use) to some extent in 
foreign commerce, or
    (ii) An asset described in paragraphs (a)(1)(ii) through (v) of this 
section.
    (2) Extent of use. On any determination date applicable to a taxable 
year of the first corporation, the extent to which the assets of the 
second corporation are used in foreign base company shipping operations 
shall be determined on the basis of the proportion which the amount of 
such second corporation's qualified investments in foreign base company 
shipping operations bears to its net worth, such proportion to be 
determined at the close of the second corporation's last taxable year 
which ends on or before such determination date. For purposes of the 
preceding sentence--
    (i) A controlled foreign corporation's net worth is the total 
adjusted basis of the corporate assets reduced by the total outstanding 
principal amount of the corporate liabilities, and
    (ii) The determination dates applicable to a taxable year of a 
controlled foreign corporation are--
    (A) Except as provided in (B) of this subdivision, the close of such 
taxable year and the close of the preceding taxable year, and
    (B) With respect to a United States shareholder who has made an 
election under section 955(b)(3) to determine such corporation's 
increase in qualified investments in foreign base company shipping 
operations at the close of the following taxable year, the close of such 
taxable year and the close of the taxable year immediately following 
such taxable year.
    (3) Illustrations. The application of this paragraph may be 
illustrated by the following examples:


[[Page 388]]


    Example 1. On December 31, 1976, controlled foreign corporation X 
owns 100 percent of the single class of stock of controlled foreign 
corporation Y. X and Y both use the calendar year as the taxable year. 
On December 31, 1976, Y's assets consist of a vessel used in foreign 
commerce, related shipping assets, and other assets unrelated to its 
foreign base company shipping operations. On such date Y has qualified 
investments in foreign base company shipping operations (determined 
under paragraph (g) of this section) of $60,000, and a net worth of 
$100,000. If X's investment in the stock of Y is $50,000, then $30,000 
of such amount, i.e.,
[GRAPHIC] [TIFF OMITTED] TC09OC91.012


is a qualified investment in foreign base company shipping operations.
    Example 2. The facts are the same as in example 1, except that on 
December 31, 1976, Y's assets consist entirely of a vessel used in 
foreign commerce and related shipping assets, Y has qualified 
investments in foreign base company shipping operations (determined 
under paragraph (g) of this section) of $16,000 and (therefore) a net 
worth of $16,000. If X's investment in the stock of Y is $50,000, then 
the entire $50,000, i.e.,
[GRAPHIC] [TIFF OMITTED] TC09OC91.013


is a qualified investment in foreign base company shipping operations.
    Example 3. On December 31, 1980, controlled foreign corporation J 
owns two notes of controlled foreign corporation K, which is a related 
person (within the meaning of section 954(d)(3)). Both J and K use the 
calendar year as the taxable year. J's adjusted basis in each of the two 
notes is $100,000. The first note is secured only by the general credit 
of K. The second note is secured by (and, therefore, constitutes a 
specific charge on) a hotel owned by K in a foreign country. On December 
31, 1980, K has qualified investments in foreign base company shipping 
operation with an adjusted basis of $500,000 (before applying the rules 
of paragraph (g) of this section). The adjusted basis of all of K's 
corporate assets is $1,100,000. K's only liabilities are the two notes. 
The amount of K's qualified investments in foreign base company shipping 
operations (determined under paragraph (g) of this section) is $450,000. 
K's net worth is $900,000. The amount of J's qualified investment in 
foreign base company shipping operations in respect of the first note is 
$50,000, i.e.,
[GRAPHIC] [TIFF OMITTED] TC09OC91.014


The amount of J's qualified investment in respect of the second note is 
zero (see the last sentence of paragraph (c)(1) of this section).

    (d) Partnerships--(1) In general. A controlled foreign corporation's 
investment in a partnership at the close of any taxable year of such 
corporation shall be considered a qualified investment in foreign base 
company shipping operations to the extent of the proportion which such 
corporation's foreign base company shipping income for such taxable year 
would bear to its gross income for such taxable year if--
    (i) Such corporation had realized no income other than its 
distributive share of the partnership gross income, and
    (ii) Such corporation's income were adjusted in accordance with the 
rules stated in paragraphs (a)(4)(ii)(B) and (D) of this section.
    (2) Transitional rule. For purposes of subparagraph (1)(i) of this 
paragraph, the controlled foreign corporation's distributive share of 
the partnership gross income shall not include any amount attributable 
to income earned by the partnership before the first day of such 
corporation's first taxable year beginning after December 31, 1975.
    (3) Cross-reference. See paragraph (g)(4) of this section for rules 
relating to the determination of the amount of a controlled foreign 
corporation's investment in a partnership.
    (e) Trusts--(1) In general. An investment in a trust is not a 
qualified investment in a foreign base company shipping operations.
    (2) Grantor trusts. Notwithstanding subparagraph (1) of this 
pargraph, if a controlled foreign corporation is treated as the owner of 
any portion of a trust under subpart E of part I of subchapter J 
(relating to grantors and others treated as substantial owners), then 
for purposes of this section such controlled foreign corporation is 
deemed to be the actual owner of such portion of the assets of the 
trust. Accordingly, its investments in such assets (as determined under 
paragraph (g)(5) of this section) may be treated as

[[Page 389]]

a qualified investment in foreign base company shipping operations.
    (3) Definitions. For purposes of this section, the term ``trust'' 
means a trust as defined in Sec. 301.7701-4.
    (f) Excluded property. For purposes of paragraph (a) of this 
section, property acquired principally for the purpose of artificially 
increasing the amount of a controlled foreign corporation's qualified 
investments in foreign base company shipping operations will not be 
recognized; whether an item of property is acquired principally for such 
purpose will depend upon all the facts and circumstances of each case. 
One of the factors that will be considered in making such a 
determination with respect to an item of property is whether the item is 
disposed of within 6 months after the date of its acquisition.
    (g) Amount attributable to property--(1) General rule. For purposes 
of this section, the amount taken into account under section 955(b)(4) 
with respect to any property which constitutes a qualified investment in 
foreign base company shipping operations shall be its adjusted basis as 
of the applicable determination date, reduced by the outstanding 
principal amount of any liability (other than a liability described in 
subparagraph (2) of this paragraph) to which such property is subject on 
such date including a liability secured only by the general credit of 
the controlled foreign corporation. Liabilities shall be taken into 
account in the following order:
    (i) The adjusted basis of each and every item of corporate property 
shall be reduced by any specific charge (non-recourse or otherwise) to 
which such item is subject. For this purpose, if a liability constitutes 
a specific charge against several items of property and cannot 
definitely be allocated to any single item of property, the specific 
charge shall be apportioned against each of such items of property in 
that ratio which the adjusted basis of such item on the applicable 
determination date bears to the adjusted basis of all such items on such 
date. The excess against property over the adjusted basis of such 
property shall be taken into account as a liability secured only by the 
general credit of the corporation.
    (ii) A liability which is evidenced by an open account or which is 
secured only by the general credit of the controlled foreign corporation 
shall be apportioned against each and every item of corporate property 
in that ratio which the adjusted basis of such item on the applicable 
determination date (reduced as provided in subdivision (i) of this 
subparagraph) bears to the adjusted basis of all the corporate property 
on such date (reduced as provided in subdivision (i) of this 
subparagraph); provided that no liability shall be apportioned under 
this subdivision against any stock or obligations described in paragraph 
(h)(1) of this section.
    (2) Excluded charges. For purposes of subparagraph (1) of this 
paragraph, a liability created principally for the purpose of 
artificially increasing or decreasing the amount of a controlled foreign 
corporation's qualified investments in foreign base company shipping 
operations will not be recognized. Whether a liability is created 
principally for such purpose will depend upon all the facts and 
circumstances of each case. One of the factors that will be considered 
in making such a determination with respect to a loan is whether the 
loan was both created after November 20, 1974, and is from a related 
person, as defined in section 954(d)(3) and paragraph (e) of Sec. 
1.954-1. Another such factor is whether the liability was created after 
March 29, 1975, in a taxable year beginning before January 1, 1976. For 
purposes of this paragraph (g)(2), payments on liabilities which are 
represented by an open account are credited against the account 
transactions arising earliest in time.
    (3) Statement required. If for purposes of this section the adjusted 
basis of property which constitutes a qualified investment in foreign 
base company shipping operations by a controlled foreign corporation is 
reduced on the ground that such property is subject to a liability, each 
United States shareholder shall attach to his return a statement setting 
forth the adjusted basis of the property before the reduction and the 
amount and nature of the reduction.

[[Page 390]]

    (4) Partnership interest. If a controlled foreign corporation is a 
partner in a partnership, its investment in the partnership taken into 
account under section 955(b)(4) shall be its adjusted basis in the 
partnership determined under section 722 or 742, adjusted as provided in 
section 705, and reduced as provided in subparagraph (1) of this 
paragraph. (However, if the partnership is not engaged solely in the 
conduct of foreign base company shipping operations, such amount shall 
be taken into account only to the extent provided in paragraph (d)(1) of 
this section).
    (5) Grantor trust. If a controlled foreign corporation is deemed to 
own a portion of the assets of a trust under paragraph (e)(2) of this 
section then the amount taken into account under section 955 (b)(4) with 
respect to such assets shall be determined as provided in subparagraph 
(1) of this paragraph by the application of the following rules:
    (i) Such controlled foreign corporation's adjusted basis in such 
assets shall be deemed to be a proportionate share of the trust's 
adjusted basis in such assets, and
    (ii) A proportionate share of the liabilities of the trust shall be 
deemed to be liabilities of such controlled foreign corporation and to 
constitute specific charges against such assets.
    (6) Translation into United States dollars. The amounts determined 
in accordance with this paragraph shall be translated into United States 
dollars in accordance with the principles of Sec. 1.964-1(e)(4).
    (h) Investments in shipping companies under prior law--(1) In 
general. If an amount invested in stock or obligations of a less 
developed country shipping company described in Sec. 1.955-5(b) is 
treated as a qualified investment in less developed countries under 
Sec. 1.955-2 (applied without regard to paragraph (b)(5)(ii) thereof) 
on the applicable determination date for purposes of section 954(g) or 
section 955(a)(2) with respect to a taxable year beginning after 
December 31, 1975, then such amount shall be treated as a qualified 
investment in foreign base company shipping operations on such 
determination date. See section 955(b)(5).
    (2) Effect on prior law. See Sec. 1.955-2(b)(5)(ii) for the rule 
that investments which are treated as qualified investments in foreign 
base company shipping operations under subparagraph (1) of this 
paragraph shall not be treated as qualified investments in less 
developed countries for purposes of section 951(a)(1)(A)(ii).
    (3) Illustration. The application of this paragraph may be 
illustrated by the following example:

    Example. (a) Throughout the period here involved, controlled foreign 
corporation X owns 100 percent of the single class of stock of 
controlled foreign corporation Y, X and Y each use the calendar years as 
the taxable year. At the close of 1975, X's $50,000 investment in the 
stock of Y is treated as a qualified investment in less developed 
countries under Sec. 1.955-2 (applied without regard to Sec. 1.955-
2(b)(5)(ii), and Y is a less developed country shipping company 
described in Sec. 1.955-5(b).
    (b) On December 31, 1976, Y is still a less developed country 
shipping company and X's $50,000 investment in the stock of Y is still 
treated as a qualified investment in less developed countries under 
Sec. 1.955-2 (applied without regard to Sec. 1.955-2(b)(5)(ii). Under 
subparagraph (1) of this paragraph X's entire $50,000 investment in the 
stock of Y is treated as a qualified investment in foreign base company 
shipping operations.
    (c) For 1977, Y's gross income is $10,000 and Y's foreign base 
company shipping income is $7,500. Since Y fails to meet the 80-percent 
income test of Sec. 1.955-5(b)(1), Y is no longer a less developed 
country shipping company described in Sec. 1-955-5(b), and X's 
investment in the stock of Y is no longer treated as a qualified 
investment in less developed countries under Sec. 1.955-2 (applied 
without regard to Sec. 1.955-2(b)(5)(ii). However, assume that on 
December 31, 1977, Y's net worth (as defined in paragraph (c)(2)(1) of 
this section) is $100,000, that Y's qualified investments in foreign 
base company shipping operations (determined under this section) on 
December 31, 1977, are $75,000, and that X's investment in the stock of 
Y (as determined under paragraph (g) of this section) continues to be 
$50,000. Then $67,500, i.e.,
[GRAPHIC] [TIFF OMITTED] TC09OC91.015


of X's $50.000 investment in the stock of Y is treated as a qualified 
investment in foreign company shipping operations under paragraph (c) of 
this section.
    (d) For 1978, all of Y's gross income is foreign base company 
shipping income. Although Y is again a less developed country shipping 
company described in Sec. 1.955-5(b), X's investment in the stock of Y 
is no longer

[[Page 391]]

treated as a qualified investment in less developed countries under 
Sec. 1.955-2(b)(5)(iii). Thus, X's investment in the stock of Y is not 
treated as a qualified investment in foreign base company shipping 
operations under subparagraph (1) of this paragraph. However, X's 
investment in the stock of Y may be so treated under another provision 
of this section, as was the case in item (c) of this example.

(Secs. 955 (b)(2) and 7805 of the Internal Revenue Code of 1954 (89 
Stat. 63; 26 U.S.C. 955(b)(2), and 68A Stat. 917; 26 U.S.C. 7805))

[T.D. 7894, 48 FR 22532, May 19, 1983; 48 FR 40888, Sept. 12, 1983, as 
amended by T.D. 7959, 49 FR 22280, May 29, 1984]



Sec. 1.955A-3  Election as to qualified investments by related persons.

    (a) In general. If a United States shareholder elects the benefits 
of section 955(b) 2 with respect to a related group (as defined in 
paragraph (b)(1) of this section) of controlled foreign corporations, 
then an investment in foreign base company shipping operation made by 
one member of such group will be treated as having been made by another 
member to the extent provided in paragraph (c)(4) of this section, and 
each member will be subject to the other provisions of paragraph (c) of 
this section. An election once made shall apply for the taxable year for 
which it is made and for all subsequent years unless the election is 
revoked or a new election is made to add one or more controlled foreign 
corporations to election coverage. For the manner of making an election 
under section 955(b)(2), and for rules relating to the revocation of 
such an election, see paragraph (d) of this section. For rules relating 
to the coordination of sections 955(b)(2) and 955(b)(3), see paragraph 
(e) of this section.
    (b) Related group--(1) Related group defined. The term ``related 
group'' means two or more controlled foreign corporations, but only if 
all of the following requirements are met:
    (i) All such corporations use the same taxable year.
    (ii) The same United States shareholder controls each such 
corporation within the meaning of section 954(d)(3) at the end of such 
taxable year, and
    (iii) Such United States shareholder elects to treat such 
corporations as a related group.
    (iv) If any of the corporations is on a 52-53 week taxable year and 
if all of the taxable years of the corporations end within the same 7-
day period, the rule of paragraph (b)(1)(i) of this section shall be 
deemed satisfied.
    (v) An election under paragraph (b)(1)(iii) of this section will not 
be valid in the case of an election by a U.S. shareholder (the ``first 
U.S. shareholder'') if--
    (A) The first U.S. shareholder controls a second U.S. shareholder,
    (B) The second U.S. shareholder controls one or more controlled 
foreign corporations, and
    (C) Any of the controlled foreign corporations are the subject of 
the election by the first U.S. shareholder, unless the second U.S. 
shareholder consents to the election by the first U.S. shareholder.
    (2) Group taxable years defined. The ``group taxable year'' is the 
common taxable year of a related group.
    (3) Limitation. If a United States shareholder elects to treat two 
or more corporations as a related group for a group taxable year (the 
``first group taxable year''), then such United States shareholder (and 
any other United States shareholder which is controlled by such 
shareholder) may not also elect to treat two or more other corporations 
as a related group for a group taxable year any day of which falls 
within the first group taxable year.
    (4) Illustrations. The application of this paragraph may be 
illustrated by the following examples:

    Example 1. Domestic corporation M owns 100 percent of the only class 
of stock of controlled foreign corporations A, B, C, D, and E. A, B, and 
C use the calendar year as the taxable year. D and E use the fiscal year 
ending on June 30 as the taxable year. M may elect to treat A, B and C 
as a related group. However, M may not elect to treat C, D, and E as a 
related group.
    Example 2. The facts are the same as in example 1. In addition, M 
elects to treat A, B, and C as a related group for the group taxable 
year which ends on December 31, 1976. M may not also elect to treat D 
and E as a related group for the group taxable year ending on June 30, 
1977.
    Example 3. United States shareholder A owns 60 percent of the only 
class of stock of controlled foreign corporation X and 40 percent of the 
only class of stock of controlled

[[Page 392]]

foreign corporation Y. United States shareholder B owns the other 40 
percent of the stock of X and the other 60 percent of the stock of Y. 
Neither A nor B (nor both together) may elect to treat X and Y as a 
related group.

    (c) Effect of election. If a United States shareholder elects to 
treat two or more controlled foreign corporations as a related group for 
any group taxable year then, for purposes of determining the foreign 
base company income (see Sec. 1.954-1) and the increase or decrease in 
qualified investments in foreign base company shipping operations (see 
Sec. Sec. 1.954-7. 1.955A-1, and 1.955A-4) of each member of such group 
for such year, the following rules shall apply:
    (1) Intragroup dividends. The gross income of each member of the 
related group shall be deemed not to include dividends received from any 
other member of such group, to the extent that such dividends are 
attributable (within the meaning of Sec. 1.954-6(f)(4)) to foreign base 
company shipping income. In determining net foreign base company 
shipping income, deductions allocable to intragroup dividends 
attributable to foreign base company shipping income shall not be 
allowed.
    (2) Group excess deduction. (i) The deductions allocable under Sec. 
1.954-1(c) to the foreign base company shipping income of each member of 
the related group shall be deemed to include such member's pro rata 
share of the group excess deduction.
    (ii) The group excess deduction for the group taxable year is the 
sum of the excesses for each member of the related group (having an 
excess) of--
    (A) The member's deductions (determined without regard to this 
subparagraph) allocable to foreign base company shipping income for such 
year, over
    (B) The member's foreign base company shipping income for such year.
    (iii) A member's pro rata share of the group excess deduction is the 
amount which bears the same ratio to such group excess deduction as--
    (A) The excess of such member's foreign base company shipping income 
over the deductions (so determined) allocable thereto, bears to
    (B) The sum of such excesses for each member of the related group 
having an excess.
    (iv) For purposes of this subparagraph, ``foreign base company 
shipping income'' means foreign base company shipping income (as defined 
in Sec. 1.954-6), reduced by excluding therefrom all amounts which 
are--
    (A) Excluded from subpart F income under section 952(b) (relating to 
exclusion of United States income) or
    (B) Excluded from foreign base company income under section 
954(b)(4) (relating to exception for foreign corporation not availed of 
to reduce taxes).
    (v) The application of this subparagraph may be illustrated by the 
following example:

    Example. Controlled foreign corporations X, Y, and Z are a related 
group for calendar year 1976. The excess group deduction for 1976 is $9, 
X's pro rata share of the group excess deduction is $6, and Y's pro rata 
share is $3, determined as follows on the basis of the facts shown in 
the following table:

------------------------------------------------------------------------
                                               X      Y      Z     Group
------------------------------------------------------------------------
(1) Gross shipping income.................    $100    $90    $90
(2) Shipping deductions...................      60     70     80
(3) Net shipping income...................      40     20    (9)
(4) Group excess deduction................  ......  .....  .....      80
(5) X's pro rata share of group excess           6
 deduction ($9 x $40/$60).................
(6) Y's pro rata share of group excess      ......      3  .....  ......
 deduction ($9 x $20/$60).................
------------------------------------------------------------------------

    (3) Intragroup investments. On both of the determination dates 
applicable to the group taxable year for purposes of section 954(g) or 
section 955(a)(2), the qualified investments in foreign base company 
shipping operations of each member of the related group shall be deemed 
not to include stock of any other member of the related group. In 
addition, neither the gains nor the losses on dispositions of such stock 
during the group taxable year shall be taken into account under Sec. 
1.955A-1(b)(1)(ii) in determining the decrease in qualified investments 
in foreign base company shipping operations of any member of such 
related group.
    (4) Group excess investment. (i) On the later (and only the later) 
of the two determination dates applicable to the group taxable year for 
purposes of section 954(g) or section 955(a)(2), the

[[Page 393]]

qualified investments in foreign base company shipping operations of 
each member of the related group shall be deemed to include such 
member's pro rata share of the group excess investment.
    (ii) The group excess investment for the group taxable year is the 
sum of the excess for each member of the related group (having an 
excess) of--
    (A) The member's increase in qualified investments in foreign base 
company shipping operations (determined under Sec. 1.954-7 after the 
application of subparagraph (3) of this paragraph) for such year, over
    (B) The member's foreign base company shipping income for such year.
    (iii) A member's pro rata share of the group excess investment is 
the amount which bears the same ratio to such group excess investment 
as--
    (A) Such member's shortfall, in qualified investments bears to
    (B) the sum of the shortfalls in qualified investments of each 
member of such related group having a shortfall.
    (iv) If a member has an increase in qualified investments in foreign 
base company shipping operations (determined as provided in Sec. 1.954-
7 after the application of subparagraph (3) of this paragraph) for the 
group taxable year, then such member's ``shortfall in qualified 
investments'' is the excess of--
    (A) Such member's foreign base company shipping income for such 
year, over
    (B) Such increase.
    (v) If a member has a decrease in qualified investments in foreign 
base company shipping operations (determined under Sec. 1.955A-1(b)(1) 
or Sec. 1.955A-4(a), whichever is applicable, after the application of 
subparagraph (3) of this paragraph) for the group taxable year, then 
such member's ``shortfall in qualified investments'' is the sum of--
    (A) Such member's foreign base company shipping income for such year 
and
    (B) Such decrease.
    (vi) For purposes of this subparagraph, ``foreign base company 
shipping income'' means foreign base company shipping income (as defined 
in subparagraph (2)(iv) of this paragraph), reduced by the deductions 
allocable thereto under Sec. 1.954-1(c) (including the additional 
deductions described in subparagraph (2) of this paragraph).
    (vii) The application of paragraphs (c)(1), (3), and (4) of this 
section may be illustrated by the following example:

    Example. (a) Controlled foreign corporations R, S, and T are a 
related group for calendar year 1977. R and S do not own the stock of 
any member of the related group.
    (b) On December 31, 1977, T has qualified investments in foreign 
base company shipping operations (determined without regard to 
paragraphs (c)(3) and (4)) of $105, of which $15 consists of stock of S. 
After application of paragraph (c)(3) (but before application of 
paragraph (c)(4)), on December 31, 1977, T has qualified investments in 
foreign base company shipping operations of $90, determined as follows:

(1) Qualified investments (determined without regard to             $105
 paragraph (c)(3)) on December 31, 1977.........................
(2) Less: Qualified investments in stock of another member of a       15
 related group (as required by paragraph (c)(3))................
                                                                 -------
(3) Balance.....................................................      90
 

    (c) During 1977, T's foreign base company shipping income is $180, 
determined without regard to paragraph (c)(1). Included in the $180 is 
$5 in dividends in respect of T's stock in S. During 1977, T has 
shipping deductions of $91. Of T's shipping deductions, $1 is allocable 
to the dividends from S. After application of paragraph (c)(1), T's net 
shipping income during 1977 is $85, determined as follows:

(1) Foreign base company shipping income.................  .....    $180
(2) Less: intragroup dividends (as required by paragraph   .....       5
 (c)(1)).................................................
                                                                 -------
(3) Balance..............................................  .....     175
(4) Shipping deductions..................................    $91
(5) Less: deductions allocable to intragroup dividends         1
 (as required by paragraph (c)(1)).......................
                                                          -------
(6) Balance..............................................     90
(7) Net shipping income (line (3) minus line (6))........  .....      85
 

    (d) During 1977 (without regard to paragraph (c)(4)), R's increase 
in qualified investments in foreign base company shipping operations is 
$120; S's decrease is $55; and T's increase is $35, determined on the 
basis of the facts shown in the following table. In all cases, the 
listed amounts of qualified investments on December 31, 1976, reflect 
any adjustments required by paragraph (c)(3) for 1976, but not any 
adjustment required by paragraph (c)(4) for 1976 (see Sec. Sec. 1.955A-
3 (c)(3) and (4)(i)).

------------------------------------------------------------------------
                                                       R      S      T
------------------------------------------------------------------------
(1) Qualified investments on December 31, 1977 (in    $220   $150    $90
 the case of T, taken from line (3) of part (b) of
 this example).....................................

[[Page 394]]

 
(2) Qualified investments on December 31, 1976.....    100    205     55
                                                    --------------------
(3) Increase (decrease) (line (1) minus line (2))..    120   (55)     35
------------------------------------------------------------------------

    (e) In 1977, R's net shipping income is $100; S's is $95; and T's is 
$85, determined as follows:

------------------------------------------------------------------------
                                                       R      S      T
------------------------------------------------------------------------
(1) Gross foreign base company shipping income (in    $200   $180   $175
 the case of T, taken from line (3) of part (c) of
 this example).....................................
(2) Shipping deductions (in the case of T, taken       100     85     90
 from line (6) of part (c) of this example)........
                                                    --------------------
(3) Net shipping income (line (1) minus line (2))..    100     95     85
------------------------------------------------------------------------

    (f) By application of paragraph (c)(4) for 1977, S's pro rata share 
of the group excess investment is $15, and T's pro rata share is $5, 
determined as follows:

------------------------------------------------------------------------
                                               R      S      T     Group
------------------------------------------------------------------------
(1) Net shipping income (taken from line      $100    $95    $85
 (3) of part (e) of this example).........
(2) Increase (decrease) in qualified           120   (55)     35
 investments (taken from line (3) of part
 (d) of this example).....................
(3) Excess investment.....................      20  .....  .....     $20
(4) Shortfall.............................  ......    150     50     200
(5) S's pro rata share of group excess      ......     15
 investment ($20 x $150/$200).............
(6) T's pro rata share of group excess      ......  .....      5  ......
 investment ($20 x $50/$200)..............
------------------------------------------------------------------------

    (g) After application of paragraph (c)(4), for purposes of 
determining their increase or decrease in qualified investments in 
foreign base company shipping operations for 1977, on December 31, 1977, 
the amount of R's qualified investments is $200; the amount of S's is 
$165; and the amount of T's is $95, determined as follows:

------------------------------------------------------------------------
                                                       R      S      T
------------------------------------------------------------------------
(1) Qualified investments on December 31, 1977        $220   $150    $90
 (taken from line (1) of part (d) of this example).
(2) Plus: pro rata share of group excess investment  .....     15      5
 (as required by paragraph (c)(4)) (taken from
 lines (5) and (6) of part (f) of this example)....
(3) Minus: Excess investment treated as investments     20
 of related group members (taken from line (3) of
 part (f) of this example).........................
                                                    --------------------
(4) Total qualified investments....................    200    165     95
------------------------------------------------------------------------

    (h) After application of paragraph (c)(1), (3), and (4), during 
1977, R's increase in qualified investments in foreign base company 
shipping operations is $100; S's decrease is $40; and T's increase is 
$40, determined as set forth in the table below. In all cases, the 
listed amounts of qualified investments on December 31, 1976, reflect 
any similar adjustments required by paragraph (c)(3) for 1976, but not 
any adjustment required by paragraph (c)(4) for 1976 (see Sec. 1.955A-
3(c)(3) and (4)(i)).

------------------------------------------------------------------------
                                                       R      S      T
------------------------------------------------------------------------
(1) Qualified investments on December 31, 1977        $200   $165    $95
 (taken from line (4) of part (g) of this example).
(2) Qualified investments on December 31, 1976 (see    100    205     55
 line (2) of part (d) of this example).............
                                                    --------------------
(3) Increase (decrease) (line (1) minus line (2))..    100   (40)     40
------------------------------------------------------------------------

    (5) Collateral effect. (i) An election under this section by a 
United States shareholder to treat two or more controlled foreign 
corporations as a related group for a group taxable year shall have no 
effect on--
    (A) Any other United States shareholder (including a minority 
shareholder of a member of such related group).
    (B) Any other controlled foreign corporation, and
    (C) The foreign personal holding company income, foreign base 
company sales income, and foreign base company services income, and the 
deductions allocable under Sec. 1.954-1(c) thereto, of any member of 
such related group.
    (ii) See Sec. 1.952-1(c)(2)(ii) for the effect of an election under 
this section on the computation of earnings and profits and deficits in 
earnings and profits under section 952 (c) and (d).
    (iii) The application of this subparagraph may be illustrated by the 
following example:

    Example. United States shareholder A owns 80 percent of the only 
class of stock of controlled foreign corporations X and Y. United States 
shareholder B owns the other 20 percent of the stock of X and Y. X and Y 
both use the calendar year as the taxable year. A elects to treat X and 
Y as a related group for 1977. For purposes of determining the amounts 
includible in B's gross income under section 951(a) in respect of X and 
Y, the election made by A shall be disregarded and all of B's 
computations shall be made

[[Page 395]]

without regard to this section, as illustrated in Sec. 1.952-3(d).

    (d) Procedure--(1) Time and manner of making election. A United 
States shareholder shall make an election under this section to treat 
two or more controlled foreign corporations as a related group for a 
group taxable year and subsequent years by filing a statement to such 
effect with the return for the taxable year within which or with which 
such group taxable year ends. The statement shall include the following 
information:
    (i) The name, address, taxpayer identification number, and taxable 
year of the United States shareholder;
    (ii) The name, address, and taxable year of each controlled foreign 
corporation which is a member of the related group and is to be subject 
to the election; and
    (iii) A schedule showing the calculations by which the amounts 
described in this section have been determined for the taxable year for 
which the election is first effective. With respect to each subsequent 
taxable year to which the election applies, a new schedule showing 
calculations of such amounts for that taxable year must be filed with 
the return for that taxable year. A consent to an election required by 
paragraph (b)(1)(v) of this section shall include the same information 
required for the election statement.
    (2) Revocation. (i) Except as provided in subdivision (ii) of this 
subparagraph, an election under this section by a United States 
shareholder shall be binding for the group taxable year for which it is 
made and for subsequent years.
    (ii) Upon application by the United States shareholder (and any 
other United States shareholder controlled by such shareholder which 
consented under paragraph (b)(1)(v) of this section to the election), an 
election made under this section may, subject to the approval of the 
Commissioner, be revoked. An application to revoke the election, as of a 
specified group taxable year, with respect to one or more (but not all) 
controlled foreign corporations, subject to an election shall be deemed 
to be an application to revoke the election. Approval will not be 
granted unless a material and substantial change in circumstances occurs 
which could not have been anticipated when the election was made. The 
application for consent to revocation shall be made by mailing a letter 
for such purpose to Commissioner of Internal Revenue, Attention: T:C:C, 
Washington, DC 20224, containing a statement of the facts which justify 
such consent. If a member of a related group subject to an election 
ceases to meet the requirements of paragraph (b) of this section for 
membership in the group by reason of any action taken by it or any 
member of the group or the electing United States shareholder, then the 
election will be deemed to be revoked as of the beginning of the taxable 
year in which such action occurred. If such action is taken principally 
for the purpose of revoking the election without applying for and 
obtaining the approval of the Commissioner to the revocation, then no 
further election covering any member of that related group may be made 
by any United States shareholder for the remainder of the taxable year 
in which the action occurred and the five succeeding taxable years.
    (e) Coordination with section 955(b)(3). If a United States 
shareholder elects under this section to treat two or more controlled 
foreign corporations as a related group for any taxable year, and if 
such United States shareholder is required under Sec. 1.955A-4(c)(2) 
for purposes of filing any return to estimate the qualified investments 
in foreign base company shipping operations of any member of such group, 
then such United States shareholder shall, for purposes of filing such 
return, determine the amount includible in his gross income in respect 
of each member of such related group on the basis of such estimate. If 
the actual amount of such investments is not the same as the amount of 
the estimate, the United States shareholder shall immediately notify the 
Commissioner. The Commissioner will thereupon redetermine the amount of 
tax of such United States shareholder for the year or years with respect 
to which the incorrect amount was taken into account. The amount of tax, 
if any, due upon such redetermination shall be paid by the United States 
shareholder upon notice and demand by

[[Page 396]]

the district director. The amount of tax, if any, shown by such 
redetermination to have been overpaid shall be credited or refunded to 
the United States shareholder in accordance with the provisions of 
sections 6402 and 6511 and the regulations thereunder. If a United 
States shareholder elects under this section and if the United States 
shareholder has made an election under section 955(b)(3) as to at least 
one member of the related group, then the qualified investment amounts 
necessary for the calculations of paragraphs (c)(3) and (4) of this 
section shall be obtained, for each member of the related group, as of 
the determination dates applicable to each of the members.
    (f) Illustrations. The application of this section may be 
illustrated by the following examples:

    Example 1. (a) Controlled foreign corporations X and Y are wholly 
owned subsidiaries of domestic corporation M, X and Y use the calendar 
year as the taxable year. For 1977, X and Y are not export trade 
corporations (as defined in section 971(a)), nor have they any income 
derived from the insurance of United States risks (within the meaning of 
section 963(a)). M does not elect to treat X and Y as a related group 
for 1977.
    (b) For 1977, X and Y each have gross income (determined as provided 
in Sec. 1.951-6(h)(1)) of $1,000. X's foreign base company income is 
$20 and Y's foreign base company imcome is $0, determined as follows, 
based on the facts shown in the following table:

------------------------------------------------------------------------
                                                          X         Y
------------------------------------------------------------------------
(1) Foreign lease company shipping income...........    $1,000    $1,000
(2) Less: amounts excluded from subpart F income             0         0
 under section 952(b) (relating to U.S. income) and
 amounts excluded from foreign base company income
 under section 945(b)(4) (relating to corporation
 not availed of to reduce taxes)....................
                                                     -------------------
(3) Balance.........................................     1,000     1,000
(4) Less: deductions allocable under Sec. 1.954-         800     1,040
 1(c) to balance....................................
                                                     -------------------
(5) Remaining balance...............................       200         0
                                                     ===================
(6) Less: Increase in qualified investments in             180
 foreign base company shipping operations...........
                                                     -------------------
(7) Foreign base company income.....................        20  ........
------------------------------------------------------------------------

    (c) For 1977, Y has a withdrawal of previously excluded Subpart F 
income from investment in foreign base company shipping operations of 
$20, determined as follows, on the basis of the facts shown in the 
following table:

(1) Qualified investments in foreign base company shipping        $1,210
 operations at December 31, 1976..............................
(2) Less: qualified investments in foreign base company            1,170
 shipping operations at December 31, 1977.....................
                                                               ---------
(3) Balance...................................................        40
(4) Less: excess of recognized losses over recognized gains on        20
 sales during 1977 of qualified investments in foreign base
 company shipping operations..................................
                                                               ---------
(5) Tentative decrease in qualified investments in foreign            20
 base company shipping operations for 1977....................
                                                               =========
(6) Limitation described in Sec. 1.955A-1(b)(2).............       160
(7) Y's amount of previously excluded subpart F income                20
 withdrawn from investment in foreign base company shipping
 operations (lesser of lines (5) and (6)).....................
                                                               =========
 

    Example 2. (a) The facts are the same as in example 1, except that M 
does elect to treat X and Y as a related group for 1977.
    (b) The group excess deduction, which is solely attributable to Y's 
net shipping loss, is $40 (i.e., $1,040-$1,000). Since X is the only 
member of the related group with net shipping income, X's pro rata share 
of the group excess deduction is the entire $40 amount.
    (c) X's foreign base company income for 1977 is zero, determined as 
follows:

(1) Preliminary net foreign base company shipping income (line      $200
 (b)(5) of example 1).........................................
(2) Less: X's pro rata share of group excess deduction........        40
                                                               ---------
(3) Remaining balance.........................................       160
(4) Less: increase in qualified investments in foreign base          180
 company shipping operations..................................
                                                               ---------
(5) Foreign base company income...............................         0
                                                               =========
 

    (d) The group excess investment, which is solely attributable to X's 
excess investment, is $20 (i.e., $180 minus $160). Since Y is the only 
member of the related group with a shortfall in qualified investments, 
Y's share of the group excess investment is the entire $20 amount.
    (e) During 1976 and 1977, Y owns no stock of X. Y's withdrawal of 
previously excluded subpart F income from investment in foreign base 
company shipping operations for 1977 is zero, determined as follows:

(1) Qualified investments at December 31, 1976................    $1,210
(2)(i) Qualified investments at December 31, 1977 (determined      1,170
 without regard to paragraph (c)(4) of this section)..........
  (ii) Y's pro rata share of group excess investment..........        20
                                                               ---------
  (iii) Total qualified investments at December 31, 1977 (Line     1,190
   (i) plus line (ii).........................................
                                                               ---------
(3) Balance (line (1) minus line (2)(iii).....................        20

[[Page 397]]

 
(4) Less: excess of recognized losses over recognized gains on        20
 sales during 1977 of qualified investments in foreign base
 company shipping operations..................................
                                                               ---------
(5) Decrease in qualified investments for 1977................         0
                                                               =========
 


(Secs. 955 (b)(2) and 7805 of the Internal Revenue Code of 1954 (89 
Stat. 63; 26 U.S.C. 955(b)(2), and 68A Stat. 917; 26 U.S.C. 7805))

[T.D. 7894, 48 FR 22535, May 19, 1983; 48 FR 40888, Sept. 12, 1983, as 
amended by T.D. 7959, 49 FR 22280, May 29, 1984]



Sec. 1.955A-4  Election as to date of determining qualified investment
in foreign base company shipping operations.

    (a) Nature of election. In lieu of determining the increase under 
the provisions of section 954(g) and Sec. 1.954-7(a) or the decrease 
under the provisions of section 955(a)(2) and Sec. 1.955A-1(b) in a 
controlled foreign corporation's qualified investments in foreign base 
company shipping operations for a taxable year in the manner provided in 
such provisions, a United States shareholder of such controlled foreign 
corporation may elect, under the provisions of section 955(b)(3) and 
this section, to determine such increase in accordance with the 
provisions of Sec. 1.954-7(b) and to determine such decrease by 
ascertaining the amount by which--
    (1) Such controlled foreign corporation's qualified investments in 
foreign base company shipping operations at the close of such taxable 
year exceed its qualified investments in foreign base company shipping 
operations at the close of the taxable year immediately following such 
taxable year, and reducing such excess by
    (2) The amount determined under Sec. 1.955A-1(b)(1)(ii) for such 
taxable year subject to the limitation provided in Sec. 1.995A-1(b)(2) 
for such taxable year. An election under this section may be made with 
respect to each controlled foreign corporation with respect to which a 
person is a United States shareholder within the meaning of section 
951(b), but the election may not be exercised separately with respect to 
the increases and the decreases of such controlled foreign corporation. 
If an election is made under this section to determine the increase of a 
controlled foreign corporation in accordance with the provisions of 
Sec. 1.954-7(b), subsequent decreases of such controlled foreign 
corporation shall be determined in accordance with this paragraph and 
not in accordance with Sec. 1.955A-1(b).
    (b) Time and manner of making election--(1) Without consent. An 
election under this section with respect to a controlled foreign 
corporation shall be made without the consent of the Commissioner by a 
United States shareholder's filing a statement to such effect with his 
return for his taxable year in which or with which ends the first 
taxable year of such controlled foreign corporation in which--
    (i) Such shareholder is a United States shareholder, and
    (ii) Such controlled foreign corporation realizes foreign base 
company shipping income, as defined in Sec. 1.954-6.


The statement shall contain the name and address of the controlled 
foreign corporation and identification of such first taxable year of 
such corporation.
    (2) With consent. An election under this section with respect to a 
controlled foreign corporation may be made by a United States 
shareholder at any time with the consent of the Commissioner. Consent 
will not be granted unless the United States shareholder and the 
Commissioner agree to the terms, conditions, and adjustments under which 
the election will be effected. The application for consent to elect 
shall be made by the United States shareholder's mailing a letter for 
such purpose to the Commissioner of Internal Revenue, Washington, DC 
20224. The application shall be mailed before the close of the first 
taxable year of the controlled foreign corporation with respect to which 
the shareholder desires to compute an amount described in section 
954(b)(2) in accordance with the election provided in this section. The 
application shall include the following information.
    (i) The name, address, and taxpayer identification number, and 
taxable year of the United States shareholder;
    (ii) The name and address of the controlled foreign corporation;
    (iii) The first taxable year of the controlled foreign corporation 
for which income is to be computed under the election;

[[Page 398]]

    (iv) The amount of the controlled foreign corporation's qualified 
investments in foreign base company shipping operations at the close of 
its preceding taxable year; and
    (v) The sum of the amounts excluded under section 954(b)(2) and 
Sec. 1.954-1(b)(1) from the foreign base company income of the 
controlled foreign corporation for all prior taxable years during which 
such shareholder was a United States shareholder of such corporation and 
the sum of the amounts of its previously excluded subpart F income 
withdrawn from investment in foreign base company shipping operations 
for all prior taxable years during which such shareholder was a United 
States shareholder of such corporation.
    (c) Effect of election--(1) General. Except as provided in 
subparagraphs (3) and (4) of this paragraph, an election under this 
section with respect to a controlled foreign corporation shall be 
binding on the United States shareholder and shall apply to all 
qualified investments in foreign base company shipping operations 
acquired, or disposed of, by such controlled foreign corporation during 
the taxable year following its taxable year for which income is first 
computed under the election and during all succeeding taxable years of 
such corporation.
    (2) Returns. Any return of a United States shareholder required to 
be filed before the completion of a period with respect to which 
determinations are to be made as to a controlled foreign corporation's 
qualified investments in foreign base company shipping operations for 
purposes of computing such shareholder's taxable income shall be filed 
on the basis of an estimate of the amount of the controlled foreign 
corporation's qualified investments in foreign base company shipping 
operations at the close of the period. If the actual amount of such 
investments is not the same as the amount of the estimate, the United 
States shareholder shall immediately notify the Commissioner. The 
Commissioner will thereupon redetermine the amount of tax of such United 
States shareholder for the year or years with respect to which the 
incorrect amount was taken into account. The amount of tax, if any, due 
upon such redetermination shall be paid by the United States shareholder 
upon notice and demand by the district director. The amount of tax, if 
any, shown by such redetermination to have been overpaid shall be 
credited or refunded to the United States shareholder in accordance with 
the provisions of sections 6402 and 6511 and the regulations thereunder.
    (3) Revocation. Upon application by the United States shareholder, 
the election made under this section may, subject to the approval of the 
Commissioner, be revoked. Approval will not be granted unless the United 
States shareholder and the Commissioner agree to the terms, conditions, 
and adjustments under which the revocation will be effected. Unless such 
agreement provides otherwise, the change in the controlled foreign 
corporation's qualified investments in foreign base company shipping 
operations for its first taxable year for which income is computed 
without regard to the election previously made will be considered to be 
zero for purposes of effectuating the revocation. The application for 
consent to revocation shall be made by the United States shareholder's 
mailing a letter for such purpose to the Commissioner of Internal 
Revenue, Washington, DC 20224. The application shall be mailed before 
the close of the first taxable year of the controlled foreign 
corporation with respect to which the shareholder desires to compute the 
amounts described in section 954(b)(2) or 955(a) without regard to the 
election provided in this section. The application shall include the 
following information:
    (i) The name, address, and taxpayer identification number of the 
United States shareholder:
    (ii) The name and address of the controlled foreign corporation;
    (iii) The taxable year of the controlled foreign corporation for 
which such amounts are to be computed;
    (iv) The amount of the controlled foreign corporation's qualified 
investments in foreign base company shipping operations at the close of 
its preceding taxable year;
    (v) The sum of the amounts excluded under section 954(b)(2) and 
Sec. 1.954-1(b)(1) from the foreign base company income of the 
controlled foreign corporation

[[Page 399]]

for all prior taxable years during which such shareholder was a United 
States shareholder of such corporation and the sum of the amounts of its 
previously excluded subpart F income withdrawn from investment in 
foreign base company shipping operations for all prior taxable years 
during which such shareholder was a United States shareholder of such 
corporation; and
    (vi) The reasons for the request for consent to revocation.
    (4) Transfer of stock. If during any taxable year of a controlled 
foreign corporation--
    (i) A United States shareholder who has made an election under this 
section with respect to such controlled foreign corporation sells, 
exchanges, or otherwise disposes of all or part of his stock in such 
controlled foreign corporation, and
    (ii) The foreign corporation is a controlled foreign corporation 
immediately after the sale, exchange, or other disposition,


then, with respect to the stock so sold, exchanged, or disposed of, the 
change in the controlled foreign corporation's qualified investments in 
foreign base company shipping operations for such taxable year shall be 
considered to be zero. If the United States shareholder's successor in 
interest is entitled to and does make an election under paragraph (b)(1) 
of this section to determine the controlled foreign corporation's 
increase in qualified investments in foreign base company shipping 
operations for the taxable year in which he acquires such stock, such 
increase with respect to the stock so acquired shall be determined in 
accordance with the provisions of Sec. 1.954-7(b)(1). If the controlled 
foreign corporation realizes no foreign base company income from which 
amounts are excluded under section 954(b)(2) and Sec. 1.954-1(b)(1) for 
the taxable year in which the United States shareholder's successor in 
interest acquires such stock and such successor in interest makes an 
election under paragraph (b)(1) of this section with respect to a 
subsequent taxable year of such controlled foreign corporation, the 
increase in the controlled foreign corporation's qualified investments 
in foreign base company shipping operations for such subsequent taxable 
year shall be determined in accordance with the provisions of Sec. 
1.954-7(b)(2).
    (d) Illustrations. The application of this section may be 
illustrated by the following examples:

    Example 1. Foreign corporation A is a wholly owned subsidiary of 
domestic corporation M. Both corporations use the calendar year as a 
taxable year. In a statement filed with its return for 1977, M makes an 
election under section 955(b)(3) and the election remains in force for 
the taxable year 1978. At December 31, 1978, A's qualified investments 
in foreign base company shipping operations amount to $100,000; and, at 
December 31, 1979, to $80,000. For purposes of paragraph (a)(1) of this 
section, A Corporation's decrease in qualified investments in foreign 
base company shipping operations for the taxable year 1978 is $20,000 
and is determined by ascertaining the amount by which A Corporation's 
qualified investments in foreign base company shipping operations at 
December 31, 1978 ($100,000) exceed its qualified investments in foreign 
base company shipping operations at December 31, 1979 ($80,000).
    Example 2. The facts are the same as in example 1 except that A 
experiences no changes in qualified investments in foreign base company 
shipping operations during its taxable years 1980 and 1981. If M's 
election were to remain in force, A's acquisitions and dispositions of 
qualified investments in foreign base company shipping operations during 
A's taxable year 1982 would be taken into account in determining whether 
A has experienced an increase or a decrease in qualified investments in 
foreign base company shipping operations for its taxable year 1981. 
However, M duly files before the close of A's taxable year 1981 as 
application for consent to revocation of M Corporation's election under 
section 955(b)(3), and, pursuant to an agreement between the 
Commissioner and M, consent is granted by the Commissioner. Assuming 
such agreement does not provide otherwise, A's change in qualifed 
investments in foreign base company shipping operations for its taxable 
year 1981 is zero because the effect of the revocation of the election 
is to treat acquisitions and dispositions of qualified investments in 
foreign base company shipping operations actually occurring in 1982 as 
having occurred in such year rather than in 1981.
    Example 3. The facts are the same as in example 2 except that A's 
qualified investments in foreign base company shipping operations at 
December 31, 1982, amount to $70,000. For purposes of paragraph 
(b)(1)(i) of Sec. 1.955A-1, the decrease in A's qualified investments 
in foreign base company shipping operations for the taxable year 1982 is 
$10,000 and is determined by ascertaining the

[[Page 400]]

amount by which A's qualified investments in foreign base company 
shipping operations at December 31, 1981 ($80,000) exceed its qualified 
investments in foreign base company shipping operations at December 31, 
1982 ($70,000).
    Example 4. The facts are the same as in example 1. Assume further 
that on September 30, 1979, M sells 40 percent of the only class of 
stock of A to N Corporation, a domestic corporation. N uses the calendar 
year as a taxable year. A remains a controlled foreign corporation 
immediately after such sale of its stock. A's qualified investments in 
foreign base company shipping operations at December 31, 1980, amount to 
$90,000. The changes in A Corporation's qualified investments in foreign 
base company shipping operations occurring in its taxable year 1979 are 
considered to be zero with respect to the 40-percent stock interest 
acquired by N Corporation. The entire $20,000 reduction in A 
Corporation's qualified investments in foreign base company shipping 
operations which occurs during the taxable year 1979 is taken into 
account by M for purposes of paragraph (c)(1) of this section in 
determining its tax liability for the taxable year 1978. A's increase in 
qualified investments in foreign base company shipping operations for 
the taxable year 1979 with respect to the 60-percent stock interest 
retained by M is $6,000 and is determined by ascertaining M's pro rata 
share (60 percent) of the amount by which A's qualified investments in 
foreign base company shipping operations at December 31, 1980 ($90,000) 
exceed its qualified investments in foreign base company shipping 
operations at December 31, 1979 ($80,000). N does not make an election 
under section 955(b)(3) in its return for its taxable year 1980. 
Corporation A's increase in qualified investments in foreign base 
company shipping operations for the taxable year 1980 with respect to 
the 40-percent stock interest acquired by N is $4,000.

[T.D. 7894, 48 FR 22539, May 19, 1983]



Sec. 1.956-1  Shareholder's pro rata share of a controlled foreign
corporation's increase in earnings invested in United States property.

    (a) In general. Section 956(a)(1) and paragraph (b) of this section 
provide rules for determining the amount of a controlled foreign 
corporation's earnings invested in United States property at the close 
of any taxable year. Such amount is the aggregate amount invested in 
United States property to the extent such amount would have constituted 
a dividend if it had been distributed on such date. Subject to the 
provisions of section 951(a)(4) and the regulations thereunder, a United 
States shareholder of a controlled foreign corporation is required to 
include in his gross income his pro rata share, as determined in 
accordance with paragraph (c) of this section, of the controlled foreign 
corporation's increase for any taxable year in earnings invested in 
United States property but only to the extent such share is not 
excludable from his gross income under the provisions of section 
959(a)(2) and the regulations thereunder.
    (b) Amount of a controlled foreign corporation's investment of 
earnings in United States property--(1) Dividend limitation. The amount 
of a controlled foreign corporation's earnings invested at the close of 
its taxable year in United States property is the aggregate amount of 
such property held, directly or indirectly, by such corporation at the 
close of its taxable year to the extent such amount would have 
constituted a dividend under section 316 and Sec. Sec. 1.316-1 and 
1.316-2 (determined after the application of section 955(a)) if it had 
been distributed on such closing day. For purposes of this subparagraph, 
the determination of whether an amount would have constituted a dividend 
if distributed shall be made without regard to the provisions of section 
959(d) and the regulations thereunder.
    (2) Aggregate amount of United States property. For purposes of 
determining an increase in earnings invested in United States property 
for any taxable year beginning after December 31, 1975, the aggregate 
amount of United States property held by a controlled foreign 
corporation at the close of--
    (i) Any taxable year beginning after December 31, 1975, and
    (ii) The last taxable year beginning before January 1, 1976 does not 
include stock or obligations of a domestic corporation described in 
section 956(b)(2)(F) or movable property described in section 
956(b)(2)(G).
    (3) Treatment of earnings and profits. For purposes of making the 
determination under subparagraph (1) of this paragraph as to whether an 
amount of investment would have constituted a dividend if distributed at 
the close of any taxable year of a controlled foreign corporation, 
earnings and profits of the controlled foreign corporation shall be

[[Page 401]]

considered not to include any amounts which are attributable to--
    (i) Amounts which have been included in the gross income of a United 
States shareholder of such controlled foreign corporation under section 
951(a)(1)(B) (or which would have been so included but for section 
959(a)(2)) and have not been distributed, or
    (ii)(a) Amounts which are included in the gross income of a United 
States shareholder of such controlled foreign corporation under section 
551(b) or would be so included under such section but for the fact that 
such amounts were distributed to such shareholder during the taxable 
year, or
    (b) Amounts which, for any prior taxable year, have been included in 
the gross income of a United States shareholder of such controlled 
foreign corporation under section 551(b) and have not been distributed.


The rules of this subparagraph apply only in determining the limitation 
on a controlled foreign corporation's increase in earnings invested in 
United States property. See section 959 and the regulations thereunder 
for limitations on the exclusion from gross income of previously taxed 
earnings and profits.
    (4) [Reserved]. For further guidance, see Sec. 1.956-1T(b)(4).
    (5) [Reserved]. For further guidance, see Sec. 1.956-1T(b)(5).
    (c) Shareholder's pro rata share of increase--(1) General rule. A 
United States shareholder's pro rata share of a controlled foreign 
corporation's increase for any taxable year in earnings invested in 
United States property is the amount determined by subtracting the 
shareholder's pro rata share of--
    (i) The controlled foreign corporation's earnings invested in United 
States property at the close of its preceding taxable year, as 
determined under paragraph (b) of this section, reduced by amounts paid 
by such corporation during such preceding taxable year to which section 
959(c)(1) and the regulations thereunder apply, from his pro rata share 
of
    (ii) The controlled foreign corporation's earnings invested in 
United States property at the close of its current taxable year, as 
determined under paragraph (b) of this section.
    (2) Illustration. The application of this paragraph may be 
illustrated by the following examples:

    Example 1. A is a United States shareholder and direct owner of 60 
percent of the only class of stock of R Corporation, a controlled 
foreign corporation during the entire period here involved. Both A and R 
Corporation use the calendar year as a taxable year. Corporation R's 
aggregate investment in United States property on December 31, 1964, 
which would constitute a dividend (as determined under paragraph (b) of 
this section) if distributed on such date is $150,000. During the 
taxable year 1964, R Corporation distributed $50,000 to which section 
959(c)(1) applies. Corporation R's aggregate investment in United States 
property on December 31, 1965, is $250,000; and R Corporation's current 
and accumulated earnings and profits on such date (determined as 
provided in paragraph (b) of this section) are $225,000. A's pro rata 
share of R Corporation's increase for 1965 in earnings invested in 
United States property is $75,000, determined as follows:

(i) Aggregate investment in United States property on           $250,000
 December 31, 1965...........................................
                                                   ------------
(ii) Current and accumulated earnings and profits on December    225,000
 31, 1965....................................................
                                                   ------------
(iii) Amount of earnings invested in United States property      225,000
 on December 31, 1965, which would constitute a dividend if
 distributed on such date (lesser of item (i) or item (ii))..
(iv) Aggregate investment in United States           $150,000
 property on December 31, 1964, which would
 constitute a dividend if distributed on such date
  Less: Amounts distributed during 1964 to which       50,000    100,000
   section 959(c)(1) applies......................
                                                   ------------
(v) R Corporation's increase for 1965 in earnings invested in    125,000
 United States property (item (iii) minus item (iv)).........
                                                   ============
(vi) A's pro rata share of R Corporation's increase for 1965      75,000
 in earnings invested in United States property (item (v)
 times 60 percent)...........................................
 

    Example 2. The facts are the same as in example 1, except that R 
Corporation's current and accumulated earnings and profits on December 
31, 1965, are $100,000 instead of $225,000. Accordingly, even through R 
Corporation's aggregate investment in United States property on December 
31, 1965, of $250,000 exceeds the net amount ($100,000) taken into 
account under subparagraph (1)(i) of this paragraph as of December 31, 
1964, by $150,000, there is no increase for taxable year 1965 in 
earnings invested in United States property because of the dividend 
limitation of paragraph (b)(1) of this section. Corporation R's 
aggregate investment in United States property on December 31, 1966, is 
unchanged ($250,000) Corporation R's current

[[Page 402]]

and accumulated earnings and profits on December 31, 1966, are $175,000, 
and, as a consequence, its aggregate investment in United States 
property which would constitute a dividend if distributed on that date 
is $175,000. Corporation R pays no amount during 1965 to which section 
959(c)(1) applies. Corporation R's increase for the taxable year 1966 in 
earnings invested in United States property is $75,000, and A's pro rata 
share of that amount is $45,000 ($75,000 times 60 percent).

    (d) Date and basis of determinations. The determinations made under 
paragraph (c)(1)(i) of this section with respect to the close of the 
preceding taxable year of a controlled foreign corporation and under 
paragraph (c)(1)(ii) with respect to the close of the current taxable 
year of such controlled foreign corporation, for purposes of determining 
the United States shareholder's pro rata share of such corporation's 
increased investment of earnings in United States property for the 
current taxable year, shall be made as of the last day of the current 
taxable year of such corporation but on the basis of stock owned, within 
the meaning of section 958(a) and the regulations thereunder, by such 
United States shareholder on the last day of the current taxable year of 
the foreign corporation on which such corporation is a controlled 
foreign corporation. See the last sentence of section 956(a)(2). The 
application of this paragraph may be illustrated from the following 
example:

    Example. Domestic corporation M owns 60 percent of the only class of 
stock of A Corporation, a controlled foreign corporation during the 
entire period here involved. Both M Corporation and A Corporation use 
the calendar year as a taxable year. Corporation A's investment of 
earnings in United States property at the close of the taxable year 1963 
is $100,000, as determined under paragraph (b) of this section, and M 
Corporation includes its pro rata share of such amount ($60,000) in 
gross income for its taxable year 1963. On June 1, 1964, M Corporation 
acquires an additional 25 percent of A Corporation's outstanding stock 
from a person who is not a United States person as defined in section 
957(d). Corporation A's investment of earnings in United States property 
at the close of the taxable year 1964, as determined under paragraph (b) 
of this section, is unchanged ($100,000). Corporation A pays no amount 
during 1963 to which section 959(c)(1) applies. Corporation M is not 
required, by reason of the acquisition in 1964 of A Corporation's stock, 
to include an additional amount in its gross income with respect to A 
Corporation's investment of earnings in United States property even 
though the earnings invested in United States property by A Corporation 
attributable to the stock acquired by M Corporation were not previously 
taxed. The determination made under paragraph (c)(1)(i) of this section 
as well as the determination made under paragraph (c)(1)(ii) of this 
section with respect to A Corporation's investment for 1964 of earnings 
in United States property are made on the basis of stock owned by M 
Corporation (85 percent) at the close of 1964.

    (e) Amount attributable to property--(1) General rule. Except as 
provided in subparagraph (2) of this paragraph, for purposes of 
paragraph (b)(1) of this section the amount taken into account with 
respect to any United States property shall be its adjusted basis, as of 
the applicable determination date, reduced by any liability (other than 
a liability described in subparagraph (3) of this paragraph) to which 
such property is subject on such date. To be taken into account under 
this subparagraph, a liability must constitute a specific charge against 
the property involved. Thus, a liability evidenced by an open account or 
a liability secured only by the general credit of the controlled foreign 
corporation will not be taken into account. On the other hand, if a 
liability constitutes a specific charge against several items of 
property and cannot definitely be allocated to any single item of 
property, the liability shall be apportioned against each of such items 
of property in that ratio which the adjusted basis of such item on the 
applicable determination date bears to the adjusted basis of all such 
items at such time. A liability in excess of the adjusted basis of the 
property which is subject to such liability shall not be taken into 
account for the purpose of reducing the adjusted basis of other property 
which is not subject to such liability. See Sec. 1.956-1(e)(6) for a 
special rule for determining amounts attributable to United States 
property acquired as the result of certain nonrecognition transactions.
    (2) Rule for pledges and guarantees. For purposes of this section 
the amount taken into account with respect to any pledge or guarantee 
described in paragraph (c)(1) of Sec. 1.956-2

[[Page 403]]

shall be the unpaid principal amount on the applicable determination 
date of the obligation with respect to which the controlled foreign 
corporation is a pledgor or guarantor.
    (3) Excluded charges. For purposes of subparagraph (1) of this 
paragraph, a specific charge created with respect to any item of 
property principally for the purpose of artificially increasing or 
decreasing the amount of a controlled foreign corporation's investment 
of earnings in United States property will not be recognized; whether a 
specific charge is created principally for such purpose will depend upon 
all the facts and circumstances of each case. One of the factors that 
will be considered in making such a determination with respect to a loan 
is whether the loan is from a related person, as defined in section 954 
(d)(3) and paragraph (e) of Sec. 1.954-1.
    (4) Statement required. If for purposes of this section a United 
States shareholder of a controlled foreign corporation reduces the 
adjusted basis of property which constitutes United States property on 
the ground that such property is subject to a liability, he shall attach 
to his return a statement setting forth the adjusted basis of the 
property before the reduction and the amount and nature of the 
reduction.
    (5) [Reserved] For further guidance, see Sec. 1.956-1T(e)(5).
    (6) Adjusted basis of property acquired in certain nonrecognition 
transactions--(i) Scope. This paragraph (e)(6) provides rules for 
determining, solely for purposes of applying section 956, the adjusted 
basis of specified United States property acquired by a controlled 
foreign corporation pursuant to an exchange in which the controlled 
foreign corporation's basis in such specified United States property is 
determined under section 362(a). This paragraph (e)(6) also applies if 
specified United States property, the adjusted basis in which has been 
determined under these regulations, is transferred (in one or more 
subsequent exchanges) to a related person (within the meaning of section 
954(d)(3)), pursuant to one or more exchanges in which the related 
person's adjusted basis in such property is determined, in whole or in 
part, by reference to the transferor controlled foreign corporation's 
adjusted basis in such property.
    (ii) Definition of specified United States property. For purposes of 
this paragraph (e)(6), specified United States property is stock of a 
domestic corporation described in section 956(c)(1)(B) or an obligation 
of a domestic corporation described in section 956(c)(1)(C) that is 
acquired by a controlled foreign corporation from the domestic issuing 
corporation. Specified United States property does not include property 
described in section 956(c)(2).
    (iii) Adjusted basis of specified United States property. Solely for 
purposes of applying section 956, the adjusted basis of specified United 
States property acquired by a controlled foreign corporation in 
connection with an exchange to which this paragraph (e)(6) applies shall 
be no less than the fair market value of any property transferred by the 
controlled foreign corporation in exchange for such specified United 
States property. For purposes of this paragraph (e)(6), the term 
property has the meaning set forth in section 317(a), but also includes 
any liability that is assumed by the controlled foreign corporation in 
connection with the exchange notwithstanding the application of section 
357(a). The assumption of a liability by the controlled foreign 
corporation in connection with the exchange will be considered the 
transfer of property. The fair market value of such property will be the 
amount of the liability assumed. The fair market value of any property 
transferred by the controlled foreign corporation in exchange for the 
specified United States property shall be determined at the time of the 
exchange.
    (iv) Timing. For purposes of Sec. 1.956-2(d)(1)(i)(a), a controlled 
foreign corporation that acquires specified United States property in an 
exchange to which this paragraph (e)(6) applies acquires an adjusted 
basis in such property at the time of the controlled foreign 
corporation's exchange of property for such specified United States 
property.
    (v) Transfers to related persons. If a controlled foreign 
corporation transfers specified United States property, the adjusted 
basis in which has been determined under this paragraph (e)(6),

[[Page 404]]

to a related person (within the meaning of section 954(d)(3)) (related 
person transferee) in one or more exchanges pursuant to which the 
related person transferee's adjusted basis in such specified United 
States property is determined, in whole or in part, by reference to the 
controlled foreign corporation's adjusted basis in such specified United 
States property, then, solely for purposes of applying section 956 
following such exchange, the controlled foreign corporation's adjusted 
basis in any United States property received in the exchange (or 
exchanges) shall be no less than the aggregate adjusted basis of the 
specified United States property as determined under paragraph 
(e)(6)(iii) of this section, and the related person transferee's 
adjusted basis in such specified United States property shall be no less 
than the adjusted basis of such specified United States property in the 
hands of the controlled foreign corporation as determined under 
paragraph (e)(6)(iii) of this section. This paragraph (e)(6)(v) shall 
also apply in the case of one or more successive transfers of the 
specified United States property by a related person transferee to one 
or more persons related to the controlled foreign corporation (within 
the meaning of section 954(d)(3)). This paragraph (e)(6)(v) shall apply 
regardless of whether a subsequent transfer was part of a plan (or 
series of related transactions) that includes the controlled foreign 
corporation's acquisition of the specified United States property.
    (vi) Examples. The rules of this paragraph (e)(6) are illustrated by 
the following examples:

    Example 1. (i) Facts. USP, a domestic corporation, is the common 
parent of an affiliated group that joins in the filing of a consolidated 
return. USP owns 100 percent of the stock of US1 and US2, both domestic 
corporations and members of the USP consolidated group. US1 owns 100 
percent of the stock of CFC, a controlled foreign corporation. US2 
issues $100x of its stock to CFC in exchange for $10x of CFC stock and 
$90x cash. US2's transfer of its stock to CFC is described in section 
351, US2 recognizes no gain in the exchange under section 1032(a), and 
CFC's basis in the US2 stock acquired in the exchange is determined 
under section 362(a).
    (ii) Analysis. The US2 stock acquired by CFC in the exchange 
constitutes specified United States property under paragraph (e)(6)(ii) 
of this section because CFC acquires the US2 stock from US2, the issuing 
corporation. Therefore, because CFC's adjusted basis in the US2 stock is 
determined under section 362(a), then for purposes of applying section 
956, CFC's adjusted basis in the US2 stock shall, under paragraph 
(e)(6)(iii) of this section, be no less than $90x, the fair market value 
of the property exchanged by CFC for the US2 stock (the $10x of CFC 
stock issued in the exchange does not constitute property for purposes 
of paragraph (e)(6)(iii) of this section). Pursuant to paragraph 
(e)(6)(iv) of this section, for purposes of Sec. 1.956-2(d)(1)(i)(a) 
CFC shall be treated as acquiring its adjusted basis of no less than 
$90x in the US2 stock at the time of its transfer of property to US2 in 
exchange for the US2 stock. The result would be the same if, instead of 
CFC transferring $90x of cash to US2 in the exchange, CFC assumes a $90x 
liability of US2.
    Example 2. (i) Facts. USP, a domestic corporation, owns 100 percent 
of the stock of USS, a domestic corporation. USP also owns 100 percent 
of the stock of CFC, a controlled foreign corporation. USP's adjusted 
basis in its USS stock equals the fair market value of the USS stock, or 
$100x. USP transfers its USS stock to CFC in exchange for $100x of CFC 
stock. USP's transfer of its USS stock to CFC is described in section 
351, USP recognizes no gain in the exchange under section 351(a), and 
CFC's adjusted basis in the USS stock acquired in the exchange, 
determined under section 362(a), equals $100x.
    (ii) Analysis. The USS stock acquired by CFC in the exchange does 
not constitute specified United States property under paragraph 
(e)(6)(ii) of this section because CFC acquires the USS stock from USP. 
Therefore, CFC's adjusted basis in the USS stock, for purposes of 
section 956, is not determined under this paragraph (e)(6). Instead, 
CFC's adjusted basis in the USS stock is determined under the general 
rule of section 956(a) and under paragraphs (e)(1) through (4) of this 
section. As determined under section 362(a), CFC's adjusted basis in the 
USS stock is $100x.
    Example 3. (i) Facts. USP, a domestic corporation, owns 100 percent 
of the stock of CFC1, a controlled foreign corporation. CFC1 holds 
specified United States property (within the meaning of paragraph 
(e)(6)(ii) of this section) with an adjusted basis of $30x for purposes 
of applying section 956 that was determined under paragraph (e)(6)(iii) 
of this section. CFC1 owns 100 percent of the stock of CFC2, a 
controlled foreign corporation. CFC1 transfers the specified United 
States property to CFC2 in an exchange described in section 351. CFC2's 
adjusted basis in the specified United States property is determined 
under section 362(a).
    (ii) Analysis. In the section 351 exchange, CFC1 transferred 
specified United States

[[Page 405]]

property to CFC2 with an adjusted basis that was determined under 
paragraph (e)(6)(iii) of this section. Further, CFC2's adjusted basis in 
the specified United States property is determined under section 362(a) 
by reference, in whole or in part, to CFC1's adjusted basis in such 
property. Therefore, for purposes of applying section 956, pursuant to 
paragraph (e)(6)(v) of this section CFC2's adjusted basis in the 
specified United States property shall be no less than $30x. Paragraph 
(e)(6)(v) of this section would also apply if CFC2 subsequently 
transfers the specified United States property to another person related 
to CFC1 (within the meaning of section 954(d)(3)) if such related 
person's adjusted basis in the specified United States property is 
determined by reference, in whole or in part, to CFC2's adjusted basis 
in such property. See also Sec. 1.956-1T(b)(4) if one of the principal 
purposes of CFC1's transfer of property to CFC2 was the avoidance of the 
application of section 956 with respect to CFC1.

    (f) [Reserved]. For further guidance, see Sec. 1.956-1T(f).
    (g) introductory text through (g)(3) [Reserved]. For further 
guidance, see Sec. 1.956-1T(g) introductory text through (g)(3).
    (4) Paragraph (e)(6) of this section applies to property acquired in 
exchanges occurring on or after June 24, 2011. For transactions that 
occur prior to June 24, 2011, see Sec. 1.956-1T(e)(6) as contained in 
26 CFR part 1 revised as of April 1, 2011.

(Secs. 956(c), 7805, Internal Revenue Code of 1954 (76 Stat. 1017, 68A 
Stat. 917; (26 U.S.C. 956(c) and 7805 respectively)))

[T.D. 6704, 29 FR 2600, Feb. 20, 1964, as amended by T.D. 6795, 30 FR 
942, Jan. 29, 1965; T.D. 7712, 45 FR 52374, Aug. 7, 1980; T.D. 8209, 53 
FR 22171, June 14, 1988; T.D. 9402, 73 FR 35582, June 24, 2008; T.D. 
9630, 76 FR 36994, June 24, 2011; T.D. 9733, 80 FR 52981, Sept. 2, 2015; 
80 FR 66416, Oct. 29, 2015]



Sec. 1.956-1T  Shareholder's pro rata share of a controlled foreign
corporation's increase in earnings invested in United States property
(temporary).

    (a) [Reserved]
    (b)(1)-(3) [Reserved]
    (4) Certain indirectly held United States property--(i) General 
rule. For purposes of section 956, United States property held 
indirectly by a controlled foreign corporation includes--
    (A) United States property held on behalf of the controlled foreign 
corporation by a trustee or a nominee;
    (B) United States property acquired by any other foreign corporation 
that is controlled by the controlled foreign corporation if a principal 
purpose of creating, organizing, or funding by any means (including 
through capital contributions or debt) the other foreign corporation is 
to avoid the application of section 956 with respect to the controlled 
foreign corporation; and
    (C) Property acquired by a partnership that is controlled by the 
controlled foreign corporation if the property would be United States 
property if held directly by the controlled foreign corporation, and a 
principal purpose of creating, organizing, or funding by any means 
(including through capital contributions or debt) the partnership is to 
avoid the application of section 956 with respect to the controlled 
foreign corporation.
    (ii) Control. For purposes of paragraphs (b)(4)(i)(B) and (C) of 
this section, a controlled foreign corporation controls a foreign 
corporation or partnership if the controlled foreign corporation and the 
other foreign corporation or partnership are related within the meaning 
of section 267(b) or section 707(b). For this purpose, in determining 
whether two corporations are members of the same controlled group under 
section 267(b)(3), a person is considered to own stock owned directly by 
such person, stock owned for the purposes of section 1563(e)(1), and 
stock owned with the application of section 267(c).
    (iii) Coordination rule. Paragraph (b)(4)(i)(C) of this section 
applies only to the extent that the amount of United States property 
that is treated as held indirectly by a controlled foreign corporation 
under that paragraph exceeds the amount of United States property that 
is treated as held by the controlled foreign corporation under Sec. 
1.956-2(a)(3).
    (iv) Examples. The following examples illustrate the rules of this 
paragraph (b)(4). In each example, unless otherwise provided, P is a 
domestic corporation that wholly owns two controlled foreign 
corporations, FS1 and FS2.

    Example 1. (i) Facts. FS1 sells inventory to FS2 in exchange for 
trade receivables due in 60 days. Avoiding the application of section 
956 with respect to FS1 was not a principal purpose of establishing the 
trade receivables.

[[Page 406]]

FS2 has no earnings and profits, and FS1 has substantial accumulated 
earnings and profits. FS2 makes a loan to P equal to the amount it owes 
FS1 under the trade receivables. FS2 pays the trade receivables 
according to their terms.
    (ii) Result. FS1 will not be considered to indirectly hold United 
States property under this paragraph (b)(4) because the funding of FS2 
through the sale of inventory in exchange for the establishment of trade 
receivables was not undertaken with a principal purpose of avoiding the 
application of section 956 with respect to FS1.
    Example 2. (i) Facts. The facts are the same as in Example 1, except 
that, with a principal purpose of avoiding the application of section 
956 with respect to FS1, FS1 and FS2 agree to defer FS2's payment 
obligation, and FS2 does not timely pay the receivables.
    (ii) Result. FS1 is considered to hold indirectly United States 
property under this paragraph (b)(4), because there was a funding of 
FS2, a principal purpose of which was to avoid the application of 
section 956 with respect to FS1.
    Example 3. (i) Facts. FS1 has $100x of post-1986 undisturbed 
earnings and profits and $100x post-1986 foreign income taxes, but does 
not have any cash. FS2 has earnings and profits of at least $100x, no 
post-1986 foreign income taxes, and substantial cash. Neither FS1 nor 
FS2 has earnings and profits described in section 959(c)(1) or section 
959(c)(2). FS2 loans $100x to FS1. FS1 then loans $100x to P. An income 
inclusion by P of $100x under sections 951(a)(1)(B) and 956 with respect 
to FS1 would result in foreign income taxes deemed paid by P under 
section 960. A principal purpose of funding FS1 through the loan from 
FS2 is to avoid the application of section 956 with respect to FS2.
    (ii) Result. Under paragraph (b)(4)(i)(B) of this section, FS2 is 
considered to indirectly hold the $100x obligation of P that is held by 
FS1. As a result, P has an income inclusion of $100x under sections 
951(a)(1)(B) and 956 with respect to FS2, and the foreign income taxes 
deemed paid by P under section 960 is $0. P does not have an income 
inclusion under sections 951(a)(1)(B) and 956 with respect to FS1 
related to the $100x loan from FS1 to P.
    Example 4. (i) Facts. FS1 has substantial earnings and profits. P 
and FS1 are the only partners in a foreign partnership, FPRS. FS1 
contributes $600x cash to FPRS in exchange for a 60% interest in the 
partnership, and P contributes real estate located outside the United 
States ($400x value) to FPRS in exchange for a 40% interest in the 
partnership. There are no special allocations in the FPRS partnership 
agreement. FPRS lends $100x to P. Under Sec. 1.956-2(a)(3), FS1 is 
treated as holding United States property of $60x (60% x $100x) as a 
result of the FPRS loan to P. A principal purpose of creating, 
organizing, or funding FPRS is to avoid the application of section 956 
with respect to FS1.
    (ii) Result. Before taking into account paragraph (b)(4)(iii) of 
this section, because FS1 controls FPRS and a principal purpose of 
creating, organizing, or funding FPRS was to avoid the application of 
section 956 with respect to FS1, FS1 is considered under paragraph 
(b)(4)(i)(C) of this section to indirectly hold the $100x obligation of 
P that would be United States property if held directly by FS1. However, 
under paragraph (b)(4)(iii) of this section, FS1 is treated as holding 
United States property under paragraph (b)(4)(i)(C) only to the extent 
the amount held indirectly under paragraph (b)(4)(i)(C) of this section 
exceeds the amount of United States property that FS1 is treated as 
holding under Sec. 1.956-2(a)(3). The amount of United States property 
that FS1 is treated as indirectly holding under paragraph (b)(4)(i)(C) 
of this section ($100x) exceeds the amount determined under Sec. 1.956-
2(a)(3) ($60x) by $40x. Thus, FS1 is considered to hold United States 
property within the meaning of section 956(c) in the amount of $100x 
($60x under Sec. 1.956-2(a)(3) and $40x under paragraphs (b)(4)(i)(C) 
and (b)(4)(iii) of this section).

    (5) Certain foreign partnership distributions funded by CFCs--(i) 
General rule. For purposes of section 956, an obligation of a foreign 
partnership that is held (or that would be treated as held under Sec. 
1.956-2(c) if the obligation were an obligation of a United States 
person) by a controlled foreign corporation is treated as a separate 
obligation of a partner in the partnership when--
    (A) The foreign partnership distributes an amount of money or 
property to the partner;
    (B) The foreign partnership would not have made the distribution but 
for a funding of the partnership through the obligation; and
    (C) The partner is related to the controlled foreign corporation 
within the meaning of section 954(d)(3).
    (ii) Amount of obligation. Notwithstanding Sec. 1.956-1(e), the 
amount that is treated as an obligation of the distributee partner 
pursuant to paragraph (b)(5)(i) of this section is equal to the lesser 
of the amount of the partnership distribution that would not have been 
made but for the funding of the partnership or the amount (as determined 
under Sec. 1.956-1(e)) of the obligation of the foreign partnership 
that is held (or that would be treated as held under

[[Page 407]]

Sec. 1.956-2(c) if the obligation were an obligation of a United States 
person) by the controlled foreign corporation.
    (iii) Example. (A) Facts. P, a domestic corporation, wholly owns FS, 
a controlled foreign corporation. P owns a 70% interest in FPRS, a 
foreign partnership. A domestic corporation that is unrelated to P and 
FS owns the remaining 30% interest in FPRS. FPRS borrows $100x from FS, 
and distributes $80x to P. FPRS would not have made the distribution to 
P but for the funding by FS.
    (B) Result. Under paragraph (b)(5)(i) of this section, a portion of 
the obligation of FPRS that FS holds is treated as an obligation of P, 
which constitutes United States property, because FPRS made a 
distribution to P that FPRS would not have made but for the funding of 
FPRS through the obligation held by FS. Under paragraph (b)(5)(ii) of 
this section, the amount that is treated as an obligation of P is the 
lesser of the amount of the distribution, $80x, or the amount of the 
entire obligation of FPRS held by FS, $100x. For purposes of section 
956, therefore, on the date the loan to FPRS is made, FS is considered 
to hold United States property of $80x.
    (c)-(d) [Reserved]
    (e)(1)-(4) [Reserved]
    (5) Exclusion for certain recourse obligations. For purposes of 
Sec. 1.956-1(e)(1) of the regulations, in the case of an investment in 
United States property consisting of an obligation of a related person, 
as defined in section 954(d)(3) and paragraph (e) of Sec. 1.954-1, a 
liability will not be recognized as a specific charge if the liability 
representing the charge is with recourse with respect to the general 
credit or other assets of the investing controlled foreign corporation.
    (e)(6) [Reserved]. For further guidance, see Sec. 1.956-1(e)(6).
    (f) Effective/applicability date. Paragraph (e)(5) of this section 
applies to investments made on or after June 14, 1988.
    (g) Effective/applicability date. (1) Paragraph (b)(4) of this 
section applies to taxable years of controlled foreign corporations 
ending on or after September 1, 2015, and to taxable years of United 
States shareholders in which or with which such taxable years end, with 
respect to property acquired on or after September 1, 2015. See 
paragraph (b)(4) of Sec. 1.956-1T, as contained in 26 CFR part 1 
revised as of April 1, 2015, for the rules applicable to taxable years 
of controlled foreign corporations ending before September 1, 2015, and 
property acquired before September 1, 2015. For purposes of this 
paragraph (g)(1), a deemed exchange of property pursuant to section 1001 
on or after September 1, 2015, constitutes an acquisition of the 
property on or after that date.
    (2) Paragraph (b)(5) of this section applies to taxable years of 
controlled foreign corporations ending on or after September 1, 2015, 
and to taxable years of United States shareholders in which or with 
which such taxable years end, in the case of distributions made on or 
after September 1, 2015.
    (3) [Reserved]
    (4) [Reserved]. For further guidance, see Sec. 1.956-1(g)(4).
    (h) Expiration date. The applicability of paragraphs (b)(4) and 
(b)(5) of this section expires on or before August 31, 2018.

[T.D. 8209, 53 FR 22171, June 14, 1988, as amended at T.D. 9402, 73 FR 
35582, June 24, 2008; T.D. 9630, 76 FR 36995, June 24, 2011; T.D. 9733, 
80 FR 52981, Sept. 2, 2015; 80 FR 66416, Oct. 29, 2015]



Sec. 1.956-2  Definition of United States property.

    (a) Included property--(1) In general. For purposes of section 
956(a) and Sec. 1.956-1, United States property is (except as provided 
in paragraph (b) of this section) any property acquired (within the 
meaning of paragraph (d)(1) of this section) by a foreign corporation 
(whether or not a controlled foreign corporation at the time) during any 
taxable year of such foreign corporation beginning after December 31, 
1962, which is--
    (i) Tangible property (real or personal) located in the United 
States;
    (ii) Stock of a domestic corporation;
    (iii) An obligation (as defined in paragraph (d)(2) of this section) 
of a United States person (as defined in section 957(d)); or
    (iv) Any right to the use in the United States of--

[[Page 408]]

    (a) A patent or copyright,
    (b) An invention, model, or design (whether or not patented),
    (c) A secret formula or process, or
    (d) Any other similar property right, which is acquired or developed 
by the foreign corporation for use in the United States by any person. 
Whether a right described in this subdivision has been acquired or 
developed for use in the United States by any person is to be determined 
from all the facts and circumstances of each case. As a general rule, a 
right actually used principally in the United States will be considered 
to have been acquired or developed for use in the United States in the 
absence of affirmative evidence showing that the right was not so 
acquired or developed for such use.
    (2) Illustrations. The application of the provisions of this 
paragraph may be illustrated by the following examples:

    Example 1. Foreign corporation R uses as a taxable year a fiscal 
year ending on June 30. Corporation R acquires on June 1, 1963, and 
holds on June 30, 1963, $100,000 of tangible property (not described in 
section 956(b)(2)) located in the United States. Corporation R's 
aggregate investment in United States property at the close of its 
taxable year ending June 30, 1963, is zero since the property which is 
acquired on June 1, 1963, is not acquired during a taxable year of R 
Corporation beginning after December 31, 1962. Assuming no change in R 
Corporation's aggregate investment in United States property during its 
taxable year ending June 30, 1964, R Corporation's increase in earnings 
invested in United States property for such taxable year is zero.
    Example 2. Foreign corporation S uses the calendar year as a taxable 
year and is a controlled foreign corporation for its entire taxable year 
1965. Corporation S is not a controlled foreign corporation at any time 
during its taxable years 1963 and 1964. Corporation S owns on December 
31, 1964, $100,000 of tangible property (not described in section 
956(b)(2)) located in the United States which it acquires during taxable 
years beginning after December 31, 1962. Corporation S's aggregate 
investment in United States property on December 31, 1964, is $100,000. 
Corporation S's current and accumulated earnings and profits (determined 
as provided in paragraph (b) of Sec. 1.956-1) as of December 31, 1964, 
are in excess of $100,000. Assuming no change in S Corporation's 
aggregate investment in United States property during its taxable year 
1965, S Corporation's increase in earnings invested in United States 
property for such taxable year is zero.
    Example 3. Foreign corporation T uses the calendar year as a taxable 
year and is a controlled foreign corporation for its entire taxable 
years 1963, 1964, and 1966. At December 31, 1964, T Corporation's 
investment in United States property is $100,000. Corporation T is not a 
controlled foreign corporation at any time during its taxable year 1965 
in which it acquires $25,000 of tangible property (not described in 
section 956(b)(2)) located in the United States. On December 31, 1965, T 
Corporation holds the United States property of $100,000 which it held 
on December 31, 1964, and, in addition, the United States property 
acquired in 1965. Corporation T's aggregate investment in United States 
property at December 31, 1965, is $125,000. Corporation T's current and 
accumulated earnings and profits (determined as provided in paragraph 
(b) of Sec. 1.956-1) as of December 31, 1965, are in excess of 
$125,000, and T Corporation pays no amount during 1965 to which section 
959 (c)(1) applies. Assuming no change in T Corporation's aggregate 
investment in United States property during its taxable year 1966, T 
Corporation's increase in earnings invested in United States property 
for such taxable year is zero.

    (3) Property owned through partnership. For purposes of section 956, 
if a controlled foreign corporation is a partner in a partnership that 
owns property that would be United States property, within the meaning 
of paragraph (a)(1) of this section, if owned directly by the controlled 
foreign corporation, the controlled foreign corporation will be treated 
as holding an interest in the property equal to its interest in the 
partnership and such interest will be treated as an interest in United 
States property. This paragraph (a)(3) applies to taxable years of a 
controlled foreign corporation beginning on or after July 23, 2002.
    (b) Exceptions--(1) Excluded property. For purposes of section 
956(a) and paragraph (a) of this section, United States property does 
not include the following types of property held by a foreign 
corporation:
    (i) Obligations of the United States.
    (ii) Money.
    (iii) Deposits with persons carrying on the banking business, unless 
the deposits serve directly or indirectly as a pledge or guarantee 
within the meaning of paragraph (c) of this section. See paragraph 
(e)(2) of Sec. 1.956-1.

[[Page 409]]

    (iv) Property located in the United States which is purchased in the 
United States for export to, or use in, foreign countries. For purposes 
of this subdivision, property to be used outside the United States will 
be considered property to be used in a foreign country. Whether property 
is of a type described in this subdivision is to be determined from all 
the facts and circumstances in each case. Property which constitutes 
export trade assets within the meaning of section 971(c)(2) and 
paragraph (c)(3) of Sec. 1.971-1 will be considered property of a type 
described in this subdivision.
    (v) Any obligation (as defined in paragraph (d)(2) of this section) 
of a United States person (as defined in section 957(d)) arising in 
connection with the sale or processing of property if the amount of such 
obligation outstanding at any time during the taxable year of the 
foreign corporation does not exceed an amount which is ordinary and 
necessary to carry on the trade or business of both the other party to 
the sale or processing transaction and the United States person, or, if 
the sale or processing transaction occurs between related persons, would 
be ordinary and necessary to carry on the trade or business of both the 
other party to the sale or processing transaction and the United States 
person if such persons were unrelated persons. Whether the amount of an 
obligation described in this subdivision is ordinary and necessary is to 
be determined from all the facts and circumstances in each case.
    (vi) Any aircraft, railroad rolling stock, vessel, motor vehicle, or 
container used in the transportation of persons or property in foreign 
commerce and used predominantly outside the United States. Whether 
transportation property described in this paragraph (b)(1)(vi) is used 
in foreign commerce and predominantly outside the United States is to be 
determined from all the facts and circumstances of each case. As a 
general rule, such transportation property will be considered to be used 
predominantly outside the United States if 70 percent or more of the 
miles traversed (during the taxable year at the close of which a 
determination is made under section 956(a)(2)) in the use of such 
property are traversed outside the United States or if such property is 
located outside the United States 70 percent of the time during such 
taxable year. Notwithstanding the above, an aircraft or vessel, 
including component parts, is excluded from United States property if 
the aircraft or vessel is leased in foreign commerce (as the term is 
defined in Sec. 1.954-2(c)(2)(v)) and rents derived from leasing such 
aircraft or vessel are excluded from foreign personal holding company 
income under section 954(c)(2)(A).
    (vii) An amount of assets described in paragraph (a) of this section 
of an insurance company equivalent to the unearned premiums or reserves 
which are ordinary and necessary for the proper conduct of that part of 
its insurance business which is attributable to contracts other than 
those described in section 953(a)(1) and the regulations thereunder. For 
purposes of this subdivision, a reserve will be considered ordinary and 
necessary for the proper conduct of an insurance business if, under the 
principles of paragraph (c) of Sec. 1.953-4, such reserve would qualify 
as a reserve required by law. See paragraph (d)(3) of Sec. 1.954-2 for 
determining, for purposes of this subdivision, the meaning of insurance 
company and of unearned premiums.
    (viii) For taxable years beginning after December 31, 1975, the 
voting or nonvoting stock or obligations of an unrelated domestic 
corporation. For purposes of this subdivision, an unrelated domestic 
corporation is a domestic corporation which is neither a United States 
shareholder (as defined in section 951(b)) of the controlled foreign 
corporation making the investment, nor a corporation 25 percent or more 
of whose total combined voting power of all classes of stock entitled to 
vote is owned or considered as owned (within the meaning of section 958 
(b)) by United States shareholders of the controlled foreign corporation 
making the investment. The determination of whether a domestic 
corporation is an unrelated corporation is made immediately after each 
acquisition of stock or obligations by the controlled foreign 
corporations.
    (ix) For taxable years beginning after December 31, 1975, movable 
drilling rigs

[[Page 410]]

or barges and other movable exploration and exploitation equipment 
(other than a vessel or an aircraft) when used on the Continental Shelf 
(as defined in section 638) of the United States in the exploration for, 
development, removal, or transportation of natural resources from or 
under ocean waters. Property used on the Continental Shelf includes 
property located in the United States which is being constructed or is 
in storage or in transit within the United States for use on the 
Continental Shelf. In general, the type of property which qualifies for 
the exception under this subdivision includes any movable property which 
would be entitled to the investment credit if used outside the United 
States in certain geographical areas of the Western Hemisphere pursuant 
to section 48(a)(2)(B)(x) (without reference to sections 49 and 50).
    (x) An amount of--
    (a) A controlled foreign corporation's assets described in paragraph 
(a) of this section equivalent to its earnings and profits which are 
accumulated after December 31, 1962, and are attributable to items of 
income described in section 952(b) and the regulations thereunder, 
reduced by the amount of
    (b) The earnings and profits of such corporation which are applied 
in a taxable year of such corporation beginning after December 31, 1962, 
to discharge a liability on property, but only if the liability was in 
existence at the close of such corporation's taxable year immediately 
preceding its first taxable year beginning after December 31, 1962, and 
the property would have been United States property if it had been 
acquired by such corporation immediately before such discharge.


For purposes of this subdivision, distributions made by such corporation 
for any taxable year shall be considered first made out of earnings and 
profits for such year other than earnings and profits referred to in (a) 
of this subdivision.
    (xi) [Reserved] For further guidance, see Sec. 1.956-2T(b)(1)(xi).
    (2) Statement required. If a United States shareholder of a 
controlled foreign corporation excludes any property from the United 
States property of such controlled foreign corporation on the ground 
that section 956(b)(2) applies to such excluded property, he shall 
attach to his return a statement setting forth, by categories described 
in paragraph (a)(1) of this section, the amount of United States 
property of the controlled foreign corporation and, by categories 
described in subparagraph (1) of this paragraph, the amount of such 
property which is excluded.
    (c) Treatment of pledges and guarantees--(1) General rule. Except as 
provided in subparagraph (4) of this paragraph, any obligation (as 
defined in paragraph (d)(2) of this section) of a United States person 
(as defined in section 957(d)) with respect to which a controlled 
foreign corporation is a pledgor or guarantor shall be considered for 
purposes of section 956(a) and paragraph (a) of this section to be 
United States property held by such controlled foreign corporation.
    (2) Indirect pledge or guarantee. If the assets of a controlled 
foreign corporation serve at any time, even though indirectly, as 
security for the performance of an obligation of a United States person, 
then, for purposes of paragraph (c)(1) of this section, the controlled 
foreign corporation will be considered a pledgor or guarantor of that 
obligation. For this purpose the pledge of stock of a controlled foreign 
corporation will be considered as the indirect pledge of the assets of 
the corporation if at least 66\2/3\ percent of the total combined voting 
power of all classes of stock entitled to vote is pledged and if the 
pledge of stock is accompanied by one or more negative covenants or 
similar restrictions on the shareholder effectively limiting the 
corporation's discretion with respect to the disposition of assets and 
the incurrence of liabilities other than in the ordinary course of 
business. This paragraph (c)(2) applies only to pledges and guarantees 
which are made after September 8, 1980. For purposes of this paragraph 
(c)(2) a refinancing shall be considered as a new pledge or guarantee.
    (3) Illustrations. The following examples illustrate the application 
of this paragraph (c):

    Example 1. A, a United States person, borrows $100,000 from a bank 
in foreign country X on December 31, 1964. On the same date

[[Page 411]]

controlled foreign corporation R pledges its assets as security for A's 
performance of A's obligation to repay such loan. The place at which or 
manner in which A uses the money is not material. For purposes of 
paragraph (b) of Sec. 1.956-1, R Corporation will be considered to hold 
A's obligation to repay the bank $100,000, and, under the provisions of 
paragraph (e)(2) of Sec. 1.956-1, the amount taken into account in 
computing R Corporation's aggregate investment in United States property 
on December 31, 1964, is the unpaid principal amount of the obligation 
on that date ($100,000).
    Example 2. The facts are the same as in example 1, except that R 
Corporation participates in the transaction, not by pledging its assets 
as security for A's performance of A's obligation to repay the loan, but 
by agreeing to buy for $1,00,000 at maturity the note representing A's 
obligation if A does not repay the loan. Separate arrangements are made 
with respect to the payment of the interest on the loan. The agreement 
of R Corporation to buy the note constitutes a guarantee of A's 
obligation. For purposes of paragraph (b) of Sec. 1.956-1, R 
Corporation will be considered to hold A's obligation to repay the bank 
$100,000, and, under the provisions of paragraph (e)(2) of Sec. 1.956-
1, the amount taken into account in computing R Corporation's aggregate 
investment in United States property on December 31, 1964, is the unpaid 
principal amount of the obligation on that date ($100,000).
    Example 3. A, a United States person, borrows $100,000 from a bank 
on December 10, 1981, pledging 70 percent of the stock of X, a 
controlled foreign corporation, as collateral for the loan. A and X use 
the calendar year as their taxable year. in the loan agreement, among 
other things, A agrees not to cause or permit X Corporation to do any of 
the following without the consent of the bank:
    (a) Borrow money or pledge assets, except as to borrowings in the 
ordinary course of business of X Corporation;
    (b) Guarantee, assume, or become liable on the obligation of 
another, or invest in or lend funds to another;
    (c) Merge or consolidate with any other corporation or transfer 
shares of any controlled subsidiary;
    (d) Sell or lease (other than in the ordinary course of business) or 
otherwise dispose of any substantial part of its assets;
    (e) Pay or secure any debt owing by X Corporation to A; and
    (f) Pay any dividends, except in such amounts as may be required to 
make interest or principal payments on A's loan from the bank.
    A retains the right to vote the stock unless a default occurs by A. 
Under paragraph (c)(2) of this section, the assets of X Corporation 
serve indirectly as security for A's performance of A's obligation to 
repay the loan and X Corporation will be considered a pledgor or 
guarantor with respect to that obligation. For purposes of paragraph (b) 
of Sec. 1.956-1, X Corporation will be considered to hold A's 
obligation to repay the bank $100,000 and under paragraph (e)(2) of 
Sec. 1.956-1, the amount taken into account in computing X 
Corporation's aggregate investment in United States property on December 
31, 1981, is the unpaid principal amount of the obligation on that date.

    (4) Special rule for certain conduit financing arrangements. The 
rule contained in subparagraph (1) of this paragraph shall not apply to 
a pledge or a guarantee by a controlled foreign corporation to secure 
the obligation of a United States person if such United States person is 
a mere conduit in a financing arrangement. Whether the United States 
person is a mere conduit in a financing arrangement will depend upon all 
the facts and circumstances in each case. A United States person will be 
considered a mere conduit in a financing arrangement in a case in which 
a controlled foreign corporation pledges stock of its subsidiary 
corporation, which is also a controlled foreign corporation, to secure 
the obligation of such United States person, where the following 
conditions are satisfied:
    (i) Such United States person is a domestic corporation which is not 
engaged in the active conduct of a trade or business and has no 
substantial assets other than those arising out of its relending of the 
funds borrowed by it on such obligation to the controlled foreign 
corporation whose stock is pledged; and
    (ii) The assets of such United States person are at all times 
substantially offset by its obligation to the lender.
    (d) Definitions--(1) Meaning of ``acquired''--(i) Applicable rules. 
For purposes of this section--
    (a) Property shall be considered acquired by a foreign corporation 
when such corporation acquires an adjusted basis in the property;
    (b) Property which is an obligation of a United States person with 
respect to which a controlled foreign corporation is a pledgor or 
guarantor (within the meaning of paragraph (c) of this section) shall be 
considered acquired when the corporation becomes liable as a pledgor or 
guarantor or is otherwise considered a pledgor or guarantor

[[Page 412]]

(within the meaning of paragraph (c)(2) of this section); and
    (c) Property shall not be considered acquired by a foreign 
corporation if--
    (1) Such property is acquired in a transaction in which gain or loss 
would not be recognized under this chapter to such corporation if such 
corporation were a domestic corporation;
    (2) The basis of the property acquired by the foreign corporation is 
the same as the basis of the property exchanged by such corporation; and
    (3) The property exchanged by the foreign corporation was not United 
States property (as defined in paragraph (a)(1) of this section) but 
would have been such property if it had been acquired by such 
corporation immediately before such exchange.
    (ii) Illustrations. The application of this subparagraph may be 
illustrated by the following examples:

    Example 1. Foreign corporation R uses the calendar year as a taxable 
year and acquires before January 1, 1963, stock of domestic corporation 
M having as to R Corporation an adjusted basis of $10,000. The stock of 
M Corporation is not United States property of R Corporation on December 
31, 1962, since it is not acquired in a taxable year of R Corporation 
beginning on or after Janury 1, 1963. On June 30, 1963, R Corporation 
sells the M Corporation stock for $15,000 in cash and expends such 
amount in acquiring stock of domestic corporation N which has as to R 
Corporation an adjusted basis of $15,000. For purposes of determining R 
Corporation's aggregate investment in United States property on December 
31, 1963, R Corporation has, by virtue of acquiring the stock of N 
Corporation, acquired $15,000 of United States property.
    Example 2. Foreign corporation S, a controlled foreign corporation 
for the entire period here involved, uses the calendar year as a taxable 
year and purchases for $100,000 on December 31, 1963, tangible property 
(not described in section 956(b)(2)) located in the United States and 
having a remaining estimated useful life of 10 years, subject to a 
mortgage of $80,000 payable in 5 annual installments. The property 
constitutes United States property as of December 31, 1963, and the 
amount taken into account for purposes of determining the aggregate 
amount of S Corporation's investment in United States property under 
paragraph (b) of Sec. 1.956-1 is $20,000. No depreciation is sustained 
with respect to the property during the taxable year 1963. During the 
taxable year 1964, S Corporation pays $16,000 on the mortgage and 
sustains $10,000 of depreciation with respect to the property. As of 
December 31, 1964, the amount taken into account with respect to the 
property for purposes of determining the aggregate amount of S 
Corporation's investment in United States property under paragraph (b) 
of Sec. 1.956-1 is $26,000, computed as follows:

Cost of property.............................................   $100,000
  Less: Reserve for depreciation.............................     10,000
                                                    -----------
   Adjusted basis of property................................     90,000
  Less: Liability to which property is subject:
    Gross amount of mortgage.......................   $80,000
    Payment during 1964............................    16,000
                                                    ----------
                                                     ........     64,000
                                                              ----------
Amount taken into account (12-31-64).........................     26,000
 

    Example 3. Controlled foreign corporation T uses the calendar year 
as a taxable year and acquires on December 31, 1963, $10,000 of United 
States property not described in section 956(b)(2); no depreciation is 
sustained with respect to the property during 1963. Corporation T's 
current and accumulated earnings and profits (determined as provided in 
paragraph (b) of Sec. 1.956-1) as of December 31, 1963, are in excess 
of $10,000, and T Corporation's United States shareholders include in 
their gross income under section 951(a)(1)(B) their pro rata share of T 
Corporation's increase ($10,000) for 1963 in earnings invested in United 
States property. On January 1, 1964, T Corporation acquires an 
additional $10,000 of United States property not described in section 
956(b)(2). Each of the two items of property has an estimated useful 
life of 5 years, and T Corporation sustains $4,000 of depreciation with 
respect to such properties during its taxable year 1964. Corporation T's 
current and accumulated earnings and profits as of December 31, 1964, 
exceed $16,000, determined as provided in paragraph (b) of Sec. 1.956-
1. Corporation T pays no amounts during 1963 to which section 959(c)(1) 
applies. Corporation T's investment of earnings in United States 
property at December 31, 1964, is $16,000, and its increase for 1964 in 
earnings invested in United States property is $6,000.
    Example 4. Foreign corporation U uses the calendar year as a taxable 
year and acquires before January 1, 1963, stock in domestic corporation 
M having as to U Corporation an adjusted basis of $10,000. On December 
1, 1964, pursuant to a statutory merger described in section 368(a)(1), 
M Corporation merges into domestic corporation N, and U Corporation 
receives on such date one share of stock in N Corporation, the surviving 
corporation, for each share of stock it held in M Corporation. Pursuant 
to section 354 no gain or loss is recognized to U Corporation, and 
pursuant to section 358 the basis of the property received (stock of N 
Corporation) is the same as that of the property exchanged (stock of M 
Corporation). Corporation U is not considered

[[Page 413]]

for purposes of section 956 to have acquired United States property by 
reason of its receipt of the stock in N Corporation.
    Example 5. The facts are the same as in example 4, except that U 
Corporation acquires the stock of M Corporation on February 1, 1963, 
rather than before January 1, 1963. For purposes of determining U 
Corporation's aggregate investment in United States property on December 
31, 1963, U Corporation has, by virtue of acquiring the stock of M 
Corporation, acquired $10,000 of United States property. Corporation U 
pays no amount during 1963 to which section 959(c)(1) applies. The 
reorganization and resulting acquisition on December 1, 1964, by U 
Corporation of N Corporation's stock also represents an acquisition of 
United States property; however, assuming no other change in U 
Corporation's aggregate investment in United States property during 
1964, U Corporation's increase for such year in earnings invested in 
United States property is zero.

    (2) [Reserved]
    (e) Effective/applicability date. The last sentence of paragraph 
(b)(1)(vi) of this section applies to taxable years of controlled 
foreign corporations beginning on or after May 2, 2006, and for taxable 
years of United States shareholders with or within which such taxable 
years of the controlled foreign corporations end. Taxpayers may elect to 
apply the rule of the last sentence of paragraph (b)(1)(vi) of this 
section to taxable years of controlled foreign corporations beginning 
after December 31, 2004, and for taxable years of United States 
shareholders with or within which such taxable years of the controlled 
foreign corporations end. If an election is made to apply the last two 
sentences of Sec. 1.954-2(c)(2)(ii) and Sec. 1.954-2(c)(2)(v) through 
(vii) to taxable years of a controlled foreign corporation beginning 
after December 31, 2004, then the election must also be made for the 
last sentence of paragraph (b)(1)(vi) of this section.

(Secs. 956(c), 7805, Internal Revenue Code of 1954 (76 Stat. 1017, 68A 
Stat. 917; (26 U.S.C. 956(c) and 7805 respectively)))

[T.D. 6704, 29 FR 2601, Feb. 20, 1964, as amended by T.D. 7712, 45 FR 
52374, Aug. 7, 1980; T.D. 7797, 46 FR 57675, Nov. 25, 1981; T.D. 8209, 
53 FR 22171, June 14, 1988; T.D. 9008, 67 FR 48025, July 23, 2002; T.D. 
9406, 73 FR 38117, July 3, 2008; T.D. 9525, 76 FR 26181, May 6, 2011; 
T.D. 9589, 77 FR 27614, May 11, 2012]



Sec. 1.956-2T  Definition of United States Property (temporary).

    (a) through (b)(1)(x) [Reserved] For further guidance, see Sec. 
1.956-2(a) through (b)(1)(x).
    (xi) An obligation of a United States person arising from a 
nonperiodic payment by a controlled foreign corporation (within the 
meaning of section 957(a)) with respect to a notional principal contract 
described in Sec. 1.446-3T(g)(4)(ii)(B)(1) or (2) if the following 
conditions are satisfied--
    (A) The controlled foreign corporation that makes the nonperiodic 
payment is either a dealer in securities (within the meaning of section 
475(c)(1)) or a dealer in commodities; and
    (B) The conditions set forth in Sec. 1.446-3T(g)(4)(ii)(C)(1) 
(relating to full margin or collateral in cash) are satisfied.
    (C) Examples. The following examples illustrate the application of 
this paragraph (b)(1)(xi):

    Example 1. Full margin--cleared contract. (i) A domestic corporation 
(U.S.C.) wholly owns a controlled foreign corporation (CFC) that is a 
dealer in securities under section 475(c)(1). CFC enters into an 
interest rate swap contract with unrelated counterparty B. The contract 
is required to be cleared and is accepted for clearing by a U.S.-
registered derivatives clearing organization (DCO). CFC is not a member 
of the DCO. CFC uses a U.S. affiliate (CM), which is a member of the 
DCO, as its clearing member to submit the contract to be cleared. CM is 
a domestic corporation that is wholly owned by U.S.C.. The standardized 
terms of the contract provide that, for a term of X years, CFC will pay 
B a fixed coupon of 1% per year and receive a floating coupon on a 
notional principal amount of $Y. When CFC and B enter into the contract, 
the market coupon for similar interest rate swaps is 2% per year. The 
DCO requires CFC to make an upfront payment to compensate B for the 
below-market annual coupon payments that B will receive, and CFC makes 
the upfront payment in cash. CFC makes the upfront payment through CM to 
the DCO, which then makes the payment to B. The DCO also requires B to 
post initial variation margin in an amount equal to the upfront payment 
and requires each party to post and collect daily variation margin in an 
amount equal to the change in the fair market value of the contract on a 
daily basis for the entire term of the contract. B posts the initial 
variation margin in U.S. dollars, which is received by CFC (through DCO 
and CM), and the parties post and collect daily variation margin in U.S. 
dollars.

[[Page 414]]

    (ii) Because the contract is subject to initial variation margin in 
an amount equal to the upfront payment and daily variation margin in an 
amount equal to the change in the fair market value of the contract on a 
daily basis for the entire term of the contract, the contract is 
described in Sec. 1.446-3T(g)(4)(ii)(B)(1). Furthermore, because the 
additional conditions set forth in this paragraph (b)(1)(xi) are 
satisfied, the obligation of CM arising from the upfront payment by CFC 
does not constitute United States property for purposes of section 956.
    Example 2. Full margin--uncleared contract. (i) Assume the same 
facts as in Example 1, except for the following. CFC's counterparty to 
the contract is U.S.C., CM is not involved, and the contract is not 
required to be cleared and is not accepted for clearing by a U.S.-
registered derivatives clearing organization. The contract requires CFC 
to make an upfront payment to compensate U.S.C. for the below-market 
annual coupon payments that U.S.C. will receive, and CFC makes the 
upfront payment in U.S. dollars. Pursuant to the requirements of a 
federal regulator, U.S.C. is obligated to post initial variation margin 
with CFC in an amount equal to CFC's upfront payment, and U.S.C. and CFC 
are obligated to post and collect daily variation margin in an amount 
equal to the change in the fair market value of the contract on a daily 
basis for the entire term of the contract. U.S.C. posts the initial 
variation margin in U.S. dollars, which is received by CFC, and the 
parties post and collect daily variation margin in U.S. dollars.
    (ii) Because the contract is subject to initial variation margin in 
an amount equal to the upfront payment and daily variation margin in an 
amount equal to the change in the fair market value of the contract on a 
daily basis for the entire term of the contract, the contract is 
described in Sec. 1.446-3T(g)(4)(ii)(B)(2). Furthermore, because the 
additional conditions set forth in this paragraph (b)(1)(xi) are 
satisfied, the obligation of U.S.C. arising from the upfront payment by 
CFC does not constitute United States property for purposes of section 
956.

    (b)(2)-(d)(1) [Reserved] For further guidance, see Sec. 1.956-
2(b)(2) through (d)(1).
    (2) Obligation defined--(i) Rule. For purposes of Sec. 1.956-2 of 
the regulations, the term ``obligation'' includes any bond, note, 
debenture, certificate, bill receivable, account receivable, note 
receivable, open account, or other indebtedness, whether or not issued 
at a discount and whether or not bearing interest, except that such term 
shall not include:
    (A) Any indebtedness arising out of the involuntary conversion of 
property which is not United States property within the meaning of 
paragraph (a)(1) of Sec. 1.956-2, or
    (B) Any obligation of a United States person (as defined in section 
957(c)) arising in connection with the provision of services by a 
controlled foreign corporation to the United States person if the amount 
of such obligation outstanding at any time during the taxable year of 
the controlled foreign corporation does not exceed an amount which would 
be ordinary and necessary to carry on the trade or business of the 
controlled foreign corporation and the United States person if they were 
unrelated. The amount of such obligations shall be considered to be 
ordinary and necessary to the extent of such receivables that are paid 
within 60 days.


See Sec. 1.956-2(b)(1)(v) for the exclusion from United States property 
of obligations arising in connection with the sale or processing of 
property where such obligations are ordinary and necessary as to amount.
    (ii) Effective date. This section is effective June 14, 1988, with 
respect to investments made on or after June 14, 1988.
    (e) [Reserved] For further guidance see Sec. 1.956-2(e).
    (f) Effective/applicability date. Paragraph (b)(1)(xi) of this 
section applies to payments described in Sec. 1.956-2T(b)(1)(xi) made 
on or after May 8, 2015. Taxpayers may apply the rules of paragraph 
(b)(1)(xi) to payments made before May 8, 2015.
    (g) Expiration date. The applicability of paragraph (b)(1)(xi) of 
this section expires on May 7, 2018.

[T.D. 8209, 53 FR 22171, June 14, 1988, as amended at T.D. 9406, 73 FR 
38117, July 3, 2008; T.D. 9525, 76 FR 26181, May 6, 2011; T.D. 9589, 77 
FR 27614, May 11, 2012; T.D. 9719, 80 FR 26442, May 8, 2015]



Sec. 1.956-3T  Certain trade or service receivables acquired from
United States persons (temporary).

    (a) In general. For purposes of section 956(a) and Sec. 1.956-1, 
the term ``United States property'' also includes any trade or service 
receivable if the trade or service receivable is acquired (directly or 
indirectly) after March 1,

[[Page 415]]

1984, from a related person who is a United States person (as defined in 
section 7701(a)(30)) (hereinafter referred to as a ``related United 
States person'') and the obligor under the receivable is a United States 
person. A trade or service receivable described in this paragraph shall 
be considered to be United States property notwithstanding the 
exceptions (other than subparagraph (H)) contained in section 956(b)(2). 
The terms ``trade or service receivable'' and ``related person'' have 
the respective meanings given to such terms by section 864(d) and the 
regulations thereunder. For purposes of this section, the exception 
contained in Sec. 1.956-2T(d)(2)(i)(B) for short-term obligations shall 
not apply to service receivables described in this paragraph.
    (b) Acquisition of a trade or service receivable--(1) General rule. 
The rules of Sec. 1.864-8T(c)(1) shall be applied to determine whether 
a controlled foreign corporation has acquired a trade or service 
receivable.
    (2) Indirect acquisitions--(i) Acquisition through unrelated person. 
A trade or service receivable will be considered to be acquired from a 
related person if it is acquired from an unrelated person who acquired 
(directly or indirectly) such receivable from a person who is a related 
person to the acquiring person.
    (ii) Acquisition by nominee or pass-through entity. A controlled 
foreign corporation will be considered to have acquired a trade or 
service receivable of a related United States person held on its behalf:
    (A) By a nominee or by a partnership, simple trust, S corporation or 
other pass-through entity to the extent the controlled foreign 
corporation owns (directly or indirectly) a beneficial interest in such 
partnership or other pass-through entity; or
    (B) By another foreign corporation that is controlled by the 
controlled foreign corporation, if one of the principal purposes for 
creating, organizing, or funding such other foreign corporation (through 
capital contributions or debt) is to avoid the application of section 
956. See Sec. 1.956-1T.


The rule of this paragraph (b)(2)(ii) does not limit the application of 
paragraph (b)(2)(iii) of this section regarding the characterization of 
trade or service receivables of unrelated persons acquired pursuant to 
certain swap or pooling arrangements. The following examples illustrate 
the application of this paragraph (b)(2)(ii).

    Example 1. FS1, a controlled foreign corporation with substantial 
accumulated earnings and profits, contributes $2,000,000 to PS, a 
partnership, in exchange for a 20 percent limited partnership interest 
in PS. PS purchases trade or service receivables of FS1's domestic 
parent, P. The obligors under the receivables are United States persons. 
PS does not purchase receivables of any person who is related to any 
other partner in PS. Under paragraph (b)(2)(ii)(A) of this section, 
there is an investment of the earnings of FS1 in United States property 
equal to 20 percent of PS's basis in the receivables of P.
    Example 2. FS1, a controlled foreign corporation, has accumulated 
more than $3,000,000 in earnings and profits. It organizes a wholly-
owned foreign corporation, FS2, with a $2,000,000 equity contribution. 
FS2 has no earnings and profits. FS2 uses the funds to purchase trade or 
service receivables of FS1's domestic parent, P. The obligors under the 
receivables are United States persons. Under paragraph (b)(2)(ii)(B) of 
this section, there is an investment of the earnings of FS1 in United 
States property equal to $2,000,000.

    (iii) Swap or pooling arrangements. A trade or service receivable of 
an unrelated person will be considered to be a trade or service 
receivable acquired from a related United States person and subject to 
the rules of this section if it is acquired in accordance with an 
arrangement that involves two or more groups of related persons that are 
unrelated to each other and the effect of the arrangement is that one or 
more related persons in each group acquire (directly or indirectly) 
trade or service receivables of one or more unrelated United States 
persons who are also parties to the arrangement, in exchange for 
reciprocal purchases of receivables of United States persons in the 
first group. The following example illustrates the application of this 
paragraph (b)(2)(iii).

    Example. Controlled foreign corporations A, B, C, and D are wholly-
owned subsidiaries of domestic corporations M, N, O, and P, 
respectively. M, N, O, and P are not related persons. According to a 
prearranged plan, A, B, C, and D each acquire trade or service 
receivables of M, N, O, and/or P. The obligors under some or all of the 
receivables acquired by each of A, B, C, and D are United States

[[Page 416]]

persons. Because the effect of this arrangement is that the unrelated 
groups acquire each other's trade or service receivables of United 
States persons pursuant to the arrangement, there is an investment of 
the earnings of each of A, B, C, and D in United States property to the 
extent of the purchase price of those receivables under which the 
obligors are United States persons.

    (iv) Financing arrangements. If a controlled foreign corporation 
participates (directly or indirectly) in a lending transaction that 
results in a loan to a United States person who purchases property 
described in section 1221(1) (hereinafter referred to as ``inventory 
property'') or services of a related United States person, or to any 
person who purchases trade or service receivables of a related United 
States person under which the obligor is a United States person, or to a 
person who is related to any such purchaser, and if the loan would not 
have been made or maintained on the same terms but for the corresponding 
purchase, then the controlled foreign corporation shall be considered to 
have indirectly acquired a trade or service receivable described in 
paragraph (a) of this section. For purposes of this paragraph 
(b)(2)(iv), it is immaterial that the sums lent are not, in fact, the 
sums used to finance the purchase of the inventory property or services 
or trade or service receivables of a related United States person. The 
amount to be taken into account with respect to the controlled foreign 
corporation's investment in United States property (resulting from 
application of this paragraph (b)(2)(iv)) shall be the amount lent 
pursuant to a lending transaction described in this paragraph 
(b)(2)(iv), if the amount lent is equal to or less than the purchase 
price of the inventory property, services, or trade or service 
receivables. If the amount lent is greater than the purchase price of 
the inventory property, services or receivables, the amount to be taken 
into account shall be the purchase price. The following examples 
illustrate the application of this paragraph (b)(2)(iv).

    Example 1. P, a domestic corporation, owns all of the outstanding 
stock of FS1, a controlled foreign corporation. P sells equipment for 
$2,000,000 to X, an unrelated United States person. FS1 makes a 
$1,000,000 short-term loan to X, which loan would not have been made or 
maintained on the same terms but for X's purchase of P's equipment. 
Because FS1 directly participates in a lending transaction described in 
this paragraph (b)(2)(iv), FS1 is considered to have acquired the 
receivable of a related United States person. Thus, there is an 
investment of FS1's earnings and profits in United States property in 
the amount of $1,000,000.
    Example 2. The facts are the same as in Example 1, except that 
instead of loaning money to X directly, FS1 deposits $3,000,000 with an 
unrelated financial institution that loans $2,000,000 to X in order for 
X to purchase P's equipment. The loan would not have been made or 
maintained on the same terms but for the corresponding deposit. 
Accordingly, the deposit and the loan are treated as a direct loan from 
FS1 to X. See Rev. Rul. 87-89, 1987-37 I.R.B. 16. Because FS1 indirectly 
participates in a lending transaction described in this paragraph 
(b)(2)(iv), FS1 is considered to have acquired the receivable of a 
related United States person. Thus, there is an investment of FS1's 
earnings and profits in United States property in the amount of 
$2,000,000.
    Example 3. P, a domestic corporation, owns all of the outstanding 
stock of FS1, a controlled foreign corporation. FS1 makes a $3,000,000 
loan to U, an unrelated foreign corporation, in connection with U's 
purchase for $2,000,000 of receivables from the sale of inventory 
property by P to United States obligors. Because FS1 directly 
participates in a lending transaction described in this paragraph 
(b)(2)(iv), FS1 is considered to have acquired receivables of a related 
United States person. Thus, there is an investment of FS1's earnings and 
profits in United States property in the amount of $2,000,000.

    (c) Substitution of obligor. For purposes of this section, the 
substitution of another person for a United States obligor may be 
disregarded. Thus, if a purchaser who is a United States person arranges 
for a foreign person to pay a United States seller of inventory property 
or services and the seller transfers by sale or otherwise to its own 
controlled foreign corporation the foreign person's obligation for 
payment, then the acquisition of the foreign person's obligation shall 
constitute an investment in United States property by the seller's 
controlled foreign corporation, unless it can be demonstrated by the 
parties to the transaction that the primary purpose for the arrangement 
was not the avoidance of section 956. The following example illustrates 
the application of this paragraph.


[[Page 417]]


    Example. P, a domestic corporation, owns all of the outstanding 
stock of FS1, a controlled foreign corporation with substantial 
accumulated earnings and profits. P sells equipment to X, a domestic 
corporation unrelated to P. To pay for the equipment, X arranges for a 
foreign financing entity to issue a note to P. P then sells the note to 
FS1. FS1 has made an investment in United States property in the amount 
of the purchase price of the note.

[T.D. 8209, 53 FR 22169, June 14, 1988]



Sec. 1.957-1  Definition of controlled foreign corporation.

    (a) In general. The term controlled foreign corporation means any 
foreign corporation of which more than 50 percent (or such lesser amount 
as is provided in section 957(b) or section 953(c)) of either--
    (1) The total combined voting power of all classes of stock of the 
corporation entitled to vote; or
    (2) The total value of the stock of the corporation, is owned within 
the meaning of section 958(a), or (except for purposes of section 
953(c)) is considered as owned by applying the rules of section 958(b) 
and Sec. 1.958-2, by United States shareholders on any day during the 
taxable year of such foreign corporation. For the definition of the term 
United States shareholder, see sections 951(b) and 953(c)(1)(A). For the 
definition of the term foreign corporation, see Sec. 301.7701-5 of this 
chapter (Procedure and Administration Regulations). For the treatment of 
associations as corporations, see section 7701(a)(3) and Sec. Sec. 
301.7701-1 and 301.7701-2 of this chapter. For the definition of the 
term stock, see sections 958(a)(3) and 7701(a)(7). For the 
classification of a member in an association, joint stock company or 
insurance company as a shareholder, see section 7701(a)(8).
    (b) Percentage of total combined voting power owned by United States 
shareholders--(1) Meaning of combined voting power. In determining for 
purposes of paragraph (a) of this section whether United States 
shareholders own the requisite percentage of total combined voting power 
of all classes of stock entitled to vote, consideration will be given to 
all the facts and circumstances of each case. In all cases, however, 
United States shareholders of a foreign corporation will be deemed to 
own the requisite percentage of total combined voting power with respect 
to such corporation--
    (i) If they have the power to elect, appoint, or replace a majority 
of that body of persons exercising, with respect to such corporation, 
the powers ordinarily exercised by the board of directors of a domestic 
corporation;
    (ii) If any person or persons elected or designated by such 
shareholders have the power, where such shareholders have the power to 
elect exactly one-half of the members of such governing body of such 
foreign corporation, either to cast a vote deciding an evenly divided 
vote of such body or, for the duration of any deadlock which may arise, 
to exercise the powers ordinarily exercised by such governing body; or
    (iii) If the powers which would ordinarily be exercised by the board 
of directors of a domestic corporation are exercised with respect to 
such foreign corporation by a person whom such shareholders have the 
power to elect, appoint, or replace.
    (2) Shifting of formal voting power. Any arrangement to shift formal 
voting power away from United States shareholders of a foreign 
corporation will not be given effect if in reality voting power is 
retained. The mere ownership of stock entitled to vote does not by 
itself mean that the shareholder owning such stock has the voting power 
of such stock for purposes of section 957. For example, if there is any 
agreement, whether express or implied, that any shareholder will not 
vote his stock or will vote it only in a specified manner, or that 
shareholders owning stock having not more than 50 percent of the total 
combined voting power will exercise voting power normally possessed by a 
majority of stockholders, then the nominal ownership of the voting power 
will be disregarded in determining which shareholders actually hold such 
voting power, and this determination will be made on the basis of such 
agreement. Moreover, where United States shareholders own shares of one 
or more classes of stock of a foreign corporation which has another 
class of stock outstanding, the voting power ostensibly provided such 
other class of stock will be deemed owned by any person or

[[Page 418]]

persons on whose behalf it is exercised or, if not exercised, will be 
disregarded if the percentage of voting power of such other class of 
stock is substantially greater than its proportionate share of the 
corporate earnings, if the facts indicate that the shareholders of such 
other class of stock do not exercise their voting rights independently 
or fail to exercise such voting rights, and if a principal purpose of 
the arrangement is to avoid the classification of such foreign 
corporation as a controlled foreign corporation under section 957.
    (c) Illustrations. The application of this section may be 
illustrated by the following examples:

    Example 1. Foreign corporation R has two classes of capital stock 
outstanding, 60 shares of class A stock, and 40 shares of class B stock. 
Each share of each class of stock has one vote for all purposes. E, a 
United States person, owns 51 shares of class A stock. Corporation R is 
a controlled foreign corporation.
    Example 2. Foreign corporation S has three classes of capital stock 
outstanding, consisting of 60 shares of class A stock, 40 shares of 
class B stock, and 200 shares of class C stock. The owners of a majority 
of class A stock are entitled to elect 6 of the 10 corporate directors, 
and the owners of a majority of the class B stock are entitled to elect 
the other 4 of the 10 directors. Class C stock has no voting rights. D, 
a United States person, owns all of the shares of the class C stock. He 
also owns 31 shares of class A stock and as such an owner can elect 6 
members of the board of directors. None of the remaining shares of class 
A stock, or the 40 shares of class B stock, is owned, or considered as 
owned, within the meaning of section 958, by a United States person. 
Since, as owner of 31 shares of the class A stock, D has sufficient 
voting power to elect 6 directors, D has more than 50 percent of the 
total combined voting power of all classes of stock entitled to vote, 
and S Corporation is a controlled foreign corporation.
    Example 3. M, a United States person, owns a 51-percent interest in 
R Company, a foreign company of which he is a member. The company, if it 
were domestic, would be taxable as a corporation. The remaining interest 
of 49 percent in the company is owned by seven other members none of 
whom is a United States person. The memorandum of association of R 
Company provides for only one manager, who with respect to the company 
exercises the powers ordinarily exercised by a board of directors of a 
domestic corporation. The manager is to be elected by unanimous 
agreement of all the members. Since M owns 51 percent of the company, he 
will be deemed to own more than 50 percent of the total combined voting 
power of all classes of stock of R Company entitled to vote, 
notwithstanding that he has power to elect a manager only with the 
agreement of the other members. Company R is a controlled foreign 
corporation.
    Example 4. Domestic corporation M owns a 49-percent interest in S 
Company, a foreign company of which it is a member. The company, if it 
were domestic, would be taxable as a corporation. Company S is formed 
under the laws of foreign country Y. The remaining interest of 51 
percent in S Company is owned by persons who are not United States 
persons. The organization contract of S Company provides for one 
manager, B, a citizen and resident of country Y who is an officer of M 
Corporation in charge of its foreign operations in such country, or any 
person M Corporation may at any time appoint to succeed B in such 
capacity. The manager has the sole authority with respect to S Company 
to exercise powers ordinarily exercised by a board of directors of a 
domestic corporation. Since M Corporation has the discretionary power to 
replace B and to appoint his successor as manager of S Company, the 
company is a controlled foreign corporation.
    Example 5. N, a United States person, owns 50 percent of the 
outstanding shares of the only class of capital stock of foreign 
corporation R. An additional 48 percent of the outstanding shares is 
owned by foreign corporation S. The remaining 2 percent of shares is 
owned by P, a citizen and resident of foreign country T, who regularly 
acts as attorney for N in the conduct of N's business affairs in country 
T. All of the shares of the outstanding capital stock of R Corporation 
are bearer shares. At the time of the issuance of the shares to him, P 
places the certificates for such shares in a depository to which N has 
access. On several occasions N, with P's acquiescence, has taken such 
shares from the depository and, on one such occasion, used the shares as 
collateral in borrowing funds on a loan. Although dividends, when paid, 
are paid to P on his shares, his charges to N for legal fees are reduced 
by the amount of the dividends paid on such shares. Although P votes his 
shares at meetings of shareholders, the facts set forth above indicate 
an implied agreement between P and N that N is really to retain dominion 
over the stock. N is deemed to own the voting rights ostensibly attached 
to the stock owned by P, and R Corporation is a controlled foreign 
corporation.
    Example 6. M, a domestic corporation which manufactures in the 
United States and distributes all of its production for foreign 
consumption through N, a person other than a related person or a United 
States person, forms foreign corporation S to purchase products from M 
Corporation and sell them

[[Page 419]]

to N. Corporations S and M have common directors. The outstanding 
capital stock of S Corporation consists of 10,000 shares of $100 par 
value class A stock, which has no voting rights except to vote for 
dissolution of the corporation on a share-for-share basis, and 500 
shares of no par class B stock which has full voting rights. Each class 
of the outstanding stock is to participate on a share for share basis in 
any dividend. The class A stock has a preference as to assets on 
dissolution of the corporation to the extent of its par value as well as 
the right to participate with the class B stock in all other assets on a 
share for share basis. All of the shares of class A stock are issued to 
M Corporation in return for property having a value of $1 million. Of 
the class B stock, 300 of the shares are issued to N in return for 
$3,000 in cash and 200 shares are issued to M Corporation for $2,000 in 
cash. At stockholder meetings N never votes in opposition to M 
Corporation on important issues. Corporation S has average annual 
earnings of $200,000, all of which will be subpart F income if S 
Corporation is held to be a controlled foreign corporation. All such 
earnings are accumulated. Although N ostensibly has 60 percent of the 
voting power of S Corporation by virtue of his ownership of 300 shares 
of class B stock, he has the right to only approximately 3 percent of 
any dividends which may be paid by S Corporation; in addition, upon 
liquidation of S Corporation, N is entitled to share in the assets only 
after M Corporation has received the par value of its 10,000 shares of 
class A stock, or $1 million. Thus, the voting power owned by N is 
substantially greater than its proportionate share of the earnings of S 
Corporation. In addition, the facts set forth above indicate that N is 
not exercising his voting rights independently and that a principal 
purpose of the capitalization arrangement is to avoid classification of 
S Corporation as a controlled foreign corporation. For these reasons, 
the voting power ostensibly provided the class B stock will be deemed 
owned by M Corporation, and S Corporation is a controlled foreign 
corporation.
    Example 7. Foreign corporation A, authorized to issue 100 shares of 
one class of capital stock, issues, for $1,000 per share, 45 shares to 
domestic corporation M, 45 shares to foreign corporation B, and 10 
shares to foreign corporation C. Corporation C, a bank, lends $3 million 
to finance the operations of A Corporation. In the course of negotiating 
these financial arrangements, D, an officer of C Corporation, and E, an 
officer of M Corporation, orally agree that C Corporation will vote its 
stock as M Corporation directs. By virtue of such oral agreement M 
Corporation possesses the voting power ostensibly owned by C 
Corporation, and A Corporation is a controlled foreign corporation.
    Example 8. For its prior taxable year, JV, a foreign corporation, 
had outstanding 1000 shares of class A stock, which is voting common, 
and 1000 shares of class B stock, which is nonvoting preferred. DP, a 
domestic corporation, and FP, a foreign corporation, each owned 
precisely 500 shares of both class A and class B stock, and each elected 
5 of the 10 members of JV's board of directors. The other facts and 
circumstances were such that JV was not a controlled foreign corporation 
on any day of the prior taxable year. On the first day of the current 
taxable year, DP purchased one share of class B stock from FP. JV was a 
controlled foreign corporation on the following day because over 50 
percent of the total value in the corporation was held by a person that 
was a United States shareholder under section 951(b). See Sec. 1.951-
1(f).
    Example 9. The facts are the same as in Example 8 except that the 
stock of FP was publicly traded, FP had one class of stock, and on the 
first day of the current taxable year DP purchased one share of FP stock 
on the foreign stock exchange instead of purchasing one share of JV 
stock from FP. JV became a controlled foreign corporation on the 
following day because over 50 percent of the total value in the 
corporation was held by a person that was a United States shareholder 
under section 951(b).
    Example 10. X, a foreign corporation, is incorporated under the laws 
of country Y. Under the laws of country Y, X is considered a mutual 
insurance company. X issues insurance policies that provide the 
policyholder with the right to vote for directors of the corporation, 
the right to a share of the assets upon liquidation in proportion to 
premiums paid, and the right to receive policyholder dividends in 
proportion to premiums paid. Only policyholders are provided with the 
right to vote for directors, share in assets upon liquidation, and 
receive distributions. United States policyholders contribute 25 percent 
of the premiums and have 25 percent of the outstanding rights to vote 
for the board of directors. Based on these facts, the United States 
policyholders are United States shareholders owning the requisite 
combined voting power and value. Thus, X is a controlled foreign 
corporation for purposes of taking into account related person insurance 
income under section 953(c).

    (d) Effective date. Paragraphs (a) and (c) Examples 8 through 10 of 
this section are effective for taxable years of a controlled foreign 
corporation beginning after November 6, 1995.

[T.D. 6688, 28 FR 11631, Oct. 31, 1963, as amended by T.D. 8216, 53 FR 
27510, July 21, 1988; T.D. 8618, 60 FR 46529, Sept. 7, 1995; 60 FR 
62026, Dec. 4, 1995; T.D. 8704, 62 FR 21, Jan. 2, 1997]

[[Page 420]]



Sec. 1.957-2  Controlled foreign corporation deriving income from
insurance of United States risks.

    (a) In general. For purposes of taking into account only the income 
derived from the insurance of United States risks under Sec. 1.953-1, 
the term ``controlled foreign corporation'' means any foreign 
corporation of which more than 25 percent, but not more than 50 percent, 
of the total combined voting power of all classes of stock entitled to 
vote is owned within the meaning of section 958(a), or is considered as 
owned by applying the rules of ownership of section 958(b), by United 
States shareholders on any day of the taxable year of such foreign 
corporation, but only if the gross amount of premiums received by such 
foreign corporation during such taxable year which are attributable to 
the reinsuring and the issuing of insurance and annuity contracts in 
connection with United States risks, as defined in Sec. 1.953-2 or 
1.953-3, exceeds 75 percent of the gross amount of all premiums received 
by such foreign corporation during such year which are attributable to 
the reinsuring and the issuing of insurance and annuity contracts in 
connection with all risks. The subpart F income for a taxable year of a 
foreign corporation which is a controlled foreign corporation for such 
taxable year within the meaning of this paragraph shall, subject to the 
provisions of section 952(b), (c), and (d), and Sec. 1.952-1, include 
only the income derived from the insurance of United States risks, as 
determined under Sec. 1.953-1.
    (b) Gross amount of premiums defined. For a foreign corporation 
which is engaged in the business of reinsuring or issuing insurance or 
annuity contracts and which, if it were a domestic corporation engaged 
only in such business, would be taxable as--
    (1) A life insurance company to which part I (sections 801 through 
820) of subchapter L of the Code applies,
    (2) A mutual insurance company to which part II (sections 821 
through 826) of subchapter L of the Code applies, or
    (3) A mutual marine insurance or other insurance company to which 
part III (sections 831 and 832) of subchapter L of the Code applies,


the term ``gross amount of premiums'' means, for purposes of paragraph 
(a) of this section, the gross amount of premiums and other 
consideration which are taken into account by a life insurance company 
under section 809(c)(1). Determinations for purposes of this paragraph 
shall be made without regard to section 501(a).

[T.D. 6795, 30 FR 942, Jan. 29, 1965]



Sec. 1.957-3  United States person defined.

    (a) Basic rule--(1) In general. The term United States person has 
the same meaning for purposes of sections 951 through 965 that it has 
under section 7701(a)(30) and the regulations under that section, except 
as provided in paragraphs (b) and (c) of this section, which provide, 
with respect to corporations organized in possessions of the United 
States, that certain residents of such possessions are not United States 
persons. The effect of determining that an individual is not a United 
States person for such purposes is to exclude such individual in 
determining whether a foreign corporation created or organized in, or 
under the laws of, a possession of the United States is a controlled 
foreign corporation. See Sec. 1.957-1 for the definition of the term 
``controlled foreign corporation.''
    (2) Special provisions applicable to possessions of the United 
States. For purposes of this section--
    (i) The term possession of the United States means Puerto Rico or 
any section 931 possession;
    (ii) The term section 931 possession has the same meaning that it 
has under Sec. 1.931-1(c)(1);
    (iii) The rules of Sec. 1.937-1 will apply for determining whether 
an individual is a bona fide resident of a possession of the United 
States;
    (iv) Except as provided in paragraph (b)(2) of this section, the 
rules of Sec. 1.937-2 will apply for determining whether income is from 
sources within a possession of the United States; and
    (v) The rules of Sec. 1.937-3 will apply for determining whether 
income is effectively connected with the conduct of a trade or business 
in a possession of the United States.
    (b) Puerto Rico corporation and resident. An individual (who, 
without regard to this paragraph (b), is a United

[[Page 421]]

States person) will not be considered a United States person with 
respect to a foreign corporation created or organized in, or under the 
laws of, Puerto Rico for the taxable year of such corporation that ends 
with or within the taxable year of such individual if--
    (1) Such individual is a bona fide resident of Puerto Rico during 
his entire taxable year in which or with which the taxable year of such 
foreign corporation ends; and
    (2) A dividend received by such individual from such corporation 
during the taxable year of such corporation would, for purposes of 
section 933(1), be treated as income derived from sources within Puerto 
Rico. For purposes of this paragraph (b)(2), the rules of Sec. 1.937-
2(g)(1) will not apply.
    (c) Section 931 possession corporation and resident. An individual 
(who, without regard to this paragraph (c), is a United States person) 
will not be considered a United States person with respect to a foreign 
corporation created or organized in, or under the laws of, a section 931 
possession for the taxable year of such corporation that ends with or 
within the taxable year of such individual if--
    (1) Such individual is a bona fide resident of such section 931 
possession during his entire taxable year in which or with which the 
taxable year of such foreign corporation ends; and
    (2) Such corporation satisfies the following conditions--
    (i) 80 percent or more of its gross income for the 3-year period 
ending at the close of the taxable year (or for such part of such period 
as such corporation or any predecessor has been in existence) was 
derived from sources within section 931 possessions or was effectively 
connected with the conduct of a trade or business in section 931 
possessions; and
    (ii) 50 percent or more of its gross income for such period (or 
part) was derived from the active conduct of a trade or business within 
section 931 possessions.
    (d) Effective/applicability date. This section applies to taxable 
years ending after April 9, 2008.

[T.D. 9391, 73 FR 19375, Apr. 9, 2008]



Sec. 1.958-1  Direct and indirect ownership of stock.

    (a) In general. Section 958(a) provides that, for purposes of 
sections 951 to 964 (other than sections 955(b)(1)(A) and (B) and 
955(c)(2)(A)(ii) (as in effect before the enactment of the Tax Reduction 
Act of 1975), and 960(a)(1)), stock owned means--
    (1) Stock owned directly; and
    (2) Stock owned with the application of paragraph (b) of this 
section.


The rules of section 958(a) and this section provide a limited form of 
stock attribution primarily for use in determining the amount taxable to 
a United States shareholder under section 951(a). These rules also apply 
for purposes of other provisions of the Code and regulations which make 
express reference to section 958(a).
    (b) Stock ownership through foreign entities. For purposes of 
paragraph (a)(2) of this section, stock owned, directly or indirectly, 
by or for a foreign corporation, foreign partnership, foreign trust 
(within the meaning of section 7701(a)(31)) described in sections 671 
through 679, or other foreign trust or foreign estate (within the 
meaning of section 7701(a)(31)) shall be considered as being owned 
proportionately by its shareholders, partners, grantors or other persons 
treated as owners under sections 671 through 679 of any portion of the 
trust that includes the stock, or beneficiaries, respectively. Stock 
considered to be owned by reason of the application of this paragraph 
shall, for purposes of reapplying this paragraph, be treated as actually 
owned by such person. Thus, this rule creates a chain of ownership; 
however, since the rule applies only to stock owned by a foreign entity, 
attribution under the rule stops with the first United States person in 
the chain of ownership running from the foreign entity. The application 
of this paragraph may be illustrated by the following example:

    Example. Domestic corporation M owns 75 percent of the one class of 
stock in foreign corporation R, which in turn owns 80 percent of the one 
class of stock in foreign corporation S, which in turn owns 90 percent 
of the one class of stock in foreign corporation T. Under this 
paragraph, R Corporation is considered as owning 80 percent of the 90 
percent of the stock which S Corporation owns in T

[[Page 422]]

Corporation, or 72 percent. Corporation M is considered as owning 75 
percent of such 72 percent of the stock in T Corporation, or 54 percent. 
Since M Corporation is a domestic corporation, the attribution under 
this paragraph stops with M Corporation, even though, illustratively, 
such corporation is wholly owned by domestic corporation N.

    (c) Rules of application--(1) Special rule for mutual insurance 
companies. For purposes of applying paragraph (a) of this section in the 
case of a foreign mutual insurance company, the term ``stock'' shall 
include any certificate entitling the holder to voting power in the 
corporation.
    (2) Amount of interest in foreign corporation, foreign partnership, 
foreign trust, or foreign estate. The determination of a person's 
proportionate interest in a foreign corporation, foreign partnership, 
foreign trust, or foreign estate will be made on the basis of all the 
facts and circumstances in each case. Generally, in determining a 
person's proportionate interest in a foreign corporation, the purpose 
for which the rules of section 958(a) and this section are being applied 
will be taken into account. Thus, if the rules of section 958(a) are 
being applied to determine the amount of stock owned for purposes of 
section 951(a), a person's proportionate interest in a foreign 
corporation will generally be determined with reference to such person's 
interest in the income of such corporation. If the rules of section 
958(a) are being applied to determine the amount of voting power owned 
for purposes of section 951(b) or 957, a person's proportionate interest 
in a foreign corporation will generally be determined with reference to 
the amount of voting power in such corporation owned by such person. 
However, any arrangement which artificially decreases a United States 
person's proportionate interest will not be recognized. See Sec. Sec. 
1.951-1 and 1.957-1.
    (d) Illustration. The application of this section may be illustrated 
by the following examples:

    Example 1. United States persons A and B own 25 percent and 50 
percent, respectively, of the one class of stock in foreign corporation 
M. Corporation M owns 80 percent of the one class of stock in foreign 
corporation N, and N Corporation owns 60 percent of the one class of 
stock in foreign corporation P. Under paragraph (b) of this section, M 
Corporation is considered to own 48 percent (80 percent of 60 percent) 
of the stock in P Corporation; such 48 percent is treated as actually 
owned by M Corporation for the purpose of again applying paragraph (b) 
of this section. Thus, A and B are considered to own 12 percent (25 
percent of 48 percent) and 24 percent (50 percent of 48 percent), 
respectively, of the stock in P Corporation.
    Example 2. United States person C is a 60-percent partner in foreign 
partnership X. Partnership X owns 40 percent of the one class of stock 
in foreign corporation Q. Corporation Q is a 50-percent partner in 
foreign partnership Y, and partnership Y owns 100 percent of the one 
class of stock in foreign corporation R. By the application of paragraph 
(b) of this section, C is considered to own 12 percent (60 percent of 40 
percent of 50 percent of 100 percent) of the stock in R Corporation.
    Example 3. Foreign trust Z was created for the benefit of United 
States persons D, E, and F. Under the terms of the trust instrument, the 
trust income is required to be divided into three equal shares. Each 
beneficiary's share of the income may either be accumulated for him or 
distributed to him in the discretion of the trustee. In 1970, the trust 
is to terminate and there is to be paid over to each beneficiary the 
accumulated income applicable to his share and one-third of the corpus. 
The corpus of trust Z is composed of 90 percent of the one class of 
stock in foreign corporation S. By the application of this section, each 
of D, E, and F is considered to own 30 percent (\1/3\ of 90 percent) of 
the stock in S Corporation.
    Example 4. Among the assets of foreign estate W are Blackacre and a 
block of stock, consisting of 75 percent of the one class of stock of 
foreign corporation T. Under the terms of the will governing estate W, 
Blackacre is left to G, a nonresident alien, for life, remainder to H, a 
nonresident alien, and the block of stock is left to United States 
person K. By the application of this section, K is considered to own the 
75 percent of the stock of T Corporation, and G and H are not considered 
to own any of such stock.

[T.D. 6889, 31 FR 9455, July 12, 1966, as amended by T.D. 7893, 48 FR 
22509, May 19, 1983; T.D. 8955, 66 FR 37897, July 20, 2001]



Sec. 1.958-2  Constructive ownership of stock.

    (a) In general. Section 958(b) provides that, for purposes of 
sections 951(b), 954(d)(3), 956(b)(2), and 957, the rules of section 
318(a) as modified by section 958(b) and this section shall apply to the 
extent that the effect is to treat a United States person as a United 
States shareholder within the meaning

[[Page 423]]

of section 951(b), to treat a person as a related person within the 
meaning of section 954(d)(3), to treat the stock of a domestic 
corporation as owned by a United States shareholder of a controlled 
foreign corporation under section 956(b)(2), or to treat a foreign 
corporation as a controlled foreign corporation under section 957. The 
rules contained in this section also apply for purposes of other 
provisions of the Code and regulations which make express reference to 
section 958(b).
    (b) Members of family--(1) In general. Except as provided in 
subparagraph (3) of this paragraph, an individual shall be considered as 
owning the stock owned, directly or indirectly, by or for--
    (i) His spouse (other than a spouse who is legally separated from 
the individual under a decree of divorce or separate maintenance); and
    (ii) His children, grandchildren, and parents.
    (2) Effect of adoption. For purposes of subparagraph (1)(ii) of this 
paragraph, a legally adopted child of an individual shall be treated as 
a child of such individual by blood.
    (3) Stock owned by nonresident alien individual. For purposes of 
this paragraph, stock owned by a nonresident alien individual (other 
than a foreign trust or foreign estate) shall not be considered as owned 
by a United States citizen or a resident alien individual. However, this 
limitation does not apply for purposes of determining whether the stock 
of a domestic corporation is owned or considered as owned by a United 
States shareholder under section 956(b)(2) and Sec. 1.956-
2(b)(1)(viii). See section 958(b)(1).
    (c) Attribution from partnerships, estates, trusts, and 
corporations--(1) In general. Except as provided in subparagraph (2) of 
this paragraph--
    (i) From partnerships and estates. Stock owned, directly or 
indirectly, by or for a partnership or estate shall be considered as 
owned proportionately by its partners or beneficiaries.
    (ii) From trusts--(a) To beneficiaries. Stock owned, directly or 
indirectly, by or for a trust (other than an employees' trust described 
in section 401(a) which is exempt from tax under section 501(a)) shall 
be considered as owned by its beneficiaries in proportion to the 
actuarial interest of such beneficiaries in such trust.
    (b) To owner. Stock owned, directly or indirectly, by or for any 
portion of a trust of which a person is considered the owner under 
sections 671 to 679 (relating to grantors and others treated as 
substantial owners) shall be considered as owned by such person.
    (iii) From corporations. If 10 percent or more in value of the stock 
in a corporation is owned, directly or indirectly, by or for any person, 
such person shall be considered as owning the stock owned, directly or 
indirectly, by or for such corporation, in that proportion which the 
value of the stock which such person so owns bears to the value of all 
the stock in such corporation. See section 958(b)(3).
    (2) Rules of application. For purposes of subparagraph (1) of this 
paragraph, if a partnership, estate, trust, or corporation owns, 
directly or indirectly, more than 50 percent of the total combined 
voting power of all classes of stock entitled to vote in a corporation, 
it shall be considered as owning all the stock entitled to vote. See 
section 958(b)(2).
    (d) Attribution to partnerships, estates, trusts, and corporations--
(1) In general. Except as provided in subparagraph (2) of this 
paragraph--
    (i) To partnerships and estates. Stock owned, directly or 
indirectly, by or for a partner or a beneficiary of an estate shall be 
considered as owned by the partnership or estate.
    (ii) To trusts--(a) From beneficiaries. Stock owned, directly or 
indirectly, by or for a beneficiary of a trust (other than an employees' 
trust described in section 401(a) which is exempt from tax under section 
501(a)) shall be considered as owned by the trust, unless such 
beneficiary's interest in the trust is a remote contingent interest. For 
purposes of the preceding sentence, a contingent interest of a 
beneficiary in a trust shall be considered remote if, under the maximum 
exercise of discretion by the trustee in favor of such beneficiary, the 
value of such interest, computed actuarially, is 5 percent or less of 
the value of the trust property.
    (b) From owner. Stock owned, directly or indirectly, by or for a 
person who is considered the owner of any portion of

[[Page 424]]

a trust under sections 671 to 678 (relating to grantors and others 
treated as substantial owners) shall be considered as owned by the 
trust.
    (iii) To corporations. If 50 percent or more in value of the stock 
in a corporation is owned, directly or indirectly, by or for any person, 
such corporation shall be considered as owning the stock owned, directly 
or indirectly, by or for such person. This subdivision shall not be 
applied so as to consider a corporation as owning its own stock.
    (2) Limitation. Subparagraph (1) of this paragraph shall not be 
applied so as to consider a United States person as owning stock which 
is owned by a person who is not a United States person. This limitation 
does not apply for purposes of determining whether the stock of a 
domestic corporation is owned or considered as owned by a United States 
shareholder under section 956(b)(2) and Sec. 1.956-2(b)(1)(viii). See 
section 958(b)(4).
    (e) Options. If any person has an option to acquire stock, such 
stock shall be considered as owned by such person. For purposes of the 
preceding sentence, an option to acquire such an option, and each one of 
a series of such options, shall be considered as an option to acquire 
such stock.
    (f) Rules of application. For purposes of this section--
    (1) Stock treated as actually owned--(i) In general. Except as 
provided in subdivisions (ii) and (iii) of this subparagraph, stock 
constructively owned by a person by reason of the application of 
paragraphs (b), (c), (d), and (e) of this section shall, for purposes of 
applying such paragraphs, be considered as actually owned by such 
person.
    (ii) Members of family. Stock constructively owned by an individual 
by reason of the application of paragraph (b) of this section shall not 
be considered as owned by him for purposes of again applying such 
paragraph in order to make another the constructive owner of such stock.
    (iii) Partnerships, estates, trusts, and corporation. Stock 
constructively owned by a partnership, estate, trust, or corporation by 
reason of the application of paragraph (d) of this section shall not be 
considered as owned by it for purposes of applying paragraph (c) of this 
section in order to make another the constructive owner of such stock.
    (iv) Option rule in lieu of family rule. For purposes of this 
subparagraph, if stock may be considered as owned by an individual under 
paragraph (b) or (e) of this section, it shall be considered as owned by 
him under paragraph (e).
    (2) Coordination of different attribution rules. For purposes of any 
one determination, stock which may be owned under more than one of the 
rules of Sec. 1.958-1 and this section, or by more than one person, 
shall be owned under that attribution rule which imputes to the person, 
or persons, concerned the largest total percentage of such stock. The 
application of this subparagraph may be illustrated by the following 
examples:

    Example 1. (a) United States persons A and B, and domestic 
corporation M, own 9 percent, 32 percent, and 10 percent, respectively, 
of the one class of stock in foreign corporation R. A also owns 10 
percent of the one class of stock in M Corporation. For purposes of 
determining whether A is a United States shareholder with respect to R 
Corporation, 10 percent of the 10-percent interest of M Corporation in R 
Corporation is considered as owned by A. See paragraph (c)(1)(iii) of 
this section. Thus, A owns 10 percent (9 percent plus 10 percent of 10 
percent) of the stock in R Corporation and is a United States 
shareholder with respect to such corporation. Corporation M and B, by 
reason of owning 10 percent and 32 percent, respectively, of the stock 
in R Corporation are United States shareholders with respect to such 
corporation.
    (b) For purposes of determining whether R Corporation is a 
controlled foreign corporation, the 1 percent of the stock in R 
Corporation directly owned by M Corporation and considered as owned by A 
cannot be counted twice. Therefore, the total amount of stock in R 
Corporation owned by United States shareholders is 51 percent, 
determined as follows:

                    Stock Ownership in R Corporation
                                [percent]
A..............................................................        9
B..............................................................       32
M Corporation..................................................       10
                                                                --------
  Total........................................................       51
 

    Example 2. United States person C owns 10 percent of the one class 
of stock in foreign corporation N, which owns 60 percent of the one 
class of stock in foreign corporation S.

[[Page 425]]

Under paragraph (a)(2) of Sec. 1.958-1, C is considered as owning 6 
percent (10 percent of 60 percent) of the stock in S Corporation. Under 
paragraph (c)(1)(iii) and (2) of this section N Corporation is 
considered as owning 100 percent of the stock in S Corporation and C is 
considered as owning 10 percent of such 100 percent, or 10 percent of 
the stock in S Corporation. Thus, for purposes of determining whether C 
is a United States shareholder with respect to S Corporation, the 
attribution rules of paragraph (c)(1)(iii) and (2) of this section are 
used inasmuch as C owns a larger total percentage of the stock of S 
Corporation under such rules.

    (g) Illustration. The application of this section may be illustrated 
by the following examples:

    Example 1. United States persons A and B own 5 percent and 25 
percent, respectively, of the one class of stock in foreign corporation 
M. Corporation M owns 60 percent of the one class of stock in foreign 
corporation N. Under paragraph (a)(2) of Sec. 1.958-1, A and B are 
considered as owning 3 percent (5 percent of 60 percent) and 15 percent 
(25 percent of 60 percent), respectively, of the stock in N Corporation. 
Under paragraph (c)(2) of this section, M Corporation is treated as 
owning all the stock in N Corporation, and, under paragraph (c)(1)(iii) 
of this section, B is considered as owning 25 percent of such 100 
percent, or 25 percent of the stock in N Corporation. Inasmuch as A owns 
less than 10 percent of the stock in M Corporation, he is not considered 
as owning, under paragraph (c)(1)(iii) of this section, any of the stock 
in N Corporation owned by M Corporation. Thus, the attribution rules of 
paragraph (a)(2) of Sec. 1.958-1 are used with respect to A inasmuch as 
he owns a larger total percentage of the stock of N Corporation under 
such rules; and the attribution rules of paragraph (c)(1)(iii) and (2) 
of this section are used with respect to B inasmuch as he owns a larger 
total percentage of the stock of N Corporation under such rules.
    Example 2. United States person C owns 60 percent of the one class 
of stock in domestic corporation P; corporation P owns 60 percent of the 
one class of stock in foreign corporation Q; and corporation Q owns 60 
percent of the one class of stock in foreign corporation R. Under 
paragraph (a)(2) of Sec. 1.958-1, P Corporation is considered as owning 
36 percent (60 percent of 60 percent) of the stock in R Corporation, and 
C is considered as owning none of the stock in R Corporation inasmuch as 
the chain of ownership stops at the first United States person and P 
Corporation is such a person. Under paragraph (c)(2) of this section, Q 
Corporation is treated as owning 100 percent of the stock in R 
Corporation, and under paragraph (c)(1)(iii) of this section, P 
Corporation is considered as owning 60 percent of such 100 percent, or 
60 percent of the stock in R Corporation. For purposes of determining 
the amount of stock in R Corporation which C is considered as owning, P 
Corporation is treated under paragraph (c)(2) of this section as owning 
100 percent of the stock in R Corporation; therefore, C is considered as 
owning 60 percent of the stock in R Corporation. Thus, the attribution 
rules of paragraph (c)(1)(iii) and (2) of this section are used with 
respect to C and P Corporation inasmuch as they each own a larger total 
percentage of the stock of R Corporation under such rules.
    Example 3. United States person D owns 25 percent of the one class 
of stock in foreign corporation S. D is also a 40-percent partner in 
domestic partnership X, which owns 50 percent of the one class of stock 
in domestic corporation T. Under paragraph (d)(1)(i) of this section, 
the 25 percent of the stock in S Corporation owned by D is considered as 
being owned by partnership X; since such stock is treated as actually 
owned by partnership X under paragraph (f)(1)(i) of this section, such 
stock is in turn considered as being owned by T Corporation under 
paragraph (d)(1)(iii) of this section. Thus, under paragraphs (d)(1) and 
(f)(1)(i) of this section, T Corporation is considered as owning 25 
percent of the stock in S Corporation.
    Example 4. Foreign corporation U owns 100 percent of the one class 
of stock in domestic corporation V and also 100 percent of the one class 
of stock in foreign corporation W. By virtue of paragraph (d)(2) of this 
section, V Corporation may not be considered under paragraph (d)(1) of 
this section as owning the stock owned by its sole shareholder, U 
Corporation, in W Corporation.
    Example 5. United States citizen E owns 15 percent of the one class 
of stock in foreign corporation Y, and United States citizen F, E's 
spouse, owns 5 percent of such stock. E and F's four nonresident alien 
grandchildren each own 20 percent of the stock in Y Corporation. Under 
paragraph (b)(1) of this section, E is considered as owning the stock 
owned by F in Y Corporation; however, by virtue of paragraph (b)(3) of 
this section, E may not be considered under paragraph (b)(1) of this 
section as owning any of the stock in Y Corporation owned by such 
grandchildren.
    Example 6. United States person F owns 10 percent of the one class 
of stock in foreign corporation Z; corporation Z owns 10 percent of the 
one class of stock in foreign corporation K; and corporation K owns 100 
percent of the one class of stock in foreign corporation L. United 
States person G, F's spouse, owns 9 percent of the stock in K 
Corporation. Under paragraph (c)(1)(iii) of this section or paragraph 
(a)(2) of Sec. 1.958-1, F is considered as owning 1 percent (10 percent 
of 10 percent of 100 percent) of the stock in L Corporation by reason of 
his ownership of stock in Z Corporation, and, under paragraph (b)(1) of 
this

[[Page 426]]

section, G is considered as owning such 1 percent of the stock in L 
Corporation. Under paragraph (a)(2) of Sec. 1.958-1, G is considered as 
owning 9 percent (9 percent of 100 percent) of the stock in L 
Corporation by reason of her ownership of stock in K Corporation, and, 
under paragraph (b)(1) of this section, F is considered as owning such 9 
percent of the stock in L Corporation. Thus, for the purpose of 
determining whether F or G is a United States shareholder with respect 
to L Corporation, each of F and G is considered as owning a total of 10 
percent of the stock in L Corporation by applying the rules of paragraph 
(a)(2) of Sec. 1.958-1 and paragraphs (b)(1) and (c)(1)(iii) of this 
section.

(Secs. 956(c), 7805, Internal Revenue Code of 1954 (76 Stat. 1017, 68A 
Stat. 917; (26 U.S.C. 956(c) and 7805 respectively)))

[T.D. 6889, 31 FR 9455, July 12, 1966, as amended by T.D. 7712, 45 FR 
52375, Aug. 7, 1980; T.D. 8955, 66 FR 37897, July 20, 2001]



Sec. 1.959-1  Exclusion from gross income of United States persons 
of previously taxed earnings and profits.

    (a) In general. Sections 951 through 964 provide that certain types 
of income of controlled foreign corporations will be subject to United 
States income tax even though such amounts are not currently distributed 
to the United States shareholders of such corporations. The amounts so 
taxed to certain United States shareholders are described as subpart F 
income, previously excluded subpart F income withdrawn from investment 
in less developed countries, previously excluded subpart F income 
withdrawn from investment in foreign base company shipping operations, 
and increases in earnings invested in United States property. Section 
959 provides that amounts taxed as subpart F income, as previously 
excluded subpart F income withdrawn from investment in less developed 
countries, or as previously excluded subpart F income withdrawn from 
investment in foreign base company shipping operations are not taxed 
again as increases in earnings invested in United States property. 
Section 959 also provides an exclusion whereby none of the amounts so 
taxed are taxed again when actually distributed directly, or indirectly 
through a chain of ownership described in section 958(a), to United 
States shareholders or to such shareholders' successors in interest. The 
exclusion also applies to amounts taxed to United States shareholders as 
income of one controlled foreign corporation and later distributed to 
another controlled foreign corporation in such a chain of ownership 
where such amounts would otherwise be again included in the income of 
such shareholders or their successors in interest as subpart F income of 
the controlled foreign corporation to which they are distributed. 
Section 959 also provides rules for the allocation of distributions to 
earnings and profits and for the non-dividend treatment of actual 
distributions which are excluded from gross income.
    (b) Actual distributions to United States persons. The earnings and 
profits for a taxable year of a foreign corporation attributable to 
amounts which are, or have been, included in the gross income of a 
United States shareholder of such corporation under section 951(a) shall 
not, when such amounts are distributed to such shareholder directly, or 
indirectly through a chain of ownership described in section 958(a), be 
again included in the gross income of such United States shareholder. 
See section 959(a)(1). Thus, earnings and profits attributable to 
amounts which are, or have been, included in the gross income of a 
United States shareholder of a foreign corporation under section 951 
(a)(1)(A)(i) as subpart F income, under section 951(a)(1)(A)(ii) as 
previously excluded subpart F income withdrawn from investment in less 
developed countries, under section 951(a)(1)(A)(iii) as previously 
excluded subpart F income withdrawn from investment in foreign base 
company shipping operations, or under section 951(a)(1)(B) as earnings 
invested in United States property, shall not be again included in the 
gross income of such shareholder when such amounts are actually 
distributed, directly or indirectly, to such shareholder. See paragraph 
(d) of this section for exclusion applicable to such shareholder's 
successor in interest. The application of this paragraph may be 
illustrated by the following example:

    Example. (a) A, a United States shareholder, owns 100 percent of the 
only class of stock of R Corporation, a corporation organized on January 
1, 1963, which is a controlled foreign corporation throughout the

[[Page 427]]

period here involved. Both A and R Corporation use the calendar year as 
a taxable year.
    (b) During 1964, R Corporation derives $100 of subpart F income, and 
A includes such amount in his gross income under section 
951(a)(1)(A)(i). Corporation R's current and accumulated earnings and 
profits (before taking into account distributions made during 1964) are 
$150. Also, during 1964, R Corporation distributes $50 to A. The $50 
distribution is excludable from A's gross income for 1964 under this 
paragraph and Sec. 1.959-3 because such distribution represents 
earnings and profits attributable to amounts which are included in A's 
gross income for such year under section 951(a).
    (c) If instead of deriving the $100 of subpart F income in 1964, R 
Corporation derives such amount during 1963 and has earnings and profits 
for 1963 in excess of $100, A must include $100 in his gross income for 
1963 under section 951(a)(1)(A)(i). However, the $50 distribution made 
by R Corporation to A during 1964 is excludable from A's gross income 
for such year under this paragraph and Sec. 1.959-3 because such 
distribution represents earnings and profits attributable to amounts 
which have been included in A's gross income for 1963 under section 
951(a).
    (d) If, with respect to 1964--
    (1) Instead of owning the stock of R Corporation directly, A owns 
such stock through a chain of ownership described in section 958(a), 
that is, A owns 100 percent of M Corporation which owns 100 percent of N 
Corporation which owns 100 percent of R Corporation,
    (2) Both M and N Corporations use the calendar year as a taxable 
year and are controlled foreign corporations throughout the period here 
involved,
    (3) Corporation R derives $100 of subpart F income and has earnings 
and profits in excess of $100,
    (4) Neither M Corporation nor N Corporation has earnings and profits 
or a deficit in earnings and profits, and
    (5) The $50 distribution is from R Corporation to N Corporation to M 
Corporation to A,


A must include $100 in his gross income for 1964 under section 
951(a)(1)(A)(i) by reason of his indirect ownership of R Corporation. 
However, the $50 distribution is excludable from A's gross income for 
1964 under this paragraph and Sec. 1.959-3 because such distribution 
represents earnings and profits attributable to amounts which are 
included in A's gross income for such year under section 951(a) and are 
distributed indirectly to A through a chain of ownership described in 
section 958(a).

    (c) Excludable investment of earnings in United States property. The 
earnings and profits for a taxable year of a foreign corporation 
attributable to amounts which are, or have been, included in the gross 
income of a United States shareholder of such corporation under section 
951(a)(1)(A) shall not, when such amounts would, but for section 
959(a)(2) and this paragraph, be included under section 951(a)(1)(B) in 
the gross income of such shareholder directly, or indirectly through a 
chain of ownership described in section 958(a), be again included in the 
gross income of such United States shareholder. Thus, earnings and 
profits attributable to amounts which are, or have been, included in the 
gross income of a United States shareholder of a foreign corporation 
under section 951(a)(1)(A)(i) as subpart F income, under section 
951(a)(1)(A)(ii) as previously excluded subpart F income withdrawn from 
investment in less developed countries, or under section 
951(a)(1)(A)(iii) as previously excluded subpart F income withdrawn from 
investment in foreign base company shipping operations, may be invested 
in United States property without being again included in such 
shareholder's income under section 951 (a). Moreover, the first amount 
deemed invested in United States property are amounts previously 
included in the gross income of a United States shareholder under 
section 951(a)(1)(A). See paragraph (d) of this section for exclusion 
applicable to such shareholder's successor in interest. The application 
of this paragraph may be illustrated by the following example:

    Example. (a) A, a United States shareholder, owns 100 percent of the 
only class of stock of R Corporation, a corporation organized on January 
1, 1963, which is a controlled foreign corporation throughout the period 
here involved. Both A and R Corporation use the calendar year as a 
taxable year.
    (b) During 1964, R Corporation derives $35 of subpart F income, and 
A includes such amount in his gross income under section 
951(a)(1)(A)(i). During 1964, R Corporation also invests $50 in tangible 
property (other than property described in section 956(b)(2)) located in 
the United States. Corporation R makes no distributions during the year, 
and its current earnings and profits are in excess of $50. Of the $50 
investment of earnings in United States property, $35 is excludable from 
A's gross income for 1964 under section 959(a)(2) because such amount 
represents earnings and profits which are attributable to amounts which 
are included in A's gross income for such year under section

[[Page 428]]

951(a)(1)(A)(i) and therefore may be invested in United States property 
without again being included in A's gross income. The remaining $15 is 
includible in A's gross income for 1964 under section 951(a)(1)(B).
    (c) If, instead of deriving $35 of subpart F income in 1964, R 
Corporation has no subpart F income for 1964 but derives the $35 of 
subpart F income during 1963 and has earnings and profits for such year 
in excess of $35, A must include $35 in his gross income for 1963 under 
section 951(a)(1)(A)(i). However, of the $50 investment of earnings in 
United States property made by R Corporation during 1964, $35 is 
excludable from A's gross income for 1964 under section 959(a)(2) 
because such amount represents earnings and profits attributable to 
amounts which have been included in A's gross income for 1963 under 
section 951(a)(1)(A)(i). The remaining $15 is includible in A's gross 
income for 1964 under section 951(a)(1)(B).

    (d) Application of exclusions to shareholder's successor in 
interest. If a United States person (as defined in Sec. 1.957-4) 
acquires from any person any portion of the interest in the foreign 
corporation of a United States shareholder referred to in paragraph (b) 
or (c) of this section, the rules of such paragraph shall apply to such 
acquiring person but only to the extent that the acquiring person 
establishes to the satisfaction of the district director his right to 
the exclusion provided by such paragraph. The information to be 
furnished by the acquiring person to the district director with his 
return for the taxable year to support such exclusion shall include:
    (1) The name, address, and taxable year of the foreign corporation 
from which the distribution is received and of all other corporations, 
partnerships, trusts, or estates in any applicable chain of ownership 
described in section 958(a);
    (2) The name, address, and (in the case of information required to 
be furnished after June 20, 1983) taxpayer identification number of the 
person from whom the stock interest was acquired;
    (3) A description of the stock interest acquired and its relation, 
if any, to a chain of ownership described in section 958(a);
    (4) The amount for which an exclusion under section 959(a) is 
claimed; and
    (5) Evidence showing that the earnings and profits for which an 
exclusion is claimed are attributable to amounts which were included in 
the gross income of a United States shareholder under section 951(a), 
that such amounts were not previously excluded from the gross income of 
a United States person, and the identity of the United States 
shareholder including such amounts.


The acquiring person shall also furnish to the district director such 
other information as may be required by the district director in support 
of the exclusion.

    Example. (a) A, a United States shareholder, owns 100 percent of the 
only class of stock of R Corporation, a corporation organized on January 
1, 1964, and a controlled foreign corporation throughout the period here 
involved. Both A and R Corporation use the calendar year as a taxable 
year.
    (b) During 1964, R Corporation has $100 of subpart F income and 
earnings and profits in excess of $100. A includes $100 in his gross 
income for 1964 under section 951(a)(1)(A)(i). During 1965, A sells 40 
percent of his stock in R Corporation to B, a United States person who 
uses the calendar year as a taxable year. In 1965, R Corporation has no 
earnings and profits and experiences no increase in earnings invested in 
United States property. Corporation R distributes $40 to B on December 
1, 1965. If B establishes his right to the exclusion to the satisfaction 
of the district director, he may exclude $40 from his gross income for 
1965 under section 959(a)(1).
    (c) If, instead of selling his 40-percent interest directly to B, A 
sells on February 1, 1965, 40 percent of his stock in R Corporation to 
C, a nonresident alien, and on October 1, 1965, B acquires the 40-
percent interest in R Corporation from C, the result is the same as in 
paragraph (b) of this example, if B establishes his right to the 
exclusion to the satisfaction of the district director.
    (d) If, instead of acquiring 40 percent, B acquires only 5 percent 
of A's stock in R Corporation and R Corporation distributes $5 to B 
during 1965, B is not a United States shareholder (within the meaning of 
section 951(b)) with respect to R Corporation since he owns only 5 
percent of the stock of R Corporation. Notwithstanding, B may exclude 
the $5 distribution from his gross income for 1965 under section 
959(a)(1) if he establishes his right to the exclusion to the 
satisfaction of the district director.
    (e) If the facts are assumed to be the same as in paragraphs (a) and 
(b) of this example except that--
    (1) A owns the stock of R Corporation indirectly through a chain of 
ownership described in section 958(a), that is, A owns 100

[[Page 429]]

percent of M Corporation which owns 100 percent of N Corporation which 
owns 100 percent of R Corporation,
    (2) B acquires from N Corporation 40 percent of the stock in R 
Corporation,
    (3) Both M Corporation and N Corporation are controlled foreign 
corporations which use the calendar year as a taxable year,
    (4) Neither M Corporation nor N Corporation has any amount in 1964 
or 1965 which is includible in gross income of United States 
shareholders under section 951(a), and
    (5) Neither M Corporation nor N Corporation has a deficit in 
earnings and profits for 1964;


the result is the same as in paragraph (b) of this example if B 
establishes his right to the exclusion to the satisfaction of the 
district director.

[T.D. 6795, 30 FR 943, Jan. 29, 1965, as amended by T.D. 7893, 48 FR 
22509, May 19, 1983]



Sec. 1.959-2  Exclusion from gross income of controlled foreign
corporations of previously taxed earnings and profits.

    (a) Applicable rule. The earnings and profits for a taxable year of 
a controlled foreign corporation attributable to amounts which are, or 
have been, included in the gross income of a United States shareholder 
under section 951(a) shall not, when distributed through a chain of 
ownership described in section 958(a), be also included in the gross 
income of another controlled foreign corporation in such chain for 
purposes of the application of section 951(a) to such other controlled 
foreign corporation with respect to such United States shareholder. See 
section 959(b). The exclusion from the income of such other foreign 
corporation also applies with respect to any other United States 
shareholder who acquires from such United States shareholder or any 
other person any portion of the interest of such United States 
shareholder in the controlled foreign corporation, but only to the 
extent the acquiring shareholder establishes to the satisfaction of the 
district director his right to such exclusion. An acquiring shareholder 
claiming the exclusion under section 959(b) shall furnish to the 
district director with his return for the taxable year the information 
required under paragraph (d) of Sec. 1.959-1 to support the exclusion 
under this paragraph.
    (b) Illustration. The application of this section may be illustrated 
by the following example:

    Example. (a) A, a United States shareholder, owns 100 percent of the 
only class of stock of M Corporation which in turn owns 100 percent of 
the only class of stock of N Corporation. A and corporations M and N use 
the calendar year as a taxable year and corporations M and N are 
controlled foreign corporations throughout the period here involved.
    (b) During 1963, N Corporation invests $100 in tangible property 
(other than property described in section 956(b)(2)) located in the 
United States and has earnings and profits in excess of $100. A is 
required to include $100 in his gross income for 1963 under section 
951(a)(1)(B) by reason of his indirect ownership of the stock of N 
Corporation. During 1963, M Corporation has no income or investments 
other than the income derived from a distribution of $100 from N 
Corporation. Corporation M has earnings and profits of $100 for 1963. 
Under paragraph (a) of Sec. 1.954-2, the $100 distribution received by 
M Corporation from N Corporation would otherwise constitute subpart F 
income of M Corporation; however, by reason of section 959(b) and this 
section, this amount does not constitute gross income of M Corporation 
for purposes of determining amounts includible in A's gross income under 
section 951(a)(1)(A)(i).
    (c) During 1964, N Corporation derives $100 of subpart F income and 
distributes $100 to M Corporation which has no subpart F income for 1964 
but which invests the $100 distribution in tangible property (other than 
property described in section 956(b)(2)) located in the United States. 
Corporation N's earnings and profits for 1964 are in excess of $100, and 
M Corporation's current and accumulated earnings and profits (before 
taking into account distributions made during 1964) are in excess of 
$100. A is required with respect to N Corporation to include $100 in his 
gross income for 1964 under section 951(a)(1)(A)(i) by reason of his 
indirect ownership of the stock of N Corporation. The investment by M 
Corporation in United States property would otherwise constitute an 
investment of earnings in United States property to which section 956 
applies; however, by reason of section 959(b) and this section, such 
amount does not constitute gross income of M Corporation for purposes of 
determining amounts includible in A's gross income under section 
951(a)(1)(B).
    (d) If during 1965, N Corporation invests $100 in tangible property 
(other than property described in section 956(b)(2)) located in the 
United States and has earnings and profits in excess of $100, A will be 
required with respect to N Corporation to include $100 in his gross 
income for 1965 under section 951(a)(1)(B), because the $100 of earnings 
and

[[Page 430]]

profits for 1964 attributable to N Corporation's subpart F income which 
was taxed to A in 1964 was distributed to M Corporation in such year.
    (e) If, with respect to 1966--
    (1) Corporation N owns 100 percent of the only class of stock of R 
Corporation,
    (2) Corporation R derives $100 of subpart F income, has earnings and 
profits in excess of $100, and makes no distributions to N Corporation,
    (3) Corporation N invests $25 in tangible property (other than 
property described in section 956(b)(2)) located in the United States 
and has current and accumulated earnings and profits in excess of $25, 
and
    (4) Corporation M has no income or investments and does not have a 
deficit in earnings and profits,


the $100 of subpart F income derived by R Corporation is includible in 
A's gross income for 1966 under section 951(a)(1)(A)(i) and the $25 
investment of earnings in United States property by N Corporation is 
includible in A's gross income for 1966 under section 951(a)(1)(B).
    (f) If, however, the facts are the same as in paragraph (e) of this 
example except that--
    (1) During 1966, R Corporation distributes $20 to N Corporation, and
    (2) Corporation N makes no distributions during such year to M 
Corporation,

of the $25 investment in United States property by N Corporation, $20 is 
not includible in A's gross income for 1966 because such amount 
represents earnings and profits which are attributable to amounts 
included in A's gross income for such year under section 951(a)(1)(A)(i) 
with respect to R Corporation and which have been distributed to N 
Corporation by R Corporation. By reason of section 959(B) and this 
section, such $20 distribution to N Corporation does not constitute 
gross income of N Corporation for purposes of determining amounts 
includible in A's gross income under section 951(a)(1)(B); however, the 
remaining $5 of investment of earnings in United States property by N 
Corporation in 1966 is includible in A's gross income for such year 
under section 951(a)(1)(B).

[T.D. 6795, 30 FR 944, Jan. 29, 1965]



Sec. 1.959-3  Allocation of distributions to earnings and profits
of foreign corporations.

    (a) In general. For purposes of Sec. Sec. 1.959-1 and 1.959-2, the 
source of the earnings and profits from which distributions are made by 
a foreign corporation as between earnings and profits attributable to 
increases in earnings invested in United States property, previously 
taxed subpart F income, previously excluded subpart F income withdrawn 
from investment in less developed countries, previously excluded subpart 
F income withdrawn from investment in foreign base company shipping 
operations, and other amounts shall be determined in accordance with 
section 959(c) and paragraphs (b) through (e) of this section.
    (b) Applicability of section 316(a). For purposes of this section, 
section 316(a) shall be applied, in determining the source of 
distributions from the earnings and profits of a foreign corporation, by 
first applying section 316(a)(2) and then by applying section 
316(a)(1)--
    (1) First, as provided by section 959 (c)(1), to earnings and 
profits attributable to amounts included in gross income of a United 
States shareholder under section 951(a)(1)(B) (or which would have been 
so included but for section 959(a)(2) and paragraph (c) of Sec. 1.959-
1),
    (2) Secondly, as provided by section 959(c)(2), to earnings and 
profits attributable to amounts included in gross income of a United 
States shareholder under section 951(a)(1)(A) (but reduced by amounts 
not included in such gross income under section 951(a)(1)(B) because of 
the exclusion provided by section 959(a)(2) and paragraph (c) of Sec. 
1.959-1), and
    (3) Finally, as provided by section 959(c)(3), to other earnings and 
profits. Thus, distributions shall be considered first attributable to 
amounts, if any, described in subparagraph (1) of this paragraph (first 
for the current taxable year and then for prior taxable years beginning 
with the most recent prior taxable year), secondly to amounts, if any, 
described in subparagraph (2) of this paragraph (first for the current 
taxable year and then for prior taxable years beginning with the most 
recent prior taxable year), and finally to the amounts, if any, 
described in subparagraph (3) of this paragraph (first for the current 
taxable year and then for prior taxable years beginning with the most 
recent prior taxable year). See, however, paragraph (e) of Sec. 1.963-3 
(applied as if section 963 had not been repealed by the Tax Reduction 
Act of 1975) for a special rule for determination of the source of 
distributions counting as minimum distributions. Earnings and

[[Page 431]]

profits are classified as to year and as to section 959(c) amount in the 
year in which such amounts are included in gross income of a United 
States shareholder under section 951(a) and are reclassified as to 
section 959(c) amount in the year in which such amounts would be so 
included but for the provisions of section 959(a)(2); any subsequent 
distribution of such amounts to a higher tier in a chain of ownership 
described in section 958(a) does not of itself change such 
classifications. For example, earnings and profits of a foreign 
corporation attributable to amounts of previously excluded subpart F 
income withdrawn from investment in less developed countries (or from 
investments in export trade assets or foreign base company shipping 
operations) shall be reclassified as amounts to which subparagraph (2), 
rather than subparagraph (3), of this paragraph applies for purposes of 
determining priority of distribution, and such earnings and profits 
shall be considered attributable to the taxable year in which the 
withdrawal occurs. This paragraph shall apply to distributions by one 
foreign corporation to another foreign corporation and by a foreign 
corporation to a United States person. The application of this paragraph 
may be illustrated by the following example:

    Example. (a) M, a controlled foreign corporation, is organized on 
January 1, 1963, and is 100-percent owned by A, a United States 
shareholder. Both A and M Corporation use the calendar year as a taxable 
year, and M Corporation is a controlled foreign corporation throughout 
the period here involved. As of December 31, 1966, M Corporation's 
accumulated earnings and profits of $450 (before taking into account 
distributions made in 1966) applicable to A's interest in such 
corporation are classified for purposes of section 959(c) as follows:

------------------------------------------------------------------------
                                        Classification of earnings and
                                        profits for purposes of section
                Year                                  959
                                     -----------------------------------
                                        (c)(1)      (c)(2)      (c)(3)
------------------------------------------------------------------------
1963................................        $100
1964................................         100         $75
1965................................  ..........          75         $50
1966................................  ..........  ..........          50
------------------------------------------------------------------------

    (b) During 1966, M Corporation makes three separate distributions to 
A of $150 each, and the source of such distributions under section 
959(c) is as follows:

------------------------------------------------------------------------
                                                           Allocation of
                                                           distributions
                                         Amount     Year   under section
                                                                959
------------------------------------------------------------------------
Distribution No. 1...................       $100     1964        (c)(1)
                                              50     1963        (c)(1)
                                      -----------
                                             150
                                      ===========
Distribution No. 2...................         50     1963        (c)(1)
                                              75     1965        (c)(2)
                                              25     1964        (c)(2)
                                      -----------
                                             150
                                      ===========
Distribution No. 3...................         50     1964        (c)(2)
                                              50     1966        (c)(3)
                                              50     1965        (c)(3)
                                      -----------
                                             150  .......  .............
------------------------------------------------------------------------

    (c) If, in addition to the above facts--
    (1) M Corporation owns throughout the period here involved 100 
percent of the only class of stock of N Corporation, a controlled 
foreign corporation which uses the calendar year as a taxable year,
    (2) Corporation N derives $60 of subpart F income for 1963 which A 
includes in his gross income for such year under section 
951(a)(1)(A)(i),
    (3) Corporation N has earnings and profits for 1963 of $60 but has 
neither earnings or profits nor a deficit in earnings and profits for 
1964, 1965, or 1966, and
    (4) During 1966, N Corporation invests $20 in tangible property (not 
described in section 956(b)(2)) located in the United States and 
distributes $45 to M Corporation,


the $20 investment of earnings in United States property is excludable 
from A's gross income for 1966, under section 959(a)(2) and paragraph 
(c) of Sec. 1.959-1, with respect to N Corporation and the $45 dividend 
received by M Corporation does not, under section 959(b) and Sec. 
1.959-2, constitute gross income of M Corporation for 1966 for purposes 
of determining amounts includible in A's gross income under section 
951(a)(1)(A)(i) with respect to M Corporation. However, the $45 dividend 
paid by N Corporation to M Corporation is allocated under section 959(c) 
and this paragraph to the earnings and profits of N Corporation as 
follows: $20 to 1963 earnings described in section 959(c)(1) and $25 to 
1963 earnings described in section 959(c)(2). In such case, M 
Corporation's earnings and profits of $495 (before taking into account 
distributions made in 1966) would be classified as follows for purposes 
of section 959(c):

------------------------------------------------------------------------
                                        Classification of earnings and
                                        profits for purposes of section
                Year                                  959
                                     -----------------------------------
                                        (c)(1)      (c)(2)      (c)(3)
------------------------------------------------------------------------
1963................................        $120         $25
1964................................         100          75
1965................................  ..........          75         $50

[[Page 432]]

 
1966................................  ..........  ..........          50
------------------------------------------------------------------------

    (d) The three distributions to A in 1966 of $150 each would then 
have the following source under section 959(c):

------------------------------------------------------------------------
                                                           Allocation of
                                                           distributions
                                         Amount     Year   under section
                                                                959
------------------------------------------------------------------------
Distribution No. 1...................       $100     1964        (c)(1)
                                              50     1963        (c)(1)
                                      -----------
                                             150
                                      ===========
Distribution No. 2...................         70     1963        (c)(1)
                                              75     1965        (c)(2)
                                               5     1964        (c)(2)
                                      -----------
                                             150
                                      ===========
Distribution No. 3...................         70     1964        (c)(2)
                                              25     1963        (c)(2)
                                              50     1966        (c)(3)
                                               5     1965        (c)(3)
 
                                      -----------
                                             150  .......  .............
------------------------------------------------------------------------

    (c) Treatment of deficits in earnings and profits. For purposes of 
this section, a United States shareholder's pro rata share (determined 
in accordance with the principles of paragraph (e) of Sec. 1.951-1) of 
a foreign corporation's deficit in earnings and profits, determined 
under section 964(a) and Sec. 1.964-1, for any taxable year shall be 
applied only to earnings and profits described in paragraph (b)(3) of 
this section.
    (d) Treatment of certain foreign taxes. For purposes of this 
section, any amount described in subparagraph (1), (2), or (3) of 
paragraph (b) of this section which is distributed by a foreign 
corporation through a chain of ownership described in section 958(a)(2) 
shall be reduced by any income, war profits, or excess profits taxes 
imposed on or with respect to such distribution by any foreign country 
or possession of the United States.

    Example. (a) Domestic corporation M owns 100 percent of the only 
class of stock of foreign corporation A, which is incorporated under the 
laws of foreign country X and which, in turn, owns 100 percent of the 
only class of stock of foreign corporation B, which is incorporated 
under the laws of foreign country Y. All corporations use the calendar 
year as a taxable year and corporations A and B are controlled foreign 
corporations throughout the period here involved.
    (b) During 1963, B Corporation (a less developed country corporation 
for 1963 within the meaning of Sec. 1.955-5) derives $90 of subpart F 
income, after incurring $10 of foreign income tax allocable to such 
income under paragraph (c) of Sec. 1.954-1, has earnings and profits in 
excess of $90, and makes no distributions. Corporation M must include 
$90 in its gross income for 1963 under section 951(a)(1)(A)(i). As of 
December 31, 1963, with respect to M Corporation, B Corporation has 
earnings and profits for 1963 described in section 959(c)(2) of $90.
    (c) During 1964, B Corporation has neither earnings and profits nor 
a deficit in earnings and profits but distributes $90 to A Corporation, 
and, by reason of section 959(b) and Sec. 1.959-2, such amount is not 
includible in the gross income of M Corporation for 1964 under section 
951(a) with respect to A Corporation. Corporation A incurs a withholding 
tax of $13.50 on the $90 dividend distributed from B Corporation (15 
percent of $90) and an additional foreign income tax of 10 percent or 
$7.65 by reason of the inclusion of the net distribution of $76.50 ($90 
minus $13.50) in its taxable income for 1964. As of December 31, 1964, 
with respect to M Corporation, B Corporation's earnings and profits for 
1963 described in section 959(c)(2) amount to zero ($90 minus $90); and 
A Corporation's earnings and profits for 1963 described in section 
959(c)(2) amount to $68.85 ($90 minus $13.50 minus $7.65).

    (e) Determination of foreign tax credit. For purposes of applying 
section 902 and section 960 in determining the foreign tax credit 
allowable under section 901 in a case in which distributions are made by 
a second-tier corporation or a first-tier corporation, as the case may 
be, from its earnings and profits for a taxable year which are 
attributable to an amount included in the gross income of a U.S. 
shareholder under section 951(a) or which are attributable to amounts 
excluded from the gross income of such foreign corporation under section 
959(b) and Sec. 1.959-2 with respect to a U.S. shareholder, the rules 
of paragraph (b) of this section shall apply except that in applying 
subparagraph (1) or (2) of such paragraph--
    (1) Distributions from the earnings and profits for such taxable 
year of the second-tier corporation shall be considered first 
attributable to its earnings and profits attributable to distributions 
from the earnings and profits of the foreign corporation, if any, next

[[Page 433]]

lower in the chain of ownership described in section 958(a), to the 
extent of such earnings and profits of the second-tier corporation, and 
then to the other earnings and profits of such second-tier corporation, 
and
    (2) Distributions from the earnings and profits for such taxable 
year of the first-tier corporation shall be considered first 
attributable to its earnings and profits attributable to distributions 
from the earnings and profits of the second-tier corporation, to the 
extent of such earnings and profits of the first-tier corporation, and 
then to the other earnings and profits of such first-tier corporation. 
For purposes of this paragraph, a second-tier corporation is a foreign 
corporation referred to in section 960(a)(1)(B), and a first-tier 
corporation is a foreign corporation referred to in section 960 
(a)(1)(A). The application of this paragraph may be illustrated by the 
following examples:

    Example 1. (a) Domestic corporation A, a United States shareholder, 
owns 100 percent of the only class of stock of foreign corporation R 
which, in turn, owns 100 percent of the only class of stock of foreign 
corporation S. All corporations use the calendar year as a taxable year, 
and corporations R and S are controlled foreign corporations throughout 
the period here involved.
    (b) Neither R Corporation nor S Corporation has subpart F income for 
1963. During 1963, S Corporation increases by $100 its investment in 
tangible property (not described in section 956(b)(2)) located in the 
United States, makes no distributions, and has earnings and profits of 
$100. Corporation A must include $100 in its gross income for 1963 under 
section 951(a)(1)(B) with respect to S Corporation. During 1963, R 
Corporation also increases by $100 its investment in tangible property 
(not described in section 956(b)(2)) located in the United States, makes 
no distributions, and has earnings and profits of $100. Corporation A 
must include $100 in its gross income for 1963 under section 
951(a)(1)(B) with respect to R Corporation.
    (c) During 1964, S Corporation distributes $100 to R Corporation, 
and R Corporation distributes $100 to A Corporation. Neither corporation 
has any earnings or profits or deficit in earnings and profits for such 
year. On December 31, 1964, R Corporation has earnings and profits 
(computed before distributions to A Corporation made for the year) of 
$200, consisting of $100 of section 959(c)(1) amounts of R Corporation 
for 1963 and of $100 of section 959(c)(1) amounts of S Corporation for 
1963. For purposes of determining the foreign tax credit under section 
960 and the regulations thereunder, the $100 distribution by R 
Corporation shall be considered attributable to S Corporation's earnings 
and profits for 1963 described in section 959(c)(1).
    Example 2. (a) Domestic corporation A, a United States shareholder, 
owns 100 percent of the only class of stock of foreign corporation T 
which, in turn, owns 100 percent of the only class of stock of foreign 
corporation U. All corporations use the calendar year as a taxable year, 
and corporations T and U are controlled foreign corporations throughout 
the period here involved.
    (b) During 1964, T Corporation invests $100 in tangible property 
(not described in section 956(b)(2)) located in the United States. For 
1964, T Corporation has no subpart F income and makes no distributions; 
A must include $100 in its gross income for 1964 under section 
951(a)(1)(B) with respect to T Corporation. For 1964, U Corporation has 
no subpart F income or investment of earnings in United States property 
but U Corporation has $100 of earnings and profits which it distributes 
to T Corporation. At December 31, 1964, T Corporation has earnings and 
profits of $300, consisting of operating income of $100 for each of the 
years 1963 and 1964 and $100 in dividends received from the earnings and 
profits of U Corporation for 1964. These earnings and profits are 
classified as follows under section 959(c): $100 of section 959(c)(1) 
amounts of T Corporation for 1964, $100 of section 959(c)(3) amounts of 
U Corporation for 1964, and $100 of section 959(c)(3) amounts of T 
Corporation for 1963.
    (c) During 1965 neither T Corporation nor U Corporation has any 
earnings and profits or deficit in earnings and profits or investment of 
earnings in U.S. property, but T Corporation distributes $100 to A 
Corporation. For purposes of determining the foreign tax credit under 
section 960 and the regulations thereunder, the $100 distribution of T 
Corporation shall be considered attributable to T Corporation's earnings 
and profits for 1964 described in section 959(c)(1).

    (f) Illustration. The application of this section may be illustrated 
by the following example:

    Example. (a) M, a controlled foreign corporation is organized on 
January 1, 1963, and is wholly owned by A, a United States shareholder. 
Both A and Corporation M use the calendar year as a taxable year.
    (b) Corporation M's earnings and profits (before distributions) for 
1963 are $200, $100, of which is attributable to subpart F income. 
Corporation M's earnings and profits for such year also include $25 
attributable to subpart F income which is excluded from M Corporation's 
foreign base company income under section 954(b)(1) as dividends, 
interest, and gains invested in qualified investments in less developed 
countries. Corporation M's

[[Page 434]]

increase in earnings invested in tangible property (not described in 
section 956(b)(2)) located in the United States for 1963, is $50, and M 
Corporation makes a distribution of such property during such year of 
$20. For purposes of section 959, A's interest in M Corporation's 
earnings and profits as of December 31, 1963, determined after the 
distributions of $20, is classified as follows:

Section 959(c)(1) amounts:
  Earnings for 1963 attributable to increased               $50
   investment in U.S. property which would have been
   included in A's gross income but for application of
   section 959(a)(2) and Sec. 1.959-1(c)............
  Less: Distribution for 1963 allocated under section        20      $30
   959(c)(1) and paragraph (b)(1) of this section to
   such amounts.......................................
                                              ---------
Section 959(c)(2) amounts:
  Earnings for 1963 attributable to subpart F income        100
   included in A's gross income under section
   951(a)(1)(A)(i)....................................
  Less: Earnings for 1963 attributable to increased          50       50
   investment in U.S. property which would have been
   included in A's gross income but for application of
   section 959(a)(2) and Sec. 1.959-1(c)............
                                              ---------
Section 959(c)(3) amounts:
  Predistribution earnings for 1963...................      200
  Less: Earnings for 1963 classified as:
    Section 959(c)(1) amounts................      $50
    Section 959(c)(2) amounts................       50      100      100
                                              --------------------------
A's total interest in M Corporation's          .......  .......      180
 earnings and profits........................
------------------------------------------------------------------------
 


For 1963, A is required to include $100 of subpart F income in his gross 
income under section 951(a)(1)(A)(i). He would have been required to 
include $50 in his gross income under section 951(a)(1)(B) as M 
Corporation's increase in earnings invested in United States property, 
except that section 959(a)(2) and paragraph (c) of Sec. 1.959-1 provide 
in effect that earnings and profits taxed to A under section 
951(a)(1)(A) with respect to M Corporation (whether in the current 
taxable year or in prior years) may be invested in United States 
property without again being included in gross income under section 
951(a). The $20 dividend from M Corporation is excluded from A's gross 
income under section 959(a)(1) and paragraph (b) of Sec. 1.959-1, since 
such distribution is allocated under section 959(c)(1) and paragraph 
(b)(1) of this section to amounts described in section 959(c)(1).
    (c) During 1964, M Corporation's earnings and profits (before 
distributions) are $300, $75 of which is attributable to subpart F 
income. Corporation M has no change in investments in United States 
property during such year and withdraws $15 of previously excluded 
subpart F income from investment in less developed countries. 
Corporation M makes a cash distribution of $250 to A during 1964. For 
purposes of section 959, A's interest in M Corporation's earnings and 
profits as of December 31, 1964, determined after the distribution of 
$250, is classified as follows:

Section 959 (c)(1) amounts:
  Section 959(c)(1) net amount for 1963 (as determined      $30
   under paragraph (b) of this example)...............
  Less: Distribution for 1964 allocated under section        30
   959(c)(1) and paragraph (b)(1) of this section to
   such amount........................................
                                     =========
Section 959(c)(2) amounts:
  Section 959(c)(2) net amount for 1963 (as determined       50
   under paragraph (b) of this example)...............
  Plus: Earnings for 1964 attributable to:
    Subpart F income for 1964 included in A's gross          75
     income under section 951(a)(1)(A)(i).............
    Previously excluded subpart F income withdrawn in        15
     1964 from investment in less developed countries
     and included in A's gross income under section
     951(a)(1)(A)(ii).................................
                                     ---------
                                                            140
  Less: Distribution for 1964 allocated under section       140
   959(c)(2) and paragraph (b)(2) of this section to
   such amounts.......................................
                                     =========
Section 959(c)(3) amounts:
  Section 959(c)(3) net amount for 1963 (as determined      100
   under paragraph (b) of this example)...............
  Plus: Section 959(c)(3) net amount
   for 1964:
    Predistribution earnings for      .......     $300
     1964...........................
    Less:
      Earnings for 1964 classified        $90
       as section 959(c)(1) amounts
       ($0) and as section 959(c)(2)
       amounts ($75 + $15)..........
      Distributions for 1964               80      170      130     $230
       allocated under section
       959(c)(3) and paragraph
       (b)(3) of this section.......
                                     -----------------------------------

[[Page 435]]

 
A's total interest in M               .......  .......  .......      230
 Corporation's earnings and profits.
------------------------------------------------------------------------
 

For 1964, A is required to include in his gross income under section 
951(a)(1)(A)(i) $75 of subpart F income, and under section 951 
(a)(1)(A)(ii) $15 of previously excluded subpart F income withdrawn from 
investment in less developed countries. Of the $250 cash distribution, A 
may exclude $170 from his gross income under section 959(a)(1) and 
paragraph (b) of Sec. 1.959-1 and $80 is includible in his gross income 
as a dividend.
    (d) The source under section 959(c) of the 1964 distribution of $250 
to A is as follows:

------------------------------------------------------------------------
                                                           Allocation of
                                                           distribution
                  Year                        Amount       under section
                                                                959
------------------------------------------------------------------------
1963....................................             $30         (c)(1).
1964....................................              90         (c)(2).
1963....................................              50         (c)(2).
1964....................................              80         (c)(3).
                                         ----------------
                                                     250  ..............
------------------------------------------------------------------------


[T.D. 6795, 30 FR 945, Jan. 29, 1965, as amended by T.D. 7334, 39 FR 
44211, Dec. 23, 1974; T.D. 7545, 43 FR 19652, May 8, 1978; T.D. 7893, 48 
FR 22510, May 19, 1983]



Sec. 1.959-4  Distributions to United States persons not counting
as dividends.

    Except as provided in section 960(a)(3) and Sec. 1.960-2, any 
distribution to a United States person which is excluded from the gross 
income of such person under section 959(a)(1) and Sec. 1.959-1 shall be 
treated for purposes of chapter 1 (relating to normal taxes and 
surtaxes) of subtitle A (relating to income taxes) of the Code as a 
distribution which is not a dividend. However, see paragraph (b)(1) of 
Sec. 1.956-1, relating to the dividend limitation on the amount of a 
controlled foreign corporation's investment of earnings in United States 
property.

[T.D. 7120, 36 FR 10860, June 4, 1971]



Sec. 1.960-1  Foreign tax credit with respect to taxes paid on earnings
and profits of controlled foreign corporations.

    (a) Scope of regulations under section 960. This section prescribes 
rules for determining the foreign income taxes deemed paid under section 
960(a)(1) by a domestic corporation which is required under section 951 
to include in gross income an amount attributable to a first-, second-, 
or third-tier corporation's earnings and profits. Section 1.960-2 
prescribes rules for applying section 902 to dividends paid by a third-, 
second-, or first-tier corporation from earnings and profits 
attributable to an amount which is, or has been, included in gross 
income under section 951. Section 1.960-3 provides special rules for the 
application of the gross-up provisions of section 78 where an amount is 
included in gross income under section 951. Section 1.960-4 prescribes 
rules for increasing the applicable foreign tax credit limitation under 
section 904(a) of the domestic corporation for the taxable year in which 
it receives a distribution of earnings and profits in respect of which 
it was required under section 951 to include an amount in its gross 
income for a prior taxable year. Section 1.960-5 prescribes rules for 
disallowing a deduction for foreign income taxes for such taxable year 
of receipt where the domestic corporation received the benefits of the 
foreign tax credit for such previous taxable year of inclusion. Section 
1.960-6 provides that the excess of such an increase in the applicable 
limitation under section 904(a) over the tax liability of the domestic 
corporation for such taxable year of receipt results in an overpayment 
of tax. Section 1.960-7 prescribes the effective dates for application 
of these rules.
    (b) Definitions. For purposes of section 960 and Sec. Sec. 1.960-1 
through 1.960-7--
    (1) First-tier corporation. The term ``first-tier corporation'' 
means a foreign corporation at least 10 percent of the voting stock of 
which is owned by the domestic corporation described in paragraph (a) of 
this section.
    (2) Second-tier corporation. In the case of amounts included in the 
gross income of the taxpayer under section 951--
    (i) For taxable years beginning before January 1, 1977, the term 
``second-tier corporation'' means a foreign corporation at least 50 
percent of the voting stock of which is owned by such first-tier 
corporation.

[[Page 436]]

    (ii) For taxable years beginning after December 31, 1976, the term 
``second-tier corporation'' means a foreign corporation as least 10 
percent of the voting stock of which is owned by such first-tier 
corporation.
    (3) Third-tier corporation. In the case of amounts included in the 
gross income of a domestic shareholder under section 951 for taxable 
years beginning after December 31, 1976, the term ``third-tier 
corporation'' means a foreign corporation at least 10 percent of the 
voting stock of which is owned by such second-tier corporation.
    (4) Immediately lower-tier corporation. In the case of a first-tier 
corporation the term ``immediately lower-tier corporation'' means a 
second-tier corporation. In the case of a second-tier corporation, the 
term ``immediately lower-tier corporation'' means a third-tier 
corporation. In the case of a third-tier corporation, the term 
``immediately lower-tier corporation'' means a fourth-tier corporation.
    (5) Foreign income taxes. The term ``foreign income taxes'' means 
income, war profits, and excess profits taxes, and taxes included in the 
term ``income, war profits, and excess profits taxes'' by reason of 
section 903, imposed by a foreign country or a possession of the United 
States.
    (c) Amount of foreign income taxes deemed paid by domestic 
corporation in respect of earnings and profits of foreign corporation 
attributable to amount included in income under section 951--(1) In 
general. For purposes of section 901--
    (i) If for the taxable year there is included in the gross income of 
a domestic corporation under section 951 an amount attributable to the 
earnings and profits of a first- or second-tier corporation for any 
taxable year, the domestic corporation shall be deemed to have paid the 
same proportion of the total foreign income taxes paid, accrued, or 
deemed (in accordance with paragraph (b) of Sec. 1.960-2) to be paid by 
such foreign corporation on or with respect to its earnings and profits 
for its taxable year as the amount (in the case of a first-tier 
corporation, determined without regard to section 958(a)(2); in the case 
of a second-tier corporation, determined without regard to section 
958(a)(1)(A) and, to the extent that stock of such second-tier 
corporation is owned by the domestic corporation through a foreign 
corporation other than the first-tier corporation, determined without 
regard to section 958(a)(2)) so included in the gross income of the 
domestic corporation under section 951 with respect to such foreign 
corporation bears to the total earnings and profits of such foreign 
corporation for its taxable year. This paragraph (c)(1)(i) shall not 
apply to amounts included in the gross income of the domestic 
corporation under section 951 with respect to the second-tier 
corporation unless the percentage-of-voting-stock requirement of section 
902(b)(3)(A) is satisfied.
    (ii) If for the taxable year there is included in the gross income 
of a domestic corporation under section 951 an amount attributable to 
the earnings and profits of a third-tier corporation for any taxable 
year, the domestic corporation shall be deemed to have paid the same 
proportion of the total foreign income taxes paid or accrued by such 
foreign corporation on or with respect to its earnings and profits for 
its taxable year as the amount (determined without regard to section 
958(a)(1)(A) and, to the extent that stock of such third-tier 
corporation is owned by the domestic corporation through a foreign 
corporation other than the second-tier corporation, determined without 
regard to section 958(a)(2)) so included in the gross income of the 
domestic corporation under section 951 with respect to such foreign 
corporation bears to the total earnings and profits of such foreign 
corporation. This paragraph (c)(1)(ii) shall not apply unless the 
percentage-of-voting-stock requirement of section 902(b)(3)(B) is 
satisfied.
    (iii) In applying paragraph (c)(1)(i) or (c)(1)(ii) of this section 
to a first-, second-, or third-tier corporation which for the taxable 
year has income excluded under section 959(b), paragraph (c)(3) of this 
section shall apply for purposes of excluding certain earnings and 
profits of such foreign corporation and foreign income taxes, if any, 
attributable to such excluded income.
    (iv) This paragraph (c)(1) applies whether or not the first-, 
second-, or

[[Page 437]]

third-tier corporation makes a distribution for the taxable year of its 
earnings and profits which are attributable to the amount included in 
the gross income of the domestic corporation under section 951.
    (v) This paragraph (c)(1) does not apply to an increase in current 
earnings invested in United States property which, but for paragraph (e) 
of Sec. 1.963-3 (applied as if section 963 had not been repealed by the 
Tax Reduction Act of 1975), would be included in the gross income of the 
domestic corporation under section 951(a)(1)(B) but which, pursuant to 
such paragraph, counts toward a minimum distribution for the taxable 
year. This subdivision shall apply in taxable years subsequent to the 
Tax Reduction Act of 1975 only in those cases where an adjustment is 
required as a result of an election made under section 963 prior to the 
Act.
    (2) Taxes paid or accrued on or with respect to earnings and profits 
of foreign corporation. For purposes of paragraph (c)(1) of this 
section, the foreign income taxes paid or accrued by a first-, second- 
or third-tier corporation on or with respect to its earnings and profits 
for its taxable years shall be the total amount of the foreign income 
taxes paid or accrued by such foreign corporation for such taxable year.
    (3) Exclusion of earnings and profits and taxes of a first-, second-
, or third-tier corporation having income excluded under section 959(b). 
If in the case of a first-, second-, or third-tier corporation to which 
paragraph (c)(1)(i) or (c)(1)(ii) of this section is applied--
    (i) The earnings and profits of such foreign corporation for its 
taxable year consist of (A) earnings and profits attributable to 
dividends received from an immediately lower-tier corporation which are 
attributable to amounts included in the gross income of a domestic 
corporation under section 951 with respect to the immediately lower- or 
lower-tier corporations, and (B) other earnings and profits, and
    (ii) The effective rate of foreign income taxes paid or accrued by 
such foreign corporation in respect to the dividends to which its 
earnings and profits described in paragraph (c)(3)(i)(A) of this section 
are attributable is higher or lower than the effective rate of foreign 
income taxes paid or accrued by such foreign corporation in respect to 
the income to which its earnings and profits described in paragraph 
(c)(3)(i)(B) of this section are attributable,


then, for the purposes of applying paragraph (c)(1)(i) or (c)(1)(ii) of 
this section to the foreign income taxes paid, accrued, or deemed to be 
paid, by such foreign corporation on or with respect to its earnings and 
profits for such taxable year, the earnings and profits of such foreign 
corporation for such taxable year shall be considered not to include the 
earnings and profits described in paragraph (c)(3)(i)(A) of this section 
and only the foreign income taxes paid, accrued, or deemed to be paid, 
by such foreign corporation in respect to the income to which its 
earnings and profits described in paragraph (c)(3)(i)(B) of this section 
are attributable shall be taken into account. For purposes of applying 
this paragraph (c)(3), the effective rate of foreign income taxes paid 
or accrued in respect to income shall be determined consistently with 
the principles of paragraphs (b)(3)(iv) and (viii) and (c) of Sec. 
1.954-1. Thus, for example, the effective rate of foreign income taxes 
paid or accrued in respect to dividends received by such foreign 
corporation shall be determined by taking into account any 
intercorporate dividends received deduction allowed to such corporation 
for such dividends.
    (4) Illustrations. The application of this paragraph may be 
illustrated by the following examples:

    Example 1. Domestic corporation N owns all the one class of stock of 
controlled foreign corporation A. Both corporations use the calendar 
year as the taxable year. For 1978, N Corporation is required under 
section 951 to include in gross income $50 attributable to the earnings 
and profits of A Corporation for such year, but A Corporation does not 
distribute any earnings and profits for such year. The foreign income 
taxes paid by A Corporation for 1978 which are deemed paid by N 
Corporation for such year under section 960(a)(1) are determined as 
follows upon the basis of the facts assumed:

Pretax earnings and profits of A Corporation..................   $100.00
Foreign income taxes (20%)....................................     20.00
Earnings and profits..........................................     80.00
Amount required to be included in N Corporation's gross income     50.00
 under section 951............................................
Dividends paid to N Corporation...............................         0

[[Page 438]]

 
Foreign income taxes paid on or with respect to earnings and       20.00
 profits of A Corporation.....................................
Foreign income taxes of A Corporation deemed paid by N             12.50
 Corporation under section 960(a)(1) ($50/$80 x $20)..........
 

    Example 2. Domestic corporation N owns all the one class of stock of 
controlled foreign corporation A, which owns all the one class of stock 
of controlled foreign corporation B. All such corporations use the 
calendar year as the taxable year. For 1978, N Corporation is required 
under section 951 to include in gross income $45 attributable to the 
earnings and profits of B Corporation for such year, but is not required 
to include any amount in gross income under section 951 attributable to 
the earnings and profits of A Corporation for such year. Neither B 
Corporation nor A Corporation distributes any earnings and profits for 
1978. The foreign income taxes paid by B Corporation for 1978 which are 
deemed paid by N Corporation for such year under section 960(a)(1) are 
determined as follows upon the basis of the facts assumed:

Pretax earnings and profits of B Corporation..................   $100.00
Foreign income taxes (40%)....................................     40.00
Earnings and profits..........................................     60.00
Amounts required to be included in N Corporation's gross           45.00
 income under section 951 with respect to B Corporation.......
Dividends paid................................................         0
Foreign income taxes paid on or with respect to earnings and       40.00
 profits of B Corporation.....................................
Foreign income taxes of B Corporation deemed paid by N             30.00
 Corporation under section 960(a)(1) ($45/$60 x $40)..........
 

    Example 3. Domestic corporation N owns all the one class of stock of 
controlled foreign corporation A, which owns all the one class of stock 
of controlled foreign corporation B, which owns all the one class of 
stock of foreign corporation C. All such corporations use the calendar 
year as the taxable year. For 1978, N Corporation is required under 
section 951 to include in gross income $80 attributable to the earnings 
and profits of C Corporation for such year, $45 attributable to the 
earnings and profits of B Corporation for such year and $50 attributable 
to the earnings and profits of A Corporation for such year. Neither C 
Corporation nor B corporation distributes any earnings and profits for 
1978. The foreign income taxes which are deemed paid by N Corporation 
for such year under section 960(a)(1) are determined as follows upon the 
basis of the facts assumed:
    C Corporation (third-tier corporation):

Pretax earnings of C Corporation..............................   $150.00
Foreign income taxes (40%)....................................     60.00
Earnings and profits..........................................     90.00
Amounts required to be included in N Corporation's gross           80.00
 income under section 951.....................................
Dividends paid to B Corporation...............................         0
Foreign income taxes paid on or with respect to earnings and       60.00
 profits of C Corporation.....................................
 

    B Corporation (second-tier corporation):

Pretax earnings of B Corporation..............................   $100.00
Foreign income taxes (40%)....................................     40.00
Earnings and profits..........................................     60.00
Amount required to be included in N Corporation's gross income     45.00
 under section 951............................................
Dividends paid to A Corporation...............................         0
Foreign income taxes paid on or with respect to earnings and       40.00
 profits of B Corporation.....................................
 

    A Corporation (first-tier corporation):

Pretax earnings and profits of A Corporation..................   $100.00
Foreign income taxes (20%)....................................     20.00
Earnings and profits..........................................     80.00
Amount required to be included in N Corporation's gross income     50.00
 under section 951............................................
Dividends paid to N Corporation...............................         0
Foreign income taxes paid on or with respect to earnings and       20.00
 profits of A Corporation.....................................
 

    N Corporation (domestic corporation):

Foreign income taxes deemed paid by N Corporation under
 section 960(a)(1):
  Taxes of C Corporation $80/$90 x $60........................    $53.33
  Taxes of B Corporation $45/$60 x $40........................     30.00
  Taxes of A Corporation $50/$80 x $20........................     12.50
                                                               ---------
    Total taxes deemed paid under section 960(a)(1)...........    $95.83
 

    Example 4. Domestic corporation N owns all the one class of stock of 
controlled foreign corporation A, which owns 5 percent of the one class 
of stock of controlled foreign corporation B. N Corporation also 
directly owns 95 percent of the one class of stock of B Corporation. 
(Under these facts, B Corporation is only a first-tier corporation with 
respect to N Corporation) all such corporations use the calendar year as 
the taxable year. For 1978, N Corporation is required under section 951 
to include in gross income $60 attributable to the earnings and profits 
of B Corporation and $79.20 attributable to the earnings and profits of 
A Corporation. For 1978, B Corporation distributes $19 to N Corporation 
and $1 to A Corporation, but A Corporation makes no distribution to N 
Corporation. The foreign income taxes paid by N Corporation for such 
year under section 960(a)(1) are determined as follows upon the basis of 
the facts assumed in accordance with Sec. 1.960-1(c)(1)(i):
    B Corporation (first-tier corporation):

Pretax earnings and profits...................................   $100.00
Foreign income taxes (40%)....................................     40.00
Earnings and profits..........................................     60.00
Amount required to be included in N Corporation's gross income     60.00
 under section 951 with respect to B Corporation..............
 

    A Corporation (first-tier corporation):

Pretax earnings and profits (including $1 dividend from B        $100.00
 Corporation).................................................
Foreign income taxes (20%)....................................     20.00
Earnings and profits..........................................     80.00
Amount required to be included in N Corporation's gross income     79.20
 with respect to A Corporation ($99-[$99 x 0.20]..............
 

    N Corporation (domestic corporation):

Foreign income taxes deemed paid by N Corporation under
 section 960(a)(1) with respect to--
  B Corporation ([$60 x 0.95/$60] x $40)......................    $38.00

[[Page 439]]

 
  A Corporation ($79.20/$80 x $20)............................     19.80
                                                               ---------
    Total taxes deemed paid under section 960(a)(1)...........    $57.80
 

    Example 5. Domestic corporation N owns all the one class of stock of 
controlled foreign corporation A, which owns all the one class of stock 
of controlled foreign corporation B. All such corporations use the 
calendar year as the taxable year. For 1978, N Corporation is required 
under section 951 to include in gross income $175 attributable to the 
earnings and profits of A Corporation for such year. For 1978, B 
Corporation has earnings and profits of $225, on which it pays foreign 
income taxes of $75. In 1978, B Corporation distributes $150, which, 
under paragraph (b) of Sec. 1.960-2, consists of $100 to which section 
902(b)(1) does not apply (from B Corporation's earnings and profits 
attributable to an amount required under section 951 to be included in N 
Corporation's gross income with respect to B Corporation) and $50 to 
which section 902(b)(1) applies (from B Corporation's other earnings and 
profits). The country under the laws of which A Corporation is 
incorporated imposes an income tax of 40 percent on all income but 
exempts from tax dividends received from a subsidiary corporation. A 
Corporation makes no distribution for 1978. Under paragraph (b) of Sec. 
1.960-2, A Corporation is deemed to have paid $25 ($50/$150 x $75) of 
the $75 foreign income taxes paid by B Corporation on its pretax 
earnings and profits of $225. The foreign income taxes deemed paid by N 
Corporation for 1978 under section 960(a)(1) with respect to A 
Corporation are determined as follows upon the basis of the following 
assumed facts:

Pretax earnings and profits of A Corporation:
  Dividends received from B Corporation.......................   $150.00
  Other income................................................    250.00
                                           -----------
 
    Total pretax earnings and profits.........................   $400.00
 
Foreign income taxes:
  On dividends received from B Corporation..........         0
  On other income ($250 x 0.40).....................    100.00
                                           -----------
 
    Total foreign income taxes................................    100.00
 
Earnings and profits:
  Attributable to dividends received from B             100.00
   Corporation which are attributable to amounts
   included in N Corporation's gross income under
   section 951 with respect to B Corporation........
  Attributable to other income:
    Attributable to dividends received        $50.00
     from B Corporation which are
     attributable to amounts not included
     in N Corporation's gross income under
     951 with respect to B Corporation....
    Attributable to other income ($250-       150.00   $200.00
     $100 [$250 x 0.40])..................
                                                     -----------
      Total earnings and profits..............................   $300.00
                                           -----------
 
Foreign income taxes deemed paid by N Corporation under
 section 960(a)(1) with respect to A Corporation:
  Tax paid by A Corporation in respect to its income other         87.50
   than dividends received from B Corporation attributable to
   amounts included in N Corporation's gross income under
   section 951 with respect to B Corporation ($175/$200 x
   $100)......................................................
  Tax of B Corporation deemed paid by A Corporation under          21.88
   section 902(b)(1) in respect to such income ($175/$200 x
   $25).......................................................
                                           -----------
 
    Total foreign income taxes deemed paid by N Corporation      $109.38
     under section 960(a)(1) with respect to A Corporation....
                                           ===========
 

    (d) Time for meeting stock ownership requirements--(1) In general. 
For the purposes of applying paragraph (c) of this section to amounts 
included in the gross income of a domestic corporation attributable to 
the earnings and profits of a first-, second-, or third-tier 
corporation, the stock ownership requirements of paragraph (b)(1), (2), 
and (3) of this section and the percentage of voting stock requirements 
of paragraph (c)(1)(i) and (ii) of this section, if applicable, must be 
satisfied on the last day in the taxable year of such first-, second-, 
or third-tier corporation, as the case may be, on which such foreign 
corporation is a controlled foreign corporation. For paragraph (c) to 
apply to amounts included in a domestic corporation's gross income 
attributable to the earnings and profits of a second-tier corporation, 
the requirements of paragraph (b)(1) and (2) of this section and the 
percentage of voting stock requirement of paragraph (c)(1)(i) of this 
section must be met on such date. For paragraph (c) to apply to amounts 
included in a domestic corporation's gross income attributable to the 
earnings and profits of a third-tier corporation, the requirements of 
paragraph (b)(1), (2), and (3) of this section and the percentage of 
voting stock requirement of paragraph (c)(1)(ii) of this section must be 
met on such date.
    (2) Illustrations. The application of this paragraph may be 
illustrated by the following examples:

    Example 1. Domestic corporation N is required for its taxable year 
ending June 30,

[[Page 440]]

1978, to include in gross income under section 951 an amount 
attributable to the earnings and profits of controlled foreign 
corporation A for 1977 and another amount attributable to the earnings 
and profits of controlled foreign corporation B for such year. 
Corporations A and B use the calendar year as the taxable year. Such 
amounts are required to be included in N Corporation's gross income by 
reason of its ownership of stock in A Corporation and in turn by A 
Corporation's ownership of stock in B Corporation. Corporation A is a 
controlled foreign corporation throughout 1977, but B Corporation is a 
controlled foreign corporation only from January 1, 1977, through 
September 30, 1977. Corporation N may obtain credit under section 
960(a)(1) for the year ending June 30, 1978, for foreign income taxes 
paid by A Corporation for 1977, only if N Corporation owns at least 10 
percent of the voting stock of A Corporation on December 31, 1977. 
Corporation N may obtain credit under section 960(a)(1) for the year 
ending June 30, 1978, for foreign income taxes paid by B Corporation for 
1977, only if on September 30, 1977, N Corporation owns at least 10 
percent of the voting stock of A Corporation, A Corporation owns at 
least 10 percent of the voting stock of B Corporation, and the 
percentage of voting stock requirement of paragraph (c)(1)(i) of this 
section is met.
    Example 2. The facts are the same as in example 1, except that A 
Corporation is a controlled foreign corporation only from January 1, 
1977, through March 31, 1977. Corporation N may obtain credit under 
section 960(a)(1) for the year ending June 30, 1978, for foreign income 
taxes paid by A Corporation for 1977, only if N Corporation owns at 
least 10 percent of the voting stock of A Corporation on March 31, 1977. 
Corporation N may obtain credit under section 960(a)(1) for the year 
ending June 30, 1978, for foreign income taxes paid by B Corporation for 
1977, only if on September 30, 1977, N Corporation owns at least 10 
percent of the voting stock of A Corporation, A Corporation owns at 
least 10 percent of the voting stock of B Corporation, and the 
percentage of voting stock requirement of paragraph (c)(1)(i) of this 
section is met.
    Example 3. Domestic Corporation N owns 100 percent of the stock of 
controlled foreign corporation A. A Corporation owns 20 percent of the 
stock of controlled foreign corporation B. B Corporation owns 10 percent 
of the voting stock of controlled foreign corporation C. For calendar 
year 1983, N Corporation is required to include amounts in its gross 
income attributable to the earnings and profits of A, B, and C 
Corporations. A, B, and C Corporations were all controlled foreign 
corporations throughout their respective taxable years ending as 
follows: A Corporation, December 31, 1983; B Corporation, November 31, 
1983; and C Corporation, August 31, 1983. Paragraph (c) of this section 
applies to amounts included in gross income of N Corporation with 
respect to the earnings and profits of A Corporation because the 10 
percent ownership requirement of paragraph (b)(1) of this section is met 
on December 31, 1983. Paragraph (c) of this section applies to amounts 
included in the gross income of N Corporation with respect to the 
earnings and profits of B Corporation because the 10 percent stock 
ownership requirements of paragraphs (b)(1) and (2) of this section are 
met on November 30, 1983, and the percentage of voting stock requirement 
of paragraph (c)(1)(i) of this section (5 percent) is also met on such 
date. The percentage of voting stock in A Corporation owned by N 
Corporation (100 percent) multiplied by the percentage of voting stock 
in B Corporation owned by A Corporation (20 percent) is 20 percent. 
Paragraph (c) of this section will not apply to amounts included in N 
Corporation's gross income attributable to the earnings and profits of C 
Corporation even though on August 31, 1983, the 10 percent stock 
ownership requirements of paragraphs (b)(1), (2), and (3) of this 
section are met, because the percentage of voting stock requirement of 
paragraph (c)(1)(ii) of this section (5 percent) is not met on such 
date. The percentage of voting stock of C Corporation owned by B 
Corporation (10 percent) multiplied by 20 percent (the percentage of 
voting stock of A Corporation owned by N Corporation multiplied by the 
percentage of voting stock of B Corporation owned by A Corporation) is 2 
percent.

    (e) Information to be furnished. If the credit for foreign income 
taxes claimed under section 901 includes taxes deemed paid under section 
960(a)(1), the domestic corporation must furnish the same information 
with respect to the taxes so deemed paid as it is required to furnish 
with respect to the taxes actually paid or accrued by it and for which 
credit is claimed. See Sec. 1.905-2. For other information required to 
be furnished by the domestic corporation for the annual accounting 
period of certain foreign corporations ending with or within such 
corporation's taxable year, see section 6038(a) and the regulations 
thereunder.
    (f) Reduction of foreign income taxes paid or deemed paid. For 
reduction of the amount of foreign income taxes paid or deemed paid by a 
foreign corporation for purposes of section 960, see section 6038(c) (as 
amended by section 338 of the Tax Equity and Fiscal Responsibility Act 
of 1982) and the regulations thereunder, relating to failure to furnish 
information with respect to

[[Page 441]]

certain foreign corporations. For reduction of the foreign income taxes 
deemed paid by a domestic corporation under section 960 with respect to 
foreign oil and gas extraction income, see section 907(a).
    (g) Amounts under section 951 treated as distributions for purposes 
of applying effective dates. For purposes of applying section 902 in 
determining the amount of credit allowed under section 960(a)(1) and 
paragraph (c) of this section, the effective date provisions of the 
regulations under section 902 shall apply, and for purposes of so 
applying the regulations under section 902, any amount attributable to 
the earnings and profits for the taxable year of a first-, second-, or 
third-tier corporation which is included in the gross income of a 
domestic corporation under section 951 shall be treated as a 
distribution received by such domestic corporation on the last day in 
such taxable year on which such foreign corporation is a controlled 
foreign corporation.
    (h) Source of income and country to which tax is deemed paid--(1) 
Source of income. For purposes of section 904--
    (i) The amount included in gross income of a domestic corporation 
under section 951 for the taxable year with respect to a first-, second-
, or third-tier corporation, plus
    (ii) Any section 78 dividend to which such section 951 amount gives 
rise by reason of taxes deemed paid by such domestic corporation under 
section 960(a)(1),


shall be deemed to be derived from sources within the foreign country or 
possession of the United States under the laws of which such first-tier 
corporation, or the first-tier corporation in the same chain of 
ownership as such second- or third-tier corporation, is created or 
organized.
    (2) Country to which taxes deemed paid. For purposes of section 904, 
the foreign income taxes paid by the first-, second-, or third-tier 
corporation and deemed to be paid by the domestic corporation under 
section 960(a)(1) by reason of the inclusion of the amount described in 
paragraph (h)(1)(i) of this section in the gross income of such domestic 
corporation shall be deemed to be paid to the foreign country or 
possession of the United States under the laws of which such first-tier 
corporation, or the first-tier corporation in the same chain of 
ownership as such second- or third-tier corporation, is created or 
organized.
    (3) Illustration. The application of this paragraph may be 
illustrated by the following example:

    Example. Domestic corporation N owns all the one class of stock of 
controlled foreign corporation A, incorporated under the laws of foreign 
country X, which owns all the one class of stock of controlled foreign 
corporation B, incorporated under the laws of foreign country Y. All 
such corporations use the calendar year as the taxable year. For 1978, N 
Corporation is required under section 951 to include in gross income $45 
attributable to the earnings and profits of B Corporation for such year 
and $50 attributable to the earnings and profits of A Corporation for 
such year. For 1978, because of the inclusion of such amounts in gross 
income, N Corporation is deemed under section 960(a)(1) and paragraph 
(c) of this section to have paid $15 of foreign income taxes paid by B 
Corporation for such year and $10 of foreign income taxes paid by A 
Corporation for such year. For purposes of section 904, the amount ($95) 
included in N Corporation's gross income under section 951 attributable 
to the earnings and profits of corporations A and B is deemed to be 
derived from sources within country X, and the section 78 dividend 
consisting of the foreign income taxes ($25) deemed paid by N 
Corporation under section 960(a)(1) with respect to such $95 is deemed 
to be derived from sources within country X. The $25 of foreign income 
taxes so deemed paid by N Corporation are deemed to be paid to country X 
for purposes of section 904.

    (i) Computation of deemed-paid taxes in post-1986 taxable years--(1) 
General rule. If a domestic corporation is eligible to compute deemed-
paid taxes under section 960(a)(1) with respect to an amount included in 
gross income under section 951(a), then, such domestic corporation shall 
be deemed to have paid a portion of the foreign corporation's post-1986 
foreign income taxes determined under section 902 and the regulations 
under that section in the same manner as if the amount so included were 
a dividend paid by such foreign corporation (determined by applying 
section 902(c) in accordance with section 904(d)(3)(B)).
    (2) Ordering rule for computing deemed-paid taxes under sections 902 
and 960. If a domestic corporation computes deemed-paid taxes under both 
sections 902 and 960 in the same taxable year,

[[Page 442]]

section 960 shall be applied first. After the deemed-paid taxes are 
computed under section 960 with respect to a deemed income inclusion, 
post-1986 undistributed earnings and post-1986 foreign income taxes in 
each separate category shall be reduced by the appropriate amounts 
before deemed-paid taxes are computed under section 902 with respect to 
a dividend distribution.
    (3) Computation of post-1986 undistributed earnings. Post-1986 
undistributed earnings (or an accumulated deficit in post-1986 
undistributed earnings) are computed under section 902 and the 
regulations under that section.
    (4) Allocation of accumulated deficits. For purposes of computing 
post-1986 undistributed earnings under sections 902 and 960, a post-1986 
accumulated deficit in a separate category shall be allocated 
proportionately to reduce post-1986 undistributed earnings in the other 
separate categories. However, a deficit in any separate category shall 
not permanently reduce earnings in other separate categories, but after 
the deemed-paid taxes are computed the separate limitation deficit shall 
be carried forward in the same separate category in which it was 
incurred. In addition, because deemed-paid taxes may not exceed taxes 
paid or accrued by the controlled foreign corporation, in computing 
deemed-paid taxes with respect to an inclusion out of a separate 
category that exceeds post-1986 undistributed earnings in that separate 
category, the numerator of the deemed-paid credit fraction (deemed 
inclusion from the separate category) may not exceed the denominator 
(post-1986 undistributed earnings in the separate category).
    (5) Examples. The application of this paragraph (i) may be 
illustrated by the following examples. See Sec. 1.952-1(f)(4) for 
additional illustrations of these rules.

    Example 1. (i) A, a U.S. person, is the sole shareholder of CFC, a 
controlled foreign corporation formed on January 1, 1998, whose 
functional currency is the u. In 1998 CFC earns 100u of general 
limitation income described in section 904(d)(1)(I) that is not subpart 
F income and 100u of foreign personal holding company income that is 
passive income described in section 904(d)(1)(A). In 1998 CFC also 
incurs a (50u) loss in the shipping category described in section 
904(d)(1)(D). CFC's subpart F income for 1998, 100u, does not exceed 
CFC's current earnings and profits of 150u. Accordingly, all 100u of 
CFC's subpart F income is included in A's gross income under section 
951(a)(1)(A). Under section 904(d)(3)(B) of the Internal Revenue Code 
and paragraph (i)(1) of this section, A includes 100u of passive 
limitation income in gross income for 1998.
    (ii) For purposes of computing post-1986 undistributed earnings 
under sections 902, 904(d) and 960 with respect to the subpart F 
inclusion, the shipping limitation deficit of (50u) is allocated 
proportionately to reduce general limitation earnings of 100u and 
passive limitation earnings of 100u. Thus, general limitation earnings 
are reduced by 25u to 75u (100u general limitation earnings/200u total 
earnings in positive separate categories x (50u) shipping deficit = 25u 
reduction), and passive limitation earnings are reduced by 25u to 75u 
(100u passive earnings/200u total earnings in positive separate 
categories x (50u) shipping deficit = 25u reduction). All of CFC's post-
1986 foreign income taxes with respect to passive limitation earnings 
are deemed paid by A under section 960 with respect to the 100u subpart 
F inclusion of passive income (75u inclusion (numerator limited to 
denominator under paragraph (i)(4) of this section)/75u passive 
earnings). After the inclusion and deemed-paid taxes are computed, at 
the close of 1998 CFC has 100u of general limitation earnings, 0 of 
passive limitation earnings (100u of foreign personal holding company 
income - 100u inclusion), and a (50u) deficit in shipping limitation 
earnings.
    Example 2. (i) The facts are the same as in Example 1 with the 
addition of the following facts. In 1999, CFC distributes 150u to A. CFC 
has 100u of previously-taxed earnings and profits described in section 
959(c)(2) attributable to 1998, all of which is passive limitation 
earnings and profits. Under section 959(c), 100u of the 150u 
distribution is deemed to be made from earnings and profits described in 
section 959(c)(2). The remaining 50u is deemed to be made from earnings 
and profits described in section 959(c)(3). The entire dividend 
distribution of 50u is treated as made out of CFC's general limitation 
earnings and profits. See section 904(d)(3)(D).
    (ii) For purposes of computing post-1986 undistributed earnings 
under section 902 with respect to the 1999 dividend of 50u, the shipping 
limitation accumulated deficit of (50u) reduces general limitation 
earnings and profits of 100u to 50u. Thus, 100% of CFC's post-1986 
foreign income taxes with respect to general limitation earnings are 
deemed paid by A under section 902 with respect to the 1999 dividend of 
50u (50u dividend/50u general limitation earnings). After the deemed-
paid taxes are computed, at the close of 1999 CFC has 50u of general 
limitation earnings (100u opening balance--50u distribution), 0 of

[[Page 443]]

passive limitation earnings, and a (50u) deficit in shipping limitation 
earnings.

    (6) Effective date. This paragraph (i) applies to taxable years of a 
controlled foreign corporation beginning after March 3, 1997.

[T.D. 7120, 36 FR 10852, June 4, 1971; 36 FR 11924, June 23, 1971, as 
amended by T.D. 7334, 39 FR 44211, Dec. 23, 1974; 40 FR 1014, Jan. 6, 
1975; T.D. 7649, 44 FR 60088, 60089, Oct. 18, 1979; T.D. 7843, 47 FR 
50472, Nov. 8, 1982; 47 FR 55477, Dec. 10, 1982; T.D. 7961, 49 FR 26225, 
June 27, 1984; T.D. 8704, 62 FR 21, Jan. 2, 1997]



Sec. 1.960-2  Interrelation of section 902 and section 960 when
dividends are paid by third-, second-, or first-tier corporation.

    (a) Scope of this section. This section prescribes rules for the 
application of section 902 in a case where dividends are paid by a 
third-, second-, or first-tier corporation, as the case may be, from its 
earnings and profits for a taxable year when an amount attributable to 
such earnings and profits is included in the gross income of a domestic 
corporation under section 951, or when such earnings and profits are 
attributable to an amount excluded from the gross income of such foreign 
corporation under section 959(b) and Sec. 1.959-2, with respect to the 
domestic corporation. In making determinations under this section, any 
portion of a distribution received from a first-tier corporation by the 
domestic corporation which is excluded from the domestic corporation's 
gross income under section 959(a) and Sec. 1.959-1, or any portion of a 
distribution received from an immediately lower-tier corporation by the 
third-, second-, or first-tier corporation which is excluded from such 
foreign corporation's gross income under section 959(b) and Sec. 1.959-
2, shall be treated as a dividend for purposes of taking into account 
under section 902 any foreign income taxes paid by such third-, second-, 
or first-tier corporation which are not deemed paid by the domestic 
corporation under section 960(a)(1) and Sec. 1.960-1.
    (b) Application of section 902(b) to dividends received from an 
immediately lower-tier corporation. For purposes of paragraph (a) of 
this section and paragraph (c)(1)(i) of Sec. 1.960-1, section 902(b) 
shall apply to all dividends received by the first- or second-tier 
corporation from the immediately lower-tier corporation other than 
dividends attributable to earnings and profits of such immediately 
lower-tier corporation in respect of which an amount is, or has been, 
included in the gross income of a domestic corporation under section 951 
with respect to such immediately lower-tier corporation.
    (c) Application of section 902(a) to dividends received by domestic 
corporation from first-tier corporation. For purposes of paragraph (a) 
of this section, section 902 (a) shall apply to all dividends received 
by the domestic corporation for its taxable year from the first-tier 
corporation other than dividends attributable to earnings and profits of 
such first-tier corporation in respect of which an amount is, or has 
been, included in the gross income of a domestic corporation under 
section 951 with respect to such first-tier corporation.
    (d) Allocation of earnings and profits of a first- or second-tier 
corporation having income excluded under section 959(b)--(1) First-tier 
corporations. If the first-tier corporation for its taxable year 
receives dividends from the second-tier corporation to which in 
accordance with paragraph (b) of this section 902(b)(1) or section 
902(b)(2) applies and other dividends from the second-tier corporation 
to which such sections do not apply, then in applying section 902(a) 
pursuant to this section and in applying section 960(a)(1) pursuant to 
Sec. 1.960-1(c)(1)(i), with respect to the foreign income taxes paid 
and deemed paid by the second-tier corporation which are deemed paid by 
the first-tier corporation for such taxable year under section 
902(b)(1)--
    (i) The earnings and profits of the first-tier corporation for such 
taxable year shall be considered not to include its earnings and profits 
which are attributable to the dividends to which section 902(b)(1) does 
not apply (in determining the domestic corporation's credit for the 
taxes paid by the second-tier corporation) or which are attributable to 
the dividends to which sections 902(b)(1) and 902(b)(2) do not apply (in 
determining the domestic corporation's credit for taxes deemed paid by 
the second-tier corporation) and

[[Page 444]]

    (ii) For the purposes of so applying section 902(a), distributions 
to the domestic corporation from such earnings and profits which are 
attributable to the dividends to which section 902(b)(1) does not apply 
(in determining the domestic corporation's credit for taxes paid by the 
second-tier corporation) or which are attributable to the dividends to 
which sections 902(b)(1) and 902(b)(2) do not apply (in determining the 
domestic corporation's credit for taxes deemed paid by the second-tier 
corporation) shall not be treated as a dividend.
    (2) Second-tier corporations. If the second-tier corporation for its 
taxable year receives dividends from the third-tier corporation to 
which, in accordance with paragraph (b) of this section, section 
902(b)(2) applies and other dividends from the third-tier corporation to 
which such section does not apply, then in applying section 902(b)(1) 
pursuant to this section, and in applying section 960(a)(1) pursuant to 
paragraph (c)(1)(i) of Sec. 1.960-1, with respect to the foreign taxes 
deemed paid by the second-tier corporation for such taxable year under 
section 902(b)(2)--
    (i) The earnings and profits of the second-tier corporation for such 
taxable year shall be considered not to include its earnings and profits 
which are attributable to such other dividends from the third-tier 
corporation, and
    (ii) For the purposes of so applying section 902(b)(1), 
distributions to the first-tier corporation from such earnings and 
profits which are attributable to such other dividends from the third-
tier corporation shall not be treated as a dividend.
    (e) Separate determinations under sections 902(a), 902(b)(1), and 
902(b)(2) in the case of a first-, second-, or third-tier corporation 
having income excluded under section 956(b). If in the case of a first-, 
second-, or third-tier corporation to which paragraph (b) or (c) of this 
section is applied--
    (1) The earnings and profits of such foreign corporation for its 
taxable year consist of--
    (i) Dividends received from an immediately lower-tier corporation 
which are attributable to amounts included in the gross income of a 
domestic corporation under section 951 with respect to the immediately 
lower- or lower-tier corporations, and
    (ii) Other earnings and profits, and
    (2) The effective rate of foreign income taxes paid or accrued by 
such foreign corporation on the dividends described in paragraph 
(e)(1)(i) of this section is higher or lower than the effective rate of 
foreign income taxes attributable to its earnings and profits described 
in paragraph (e)(1)(ii) of this section,


then, for purposes of applying paragraph (b) or (c) of this section to 
dividends paid by such foreign corporation to the domestic corporation 
or the first- or second-tier corporation, sections 902(a), 902(b)(1), 
and 902(b)(2) shall be applied separately to the portion of the dividend 
which is attributable to the earnings and profits described in paragraph 
(e)(1)(i) of this section and separately to the portion of the dividend 
which is attributable to the earnings and profits described in paragraph 
(e)(1)(ii) of this section. In making a separate determination with 
respect to the earnings and profits described in paragraph (e)(1)(i) or 
(e)(1)(ii) of this section, only the foreign income taxes paid or 
accrued (or, in the case of earnings and profits of a first- or second-
tier corporation described in paragraph (e)(1)(ii) of this section, 
deemed to be paid) by such foreign corporation on the income 
attributable to such earnings and profits shall be taken into account. 
For purposes of applying this paragraph (e), no part of the foreign 
income taxes paid, accrued, or deemed to be paid which are attributable 
to the earnings and profits described in paragraph (e)(1)(ii) of this 
section shall be attributed to the dividend described in paragraph 
(e)(1)(i) of this section; and no part of the foreign income taxes paid 
or accrued on the dividend described in paragraph (e)(1)(i) of this 
section shall be attributed to the earnings and profits described in 
paragraph (e)(1)(ii) of this section. Furthermore, the effective rate of 
foreign income taxes paid or accrued shall be determined consistently 
with the principles of paragraphs (b)(3)(iv) and (viii) and (c) of Sec. 
1.954-1. Thus, for example, the effective rate of foreign income taxes 
on dividends received by such foreign corporation shall be determined by

[[Page 445]]

taking into account any intercorporate dividends received deduction 
allowed to such corporation for such dividends.
    (f) Illustrations. The application of this section may be 
illustrated by the following examples. In all of the examples other than 
examples 6, 7, 9 and 10, it is assumed that the effective rate of 
foreign income taxes paid or accrued by the first- or second-tier 
corporation, as the case may be, in respect to dividends received from 
the immediately lower-tier corporation, is the same as the effective 
rate of foreign income taxes paid or accrued by the first- or second-
tier corporation with respect to its other income:

    Example 1. Domestic corporation N owns all the one class of stock of 
controlled foreign corporation A, which owns all the one class of stock 
of controlled foreign corporation B. All such corporations use the 
calendar year as the taxable year. For 1978, N Corporation is required 
under section 951 to include $50 in gross income attributable to the 
earnings and profits of A Corporation for such year, but is not required 
to include any amount in gross income under section 951 attributable to 
the earnings and profits of B Corporation. For such year, B Corporation 
distributes a dividend of $45, but A Corporation does not make any 
distributions. The foreign income taxes deemed paid by N Corporation for 
1978 under section 960(a)(1), after applying section 902(b)(1) for such 
year of A Corporation, are determined as follows upon the basis of the 
facts assumed:

B Corporation (second-tier corporation):
  Pretax earnings and profits.................................   $100.00
  Foreign income taxes (40%)..................................     40.00
  Earnings and profits........................................     60.00
  Dividends paid to A Corporation.............................    $45.00
  Foreign income taxes paid by B Corporation on or with            40.00
   respect to its accumulated profits.........................
  Foreign income taxes of B Corporation deemed paid by A           30.00
   Corporation for 1978 under section 902(b)(1) ($45/$60 x
   $40).......................................................
A Corporation (first-tier corporation):
  Pretax earnings and profits:
    Dividends from B Corporation.....................   $45.00
    Other income.....................................   100.00
                                                      ---------
     Total pretax earnings and profits...............  .......    145.00
  Foreign income taxes (20%).........................  .......     29.00
  Earnings and profits...............................  .......    116.00
  Foreign income taxes paid, and deemed to be paid, by A           59.00
   Corporation on or with respect to its earnings and profits
   ($29 + $30)................................................
  Amount required to be included in N Corporation's gross          50.00
   income under section 951 with respect to A Corporation.....
  Dividends paid to N Corporation.............................         0
N Corporation (domestic corporation):
  Foreign income taxes of A Corporation deemed paid by N           25.43
   Corporation for 1978 under section 960(a)(1) ($50/$116 x
   $59).......................................................
 

    Example 2. Domestic corporation N owns all the one class of stock of 
controlled foreign corporation A, which owns all the one class of stock 
of controlled foreign corporation B. All such corporations use the 
calendar year as the taxable year. For 1978, N Corporation is required 
under section 951 to include in gross income $150 attributable to the 
earnings and profits of B Corporation for such year, which B Corporation 
distributes during such year. Corporation N is not required for 1978 to 
include any amount in gross income under section 951 attributable to the 
earnings and profits of A Corporation, but A Corporation distributes for 
such year $135 from its earnings and profits attributable to B 
Corporation's dividend. The foreign income taxes deemed paid by N 
Corporation for 1978 under section 960(a)(1)(C) and section 902(a) are 
determined as follows upon the basis of the facts assumed:

B Corporation (second-tier corporation):
  Pretax earnings and profits.................................   $250.00
  Foreign income taxes (20%)..................................     50.00
  Earnings and profits........................................    200.00
  Amounts required to be included in N Corporation's gross        150.00
   income under section 951 with respect to B Corporation.....
  Dividends paid to A Corporation.............................    150.00
  Foreign income taxes paid on or with respect to earnings and     50.00
   profits of B Corporation...................................
A Corporation (first-tier corporation):
  Pretax earnings and profits:
    Dividends from B Corporation....................   $150.00
    Other income....................................    200.00
                                                     ----------
     Total pretax earnings and profits........................    350.00
  Foreign income taxes (10%)..................................     35.00
  Earnings and profits........................................    315.00
  Dividends paid to N Corporation.............................    135.00
  Foreign income taxes paid by A Corporation on or with            35.00
   respect to its accumulated profits.........................
N Corporation (domestic corporation):
  Foreign income taxes of B Corporation deemed paid by N           37.50
   Corporation for 1978 under section 960(a)(1) ($150/$200 x
   $50).......................................................
  Foreign income taxes of A Corporation deemed paid by N           15.00
   Corporation for 1978 under section 902(a) ($135/$315 x $35)
                                                     -----------
     Total foreign income taxes deemed paid by N Corporation       52.50
     under section 901........................................
 

    Example 3. Domestic corporation N owns all the one class of stock of 
controlled foreign corporation A, which owns all the one class of stock 
of controlled foreign corporation B. All such corporations use the 
calendar year as the taxable year. For 1978, N Corporation is required 
under section 951 to include $180 in gross income attributable to the 
earnings and profits of A Corporation for such year, but is not required 
to include any amount in gross income under section 951 attributable to 
the earnings and profits of B Corporation. Corporation B distributes 
from its earnings and profits for 1978 a dividend of $50. For 1978, A 
Corporation distributes $180 from its earnings and profits attributable 
to the amount required under section 951 to be

[[Page 446]]

included in N Corporation's gross income for such year with respect to A 
Corporation and $20 from its other earnings and profits. The foreign 
income taxes deemed paid by N Corporation for 1978 under section 
960(a)(1) and section 902(a) are determined as follows upon the basis of 
the facts assumed:

B Corporation (second-tier corporation):
  Pretax earnings and profits.................................   $100.00
  Foreign income taxes (40%)..................................     40.00
  Earnings and profits........................................     60.00
  Dividends paid to A Corporation.............................     50.00
  Foreign income taxes paid by B Corporation on or with            40.00
   respect to its accumulated profits.........................
  Foreign income taxes of B Corporation deemed paid by A           33.33
   Corporation for 1978 under section 902(b)(1) ($50/$60 x
   $40).......................................................
A Corporation (first-tier corporation):
  Pretax earnings and profits:
    Dividends from B Corporation....................    $50.00
    Other income....................................    200.00
                                                     ----------
    Total pretax earnings and profits.........................    250.00
  Foreign income taxes (10%)..................................     25.00
  Earnings and profits........................................    225.00
  Foreign income taxes paid, and deemed to be paid, by A           58.33
   Corporation on or with respect to its earnings and profits
   ($25.00 + $33.33)..........................................
  Amounts required to be included in N Corporation's gross        180.00
   income for 1978 under section 951 with respect to A
   Corporation................................................
  Dividends paid to N Corporation:
    Dividends to which section 902(a) does not apply    180.00
     (from A Corporation's earnings and profits in
     respect of which an amount is required under
     section 951 to be included in N Corporation's
     gross income with respect to A Corporation)....
    Dividends to which section 902(a) applies (from      20.00
     A Corporation's other earnings and profits)....
                                                     ----------
    Total dividends paid to N Corporation.....................   $200.00
N Corporation (domestic corporation):
  Foreign income taxes of corporations A and B deemed paid by      46.66
   N Corporation under section 960(a)(1) ($180/$225 x $58.33).
  Foreign income taxes of corporations A and B deemed paid by       5.18
   N Corporation under section 902(a) ($20/$225 x $58.33).....
                                                     -----------
     Total foreign income taxes deemed paid by N Corporation       51.84
     under section 901........................................
 

    Example 4. Domestic corporation N owns all the one class of stock of 
controlled foreign corporation A, which owns all the one class of stock 
of controlled foreign corporation B. All such corporations use the 
calendar year as the taxable year. For 1978, N Corporation is required 
under section 951 to include in gross income $150 attributable to the 
earnings and profits of B Corporation for such year and $22.50 
attributable to the earnings and profits of A Corporation for such year. 
For 1978, B Corporation distributes $175, consisting of $150 from its 
earnings and profits attributable to amounts required under section 951 
to be included in N Corporation's gross income with respect to B 
Corporation and $25 from its other earnings and profits. Corporation A 
does not distribute any dividends for 1978. The foreign income taxes 
deemed paid by N Corporation for 1978 under section 960(a)(1) are 
determined as follows upon the basis of the facts assumed:

B Corporation (second-tier corporation):
  Pretax earnings and profits.................................   $250.00
  Foreign income taxes (20%)..................................     50.00
  Earnings and profits........................................    200.00
  Amounts required to be included in N Corporation's gross        150.00
   income under section 951 for 1978 with respect to B
   Corporation................................................
  Dividends paid by B Corporation:
    Dividends to which section 902(b) does not apply   $150.00
     (from B Corporation's earnings and profits in
     respect of which an amount is required under
     section 951 to be included in N Corporation's
     gross income with respect to B Corporation)....
    Dividends to which section 902(b)(1) applies         25.00
     (from B Corporation's other earnings and
     profits).......................................
                                                     ----------
     Total dividends paid to A Corporation....................    175.00
  Foreign income taxes paid by B Corporation on or with            50.50
   respect to its accumulated profits.........................
  Foreign income taxes of B Corporation deemed paid by A            6.25
   Corporation for 1978 under section 902(b)(1) ($25/$200 x
   $50).......................................................
A Corporation (first-tier corporation):
  Pretax earnings and profits.................................    175.00
  Foreign income tax (10 percent).............................     17.50
  Earnings and profits........................................    157.50
  Earnings and profits after exclusion of amounts attributable     22.50
   to dividends to which section 902(b) does not apply
   ($157.50 less [$150- ($150 x 0.10)]).......................
  Amount required to be included in N Corporation's gross          22.50
   income for 1978 under section 951 with respect to A
   Corporation................................................
  Dividends paid to N Corporation.............................         0
N Corporation (domestic corporation):
  Foreign income taxes deemed paid by N Corporation
   under section 960(a)(1)(C) with respect to A
   Corporation:
    Tax actually paid by A Corporation ($22.50/           2.50
     $157.50 x $17.50)..............................
    Tax of B Corporation deemed paid by A                 6.25
     Corporation under section 902(b)(1) ($22.50/
     $22.50 x $6.25)................................
                                                     -----------
                                                      ........      8.75
  Foreign income taxes deemed paid by N Corporation under          37.50
   section 960(a)(1)(C) with respect to B Corporation ($150/
   $200 x $50)................................................
                                                     -----------
      Total taxes deemed paid under section 960(a)(1)(C)......     46.20
 

    Example 5. Domestic corporation N owns all the one class of stock of 
controlled foreign corporation A, which owns all the one class of stock 
of controlled foreign corporation B. All such corporations use the 
calendar year as the taxable year. For 1978, N

[[Page 447]]

Corporation is required under section 951 to include in gross income 
$150 attributable to the earnings and profits of B Corporation for such 
year and $22.50 attributable to the earnings and profits of A 
Corporation for such year. For 1978, B Corporation distributes $175, 
consisting of $150 from its earnings and profits attributable to amounts 
required under section 951 to be included in N Corporation's gross 
income with respect to B Corporation and $25 from its other earnings and 
profits. For 1978, A Corporation distributes $225, consisting of $135 
from its earnings and profits attributable to the amount required under 
section 951 to be included in N Corporation's gross, income with respect 
to B Corporation, $22.50 from its earnings and profits attributable to 
the amount required under section 951 to be included in N Corporation's 
gross income with respect to A Corporation, and $67.50 from its other 
earnings and profits. The foreign income taxes deemed paid by N 
Corporation for 1978 under section 960(a)(1) and section 902(a)(1) are 
determined as follows upon the basis of the facts assumed:

B Corporation (second-tier corporation):
  Pretax earnings and profits.................................   $250.00
  Foreign income taxes (20%)..................................     50.00
  Earnings and profits........................................    200.00
  Amounts required to be included in N Corporation's gross        150.00
   income for 1978 under section 951 with respect to B
   Corporation................................................
  Dividends paid by B Corporation:
    Dividends to which section 902(b) does not apply   $150.00
     (from B Corporation's earnings and profits in
     respect of which an amount is required under
     section 951 to be included in N Corporation's
     gross income with respect to B Corporation)....
    Dividends to which section 902(b) applies (from     $25.00
     B Corporation's other earnings and profits)....
                                                     ----------
     Total dividends paid to A Corporation....................   $175.00
  Foreign income taxes paid by B Corporation on or with            50.00
   respect to its accumulated profits.........................
  Foreign income taxes of B Corporation deemed paid by A           6.25
   Corporation for 1978 under section 902(b)(1) ($25/$200 x
   $50).......................................................
A Corporation (first-tier corporation):
  Pretax earnings and profits:
    Dividends received from B Corporation...........    175.00
    Other income....................................    100.00
                                                     ----------
     Total pretax earnings and profits........................    275.00
  Foreign income taxes (10 percent)...........................     27.50
  Earnings and profits........................................    247.50
  Earnings and profits after exclusion of amounts attributable    112.50
   to dividends to which section 902(b) does not apply
   ($247.50 less [$150 -($150 x 0.10)]).......................
  Amount required to be included in N Corporation's gross          22.50
   income for 1978 under section 951 with respect to A
   Corporation................................................
Distributions paid by A Corporation:
  Dividends to which section 902(a) does not apply       22.50
   (From A Corporation's earnings and profits in
   respect of which an amount is required under
   section 951 to be included in N Corporation's
   gross income with respect to A Corporation)......
  Dividends to which section 902(a) applies (from A     202.50
   Corporation's other earnings and profits)........
                                                     ----------
    Total dividends paid to N Corporation...........    225.00
N Corporation (domestic corporation):
  Foreign income taxes deemed paid by N Corporation
   under section 960(a)(1) with respect to--
    B Corporation ($150/$200 x $50).................  ........     37.50
    A Corporation:
      Tax paid by A Corporation ($22.50/ $247.50 x        2.50
       $27.50)......................................
      Tax of B Corporation deemed paid by A               1.25      3.75
       Corporation under section 902(b)(1) ($22.50/
       $112.50 x $6.25).............................
                                                     -----------
        Total taxes deemed paid under section 960(a)(1).......     41.25
  Foreign income taxes deemed paid by N Corporation
   under section 902(a)(1) with respect to A
   Corporation:
    Tax paid by A Corporation ($200.50/$247.50 x         22.50
     $27.50)........................................
    Tax of B Corporation deemed paid by A                 3.75
     Corporation ($67.50/ $112.50 x $6.25)..........
                                                     ----------
      Total taxes deemed paid under section 902(a)(1).........     26.52
                                                     -----------
    Total foreign income taxes deemed paid by N Corporation        67.05
     under section 901........................................
 

    Example 6. Domestic corporation N owns all the one class of stock of 
controlled foreign corporation A, which owns all the one class of stock 
of controlled foreign corporation B. All such corporations use the 
calendar year as the taxable year. A and B corporations are organized 
under the laws of foreign country X. All of B corporation's assets used 
in a trade or business are located in country X. Country X imposes an 
income tax of 20 percent on B corporation's income. For 1978, N 
Corporation is required under section 951 to include in gross income 
$100 attributable to the earnings and profits of B Corporation for such 
year. For 1978, B Corporation distributes $150, consisting of $100 from 
its earnings and profits attributable to the amount required under 
section 951 to be included in N Corporation's gross income with respect 
to B Corporation and $50 from its other earnings and profits. Country X 
imposes an income tax of 10 percent on A Corporation's income but 
exempts from tax dividends received from B Corporation. N is not

[[Page 448]]

required to include any amount in gross income under section 951 for 
1978 attributable to the earnings and profits of A Corporation for such 
year. For 1978, A Corporation distributes $175, consisting of $100 from 
its earnings and profits attributable to the amount required under 
section 951 to be included in N Corporation's gross income with respect 
to B Corporation, and $75 from its other earnings and profits. The 
foreign income taxes deemed paid by N Corporation for 1978 under section 
960(a)(1) and section 902(a) are determined as follows on the basis of 
the facts assumed:

B Corporation (2d-tier corporation):
  Pretax earnings and profits.................................   $200.00
  Foreign income taxes (20%)..................................     40.00
  Earnings and profits........................................    160.00
  Amount required to be included in N Corporation's gross         100.00
   income for 1978 under section 951 with respect to B
   Corporation................................................
Dividends paid by B Corporation:
  Dividends to which section 902(b) does not apply     $100.00
   (from B corporation's earnings and profits in
   respect of which an amount is required under
   section 951 to be included in N corporation's
   gross income with respect to B corporation)......
  Dividends to which section 902(b)(1) applies (from     50.00
   B corporation's other earnings and profits)......
                                                     ----------
   Total dividends paid to A corporation......................    150.00
  Foreign income taxes of B corporation deemed paid      12.50
   by A corporation for 1978 under section 902(b)(1)
   ($50/$100 x $40).................................
A corporation (1st-tier corporation):
  Pretax earnings and profits:
    Dividends received from B corporation...........    150.00
    Other income....................................    100.00
                                                     ----------
      Total pretax earnings and profits.............  ........    250.00
  Foreign income taxes:
    On dividends received from B corporation........      None
    On other income ($100 x 0.10)...................     10.00
     Total foreign income taxes.....................  ........     10.00
Earnings and profits:
  Attributable to dividends received from B corporation to        100.00
   which section 902(b) does not apply........................
Attributable to other income:
  Attributable to dividends received from B              50.00
   Corporation to which section 902(b)(1) applies...
  Attributable to other income ($100-$10)...........     90.00
                                                     ----------
   Subtotal...................................................    140.00
   Total earnings and profits.................................    240.00
  Earnings and profits after exclusion of amounts attributable    140.00
   to dividends to which section 902(b) does not apply ($240-
   $100)......................................................
  Amount required to be included in N corporation's gross           None
   income for 1978 under section 951 with respect to A
   corporation................................................
  Dividends paid by A corporation:
    Dividends to which section 902(a) does not apply      None
     (from A corporation's earnings and profits in
     respect of which an amount is required under
     section 951 to be included in N corporation's
     gross income with respect to A corporation)....
    Dividends to which section 902(a) applies (from    $175.00
     A corporation's other earnings and profits)....
                                                     ----------
     Total dividends paid to N corporation....................   $175.00
N corporation (domestic corporation):
  Foreign income taxes deemed paid by N corporation under          25.00
   section 960(a)(1) with respect to B corporation ($100/$160
   x $40).....................................................
  Foreign income taxes deemed paid by N corporation
   under section 902(a) with respect to A
   corporation (allocation of earnings and profits
   being made under pars. (c)(2) and (d) of this
   section):
    Tax paid by A corporation in respect to               None
     dividends received from B Corporation to which
     section 902(b) does not apply ($100/ $100 x $0)
    Tax paid by A corporation in respect to its           5.36
     other income ($75/ $140 x $10).................
    Tax paid by B corporation deemed paid by A            6.70
     corporation in respect to such other income
     ($75/$140 x $12.50)............................
                                                     ----------
      Total taxes deemed paid under section 902(a)............     12.06
    Total foreign income taxes deemed paid by N          37.06  ........
     corporation under section 901..................
 

    Example 7. Domestic corporation N owns all the one class of stock of 
controlled foreign corporation A, which owns all the one class of stock 
of controlled foreign corporation B. All such corporations use the 
calendar year as the taxable year. For 1978, N Corporation is required 
under section 951 to include in gross income $150 attributable to the 
earnings and profits of B Corporation for such year and $47.50 
attributable to the earnings and profits of A Corporation for such year. 
For 1978, B Corporation distributes $200, consisting of $150 from its 
earnings and profits attributable to the amount required under section 
951 to be included in N Corporation's gross income with respect to B 
Corporation and $50 from its other earnings and profits. The country 
under the laws of which A Corporation is incorporated imposes an income 
tax of 5 percent on dividends received from a subsidiary corporation and 
20 percent on other income. For 1978, A Corporation distributes $100 
from its earnings and profits to N Corporation, such amount being 
attributable under paragraph (e) of Sec. 1.959-3 to the amount required 
under section 951 to be included in N Corporation's gross income with 
respect to B Corporation.

[[Page 449]]

The foreign income taxes deemed paid by N Corporation for 1978 under 
section 960(a)(1) and section 902(a) are determined as follows on the 
basis of the facts assumed:

B Corporation (2d-tier corporation):
  Pretax earnings and profits.................................   $250.00
  Foreign income taxes (20 percent)...........................    150.00
  Earnings and profits........................................    200.00
  Amount required to be included in N Corporation's gross         150.00
   income for 1978 under section 951 with respect to B
   corporation................................................
Dividends paid by B corporation:
    Dividends to which section 902(b) does not apply   $150.00
     (from B corporation's earnings and profits in
     respect of which an amount is required under
     section 951 to be included in N corporation's
     gross income with respect to B corporation)....
    Dividends to which section 902(b)(1) applies         50.00
     (from B corporation's other earnings and
     profits).......................................
                                                     ----------
   Total dividends paid to A corporation......................    200.00
  Foreign income taxes of B corporation deemed paid by A           12.50
   corporation for 1978 under section 902(b)(1) ($50/$200 x
   $50).......................................................
A corporation (1st-tier corporation):
  Pretax earnings and profits:
    Dividends received from B corporation...........    200.00
    Other income....................................    100.00
                                                     ----------
     Total pretax earnings and profits........................    300.00
  Foreign income taxes:
    On dividends received from B corporation to which section       7.50
     902(b) does not apply ($150 x 0.05)......................
    On other income:
      Dividends received from B corporation to which      2.50
       section 902(b)(1) applies ($50 x 0.05).......
      Other income of A corporation ($100 x 0.20)...     20.00
                                                     ----------
     Total....................................................     22.50
                                                     -----------
    Total foreign income taxes................................     30.00
Earnings and profits:
  Attributable to dividends received from B corporation to        142.50
   which section 902(b) does not apply ($150-$7.50)...........
  Attributable to other income:
    Attributable to dividends received from B            47.50
     corporation to which section 902(b)(1) applies
     ($50-$2.50)....................................
    Attributable to other income ($100-$20..........     80.00
                                                     ----------
     Total....................................................    127.50
                                                     -----------
     Total earnings and profits...............................    270.00
Earnings and profits after exclusion of amounts attributable      127.50
 to dividends to which section 902(b) does not apply ($270
 less $142.50)................................................
Amount required to be included in N corporation's gross income     47.50
 for 1978 under section 951 with respect to A corporation.....
Dividends paid by A Corporation:
  Dividends to which section 902(a) does not apply        None
   (from A corporation's earnings and profits in
   respect of which an amount is required under
   section 951 to be included in N corporation's
   gross income with respect to A corporation)......
  Dividends to which section 902(a)(1) applies (from   $100.00
   A corporation's other earnings and profits)......
                                                     ----------
     Total dividends paid to N corporation....................   $100.00
N Corporation (domestic corporation):
  Foreign income taxes deemed paid by N corporation under          37.50
   section 960(a)(1) with respect to--B corporation ($150/$200
   x $50)
  A corporation (allocation of earnings and profits being made
   under Sec. 1.960-1(c)(3) and par. (d) of this section):
    Tax paid by A corporation ($47.50/$127.50 x           8.38
     $22.50)........................................
    Tax of B corporation deemed paid by A                 4.66
     corporation under section 902(b)(1) ($47.50/
     $127.50 x $12.50)..............................
                                                     ----------
     Total..........................................  ........     13.04
                                                               =========
     Total taxes deemed paid under section 960(a)(1)  ........     50.54
  Foreign income taxes deemed paid by N corporation       5.26
   under section 902(a) with respect to A
   corporation (allocations of earnings and profits
   being made under pars. (c)(2) and (d) of this
   section) ($100/$142.50 x $7.50)..................
                                                     ----------
    Total foreign income taxes deemed paid by N Corporation        55.80
     under section 901........................................
 

    Example 8. Domestic corporation N owns all the one class of stock of 
controlled foreign corporation A, which owns all the one class of stock 
of controlled foreign corporation B, which owns all the one class of 
stock of controlled foreign corporation C. All such corporations use the 
calendar year as the taxable year. For 1978, N Corporation is required 
under section 951 to include $50 attributable to the earnings and 
profits of C Corporation and $15 attributable to the earnings and 
profits of B Corporation in its gross income. N Corporation is not 
required to include any amount in its gross income with respect to A 
Corporation under section 951 in 1978. For such year, C Corporation 
distributes $75 to B Corporation. B Corporation in turn distributes $60 
of its earnings and profits to A Corporation. A Corporation has no other 
earnings and profits for 1978 and distributes $45 of its earnings and 
profits to N Corporation. The foreign income taxes deemed paid by N 
Corporation under section 960(a)(1) and section 902(a) are determined as 
follows on the basis of the facts assumed:
    C Corporation (third-tier corporation):

Pretax earnings and profits...................................   $150.00
Foreign taxes paid by C Corporation (30%).....................     45.00
Earnings and profits..........................................    105.00

[[Page 450]]

 
Amount required to be included in gross income of N                50.00
 Corporation under section 951 with respect to C Corporation..
Dividend to B Corporation.....................................     75.00
  Dividend from earnings and profits to which            50.00
   section 902(b)(2) does not apply (attributable to
   amounts included in N Corporation's gross income
   under section 951 with respect to C Corporation).
  Dividend from earnings and profits to which           $25.00
   section 902(b)(2) applies (attributable to
   amounts not included in N Corporation's gross
   income with respect to C Corporation)............
Amount of foreign income taxes of C Corporation deemed paid by
 B Corporation under section 902(b)(2) and Sec. 1.960-2(b):
 

 [GRAPHIC] [TIFF OMITTED] TC09OC91.016
 

  ($25/$105 x $45)............................................    $10.71
 

    B Corporation (second-tier corporation):

Pretax earnings and profits:
  Dividend from C Corporation.......................    $75.00
  Other earnings and profits........................    225.00
                                                     -----------
 
    Total pretax earnings and profits.........................   $300.00
 
Foreign income taxes paid by B Corporation (40%)..............    120.00
Earnings and profits..........................................    180.00
  Earnings and profits attributable to amounts to        30.00
   which section 902(b)(2) does not apply (amounts
   included in N Corporation's gross income under
   section 951 with respect to C Corporation ($50-
   ($50 x .40)).....................................
  Other earnings and profits........................    150.00
 
Earnings and profits of B Corporation after exclusion for         150.00
 amounts to which section 902(b)(2) does not apply (amounts
 attributable to earnings and profits which are included in N
 Corporation's gross income under section 951 with respect to
 C Corporation) ($180-$30)....................................
Amount to be included in gross income under section 951 of N       15.00
 Corporation with respect to B Corporation....................
Amount of dividend to A Corporation...........................     60.00
  Dividend from earnings and profits to which            30.00
   section 902(b)(2) does not apply (attributable to
   amounts included in N Corporation's gross income
   under section 951 with respect to C Corporation).
  Dividend from earnings and profits to which            15.00
   section 902(b)(1) does not apply (attributable to
   amounts included in N Corporation's gross income
   under section 951 with respect to B Corporation).
  Dividend from other earnings and profits               15.00
   (attributable to amounts not included in N
   Corporation's gross income under section 951 with
   respect to B or C Corporation)...................
 
Foreign income taxes of B Corporation deemed paid by A
 Corporation under section 902(b)(1) and Sec. 1.960-2(b):
 

 [GRAPHIC] [TIFF OMITTED] TC09OC91.017
 

  ($45/$180 x 120)............................................    $30.00
 
Foreign income taxes (of C Corporation) deemed paid by B
 Corporation deemed paid by A Corporation under section
 902(b)(1) in accordance with Sec. 1.960-2(b) and Sec.
 1.960-2(d)(2)(i) and (ii):
 


[[Page 451]]

[GRAPHIC] [TIFF OMITTED] TC09OC91.018


  ($15/$150 x $10.71).........................................      1.07
 

    A Corporation (first-tier corporation):

Pretax earnings and profits:
  Dividend from B Corporation.......................    $60.00
  Other earnings and profits........................         0
                                                     -----------
 
    Total pretax earnings and profits.........................    $60.00
 
Foreign income taxes paid by A Corporation (10%)..............      6.00
Earnings and profits..........................................     54.00
  Earnings and profits attributable to amounts to        27.00
   which section 902(b)(2) does not apply
   (attributable to amounts previously included in N
   Corporation's gross income under section 951 with
   respect to C Corporation) ($30-($30X.10))........
  Earnings and profits attributable to amounts to        13.50
   which section 902(b)(1) does not apply
   (attributable to amounts included in N
   Corporation's gross income under section 951 with
   respect to B Corporation) ($15- ($15X.10)).......
  Other earnings and profits ($15--($15X.10)).......     13.50
 
Earnings and profits of A Corporation after exclusion for          40.50
 amounts to which section 902(b)(1) does not apply
 (attributable to amounts included in N Corporation's gross
 income under section 951 with respect to B Corporation)
 ($54.00-$13.50)..............................................
Earnings and profits of A Corporation after exclusion for          13.50
 amounts to which sections 902(b)(1) and (2) do not apply
 (attributable to amounts included in N Corporation's gross
 income under section 951 with respect to B or C Corporation)
 ($40.50-$27.00)..............................................
Dividend to N Corporation.....................................     45.00
  Dividend from earnings and profits to which           $27.00
   section 902(b)(2) does not apply (attributable to
   amounts included in N Corporation's gross income
   under section 951 with respect to C Corporation).
  Dividend from earnings and profits to which            13.50
   section 902(b)(1) does not apply (attributable to
   amounts included in N Corporation's gross income
   under section 951 with respect to B Corporation).
  Dividend from earnings and profits to which                0
   section 902(a) does not apply (attributable to
   amounts included in N Corporation's gross income
   under section 951 with respect to A Corporation).
  Dividend from other earnings and profits                4.50
   (attributable to amounts not included in N
   Corporation's gross income under section 951 with
   respect to A, B, or C Corporation)...............
 

    N Corporation (domestic corporation):

Foreign income taxes deemed paid by N Corporation under
 section 960(a)(1) and Sec. 1.960-1(c)(1)(ii) with respect
 to C Corporation:
 

 [GRAPHIC] [TIFF OMITTED] TC09OC91.019
 

  ($50/$105 x $45.00).........................................    $21.43
 
Foreign income taxes deemed paid by N Corporation under            11.07
 section 960(a)(1) and Sec. 1.960-1(c)(1)(i) with respect to
 B Corporation................................................
 

    Taxes paid by B Corporation:

[[Page 452]]

[GRAPHIC] [TIFF OMITTED] TC09OC91.020


  ($15/$180 x $120).................................    $10.00
 

    Taxes deemed paid by B Corporation in accordance with Sec. 1.960-
2(d)(2)(i):
[GRAPHIC] [TIFF OMITTED] TC09OC91.021


  ($15/$150 x $10.71)...............................     $1.07
                                                     -----------
    Total taxes deemed paid by N Corporation under section        $32.50
     960(a)(1)................................................
 
Foreign income taxes deemed paid by N Corporation under
 section 902(a):
 

    Taxes paid by A Corporation in accordance with Sec. 1.960-2(c):
    [GRAPHIC] [TIFF OMITTED] TC09OC91.022
    

  ($45/$54 x $6)....................................     $5.00
 
  Taxes paid by B Corporation deemed paid by A
   Corporation in accordance with Sec. Sec. 1.960-
   2(c) and 1.960-2(d)(1)(i) and (ii):
 

   [GRAPHIC] [TIFF OMITTED] TC09OC91.023
   

  ($31.50/$40.50 x $30.00)..........................     23.33
 

    Taxes (of C Corporation) deemed paid by B Corporation deemed paid by 
A Corporation in accordance with Sec. Sec. 1.960-2(c) and 1.960-
2(d)(1)(i) and (ii):

[[Page 453]]

[GRAPHIC] [TIFF OMITTED] TC09OC91.024


  ($4.50/$13.50 x $1.07)............................       .36
                                                     -----------
    Total taxes deemed paid by N Corporation under section        $28.69
     902(a)...................................................
                                                               ---------
 
    Total foreign income taxes deemed paid by N         $61.19
     Corporation under section 901..................
                                                     ===========
 

    Example 9. Domestic corporation N owns all the one class of stock of 
controlled foreign corporation A, which owns all the one class of stock 
of controlled foreign corporation B, which owns all the one class of 
stock of controlled foreign corporation C. A and B Corporations are 
organized under the laws of foreign country X. C Corporation is 
organized under the laws of foreign country Y. All of B Corporation's 
assets used in a trade or business are located in country X. All such 
corporations use the calendar year as the taxable year. For 1978, N 
Corporation is required to include in its gross income under section 
951, $50 attributable to the earnings and profits of C Corporation and 
$100 attributable to the earnings and profits of B Corporation. N 
Corporation is not required to include any amount in its gross income 
under section 951 with respect to A Corporation. Country X imposes an 
income tax of 10 percent on dividends from foreign subsidiaries, 20 
percent on dividends from domestic subsidiaries, and 40 percent on other 
earnings and profits. For 1978, C Corporation distributes $75 to B 
Corporation. For such year, B Corporation distributes $175 of its 
earnings and profits to A Corporation. A Corporation has no other 
earnings and profits for 1978 and distributes $130 of its earnings and 
profits to N Corporation. The foreign income taxes deemed paid by N 
Corporation under sections 960(a)(1) and 902(a) are determined as 
follows on the basis of the facts assumed:
    C Corporation (third-tier corporation):

Pretax earnings and profits...................................   $150.00
Foreign income taxes paid by C Corporation (30%)..............     45.00
Earnings and profits..........................................    105.00
Amount required to be included in gross income of N                50.00
 Corporation under section 951 with respect to C Corporation..
Dividend to B Corporation.....................................     75.00
  Dividend to which section 902(b)(2) does not apply    $50.00
   (attributable to amounts included in N
   Corporation's gross income under section 951 with
   respect to C Corporation)........................
  Dividend to which section 902(b)(2) applies            25.00
   (attributable to amounts not included in N
   Corporation's gross income under section 951 with
   respect to C Corporation)........................
 
Amount of foreign income taxes of C Corporation deemed paid by     10.71
 B Corporation under section 902(b)(2) and Sec. 1.960-2(b)
 ($25/$105 x $45).............................................
  (For formula see Sec. 1.960-2(g)(1)(i)(A))
 

    B Corporation (second-tier corporation):

Pretax earnings and profits:
  Dividend from C Corporation.......................    $75.00
  Other earnings and profits........................    225.00
                                                     -----------
 
    Total pretax earnings and profits.........................   $300.00
 
Foreign income taxes paid by B Corporation....................     97.50
  On dividends received from C Corporation to which      $5.00
   section 902(b)(2) does not apply (attributable to
   amounts included in N Corporation's gross income
   under section 951 with respect to C Corporation)
   ($50 x .10)......................................
  On dividend from C Corporation to which section         2.50
   902(b)(2) applies (attributable to amounts not
   included in N Corporation's gross income under
   section 951 with respect to C Corporation) ($25 x
   .10).............................................
  On other income of B Corporation ($225 x .40).....     90.00
 
Earnings and profits..........................................    202.50
  Attributable to dividend to which section              45.00
   902(b)(2) does not apply (attributable to amounts
   included in N Corporation's gross income under
   section 951 with respect to C Corporation) ($50-
   $5)..............................................
  Attributable to dividend from C Corporation to        $22.50
   which section 902(b)(2) applies (attributable to
   amounts not included in N Corporation's gross
   income under section 951 with respect to C
   Corporation) ($25-$2.50).........................
  Attributable to other income of B Corporation         135.00
   ($225-$90).......................................
 

[[Page 454]]

 
Earnings and profits after exclusion of amounts attributable     $157.50
 to dividend to which section 902(b)(2) does not apply
 (attributable to amounts included in N Corporation's gross
 income under section 951 with respect to C Corporation)
 ($202.50-$45)................................................
Amount required to be included in N Corporation's gross income    100.00
 under section 951 with respect to B Corporation..............
Dividend paid by B Corporation................................    175.00
  Dividend to which section 902(b)(2) does not apply    $45.00
   (attributable to amounts included in N
   Corporation's gross income under section 951 with
   respect to C Corporation)........................
  Dividend to which section 902(b)(1) does not apply    100.00
   (attributable to amounts included in N
   Corporation's gross income under section 951 with
   respect to B Corporation)........................
  Dividend from other earnings and profits               30.00
   (attributable to amounts not included in N
   Corporation's gross income with respect to B or C
   Corporation).....................................
 
Foreign income taxes of B Corporation deemed paid by A
 Corporation under section 902(b)(1) (separate tax rate
 applicable to dividend received by B Corporation allocation
 in accordance with Sec. 1.960-2(e)) (for formula see Sec.
 1.960-2(g)(1)(ii)(A)(2) (i) and (ii)):
 


    Tax paid by B Corporation on earnings previously taxed with respect 
to C Corporation or lower-tiers which is deemed paid by A Corporation:
[GRAPHIC] [TIFF OMITTED] TC09OC91.025


  ($45/$45 x $5)..............................................     $5.00
 

    Tax paid by B Corporation on earnings not previously taxed with 
respect to C Corporation or lower-tiers which is deemed paid by A 
Corporation:
[GRAPHIC] [TIFF OMITTED] TC09OC91.026


  ($30/157.50 x $92.50).......................................    $17.62
 
Foreign income taxes (of C Corporation) deemed paid by B            2.04
 Corporation deemed paid by A Corporation under section
 902(b)(1) ($30/$157.50 x $10.71).............................
  (For formula see Sec. 1.960-2(g)(1)(ii)(B)(1))
 

    A Corporation (first-tier corporation):

Pretax earnings and profits:
  Dividend from B Corporation.......................   $175.00
  Other income......................................         0
                                                     -----------
 
    Total pretax earnings and profits.........................   $175.00
 
Foreign income taxes paid by A Corporation (20%)..............     35.00
Earnings and profits..........................................    140.00
  Attributable to dividend to which section             $36.00
   902(b)(2) does not apply (attributable to amounts
   included in N Corporation's gross income under
   section 951 with respect to C Corporation) ($45-
   ($45 x .20)).....................................

[[Page 455]]

 
  Attributable to amounts to which section 902(b)(1)     80.00
   does not apply (Attributable to amounts included
   in N Corporation's gross income under section 951
   with respect to B Corporation) ($100-($100 x
   .20))............................................
  Attributable to other earnings and profits             24.00
   (attributable to amounts not included in N
   Corporation's gross income with respect to B or C
   Corporation).....................................
 
Earnings and profits after exclusion for amounts to which         $60.00
 section 902(b)(1) does not apply (attributable to amounts
 included in N Corporation's gross income under section 951
 with respect to B Corporation) ($140-$80)....................
Earnings and profits after exclusion for amounts to which          24.00
 sections 902(b)(1) and 902(b)(2) do not apply (attributable
 to amounts included in N Corporation's gross income under
 section 951 with respect to B or C Corporation) ($60-$36)....
Amount required to be included in N Corporation's gross income      None
 under section 1951 with respect to A Corporation.............
Dividend to N Corporation.....................................   $130.00
  Dividend to which section 902(b)(2) does not apply    $36.00
   (attributable to amounts included in N
   Corporation's gross income under section 951 with
   respect to C Corporation)........................
  Dividend to which section 902(b)(1) does not apply     80.00
   (attributable to amounts included in N
   Corporation's gross income under section 951 with
   respect to B Corporation)........................
  Dividend to which section 902(a) does not apply            0
   (attributable to amounts included in N
   Corporation's gross income under section 951 with
   respect to A Corporation)........................
  Dividend from other earnings and profits               14.00
   (attributable to amounts not included in N
   Corporation's gross income with respect to A, B,
   or C Corporation)................................
 

    N Corporation (domestic corporation):

Foreign income taxes deemed paid by N Corporation under           $21.43
 section 960(a)(1) and Sec. 1.960-1(c) with respect to C
 Corporation ($50/$105 x $45).................................
  (for formula see Sec. 1.960-2(g)(2)(i)(A))
Foreign income taxes deemed paid by N Corporation under            65.53
 section 960(a)(1) with respect to B Corporation (allocation
 of earnings and profits being made in accordance with Sec.
 1.960-1(c)(3) and Sec. 1.960-2(e)) (Separate tax rate
 applicable to dividend received by B Corporation)............
 

    Taxes paid by B corporation (for formula see Sec. 1.960-2(g)(2)(ii) 
(A)(2)):
[GRAPHIC] [TIFF OMITTED] TC09OC91.027


  ($100/$157.50 x $92.50)...........................    $58.73
  Taxes (of C Corporation) deemed paid by B               6.80
   Corporation under section 902(b)(2) which are
   deemed paid by N Corporation under section
   960(a)(1) ($100/$157.50 x $10.71)................
  (for formula see Sec. 1.960-2(g)(2)(ii)(B)(1))
                                                     -----------
    Total taxes deemed paid by N Corporation under section        $86.96
     960(a)(1)................................................
 
Foreign income taxes deemed paid by N Corporation under
 section 902(a):
  Taxes paid by A Corporation ($130/$140 x $35).....    $32.50
  (for formula see Sec. 1.960-2(g)(1)(iii)(A)(1))
  Taxes paid by B Corporation deemed paid by A Corporation
   (Separate tax rate applicable to dividend received by B
   Corporation allocation required by Sec. 1.960-2(e)) (for
   formula see Sec. 1.960-2(g)(1)(iii)(B)(2) (i) and (ii)):
 
  Tax paid by B Corporation on earnings previously
   taxed with respect to C Corporation or lower
   tiers which is deemed paid by N Corporation:
 


[[Page 456]]

[GRAPHIC] [TIFF OMITTED] TC09OC91.028


  ($36/$36 x $5)....................................     $5.00
 
  Tax paid by B Corporation on earnings not
   previously taxed with respect to C Corporation or
   lower tiers which is deemed paid by N
   Corporation:
 

   [GRAPHIC] [TIFF OMITTED] TC09OC91.029
   

  ($14/$24 x $17.62)................................    $10.28
  Taxes (of C Corporation) deemed paid by B               1.19
   Corporation deemed paid by A Corporation ($14/$24
   x $2.04).........................................
                                                     -----------
 
  (for formula see Sec. 1.960-2(g)(1)(iii)(C)(1))
    Total taxes deemed paid by N Corporation under section        $48.97
     902(a)...................................................
                                                     -----------
 
    Total foreign income taxes deemed paid by N Corporation       135.93
     under section 901........................................
                                                     ===========
 

    Example 10. The facts are the same as in example 9 except that A 
Corporation has other earnings and profits of $200 in 1978 and country X 
imposes a tax of 50 percent on A Corporation's other earnings and 
profits. A Corporation distributes $200 of its earnings and profits to N 
Corporation in 1978. The foreign income taxes paid by N Corporation 
under sections 960 (a)(1) and 902 (a) are determined as follows on the 
basis of the facts assumed:
    C Corporation (third-tier corporation):

Pretax earnings and profits...................................   $150.00
Foreign income taxes paid by C Corporation (30%)..............     45.00
Earnings and profits..........................................    105.00
Amount required to be included in gross income of N               $50.00
 Corporation under section 951 with respect to C Corporation..
Dividend to B Corporation.....................................     75.00
  Dividend to which section 902(b)(2) does not apply     50.00
   (attributable to amounts included in N
   Corporation's gross income under section 951 with
   respect to C Corporation)........................
  Dividend to which section 902(b)(2) applies            25.00
   (attributable to amounts not included in N
   Corporation's gross income under section 951 with
   respect to C Corporation)........................
Amount of foreign income taxes of C Corporation deemed paid by     10.71
 B Corporation under section 902(b)(2) and Sec. 1.960-2(b)
 ($25/$105 x $45).............................................
  (for formula see Sec. 1.960-2(g)(1)(i)(A))
 

    B Corporation (second-tier corporation):

Pretax earnings and profits:
  Dividend from C Corporation.......................    $75.00
  Other earnings and profits........................    225.00
                                                     -----------
 
    Total pretax earnings and profits.........................   $300.00
 
Foreign income taxes of B Corporation.........................    $97.50
  On dividends received from C Corporation to which      $5.00
   section 902(b)(2) does not apply (attributable to
   amounts included in N Corporation's gross income
   under section 951 with respect to C Corporation)
   ($50 x .10)......................................
  On dividend from C Corporation to which section         2.50
   902(b)(2) applies (attributable to amounts not
   included in N Corporation's gross income under
   section 951 with respect to C Corporation) ($25 x
   .10).............................................

[[Page 457]]

 
  On other income of B Corporation ($225 x .40).....     90.00
 
Earnings and profits..........................................   $202.50
  Attributable to dividend to which section             $45.00
   902(b)(2) does not apply (attributable to amounts
   included in N Corporation's gross income under
   section 951 with respect to C Corporation) ($50-
   $5)..............................................
  Attributable to dividend from C Corporation to         22.50
   which section 902(b)(2) applies (attributable to
   amounts not included in N Corporation's gross
   income under section 951 with respect to C
   Corporation) ($25-$2.50).........................
  Attributable to other income of B Corporation         135.00
   ($225-$90).......................................
Earnings and profits after exclusion of amounts attributable      157.50
 to dividend to which section 902(b)(2) does not apply
 (attributable to amounts included in N Corporation's gross
 income under section 951 with respect to C Corporation)
 ($202.50-$45)................................................
Amount required to be included in N Corporation's gross income    100.00
 under section 951 with respect to B Corporation..............
Dividend paid by B Corporation................................    175.00
  Dividend to which section 902(b)(2) does not apply    $45.00
   (attributable to amounts included in N
   Corporation's gross income under section 951 with
   respect to C Corporation)........................
  Dividend to which section 902(b)(1) does not apply    100.00
   (attributable to amounts included in N
   Corporation's gross income under section 951 with
   respect to B Corporation)........................
  Dividend from other earnings and profits               30.00
   (attributable to amounts not included in N
   Corporation's gross income with respect to B or C
   Corporation).....................................
Foreign income taxes of B Corporation deemed paid by A
 Corporation under section 902(b)(1) with allocation required
 by Sec. 1.960-2 (e):
  ($45/$45 x $5)..............................................      5.00
  ($30/$157.50 x $92.50)......................................     17.62
  (for formula see Sec. 1.960-2(g)(1)(ii)(A)(2) (i) and
   (ii))
Foreign income taxes (of C Corporation) deemed paid by B            2.04
 Corporation deemed paid by A Corporation under section
 902(b)(1): ($30/$157.50 x $10.71)
  (for formula see Sec. 1.960-2(g)(1)(ii)(B)(1))
 

    A Corporation (first-tier corporation):

Pretax earnings and profits:
  Dividend from B Corporation.......................   $175.00
  Other earnings and profits........................    200.00
                                                     -----------
 
    Total pretax earnings and profits.........................   $375.00
Foreign income taxes paid by A Corporation....................    135.00
  On dividend received from B Corporation to which        9.00
   section 902(b)(2) does not apply (attributable to
   amounts included in N Corporation's gross income
   under section 951 with respect to C Corporation)
   ($45 x .20)......................................
  On dividend received from B Corporation to which       20.00
   section 902(b)(1) does not apply (attributable to
   amounts included in N Corporation's gross income
   under section 951 with respect to B Corporation)
   ($100 x .20).....................................
  On dividend from B Corporation attributable to B        6.00
   Corporation's other earnings and profits
   (attributable to amounts not included in N
   Corporation's gross income with respect to B or C
   Corporation) ($30 x .20).........................
  On other income of A Corporation ($200 x .50).....    100.00
Earnings and profits..........................................    240.00
  Attributable to dividend to which section              36.00
   902(b)(2) does not apply (attributable to amounts
   included in N Corporation's gross income under
   section 951 with respect to C Corporation) ($45-
   $9)..............................................
  Attributable to dividend to which section              80.00
   902(b)(1) does not apply (attributable to amounts
   included in N Corporation's gross income with
   respect to B Corporation) ($100-$20).............
  Attributable to other earnings and profits of A       124.00
   Corporation (attributable to amounts not included
   in N Corporation's gross income with respect to
   A, B, or C Corporation) [($30-$6) + ($200-$100)].
Amount required to be included in N Corporation's gross income      None
 under section 951 with respect to A Corporation..............
Earnings and profits after exclusion of amounts attributable      160.00
 to dividend to which section 902(b)(1) does not apply
 (attributable to amounts included in N Corporation's gross
 income under section 951 with respect to B Corporation)......
Earnings and profits after exclusion of amounts attributable      124.00
 to dividend to which sections 902(b)(1) and 902(b)(2) do not
 apply (attributable to amounts included in N Corporation's
 gross income under section 951 with respect to B and C
 Corporation).................................................
Dividend to N Corporation.....................................    200.00
  Dividend attributable to amounts to which section     $36.00
   902(b)(2) does not apply (attributable to amounts
   included in N Corporation's gross income under
   section 951 with respect to C Corporation).......
  Dividend attributable to amounts to which section      80.00
   902(b)(1) does not apply (attributable to amounts
   included in N Corporation's gross income with
   respect to B Corporation)........................
  Dividend attributable to amounts to which section          0
   902(a) does not apply (attributable to amounts
   included in N Corporation's gross income under
   section 951 with respect to A Corporation).......
  Dividend attributable to A Corporation's other        $84.00
   earnings and profits (attributable to amounts not
   included in N Corporation's gross income under
   section 951 with respect to A, B, or C
   Corporation).....................................
 


[[Page 458]]

    N Corporation (domestic corporation).

Foreign income taxes deemed paid by N Corporation under           $21.43
 section 960(a)(1) and Sec. 1.960-1(c) with respect to C
 Corporation ($50/$150 x $45).................................
  (for formula see Sec. 1.960-2(g)(2)(i)(A))
Foreign income taxes deemed paid by N Corporation under            65.53
 section 960(a)(1) with respect to B Corporation (allocation
 of earning and profits being made in accordance with Sec.
 1.960-1(c)(3) and Sec. 1.960-2(e)).........................
  Taxes paid by B Corporation ($100/$157.50 x           $58.73
   $92.50)..........................................
  (for formula see Sec. 1.960-2(g)(2)(ii)(A)(2))
  Taxes deemed paid by B Corporation ($100 x $157.50      6.80
   x $10.71)........................................
  (for formula see Sec. 1.960-2(g)(2)(ii)(B)(1))
                                                     ----------
    Total taxes deemed paid by N Corporation under section         86.96
     960(a)(1)................................................
 
Foreign income taxes deemed paid by N Corporation under
 section 902(a) (separate tax rate applicable to dividends
 received by A Corporation allocation required by Sec. 1.960-
 2(e)) (for formula see Sec. 1.960-2(g)(1)(iii)(A)(2) (i)
 and (ii)):
 

    Tax paid by A Corporation on earnings previously taxed with respect 
to B Corporation or lower tiers which is deemed paid by N Corporation:
[GRAPHIC] [TIFF OMITTED] TC09OC91.030


  ($116/$116 x $29).................................    $29.00
 
  Tax paid by A Corporation on earnings not
   previously taxed with respect to B Corporation or
   lower tiers which is deemed paid by N
   Corporation:
 

   [GRAPHIC] [TIFF OMITTED] TC09OC91.031
   

  ($84/$124 x $106).................................    $71.81
 
  Taxes (paid by B Corporation) deemed paid by A
   Corporation allocation required by Sec. 1.960-
   2(e):
  ($36/$36 x $5)....................................      5.00
  ($84/$124 x $17.62)...............................     11.94
  (for formula see Sec. 1.960-2(g)(1)(iii)(B)(2)
   (i) and (ii))
 
  Taxes (of C Corporation) deemed paid by B               1.38
   Corporation deemed paid by A Corporation ($84/
   $124 x $2.04)....................................
                                                     -----------
 
  (for formula see Sec. 1.960-2(g)(1)(iii)(C)(1))
 
    Total taxes deemed paid by N Corporation under section       $119.13
     902(a) credit............................................
                                                     -----------
 
    Total foreign income taxes deemed paid by N Corporation       206.09
     under section 901........................................
                                                     ===========
 

    (g) Formulas. This paragraph contains formulas for determining a 
domestic corporation's section 902 and 960 credits when amounts 
distributed through a chain of ownership have been included in whole or 
in part in the gross income of a domestic corporation

[[Page 459]]

under section 951 with respect to first-, second-, third-, or lower-tier 
corporations.
    (1) Determination of the section 902 credit--(i) Section 902(b)(2) 
credit. If the second-tier corporation receives a dividend from a third-
tier corporation attributable in whole or in part to amounts included in 
a domestic corporation's gross income under section 951 with respect to 
the third- or lower-tier corporations, the second-tier corporation's 
credit for taxes paid by the third-tier corporation under section 
902(b)(2) is determined as follows:
    (A) If the effective rate of tax on dividends received by the third-
tier corporation is the same as the effective rate of tax on its other 
earnings and profits--
[GRAPHIC] [TIFF OMITTED] TC09OC91.032

    (B) If the effective rate of tax on dividends received by the third-
tier corporation is higher or lower than the effective rate of tax on 
its other earnings and profits--
    (1) Credit for tax paid by third-tier corporation on earnings 
included in domestic corporation's gross income with respect to fourth- 
or lower-tier corporations--
[GRAPHIC] [TIFF OMITTED] TC09OC91.033

    (2) Credit for tax paid by third-tier corporation on earnings not 
included in domestic corporation's gross income with respect to fourth- 
or lower-tier corporations--
[GRAPHIC] [TIFF OMITTED] TC09OC91.034


[[Page 460]]


    (ii) Section 902(b)(1) credit. If the first-tier corporation 
receives a dividend from a second-tier corporation attributable in a 
whole or in part to amounts included in a domestic corporation's gross 
income under section 951 with respect to the second- or lower-tier 
corporations, the first-tier corporation's credit for taxes paid and 
deemed paid by the second-tier corporation under section 902(b)(1) is 
determined as follows:
    (A) Taxes paid by the second-tier corporation which are deemed paid 
by the first-tier corporation--(1) If the effective rate of tax on 
dividends received by the second-tier corporation is the same as the 
effective rate of tax on its other earnings and profits--
[GRAPHIC] [TIFF OMITTED] TC09OC91.035

    (2) If the effective rate of tax on dividends received by the 
second-tier corporation is higher or lower than the effective rate of 
tax on its other earnings and profits--
    (i) Credit for tax paid by second-tier corporation on earnings 
previously taxed with respect to third- or lower-tier corporations--
[GRAPHIC] [TIFF OMITTED] TC09OC91.036

    (ii) Credit for tax paid by second-tier corporation on earnings not 
previously taxed with respect to third- or lower-tier corporations--
[GRAPHIC] [TIFF OMITTED] TC09OC91.037


[[Page 461]]


    (B) Taxes deemed paid by the second-tier corporation which are 
deemed paid by the first-tier corporation--(1) If the effective rate of 
tax dividends received by the third-tier corporation is the same as the 
effective rate of tax on its other earnings and profits--
[GRAPHIC] [TIFF OMITTED] TC09OC91.038

    (2) If the effective rate of tax on dividends received by the third-
tier corporation is higher or lower than the effective rate of tax on 
its other earnings and profits--
    (i) Credit for tax paid by third-tier corporation on earnings 
previously taxed with respect to fourth- or lower-tier corporations--
[GRAPHIC] [TIFF OMITTED] TC09OC91.039

    (ii) Credit for tax paid by third-tier corporation on earnings not 
previously taxed with respect to fourth- or lower-tier corporations--
[GRAPHIC] [TIFF OMITTED] TC09OC91.040


[[Page 462]]


    (iii) Section 902(a) credit. If the domestic corporation receives a 
dividend from a first-tier corporation attributable in whole or in part 
to amounts included in a domestic corporation's gross income under 
section 951 with respect to the first- or lower-tier corporations, the 
domestic corporation's credit for taxes paid and deemed paid by the 
first-tier corporation under section 902(a) is determined as follows:
    (A) Taxes paid by the first-tier corporation which are deemed paid 
by domestic corporation--(1) If the effective rate of tax on dividends 
received by the first-tier corporation is the same as the effective rate 
of tax on its other earnings and profits--
[GRAPHIC] [TIFF OMITTED] TC09OC91.041

    (2) If the effective rate of tax on dividends received by the first-
tier corporation is higher or lower than the effective rate of tax on 
its other earnings and profits--
    (i) Credit for tax paid by first-tier corporation on earnings 
previously taxed with respect to second- or lower-tier corporations--
[GRAPHIC] [TIFF OMITTED] TC09OC91.042

    (ii) Credit for tax paid by first-tier corporation on earnings not 
previously taxed with respect to second- or lower-tier corporations--

[[Page 463]]

[GRAPHIC] [TIFF OMITTED] TC09OC91.043

    (B) Taxes (paid by second-tier corporation) deemed paid by first-
tier corporation which are deemed paid by domestic corporation--(1) If 
the effective rate of tax on dividends received by the second-tier 
corporation is the same as its tax rate on other earnings and profits--
[GRAPHIC] [TIFF OMITTED] TC09OC91.044

    (2) If the effective rate of tax on dividends received by the 
second-tier corporation is higher or lower than the effective rate of 
tax on its other earnings and profits--
    (i) Credit for tax paid by second-tier corporation on earnings 
previously taxed with respect to third-tier or lower-tier corporations--
[GRAPHIC] [TIFF OMITTED] TC09OC91.045

    (ii) Credit for tax paid by second-tier corporation on earnings not 
previously taxed with respect to third- or lower-tier corporations--

[[Page 464]]

[GRAPHIC] [TIFF OMITTED] TC09OC91.046

    (C) Taxes (of third-tier corporation) deemed paid by first-tier 
corporation which are deemed paid by domestic corporation--(1) If the 
effective rate of tax on dividends received by the third-tier 
corporation is the same as the effective rate of tax on its other 
earnings and profits--
[GRAPHIC] [TIFF OMITTED] TC09OC91.047

    (2) If the effective rate of tax on dividends received by the third-
tier corporation is higher or lower than the effective rate of tax on 
its other earnings and profits--
    (i) Credit for tax (of third-tier corporation) deemed paid by 
second-tier corporation on earnings previously taxed with respect to 
fourth- or lower-tier corporations--
[GRAPHIC] [TIFF OMITTED] TC09OC91.048


[[Page 465]]


    (ii) Credit for tax (of third-tier corporation) deemed paid by 
second-tier on earnings not previously taxed with respect to fourth- or 
lower-tier corporations--
[GRAPHIC] [TIFF OMITTED] TC09OC91.049

    (2) Determination of domestic corporation's section 960 credit for 
amounts included in its gross income with respect to a first-, second-, 
or third-tier corporation which has received a distribution previously 
included in the gross income of a domestic corporation under section 
951--(i) Third-tier credit. If a domestic corporation is required to 
include an amount in its gross income under section 951 with respect to 
a third-tier corporation which has received a distribution from a 
fourth-tier corporation of amounts included in a domestic corporation's 
gross income under section 951 with respect to the fourth- or lower-tier 
corporations, the domestic corporation's credit for taxes paid by the 
third-tier corporation under section 960(a)(1) is determined as follows:
    (A) If the effective rate of tax on dividends received by the third-
tier corporation is the same as the effective rate of tax on its other 
earnings and profits--
[GRAPHIC] [TIFF OMITTED] TC09OC91.050

    (B) If the effective rate of tax on dividends received by the third-
tier corporation is higher or lower than the effective rate of tax on 
its other earnings and profits--
[GRAPHIC] [TIFF OMITTED] TC09OC91.051


[[Page 466]]


    (ii) Second-tier credit. If a domestic corporation is required to 
include an amount in its gross income under section 951 with respect to 
a second-tier corporation which has received a distribution from a 
third-tier corporation of amounts included in a domestic corporation's 
gross income under section 951 with respect to the third- or lower-tier 
corporations, the domestic corporation's credit for taxes paid and 
deemed paid by the second-tier corporation under section 960(a)(1) is 
determined as follows:
    (A) Credit for taxes paid by the second-tier corporation which are 
deemed paid by the domestic corporation.
    (1) If the effective rate of tax on dividends received by the 
second-tier corporation is the same as the effective rate of tax on its 
other earnings and profits--
[GRAPHIC] [TIFF OMITTED] TC09OC91.052

    (2) If the effective rate of tax on dividends received by the 
second-tier is higher or lower than the effective rate of tax on its 
other earnings and profits--
[GRAPHIC] [TIFF OMITTED] TC09OC91.053

    (B) Credit for taxes (of the third-tier corporation) deemed paid by 
the second-tier corporation under section 902(b)(2), (1) If the 
effective rate of tax on dividends received by the third-tier 
corporation is the same as the effective rate of tax on its other 
earnings and profits--
[GRAPHIC] [TIFF OMITTED] TC09OC91.054


[[Page 467]]


    (2) If the effective rate of tax on dividends received by the third-
tier corporation is higher or lower than the effective rate of tax on 
its other earnings and profits--
[GRAPHIC] [TIFF OMITTED] TC09OC91.055

    (iii) First-tier credit. If a domestic corporation is required to 
include amounts in its gross income under section 951 with respect to a 
first-tier corporation which has received a distribution from a second-
tier corporation of amounts included in a domestic corporation's gross 
income under section 951 with respect to the second- or lower-tier 
corporations, the domestic corporation's credit for taxes paid and 
deemed paid by the first-tier corporation under section 960(a)(1) shall 
be determined as follows:
    (A) Credit for taxes paid by the first-tier corporation.
    (1) If the effective rate of tax on dividends received by the first-
tier corporation is the same as the effective rate of tax on its other 
earnings and profits--
[GRAPHIC] [TIFF OMITTED] TC09OC91.056

    (2) If the effective rate of tax on dividends received by the first-
tier corporation is higher or lower than the effective rate of tax on 
its other earnings and profits--
[GRAPHIC] [TIFF OMITTED] TC09OC91.057

    (B) Credit for taxes paid by the second-tier corporation deemed paid 
by the first-tier corporation under section 902(b)(1).
    (1) If the effective rate of tax on dividends received by the 
second-tier corporation is the same as the effective

[[Page 468]]

rate of tax on its other earnings and profits--
[GRAPHIC] [TIFF OMITTED] TC09OC91.058

    (2) If the effective rate of tax on dividends received by the 
second-tier corporation is higher or lower than the effective rate of 
tax on its other earnings and profits--
[GRAPHIC] [TIFF OMITTED] TC09OC91.059

    (C) Credit for taxes (of the third-tier corporation) deemed paid by 
the second-tier corporation which are deemed paid by first-tier 
corporation under section 902(b)(1).
    (1) If the effective rate of tax on dividends received by the third-
tier corporation is the same as the effective rate of tax on its other 
earnings and profits--
[GRAPHIC] [TIFF OMITTED] TC09OC91.060

    (2) If the effective rate of tax on dividends received by the third-
tier corporation is higher or lower than the effective rate of tax on 
its other earnings and profits--

[[Page 469]]

[GRAPHIC] [TIFF OMITTED] TC09OC91.061


[T.D. 7120, 36 FR 10854, June 4, 1971; 36 FR 11924, June 23, 1971, as 
amended by T.D. 7334, 39 FR 44212, Dec. 23, 1974; 40 FR 1014, Jan. 6, 
1975; 40 FR 2802, Jan. 16, 1975; T.D. 7649, 44 FR 60089, Oct. 18, 1979; 
T.D. 7843, 47 FR 50476, Nov. 8, 1982; 47 FR 55477, Dec. 10, 1982]



Sec. 1.960-3  Gross-up of amounts included in income under section 951.

    (a) General rule for including taxes in income. Any taxes deemed 
paid by a domestic corporation for the taxable year pursuant to section 
960(a)(1) shall, except as provided in paragraph (b) of this section, be 
included in the gross income of such corporation for such year as a 
dividend pursuant to section 78 and Sec. 1.78-1.
    (b) Certain taxes not included in income. Any taxes deemed paid by a 
domestic corporation for the taxable year pursuant to section 902(a) or 
section 960(a)(1) shall not be included in the gross income of such 
corporation for such year as a dividend pursuant to section 78 and Sec. 
1.78-1 to the extent that such taxes are paid or accrued by the first-, 
second-, or third-tier corporation, as the case may be, on or with 
respect to an amount which is excluded from the gross income of such 
foreign corporation under section 959(b) and Sec. 1.959-2 as 
distributions from the earnings and profits of another controlled 
foreign corporation attributable to an amount which is, or has been, 
required to be included in the gross income of the domestic corporation 
under section 951.
    (c) Illustrations. The application of this section may be 
illustrated by the following examples:

    Example 1. Domestic corporation N owns all the one class of stock of 
controlled foreign corporation A, which owns all the one class of stock 
of controlled foreign corporation B. All such corporations use the 
calendar year as the taxable year. For 1978, B Corporation, after having 
paid $20 of foreign income taxes, has $80 in earnings and profits, which 
are attributable to the amount required to be included in N 
Corporation's gross income for such year under section 951 with respect 
to B Corporation and all of which are distributed to A Corporation in 
such year. The dividend so received from B Corporation is excluded from 
A Corporation's gross income under section 959(b) and Sec. 1.959-2. An 
income tax of 10 percent is required to be withheld from such dividend 
by the foreign country under the laws of which B Corporation is created, 
and the foreign country under the laws of which A Corporation is created 
imposes an income tax of $22 on the dividend received from B 
Corporation. For 1978, A Corporation's earnings and profits are $50 
($80-[0.10 x $80]-$22), which it distributes in such year to N 
Corporation. For 1978, N Corporation is required under section 951 to 
include $80 in gross income with respect to B Corporation and also is 
required under the gross-up provisions of section 78 to include in gross 
income $20 ($80/$80 x $20), the amount equal to the foreign income taxes 
of B Corporation which are deemed paid by N Corporation under section 
960(a)(1). Under paragraph (b) of this section N Corporation is not 
required to include in gross income the $30 ($8 + $22) of foreign income 
taxes which are paid by A Corporation in connection with the dividend 
received from B Corporation and which are deemed paid by N Corporation 
under section 902(a) and paragraph (c) of Sec. 1.960-2.
    Example 2. Domestic corporation N owns all the one class of stock of 
controlled foreign corporation A, which owns all the one class of stock 
of controlled foreign corporation B, which in turn owns all the one 
class of stock of controlled foreign corporation C. All such 
corporations use the calendar year as the taxable year. For 1978, C 
Corporation, after having paid $20 of foreign income taxes, has $80 in 
earnings and profits, which are attributable to the amount required to 
be included in N Corporation's gross income for such year under section 
951 with respect to C Corporation and all of which are distributed to B 
Corporation in such year. After having

[[Page 470]]

paid foreign income taxes of $10 on the dividend received from C 
Corporation, B Corporation distributes the balance of $70 to A 
Corporation. After having paid foreign income taxes of $5 on the 
dividend received from B Corporation, A Corporation distributes the 
balance of $65 to N Corporation. The dividend so received by B 
Corporation, and in turn by A Corporation, is excluded from the gross 
income of such corporations under section 959(b) and Sec. 1.959-2. 
Under paragraph (b) of this section N Corporation is not required to 
include in gross income the $15 ($10 + $5) of foreign income taxes which 
are paid by corporations B and A, respectively, in connection with the 
dividend so received and which are deemed paid by N Corporation under 
section 902(a) and paragraphs (b) and (c) of Sec. 1.960-2.

[T.D. 7120, 36 FR 10856, June 4, 1971, as amended by T.D. 7481, 42 FR 
20130, Apr. 18, 1977; T.D. 7649, 44 FR 60089, Oct. 18, 1979; T.D. 7843, 
47 FR 50484, Nov. 8, 1982]



Sec. 1.960-4  Additional foreign tax credit in year of receipt of 
previously taxed earnings and profits.

    (a) Increase in section 904(a) limitation for the taxable year of 
exclusion--(1) In general. The applicable limitation under section 
904(a) for a taxpayer's taxable year (hereinafter in this section 
referred to as the ``taxable year of exclusion'') in which he receives 
an amount which is excluded from gross income under section 959(a)(1) 
and which is attributable to a controlled foreign corporation's earnings 
and profits in respect of which an amount was required to be included in 
the gross income of such taxpayer under section 951(a) for a taxable 
year (hereinafter in this section referred to as the ``taxable year of 
inclusion'') previous to the taxable year of exclusion shall be 
increased under section 960(b)(1) by the amount described in paragraph 
(b) of this section if the conditions described in subparagraph (2) of 
this paragraph are satisfied.
    (2) Conditions under which increase in limitation is allowed for the 
taxable year of exclusion. The increase in limitation described in 
subparagraph (1) of this paragraph for the taxable year of exclusion 
shall be made only if the taxpayer--
    (i) For the taxable year of inclusion either chose to claim a 
foreign tax credit as provided in section 901 or did not pay or accrue 
any foreign income taxes,
    (ii) Chooses to claim a foreign tax credit as provided in section 
901 for the taxable year of exclusion, and
    (iii) For the taxable year of exclusion pays, accrues, or is deemed 
to have paid foreign income taxes with respect to the amount, described 
in subparagraph (1) of this paragraph, which is excluded from his gross 
income for such year under section 959(a)(1).
    (b) Amount of increase in limitation for the taxable year of 
exclusion. The amount of increase under section 960 (b)(1) in the 
applicable limitation under section 904(a) for the taxable year of 
exclusion shall be--
    (1) The amount by which the applicable section 904(a) limitation for 
the taxable year of inclusion was increased, determined as provided in 
paragraph (c) of this section, by reason of the inclusion of the amount 
in the taxpayer's income for such year under section 951(a), reduced by
    (2) The amount of foreign income taxes allowed as a credit under 
section 901 for such taxable year of inclusion and which were allowable 
to such taxpayer solely by reason of the inclusion of such amount in his 
gross income under section 951(a), as determined under paragraph (d) of 
this section, and then by
    (3) The additional reduction for such taxable year of inclusion 
arising by reason of increases in limitation under section 960(b)(1) for 
taxable years intervening between such taxable year of inclusion and 
such taxable year of exclusion, as determined under paragraph (e) of 
this section in respect of such inclusion under section 951(a),


except that the amount of increase determined under this paragraph for 
the taxable year of exclusion shall in no case exceed the amount of 
foreign income taxes paid, accrued, or deemed to be paid by such 
taxpayer for such taxable year of exclusion with respect to the amount, 
described in paragraph (a)(1) of this section, which is excluded from 
gross income for such year under section 959(a)(1).
    (c) Determination of increase in limitation for the taxable year of 
inclusion. The amount of the increase in the applicable limitation under 
section 904(a) for

[[Page 471]]

the taxable year of inclusion which arises by reason of the inclusion of 
the amount in gross income under section 951(a) shall be the amount of 
the applicable limitation under section 904(a) for such year reduced by 
the amount which would have been the applicable limitation under section 
904(a) for such year if the amount had not been included in gross income 
for such year under section 951(a).
    (d) Determination of foreign income taxes allowed for taxable year 
of inclusion by reason of section 951(a) amount. The amount of foreign 
income taxes allowed as a credit under section 901 for the taxable year 
of inclusion which were allowable solely by reason of the inclusion of 
the amount in gross income for such year under section 951(a) shall be 
the amount of foreign income taxes allowed as a credit under section 901 
for such year reduced by the amount of foreign income taxes which would 
have been allowed as a credit under section 901 for such year if the 
amount had not been included in gross income for such year under section 
951(a). For purposes of this paragraph, the term ``foreign income 
taxes'' includes foreign income taxes paid or accrued, and foreign 
income taxes deemed paid under section 902, section 904(d), and section 
960(a), for the taxable year of inclusion.
    (e) Additional reduction for the taxable year of inclusion arising 
by reason of increases in limitation for intervening years. The amount 
of increase in the applicable limitation under section 904(a) for the 
taxable year of inclusion shall also be reduced, after first deducting 
the foreign income taxes described in paragraph (b)(2) of this section, 
by any increases in limitation which arise under section 960(b)(1)--by 
reason of any earlier exclusions under section 959(a)(1) in respect of 
the same inclusion under section 951(a) for such taxable year of 
inclusion--for the first, second, third, fourth, etc., succeeding 
taxable years of exclusion, in that order, which follow such taxable 
year of inclusion and precede the taxable year of exclusion in respect 
of which the increase in limitation under section 960(b)(1) and 
paragraph (b) of this section is being determined. The amount of any 
increase in limitation which arises under section 960(b)(1) for any such 
succeeding taxable year of exclusion shall be the amount of foreign 
income taxes allowed as a credit under section 901 for each such taxable 
year reduced by the amount of foreign income taxes which would have been 
allowed as a credit under section 901 for each such year if the 
limitation for each such year were not increased under section 
960(b)(1). For any such succeeding taxable year of exclusion for which 
the taxpayer does not choose to claim a foreign tax credit as provided 
in section 901, the same increase in limitation under section 960(b)(1) 
shall be treated as having been made, for purposes of this paragraph, 
which would have been made for such taxable year if the taxpayer had 
chosen to claim the foreign tax credit for such year.
    (f) Illustrations. The application of this section may be 
illustrated by the following examples:

    Example 1. Domestic corporation N owns all of the one class of stock 
of controlled foreign corporation A. Corporation A, after paying foreign 
income taxes of $30, has earnings and profits for 1978 of $70, all of 
which are attributable to an amount required under section 951(a) to be 
included in N Corporation's gross income for 1978. Both corporations use 
the calendar year as the taxable year. For 1979 and 1980, A Corporation 
has no earnings and profits attributable to an amount required to be 
included in N Corporation's gross income under section 951(a); for each 
such year it makes a distribution of $35 (from its earnings and profits 
for 1978) from which a foreign income tax of $6 is withheld. For each of 
1978, 1979, and 1980, N Corporation derives taxable income of $50 from 
sources within the United States and claims a foreign tax credit under 
section 901, determined by applying the overall limitation under section 
904(a)(2).

The United States tax payable by N Corporation is determined as follows, 
assuming a corporate tax rate of 48 percent:

                                  1978
Taxable income of N Corporation:
  U.S. sources...............................................     $50.00
  Sources without the U.S.:
    Amount required to be included in N                $70.00
     Corporation's gross income under section
     951(a).......................................

[[Page 472]]

 
    Foreign income taxes deemed paid by N               30.00     100.00
     Corporation under section 960(a)(1) and
     included in N Corporation's gross income
     under section 78 ($30 x $70/$70).............
                                                   ---------------------
    Total taxable income..........................  .........     150.00
                                                              ==========
U.S. tax payable for 1978:
  U.S. tax before credit ($150 x 0.48).......................      72.00
  Credit: Foreign income taxes of $30, but not to exceed           30.00
   overall limitation of $48 for 1978 ($100/$150 x $72)......
                                                   ------------
  U.S. tax payable...........................................      42.00
                                                   ============
 


                                  1979
Taxable income of N Corporation, consisting of income from        $50.00
 U.S. sources................................................
U.S. tax before credit ($50 x 0.48)..........................      24.00
Section 904(a)(2) overall limitation for 1979:
  Limitation for 1979 before increase under section 960(b)(1)          0
   ($24 x $0/$50)............................................
  Plus: Increase in overall limitation for 1979
   under section 960(b)(1):
    Amount by which 1978 overall limitation was        $48.00
     increased by reason of inclusion in N
     Corporation's gross income under section
     951(a) for 1978 ($48-[($50 x 0.48) x $0/$50])
    Less: Foreign income taxes allowed as a credit      30.00
     for 1978 which were allowable solely by
     reason of such section 951(a) inclusion ($30-
     $0)..........................................
                                                   -----------
    Balance.......................................      18.00
    But: Such balance not to exceed foreign income       6.00       6.00
     taxes paid by N Corporation for 1979 with
     respect to $35 distribution excluded under
     section 959(a)(1) ($6 tax withheld)..........
                                                   ---------------------
  Overall limitation for 1979................................       6.00
                                                   ============
U.S. tax payable for 1979:
  U.S. tax before credit ($50 x 0.48)........................      24.00
  Credit: Foreign income taxes of $6, but not to exceed             6.00
   overall limitation of $6 for 1966.........................
                                                   ------------
  U.S. tax payable...........................................      18.00
                                                   ============
 


                                  1980
Taxable income of N Corporation, consisting of income from U.S.   $50.00
 sources.......................................................
U.S. tax before credit ($50 x 0.48)............................    24.00
                                                       ==========
Section 904(a)(2) overall limitation for 1980:
  Limitation for 1980 before increase under section 960(b)(1)          0
   ($24 x $0/$50)..............................................
  Plus: Increase in overall limitation for 1980 under
   section 960(b)(1):
    Amount by which 1978 overall limitation was          $48.00
     increased by reason of inclusion in N
     Corporation's gross income under section 951(a)
     for 1978 ($48-[($50 x 0.48) x $0/$50])...........
    Less: Foreign income taxes allowed as a credit for    30.00
     1978 which were allowable solely by reason of
     such section 951(a) inclusion ($30-$0)...........
                                                       ---------
    Tentative balance.................................    18.00
    Less: Increase in overall limitation under section    $6.00
     960(b)(1) for 1979 by reason of such section
     951(a) inclusion.................................
                                                       ---------
    Balance...........................................    12.00
  But: Such balance not to exceed foreign income taxes     6.00    $6.00
   paid by N Corporation for 1980 with respect to $35
   distribution excluded under section 959(a)(1) ($6
   tax withheld)......................................
                                                       -----------------
  Overall limitation for 1980..................................     6.00
                                                       ==========
U.S. tax payable for 1980:
  U.S. tax before credit ($50 x 0.48)..........................    24.00
  Credit: Foreign income taxes of $6, but not to exceed overall     6.00
   limitation of $6 for 1967...................................
                                                       ----------
  U.S. tax payable.............................................    18.00
 

    Example 2. The facts for 1978, 1979, and 1980, are the same as in 
example 1, except that in 1977, to which the section 904(a)(2) overall 
limitation applies, N Corporation pays $18 of foreign income taxes in 
excess of the overall limitation and that such excess is not absorbed as 
a carryback to 1975 or 1976 under section 904(c). Therefore, there is no 
increase under section 960(b)(1) in the overall limitation for 1979 or 
1980 since the amount ($48) by which the 1978 overall limitation was 
increased by reason of the inclusion in N Corporation's gross income for 
1978 under section 951(a), less the foreign income taxes ($48) allowed 
as a credit which were allowable solely by reason of such inclusion, is 
zero. The foreign income taxes so allowed as a credit for 1978 which 
were allowable solely by reason of such section 951(a) inclusion consist 
of the $30 of foreign income taxes deemed paid for 1978 under section 
960(a)(1) and the $18 of foreign income taxes for 1977 carried over and 
deemed paid for 1978 under section 904(c).
    Example 3. (a) Domestic corporation N owns all the one class of 
stock of controlled foreign corporation A, which in turn owns all the 
one class of stock of controlled foreign corporation B. All corporations 
use the calendar years as the taxable year. Corporation B, after paying 
foreign income taxes of $30, has earnings and profits for 1978 of $70, 
all of which is attributable to an amount required under section 951(a) 
to be included in N Corporation's gross income for 1978, and $35 of

[[Page 473]]

which it distributes in such year to A Corporation. For 1978, A 
Corporation, after paying foreign income taxes of $5 on such dividend 
from B Corporation, has total earnings and profits of $30, all of which 
it distributes in such year to N Corporation, a foreign income tax of $3 
being withheld therefrom.
    (b) For 1979, B Corporation has no earnings and profits, but 
distributes in such year to A Corporation the $35 remaining of its 
earnings and profits for 1965. For 1979, A Corporation, after paying 
foreign income taxes of $5 on such dividend from B Corporation, has 
total earnings and profits of $30, all of which it distributes to N 
Corporation, a foreign income tax of $3 being withheld therefrom.
    (c) For each of 1978 and 1979, N Corporation has taxable income of 
$100 from United States sources and claims a foreign tax credit under 
section 901, determined by applying the overall limitation under section 
904(a)(2). The United States tax payable by N Corporation is determined 
as follows, assuming a corporate tax rate of 48 percent:

                                  1978
Taxable income of N Corporation:
  U.S. sources..................................................    $100
  Sources without the U.S.:
    Amount required to be included in N Corporation's        $70
     gross income under section 951(a) with respect to B
     Corporation.........................................
    Foreign income taxes deemed paid by N Corporation         30     100
     under section 960(a)(1) and included in N
     Corporation's gross income under section 78 ($30 x
     $70/$70)............................................
                                                          --------------
  Total taxable income...................................  .....     200
                                                                 =======
U.S. tax payable for 1978:
  U.S. tax before credit ($200 x 0.48)..........................      96
  Credit: Foreign income taxes of $38 ([$30 x $70/$70] + $3),         38
   but not to exceed overall limitation of $48 ($96 x $100/$200)
                                                          --------
  U.S. tax payable..............................................      58
                                                          ========
 


                                  1979
Taxable income of N Corporation, consisting of income from U.S.     $100
 sources.......................................................
U.S. tax before credit ($100 x 0.48)...........................       48
Section 904(a)(2) overall limitation for 1979:
  Limitation for 1979 before increase under section 960(b)(1)          0
   ($48 x $0/$100).............................................
  Plus: Increase in overall limitation for 1979 under
   section 960(b)(1):
    Amount by which 1978 overall limitation was             $48
     increased by reason of inclusion in N
     Corporation's gross income under section 951(a)
     for 1978 ($48-[($100 x 0.48) x $0/$100])..........
    Less: Foreign income taxes allowed as a credit for       38
     1978 which were allowable solely by reason of such
     section 951(a) inclusion ($38-$0).................
                                                        --------
     Balance...........................................      10
    But: Such balance not to exceed foreign income            8        8
     taxes paid and deemed paid by N Corporation for
     1979 with respect to $30 distribution excluded
     under section 959(a)(1) ([$5 x $30/$30] + $3).....
                                                        ----------------
  Overall limitation for 1979..........................  ......        8
                                                                ========
U.S. tax payable for 1979:
  U.S. tax before credit ($100 x 0.48).........................       48
  Credit: Foreign income taxes of $8 ($3 + $5), but not to             8
   exceed overall limitation of $8 for 1979....................
                                                        ---------
  U.S. tax payable.............................................       40
 


[T.D. 7120, 36 FR 10859, June 4, 1971, as amended by T.D. 7649, 44 FR 
60089, Oct. 18, 1979]



Sec. 1.960-5  Credit for taxable year of inclusion binding for taxable
year of exclusion.

    (a) Taxes not allowed as a deduction for taxable year of exclusion. 
In the case of any taxpayer who--
    (1) Chooses to claim a foreign tax credit as provided in section 901 
for the taxable year for which he is required to include in gross income 
under section 951(a) an amount attributable to the earnings and profits 
of a controlled foreign corporation, and
    (2) Does not choose to claim a foreign tax credit as provided in 
section 901 for a taxable year in which he receives an amount which is 
excluded from gross income under section 959(a)(1) and which is 
attributable to such earnings and profits of such controlled foreign 
corporation,


No deduction shall be allowed under section 164 for the taxable year of 
such exclusion for any foreign income taxes paid or accrued on or with 
respect to such excluded amount.
    (b) Illustration. The application of this section may be illustrated 
by the following example:

    Example. Domestic Corporation N owns all the one class of stock of 
controlled foreign corporation A. Both corporations use the calendar 
year as the taxable year. All of A Corporation's earnings and profits of 
$80 for 1978 (after payment of foreign income taxes of $20 on its total 
income of $100 for such year) are attributable to amount required under 
section 951(a) to be included in N Corporation's gross income for 1978. 
For 1978, N Corporation chooses to claim a foreign tax credit for the 
$20 of foreign income taxes

[[Page 474]]

which for such year are paid by A Corporation and deemed paid by N 
Corporation under section 960(a)(1) and paragraph (c)(1) of Sec. 1.960-
1. For 1979, A Corporation distributes the entire $80 of 1978 earnings 
and profits, a foreign income tax of $8 being withheld therefrom. 
Although N Corporation does not choose to claim a foreign tax credit for 
1979, it may not deduct such $8 of foreign income taxes under section 
164. Corporation N may, however, deduct under such section a foreign 
income tax of $4 which is withheld from a distribution of $40 by A 
Corporation during 1979 from its 1979 earnings and profits.

[T.D. 7120, 36 FR 10859, June 4, 1971, as amended by T.D. 7649, 44 FR 
60089, Oct. 18, 1979]



Sec. 1.960-6  Overpayments resulting from increase in limitation 
for taxable year of exclusion.

    (a) Amount of overpayment. If an increase in the limitation under 
section 960(b)(1) and Sec. 1.960-4 for a taxable year of exclusion 
exceeds the tax (determined before allowance of any credits against tax) 
imposed by chapter 1 of the Code for such year, the amount of such 
excess shall be deemed an overpayment of tax for such year and shall be 
refunded or credited to the taxpayer in accordance with chapter 65 
(section 6401 and following) of the Code.
    (b) Illustration. The application of this section may be illustrated 
by the following example:

    Example. Domestic corporation N owns all the one class of stock of 
controlled foreign corporation A. Both corporations use the calendar 
year as the taxable year. For 1978, A Corporation has total income of 
$100,000 on which it pays foreign income taxes of $20,000. All of A 
Corporation's earnings and profits for 1978 of $80,000 are attributable 
to an amount which is required under section 951(a) to be included in N 
Corporation's gross income for 1978. By reason of such income inclusion 
N Corporation is deemed for 1978 to have paid under section 960(a)(1), 
and is required under section 78 to include in gross income for such 
year, the $20,000 ($20,000 x $80,000/$80,000) of foreign income taxes 
paid by A Corporation for such year. Corporation N also derives $100,000 
taxable income from sources within the United States for 1978. For 1979, 
N Corporation has $25,000 of taxable income, all of which is derived 
from sources within the United States. No part of A Corporation's 
earnings and profits for 1979 is attributable to an amount required 
under section 951(a) to be included in N Corporation's gross income. 
During 1979, A Corporation makes one distribution consisting of its 
$80,000 earnings and profits for 1978, all of which is excluded under 
section 959(a)(1) from N Corporation's gross income for 1979, and from 
which distribution foreign income taxes of $10,000 are withheld. For 
1978 and 1979, N Corporation claims the foreign tax credit under section 
901, determined by applying the overall limitation under section 
904(a)(2). The United States tax of N Corporation is determined as 
follows for such years, assuming a corporate tax rate of 22 percent, a 
surtax of 26 percent and a surtax exemption of $25,000:

                                  1978
Taxable income of N Corporation:
  U.S. sources.............................................     $100,000
  Sources without the U.S.:
    Amount required to be included in N             $80,000
     Corporation's gross income under section
     951(a)...................................
    Foreign income taxes deemed paid by N            20,000      100,000
     Corporation under section 960(a)(1) and
     included in N Corporation's gross income
     under section 78 ($20,000 x $80,000/
     $80,000).................................
                                               -------------------------
     Total taxable income.....................  ...........      200,000
                                                            ============
U.S. tax payable for 1978:
  U.S. tax before credit ([$200,000 x 0.22] + [$175,000 x         89,500
   0.26])..................................................
  Credit: Foreign income taxes of $20,000, but not to             20,000
   exceed overall limitation of $44,750 ($89,500 x $100,000/
   $200,000)...............................................
                                               --------------
  U.S. tax payable.........................................       69,500
                                               ==============
 


                                  1979
Taxable income of N Corporation, consisting of income from       $25,000
 U.S. sources..............................................
U.S. tax before credit ($25,000 x 0.22)....................        5,500
Section 904(a)(2) overall limitation for 1979:
  Limitation for 1979 before increase under section                    0
   960(b)(1) ($5,500 x $0/$25,000).........................
  Plus: Increase in overall limitation for
   1979 under section 960(b)(1):
    Amount by which 1978 overall limitation         $44,750
     was increased by reason of inclusion in N
     Corporation's gross income under section
     951(a) for 1978 ($44,750 - [$41,500 x $0/
     $100,000])...............................
    Less: Foreign income taxes allowed as a          20,000
     credit for 1978 which were allowable
     solely by reason of such section 951(a)
     inclusion ($20,000-$0)...................
                                               -------------
     Balance..................................       24,750

[[Page 475]]

 
    But: Such balance not to exceed foreign          10,000       10,000
     income taxes paid by N Corporation for
     1979 with respect to $80,000 distribution
     excluded under section 959(a)(1) ($10,000
     tax withheld)............................
                                               -------------------------
  Overall limitation for 1979..............................       10,000
                                               ==============
U.S. tax payable for 1979:
  U.S. tax before credit ($25,000 x 0.22)..................        5,500
  Credit: Foreign income taxes of $10,000, but not to             10,000
   exceed overall limitation of $10,000 for 1979...........
                                               --------------
  U.S. tax payable.........................................         None
                                               ==============
Overpayment of tax for 1979:
  Increase in limitation under section 960(b)(1) for 1979..       10,000
  Less: Tax imposed for 1979 under chapter 1 of the Code...        5,500
                                               --------------
  Excess treated as overpayment............................        4,500
 


[T.D. 7120, 36 FR 10859, June 4, 1971, as amended by T.D. 7649, 44 FR 
60089, Oct. 18, 1979]



Sec. 1.960-7  Effective dates.

    (a) General rule. Except as provided in paragraph (b), the rules 
contained in Sec. Sec. 1.960-1--1.960-6 shall apply to taxable years of 
foreign corporations beginning after December 31, 1962, and taxable 
years of U.S. corporate shareholders within which or with which the 
taxable year of such foreign corporation ends.
    (b) Exception for less developed country corporations. If for any 
taxable year beginning after December 31, 1962, and before January 1, 
1976, a first-tier foreign corporation qualified as a less developed 
country corporation as defined in 26 CFR 1.902-2 revised as of April 1, 
1978, the rules pertaining to less developed country corporations 
contained in 26 CFR 1.960-1--1.960-6 revised as of April 1, 1978, shall 
apply to any amounts required to be included in gross income under 
section 951 for such taxable year.
    (c) Third-tier credit. The rules contained in Sec. Sec. 1.960-1--
1.960-6 shall apply to amounts included in the gross income of a 
domestic corporation under section 951 with respect to the earnings and 
profits of third-tier corporations (as defined in Sec. 1.960-1) in 
taxable years beginning after December 31, 1976.

[T.D. 7649, 44 FR 60089, Oct. 18, 1979, as amended by T.D. 7843, 47 FR 
50484, Nov. 8, 1982]



Sec. 1.961-1  Increase in basis of stock in controlled foreign 
corporations and of other property.

    (a) Increase in basis--(1) In general. Except as provided in 
subparagraph (2) of this paragraph, the basis of a United States 
shareholder's--
    (i) Stock in a controlled foreign corporation; or
    (ii) Property (as defined in paragraph (b)(1) of this section) by 
reason of the ownership of which he is considered under section 
958(a)(2) as owning stock in a controlled foreign corporation shall be 
increased under section 961(a), as of the last day in the taxable year 
of such corporation on which it is a controlled foreign corporation, by 
the amount required to be included with respect to such stock or such 
property in such shareholder's gross income under section 951(a) for his 
taxable year in which or with which such taxable year of such 
corporation ends. The increase in basis provided by the preceding 
sentence shall be made only to the extent to which such amount required 
to be included in gross income under section 951(a) was so included in 
gross income.
    (2) Limitation on amount of increase in case of election under 
section 962. In the case of a United States shareholder who makes the 
election under section 962 for the taxable year, the amount of the 
increase in basis provided by subparagraph (1) of this paragraph shall 
not exceed the amount of United States tax paid in accordance with such 
election with respect to the amounts included in such shareholder's 
gross income under section 951(a) for such year (as determined under 
Sec. 1.962-1).
    (b) Rules of application--(1) Property defined. The property of a 
United States shareholder referred to in paragraph (a)(1)(ii) of this 
section shall consist of--
    (i) Stock in a foreign corporation;
    (ii) An interest in a foreign partnership; or

[[Page 476]]

    (iii) A beneficial interest in a foreign estate or trust (as defined 
in section 7701(a)(31)).
    (2) Increase with respect to each share of stock. Any increase under 
paragraph (a) of this section in the basis of a United States 
shareholder's stock in a foreign corporation shall be made in the amount 
included in gross income under section 951(a) or in the amount of United 
States tax paid in accordance with an election under section 962, as the 
case may be, with respect to each share of such stock.
    (c) Illustration. The application of this section may be illustrated 
by the following examples:

    Example 1. Domestic corporation M owns 800 of the 1,000 shares of 
the one class of stock in controlled foreign corporation R which owns 
all of the one class of stock in controlled foreign corporation S. 
Corporations M, R, and S use the calendar year as a taxable year. In 
1964, S Corporation has $100,000 of earnings and profits after the 
payment of $11,250 of foreign income taxes, and $100,000 of subpart F 
income. Corporation R has no earnings and profits. With respect to S 
Corporation, M Corporation is required to include in gross income 
$80,000 (800/1,000 x $100,000) under section 951(a), and $9,000 
($80,000/$100,000 x $11,250) under section 78. On December 31, 1964, M 
Corporation must increase the basis of each share of its stock in R 
Corporation by $100 ($80,000/800).
    Example 2. A, an individual United States shareholder, owns all of 
the 1,000 shares of the one class of stock in controlled foreign 
corporation T. Corporation T and A use the calendar year as a taxable 
year. In 1964, T Corporation has $80,000 of earnings and profits after 
the payment of $20,000 of foreign income taxes, and $80,000 of subpart F 
income. A makes the election under section 962 for 1964 and in 
accordance with such election pays a United States tax of $23,000 with 
respect to the $80,000 included in his gross income under section 
951(a). On December 31, 1964, A must increase the basis of each share of 
his stock in T Corporation by $23 ($23,000/1,000).

[T.D. 6850, 30 FR 11854, Sept. 16, 1978]



Sec. 1.961-2  Reduction in basis of stock in foreign corporations 
and of other property.

    (a) Reduction in basis--(1) In general. Except as provided in 
subparagraph (2) of this paragraph, the adjusted basis of a United 
States person's--
    (i) Stock in a foreign corporation;
    (ii) Interest in a foreign partnership; or
    (iii) Beneficial interest in a foreign estate or trust (as defined 
in section 7701(a)(31)),


with respect to which such United States person receives an amount which 
is excluded from gross income under section 959(a), shall be reduced 
under section 961(b), as of the time such person receives such excluded 
amount, by the sum of the amount so excluded and any income, war 
profits, or excess profits taxes imposed by any foreign country or 
possession of the United States on or with respect to the earnings and 
profits attributable to such excluded amount when such earnings and 
profits were actually distributed directly or indirectly through a chain 
of ownership described in section 958(a)(2).
    (2) Limitation on amount of reduction in case of election under 
section 962. In the case of a distribution of earnings and profits 
attributable to amounts with respect to which an election under section 
962 has been made, the amount of the reduction in basis provided by 
subparagraph (1) of this paragraph shall not exceed the sum of--
    (i) The amount of such distribution which is excluded from gross 
income under section 959(a) after the application of section 962(d) and 
Sec. 1.962-3; and
    (ii) Any income, war profits, or excess profits taxes imposed by any 
foreign country or possession of the United States on or with respect to 
the earnings and profits attributable to such excluded amount when such 
earnings and profits were actually distributed directly or indirectly 
through a chain of ownership described in section 958(a)(2).
    (b) Reduction with respect to each share of stock. Any reduction 
under paragraph (a) of this section in the adjusted basis of a United 
States person's stock in a foreign corporation shall be made with 
respect to each share of such stock in the sum of--
    (1)(i) The amount excluded from gross income under section 959(a); 
or
    (ii) The amount excluded from gross income under section 959(a) 
after the application of section 962(d) and Sec. 1.962-3; and

[[Page 477]]

    (2) The amount of any income, war profits, or excess profits taxes 
imposed by any foreign country or possession of the United States on or 
with respect to the earnings and profits attributable to such excluded 
amount when such earnings and profits were actually distributed directly 
or indirectly through a chain of ownership described in section 
958(a)(2).
    (c) Amount in excess of basis. To the extent that the amount of the 
reduction in the adjusted basis of property provided by paragraph (a) of 
this section exceeds such adjusted basis, the amount shall be treated as 
gain from the sale or exchange of property.
    (d) Illustration. The application of this section may be illustrated 
by the following examples:

    Example 1. (a) Domestic corporation M owns all of the 1,000 shares 
of the one class of stock in controlled foreign corporation R, which 
owns all of the 500 shares of the one class of stock in controlled 
foreign corporation S. Each share of M Corporation's stock in R 
Corporation has a basis of $200. Corporations M, R, and S use the 
calendar year as a taxable year. In 1963, S Corporation has $100,000 of 
earnings and profits after the payment of $50,000 of foreign income 
taxes and $100,000 of subpart F income. For 1963, M Corporation includes 
$100,000 in gross income under section 951(a) with respect to S 
Corporation. In accordance with the provisions of Sec. 1.961-1, M 
Corporation increases the basis of each of its 1,000 shares of stock in 
R Corporation to $300 ($200 + $100,000/1,000) as of December 31, 1963.
    (b) On July 31, 1964, M Corporation sells 250 of its shares of stock 
in R Corporation to domestic corporation N at a price of $350 per share. 
Corporation N satisfies the requirements of paragraph (d) of Sec. 
1.959-1 so as to qualify as M Corporation's successor in interest. On 
September 30, 1964, the earnings and profits attributable to the 
$100,000 included in M Corporation's gross income under section 951(a) 
for 1963 are distributed to R Corporation which incurs a withholding tax 
of $10,000 on such distribution (10 percent of $100,000) and an 
additional foreign income tax of 33\1/3\ percent or $30,000 by reason of 
the inclusion of the net distribution of $90,000 ($100,000 minus 
$10,000) in its taxable income for 1964. On June 30, 1965, R Corporation 
distributes the remaining $60,000 of such earnings and profits to 
corporations M and N: Corporation M receives $45,000 (750/1,000 x 
$60,000) and excludes such amount from gross income under section 
959(a); Corporation N receives $15,000 (250/1,000 x $60,000) and, as M 
Corporation's successor in interest, excludes such amount from gross 
income under section 959(a). As of June 30, 1965, M Corporation must 
reduce the adjusted basis of each of its 750 shares of stock in R 
Corporation to $200 ($300 minus ($45,000/750 + $10,000/1,000 + $30,000/
1,000)); and N Corporation must reduce the basis of each of its 250 
shares of stock in R Corporation to $250 ($350 minus ($15,000/250 + 
$10,000/1,000 + $30,000/1,000)).
    Example 2. The facts are the same as in paragraph (a) of example 1, 
except that in addition, on July 31, 1964, R Corporation sells its 500 
shares of stock in S Corporation to domestic corporation P at a price of 
$600 per share. Corporation P satisfies the requirements of paragraph 
(d) of Sec. 1.959-1 so as to qualify as M Corporation's successor in 
interest. On September 30, 1964, S Corporation distributes $100,000 of 
earnings and profits to P Corporation, which earnings and profits are 
attributable to the $100,000 included in M Corporation's gross income 
under section 951(a) for 1963. Corporation P incurs a withholding tax of 
$10,000 on the distribution from S Corporation (10 percent of $100,000). 
As M Corporation's successor in interest, P Corporation excludes the 
$90,000 it receives from gross income under section 959(a). As of 
September 30, 1964, P Corporation must reduce the basis of each of its 
500 shares of stock in S Corporation to $400 ($600 minus ($90,000/500 + 
$10,000/500)).

[T.D. 6850, 30 FR 11854, Sept. 16, 1965]



Sec. 1.962-1  Limitation of tax for individuals on amounts included
in gross income under section 951(a).

    (a) In general. An individual United States shareholder may, in 
accordance with Sec. 1.962-2, elect to have the provisions of section 
962 apply for his taxable year. In such case--
    (1) The tax imposed under chapter 1 of the Internal Revenue Code on 
all amounts which are included in his gross income for such taxable year 
under section 951(a) shall (in lieu of the tax determined under section 
1) be an amount equal to the tax which would be imposed under section 11 
if such amounts were received by a domestic corporation (determined in 
accordance with paragraph (b)(1) of this section), and
    (2) For purposes of applying section 960(a)(1) (relating to foreign 
tax credit) such amounts shall be treated as if received by a domestic 
corporation (as provided in paragraph (b)(2) of this section).


Thus, an individual United States shareholder may elect to be subject to

[[Page 478]]

tax at corporate rates on amounts included in his gross income under 
section 951(a) and to have the benefit of a credit for certain foreign 
taxes paid with respect to the earnings and profits attributable to such 
amounts. Section 962 also provides rules for the treatment of an actual 
distribution of earnings and profits previously taxed in accordance with 
an election of the benefits of this section. See Sec. 1.962-3. For 
transitional rules for certain taxable years, see Sec. 1.962-4.
    (b) Rules of application. For purposes of this section--
    (1) Application of section 11. For purposes of applying section 11 
for a taxable year as provided in paragraph (a)(1) of this section in 
the case of an electing United States shareholder--
    (i) Determination of taxable income. The term ``taxable income'' as 
used in section 11 shall mean the sum of--
    (a) All amounts required to be included in his gross income under 
section 951(a) for such taxable year; plus
    (b) All amounts which would be required to be included in his gross 
income under section 78 for such taxable year with respect to the 
amounts referred to in (a) of this subdivision if such shareholder were 
a domestic corporation.


For purposes of this section, such sum shall not be reduced by any 
deduction of the United States shareholder even if such shareholder's 
deductions exceed his gross income.
    (ii) Limitation on surtax exemption. The surtax exemption provided 
by section 11(c) shall not exceed an amount which bears the same ratio 
to $25,000 ($50,000 in the case of a taxable year ending after December 
31, 1974, and before January 1, 1976) as the amounts included in his 
gross income under section 951(a) for the taxable year bear to his pro 
rata share of the earnings and profits for the taxable year of all 
controlled foreign corporations with respect to which such United States 
shareholder includes any amount in his gross income under section 951(a) 
for the taxable year.
    (2) Allowance of foreign tax credit--(i) In general. Subject to the 
applicable limitation of section 904 and to the provisions of this 
subparagraph, there shall be allowed as a credit against the United 
States tax on the amounts described in subparagraph (1)(i) of this 
paragraph the foreign income, war profits, and excess profits taxes 
deemed paid under section 960(a)(1) by the electing United States 
shareholder with respect to such amounts.
    (ii) Application of section 960(a)(1). In applying section 960(a)(1) 
for purposes of this subparagraph in the case of an electing United 
States shareholder, the term ``domestic corporation'' as used in 
sections 960(a)(1) and 78, and the term ``corporation'' as used in 
section 901, shall be treated as referring to such shareholder with 
respect to the amounts described in subparagraph (1)(i) of this 
paragraph.
    (iii) Carryback and carryover of excess tax deemed paid. For 
purposes of this subparagraph, any amount by which the foreign income, 
war profits, and excess profits taxes deemed paid by the electing United 
States shareholder for any taxable year under section 960(a)(1) exceed 
the limitation determined under subdivision (iv)(a) of this subparagraph 
shall be treated as a carryback and carryover of excess tax paid under 
section 904(d), except that in no case shall excess tax paid be deemed 
paid in a taxable year if an election under section 962 by such 
shareholder does not apply for such taxable year. Such carrybacks and 
carryovers shall be applied only against the United States tax on 
amounts described in subparagraph (1)(i) of this paragraph.
    (iv) Limitation on credit. For purposes of determining the 
limitation under section 904 on the amount of the credit for foreign 
income, war profits, and excess profits taxes--
    (a) Deemed paid with respect to amounts described in subparagraph 
(1)(i) of this paragraph, the electing United States shareholder's 
taxable income shall be considered to consist only of the amounts 
described in such subparagraph (1)(i), and
    (b) Paid with respect to amounts other than amounts described in 
subparagraph (1)(i) of this paragraph, the electing United States 
shareholder's taxable income shall be considered to consist only of 
amounts other than the amounts described in such subparagraph (1)(i).

[[Page 479]]

    (v) Effect of choosing benefits of sections 901 to 905. The 
provisions of this subparagraph shall apply for a taxable year whether 
or not the electing United States shareholder chooses the benefits of 
subpart A of part III of subchapter N of chapter 1 (sections 901 to 905) 
of the Internal Revenue Code for such year.
    (c) Illustration. The application of this section may be illustrated 
by the following example:

    Example. Throughout his taxable year ending December 31, 1964, A, an 
unmarried individual who is not the head of a household, owns 60 of the 
100 shares of the one class of stock in foreign corporation M and 80 of 
the 100 shares of the one class of stock in foreign corporation N. A and 
corporations M and N use the calendar year as a taxable year, 
corporations M and N are controlled foreign corporations throughout the 
period here involved, and neither corporation is a less developed 
country corporation. The earnings and profits and subpart F income of, 
and the foreign income taxes paid by, such corporations for 1964 are as 
follows:

------------------------------------------------------------------------
                                                       M           N
------------------------------------------------------------------------
Pretax earnings and profits.....................    $500,000  $1,200,000
Foreign income taxes............................     200,000     400,000
Earnings and profits............................     300,000     800,000
Subpart F income................................     150,000     750,000
------------------------------------------------------------------------


Apart from his section 951(a) income, A has gross income of $200,600 and 
$100,000 of deductions attributable to such income. He is required to 
include $90,000 (0.60 x $150,000) in gross income under section 951(a) 
with respect to M Corporation and $600,000 (0.80 x $750,000) with 
respect to N Corporation. A elects to have the provisions of section 962 
apply for 1964 and computes his tax as follows:

----------------------------------------------------------------------------------------------------------------
 
----------------------------------------------------------------------------------------------------------------
Tax on amounts included under section 951(a):
  Income under section 951(a) from M Corporation................         $90,000
  Gross-up under sections 960(a)(1) and 78 ($90,000/$300,000 x            60,000
   $200,000)....................................................
  Income under section 951(a) from N Corporation................         600,000
  Gross-up under sections 960(a)(1) and 78 ($600,000/$800,000 x          300,000
   $400,000)....................................................
                                                                 ----------------
  Taxable income under section 11...............................       1,050,000
  Normal tax (0.22 x $1,050,000)................................................        $231,000
  Surtax exemption ([$90,000 + $600,000]/[0.60 x $300,000 +               21,036
   (0.80 x $800,000)] x $25,000)................................
  Subject to surtax under section 11 ($1,050,000-$21,036).......       1,028,964
  Surtax (0.28 x $1,028,964)....................................................         288,110
                                                                 ----------------
  Tentative U.S. tax............................................................         519,110
  Foreign tax credit ($60,000 + $300,000).......................         360,000
                                                                 ----------------
    Total U.S. tax payable on amounts included under section 951(a).............................        $159,110
Tax with respect to other income:
  Gross income..................................................................         200,600
  Less:
    Personal exemption..........................................             600
    Deductions..................................................         100,000
                                                                 -----------------
                                                                         100,600
                                                                                 ----------------
  Taxable income................................................................         100,000
  Tax with respect to such other taxable income.................  ..............          59,340
                                                                                 -----------------
    Total tax ($159,110 + $59,340)..............................................................         218,450
----------------------------------------------------------------------------------------------------------------


[T.D. 6858, 30 FR 13695, Oct. 28, 1965, as amended by T.D. 7413, 41 FR 
12640, Mar. 26, 1976]



Sec. 1.962-2  Election of limitation of tax for individuals.

    (a) Who may elect. The election under section 962 may be made only 
by a United States shareholder who is an individual (including a trust 
or estate).
    (b) Time and manner of making election. Except as provided in Sec. 
1.962-4, a United States shareholder shall make an election under this 
section by filing a statement to such effect with his return for the 
taxable year with respect to which the election is made. The statement 
shall include the following information:
    (1) The name, address, and taxable year of each controlled foreign 
corporation with respect to which the

[[Page 480]]

electing shareholder is a United States shareholder and of all other 
corporations, partnerships, trusts, or estates in any applicable chain 
of ownership described in section 958(a);
    (2) The amounts, on a corporation-by-corporation basis, which are 
included in such shareholder's gross income for his taxable year under 
section 951(a);
    (3) Such shareholder's pro rata share of the earnings and profits 
(determined under Sec. 1.964-1) of each such controlled foreign 
corporation with respect to which such shareholder includes any amount 
in gross income for his taxable year under section 951(a) and the 
foreign income, war profits, excess profits, and similar taxes paid on 
or with respect to such earnings and profits;
    (4) The amount of distributions received by such shareholder during 
his taxable year from each controlled foreign corporation referred to in 
subparagraph (1) of this paragraph from excludable section 962 earnings 
and profits (as defined in paragraph (b)(1)(i) of Sec. 1.962-3), from 
taxable section 962 earnings and profits (as defined in paragraph 
(b)(1)(ii) of Sec. 1.962-3), and from earnings and profits other than 
section 962 earnings and profits, showing the source of such amounts by 
taxable year; and
    (5) Such further information as the Commissioner may prescribe by 
forms and accompanying instructions relating to such election.
    (c) Effect of election--(1) In general. Except as provided in 
subparagraph (2) of this paragraph and Sec. 1.962-4, an election under 
this section by a United States shareholder for a taxable year shall be 
applicable to all controlled foreign corporations with respect to which 
such shareholder includes any amount in gross income for his taxable 
year under section 951(a) and shall be binding for the taxable year for 
which such election is made.
    (2) Revocation. Upon application by the United States shareholder, 
an election made under this section may, subject to the approval of the 
Commissioner, be revoked. Approval will not be granted unless a material 
and substantial change in circumstances occurs which could not have been 
anticipated when the election was made. The application for consent to 
revocation shall be made by the United States shareholder's mailing a 
letter for such purpose to Commissioner of Internal Revenue, Attention: 
T:R, Washington, DC 20224, containing a statement of the facts upon 
which such shareholder relies in requesting such consent.

[T.D. 6858, 30 FR 13696, Oct. 28, 1965]



Sec. 1.962-3  Treatment of actual distributions.

    (a) In general. Section 962(d) provides that the earnings and 
profits of a foreign corporation attributable to amounts which are, or 
have been, included in the gross income of an individual United States 
shareholder under section 951(a) by reason of such shareholder's 
ownership (within the meaning of section 958(a)) of stock in such 
corporation and with respect to which amounts an election under Sec. 
1.962-2 applies or applied shall, when such earnings and profits are 
distributed to such shareholder with respect to such stock, 
notwithstanding the provisions of section 959(a)(1), be included in his 
gross income to the extent that such earnings and profits exceed the 
amount of income tax paid by such shareholder under this chapter on the 
amounts to which such election applies or applied. Thus, when such 
shareholder receives an actual distribution of section 962 earnings and 
profits (as defined in paragraph (b)(1) of this section) from a foreign 
corporation, only the excludable section 962 earnings and profits (as 
defined in paragraph (b)(1)(i) of this section) may be excluded from his 
gross income.
    (b) Rules of application. For purposes of this section--
    (1) Section 962 earnings and profits defined. With respect to an 
individual United States shareholder, the term ``section 962 earnings 
and profits'' means the earnings and profits of a foreign corporation 
referred to in paragraph (a) of this section. Such earnings and profits 
include--
    (i) Excludable section 962 earnings and profits. Excludable section 
962 earnings and profits which are the amount of the section 962 
earnings and profits equal to the amount of income tax paid under this 
chapter by such shareholder

[[Page 481]]

on the amounts included in his gross income under section 951(a); and
    (ii) Taxable section 962 earnings and profits. Taxable section 962 
earnings and profits which are the excess of section 962 earnings and 
profits over the amount described in subdivision (i) of this 
subparagraph.
    (2) Determinations made separately for each taxable year. If section 
962 earnings and profits attributable to more than one taxable year are 
distributed by a foreign corporation the determinations under this 
section shall be made separately with respect to each such taxable year.
    (3) Source of distributions--(i) In general. Except as otherwise 
provided in this subparagraph, the provisions of paragraphs (a) through 
(d) of Sec. 1.959-3 shall apply in determining the source of 
distributions of earnings and profits by a foreign corporation.
    (ii) Treatment of section 962 earnings and profits under Sec. 
1.959-3. For purposes of a section 959(c) amount and year classification 
under paragraph (b) of Sec. 1.959-3, a distribution of earnings and 
profits by a foreign corporation shall be first allocated to earnings 
and profits other than section 962 earnings and profits (as defined in 
subparagraph (1) of this paragraph) and then to section 962 earnings and 
profits. Thus distributions shall be considered first attributable to 
amounts described in paragraph (b)(1) of Sec. 1.959-3 which are not 
section 962 earnings and profits and then to amounts described in such 
paragraph (b)(1) which are section 962 earnings and profits (first for 
the current taxable year and then for prior taxable years beginning with 
the most recent prior taxable year), secondly to amounts described in 
paragraph (b)(2) of Sec. 1.959-3 which are not section 962 earnings and 
profits and then to amounts described in such paragraph (b)(2) which are 
section 962 earnings and profits (first for the current taxable year and 
then for prior taxable years beginning with the most recent prior 
taxable year), and finally to the amounts described in paragraph (b)(3) 
of Sec. 1.959-3 (first for the current taxable year and then for prior 
taxable years beginning with the most recent prior taxable year).
    (iii) Allocation to excludable section 962 earnings and profits. A 
distribution of section 962 earnings and profits by a foreign 
corporation for any taxable year shall be considered first attributable 
to the excludable section 962 earnings and profits (as defined in 
subparagraph (1)(i) of this paragraph) and then to taxable section 962 
earnings and profits.
    (iv) Allocation of deficits in earnings and profits. A United States 
shareholder's pro rata share (determined in accordance with the 
principles of paragraph (e) of Sec. 1.951-1) of a foreign corporation's 
deficit in earnings and profits (determined under Sec. 1.964-1) for any 
taxable year shall be applied in accordance with the provisions of 
paragraph (c) of Sec. 1.959-3 except that such deficit shall also be 
applied to taxable section 962 earnings and profits (as defined in 
subparagraph (1)(ii) of this paragraph).
    (4) Distribution in exchange for stock. The provisions of this 
section shall not apply to a distribution of section 962 earnings and 
profits which is treated as in part or full payment in exchange for 
stock under subchapter C of chapter 1 of the Internal Revenue Code. The 
application of this subparagraph may be illustrated by the following 
example:

    Example. Individual United States shareholder A owns 60 percent of 
the only class of stock in foreign corporation M, the basis of which is 
$10,000. Both A and M Corporation use the calendar year as a taxable 
year. In each of the taxable years 1964, 1965, and 1966, M Corporation 
has $1,000 of earnings and profits and $1,000 of subpart F income. With 
respect to each such amount, A includes $600 in gross income under 
section 951(a), makes the election under section 962, and pays a United 
States tax of $132 (22 percent of $600). Accordingly, A increases the 
basis of his stock in M corporation under section 961(a) by $132 in each 
of the years 1964, 1965, and 1966, and thus on December 31, 1966, the 
adjusted basis for A's stock in M Corporation is $10,396. In 1967, M 
Corporation is completely liquidated (in a transaction described in 
section 331) and A receives $13,800, consisting of $1,800 of earnings 
and profits attributable to the amounts which A included in gross income 
under section 951(a) in 1964, 1965, and 1966, and $12,000 attributable 
to the other assets of M Corporation. No amount of the $3,404 gain 
realized by A on such distribution ($13,800 minus $10,396) may be 
excluded from gross income under section 959(a)(1). However, section 
962(d) will not prevent any part

[[Page 482]]

of such $3,404 from being treated as a capital gain under section 331.

    (5) Illustration. The application of this paragraph may be 
illustrated by the following example:

    Example. (a) M, a controlled foreign corporation is organized on 
January 1, 1963; A and B, individual United States shareholders, own 50 
percent and 25 percent, respectively, of the only class of stock in M 
Corporation. Corporation M, A, and B use the calendar year as a taxable 
year, and M Corporation is a controlled foreign corporation throughout 
the period here involved. For the taxable years 1963, 1964, 1965, and 
1966, A and B must include amounts in gross income under section 951(a) 
with respect to M Corporation. For the years 1963, 1965, and 1966, A 
makes the election under section 962. On January 1, 1967, B sells his 
25-percent interest in M Corporation to A; A satisfies the requirements 
of paragraph (d) of Sec. 1.959-1 so as to qualify as B's successor in 
interest. As of December 31, 1967, M Corporation's accumulated earnings 
and profits of $675 (before taking into account distributions made in 
1967) applicable to A's interest (including his interest as B's 
successor in interest) in such corporation are classified under Sec. 
1.959-3 and this section for purposes of section 962(d) as follows:

                      Classification of Earnings and Profits for Purposes of Sec. 1.962-3
----------------------------------------------------------------------------------------------------------------
                                           Section 959(c)(1)                 Section 959(c)(2)
                                  --------------------------------------------------------------------
                                      Non-    Excludable   Taxable      Non-    Excludable   Taxable
                                    section     section    section    section     section    section    Section
               Year                   962         962        962,       962         962        962        959
                                    earnings   earnings    earnings   earnings   earnings    earnings    (c)(3)
                                      and         and        and        and         and        and
                                    profits     profits    profits    profits     profits    profits
----------------------------------------------------------------------------------------------------------------
1963.............................        $25         $11        $39
1964.............................         75  ..........  .........        $60  ..........  .........        $15
1965.............................  .........  ..........  .........         75         $33       $117
1966.............................  .........  ..........  .........         50          22         78
1967.............................  .........  ..........  .........  .........  ..........  .........         75
----------------------------------------------------------------------------------------------------------------

    (b) During 1967, M Corporation makes three separate distributions to 
A of $200, $208, and $267. The source of such distributions under Sec. 
1.959-3 and this section is as follows:

------------------------------------------------------------------------
                                                      Classification of
                                                     distributions under
           Distribution             Amount    Year     sections 959 and
                                                            962(d)
------------------------------------------------------------------------
No. 1............................       $75    1964  (c)(1) non-section
                                         25    1963   962.
                                         11    1963   Do.
                                         39    1963  (c)(1) excludable
                                         50    1966   section 962.
                                                     (c)(1) taxable
                                                      section 962.
                                                     (c)(2) non-section
                                                      962.
                                  ----------
  Total..........................       200
------------------------------------------------------------------------
No. 2............................        22    1966  (c)(2) excludable
                                         78    1966   section 962
                                         75    1965  (c)(2) taxable
                                         33    1965   section 962.
                                                     (c)(2) non-section
                                                      962.
                                                     (c)(2) excludable
                                                      section 962.
 
  Total..........................       208
------------------------------------------------------------------------
No. 3............................       117    1965  (c)(2) taxable
                                         60    1964   section 962.
                                         75    1967  (c)(2) non-section
                                         15    1964   962.
                                                     (c)(3).
                                                      Do.
                                  ----------
  Total..........................       267
------------------------------------------------------------------------

    (c) A must include $324 in his gross income for 1967. The source of 
these amounts is as follows:

------------------------------------------------------------------------
           Distribution             Amount    Year      Classification
------------------------------------------------------------------------
No. 1............................       $39    1963  (c)(1) taxable
                                                      section 962.
No. 2............................        78    1966  (c)(2) taxable
                                                      section 962.
No. 3............................       117    1965   Do.
                                         75    1967  (c)(3).
                                         15    1964   Do.
                                  ----------
  Total..........................       324
------------------------------------------------------------------------

    (c) Treatment of shareholder's successor in interest--(1) In 
general. If a United States person (as defined in Sec. 1.957-4) 
acquires from any person any portion of the interest in the foreign 
corporation of a United States shareholder referred to in this section, 
the rules of paragraphs (a) and (b) of this section shall apply to such 
acquiring person. However, no exclusion of section 962 earnings and 
profits under paragraph (a) of this section shall be allowed unless such 
acquiring person establishes to the satisfaction of the district 
director his right to such exclusion. The information to be furnished by 
the acquiring person to the district director with his return for the 
taxable year to support such exclusion shall include:
    (i) The name, address, and taxable year of the foreign corporation 
from which a distribution of section 962

[[Page 483]]

earnings and profits is received and of all other corporations, 
partnerships, trusts, or estates in any applicable chain of ownership 
described in section 958(a);
    (ii) The name and address of the person from whom the stock interest 
was acquired;
    (iii) A description of the stock interest acquired and its relation, 
if any, to a chain of ownership described in section 958(a);
    (iv) The amount for which an exclusion under paragraph (a) of this 
section is claimed; and
    (v) Evidence showing that the section 962 earnings and profits for 
which an exclusion is claimed are attributable to amounts which were 
included in the gross income of a United States shareholder under 
section 951(a) subject to an election under Sec. 1.962-2, that such 
amounts were not previously excluded from the gross income of a United 
States person, and the identity of the United States shareholder 
including such amount.


The acquiring person shall also furnish to the district director such 
other information as may be required by the district director in support 
of the exclusion.
    (2) Taxes previously deemed paid by an individual United States 
shareholder. If a corporate successor in interest of an individual 
United States shareholder receives a distribution of section 962 
earnings and profits, the income, war profits, and excess profits taxes 
paid to any foreign country or to any possession of the United States in 
connection with such earnings and profits shall not be taken into 
account for purposes of section 902, to the extent such taxes were 
deemed paid by such individual United States shareholder under paragraph 
(b)(2) of Sec. 1.962-1 and section 960(a)(1) for any prior taxable 
year.

[T.D. 6858, 30 FR 13696, Oct. 28, 1965]



Sec. 1.962-4  Transitional rules for certain taxable years.

    (a) Extension of time for making or revoking election. Paragraphs 
(b) and (c) of this section provide additional rules with respect to 
making or revoking an election under section 962 which apply only to a 
taxable year of a United States shareholder for which the last day 
prescribed by law for filing his return (including any extensions of 
time under section 6081) occurs or occurred on or before January 31, 
1966.
    (b) Manner of making election not previously made. If a United 
States shareholder who has not previously made an election under section 
962 for any taxable year referred to in paragraph (a) of this section 
desires to make such an election, he may do so by filing his return or 
an amended return for such taxable year together with a statement 
setting forth the information required under paragraph (b) of Sec. 
1.962-2. Such return or amended return and statement shall be filed on 
or before January 31, 1966.
    (c) Revocation of election previously made. If a United States 
shareholder who has made an election under section 962 on or before 
November 1, 1965, for any taxable year referred to in paragraph (a) of 
this section desires to revoke such election, he may do so by filing an 
amended return to which is attached a statement that the election 
previously made is revoked. Such amended return and statement shall be 
filed on or before January 31, 1966.

[T.D. 6858, 30 FR 13698, Oct. 28, 1965]



Sec. 1.963-0  Repeal of section 963; effective dates.

    (a) Repeal of section 963. Except as provided in paragraphs (b) and 
(c) of this section, the provisions of section 963 and Sec. Sec. 1.963-
1 through 1.963-7 are repealed for taxable years of foreign corporations 
beginning after December 31, 1975, and for taxable years of United 
States shareholders (within the meaning of section 951(b), within which 
or with which such taxable years of such foreign corporations end.
    (b) Transitional rules for chain or group election--(1) In general. 
If a United States shareholder (within the meaning of section 951(b) 
makes either a chain election pursuant to Sec. 1.963-1(e) or a group 
election pursuant to Sec. 1.963-1(f) for a taxable year of such 
shareholder beginning after December 31, 1975, then a foreign 
corporation shall be includible in such election only if--
    (i) It has a taxable year beginning before January 1, 1976, which 
ends within

[[Page 484]]

such taxable year of the United States shareholder, and
    (ii) It is either--
    (A) A controlled foreign corporation or
    (B) A foreign corporation by reason of ownership of stock in which 
such shareholder indirectly owns (within the meaning of section 
958(a)(2)) stock in a controlled foreign corporation to which this 
subparagraph applies.
    (2) Series rule. If any foreign corporation in a series of foreign 
corporations is excluded by subparagraph (i) of this paragraph from a 
chain or group election of a United States shareholder for its taxable 
year, then any foreign corporation in which the United States 
shareholder owns stock indirectly by reason of ownership of stock in 
such excluded corporation shall also be excluded from such election to 
the extent of such indirect ownership regardless of when its taxable 
year begins.
    (3) Illustration. The application of this paragraph may be 
illustrated by the following example:

    Example. (a) M is a domestic corporation, A, B, D, and E are 
controlled foreign corporations, and C is a foreign corporation other 
than a controlled foreign corporation. All five foreign corporations, 
each have only one class of stock outstanding. M owns directly all of 
the stock of A, which in turn owns directly all of the stock of B, which 
in turn owns directly 60 percent of the stock of D, which in turn owns 
directly all of the stock of E. M also owns directly 40 percent of the 
stock of C, which in turn owns directly the remaining 40 percent of the 
stock of D. M is a United States shareholder with respect to no other 
foreign corporation. M and B each use the calendar year as the taxable 
year. A, C, D, and E each use a fiscal year ending on November 30 as the 
taxable year. For calendar year 1976, M may make either a first-tier 
election with respect to A, a chain election with respect to C and D (to 
the extent of M's indirect 16-percent stock interest in D by reason of 
its direct ownership of 40 percent of the stock of C) or a group 
election with respect to A, C, D (to the extent of such 16-percent stock 
interest) and E (to the extent of M's indirect 16-percent stock interest 
in E).
    (b) M's indirect 100 percent stock interest in B will be excluded 
from any chain or group election made by M for calendar year 1976 since 
B is a controlled foreign corporation which does not have a taxable year 
beginning before January 1, 1976, which ends within the taxable year of 
M beginning after December 31, 1975, for which M has made either a chain 
or group election.
    (c) M's indirect 60 percent stock interest through A and B in D and 
E will be excluded from any chain or group election made by M for 
calendar year 1976 since such 60 percent interests are indirectly owned 
by M by reason of its indirect ownership of stock in B, which is a 
foreign corporation which does not have a taxable year beginning before 
January 1, 1976, which ends within the taxable year of M beginning after 
December 31, 1975, for which M has made either a chain or group 
election.
    (d) If C used the calendar year as its taxable year and was 
therefore excluded from a chain election made with respect to it and D, 
then D would also be excluded from such an election, since D would then 
be a foreign corporation in which M owns stock indirectly by reason of 
ownership of stock in C, which is excluded from such election.

    (c) Deficiency distributions. The rules relating to deficiency 
distributions under section 963(e)(2) and Sec. 1.963-6 shall continue 
to apply to a taxable year beginning after the effective date of the 
repeal of section 963 in which it is determined that a deficiency 
distribution must be made for an earlier taxable year for which a United 
States shareholder made an election to secure the exclusion under 
section 963 but failed to receive a minimum distribution.
    (d) Special adjustments pursuant to section 963 to be taken into 
account for taxable years subsequent to the repeal of section 963. If a 
United States shareholder of a controlled foreign corporation elects to 
receive a minimum distribution under section 963 for a taxable year, 
section 963 and the regulations thereunder may require certain elections 
and adjustments to be made in subsequent taxable years. These elections 
and adjustments shall be taken into account for subsequent taxable years 
as if section 963 were still in effect and no election to receive a 
minimum distribution were made after the effective date of the repeal of 
section 963. Examples of these elections and special adjustments 
include, but are not limited to, the election which may be made pursuant 
to Sec. 1.963-3(g)(2), relating to the special extended distribution 
period, and the special adjustments to be made pursuant to Sec. 1.963-
4,

[[Page 485]]

relating to the minimum overall tax burden test.

[T.D. 7545, 43 FR 19652, May 8, 1978]



Sec. 1.963-1  Exclusion of subpart F income upon receipt of minimum 
distribution.

    (a) In general--(1) Purpose of section 963. Section 963 sets forth 
an exception to section 951(a)(1)(A)(i) by providing that a United 
States corporate shareholder may exclude from its gross income the 
subpart F income of a controlled foreign corporation if for the taxable 
year such shareholder elects such exclusion and, where necessary, 
receives a distribution of the earnings and profits of such foreign 
corporation sufficient to bring the aggregate U.S. and foreign income 
taxes on the pretax earnings and profits of that corporation to a 
percentage level approaching the U.S. tax rate for such year on the 
income of a domestic corporation. The election to secure an exclusion 
under section 963 may be made with respect to a ``single first-tier 
corporation'' or a ``chain'' or ``group'' of controlled foreign 
corporations. This section defines the terms ``single first-tier 
corporations,'' ``chains,'' ``group,'' and certain other terms and 
prescribes the manner in which such an election is to be made. Section 
1.963-2 describes the manner in which the amount of the minimum 
distribution for any taxable year is to be determined. Section 1.963-3 
specifies the distributions counting toward a minimum distribution. 
Section 1.963-4 sets forth the requirement with respect to a minimum 
distribution from a chain or group that the overall U.S. and foreign 
income tax must equal either 90 percent of the U.S. corporate tax rate 
applied against consolidated pretax and predistribution earnings and 
profits or, with the application of the special rules set forth in that 
section, the total U.S. and foreign income taxes which would have been 
incurred in respect of a pro rata minimum distribution from the chain or 
group. Section 1.963-5 provides special rules for applying section 963 
in certain cases in which the rate of foreign income tax incurred by a 
foreign corporation varies with the amount of distributions it makes for 
the taxable year. Section 1.963-6 outlines the deficiency distribution 
procedure that may be followed if for reasonable cause a U.S. corporate 
shareholder fails to receive a complete minimum distribution for a 
taxable year for which it elects the exclusion under section 963. 
Section 1.963-7 provides transitional rules for the application of 
section 963 for certain taxable years of U.S. shareholders ending on or 
before the 90th day after September 30, 1964. Section 1.963-8 provides 
rules for the determination of the required minimum distribution during 
the period the Sec. surcharge imposed by section 51 is in effect.
    (2) Conditions for exclusion of subpart F income. To qualify for an 
exclusion under section 963 for any taxable year with respect to the 
subpart F income of a controlled foreign corporation, a corporate United 
States shareholder must--
    (i) Elect such exclusion on or before the last day (including any 
extensions of time under section 6081) prescribed by law for filing its 
return of the tax imposed by chapter 1 of the Code for the taxable year;
    (ii) Receive, if and to the extent necessary, distributions of the 
type described in paragraph (a) of Sec. 1.963-3 sufficient in amount to 
constitute a minimum distribution;
    (iii) Incur, in the case of a chain or group election, income tax 
with respect to such minimum distribution sufficient to satisfy the 
requirements of paragraph (a) of Sec. 1.963-4, relating to the minimum 
overall tax burden; and
    (iv) Consent, on or before such last day for making the election, to 
the regulations under section 963 applicable to such taxable year and to 
any amendments thereof duly prescribed before such last day.


The making of the election under section 963 by filing the return on or 
before such last day shall constitute the consent to the regulations 
under such section prescribed before such last day. For an extension of 
the time for receiving a minimum distribution and making the consent for 
certain taxable years ending on or before the 90th day after September 
30, 1964, see Sec. 1.963-7.
    (3) Subpart F income excluded. An exclusion under section 963 for a 
taxable year of a United States shareholder for

[[Page 486]]

which the election is made under such section shall apply only to the 
subpart F income for the taxable year of the single first-tier 
corporation to which the election applies or of each controlled foreign 
corporation in the chain or group to which the election applies. Only 
those amounts attributable to the stock interest to which the election 
relates may be excluded. Thus, in case of a first-tier election with 
respect to stock of a controlled foreign corporation owned directly 
within the meaning of section 958(a)(1)(A), the corporate United States 
shareholder may not exclude any subpart F income of such foreign 
corporation which is includible in its gross income under section 
951(a)(1)(A)(i) by virtue of its indirect ownership of stock in such 
foreign corporation through the operation of section 958(a)(2). Subpart 
F income of a controlled foreign corporation which is excluded from the 
gross income of a United States shareholder by reason of the receipt of 
a minimum distribution to which section 963 applies shall not be 
considered to be excluded under section 954(b)(1) or section 970(a).
    (4) Affiliated group of corporations. An affiliated group of 
domestic corporations which makes a consolidated return under section 
1501 for the taxable year shall be treated as a single United States 
shareholder for purposes of applying section 963 for such year if the 
common parent corporation in its return for such affiliated group makes 
any first-tier election, chain election, or group election under section 
963 for such affiliated group; in such case, no member of such 
affiliated group may separately make any first-tier election, chain 
election, or group election under section 963 for the taxable year. If 
the common parent of such an affiliated group so making a consolidated 
return makes no first-tier election, chain election, or group election 
for such affiliated group, then any member may make a first-tier 
election, chain election, or group election to the same extent that it 
could so elect if such affiliated group had not filed a consolidated 
return; in such case, the affiliated group will not be treated as a 
single United States shareholder.
    (b) Definitions. For purposes of section 963 and Sec. Sec. 1.963-1 
through 1.963-8--
    (1) Controlled foreign corporation. The term ``Controlled foreign 
corporation'' shall have the meaning accorded to it by section 957 and 
the regulations thereunder but shall not include any foreign corporation 
for a taxable year beginning before January 1, 1963.
    (2) Single first-tier corporation. The term ``single first-tier 
corporation'' means a controlled foreign corporation described in 
paragraph (d) of this section with respect to which a first-tier 
election has been made for the taxable year.
    (3) Chain. The term ``chain'' means collectively the foreign 
corporations described in paragraph (e) of this section with respect to 
which a chain election has been made for the taxable year.
    (4) Group. The term ``group'' means collectively the foreign 
corporations described in paragraph (f) of this section with respect to 
which a group election has been made for the taxable year.
    (5) First-tier election, etc. The term ``first-tier election'' means 
an election described in paragraph (c)(1)(i)(a) of this section; the 
term ``chain election'' means an election described in paragraph 
(c)(1)(i)(b) of this section; and the term ``group election'' means an 
election described in paragraph (c)(1)(ii) of this section.
    (6) Taxable year. (i) The term ``taxable year of a single first-tier 
corporation,'' ``taxable year of a corporation in a chain,'' or 
``taxable year of a corporation in a group,'' means, respectively, the 
taxable year of such corporation ending with or within the taxable year 
of the electing United States shareholder for which is made under 
paragraph (c)(1) of this section the election establishing it as a 
single first-tier corporation, a corporation in a chain, or corporation 
in a group, as the case may be.
    (ii) The term ``taxable year'' when used in reference to a chain or 
group refers collectively to the respective taxable years of the foreign 
corporations in such chain or group to which applies the election 
establishing such chain or group status, such taxable year being, in the 
case of each respective corporation in the chain or group, such 
corporation's taxable year ending

[[Page 487]]

with or within the taxable year of the electing United States 
shareholder, whether or not such taxable year of the corporation is the 
same as that of any other foreign corporation in the chain or group.
    (7) Foreign income tax. The term ``foreign income tax'' means 
income, war profits, and excess profits taxes, and taxes included in the 
term ``income, war profits, and excess profits taxes'' by reason of 
section 903, paid or accrued to a foreign country or possession of the 
United States and taken into account for purposes of sections 901 
through 905. Except in determining the foreign tax credit under section 
901, the term shall not include any tax which is deemed paid by a 
foreign corporation under section 902(b).
    (c) Election to exclude subpart F income--(1) Foreign corporations 
included in election. A corporate United States shareholder may for any 
taxable year exercise the election to secure an exclusion under section 
963 either--
    (i)(a) Separately with respect to any foreign corporation which as 
to such shareholder is described in paragraph (d) of this section, and/
or
    (b) Separately with respect to the foreign corporation or 
corporations which as to such shareholder are in a series described in 
paragraph (e) of this section, except to the extent of any interest (of 
such shareholder in any such corporation) with respect to which an 
election has otherwise been made under this subdivision (i); or
    (ii) With respect to all foreign corporations which as to such 
shareholder are described in paragraph (f) of this section.
    (2) Manner of making election. An election under subparagraph (1) of 
this paragraph to secure an exclusion under section 963 and the consent 
to the regulations under such section shall be made for a taxable year 
by filing with the return for such taxable year--
    (i) A written statement stating that such election is made for such 
taxable year,
    (ii) The names of the foreign corporations to which the election 
applies, the taxable year, country or incorporation, earnings and 
profits (as determined under paragraph (d) of Sec. 1.963-2), foreign 
income tax taken into account under paragraph (e) of Sec. 1.963-2, and 
outstanding capital stock, of each such corporation,
    (iii) In case of a group election, the names of all foreign 
corporations excluded from such group under paragraph (f)(2) and (3) of 
this section and identifying characterizations for all foreign branches 
included in, and excluded from, such group under paragraph (f)(4) of 
this section, together with the authority for such exclusion or 
inclusion, and
    (iv) Such other information relating to the election made as the 
Commissioner may prescribe by instructions or schedules to support such 
return.
    (3) Duration of election--(i) Year-by-year requirement. An election 
under subparagraph (1) of this paragraph to secure an exclusion under 
section 963 may be made for each taxable year of the United States 
shareholder but shall be effective only with respect to the taxable year 
for which made. An election made for any taxable year shall be 
irrevocable with respect to that taxable year once the period for the 
making of such election has expired, except to the extent provided by 
subdivision (ii) of this subparagraph.
    (ii) Revocation or modification of election for reasonable cause--
(a) Conditions under which allowed. If, after the making of an election 
under subparagraph (1) of this paragraph, the United States shareholder 
establishes to the satisfaction of the Commissioner that reasonable 
cause exists for revocation or modification of such election, it may 
withdraw that election; change from a group election to first-tier 
elections and/or chain elections or from a chain election to a first-
tier election: change from a first-tier election to a chain election or 
from first-tier elections and/or chain elections to a group election; 
or, in the case of a chain or group election, alter the composition of 
the chain or group by adding or eliminating corporations. The United 
States shareholder shall be allowed to revoke or modify elections 
pursuant to this subdivision only once for any taxable year of such 
shareholder and then only at a time prior to the expiration of the 
period prescribed by law for making an assessment of the tax imposed by 
chapter 1 of the Code for such taxable year

[[Page 488]]

and for any subsequent taxable year for which the tax liability of such 
shareholder would be affected by such revocation or modification of 
election. The Commissioner may, as a condition to such revocation or 
modification of the election, require a consent by the United States 
shareholder under section 6501 to extend, for the taxable year and such 
subsequent years affected by the revocation or modification, the period 
for the making of assessments, and the bringing of distraint or a 
proceeding in court for collection, in respect of a deficiency and all 
interest, additional amounts, and assessable penalties.
    (b) Nature of reasonable cause. Reasonable cause shall be deemed to 
exist for the revocation or modification of an election only if, after 
the making of such election, a material and substantial change in 
circumstances affecting the election occurs which reasonably could not 
have been anticipated when the election was made and which, to a 
significant degree, was beyond the control of the electing United States 
shareholder. For example, reasonable cause would exist if the minimum 
distribution were computed on the basis of a contested foreign income 
tax asserted by a foreign tax authority which, as a consequence of 
litigation occurring after the filing of the United States shareholder's 
return, is refunded, with the result that the United States shareholder 
is not entitled under the election which was made to an exclusion under 
section 963.
    (c) Request for revocation or modification. A United States 
shareholder desiring to revoke or modify the election shall mail to the 
Commissioner of Internal Revenue, Attention: T:R, Washington, DC, 20224, 
a letter requesting such revocation or modification; such letter shall 
set forth the information required by subparagraph (2) of this paragraph 
with respect to any new election and the facts and circumstances which 
the shareholder considers reasonable cause for such revocation or 
modification. The shareholder shall also consent, if required, to the 
extension of assessment period referred to in (a) of this subdivision 
and shall furnish such other information as may be required by the 
Commissioner in support of such request. If the Commissioner is 
satisfied that reasonable cause exists for the revocation or 
modification, the United States shareholder shall file an amended return 
consistent with any new election which is made.
    (d) Corporations to which a first-tier election may apply--(1) 
Includible interest. A corporate United States shareholder may make a 
first-tier election for the taxable year only with respect to a single 
controlled foreign corporation in which it owns stock directly within 
the meaning of section 958(a)(1)(A) and only with respect to the stock 
so owned. The election must apply to all of the stock so owned by such 
shareholder and shall relate only to the subpart F income of such 
corporation which would otherwise be required to be included in gross 
income by reason of owning such stock. The shareholder may for the same 
taxable year make a first-tier election with respect to one or more 
controlled foreign corporations in which it directly owns stock and not 
with respect to other controlled foreign corporations in which it 
directly owns stock.
    (2) Illustrations. The application of this paragraph may be 
illustrated by the following examples:

    Example 1. Domestic corporation M directly owns all the one class of 
stock in each of the controlled foreign corporations A, B, and C. 
Corporation M may make a first-tier election for a taxable year with 
respect to any one of corporations A, B, and C; with respect to 
corporations A and B, respectively; with respect to corporations A and 
C, respectively; with respect to corporations B and C, respectively; or 
with respect to corporations A, B, and C, respectively.
    Example 2. Domestic corporation M directly owns all the one class of 
stock of controlled foreign corporation A and 20 percent of the one 
class of stock of controlled foreign corporation B. Corporation A 
directly owns 80 percent of the stock of B Corporation. All such 
corporations use the calendar year as the taxable year. For 1964, M 
Corporation makes a first-tier election with respect to corporations A 
and B, respectively, and receives a minimum distribution from each. An 
exclusion under section 963 for 1964 will be allowed for all of A 
Corporation's subpart F income for such year but only for the amount of 
B Corporation's subpart F income which M Corporation would (without 
regard to section 963) be required to include in gross income for such 
year under section

[[Page 489]]

951(a)(1)(A)(i) by reason of directly owning 20 percent of the stock of 
B Corporation. Corporation M may not exclude any amount which it would 
be required (without regard to section 963) to include in gross income 
under section 951(a)(1)(A)(i) for such year with respect to the subpart 
F income of B Corporation by reason of its indirect ownership (through 
the operation of section 958(a)(2)) of 80 percent of the stock of B 
Corporation, unless M Corporation separately elects such exclusion and 
receives a minimum distribution with respect to such interest. See 
paragraph (e) of this section relating to chain elections.

    (e) Corporations to which a chain election may apply--(1) Includible 
interests. A Corporate United States shareholder may make a chain 
election for the taxable year with respect to one or more controlled 
foreign corporations in any series which includes only one foreign 
corporation described in subdivision (i), any one or more controlled 
foreign corporations described in subdivision (ii), and all foreign 
corporations described in subdivision (iii) of this subparagraph:
    (i) A foreign corporation, whether or not a controlled foreign 
corporation, to the extent of stock owned by such shareholder--
    (a) Directly (within the meaning of section 958(a)(1)(A)) in such 
corporation, or
    (b) Indirectly (through the operation of section 958(a)(2)) by 
virtue of the direct ownership (within the meaning of section 
958(a)(1)(A)) of stock in such corporation by a foreign trust, foreign 
estate, or foreign partnership, in which such shareholder is a 
beneficiary or partner;
    (ii) To the extent that such shareholder so elects, any controlled 
foreign corporation to the extent that, by reason of its ownership of 
stock described in subdivision (i) of this subparagraph, such 
shareholder indirectly owns within the meaning of section 958(a)(2) 
stock in such controlled foreign corporation; and
    (iii) All foreign corporations, whether or not controlled foreign 
corporations, by reason (and to the extent) of ownership of stock in 
which such shareholder indirectly owns within the meaning of section 
958(a)(2) stock in a controlled foreign corporation included in the 
series by reason of subdivision (ii) of this subparagraph.


Notwithstanding the preceding sentence, a corporate United States 
shareholder may make a chain election for the taxable year with respect 
to a single foreign corporation, but only if such foreign corporation is 
a controlled foreign corporation described in subdivision (i)(b) of this 
subparagraph. The shareholder may for the same taxable year make a chain 
election with respect to one or more series, and not with respect to 
other series, to which this subparagraph applies.
    (2) Illustrations. The application of this paragraph may be 
illustrated by the following examples:

    Example 1. Domestic corporation M directly owns all the one class of 
stock of controlled foreign corporation A, which in turn directly owns 
80 percent of the one class of stock of controlled foreign corporation 
B. Corporation M may make a chain election with respect to corporations 
A and B.
    Example 2. Domestic corporation M directly owns all the one class of 
stock of controlled foreign corporation A, which in turn directly owns 
80 percent of the one class of stock of controlled foreign corporation 
B, which in turn directly owns all the one class of stock of controlled 
foreign corporation C. Corporation M also directly owns 20 percent of 
the stock of B Corporation. Corporation M may make a chain election 
either with respect to corporations A and B or with respect to 
corporations A, B, and C. In either case corporations B and C can be 
included in the chain only to the extent of M Corporation's indirect 80-
percent stock interest in such corporations by reason of its direct 
ownership of 100 percent of the stock of A Corporation. Corporation M 
may also make a chain election with respect to corporations B and C, in 
which case the chain would include corporations B and C to the extent of 
the 20-percent stock interest which M Corporation owns directly in B 
Corporation, and indirectly owns in C Corporation by reason of its 
direct ownership of such stock interest in B Corporation.
    Example 3. Domestic corporation M directly owns all the one class of 
stock of controlled foreign corporation A, which in turn directly owns 
all the one class of stock of controlled foreign corporations B and C. 
Corporation M may make a chain election either with respect to 
corporations A, B, and C; or with respect to corporations A and B; or 
with respect to corporations A and C.
    Example 4. Domestic corporation M directly owns all the one class of 
stock of controlled foreign corporation A and 40 percent

[[Page 490]]

of the one class of stock of foreign corporation B, not a controlled 
foreign corporation. Corporation A directly owns 30 percent of the one 
class of stock of controlled foreign corporation C, and B Corporation 
directly owns the remaining 70 percent of the stock of C Corporation. 
Corporation M may make a chain election with respect to corporations A 
and C, but in such case C Corporation can be included in the chain only 
to the extent of M Corporation's indirect 30-percent stock interest in 
such corporation by reason of its direct ownership of 100 percent of the 
stock of A Corporation. Corporation M may instead make a chain election 
with respect to corporations B and C, but in such case C Corporation can 
be included in the chain only to the extent of M Corporation's indirect 
28-percent stock interest in such corporation by reason of its direct 
ownership of 40 percent of the stock of B Corporation. In the latter 
case, B Corporation must be included in the chain even though it is not 
a controlled foreign corporation. Corporation M may also make two chain 
elections, one with respect to corporations A and C, and the other with 
respect to corporations B and C, as described above.
    Example 5. Domestic corporation M directly owns all the one class of 
stock of controlled foreign corporation A, which in turn directly owns 
all the one class of stock of controlled foreign corporation B and 40 
percent of the one class of stock of foreign corporation C, not a 
controlled foreign corporation. Corporation M may make a chain election 
with respect to corporations A and B. Corporation C may not be included 
in the chain since M Corporation does not, by reason of its indirect 
ownership of stock in C Corporation, own stock in any controlled foreign 
corporation.
    Example 6. Domestic corporation M directly owns a 60-percent 
partnership interest in foreign partnership D and by reason of such 
interest owns indirectly, within the meaning of section 958(a)(2), 60 
percent of the one class of stock of controlled foreign corporation E 
(all of the stock of which is directly owned by D Partnership) and 60 
percent of the one class of stock of controlled foreign corporation F 
(all the stock of which is also directly owned by D Partnership). By 
virtue of its direct interest in D Partnership, M Corporation may make a 
chain election with respect to E Corporation alone or with respect to F 
Corporation alone. Corporation M may also make two chain elections, one 
with respect to E Corporation, the other with respect to F Corporation.

    (f) Corporations to which a group election may apply--(1) Includible 
interests. A corporate United States shareholder may make a group 
election for the taxable year with respect to a group of foreign 
corporations which includes, except as provided in subparagraphs (2) and 
(3) of this paragraph, all of the following corporations:
    (i) All controlled foreign corporations in which such shareholder 
owns stock either directly within the meaning of section 958(a)(1)(A) or 
indirectly within the meaning of section 958(a)(2), and
    (ii) All foreign corporations, whether or not controlled foreign 
corporations, by reason (and to the extent) of ownership of stock in 
which such shareholder, indirectly owns within the meaning of section 
958(a)(2) stock in a controlled foreign corporation described in 
subdivision (i) of this subparagraph.


A first-tier election or chain election may not be made for any taxable 
year with respect to any foreign corporation which for such taxable year 
has been excluded under subparagraph (2) or (3) of this paragraph from a 
group with respect to which a group election has been made for such 
year. The application of this subparagraph may be illustrated by the 
following examples:

    Example 1. Domestic corporation M directly owns all the one class of 
stock of controlled foreign corporations A and B and is a United States 
shareholder with respect to no other foreign corporation. M Corporation 
may make a group election with respect to corporations A and B.
    Example 2. Domestic corporation M directly owns all the one class of 
stock of controlled foreign corporations A and B, and B Corporation 
directly owns 80 percent of the one class of stock of controlled foreign 
corporation C. Corporation M is a United States shareholder only with 
respect to corporations A, B, and C. If M Corporation makes a group 
election, it must make the election with respect to corporations A, B, 
and C.
    Example 3. Domestic corporation M directly owns all the one class of 
stock of controlled foreign corporations A and B. Corporation A directly 
owns 70 percent of the one class of stock of controlled foreign 
corporation C. Corporation B directly owns 40 percent of the one class 
of stock of foreign corporation D, not a controlled foreign corporation, 
and D Corporation directly owns 30 percent of the stock of C 
Corporation. Corporation M is a United States shareholder with respect 
to no other foreign corporation. If M Corporation makes a group 
election, it must make the election with respect to corporations A, B, 
C, and D. Corporation D must

[[Page 491]]

be included in the group even though it is not a controlled foreign 
corporation.

    (2) Less developed country corporations. If the United States 
shareholder so elects, it may for any taxable year exclude from a group 
for purposes of a group election every controlled foreign corporation 
which is a less developed country corporation as defined in section 
955(c) and Sec. 1.955-5 for the taxable year of such foreign 
corporation ending with or within such taxable year of the shareholder 
but only if, by reason of ownership of stock in such foreign 
corporation, the shareholder does not indirectly own within the meaning 
of section 958(a)(2) stock in any other controlled foreign corporation 
which is not a less developed country corporation for its taxable year 
ending with or within such taxable year of the shareholder. The election 
under this subparagraph to exclude a less developed country corporation 
is required to be made with respect to all less developed country 
corporations of which the electing shareholder is a United States 
shareholder and which, under the preceding sentence, are eligible to be 
excluded.

    Example. Domestic corporation M directly owns all the one class of 
stock of controlled foreign corporations A and B, not less developed 
country corporations. Corporation A directly owns all of the one class 
of stock of controlled foreign corporation C, B Corporation directly 
owns all the one class of stock of controlled foreign corporation D, and 
D Corporation directly owns all the one class of stock of controlled 
foreign corporation E. Corporations C, D, and E are less developed 
country corporations under section 955(c). Corporation M may make a 
group election with respect to corporations A, B, C, D, and E; it may 
also exclude the less developed country corporations and make a group 
election with respect to corporations A and B only. If E Corporation 
were not a less developed country corporation, however, neither D 
Corporation nor E Corporation could be excluded since, by reason of 
ownership of stock in D Corporation, M Corporation would indirectly own 
stock in E Corporation, a controlled foreign corporation which is not a 
less developed country corporation.

    (3) Foreign corporations with blocked foreign income. If the United 
States shareholder so elects, it may for any taxable year exclude from a 
group for purposes of a group election any foreign corporation with 
respect to which it is established to the satisfaction of the 
Commissioner that an amount of earnings and profits of such corporation 
sufficient to constitute its share of a pro rata minimum distribution 
(as defined in paragraph (a)(2)(i) of Sec. 1.963-4) by the group cannot 
be distributed to such United States shareholder because of currency or 
other restrictions or limitations imposed under the laws of any foreign 
country. If, by reason of ownership of stock in a foreign corporation 
which is excluded from the group under the preceding sentence, a United 
States shareholder owns stock in another foreign corporation an amount 
of whose earnings and profits sufficient to constitute its share of a 
pro rata minimum distribution by the group cannot be distributed to such 
United States shareholder through such excluded foreign corporation 
because of currency or other restrictions or limitations imposed under 
the laws of any foreign country, such other foreign corporation must 
also be excluded from the group for purposes of the group election. For 
purposes of this subparagraph, the determination as to whether earnings 
and profits cannot be distributed because of currency or other 
restrictions or limitations imposed under the laws of a foreign country 
shall be made in accordance with the regulations under section 964(b), 
except that such restrictions or limitations shall be considered to 
exist notwithstanding that distributions are made by the foreign 
corporation in a foreign currency if, assuming the distributee to be the 
United States shareholder, the distributed amounts would be excludable 
from the distributee's gross income for the taxable year of receipt 
under a method of accounting in which the reporting of blocked foreign 
income is deferred until the income ceases to be blocked.
    (4) Treatment of foreign branches of domestic corporation as foreign 
subsidiary corporations--(i) In general. If the United States 
shareholder so elects, all branches (other than a branch excluded under 
subdivision (iii) of this subparagraph) maintained by such shareholder 
in foreign countries and possessions of the United States shall be 
treated, for purposes of applying subparagraph (1)

[[Page 492]]

of this paragraph, as wholly owned foreign subsidiary corporations of 
such shareholder organized under the laws of such respective foreign 
countries or possessions of the United States. Each branch treated as 
such a foreign subsidiary corporation shall be included in the group by 
the United States shareholder making the group election and shall be 
regarded, for purposes of section 963, as having distributed to such 
shareholder all of its earnings and profits for the taxable year, 
irrespective of the statutory percentage applied for the taxable year 
under paragraph (b) of Sec. 1.963-2. As used in this subparagraph, the 
term ``branch'' shall mean a permanent organization maintained in a 
foreign country or a possession of the United States to engage in the 
active conduct of a trade or business. Whether a permanent organization 
is maintained in a foreign country or possession of the United States 
shall depend upon the facts and circumstances of the particular case. As 
a general rule, a permanent organization shall be considered to be 
maintained in such country or possession if the United States 
shareholder maintains therein a significant work force or significant 
manufacturing, mining, warehousing, sales, office, or similar business 
facilities of a fixed or permanent nature. If a United States 
shareholder so operates that it satisfies the branch test with respect 
to each of several foreign countries or possessions, each such branch 
shall be treated as a separate wholly owned foreign subsidiary 
corporation organized under the laws of such country or possession in 
respect of which it satisfies such test. In no event shall a branch 
which is treated as a wholly owned foreign subsidiary corporation under 
this subparagraph be also treated as a less developed country 
corporation. The term ``possession of the United States,'' as used in 
this subparagraph, shall be construed to have the same meaning as that 
contained in paragraph (b)(2) of Sec. 1.957-3.
    (ii) Earnings and profits and taxes of a foreign branch. The 
earnings and profits (or deficit in earnings and profits) for a taxable 
year of a branch treated as a wholly owned foreign subsidiary 
corporation under this subparagraph shall be determined by applying 
against the gross income (as defined in section 61) of the branch its 
allowable deductions other than any net operating loss deduction. Any 
excess of gross income over such deductions shall constitute earnings 
and profits. Any excess of such deductions over gross income shall 
constitute a deficit in earnings and profits. For purposes of this 
subparagraph, the gross income of a branch is that which is produced by 
the trade or business activities separately conducted by it outside the 
United States and which is derived from sources without the United 
States under the provisions of sections 861 through 864 and the 
regulations thereunder; the allowable deductions of a branch are those 
which are properly allocable to or chargeable against its gross income 
and which are allowable under chapter 1 of the Code to the corporation 
of which it is a branch. Only the foreign income tax allocable to the 
gross income of the branch shall be considered paid or accrued by such 
branch. Solely for the purpose of determining under paragraph (c)(2) of 
Sec. 1.963-2 the effective foreign tax rate of a group which includes a 
branch treated as a wholly owned foreign subsidiary corporation, the 
foreign income tax considered paid or accrued by the branch shall be 
treated as an allowable deduction of such branch even though the United 
States shareholder chooses to take the benefits of section 901 for the 
taxable year.
    (iii) Excluded branches. For purposes of subdivision (i) of this 
subparagraph, a branch maintained by the United States shareholder in a 
possession of the United States shall not be treated as a wholly owned 
foreign subsidiary corporation of the United States shareholder for the 
taxable year unless such branch would be a controlled foreign 
corporation (as defined in section 957 and the regulations thereunder) 
for such taxable year if it were incorporated under the laws of such 
possession and unless the gross income of such shareholder for such 
taxable year includes for purposes of the tax imposed by Chapter 1 of 
the Code the income, if any, derived by such shareholder from sources 
within possessions of the United States, as determined under the 
provisions of sections 861

[[Page 493]]

through 864 and the regulations thereunder.
    (iv) Illustrations. The application of this subparagraph may be 
illustrated by the following examples:

    Example 1. Throughout 1964, domestic corporation M directly owns all 
of the one class of stock of controlled foreign corporations A and B. 
All corporations use the calendar year as the taxable year. During 1964, 
M Corporation engages in foreign country X in the manufacture and sale 
of steel tubing and rods, maintaining therein a significant work force 
and significant manufacturing and sales facilities for such purpose. 
Corporation M also engages in foreign country Y in the mining and sale 
of iron ore, maintaining therein a significant work force and 
substantial mining and sales facilities for such purpose. For 1964, M 
Corporation may make a group election with respect to corporations A and 
B and the branches operated in country X and country Y, treating such 
branches as wholly owned foreign subsidiary corporations. If corporation 
M elects to include one such branch in the group election, it must 
include both.
    Example 2. Throughout 1964, domestic corporation M directly owns all 
the one class of stock of controlled foreign corporations A and B. All 
corporations use the calendar year as the taxable year. During 1964, M 
Corporation exports tractors to foreign country Z, in which country its 
sole activities consist of arranging for title to the tractors to pass 
to the purchasers in that country. Corporation M's only facility in 
country Z in 1964 is a small rented office, and its work force therein 
consists only of a few clerical employees. The activities of M 
Corporation in country Z do not constitute the maintenance of a branch 
therein for purposes of this subparagraph. Corporation M may make a 
group election, only with respect to corporations A and B.

[T.D. 6759, 29 FR 13325, Sept. 25, 1964; 29 FR 13896, Oct. 8, 1964, as 
amended by T.D. 6767, 29 FR 14877, Nov. 3, 1964; T.D. 7100, 36 FR 5335, 
Mar. 20, 1971]



Sec. 1.963-2  Determination of the amount of the minimum distribution.

    (a) Application of statutory percentage to earnings and profits. The 
amount of the minimum distribution required to be received by a United 
States shareholder with respect to stock to which the election under 
paragraph (c) of Sec. 1.963-1 applies for the taxable year in order to 
qualify for a section 963 exclusion for such year shall be the amount, 
if any, determined by the multiplication of the statutory percentage 
applicable for the taxable year by--
    (1) In the case of a first-tier election, such shareholder's 
proportionate share (as determined under paragraph (d)(2) of this 
section) of the earnings and profits for the taxable year of the single 
first-tier corporation to which the election relates,
    (2) In the case of a chain election, the consolidated earnings and 
profits (as determined under paragraph (d)(3) of this section) with 
respect to such shareholder for the taxable year of the chain to which 
the election relates, or
    (3) In the case of a group election, the consolidated earnings and 
profits (as determined under paragraph (d)(3) of this section) with 
respect to such shareholder for the taxable year of the group to which 
the election relates.


For the requirement that the overall United States and foreign income 
tax incurred in respect of a minimum distribution from a chain or group 
must equal or exceed either 90 percent of the United States corporate 
tax rate applied against pretax and predistribution consolidated 
earnings and profits or, with the application of the special rules set 
forth therein, must equal or exceed the overall United States and 
foreign income tax which would have resulted from a pro rata minimum 
distribution, see paragraph (a)(1) of Sec. 1.963-4.
    (b) Statutory percentage. The statutory percentage (referred to in 
paragraph (a) of this section) for the taxable year shall be determined 
by applying the effective foreign tax rate (as defined in paragraph (c) 
of this section) for such year with respect to the single first-tier 
corporation, chain, or group, as the case may be, against--
    (1) The table set forth in section 963(b)(1) in the case of an 
election to secure an exclusion under section 963 for a taxable year of 
the United States shareholder beginning in 1963 and a taxable year 
entirely within the surcharge period ending before January 1, 1970.
    (2) The table set forth in section 963(b)(2) in the case of an 
election to secure an exclusion under section 963 for a taxable year of 
the U.S. shareholder beginning in 1964 or for a taxable year of such 
shareholder beginning in 1969

[[Page 494]]

and ending in 1970 to the extent subparagraph (B) of section 963(b)(3) 
applies,
    (3) The table set forth in section 963(b)(3) in the case of an 
election to secure an exclusion under section 963 for a taxable year of 
the U.S. shareholder beginning after December 31, 1964 except a taxable 
year which includes any part of the surcharge period, or
    (4) The table set forth in paragraph (b) of Sec. 1.963-8 in the 
case of an election to secure an exclusion under section 963 for the 
calendar year 1970.

    Example. Domestic corporation M owns all the one class of stock in 
controlled foreign corporation A. Corporation M uses the calendar year 
as its taxable year, and A Corporation uses a fiscal year ending August 
31. For 1964, M Corporation makes a first-tier election in order to 
exclude from gross income for such year the subpart F income of A 
Corporation for its taxable year ending on August 31, 1964. Although, 
such election applies to the taxable year of A Corporation beginning on 
September 1, 1963, the applicable table, for purposes of determining the 
statutory percentages to be used under paragraph (a) of this section for 
the taxable year, is that set forth in section 963(b)(2), which relates 
to taxable years of United States shareholders beginning in 1964. Thus, 
if for the taxable year of A Corporation ending August 31, 1964, the 
effective foreign tax rate is 30 percent, A Corporation would have to 
distribute 72 percent of its earnings and profits for such year in order 
for M Corporation to be entitled to an exclusion under section 963 for 
1964.

    (c) Effective foreign tax rate--(1) Single first-tier corporation. 
For purposes of section 963 the term ``effective foreign tax rate'' for 
a taxable year means, with respect to a single first-tier corporation, 
the percentage which--
    (i) The United States shareholder's proportionate share (as 
determined under paragraph (e)(1) of this section) of the foreign income 
tax of such corporation for such taxable year is of--
    (ii) The sum of--
    (a) The United States shareholder's proportionate share (as 
determined under paragraph (d)(2) of this section) of the earnings and 
profits of such corporation for such taxable year, and
    (b) The amount referred to in subdivision (i) of this subparagraph.
    (2) Chain or group of corporations. For purposes of section 963, the 
term ``effective foreign tax rate'' for a taxable year means, with 
respect to a chain or group, the percentage which--
    (i) The consolidated foreign income taxes (as determined under 
paragraph (e)(2) of this section) of such chain or group with respect to 
the United States shareholder for such taxable year is of--
    (ii) The sum of--
    (a) The consolidated earnings and profits (as determined under 
paragraph (d)(3) of this section) of such chain or group with respect to 
such United States shareholder for such taxable year, and
    (b) The amount referred to in subdivision (i) of this subparagraph.
    (3) Treatment of United States tax as foreign tax. For the purpose 
solely of determining the effective foreign tax rate under this 
paragraph, if a foreign corporation has pretax earnings and profits 
attributable to income from sources within the United States for the 
taxable year upon which it pays United States income tax and if 
distributions from the earnings and profits of such corporation for such 
year to the electing United States shareholder with respect to stock to 
which the election to secure an exclusion under section 963 relates do 
not entitled such shareholder to the dividends-received deduction under 
section 245, the amount of the United States income tax shall be taken 
into account as though such tax were foreign income tax. The amount so 
treated as foreign income tax shall not exceed 90 percent of an amount 
determined by multiplying such pretax earnings and profits attributable 
to income from sources within the United States by a percentage which is 
the sum of the normal tax rate and the surtax rate (determined without 
regard to the surtax exemption) prescribed by section 11 for the taxable 
year of the United States shareholder.
    (d) Determination of proportionate share of earnings and profits and 
consolidated earnings and profits--(1) Earnings and profits of foreign 
corporations. For purposes of Sec. Sec. 1.963-1 through 1.963-8, the 
earnings and profits, or deficit in earnings and profits, for the 
taxable year, of a single first-tier corporation or of a foreign 
corporation in a chain or group shall be the amount of its

[[Page 495]]

earnings and profits for such year, determined under section 964(a) and 
Sec. 1.964-1 but without reduction for foreign income tax or for 
distributions made by such corporation, less--
    (i) In the case of a foreign corporation included in a chain or 
group, the amount of any distributions received (computed without 
reduction for any income tax paid or accrued by such corporation with 
respect to such distributions) by such corporation during its taxable 
year from the earnings and profits (whether or not from earnings and 
profits of the taxable year to which the election under section 963 
applies) of another foreign corporation in the chain or group.
    (ii) In the case of every foreign corporation, the amount of foreign 
income tax paid or accrued by such corporation during its taxable year 
other than foreign income tax referred to in subdivision (i) and (iii) 
of this subparagraph, and
    (iii) In the case of a foreign corporation included in a chain or 
group, the foreign income tax paid or accrued by such corporation with 
respect to distributions from the earnings and profits of any other 
foreign corporation in the chain or group for the taxable year of such 
other corporation to which the election under section 963 applies, but 
only if the U.S. shareholder chooses under this subdivision to take such 
tax into account in determining the effective foreign tax rate rather 
than count it toward the amount of the minimum distribution as provided 
in paragraph (b)(2) of Sec. 1.963-3.


In the event that the foreign income tax of a corporation included in a 
chain or group depends upon the extent to which distributions are made 
by such corporation, the amount of foreign income tax referred to in 
subdivision (ii) of this subparagraph shall, only for purposes of 
determining the effective foreign tax rate, be the amount which would 
have been paid or accrued if no distributions had been made. For the 
rules in other cases involving corporations whose foreign income tax 
varies with distributions, see Sec. 1.963-5. For the manner of 
computing the earnings and profits of a foreign branch treated as a 
wholly owned foreign subsidiary corporation see paragraph (f)(4)(ii) of 
Sec. 1.963-1.
    (2) Shareholder's proportionate share of earnings and profits--(i) 
Corporation with earnings and profits--(a) In general. A United States 
shareholder's proportionate share, with respect to stock to which the 
election to secure an exclusion under section 963 relates, of the 
earnings and profits of a foreign corporation (not including a foreign 
branch described in (b) of this subdivision) for its taxable year shall 
be the share which such shareholder would receive if the total amount of 
such corporation's earnings and profits, as determined under 
subparagraph (1) of this paragraph, for such year were distributed on 
the last day of such corporation's taxable year on which such 
corporation is a controlled foreign corporation or is a foreign 
corporation by reason of the ownership of stock in which the United 
States shareholder indirectly owns within the meaning of section 
958(a)(2) stock in a controlled foreign corporation.
    (b) Foreign branch treated as a foreign subsidiary corporation. A 
United States shareholder's proportionate share of the earnings and 
profits, for the taxable year, of a branch treated as a wholly owned 
foreign subsidiary corporation and included in a group under paragraph 
(f)(4) of Sec. 1.963-1 shall be the total earnings and profits of such 
branch for the taxable year, as determined under paragraph (f)(4)(ii) of 
such section.
    (c) Indirectly held foreign corporations. If the proportionate share 
to be determined is of earnings and profits of a foreign corporation the 
stock of which is owned by the United States shareholder by reason of 
its ownership of stock (with respect to which the election relates) in 
another corporation, such shareholder's proportionate share of such 
earnings and profits for the taxable year shall be determined on the 
basis of the amount such shareholder would receive from such foreign 
corporation with respect to stock in such foreign corporation if there 
were distributed for the taxable year all such earnings and profits, as 
determined under subparagraph (1) of this paragraph, and of all the 
earnings and profits of all other corporations through

[[Page 496]]

which such earnings and profits must pass in order to be received by 
such shareholder with respect to the stock to which the election 
relates. For purposes of the preceding sentence, the amount received by 
the shareholder from the earnings and profits of a foreign corporation 
shall be determined without taking into account deductions (whether or 
not allowable under chapter 1 of the Code) of other foreign corporations 
through which such earnings and profits are distributed.
    (d) More than one class of stock. If a foreign corporation for a 
taxable year has more than one class of stock outstanding, the earnings 
and profits of such corporation for such year which shall be taken into 
account with respect to any one class of such stock shall be the 
earnings and profits which would be distributed with respect to such 
class if all earnings and profits of such corporation for such year were 
distributed on the last day of such corporation's taxable year, on which 
such corporation is a controlled foreign corporation or is a foreign 
corporation by reason of the ownership of stock in which the United 
States shareholder indirectly owns within the meaning of section 
958(a)(2) stock in a controlled foreign corporation. If an arrearage in 
dividends for prior taxable years exists with respect to a class of 
preferred stock of such corporation, the earnings and profits for the 
taxable year shall be attributed to such arrearage only to the extent 
such arrearage exceeds the earnings and profits of such corporation 
remaining from prior taxable years beginning after December 31, 1962. 
For example, if a controlled foreign corporation, using the calendar 
year as its taxable year, has earnings and profits for 1963 of $100 
accumulated at December 31, 1963, and an arrearage of $150 for such year 
in respect of preferred stock, the earnings and profits for 1964 
attributable to such arrearage may not exceed $50 ($150-$100).
    (e) Discretionary power to allocate earnings to different classes of 
stock. If the allocation of a foreign corporation's earnings and profits 
for the taxable year between two or more classes of stock depends upon 
the exercise of discretion by that body of persons which exercises with 
respect to such corporation the power ordinarily exercised by the board 
of directors of a domestic corporation, the allocation of such earnings 
and profits to such classes shall be made for purposes of this 
subdivision as if such classes constituted one class of stock in which 
each share has the same rights to dividends as any other share, unless a 
different method of allocation of such earnings and profits is made by 
such body not later than 90 days after the close of such taxable year.
    (f) Illustrations. The application of this subdivision may be 
illustrated by the following examples:

    Example 1. Domestic corporation M directly owns 80 percent of the 
one class of stock of controlled foreign corporation A, which directly 
owns 60 percent of the one class of stock of controlled foreign 
corporation B. Each such corporation has earnings and profits of $70 for 
the taxable year, as determined under subparagraph (1) of this 
paragraph. Corporation M's proportionate share of the earnings and 
profits is $56 (0.80 x $70) as to A Corporation and $33.60 (0.80 x 0.60 
x $70) as to B Corporation.
    Example 2. Throughout 1964 controlled foreign corporation A, which 
uses the calendar year as the taxable year, has outstanding 40 shares of 
common stock and 60 shares of 6-percent, nonparticipating, noncumulative 
preferred stock with a par value of $100 per share. Corporation A has 
earnings and profits of $1,000, for 1964, as determined under 
subparagraph (1) of this paragraph. In such case, $360 (0.06 x $100 x 
60) of earnings and profits would be taken into account with respect to 
the preferred stock and $640 ($1,000-$360), with respect to the common 
stock. Thus, if a United States shareholder owns 10 shares of common 
stock and 30 shares of preferred stock for 1964, its proportionate share 
of the earnings and profits for such year is $340 ([10/40 x $640] + [30/
60 x $360]).

    (ii) Deficit in earnings and profits of a corporation in a chain or 
group. A United States shareholder's proportionate share, with respect 
to stock to which the election to secure an exclusion under section 963 
relates, of a deficit in earnings and profits of a foreign corporation 
in a chain or group for a taxable year shall be the portion of such 
deficit which, if such corporation had earnings and profits for such 
year as determined under subparagraph (1) of this paragraph and all of 
such earnings and profits were distributed on the date described in 
subdivision (i)(a) of this subparagraph, the share of such

[[Page 497]]

earnings and profits such shareholder would receive bears to the total 
of the earnings and profits which would be so distributed on such date. 
For the determination of the deficit of a foreign branch treated as a 
wholly owned foreign subsidiary corporation and included in a group, see 
paragraph (f)(4)(ii) of Sec. 1.963-1. A United States shareholder's 
proportionate share of the deficit of such a branch shall be the total 
deficit of such branch for the taxable year.
    (iii) Controlled foreign corporation for part of year. If--
    (a) Stock in a foreign corporation is owned within the meaning of 
section 958(a) by a United States shareholder on the last day in the 
taxable year of such corporation for which such corporation is a 
controlled foreign corporation to which applies an election by such 
shareholder to secure an exclusion under section 963 with respect to 
such stock, or
    (b) Stock in a foreign corporation which is not a controlled foreign 
corporation is owned within the meaning of section 958(a) by a United 
States shareholder on the last day in the taxable year of such 
corporation on which another foreign corporation (which, by reason of 
the stock so owned, is owned by such shareholder within the meaning of 
section 958(a)) is a controlled foreign corporation to which applies an 
election by such shareholder to secure an exclusion under section 963 
with respect to such stock,


the earnings and profits of such foreign corporation for the taxable 
year which are taken into account in determining such shareholder's 
proportionate share thereof shall be an amount of such earnings and 
profits, determined as provided in subparagraph (1) of this paragraph, 
which bears to the total of such earnings and profits the same ratio 
which the part (computed on a daily basis) of such year during which 
such corporation is a controlled foreign corporation (or, in case such 
corporation is not a controlled foreign corporation, during which such 
other corporation is a controlled foreign corporation) bears to the 
total taxable year. If the United States shareholder by sufficient 
records and accounts establishes to the satisfaction of the district 
director the gross income received or accrued, and the deductions paid 
or accrued, for the part of such year during which such corporation is a 
controlled foreign corporation (or, in case such corporation is not a 
controlled foreign corporation, during which such other corporation is a 
controlled foreign corporation), the amount of earnings and profits 
based on such records and accounts may be used in lieu of the amount 
determined under the preceding sentence. The application of this 
subdivision may be illustrated by the following examples:

    Example 1. Domestic corporation M on June 30, 1963, purchases 60 
percent of the one class of stock of A Corporation which on July 1 
becomes a controlled foreign corporation and remains such throughout the 
remainder of 1963. Both corporations use the calendar year as the 
taxable year. Corporation M makes a first-tier election with respect to 
A Corporation. For 1963, A Corporation has $100 of earnings and profits, 
as determined under subparagraph (1) of this paragraph. Corporation M's 
proportionate share of such earnings and profits for 1963 is $30.25 
(0.60 x [184/365 x $100]).
    Example 2. (a) Throughout 1963 domestic corporation M directly owns 
20 percent of the one class of stock of foreign corporation A, not a 
controlled foreign corporation at any time, which directly owns 50 
percent of the one class of stock of foreign corporation B, which 
becomes a controlled foreign corporation on July 1, 1963, and remains 
such throughout the remainder of 1963. All such corporations use the 
calendar year as the taxable year. Each of corporations A and B has 
earnings and profits for 1963 of $100, as determined under subparagraph 
(1) of this paragraph. Corporation M makes a chain election for 1963 
with respect to corporations A and B. Corporation M's proportionate 
share of the earnings and profits of A Corporation for 1963 is $10.08 
(0.20 x [184/365 x $100]). Corporation M's proportionate share of the 
earnings and profits of B Corporation for 1963 is $5.04 (0.20 x 0.50 x 
[184/365 x $100]).
    (b) If B Corporation had been a controlled foreign corporation 
throughout 1963, M Corporation's proportionate share of the earnings and 
profits of corporations A and B for 1963 would have been $20 (0.20 x 
$100) and $10 (0.20 x 0.50 x $100), respectively.
    (c) If corporations A and B had each been a controlled foreign 
corporation only for the period of January 1, 1963, through June 30, 
1963, M Corporation's proportionate share of the earnings and profits of 
such corporations would have been $9.92 (0.20 x [181/365 x $100]) and 
$4.98 (0.20 x 0.50 x [181/365 x $100]), respectively.

[[Page 498]]

    (d) If A Corporation had been a controlled foreign corporation 
throughout 1963 or during the period of July 1, 1963, through December 
31, 1963, but B Corporation had been a controlled foreign corporation 
only during the period of January 1, 1963, through June 30, 1963, M 
Corporation's proportionate share of the earnings and profits of such 
corporations would have been $20 (0.20 x $100) and $4.96 (0.20 x 0.50 x 
[181/365 x $100]), respectively.

    (3) Consolidated earnings and profits with respect to United States 
shareholder. The consolidated earnings and profits of a chain or group 
with respect to any United States shareholder for the taxable year shall 
be the sum of such shareholder's proportionate shares of the earnings 
and profits, and of the deficit in earnings and profits, determined 
under subparagraph (2) of this paragraph, for such year of all foreign 
corporations, whether or not controlled foreign corporations, in such 
chain or group.
    (e) Foreign income taxes used in determining effective foreign tax 
rate. For purposes of determining the effective foreign tax rate under 
paragraph (c) of this section--
    (1) Shareholder's proportionate share of taxes of a foreign 
corporation. The foreign income tax of a foreign corporation for a 
taxable year shall consist of the foreign income tax referred to in 
paragraph (d)(1)(ii) of this section with respect to such year and, if 
the United States shareholder chooses to take the foreign income tax 
described in paragraph (d)(1)(iii) of this section into account in 
determining the effective foreign tax rate of a chain or group which 
includes such foreign corporation, the foreign income tax referred to in 
such paragraph with respect to such year. A United States shareholder's 
proportionate share, with respect to stock to which the election to 
secure an exclusion under section 963 applies, of the foreign income tax 
of such foreign corporation for a taxable year shall be the same 
proportion of such foreign income tax that such shareholder's 
proportionate share (as determined under paragraph (d)(2)(i) of this 
section) of the earnings and profits of such corporation for such year 
bears to the total earnings and profits of such corporation for such 
year. A United States shareholder's proportionate share of the foreign 
income tax, for the taxable year, of a branch treated as a wholly owned 
foreign subsidiary corporation and included in a group under paragraph 
(f)(4) of Sec. 1.963-1 shall be the total foreign income tax of such 
branch for the taxable year.
    (2) Consolidated foreign income taxes with respect to United States 
shareholder. The consolidated foreign income taxes of a chain or group 
with respect to a United States shareholder for the taxable year of such 
chain or group shall be the sum of such shareholder's proportionate 
shares (as determined under subparagraph (1) of this paragraph) of the 
foreign income tax of all foreign corporations, whether or not 
controlled foreign corporations, in such chain or group.
    (3) Taxes paid by foreign corporation on distributions received 
during its distribution period. If a distribution received by a foreign 
corporation in a chain or group from another foreign corporation in such 
chain or group after the close of the recipient's taxable year but 
during its distribution period for such year is allocated to the 
earnings and profits of such recipient corporation for such year under 
paragraph (c)(2) of Sec. 1.963-3, then any foreign income tax paid or 
accrued by such recipient corporation on such distribution shall be 
treated as paid or accrued for such taxable year.
    (f) Illustrations. The application of this section may be 
illustrated by the following examples:

    Example 1. For 1966, domestic corporation M makes a first-tier 
election with respect to controlled foreign corporation A, 80 percent of 
the one class of stock of which M Corporation owns directly. Both 
corporations use the calendar year as the taxable year. For 1966, A 
Corporation has earnings and profits (before reduction for foreign 
income tax) of $100 with respect to which it pays foreign income tax of 
$30. Its earnings and profits are $70 ($100-$30). Corporation M's 
proportionate share of such earnings and profits is $56 (0.80 x $70), 
and its proportionate share of the foreign income tax is $24 ($56/$70 x 
$30). The effective foreign tax rate is 30 percent ($24/[$56 + $24]). 
Based on such effective foreign tax rate, the statutory percentage under 
section 963(b)(3) for 1966 is 69 percent. Thus, the amount of the 
minimum distribution which M Corporation must receive from A 
Corporation's 1966 earnings and profits is a dividend of $38.64 (0.69 x 
$56).

[[Page 499]]

    Example 2. For 1966, domestic corporation M makes a first-tier 
election with respect to controlled foreign corporation A, all of whose 
one class of stock M Corporation owns directly. Both corporations use 
the calendar year as the taxable year. For 1966, A Corporation has 
earnings and profits (before reduction for income tax) of $100, of which 
$40 is attributable to income from sources within the United States on 
which $12 United States income tax is paid. The foreign country in which 
A Corporation is incorporated imposes an income tax at 30 percent on the 
$100 but allows a credit against its tax for the $12 of United States 
income tax, so that it imposes a net foreign income tax of $18 for 1966. 
In determining the effective foreign tax rate of A Corporation for 1966, 
such $12 of United States income tax may be treated as foreign income 
tax to the extent it does not exceed $17.28 ($40 x 0.90 x 0.48). 
Corporation A has earnings and profits of $70 for 1966. Although A 
Corporation's effective foreign tax rate for 1966 is 30 percent, 
determined by dividing $30 by the sum of $70 plus $30, none of the 
United States tax which is taken into account in determining such rate 
shall be treated as foreign income tax for purposes of determining the 
foreign tax credit of M Corporation under section 902. Based on such 
effective foreign tax rate, the statutory percentage under section 
963(b)(3) for 1966 is 69 percent. Thus, the amount of the minimum 
distribution which M Corporation must receive from A Corporation's 1966 
earnings and profits is a dividend of $48.30 (0.69 x $70).
    Example 3. Domestic corporation M directly owns throughout 1966, 60 
percent of the one class of stock of controlled foreign corporation A, 
not a less developed country corporation under section 902(d), which has 
for 1966 earnings and profits of $70 (all of which is attributable to 
subpart F income) after having paid foreign income tax of $30. Both 
corporations use the calendar year as the taxable year. Corporation A is 
created under the laws of a foreign country which imposes a 6-percent 
dividend withholding tax. Corporation M would be required, but for 
section 963, to include $42 (0.60 x $70) of A Corporation's subpart F 
income in gross income under section 951(a)(1)(A)(i). For 1966, however, 
M Corporation makes a first-tier election with respect to A Corporation. 
Since the tax withheld on distributions made by A Corporation is 
considered to have been paid by M Corporation, the effective foreign tax 
rate applicable to A Corporation for 1966 is only 30 percent, the 
percentage which such $30 of foreign income tax is of $100 (the sum of 
$30 plus $70). Thus, the statutory percentage under section 963(b) for 
1966 is 69 percent. The amount of the minimum distribution which M 
Corporation must receive from A Corporation's 1966 earnings and profits 
is the distribution M Corporation will receive if A Corporation 
distributes 69 percent of its earnings and profits for 1966. Thus, if M 
Corporation receives a distribution of 69 percent of its proportionate 
share of such earnings and profits or $28.98 (0.69 x 0.60 x $70), it may 
exclude from gross income for 1966 $42 otherwise required to be included 
in gross income under section 951(a)(1)(A)(i) and will determine its 
income tax, assuming no other income and no surtax exemption under 
section 11(c), as follows:

Dividend.......................................................   $28.98
Gross-up under section 78 ($28.98/ $70 x $30)..................    12.42
Taxable income.................................................    41.40
U.S. tax before foreign tax credit ($41.40 x 0.48).............    19.87
Foreign tax credit ($12.42 + [0.06 x $28.98])..................    14.16
U.S. tax payable...............................................     5.71
 

    Example 4. (a) For 1966 domestic corporation M makes a chain 
election with respect to controlled foreign corporation A, all of whose 
one class of stock it directly owns, and controlled foreign corporation 
B, all of whose one class of stock is directly owned by A Corporation. 
Both foreign corporations are subject to a foreign income tax at a flat 
rate of 30 percent, and all corporations use the calendar year as a 
taxable year. For 1966, B Corporation has pretax earnings and profits of 
$100 and distributes $51.50. For 1966, A Corporation has pretax earnings 
and profits of $151.50, consisting of $100 from selling activities and 
$51.50 received as a distribution from B Corporation, upon which it pays 
a foreign income tax of $45.45 (i.e., 30 percent of $151.50).
    (b) Corporation M chooses under paragraph (d)(1)(iii) of this 
section to take the foreign tax paid by A Corporation on the dividend 
received from B Corporation into account in determining the effective 
foreign tax rate of the chain rather than count it toward the amount of 
the minimum distribution. Thus, to determine consolidated earnings and 
profits of the chain for 1966, A Corporation's pretax earnings and 
profits of $151.50 are first reduced by the intercorporate dividend of 
$51.50 received from B Corporation so that A Corporation has pretax and 
predistribution earnings and profits of $100 ($151.50 less $51.50). 
Corporation A's pretax and predistribution earnings and profits of $100 
are then reduced by the foreign income tax of $30 (30 percent of $100) 
paid on such earnings and profits, resulting in predistribution earnings 
and profits of $70 ($100 less $30). Since M Corporation chooses to count 
toward the effective foreign tax rate, rather than toward the minimum 
distribution, A Corporation's foreign income tax of $15.45 (0.30 x 
51.50) imposed on the dividend received from B Corporation, such 
predistribution earnings and profits of $70 of A Corporation are further 
reduced by such $15.45 of tax to $54.55 ($70-$15.45). Corporation B, 
having received no dividends from any other corporation in the chain, 
has predistribution earnings and profits of $70 ($100 less foreign 
income tax of $30).

[[Page 500]]

    (c) The consolidated earnings and profits of the chain for 1966 are 
$124.55 ($54.55 + $70). The consolidated foreign income taxes for such 
year are $75.45 ($30 + $15.45 + $30). The effective foreign tax rate of 
the chain for 1966 is 37.73 percent ($75.45/[$124.55 + $75.45]). The 
statutory percentage for 1966 under section 963(b)(3) is 51 percent. 
Thus, the amount of the minimum distribution which M Corporation must 
receive from the 1966 consolidated earnings and profits of the chain is 
$63.52 (0.51 x $124.55).
    Example 5. The facts are the same as in example 4 except that M 
Corporation does not choose under paragraph (d)(1)(iii) of this section 
to take into account, in determining the effective foreign tax rate, the 
foreign income tax of $15.45 paid by A Corporation on the distribution 
of $51.50 received from B Corporation. In such case, the consolidated 
earnings and profits of the chain are $140 ($70 + $70) and the 
consolidated foreign income taxes are $60 ($30 + $30), the latter amount 
being determined without taking into account A Corporation's foreign 
income tax of $15.45 on the distribution of $51.50 received from B 
Corporation. The effective foreign tax rate for 1966 is 30 percent ($60/
[$140 + $60]), and the statutory percentage under section 963(b) is 69 
percent. Thus, the amount of the minimum distribution which must be made 
from the 1966 consolidated earnings and profits of the chain is $96.60 
(0.69 x $140). For the counting of such $15.45 of A Corporation's tax 
toward the $96.60 amount of the minimum distribution, see paragraph 
(b)(2) of Sec. 1.963-3.
    Example 6. For 1966 domestic corporation M directly owns the 
following percentages of the one class of stock of the following 
controlled foreign corporations in respect of which it makes a group 
election: 80 percent of A Corporation, 60 percent of B Corporation, and 
70 percent of C Corporation. All corporations use the calendar year as 
the taxable year; none of the foreign corporations is a less developed 
country corporation under section 902(d). Each foreign corporation makes 
distributions during 1966. The consolidated earnings and profits, and 
the consolidated foreign income taxes, of the group for 1966 with 
respect to M Corporation, and the amount of the minimum distribution 
which M Corporation must receive, are determined as follows, based on 
the earnings and profits and foreign income tax shown in the following 
table:

------------------------------------------------------------------------
                                                    Controlled foreign
                                                       corporations
                                                 -----------------------
                                                    A      B        C
------------------------------------------------------------------------
Predistribution and pretax earnings and profits.   $100   $100   $100.00
Foreign income tax..............................     15     25     35.00
Predistribution earnings and profits............     85     75     65.00
M Corporation's proportionate share of earnings
 and profits:
  (0.80 x $85)..................................     68
  (0.60 x $75)..................................  .....     45
  (0.70 x $65)..................................  .....  .....     45.50
Consolidated earnings and profits with respect    .....  .....    158.50
 to M Corporation ($68 + $45 + $45.50)..........
M Corporation's proportionate share of foreign
 income tax:
  ($15 x [$68/$85]).............................     12
  ($25 x [$45/$75]).............................  .....     15
  ($35 x [$45.50/$65])..........................  .....  .....     24.50
Consolidated foreign income taxes with respect    .....  .....     51.50
 to M Corporation ($12 + $15 + $24.50)..........
------------------------------------------------------------------------


The effective foreign tax rate for 1966 is 24.5 percent ($51.50/[$158.50 
+ $51.50]) and the statutory percentage under section 963(b)(3) for such 
year is 76 percent. Thus, the amount of the minimum distribution which M 
Corporation must receive from the 1966 consolidated earnings and profits 
of the group is $120.46 (0.76 x $158.50).
    Example 7. (a) For 1966 domestic corporation M makes a chain 
election with respect to the following controlled foreign corporations: 
A Corporation, 80 percent of whose one class of stock M Corporation owns 
directly; B Corporation, 60 percent of whose one class of stock is 
directly owned by A Corporation; and C Corporation, 70 percent of whose 
one class of stock is directly owned by B Corporation. All corporations 
use the calendar year as the taxable year; none of the foreign 
corporations is a less developed country corporation under section 
902(d). The predistribution and pretax earnings and profits of each 
foreign corporation are $100. Each foreign corporation pays a flat rate 
of foreign income tax on all income computed without reduction for 
dividends paid and determined by including dividends received. Such rate 
is 15 percent for A Corporation, 25 percent for B Corporation, and 35 
percent for C Corporation. Corporation C distributes $65, and B 
Corporation distributes $100, for 1966. Corporation M chooses under 
paragraph (d)(1)(iii) of this section to count toward the effective 
foreign tax rate, rather than toward the amount of the minimum 
distribution, the foreign income tax paid by corporations A and B, 
respectively, on distributions received from corporations B and C, 
respectively.
    (b) The consolidated earnings and profits, and the consolidated 
foreign income taxes, of the chain, and the amount of the minimum 
distribution for 1966, with respect to M Corporation are determined as 
follows:

[[Page 501]]



------------------------------------------------------------------------
                                      Controlled foreign corporations
                                 ---------------------------------------
                                      A         B         C       Total
------------------------------------------------------------------------
Pretax earnings and profits.....   $160.00   $145.50   $100.00
Reduction for intercorporate
 dividends:
  (0.60 x $100).................     60.00
  (0.70 x $65)..................  ........     45.50
                                 ------------------------------
Pretax and predistribution          100.00    100.00    100.00
 earnings and profits...........
Reduction for foreign income tax
 on such pretax and
 predistribution earnings and
 profits:
  (0.15 x $100).................     15.00
  (0.25 x $100).................  ........     25.00
  (0.35 x $100).................  ........  ........     35.00
                                 ------------------------------
Predistribution earnings and         85.00     75.00     65.00
 profits........................
Reduction for foreign income tax
 on intercorporate distributions
 of 1966 earnings and profits:
  (0.15 x $60)..................      9.00
  (0.25 x $45.50)...............  ........     11.38
                                 ------------------------------
                                     76.00     63.62     65.00
                                 ==============================
Consolidated earnings and
 profits with respect to M
 Corporation:
  (0.80 x $76)..................     60.80
  (0.80 x 0.60 x $63.62)........  ........     30.54
  (0.80 x 0.60 x 0.70 x $65)....  ........  ........     21.84   $113.18
Consolidated foreign income
 taxes with respect to M
 Corporation:
  ($60.80/$76 x [$15 + $9]).....     19.20
  ($30.54/$63.62 x [$25 +         ........     17.46
   $11.38]).....................
  ($21.84/$65 x $35)............  ........  ........     11.76    $48.42
Effective foreign tax rate        ........  ........  ........    29.96%
 ($48.42/[$113.18 + $48.42])....
Statutory percentage under        ........  ........  ........       69%
 section 963(b).................
Amount of minimum distribution    ........  ........  ........     $78.0
 which M Corporation must
 receive from 1966 consolidated
 earnings and profits (0.69 x
 $113.18), no amount of the tax
 on intercorporate distributions
 being counted toward the
 minimum distribution...........
------------------------------------------------------------------------

    Example 8. The facts are the same as in example 7 except that M 
Corporation does not choose under paragraph (d)(1)(iii) of this section 
to take into account, in determining the effective foreign tax rate, the 
foreign income tax paid by the recipient corporations on the 
intercorporate distributions. The consolidated earnings and profits, the 
consolidated foreign income taxes, of the chain, and the amount of the 
minimum distribution which M Corporation must receive, for 1966 are 
determined as follows:

------------------------------------------------------------------------
                                      Controlled foreign corporations
                                 ---------------------------------------
                                      A         B         C       Total
------------------------------------------------------------------------
Pretax earnings and profits.....   $160.00   $145.50   $100.00
Reduction for intercorporate
 dividends:
  (0.60 x $100).................     60.00
  (0.70 x $65)..................  ........     45.50
                                 ------------------------------
Pretax and predistribution          100.00    100.00    100.00
 earnings and profits...........
Reduction for foreign income tax
 on such pretax and
 predistribution earnings and
 profits:
  (0.15 x $100).................     15.00
  (0.25 x $100).................  ........     25.00
  (0.35 x $100).................  ........  ........     35.00
------------------------------------------------------------------------
Predistribution earnings and         85.00     75.00     65.00
 profits........................
Consolidated earnings and
 profits with respect to M
 Corporation:
  (0.80 x $85)..................     68.00
  (0.80 x 0.60 x $75)...........  ........     36.00
  (0.80 x 0.60 x 0.70 x $65)....  ........  ........     21.84   $125.84
Consolidated foreign income
 taxes with respect to M
 Corporation:
  ($68/$85 x $15)...............     12.00
  ($36/$75 x $25)...............  ........     12.00
  ($21.84/$65 x $35)............  ........  ........     11.76    $35.76
Effective foreign tax rate        ........  ........  ........    22.13%
 ($35.76/[$125.84 + $35.76])....
Statutory percentage under        ........  ........  ........       76%
 section 963(b).................
Amount of minimum distribution    ........  ........  ........    $95.64
 to be made from 1966
 consolidated earnings and
 profits with respect to M
 Corporation: (0.76 x $125.84)..

[[Page 502]]

 
Foreign income tax on
 intercorporate distributions of
 1966 earnings and profits which
 is counted toward the minimum
 distribution (see Sec. 1.963-
 3(b)(2)):
  ($68/$85 x [0.15 x $60])......      7.20
  ($36/$75 x [0.25 x $45.50])...  ........      5.46  ........    $12.66
Amount of minimum distribution    ........  ........  ........    $82.98
 which M Corporation must
 actually receive from the chain
 ($95.64-$12.66)................
------------------------------------------------------------------------


[T.D. 6759, 29 FR 13329, Sept. 25, 1964, as amended by T.D. 6767, 29 FR 
14877, Nov. 3, 1964; T.D. 7100, 36 FR 5335, Mar. 20, 1971]



Sec. 1.963-3  Distributions counting toward a minimum distribution.

    (a) Conditions under which earnings and profits are counted toward a 
minimum distribution--(1) In general. A distribution to the United 
States shareholder by a single first-tier corporation or by a foreign 
corporation included in a chain or group shall count toward a minimum 
distribution for the taxable year of such shareholder to which the 
election under section 963 relates only to the extent that--
    (i) It is received by such shareholder during such year or within 
180 days thereafter,
    (ii) It is a distribution of the type described in paragraph (b) of 
this section,
    (iii) Under paragraph (c) of this section, it is deemed to be 
distributed from the earnings and profits of the foreign corporations 
for the taxable year of such corporation to which the election relates, 
and
    (iv) Such shareholder chooses to include it in gross income for the 
taxable year of such shareholder to which the election relates 
notwithstanding that such distribution, by reason of its receipt after 
the close of such year, would ordinarily be includible in the gross 
income of a subsequent year.


Amounts taken into account under this subparagraph as gross income of 
the United States shareholder for the taxable year to which the election 
relates shall not be considered to be includible in the gross income of 
such shareholder for a subsequent taxable year. For purposes of 
determining the foreign tax credit under sections 901 through 905, 
foreign income tax paid or accrued by such shareholder on or with 
respect to such amounts shall be treated as paid or accrued during the 
taxable year of such election.
    (2) Distributions made prior to acquisition of stock. A United 
States shareholder which owns within the meaning of section 958(a) stock 
in a foreign corporation with respect to which such shareholder elects 
to secure an exclusion under section 963 for the taxable year may count 
toward the minimum distribution any distribution made with respect to 
such stock, and before its acquisition by the United States shareholder, 
to any other domestic corporation not exempt from income tax under 
chapter 1 of the Code, to the extent that such distribution is made out 
of the United States shareholder's proportionate share, as determined 
under paragraph (d)(2) of Sec. 1.963-2, of such corporation's earnings 
and profits for the taxable year and would have counted toward a minimum 
distribution if it had been distributed to such United States 
shareholder. The application of this subparagraph may be illustrated by 
the following examples:

    Example 1. Controlled foreign corporation A, which uses the calendar 
year as the taxable year, has for 1963 $100 of earnings and profits and 
100 shares of only one class of stock outstanding. Domestic corporation 
M, not exempt from income tax under chapter 1 of the Code, directly owns 
all of such shares during the period from January 1, 1963, through June 
30, 1963. On June 30, 1963, M Corporation transfers all of such shares 
to domestic corporation N, which owns them throughout the remainder of 
1963 and elects to secure an exclusion under section 963 for such year 
with respect to the subpart F income of A Corporation. During June 1963, 
M Corporation receives a dividend of $75 from A Corporation, which would 
count toward a minimum distribution if it had been distributed to N 
Corporation for such year. Corporation N's proportionate share of the 
earnings and profits of A Corporation for 1963 is

[[Page 503]]

$100; N Corporation may count toward a minimum distribution for 1963 the 
entire dividend of $75 paid to M Corporation.
    Example 2. The facts are the same as in example 1 except that M is a 
nonresident alien individual. Since A Corporation is not a controlled 
foreign corporation from January 1, 1963, through June 30, 1963, N 
Corporation's proportionate share of the earnings and profits of A 
Corporation for 1963 is $50.41 ($100 x 184/365), as determined under 
paragraph (d)(2)(iii) of Sec. 1.963-2. Although $25.41 ($75-$49.59) of 
the $75 distribution to M is paid from N Corporation's proportionate 
share of A Corporation's 1963 earnings and profits, N Corporation may 
not count toward a minimum distribution any part of the $75 dividend 
distributed to M, since M is not a domestic corporation.

    (b) Qualifying distributions--(1) Amounts not counted toward a 
minimum distribution. No distribution received by a United States 
shareholder shall count toward a minimum distribution for the taxable 
year with respect to such shareholder to the extent the distribution is 
excludable from gross income to the extent gain on the distribution is 
not recognized, or to the extent the distribution is treated as a 
distribution in part or full payment in exchange for stock. 
Undistributed amounts required to be included in gross income under 
section 551 as undistributed foreign personal holding company income or 
under section 951 as undistributed amounts of a controlled foreign 
corporation shall not count toward a minimum distribution under section 
963. An amount received by a United States shareholder as a distribution 
which under section 302 or section 331 is treated as a distribution in 
part or full payment in exchange for stock shall not count toward a 
minimum distribution even though such amount is includible in gross 
income under section 1248 as a dividend. For purposes of this 
subparagraph, any portion of a distribution of earnings and profits 
which is attributable to an increase in current earnings, invested in 
United States property which, but for paragraph (e) of this section, 
would be included in the gross income of the United States shareholder 
under section 951(a)(1)(B) shall not be treated as an amount excludable 
from gross income.
    (2) Inclusion of tax on intercorporate distributions. In the case of 
a chain or group election, the United States shareholder's proportionate 
share of the amount of the foreign income tax paid or accrued for the 
taxable year by a foreign corporation in the chain or group with respect 
to distributions received by such corporation from the earnings and 
profits, of another foreign corporation in such chain or group, for the 
taxable year of such other corporation to which the election relates 
shall count toward a minimum distribution from such chain or group for 
the taxable year, but only if the United States shareholder does not 
choose under paragraph (d)(1)(iii) of Sec. 1.963-2 to take such tax 
into account in determining the effective foreign tax rate of such chain 
or group for the taxable year. To the extent that foreign income tax 
counts toward a minimum distribution under this subparagraph, it shall 
be applied against and reduce the amount of the minimum distribution 
required to be received by the United States shareholder, determined 
without regard to this paragraph.
    (c) Rules for allocation of distributions to earnings and profits 
for a taxable year. To determine whether a distribution to the United 
States shareholder by a single first-tier corporation or by a foreign 
corporation in a chain or group is made from the earnings and profits of 
such corporation for the taxable year to which the election under 
section 963 relates, the following subparagraphs shall apply:
    (1) Exception to section 316. Section 316 shall apply except that a 
distribution of earnings and profits made by a foreign corporation 
either to another foreign corporation or to the United States 
shareholder shall be treated as having been paid from the earnings and 
profits of the distributing corporation for the taxable year of such 
corporation to which the election relates only if it is made during its 
distribution period (described in paragraph (g) of this section) for 
such year.
    (2) Distributions from other corporations. The earnings and profits 
of a foreign corporation shall be determined in accordance with 
paragraph (d)(1) of Sec. 1.963-2 (applied as though the United States 
shareholder had chosen under subparagraph (1)(iii) of such paragraph to 
take the tax described therein into

[[Page 504]]

account in determining the effective foreign tax rate) except that, in 
the case of a chain or group election, a distribution received by a 
foreign corporation in the chain or group from another foreign 
corporation in such chain or group shall be taken into account as 
earnings and profits of the recipient corporation for the taxable year 
of such recipient corporation to which the election relates but only to 
the extent that--
    (i) The distribution is received by the recipient corporation during 
the distribution period for the taxable year of such recipient 
corporation to which the election relates,
    (ii) If the distribution had been received by the United States 
shareholder, it would have constituted a distribution of the type 
described in paragraph (b) of this section, and
    (iii) The distribution is made from the earnings and profits of the 
distributing corporation for the taxable year of such distributing 
corporation to which the election relates.
    (d) Year of inclusion in income of foreign corporation and effect 
upon subpart F income. To the extent that a distribution to the United 
States shareholder counting toward a minimum distribution from a chain 
or group consists of earnings and profits distributed to a foreign 
corporation in the chain or group after the close of the recipient 
corporation's taxable year but during its distribution period for such 
year by another foreign corporation in such chain or group, such amount 
shall be treated as received by the recipient corporation on the last 
day of such taxable year and shall not be regarded as foreign personal 
holding company income (within the meaning of section 553(a) or 954(c)) 
of such corporation for the taxable year in which such amount is 
actually received. The extent to which a distribution counting toward a 
minimum distribution consists of earnings and profits distributed to a 
foreign corporation in a chain or group shall be determined under the 
ordering rules of paragraph (b)(3) of Sec. 1.963-4 (applied in each 
instance as though the United States shareholder had not chosen under 
paragraph (d)(1)(iii) of Sec. 1.963-2 to take the tax described therein 
into account in determining the effective foreign tax rate). However, 
for such purpose, the amount of foreign income tax, if any, which counts 
toward the minimum distribution shall be determined without regard to 
paragraph (b)(2) of this section but in accordance with paragraph 
(b)(3)(iii) of Sec. 1.963-4.
    (e) Distribution of current earnings invested in United States 
property. A distribution made by a foreign corporation during its 
distribution period for a taxable year shall, notwithstanding section 
959(c), first be attributed to earnings and profits for such year 
described in section 959(c)(3) and then to other earnings and profits. 
For such purposes, earnings and profits of such foreign corporation for 
such year attributable to amounts which would otherwise be included in 
gross income of the United States shareholder under section 951(a)(1)(B) 
for such year shall be treated as earnings and profits to which section 
959(c)(3) applies, shall not be excluded from gross income under section 
959 (a) or (b), and shall count toward a minimum distribution for such 
year. See paragraph (c)(1)(v) of Sec. 1.960-1 and paragraph (a) of 
Sec. 1.960-2.
    (f) Cumulative dividends in arrears. A distribution in satisfaction 
of arrearages shall be treated as being made out of earnings and profits 
of the foreign corporation for the taxable year to which the election 
under section 963 applies only to the extent the dividend is not 
attributed, under paragraph (d)(2)(i)(d) of Sec. 1.963-2, to the 
earnings and profits of such corporation remaining from prior taxable 
years beginning after December 31, 1962. The application of this 
paragraph may be illustrated by the following example:

    Example. For 1963, single first-tier corporation A, which uses the 
calendar year as the taxable year, has earnings and profits of $50; for 
1964, a deficit in earnings and profits of $20; for 1965, earnings and 
profits of $100; and for 1966, earnings and profits of $240. For each of 
such years preferred dividends accumulate at the rate of $60; but no 
dividend is paid until 1966 during which year the current dividend is 
paid and $180 is distributed toward the arrearages. Of this $180, only 
$50 ($180-$130) shall be treated as paid from 1966 earnings and profits.

    (g) Distribution period of a foreign corporation--(1) General 
distribution period. Except as provided by subparagraph (2)

[[Page 505]]

of this paragraph, the distribution period with respect to a foreign 
corporation for its taxable year shall begin immediately after the close 
of the distribution period for the preceding taxable year and shall end 
with the close of the 60th day of the next succeeding taxable year. If 
no election to secure an exclusion under section 963 applied to the 
preceding taxable year, the distribution period for the taxable year 
shall begin with the 61st day of the taxable year.
    (2) Special extended distribution period. If the United States 
shareholder of the foreign corporation so elects in statement filed with 
its return for the taxable year for which the election to secure the 
exclusion under section 963 is made, the distribution period with 
respect to such foreign corporation for its taxable year to which the 
election to secure the exclusion applies shall end with any day which 
occurs no earlier than the last day of such taxable year of such foreign 
corporation and no later than the 180th day after the close of such 
taxable year. The statement shall designate the day so elected as the 
end of the distribution period.
    (h) Illustrations. The application of this section may be 
illustrated by the following examples:

    Example 1. For 1963 domestic corporation M makes a chain election 
with respect to controlled foreign corporation A, all of whose one class 
of stock M Corporation directly owns, and controlled foreign corporation 
B, all of whose one class of stock is directly owned by A Corporation. 
All such corporations use the calendar year as the taxable year, and the 
distribution periods of corporations A and B for 1963 coincide. 
Corporations A and B each have earnings and profits (before 
distributions) of $100 for 1963. On June 1, 1963, B Corporation 
distributes earnings and profits of $120, of which $100 is from its 
earnings and profits for 1963 and $20 is from prior earnings. For 1963, 
A Corporation pays no income tax and distributes earnings and profits of 
$150 to M Corporation. Under paragraph (c) of this section, such $150 is 
allocated to A Corporation's earnings and profits of $200 for 1963, 
consisting of its total earnings and profits for that year of $220 less 
the $20 received as a distribution from B Corporation's prior earnings.
    Example 2. Domestic corporation M directly owns all of the one class 
of stock of controlled foreign corporation A. Both corporations use the 
calendar year as the taxable year, and A Corporation's taxable year and 
its distribution period for 1963 coincide. For 1963, $50 is included in 
the gross income of M Corporation under section 951(a)(1)(B) as A 
Corporation's increase in earnings invested for such year in United 
States property. For 1964, M Corporation makes a first-tier election 
with respect to A Corporation. For 1964, A Corporation has earnings and 
profits of $100, including $10 attributable to an increase in earnings 
invested for such year in United States property. During 1964, A 
Corporation distributes earnings and profits of $80 to M Corporation. 
Without regard to paragraph (e) of this section, $10 of this 
distribution is attributable under section 959(c)(1) to A Corporation's 
1964 earnings and profits required to be included in M Corporation's 
gross income under section 951(a)(1)(D). Pursuant to paragraph (e) of 
this section, however, the entire distribution of $80 counts toward a 
minimum distribution for 1964 and is considered to be from earnings and 
profits of A Corporation for 1964 described in section 959(c)(3). Thus 
the entire distribution of $80 is included in M Corporation's gross 
income as a dividend and the foreign tax credit in respect of such 
amount is determined in accordance with section 902 as modified by the 
regulations under section 963. On the other hand, if A Corporation made 
no distributions for 1964, no part of the $10 of A Corporation's 
increase in earnings invested in United States property for such year 
would count toward a minimum distribution for any other year but would 
be included in the gross income for M Corporation for 1964 under section 
951(a)(1)(B), and the foreign tax credit in respect of such amount would 
be determined in accordance with Sec. 1.960-1.
    Example 3. For 1964 domestic corporation M makes a chain election 
with respect to controlled foreign corporation A, all the one class of 
stock of which is owned directly by M Corporation, and controlled 
foreign corporation B, all the one class of stock of which is owned 
directly by A Corporation. Corporation M makes no election under section 
963 for 1963 or 1965. Corporations M and B use the calendar year as the 
taxable year, and A Corporation uses for its taxable year a fiscal year 
ending on September 30. Corporation M elects to have the distribution 
period for each controlled foreign corporation end on March 29, 1965, 
such date being the 180th day after the close of A Corporation's taxable 
year ending on September 30, 1964. Corporation A's distribution period 
for its taxable year ending on September 30, 1964, begins on November 
30, 1963, the 61st day of such taxable year. The distribution period of 
B Corporation for 1964 begins on March 1, 1964, the 61st day of such 
taxable year. A distribution counting toward a minimum distribution for 
1964 may be made from the earnings and profits of B Corporation only if

[[Page 506]]

the amount thereof is distributed by B Corporation to A Corporation, and 
in turn by A Corporation to M Corporation, during the period of March 1, 
1964, through March 29, 1965.
    Example 4. The facts are the same as in example 3, except that for 
their taxable years ending in 1964, corporations A and B each have 
earnings and profits (before distributions) of $100. On March 10, 1965, 
B Corporation distributes to A Corporation a dividend of $80 upon which 
A Corporation incurs foreign income tax at the rate of 10 percent. On 
March 15, 1965, A Corporation distributes to M Corporation a dividend of 
$50. Corporation M chooses to take into account as gross income for 1964 
from such distribution only $40. For purposes of applying this section, 
the distribution counting toward a minimum distribution is $44.44, 
consisting of the $40 of earnings and profits actually received by M 
Corporation plus the $4.44 ($40/$72 x $8) of foreign income tax incurred 
by A Corporation attributable thereto; A Corporation is deemed to have 
received $44.44 ($40 / 0.90) of the distribution from B Corporation on 
September 30, 1964, the last day of the taxable year of A Corporation to 
which the election relates; and the foreign personal holding company 
income derived by A Corporation for its taxable year ending in 1965 from 
the distribution from B is only $35.56 ($80-$44.44). Assuming that no 
exceptions, exclusions, or exemptions were applicable, subpart F income 
would be realized by A Corporation for its taxable year ending on 
September 30, 1965, upon the distribution by B Corporation to A 
Corporation, but only in the amount of $32 ($35.56 less a deduction 
under section 954(b)(5) for taxes of $3.56).

[T.D. 7100, 36 FR 10860, June 4, 1971; 36 FR 11924, June 23, 1971, as 
amended by T.D. 7334, 39 FR 44214, Dec. 23, 1974]



Sec. 1.963-4  Limitations on minimum distribution from a chain or group.

    (a) Minimum overall tax burden--(1) In general. Notwithstanding the 
fact that distributions of the type described in paragraph (a) of Sec. 
1.963-3 are made by a chain or group to the United States shareholder in 
an amount sufficient to constitute a minimum distribution for the 
taxable year of such shareholder to which the chain or group election 
relates, no exclusion shall be allowable under section 963 to such 
shareholder with respect to such chain or group for such year unless--
    (i) Without applying the special rules set forth in paragraphs (b) 
and (c) of this section, the overall United States and foreign income 
tax (as defined in subparagraph (2)(ii) of this paragraph) for the 
taxable year with respect to the distribution which is made equals or 
exceeds 90 percent of an amount determined by multiplying the sum of the 
consolidated earnings and profits (as determined under paragraph (d)(3) 
of Sec. 1.963-2) and the consolidated foreign income taxes (as 
determined under paragraph (e)(2) of Sec. 1.963-2) of such chain or 
group for the taxable year with respect to such shareholder by a 
percentage which equals the sum of the normal tax rate and the surtax 
rate (determined without regard to the surtax exemption) prescribed by 
section 11 for the taxable year of the shareholder, or
    (ii) With the application of the special rules set forth in 
paragraphs (b) and (c) of this section--
    (a) Such shareholder receives a pro rata minimum distribution (as 
defined in subparagraph (2)(i) of this paragraph) from such chain or 
group for such taxable year, or
    (b) To the extent necessary, the amount of the foreign income tax 
allowable as a credit for such year under section 901 with respect to 
the distribution which is made is reduced and credit for the reduction 
is deferred, as provided in paragraph (c)(3) of this section, so that 
the overall United States and foreign income tax for the taxable year 
with respect to such distribution equals or exceeds the lesser of--
    (1) The overall United States and foreign income tax which would be 
paid or accrued for such year with respect to a pro rata minimum 
distribution received by such shareholder from such chain or group for 
such year, and
    (2) Ninety percent of an amount determined by multiplying the sum of 
the consolidated earnings and profits (as determined under paragraph 
(b)(1) of this section) and the consolidated foreign income taxes (as 
determined under paragraph (b)(1) of this section) of such chain or 
group for the taxable year with respect to such shareholder by a 
percentage which equals the sum of the normal tax rate and the surtax 
rate (determined without regard to the surtax exemption) prescribed by 
section 11 for the taxable year of the shareholder.
    (2) Definitions. For purposes of Sec. Sec. 1.963-1 through 
1.963.8--

[[Page 507]]

    (i) Pro rata minimum distribution. A pro rata minimum distribution 
from a chain or group for the taxable year is a distribution of earnings 
and profits to the United States shareholder, with respect to stock to 
which the chain or group election relates, which is the statutory 
percentage (applicable with respect to such chain or group as determined 
under paragraph (b) of Sec. 1.963-2) of the United States shareholder's 
proportionate share of the taxable year's earnings and profits of each 
foreign corporation in such chain or group (determined in accordance 
with paragraph (d)(2) of Sec. 1.963-2 but without making any deduction 
under paragraph (d)(1)(iii) of such section).
    (ii) Overall United States and foreign income tax. The overall 
United States and foreign income tax for any taxable year of a chain or 
group with respect to a minimum distribution is the sum of--
    (a) The consolidated foreign income taxes of the chain or group for 
such year with respect to the United States shareholder making the chain 
or group election,
    (b) Any other foreign income tax paid or accrued by a foreign 
corporation in the chain or group by reason of the receipt of any 
distributions counting toward such minimum distribution from such chain 
or group for that year, and
    (c) The foreign income tax, if any, and United States income tax 
paid or accrued by such shareholder upon amounts counting toward such 
minimum distribution from such chain or group for such year.


Such overall United States and foreign income tax shall be determined 
with respect to such minimum distribution without taking into account 
any foreign income tax which is deemed paid for such year under section 
904(d), relating to carryback and carryover of excess tax paid. For 
purposes of this subdivision, the consolidated foreign income taxes of 
the chain or group shall be determined under paragraph (e)(2) of Sec. 
1.963-2, applied without regard to the second sentence of paragraph 
(d)(1) of that section.
    (3) Taxes paid by foreign corporation on distributions received 
during its distribution period. For purposes of determining foreign 
income tax deemed paid by the United States shareholder for the taxable 
year under section 902, if a distribution received by a foreign 
corporation in a chain or group from another foreign corporation in such 
chain or group after the close of the recipient's taxable year but 
during its distribution period for such year is allocated to the 
earnings and profits of such recipient corporation for such year under 
paragraph (c)(2) of Sec. 1.963-3, any foreign income tax paid or 
accrued by such recipient corporation on such distribution shall be 
treated as paid or accrued for such taxable year.
    (4) Illustration. The application of this paragraph may be 
illustrated by the following example:

    Example. (a) Domestic corporation M directly owns all of the one 
class of stock of foreign corporation A, which in turn directly owns all 
of the one class of stock of foreign corporation B. Corporation M makes 
a chain election with respect to A Corporation and B Corporation. All 
such corporations use the calendar year as the taxable year. Assuming 
that A Corporation does not incur foreign tax on amounts distributed by 
B Corporation, the foreign income tax and earnings and profits of 
corporations A and B, the effective foreign tax rate, and the statutory 
percentage for 1966, are as follows:

------------------------------------------------------------------------
                                                A      B    Consolidated
------------------------------------------------------------------------
Pretax and predistribution earnings and        $100   $100        $200
 profits....................................
Foreign income tax..........................     20     40          60
                                             ---------------------------
Earnings and profits........................     80     60         140
                                             ===========================
Effective foreign tax rate ($60/[$140 +       .....  .....         30%
 $60])......................................
Statutory percentage under section 963(b)...  .....  .....         69%
------------------------------------------------------------------------

    (b) Corporation M is entitled for 1966 to exclude its pro rata share 
of the subpart F income of corporations A and B for such year if it 
receives from the 1966 consolidated earnings and profits of the chain 
distributions totaling at least $96.60 (0.69 x $140) and if--
    (1) The sum of the consolidated foreign income taxes ($60) of the 
chain for 1966 and of the United States income tax for 1966 (determined 
by taking into account the foreign tax credit under section 901 without 
regard to paragraph (c) of this section) imposed on such distributions 
equals at least $86.40 (0.90 x 0.48 x $200);
    (2) Under the special rules of paragraphs (b) and (c) of this 
section, the distributions received consist of a distribution from each 
of corporations A and B which is 69 percent of the earnings and profits 
for 1966 of such corporation, that is, a distribution of $55.20

[[Page 508]]

(0.69 x $80) from A Corporation and of $41.40 (0.69 x $60) from B 
Corporation; or
    (3) Under the special rules of paragraphs (b) and (c) of this 
section, the foreign tax credit is reduced and deferred to such an 
extent that the sum of the consolidated foreign income taxes ($60) of 
the chain for 1966 and of the United States income tax for 1966 
(determined by taking into account the foreign tax credit under section 
901 as modified by paragraph (c) of this section) imposed on such 
distributions equals the lesser of $86.40 (0.90 x 0.48 x $200) and the 
amount which the sum of such taxes would be if M Corporation were to 
receive a distribution of $55.20 (0.69 x $80) from the 1966 earnings and 
profits of A Corporation and $41.40 (0.69 x $60) from the 1966 earnings 
and profits of B Corporation.

    (b) Special rules for determining earnings and profits and foreign 
income taxes. For purposes of determining the minimum overall tax burden 
under paragraph (a)(1)(ii) of this section, Sec. Sec. 1.963-2 and 
1.963-3 shall apply as modified by the following subparagraphs:
    (1) Exclusion of tax on intercorporate distributions. The 
consolidated earnings and profits and consolidated foreign income taxes 
of a chain or group for the taxable year shall be determined in 
accordance with Sec. 1.963-2, except that foreign income tax referred 
to in paragraph (d)(1)(iii) of such section may be taken into account in 
determining the effective foreign tax rate only--
    (i) To the extent that such tax is not deemed paid by the United 
States shareholder under section 902 (as modified by paragraph (c) of 
this section) for its taxable year to which the chain or group election 
relates, or
    (ii) If, by taking the tax into account, the effective foreign tax 
rate with respect to such chain or group, as determined under paragraph 
(c)(2) of Sec. 1.963-2, exceeds the highest effective foreign tax rate 
requiring a distribution under section 963(b) for such year of the 
shareholder.
    (2) Allocation of deficits. For purposes of determining the amount 
of each foreign corporation's share of a pro rata minimum distribution 
from a chain or group for the taxable year and for purposes of 
determining the foreign tax credit under paragraph (c) of this section 
of the United States shareholder with respect to any minimum 
distribution from a chain or group for the taxable year--
    (i) Deficits of foreign corporations. The total of the United States 
shareholder's proportionate shares, as determined under paragraph 
(d)(2)(ii) of Sec. 1.963-2, of the deficit of every foreign corporation 
in the chain or group having a deficit for the taxable year shall be 
allocated against and shall reduce such shareholder's proportionate 
share, as determined under paragraph (d)(2)(i) of Sec. 1.963-2, of the 
earnings and profits for the taxable year of each other foreign 
corporation in the chain or group having earnings and profits for such 
year in an amount which bears to such total of shares of deficit the 
same ratio which such share of earnings and profits bears to the total 
of such shareholder's proportionate shares, as so determined, of the 
earnings and profits of all foreign corporations in the chain or group 
having earnings and profits for the taxable year.
    (ii) Deficits of foreign branches. If for the taxable year a group 
includes under paragraph (f)(4) of Sec. 1.963-1 foreign branches the 
aggregate of whose allowable deductions (other than any net operating 
loss deduction) exceeds the aggregate of their gross incomes for the 
taxable year, determined as provided in paragraph (f)(4)(ii) of such 
section, the amount of such excess shall be allocated as provided by 
subdivision (i) of this subparagraph.
    (3) Distributions through a chain or group. In determining whether 
and to what extent a distribution for any taxable year has been made out 
of the earnings and profits of a foreign corporation included in a chain 
of ownership described in section 958(a) consisting of two or more 
corporations in a chain or group for the taxable year, the following 
subdivisions shall apply:
    (i) Allocation first to income received as a distribution. If any 
foreign corporation included in the chain or group for the taxable year 
receives a distribution for such year from another foreign corporation 
in the chain or group and in turn makes a distribution for the taxable 
year, the distribution so made shall first be allocated to the earnings 
and profits, to the extent thereof, attributable to the distribution so 
received; if distributions are received from more than one other 
corporation in the chain or group, the distribution

[[Page 509]]

made by the recipient corporation shall be apportioned among all such 
amounts. For purposes of determining whether a distribution is made or 
received for the taxable year, see paragraph (c) of Sec. 1.963-3.
    (ii) Successive distributions through a chain or group. If any 
foreign corporation included in the chain or group for the taxable year 
distributes an amount from its earnings and profits of such year, the 
amount so distributed shall be considered to be received from such 
earnings and profits by the United States shareholder to the extent the 
amount is distributed by successive distributions made by each other 
foreign corporation in the chain or group for the taxable year through 
the chain of ownership described in section 958(a) into the hands of 
such shareholder.
    (iii) Distribution determined without reduction by taxes of 
intervening corporations. If, for the taxable year to which the election 
to secure an exclusion under section 963 applies, the United States 
shareholder receives a distribution to which subdivision (ii) of this 
subparagraph applies, the entire amount distributed by the foreign 
corporation from such shareholder's proportionate share of its earnings 
and profits for the taxable year shall, except where taxes referred to 
in paragraph (d)(1)(iii) of Sec. 1.963-2 are taken into account as 
provided by subparagraph (1) of this paragraph, count toward a minimum 
distribution and shall not be reduced for such purpose by a foreign 
income tax paid or accrued on such amount by another foreign corporation 
in the chain or group through which such amount is distributed by 
successive distributions into the hands of such shareholder. The 
application of this subdivision may be illustrated by the following 
examples:

    Example 1. For 1966, domestic corporation M makes a chain election 
with respect to controlled foreign corporation A, all the one class of 
stock of which is directly owned by M Corporation, and controlled 
foreign corporation B, all the one class of stock of which is directly 
owned by A Corporation. All corporations use the calendar year as the 
taxable year. Corporation M complies with the special rules of this 
paragraph and paragraph (c) of this section for the taxable year. 
Corporation A's only income for 1966 is a dividend of $52.50 distributed 
in such year by B Corporation, on which A Corporation is subject to an 
income tax of $10.50. The remaining $42 ($52.50 less $10.50) is 
distributed by A Corporation for 1966 to M Corporation. The full $52.50 
distributed by B Corporation counts toward a minimum distribution by the 
chain for 1966.
    Example 2. For 1966, domestic corporation M makes a chain election 
with respect to controlled foreign corporation A, all the one class of 
stock of which it owns directly, and controlled foreign corporation B, 
all the one class of stock of which A Corporation own directly. All 
corporations use the calendar year as the taxable year. Corporation M 
complies with the special rules of this paragraph and paragraph (c) of 
this section for the taxable year. The predistribution and pretax 
earnings and profits for 1966 of B Corporation are $100, and of A 
Corporation, $0. Corporation B pays foreign income tax of $30 and during 
the year distributes $70. On such $70, A Corporation pays foreign income 
tax of $14. By applying paragraph (d)(1)(iii) of Sec. 1.963-2, the 
consolidated foreign income taxes of the chain for 1966 are $44 ($30 + 
$14) and the consolidated earnings and profits of the chain are $56 
($70-$14); in such case, the effective foreign tax rate of the chain for 
1966 is 44 percent ($44/[$56 + $44]) and thus in excess of the highest 
effective foreign tax rate requiring a distribution for such year under 
section 963(b). Since M Corporation may thus take A Corporation's tax of 
$14 into account, the statutory percentage under section 963(b) for 1966 
is zero percent and the amount of the minimum distribution required to 
be made by the chain is $0.

    (c) Special foreign tax credit rules--(1) In general. In determining 
the minimum overall tax burden under paragraph (a)(1)(ii) of this 
section, the foreign tax credit of the United States shareholder with 
respect to a minimum distribution received for the taxable year from the 
chain or group shall be determined under the provisions of sections 901 
through 905 as modified by Sec. 1.963-3 except that--
    (i) Under subparagraph (2) of this paragraph--
    (a) Taxes of a second-tier corporation making a distribution through 
a first-tier corporation shall not be averaged with taxes of such first-
tier corporation,
    (b) Taxes of a first-tier corporation or a second-tier corporation 
on a distribution made through such corporation shall not be averaged 
with such corporation's taxes on its other income; and

[[Page 510]]

    (c) Taxes of a first-tier corporation or a second-tier corporation 
shall not be deemed paid with respect to distributions from the earnings 
and profits of such corporation which are offset by a deficit allocated 
under paragraph (b)(2) of this section to the United States 
shareholder's proportionate share of the earnings and profits of such 
corporation; and
    (ii) The foreign tax credit may be reduced and the reduction 
deferred under subparagraph (3) of this paragraph to another taxable 
year of the United States shareholder.
    (2) Nonaveraging of tax--(i) Year of minimum distribution--(a) Taxes 
deemed paid by a first-tier corporation and taxes actually paid by such 
corporation. If, by successive distributions through a chain or group, a 
United States shareholder receives for a taxable year a distribution of 
the earnings and profits for such year of any corporation in such chain 
or group, and if both section 902(a) and section 902(b) apply with 
respect to such distribution, all the taxes deemed paid under section 
902(b) by the first-tier corporation described in section 902(a) with 
respect to such distribution of such earnings and profits shall be 
deemed paid by the United States shareholder for such taxable year under 
section 902(a) with respect to the earnings and profits so distributed 
and, notwithstanding the rules otherwise applicable under section 902, 
no part of the taxes so deemed paid by such first-tier corporation shall 
be attributed to other earnings and profits of such first-tier 
corporation for such year and no part of the taxes paid or accrued with 
respect to such other earnings and profits shall be attributed to the 
earnings and profits so received as a distribution.
    (b) Taxes of a foreign corporation paid on intercorporate 
distributions and on other income. If, by successive distributions 
through a chain or group, a United States shareholder receives for a 
taxable year a distribution of the earnings and profits for such year of 
any corporation in such chain or group, then in applying section 902(a) 
with respect to such distribution through a first-tier corporation 
described in section 902(a), or in applying section 902(b) with respect 
to such distribution through a second-tier corporation described in 
section 902(b), as the case may be, the taxes of such corporation which 
shall be taken into account in determining taxes deemed paid under such 
section shall be the foreign income tax actually paid or accrued for the 
taxable year by such first-tier or second-tier corporation, as the case 
may be, with respect to such distribution; and, notwithstanding the 
rules otherwise applicable under section 902, no part of the taxes so 
paid by such first-tier or second-tier corporation shall be attributed 
to other earnings and profits of such corporation for such year and no 
part of the taxes paid or accrued with respect to such other earnings 
and profits shall be attributed to the earnings and profits so received 
as a distribution.
    (c) Corporation with earnings and profits reduced by allocated 
deficits. In the application of section 902, a United States 
shareholder's proportionate share of the earnings and profits for the 
taxable year of a foreign corporation to which the chain or group 
election applies shall reflect the reduction of such earnings and 
profits by deficits allocated thereto under paragraph (b)(2) of this 
section. No taxes paid or accrued by such corporation shall be deemed 
paid under section 902 with respect to a distribution to such 
shareholder from the earnings and profits of such corporation for such 
year to the extent that such distribution exceeds the shareholder's 
proportionate share as so reduced.
    (ii) Year of distribution of remaining earnings and profits. If for 
a taxable year in respect of which a United States shareholder receives 
a minimum distribution pursuant to an election under section 963 and in 
respect of which the provisions of this subparagraph are applied--
    (a) The foreign income tax which is paid or accrued by a foreign 
corporation for such year, by reason of the receipt and payment of 
earnings and profits counting toward such minimum distribution, is 
deemed paid under subdivision (i) (a) or (b) of this subparagraph,
    (b) The pretax and predistribution earnings and profits for such 
year of a foreign corporation in a chain or group

[[Page 511]]

with respect to stock on which such minimum distribution is received are 
reduced by reason of the deduction under paragraph (d)(1)(i) of Sec. 
1.963-2 of distributions received from other corporations in such chain 
or group, or
    (c) Such shareholder's proportionate share of the earnings and 
profits for such year of a foreign corporation in a chain or group 
making a distribution counting toward such minimum distribution is 
reduced by the allocation thereto under paragraph (b)(2) of this section 
of a portion of the deficits of foreign branches or other foreign 
corporations in such chain or group,


the pretax and predistribution earnings and profits of such foreign 
corporation for such year to which such minimum distribution is 
attributable and the foreign income tax which is taken into account in 
determining tax deemed paid under section 902 on such pretax and 
predistribution earnings and profits shall not be taken into account in 
the application of section 902 when other earnings and profits of such 
foreign corporation for such year are distributed in a subsequent 
taxable year of such foreign corporation to such shareholder. For the 
purpose of applying the preceding sentence to a case in which (c) of 
this subdivision applies, the pretax and predistribution earnings and 
profits of the foreign corporation for such year to which the minimum 
distributed is attributable shall be the amount of such corporation's 
earnings and profits which are distributed and count toward the minimum 
distribution plus the foreign income tax of such foreign corporation 
allocated thereto in determining the taxes deemed paid under section 902 
for the taxable year of the minimum distribution.
    (iii) Illustrations. The application of this subparagraph may be 
illustrated by the following examples:

    Example 1. Domestic corporation M makes a chain election for 1966 
with respect to controlled foreign corporation A, which is wholly owned 
directly by M Corporation, and controlled foreign corporation B, which 
is wholly owned directly by A Corporation. Each corporation uses the 
calendar year as the taxable year. In 1966, corporations A and B are 
subject to foreign income tax at the rates of 20 percent and 30 percent, 
respectively, with no deduction being allowed for dividends received or 
paid; each such corporation has pretax and predistribution earnings and 
profits of $100. Corporation M receives from the chain a pro rata 
minimum distribution for such year and applies thereto the special rules 
of this paragraph and paragraph (b) of this section. Corporation A is 
not a less developed country corporation under section 902(d). The 1966 
foreign income tax of corporations A and B which is deemed paid by M 
Corporation under section 902(a) for 1966, and the remaining tax which 
is allocated to earnings and profits to be distributed to M Corporation 
in future years, are determined as follows:

------------------------------------------------------------------------
                                        A            B          Total
------------------------------------------------------------------------
Pretax and predistribution             $100.00      $100.00      $200.00
 earnings and profits............
Foreign income tax...............        20.00        30.00        50.00
Consolidated earnings and profits        80.00        70.00       150.00
Effective foreign tax rate ($50/   ...........  ...........          25%
 [$150 + $50])...................
Statutory percentage under         ...........  ...........          76%
 section 963(b)..................
Amount distributed as pro rata
 minimum distribution for 1966:
  (0.76 x $80)...................        60.80
  (0.76 x $70)...................  ...........        53.20       114.00
Amount received by M Corporation
 as pro rata minimum
 distribution:
  A Corporation's distribution...       $60.80
  B Corporation's distribution     ...........       $42.56      $103.36
   ($53.20 - [0.20 x $53.20]), or
   ($53.20 - $10.64).............
Amount of tax counted toward       ...........  ...........        10.64
 minimum distribution............
Tax deemed paid by M Corporation
 for 1966 for purposes of gross-
 up under section 78 and foreign
 tax credit:
  ($60.80/$80 x $20).............        15.20
  ([$42.56/$42.56 x $10.64] +      ...........        33.44        48.64
   [$53.20/$70 x $30]) or ($10.64
   + $22.80).....................
Remaining 1966 earnings and
 profits for future distribution
 to M Corporation:
  ($80-$60.80)...................        19.20
  ($70-$53.20)...................  ...........        16.80        36.00
Foreign income tax attributable
 to 1966 earnings and profits
 remaining for future
 distribution to M Corporation:
  ($19.20/$80 x $20).............         4.80
  ($16.80/$70 x $30).............  ...........         7.20        12.00
------------------------------------------------------------------------


[[Page 512]]

    Example 2. The facts are the same as in example 1 except that A 
Corporation pays foreign income tax at the rate of 30 percent and B 
Corporation, at the rate of 20 percent; and A Corporation is allowed a 
deduction, in computing its income subject to tax, for the full amount 
of dividends received. The determination of tax deemed paid for 1966 is 
as follows:

------------------------------------------------------------------------
                                                A         B       Total
------------------------------------------------------------------------
Pretax and predistribution earnings and      $100.00   $100.00   $200.00
 profits..................................
Foreign income tax........................     30.00     20.00     50.00
Consolidated earnings and profits.........     70.00     80.00     50.00
Effective foreign tax rate ($50/[$150 +     ........  ........       25%
 $50])....................................
Statutory percentage under section 963(b).  ........  ........       76%
Amount distributed by foreign corporations
 as a pro rata minimum distribution for
 1966 and amount received by M
 Corporation:
  (0.76 x $70)............................    $53.20
  (0.76 x $80)............................  ........    $60.80   $114.00
Tax deemed paid by M Corporation for 1966
 for purposes of gross-up under section 78
 and foreign tax credit:
  ($53.20/$70 x $30)......................     22.80
  ($60.80/$80 x $20)......................  ........     15.20     38.00
Remaining 1966 earnings and profits for
 future distribution to M Corporation:
  ($70-$53.20)............................     16.80
  ($80-$60.80)............................  ........     19.20     36.00
Foreign income tax attributable to 1966
 earnings and profits remaining for future
 distribution to M Corporation:
  ($16.80/$70 x $30)......................      7.20
  ($19.20/$80 x $20)......................  ........      4.80     12.00
------------------------------------------------------------------------

    Example 3. For 1966, domestic corporation M makes a group election 
with respect to controlled foreign corporations A and B, both of which 
are wholly owned directly by M Corporation, and foreign branch C of M 
Corporation. All such corporations use the calendar year as the taxable 
year. Corporation M receives a pro rata minimum distribution from the 
group for 1966 and applies thereto the special rules of this paragraph 
and paragraph (b) of this section. Neither foreign corporation is a less 
developed country corporation under section 902(d). Corporations A and B 
pay foreign income tax at a flat rate of 20 percent and 30 percent, 
respectively. The 1966 foreign income tax of corporations A and B which 
is deemed paid by M Corporation under section 902(a) for 1966, and the 
remaining tax which is allocated to earnings and profits to be 
distributed to M Corporation in future years, are determined as follows:

------------------------------------------------------------------------
                                     A         B      Branch C    Total
------------------------------------------------------------------------
Pretax and predistribution         $60.00    $60.00      ($20)   $100.00
 earnings and profits (and
 deficit) of the group.........
Foreign income tax.............     12.00     18.00  .........     30.00
Earnings and profits (and           48.00     42.00       (20)     70.00
 deficit)......................
Allocation of deficit of Branch
 C:
  ($48/[$48 + $42] x $20)......   (10.67)
  ($42/[$48 + $42] x $20)......  ........    (9.33)
Consolidated earnings and           37.33     32.67  .........     70.00
 profits of the group..........
Effective foreign tax rate ($30/ ........  ........  .........       30%
 $100).........................
Statutory percentage under       ........  ........  .........       69%
 section 963(b)................
Amount received by M
 Corporation as pro rata
 minimum distribution for 1966:
  (0.69 x $37.33)..............     25.76
  (0.69 x $32.67)..............  ........     22.54  .........    $48.30
Tax deemed paid by M
 Corporation for 1966 for
 purposes of gross-up under
 section 78 and foreign tax
 credit:
  ($25.76/$37.33 x $12)........      8.28
  ($22.54/$32.67 x $18)........  ........     12.42  .........     20.70
Remaining 1966 earnings and
 profits for future
 distribution to M Corporation:
  ($48-$25.76).................     22.24
  ($42-$22.54).................  ........     19.46  .........     41.70
Foreign income tax attributable
 to 1966 earnings and profits
 remaining for future
 distribution to M Corporation:
  ($12-$8.28)..................      3.72
  ($18-$12.42).................  ........      5.58  .........      9.30
------------------------------------------------------------------------

    Example 4. The facts are the same as in example 3 except that the 
group does not make a pro rata minimum distribution but distributes 
$48.30, consisting of $40 distributed by A Corporation and $8.30 
distributed by B Corporation. Corporation M complies with the special 
rules of this paragraph and paragraph (b) of this section. The 1966 
foreign income tax of corporations A and B which is deemed paid by M 
Corporation under section 902(a)

[[Page 513]]

for 1966, and the remaining tax which is allocated to earnings and 
profits to be distributed to M Corporation in future years, are 
determined as follows, the minimum overall tax burden for 1966 being 
such as to satisfy the requirement of paragraph (a)(1)(ii)(b) of this 
section:

------------------------------------------------------------------------
                                     A         B      Branch C    Total
------------------------------------------------------------------------
Amount received by M               $40.00     $8.30  .........    $48.30
 Corporation...................
Tax deemed paid by M
 Corporation for 1966 for
 purposes of gross-up under
 section 78 and foreign tax
 credit:
  ($37.33/$37.33 x $12)........     12.00
  ($8.30/$32.67 x $18).........  ........      4.57  .........     16.57
Remaining 1966 earnings and
 profits for future
 distribution to M Corporation:
  ($48-$40)....................      8.00
  ($42-$8.30)..................  ........     33.70  .........     41.70
------------------------------------------------------------------------


------------------------------------------------------------------------
                                     A         B      Branch C    Total
------------------------------------------------------------------------
Foreign income tax attributable
 to 1966 earnings and profits
 remaining for future
 distribution to M Corporation:
  ($12-$12)....................         0
  ($18-$4.57)..................  ........     13.43  .........     13.43
------------------------------------------------------------------------

    (3) Reduction and deferral of the foreign tax credit--(i) In 
general. To the extent specified in paragraph (a)(1)(ii)(b) of this 
section a reduction shall be made in the foreign tax credit allowable 
under section 901 for the taxable year with respect to distributions 
counting toward a minimum distribution for such year from the chain or 
group; and such reduction in credit shall be allocated, as provided in 
subdivision (ii) of this subparagraph, to foreign corporations in such 
chain or group and deferred, as provided in subdivision (iii) of this 
subparagraph, to subsequent taxable years of the United States 
shareholder.
    (ii) Allocation of reduction in foreign tax credit. The amount of 
any reduction in foreign tax credit for the taxable year which is made 
under subdivision (i) of this subparagraph with respect to a minimum 
distribution for any taxable year from the chain or group shall be 
allocated among any first-tier and second-tier corporations described in 
section 902 (a) and (b), respectively, which are in such chain or group. 
The amount of any such reduction in foreign tax credit shall be 
allocated among such first-tier and second-tier corporations in the 
ratio which the United States shareholder's proportionate share of 
undistributed earnings and profits of each such corporation for the 
taxable year bears to the total of such shareholder's proportionate 
shares of the undistributed earnings and profits of all such 
corporations for such year. None of such reduction shall be allocated to 
any other corporations in the chain or group or to any foreign branches 
included under paragraph (f)(4) of Sec. 1.963-1 in the group as wholly 
owned foreign subsidiary corporations.
    (iii) Deferral of allocated credit--(a) Allowance of credit in 
subsequent years. The reduction in foreign tax credit allocated to a 
first-tier or second-tier corporation in the chain or group for a 
taxable year under subdivision (ii) of this subparagraph shall be deemed 
paid under the principles of section 902 (applicable to foreign 
corporations which are not less developed country corporations) with 
respect to distributions, to the extent made by such corporation to the 
United States shareholder referred to in subdivision (ii) of this 
subparagraph, in a subsequent taxable year from the undistributed 
earnings and profits of such corporation for such year of allocation. 
Thus, for example, in the case of a distribution in the subsequent year 
from such earnings and profits by a first-tier corporation, the tax 
deemed paid shall be an amount which bears to the total of such 
reduction in foreign tax credit the same ratio that the distribution to 
the shareholder in the subsequent year bears to such shareholder's 
proportionate share of such undistributed earnings and profits for the 
year of allocation.
    (b) Limitations on use of deferred credit. The deferred tax so 
deemed paid shall be deemed paid for such subsequent

[[Page 514]]

taxable year and shall be allowed under section 901 (without regard to 
the limitations under section 904) as a credit against the income tax 
imposed for such year by chapter 1 of the Code, but the amount of such 
credit shall not exceed the excess of the tax so imposed for such year 
over the credit (determined without regard to this subdivision (iii) 
allowed under sections 901 through 905 for such year. Any amount by 
which the deferred tax so deemed paid in such subsequent taxable year 
exceeds the limitation under the preceding sentence shall not be carried 
back or carried over under section 904(d) to another taxable year of the 
United States shareholder. No credit shall be allowed under this 
subdivision for the subsequent taxable year to the extent that the 
credit would reduce the tax of the United States shareholder under 
chapter 1 of the Code on any minimum distribution for such year to which 
section 963 applies.
    (c) Gross-up not applicable. Any amount allowed as a credit for a 
subsequent taxable year under this subdivision shall not be included in 
the gross income of the United States shareholder for such year under 
section 78.
    (d) Illustrations. The application of this section may be 
illustrated by the following examples, in which the surtax exemption 
provided by section 11(c) is disregarded:

    Example 1. (a) For 1966, domestic corporation M makes a chain 
election with respect to controlled foreign corporation A, which it 
wholly owns directly, and controlled foreign corporation B, which A 
Corporation wholly owns directly. Corporation A is not a less developed 
country corporation under section 902(d). All corporations use the 
calendar year as the taxable year. For 1966, M Corporation complies with 
the special rules of paragraphs (b) and (c) of this section. Corporation 
A has pretax and predistribution earnings and profits for 1966 of $40 
and is subject to foreign income tax at a flat rate of 36 percent, with 
no deduction being allowed for dividends received or paid. B Corporation 
has pretax and predistribution earnings and profits of $60 for 1966 and 
is subject to a foreign income tax at a flat rate of 20 percent, with no 
deduction being allowed for dividends received or paid. For 1967, B 
Corporation has no earnings and profits, A Corporation has no earnings 
and profits other than a dividend of $21.22 from B Corporation, and M 
Corporation has taxable income of $20.98 from United States sources. 
Corporation M uses the overall limitation under section 904(a)(2) on the 
foreign tax credit.
    (b) If a pro rata minimum distribution were made for 1966, the 
overall United States and foreign income tax for such year with respect 
to such distribution would be $41.30, determined as follows:

------------------------------------------------------------------------
                                                A         B       Total
------------------------------------------------------------------------
Pretax and predistribution earnings and       $40.00    $60.00   $100.00
 profits..................................
Foreign income tax:
  (0.36 x $40)............................     14.40
  (0.20 x $60)............................  ........     12.00    $26.40
Consolidated earnings and profits.........     25.60     48.00     73.60
Effective foreign tax rate ($26.40 /        ........  ........     26.4%
 [$73.60 + $26.40]).......................
Statutory percentage under section 963(b).  ........  ........       69%
Amount distributed as pro rata minimum
 distribution:
  (0.69 x $25.60).........................     17.66
  (0.69 x $48)............................  ........     33.12    $50.78
Amount received by M Corporation as pro
 rata minimum distribution:
  Corporation's distribution..............     17.66
  B Corporation's distribution ($33.12 -    ........     21.20     38.86
   [0.36 x $33.12]), or ($33.12 - $11.92).
Gross-up under section 78:
  ($17.66/$25.60 x $14.40)................      9.94
  ($21.20 / $21.20 x [$11.92 + ($33.12 /    ........     20.20     30.14
   $48 x $12)]), or ($11.92 + $8.28)......
                                                               ---------
Taxable income of M Corporation...........  ........  ........     69.00
                                                               ---------
U.S. tax before foreign tax credit ($69 x   ........  ........     33.12
 0.48)....................................
Foreign tax credit (as determined under     ........  ........     30.14
 gross-up above)..........................
                                                               ---------
U.S. tax payable..........................  ........  ........      2.98
                                                               =========
Overall U.S. and foreign income tax with    ........  ........     41.30
 respect to pro rata minimum distribution
 ($26.40 + $11.92 + $2.98)................
                                                               =========
------------------------------------------------------------------------

    (c) The chain, however, does not make a pro rata distribution for 
1966, but distributes $24 from A Corporation's earnings and profits and 
$26.78 from B Corporation's earnings and profits, the total distribution 
of $50.78 being equal to the statutory percentage of the consolidated 
earnings and profits (0.69 x $73.60) of the chain with respect to M 
Corporation. Thus, M Corporation must make such a reduction in its 
foreign tax credit that the overall United States and foreign income tax 
for 1966 with respect to the distribution equals the lesser of $41.30 
(the overall United States and foreign income tax which would

[[Page 515]]

be paid with respect to a pro rata minimum distribution) and $43.20 (90 
percent of 48 percent of pretax and predistribution consolidated 
earnings and profits of $100). The remaining 1956 earnings and profits 
of the chain are distributed late in 1967. Corporation M determines its 
tax as follows for such years:

                                  1966
------------------------------------------------------------------------
                                                A         B       Total
------------------------------------------------------------------------
Distributions made........................    $24.00    $26.78    $50.78
  Amount received by M Corporation:
    A Corporation's distribution..........     24.00
    B Corporation's distribution ($26.78 -  ........     17.14     41.14
     [0.36 x 26.78]), or ($26.78 - $9.64).
Gross-up under section 78:
  ($24 / $25.60 x $14.40).................     13.50
  ($17.14 / $17.14 x [$9.64 + ($26.78 /     ........     16.34     29.84
   $48 x $12)]), or ($9.64 + $6.70).......
                                                               ---------
Taxable income of M Corporation...........  ........  ........    $70.98
                                                               =========
Tentative U.S. tax before foreign tax       ........  ........     34.07
 credit ($70.98 x .48)....................
Less: Tentative foreign tax credit (as      ........  ........     29.84
 computed under gross-up above)...........
                                                               ---------
Tentative U.S. tax payable................  ........  ........      4.23
                                                               =========
Tentative overall U.S. and foreign income   ........  ........     40.27
 tax ($26.40 + $9.64 + $4.23).............
Overall U.S. and foreign tax which would    ........  ........     41.30
 be paid with respect to a pro rata
 minimum distribution (part (b) of this
 example).................................
Insufficient overall U.S. and foreign       ........  ........      1.03
 income tax ($41.30-$40.27)...............
Reduced foreign tax credit ($29.84-$1.03).  ........  ........     28.81
U.S. tax payable ($34.07-$28.81)..........  ........  ........      5.26
Overall U.S. and foreign income tax         ........  ........     41.30
 ($26.40 + $9.64 + $5.26).................
Reduction in foreign tax credit to be       ........  ........      1.03
 deferred ($29.84-$28.81).................
Remaining 1966 earnings and profits of:
  A Corporation ($25.60-$24)..............     $1.60
  B Corporation ($48-$26.78)..............  ........    $21.22     22.82
Allocation of reduction in foreign tax
 credit to remaining 1966 earnings and
 profits of:
  A Corporation ($1.60/22.82 x $1.03).....       .07
  B Corporation ($21.22/$22.82 x $1.03)...  ........       .96      1.03
Foreign income tax attributable to
 remaining 1966 earnings and profits of:
  A Corporation ($1.60/$25.60 x $14.40)...       .90
  B Corporation ($21.22/$48 x $12)........  ........      5.30      6.20
------------------------------------------------------------------------
                                  1967
------------------------------------------------------------------------
Taxable income of M Corporation consisting
 of distributions from:
  A Corporation's remaining 1966 earnings       1.60
   and profits............................
  B Corporation's remaining 1966 earnings   ........     13.58     15.18
   and profits ($21.22-[.36 x 21.22]), or
   ($21.22-$7.64).........................
Gross-up under section 78:
  ($1.60/$1.60 x $0.90)...................       .90
  ($13.58/$13.58 x [$7.64 + ($21.22/ 21.22  ........     12.94     13.84
   x $5.30)]).............................
                                                               ---------
Taxable income from sources without the     ........  ........     29.02
 U.S......................................
Taxable income from sources within the      ........  ........     20.98
 U.S......................................
                                                               ---------
  Total taxable income of M Corporation...  ........  ........     50.00
                                                               =========
U.S. tax before foreign tax credit (0.48 x  ........  ........     24.00
 $50).....................................
Foreign tax credit:
  Tax deemed paid under section 902:
    $13.84, but not to exceed section 904   ........  ........     13.84
     limitation of $13.93 ($29.02/$50 x
     $24) (see gross-up above)............
  Tax deemed paid under the principles of
   section 902:
    ($1.60/$1.60 x $0.07).................       .07
    ($21.22/$21.22 x 0.96)................  ........       .96      1.03
U.S. tax payable ($24-[$13.84 + $1.03])...  ........  ........      9.13
------------------------------------------------------------------------

    Example 2. (a) For 1963, domestic corporation M makes a group 
election with respect to controlled foreign corporations A and B, both 
of which M Corporation wholly owns directly. All such corporations use 
the calendar year as the taxable year. Corporation A is created under 
the laws of foreign country X, and B Corporation is created under the 
laws of foreign country Y; neither of such corporations is a less 
developed country corporation under section 902(d). Corporation

[[Page 516]]

M complies with the special rules of paragraphs (b) and (c) of this 
section. Each foreign corporation has pretax earnings and profits of 
$100 for 1963. The income of A Corporation is subject to a foreign 
income tax rate of 20 percent, and the income of B Corporation is 
subject to a foreign income tax rate of 30 percent. Corporation M uses 
the per-country limitation under section 904(a)(1) on the foreign tax 
credit.
    (b) If a pro rata minimum distribution were made for 1963, the group 
would distribute $123 based upon an effective foreign tax rate of 25 
percent ($50/[$50 + $150]) and a statutory percentage of 82 percent 
under section 963(b); of this amount $57.40 (0.82 x $70) would be 
distributed from B Corporation's earnings and profits and $65.60 (0.82 x 
$80) would be distributed from A Corporation's earnings and profits. In 
such case, the overall United States and foreign income tax for 1963 
with respect to the pro rata minimum distribution would be determined as 
follows, using the 52 percent United States corporate income tax rate 
applicable for such year:

Taxable income of M Corporation from sources in--
  Y Country:
    B Corporation dividend..........................    $57.40
  Gross-up under section 78 ($57.40/$70 x $30)......     24.60    $82.00
                                                     ----------
X Country:
  A Corporation dividend............................     65.60
  Gross-up under section 78 ($65.60/$80 x $20)......     16.40     82.00
                                                     -------------------
    Taxable income..................................  ........    164.00
                                                               =========
U.S. tax before tax credit (0.52 x $164)............  ........     85.28
Foreign tax credit:
  Y Country tax.....................................     24.60
  X Country tax.....................................     16.40     41.00
                                                     -------------------
U.S. tax payable....................................  ........     44.28
                                                               =========
Overall U.S. and foreign income tax with respect to   ........     94.28
 pro rata minimum distribution ($44.28 + $50).......
 

    (c) The group, however, does not make a pro rata minimum 
distribution for 1963 but distributes $123, consisting of $70 from B 
Corporation's earnings and profits and $53 from A Corporation's earnings 
and profits. Thus, M Corporation must make such a reduction in its 
foreign tax credit that the overall United States and foreign income tax 
for 1963 with respect to the distribution equals the lesser of $94.28 
(the overall United States and foreign income tax which would be paid 
with respect to a pro rata minimum distribution) and $93.60 (90 percent 
of 52 percent of pretax and predistribution consolidated earnings and 
profits of $200). The remaining 1963 earnings and profits of the group 
are distributed late in 1964. Neither A Corporation nor B Corporation 
has earnings and profits for 1964. Corporation M determines its tax as 
follows for such years, assuming a 52 percent (instead of 50 percent) 
United States corporate income tax rate for 1964:

                                  1963
Taxable income of M Corporation from sources in--
  Y Country:
    B Corporation dividend..........................    $70.00
    Gross-up under section 78 ($70/$70 x $30).......     30.00   $100.00
                                                     ----------
  X Country:
  A Corporation dividend............................     53.00
    Gross-up under section 78 ($53/$80 x $20).......     13.25     66.25
                                                     -------------------
      Taxable income for 1963.......................  ........    166.25
                                                               =========
U.S. tax before foreign tax credit (0.52 x $166.25).  ........     86.45
  Less: Tentative foreign tax credit:
    Y Country tax ($30.00 but not to exceed ($100.00/    30.00
     $166.25 x $86.45)).............................
    X Country tax ($13.25 but not to exceed ($66.25/     13.24     43.25
     $166.25 x $86.45)).............................
                                                     -------------------
Tentative U.S. tax payable..........................  ........     43.20
                                                               =========
Tentative overall U.S. and foreign income tax ($50 +  ........     93.60
 $43.20)............................................
Insufficient overall U.S. and foreign income tax      ........       .40
 ($93.60-$93.20)....................................
Reduced foreign tax credit ($43.25-$0.40)...........  ........     42.85
U.S. tax payable for 1963 ($86.45-$42.85)...........  ........     43.00
Overall U.S. and foreign income tax ($50 + $43.60)..  ........     93.60
Reduction in foreign tax credit to be deferred        ........       .40
 ($43.25-$42.85)....................................
Remaining 1963 earnings and profits of:
  A Corporation ($80-$53)...........................     27.00
  B Corporation ($70-$70)...........................         0     27.00
                                                     ----------
Allocation of reduction in foreign tax credit to      ........       .40
 remaining 1963 earnings and profits of A
 Corporation ($27/$27 x $0.40)......................
Foreign income tax attributable to remaining 1963
 earnings and profits of:
  A Corporation ($20-$13.25)........................      6.75
  B Corporation ($30-$30)...........................         0      6.75
                                                     ----------
 


                                  1964
Taxable income of M Corporation from sources in X
 Country:
  A Corporation dividend............................  ........     27.00
  Gross-up under section 78 ($27/$27 x $6.75).......  ........      6.75
                                                               ---------
    Taxable income for 1964.........................  ........     33.75
                                                               =========
U.S. tax before foreign tax credit ($33.75 x 0.52)..  ........     17.55
  Less: Foreign tax credit:
    Tax deemed paid under section 902 (as computed        6.75
     under gross-up, but not to exceed $33.75/$33.75
     x $17.55)......................................
    Tax deemed paid under the principles of section        .40      7.15
     902 ($27/$27 x $0.40)..........................
                                                     -------------------
U.S. tax payable for 1964...........................  ........     10.40
                                                               =========
 


[[Page 517]]

    Example 3. (a) For 1966, domestic corporation M makes a chain 
election with respect to controlled foreign corporation A, which it 
wholly owns directly, and controlled foreign corporation B, which A 
Corporation wholly owns directly. Corporation A is a less developed 
country corporation under section 902(d). All corporations use the 
calendar year as the taxable year. For 1966, each of the foreign 
corporations has pretax and predistribution earnings and profits of 
$100. The income of A Corporation is subject to a foreign income tax 
rate of 20 percent, with no deduction being allowed for dividends 
received or paid; and the income of B Corporation is subject to a 
foreign income tax rate of 30 percent on such basis. During 1966, B 
Corporation distributes $50 to A Corporation, and A Corporation 
distributes $104 to M Corporation. During 1967 the remaining 1966 
earnings and profits of such corporations are distributed to M 
Corporation.
    (b) If M Corporation were not to comply with the special rules of 
paragraphs (b) and (c) of this section and were to deduct foreign income 
tax on intercorporate distributions under paragraph (d)(1)(iii) of Sec. 
1.963-2, the chain would not be considered to make a minimum 
distribution for 1966 because, although it makes a distribution which is 
sufficient in amount to constitute a minimum distribution, the overall 
United States and foreign income tax for such year with respect to such 
distribution would be insufficient under paragraph (a)(1)(i) of this 
section. The determination that M Corporation would not be entitled to 
the section 963 exclusion for 1966 by reason of such distribution in 
such circumstances is made as follows:

------------------------------------------------------------------------
                                                   A       B      Total
------------------------------------------------------------------------
Pretax earnings and profits...................    $150    $100
Reduction for intercorporate dividends........      50
                                               ----------------
Pretax and predistribution earnings and            100     100   $200.00
 profits......................................
Reduction for foreign income tax on such            20      30     50.00
 pretax and predistribution earnings and
 profits......................................
                                               -------------------------
Predistribution earnings and profits..........      80      70    150.00
Reduction for foreign income tax on                 10  ......     10.00
 intercorporate distributions of 1966 earnings
 and profits ($50 x 0.20).....................
                                               -------------------------
Consolidated earnings and profits of the chain      70      70    140.00
                                               -------------------------
Consolidated foreign income taxes ($30 + $20 +  ......  ......     60.00
 $10).........................................
Effective foreign tax rate ($60/ [$140 + $60])  ......  ......       30%
Statutory percentage under section 963(b).....  ......  ......       69%
Amount of a minimum distribution ($140 x 0.69)  ......  ......     96.60
Overall United States and foreign income tax    ......  ......     86.40
 required to be paid (part (a)(1)(i) of this
 section) (0.90 x [0.22 + 0.26] x $200).......
Tentative taxable income of M Corporation.....  ......  ......   $104.00
Tentative U.S. tax before foreign tax credit    ......  ......     49.92
 (0.48 x $104)................................
Tentative foreign tax credit ($104/ $120 x      ......  ......     33.80
 [($120/$150 x $30) + ($50/ $100 x $30)] or
 ($104/$120 x $39)............................
Tentative U.S. tax payable ($49.92- $33.80)...  ......  ......     16.12
Overall U.S. and foreign income tax ($60 +      ......  ......     76.12
 $16.12)......................................
Insufficient overall U.S. and foreign income    ......  ......     10.28
 tax ($86.40-$76.12)..........................
------------------------------------------------------------------------

    (c) By complying with the special rules of paragraphs (b) and (c) of 
this section, however, M Corporation will receive a minimum distribution 
for 1966 if it receives the statutory percentage of consolidated 
earnings and profits and if the overall United States and foreign income 
tax with respect to the distribution which is made is at least the 
lesser of $86.40 (0.90 x 0.48 x $200) and of the overall United States 
and foreign income tax which would be paid with respect to a pro rata 
minimum distribution from the chain. If a pro rata minimum distribution 
were made for 1966, the chain would be required to distribute earnings 
and profits of $114, based upon an effective foreign tax rate of 25 
percent ($50/[$50 + $150]) and a statutory percentage of 76 percent 
under section 963(b); of this amount $53.20 (0.76 x $70) would be 
distributed from B Corporation's earnings and profits and $60.80 (0.76 x 
$80) would be distributed from A Corporation's earnings and profits. The 
overall United States and foreign income tax with respect to such a pro 
rata minimum distribution would be $73.62, determined as follows:

Taxable income of M Corporation ($60.80 + [$53.20-    ........   $103.36
 ($53.20 x 0.20)])..................................
U.S. tax before foreign tax credit (0.48 x $103.36).  ........     49.61
Foreign tax credit:
  B Corporation's distribution ($53.20/[$70 + $30] x    $24.47
   $30) + ($42.56 + $10.64] x $10.64)...............
  A Corporation's distribution ($60.80/[$80 + 20] x      12.16     36.63
   $20).............................................
                                                     -------------------
U.S. tax payable....................................  ........     12.98
                                                               =========
Overall U.S. and foreign income tax with respect to   ........     73.62
 pro rata minimum distribution ($50 + $10.64 +
 $12.98)............................................
 

    (d) The United States income tax of M Corporation for 1966 and 1967 
is determined as follows, assuming that the minimum overall tax burden 
is determined under paragraph (a)(1)(ii)(b) of this section:

[[Page 518]]



                                  1966
Dividend from earnings and profits of--
  B Corporation ($50 minus tax of $10 on A            ........    $40.00
   Corporation at the rate of 20 percent)...........
  A Corporation.....................................  ........     64.00
                                                               ---------
Taxable income of M Corporation.....................  ........    104.00
                                                               =========
U.S. tax before foreign tax credit (0.48 x $104)....  ........    $49.92
Less: Foreign tax credit:
  B Corporation's distribution ($50/[$70 + $30] x       $23.00
   $30 + ($40/[$40 + $10] x $10), or ($15 + $8).....
  A Corporation's distribution ($64/$80 + $20] x         12.80     35.80
   $20).............................................
                                                     -------------------
U.S. tax payable....................................  ........    $14.12
                                                               =========
Overall U.S. and foreign income tax with respect to   ........     74.12
 actual distribution ($50 + $10 + $14.12)...........
Overall U.S. and foreign income tax that would be     ........     73.62
 paid with respect to a pro rata minimum
 distribution (part (c) of this example)............
Remaining 1966 earnings and profits for future
 distribution by:
  B Corporation ($70-$50)...........................  ........     20.00
  A Corporation ($80-$64)...........................  ........     16.00
                                                               ---------
   Total............................................  ........     36.00
                                                               =========
Foreign income tax attributable to remaining 1966
 earnings and profits of:
  B Corporation ($20/$70 x $30).....................  ........      8.57
  A Corporation ($16/$80 x $20).....................  ........      4.00
 
                                  1967
 
Dividend from remaining 1966 earnings and profits
 of--
  B Corporation ($20 minus tax of $4 on A             ........     16.00
   Corporation at the rate of 20 percent)...........
  A Corporation.....................................  ........     16.00
                                                               ---------
Taxable income of M Corporation.....................  ........     32.00
                                                               =========
U.S. tax before foreign tax credit (0.48 x $32).....  ........     15.36
Less: Foreign tax credit:
  B Corporation's distribution ($20/ [$20 + $8.57] x     $9.20
   $8.57) + ($16/[$16 + $4] x $4), or ($6 + $3.20)..
  A Corporation's distribution ($16/ [$16 + $4] x         3.20     12.40
   $4)..............................................
                                                     -------------------
U.S. tax payable....................................  ........      2.96
                                                               ---------
 

    Example 4. (a) Domestic corporation M directly owns 90 percent of 
the one class of stock of controlled foreign corporation A, which 
directly owns 80 percent of the one class of stock of controlled foreign 
corporation B, which in turn directly owns 60 percent of the one class 
of stock of controlled foreign corporation C. None of the foreign 
corporations are less developed country corporations under section 
902(d); all corporations use the calendar year as the taxable year. For 
1963, M Corporation makes a chain election with respect to corporations 
A, B, and C and receives a distribution from the consolidated earnings 
and profits of the chain which does not constitute a pro rata minimum 
distribution. The remaining 1963 consolidated earnings and profits of 
the chain are distributed late in 1964, for which year it is assumed 
that the United States corporate income tax rate is the same (52 
percent) as for 1963. No corporation in the chain has earnings and 
profits for 1964 other than from distributions received from remaining 
1963 earnings and profits of another corporation in the chain. The 
foreign country under the laws of which A Corporation is created does 
not tax dividends which are received by such corporation from B 
Corporation, but B Corporation is taxed on dividends received from C 
Corporation. Corporation M complies with the special rules of paragraphs 
(b) and (c) of this section and determines the minimum overall tax 
burden under paragraph (a)(1)(ii)(b) of this section with respect to the 
distribution which is made. Corporation M uses the overall limitation 
under section 904(a)(2) on the foreign tax credit. The distribution 
received by M Corporation for 1963 from the consolidated earnings and 
profits of the chain is sufficient in amount to constitute a minimum 
distribution. The overall United States and foreign income tax for 1963 
with respect to the distribution which is made must be at least equal to 
the lesser of $32.21 (the amount payable, as determined under paragraph 
(b) of this example, with respect to a pro rata minimum distribution) 
and $31.34 (90 percent of 52 percent of pretax and predistribution 
consolidated earnings and profits of $66.96).
    (b) If the chain were to make a pro rata minimum distribution, the 
distributions and the overall United States and foreign income tax for 
1963 with respect to the minimum distribution would be determined as 
follows, based upon the facts assumed:

----------------------------------------------------------------------------------------------------------------
                                                                          A          B          C        Total
----------------------------------------------------------------------------------------------------------------
Pretax and predistribution earnings and profits.....................     $20.00     $50.00     $30.00
Reduction for foreign income tax on such earnings and profits (10%,        2.00      20.00       3.00
 40%, and 10%, respectively)........................................
                                                                     ---------------------------------
Predistribution earnings and profits................................      18.00      30.00      27.00
                                                                     =================================
Consolidated earnings and profits with respect to M Corporation:
  (0.90 x $18)......................................................      16.20
  (0.90 x 0.80 x $30) or (0.72 x $30)...............................  .........      21.60
  (0.90 x 0.80 x 0.60 x $27) or (0.432 x $27).......................  .........  .........      11.66     $49.46

[[Page 519]]

 
Consolidated foreign income taxes with respect to M Corporation:
  ($16.20/$18 x $2).................................................       1.80
  ($21.60/$30 x $20)................................................  .........      14.40
  ($11.66/$27 x $3).................................................  .........  .........       1.30      17.50
Effective foreign tax rate of the chain for 1963 ($17.50/[$49.46 +    .........  .........  .........     26.14%
 $17.50]), or ($17.50/ $66.96)......................................
Statutory percentage under section 963(b)...........................  .........  .........  .........        82%
Pro rata minimum distribution (before reduction of dividend from C
 Corporation's share by B Corporation tax paid on such amount):
  (0.82 x $16.20)...................................................      13.28
  (0.82 x $21.60)...................................................  .........      17.71
  (0.82 x $11.66)...................................................  .........  .........       9.56
  (0.82 x $49.46)...................................................  .........  .........  .........      40.56
Such amounts as reduced by further foreign income tax imposed on
 distributions through the chain:
  No further foreign tax............................................      13.28
  No further foreign tax............................................  .........      17.71
  B Corporation tax ($9.56-[0.40 x $9.56]), or ($9.56-$3.82)........  .........  .........       5.74      36.73
Gross-up under section 78:
  ($13.28/$16.20 x $1.80)...........................................       1.48
  ($17.71/$21.60 x $14.40)..........................................  .........      11.81
  ($5.74/$5.74 x $3.82).............................................  .........       3.82  .........      17.11
M Corporation's taxable income for 1963 attributable to minimum       .........  .........  .........      53.84
 distribution ($36.73 + $17.11).....................................
U.S. tax before foreign tax credit ($53.84 x 0.52)..................  .........  .........  .........      28.00
Foreign tax credit (as determined under gross-up above).............  .........  .........  .........      17.11
U.S. tax payable for 1963 ($28-$17.11)..............................  .........  .........  .........      10.89
Overall U.S. and foreign income tax with respect to pro rata minimum  .........  .........  .........      32.21
 distribution ($17.50 + $3.82 + $10.89).............................
----------------------------------------------------------------------------------------------------------------

    (c) Based upon the distributions which are made by corporations A, 
B, and C, M. Corporation pays United States tax as follows for 1963 and 
1964:

                                                      1963
----------------------------------------------------------------------------------------------------------------
                                                                          A          B          C        Total
----------------------------------------------------------------------------------------------------------------
Distribution made from consolidated earnings and profits of the           $9.36     $21.60      $9.60     $40.56
 chain..............................................................
Excess of distribution over statutory percentage of consolidated      .........  .........  .........       None
 earnings and profits for 1963 ($40.56-[0.82 x $49.46]).............
Determination of whether the overall U.S. and foreign income tax
 with respect to the actual distribution is equal to, or exceeds,
 the lesser of $32.21 (paragraph (b) of example) and $31.34
 (paragraph (a) of example):
  Amount received by M Corporation after reduction by further
   foreign income tax imposed on distributions through the chain:
    No further foreign tax..........................................       9.36
    No further foreign tax..........................................  .........      21.60
    B Corporation tax ($9.60-[0.40 x $9.60]), or ($9.60-$3.84)......  .........  .........       5.76      36.72
  Gross-up under section 78:
    ($9.36/$16.20 x $1.80)..........................................       1.04
    ($21.60/$21.60 x $14.40)........................................  .........      14.40
    ($5.76/$5.76 x $3.84)...........................................  .........       3.84  .........      19.28
Taxable income of M Corporation for 1963 attributable to actual       .........  .........  .........      56.00
 distribution ($36.72 + $19.28).....................................
  U.S. tax before foreign tax credit ($56 x 0.52)...................  .........  .........  .........      29.12
  Tentative foreign tax credit (as determined under gross-up above).  .........  .........  .........      19.28
  Tentative U.S. tax payable ($29.12-$19.28)........................  .........  .........  .........       9.84
  Overall U.S. and foreign income tax with respect to actual          .........  .........  .........      31.18
   distribution ($17.50 + $3.84 + $9.84)............................
  Insufficient overall U.S. and foreign income tax ($31.34 [i.e.,     .........  .........  .........        .16
   0.90 x 0.52 x $66.96]- 31,18)....................................
Reduced foreign tax credit ($19.28-$0.16)...........................  .........  .........  .........      19.12
U.S. tax payable for 1963 ($29.12-$19.12)...........................  .........  .........  .........      10.00
Overall U.S. and foreign income tax with respect to actual            .........  .........  .........      31.34
 distribution ($17.50 + $3.84 + $10)................................
Allocation of reduction in foreign tax credit to undistributed
 consolidated 1963 earnings and profits of A and B Corporations to
 be deemed paid by M Corporation in future years:
  Reduction in foreign tax credit ($19.28-$19.12)...................  .........  .........  .........        .16
  Undistributed 1963 consolidated earnings and profits of the chain:
    ($16.20-$9.36)..................................................       6.84
    ($21.60-$21.00).................................................  .........          0

[[Page 520]]

 
    ($11.66-$9.60)..................................................  .........  .........      $2.06       8.90
  Allocation of reduction in credit:
    ($6.84/$6.84 x $0.16)...........................................        .16  .........  .........        .16
  Foreign income tax attributable to undistributed 1963 earnings and
   profits of the chain to be taken into account in determining tax
   deemed paid under section 902:
    ($1.80-$1.04)...................................................        .76
    ($14.40-$14.40).................................................  .........  .........  .........         .7
 
                                                      1964
 
Distribution from remaining 1963 consolidated earnings and profits
 of the chain:
  ($16.20-$9.36)....................................................       6.84
  ($21.60-$21.60)...................................................  .........          0
  ($11.66-$9.60)....................................................  .........  .........       2.06       8.90
Such amounts as reduced by further foreign income tax imposed on
 distributions through the chain:
  No further foreign tax............................................       6.84
  B Corporation tax ($2.06-[0.40 x $2.06]), or ($2.06-$0.82)........  .........       1.24  .........       8.08
Gross-up under section 78:
  ($6.84/$6.84 x $0.76).............................................       0.76
  ($1.24/$1.24 x $0.82).............................................  .........       0.82  .........       1.58
Taxable income of M Corporation for 1964 attributable to 1964         .........  .........  .........       9.66
 distribution ($8.08 + $1.58).......................................
U.S. tax before foreign tax credit ($9.66 x 0.52)...................  .........  .........  .........       5.02
Foreign tax credit:
  Deferred credit in accordance with principles of section 902             0.16  .........  .........       0.16
   ($6.84/$6.84 x $0.16)............................................
  Tax deemed paid under section 902 (computed under gross-up above).  .........  .........  .........       1.58
U.S. tax payable for 1964 ($5.02-[$0.16 + $1.58])...................  .........  .........  .........       3.28
----------------------------------------------------------------------------------------------------------------

    Example 5. (a) Domestic corporation M directly owns all the one 
class of stock of each of controlled foreign corporations A, B, C, and 
D. All such corporations use the calendar year as the taxable year. None 
of the foreign corporations is a less developed country corporation 
under section 902(d). For 1963, M Corporation makes a group election 
with respect to corporations A, B, C, and D and receives from the 1963 
consolidated earnings and profits of the group a distribution which is 
not a pro rata minimum distribution. None of the foreign corporations 
has earnings and profits for 1964, but the remaining 1963 earnings and 
profits of the group are distributed late in 1964, for which year it is 
assumed that the United States corporate income tax rate is the same (52 
percent) as for 1963. The overall limitation under section 904(a)(2) on 
the foreign tax credit applies for both years.
    (b) Assume that M Corporation does not comply with the special rules 
of paragraphs (b) and (c) of this section and that for 1963 it draws a 
distribution of all of B Corporation's earnings and profits and enough 
of C Corporation's earnings and profits to receive the amount of a 
minimum distribution and to assure that the overall United States and 
foreign income tax for such year with respect to the distribution from 
the group satisfies the overall minimum tax requirement of paragraph 
(a)(1)(i) of this section. In such case, the overall United States and 
foreign income tax for 1963 with respect to the distribution which is 
made, determined by using the foreign tax credit under section 901 
without applying the special credit rules of paragraph (c) of this 
section, must at least equal $37.44 (90 percent of 52 percent of pretax 
and predistribution consolidated earnings and profits of $80). 
Corporation M's United States income tax for 1963 and 1964 with respect 
to the distribution of the 1963 earnings and profits of the group is 
determined as follows, based upon the facts assumed:

                                                      1963
----------------------------------------------------------------------------------------------------------------
                                                               A          B          C          D        Total
----------------------------------------------------------------------------------------------------------------
Pretax and predistribution earnings and profits (and          $25.00     $25.00     $50.00   ($20.00)     $80.00
 deficits) of the group..................................
Consolidated foreign income taxes........................       2.50      12.50      15.00  .........      30.00
Consolidated earnings and profits........................      22.50      12.50      35.00    (20.00)      50.00
Effective foreign tax rate ($30/[$50 + $30]).............  .........  .........  .........  .........      37.5%
Statutory percentage under section 963(b)................  .........  .........  .........  .........        68%
Amount of a minimum distribution (0.68 x $50)............  .........  .........  .........  .........      34.00

[[Page 521]]

 
Tentative distribution...................................  .........      12.50      21.50  .........      34.00
Tentative gross-up under section 78:
  ($12.50/$12.50 x $12.50)                                 .........      12.50
  ($21.50/$35 x $15)                                       .........  .........       9.21  .........      21.71
Tentative taxable income of M Corporation ($34 + $21.71).  .........  .........  .........  .........      55.71
Tentative U.S. tax before foreign tax credit (0.52 x       .........  .........  .........  .........      28.97
 $55.71).................................................
Tentative foreign tax credit (as computed under gross-up   .........  .........  .........  .........      21.71
 above)..................................................
Tentative U.S. tax payable ($28.97-$21.71)...............  .........  .........  .........  .........       7.26
Tentative overall U.S. and foreign income tax ($30 +       .........  .........  .........  .........      37.26
 $7.26)..................................................
Minimum overall U.S. and foreign income tax required to    .........  .........  .........  .........      37.44
 be paid (0.90 x .52 x $80)..............................
Insufficient overall U.S. and foreign income tax ($37.44-  .........  .........  .........  .........        .18
 $37.26).................................................
Revised distribution.....................................  .........      12.50      22.07  .........      34.57
Gross-up under section 78:
  ($12.50/$12.50 x $12.50)...............................  .........      12.50
  ($22.07/$35 x $15).....................................  .........  .........       9.46  .........      21.96
Taxable income of M Corporation ($34.57 + $21.96)........  .........  .........  .........  .........      56.53
U.S. tax before foreign tax credit (.52 x $56.53)........  .........  .........  .........  .........      29.40
Foreign tax credit (as computed under gross-up above)....  .........  .........  .........  .........      21.96
U.S. tax payable ($29.40-$21.96).........................  .........  .........  .........  .........       7.44
Overall U.S. and foreign income tax on actual              .........  .........  .........  .........      37.44
 distribution ($30 + $7.44)..............................
----------------------------------------------------------------------------------------------------------------
 
                                                      1964
----------------------------------------------------------------------------------------------------------------
Distribution of remaining 1963 consolidated earnings and
 profits:
  ($22.50-$0)............................................      22.50
  ($12.50-$12.50)........................................
  ($35-$22.07)...........................................  .........  .........      12.93  .........      35.43
Gross-up under section 78:
  ($22.50/$22.50 x $2.50)................................       2.50
  ($12.93/$35 x $15).....................................  .........  .........       5.54  .........       8.04
Taxable income of M Corporation ($35.43 + $8.04).........  .........  .........  .........  .........      43.47
U.S. tax before foreign tax credit ($43.47 x 0.52).......  .........  .........  .........  .........      22.60
Foreign tax credit (as computed under gross-up above)....  .........  .........  .........  .........       8.04
U.S. tax payable ($22.60-$8.04)..........................  .........  .........  .........  .........      14.56
----------------------------------------------------------------------------------------------------------------

    (c) Assume that M Corporation does comply with the special rules of 
paragraphs (b) and (c) of this section and for 1963 receives a minimum 
distribution consisting of $20 from A Corporation and $14 from C 
Corporation. In such case, the overall United States and foreign income 
tax for 1963 with respect to the minimum distribution must at least 
equal the lesser of $37.44 (0.90 x 0.52 x $80) and the overall United 
States and foreign income tax of $37.89 that would be paid with respect 
to a pro rata minimum distribution from the group for such year. In such 
case, the determinations would be made pursuant to subparagraphs (1) and 
(2) of this paragraph.
    (1) If a pro rata minimum distribution were made for 1963 by the 
group, the overall United States and foreign income tax for such year 
with respect to such distribution would be $37.89, determined as 
follows:

----------------------------------------------------------------------------------------------------------------
                                                               A          B          C          D        Total
----------------------------------------------------------------------------------------------------------------
Pretax and predistribution earnings and profits (and          $25.00     $25.00     $50.00      ($20)     $80.00
 deficits) of the group..................................
Consolidated foreign income taxes........................       2.50      12.50      15.00  .........      30.00
Consolidated earnings and profits before allocation of         22.50      12.50      35.00  .........      70.00
 deficits................................................
Allocation of deficit of D Corporation:
  ($22.50/$70 x $20).....................................     (6.43)
  ($12.50/$70 x $20).....................................  .........     (3.57)
  ($35/$70 x $20)........................................  .........  .........    (10.00)  .........    (20.00)
Consolidated earnings and profits........................      16.07       8.93      25.00  .........      50.00
Effective foreign tax rate ($30/$80).....................  .........  .........  .........  .........     37.50%
Statutory percentage under section 963(b)................  .........  .........  .........  .........        68%
Pro rata minimum distribution:
  (0.68 x $16.07)........................................      10.93
  (0.68 x $8.93).........................................  .........       6.07
  (0.68 x $25)...........................................  .........  .........      17.00  .........      34.00
Gross-up under section 78:
  ($10.93/$16.07 x $2.50)................................       1.70
  ($6.07/$8.93 x $12.50).................................  .........       8.50

[[Page 522]]

 
  ($17/$25 x $15)........................................  .........  .........      10.20  .........      20.40
Taxable income of M Corporation ($34 + $20.40)...........  .........  .........  .........  .........      54.40
U.S. tax before foreign tax credit (0.52 x $54.40).......  .........  .........  .........  .........      28.29
Foreign tax credit (as computed under the gross-up above)  .........  .........  .........  .........      20.40
U.S. tax payable ($28.29-$20.40).........................  .........  .........  .........  .........       7.89
Overall U.S. and foreign income tax with respect to pro    .........  .........  .........  .........      37.89
 rata minimum distribution ($30 + $7.89).................
----------------------------------------------------------------------------------------------------------------

    (2) Corporation M's United States income tax for 1963 and 1964 with 
respect to the distribution of the 1963 earnings and profits of the 
group is determined as follows:

                                                      1963
----------------------------------------------------------------------------------------------------------------
                                                               A          B          C          D        Total
----------------------------------------------------------------------------------------------------------------
Distributions actually made..............................     $20.00  .........     $14.00  .........     $34.00
Gross-up under section 78:
  ($16.07/$16.07 x $2.50)................................       2.50
  ($14/$25 x $15)........................................  .........  .........       8.40  .........      10.90
Taxable income of M Corporation ($34 + $10.90)...........  .........  .........  .........  .........      44.90
U.S. tax before foreign tax credit (0.52 x $44.90).......  .........  .........  .........  .........      23.35
Foreign tax credit (as computed under gross-up above)....  .........  .........  .........  .........      10.90
U.S. tax payable ($23.35-$10.90).........................  .........  .........  .........  .........      12.45
Overall U.S. and foreign income tax with respect to the    .........  .........  .........  .........      42.45
 distribution actually made ($30 + $12.45), such amount
 being in excess of the minimum overall tax burden of
 $37.44..................................................
----------------------------------------------------------------------------------------------------------------
 
                                                      1964
----------------------------------------------------------------------------------------------------------------
Earnings and profits for 1963 to which minimum
 distribution for such year was not attributable:
  ($22.50-$20)...........................................      $2.50
  ($12.50-$0)............................................  .........     $12.50
  ($35.00-$14)...........................................  .........  .........     $21.00  .........     $36.00
Foreign income tax for 1963 not taken into account in
 determining tax deemed paid for such year on pretax
 earnings and profits to which the minimum distribution
 for such year was attributable:
  ([$16.07-$16.07]/$16.07 x $2.50).......................          0
  ([$8.93-$0]/$8.93 x $12.50)............................  .........      12.50
  ([$25-$14]/$25 x $15)..................................  .........  .........       6.60  .........      19.10
Distributions to M Corporation in 1964...................       2.50      12.50      21.00  .........      36.00
Gross-up under section 78:
  ($2.50/$2.50 x $0).....................................          0
  ($12.50/$12.50 x $12.50)...............................  .........      12.50
  ($21/$21 x $6.60)......................................  .........  .........       6.60  .........      19.10
Taxable income of M Corporation ($36 + $19.10)...........  .........  .........  .........  .........      55.10
U.S. tax before foreign tax credit (0.52 x $55.10).......  .........  .........  .........  .........      28.65
Foreign tax credit (as computed under gross-up above)....  .........  .........  .........  .........      19.10
U.S. tax payable ($28.65-$19.10).........................  .........  .........  .........  .........       9.55
----------------------------------------------------------------------------------------------------------------

    Example 6. Throughout 1963, domestic corporation M directly owns all 
the one class of stock of controlled foreign corporations A, B, and C, 
and maintains in a foreign country a branch which qualifies under 
paragraph (f)(4) of Sec. 1.963-1 for inclusion in a group as a wholly 
owned foreign subsidiary corporation. For 1963, a year for which the 
overall limitation under section 904(a)(2) on the foreign tax credit 
applies, M Corporation makes a group election with respect to A, B, and 
C Corporations and the foreign branch. All such corporations use the 
calendar year as the taxable year. The foreign branch has pretax and 
predistribution earnings and profits of $40 for 1963, as determined 
under paragraph (f)(4)(ii) of Sec. 1.963-1. None of the foreign 
corporations is a less developed country corporation under section 
902(d). Corporation M complies with the special rules of paragraphs (b) 
and (c) of this section. The United States income tax of M Corporation 
for 1963 is as follows, based upon the facts assumed:

----------------------------------------------------------------------------------------------------------------
                                                               A          B          C        Branch     Total
----------------------------------------------------------------------------------------------------------------
Pretax and predistribution consolidated earnings and          $20.00     $30.00        $10        $40    $100.00
 profits of the group....................................

[[Page 523]]

 
Consolidated income taxes................................       2.00      15.00          5         20      42.00
Effective foreign tax rate ($42/$100)....................  .........  .........  .........  .........        42%
Statutory percentage under section 963(b)................  .........  .........  .........  .........        40%
Posttax and predistribution consolidated earnings and          18.00      15.00          5         20      58.00
 profits of the group....................................
U.S. tax which would be paid on a pro rata minimum
 distribution from consolidated earnings and profits of
 the group:
  Pro rata minimum distribution (and amount which would
   be received by M Corporation):
    (0.40 x $18).........................................       7.20
    (0.40 x $15).........................................  .........       6.00
    (0.40 x $5)..........................................  .........  .........          2
    (0.40 x $40).........................................  .........  .........  .........         16      31.20
  Gross-up under section 78:
    ($7.20/$18 x $2).....................................        .80
    ($6/$15 x $15).......................................  .........       6.00
    ($2/$5 x $5).........................................  .........  .........          2  .........       8.80
  Taxable income of M Corporation ($31.20 + $8.80).......  .........  .........  .........  .........      40.00
  U.S. tax before foreign tax credit (0.52 x $40)........  .........  .........  .........  .........      20.80
  Foreign tax credit ($8.80, as computed under the gross-  .........  .........  .........  .........      16.80
   up, plus 40 percent of $20)...........................
  U.S. tax payable ($20.80-$16.80).......................  .........  .........  .........  .........       4.00
Overall U.S. and foreign income tax with respect to a pro  .........  .........  .........  .........      46.00
 rata minimum distribution for 1963 ($4 + $42)...........
Tentative tax on distribution actually received by M
 Corporation:
  Actual distribution received...........................  .........  .........         $5        $40     $45.00
  Gross-up under section 78 ($5/$5 x $5).................  .........  .........          5  .........       5.00
  Taxable income of M Corporation ($45 + $5).............  .........  .........  .........  .........      50.00
  U.S. tax before foreign tax credit (0.52 x $50)........  .........  .........  .........  .........      26.00
  Tentative foreign tax credit ($5, as computed under the  .........  .........  .........  .........      25.00
   gross-up above, plus 100 percent of $20)..............
  Tentative U.S. tax payable ($26-$25)...................  .........  .........  .........  .........       1.00
Insufficient overall U.S. and foreign income tax (the      .........  .........  .........  .........       3.00
 lesser of $46 or $46.80 [0.90 x 0.52 x $100] minus $43
 [$1 + $42]).............................................
Reduced foreign tax credit ($25-$3)......................  .........  .........  .........  .........      22.00
U.S. tax payable ($26-$22)...............................  .........  .........  .........  .........       4.00
Overall U.S. and foreign income tax with respect to        .........  .........  .........  .........      46.00
 actual distribution for 1963 ($4 + $42).................
Reduction in foreign tax credit for 1963 ($25-$22).......  .........  .........  .........  .........       3.00
Allocation of reduction in foreign tax credit to
 undistributed 1963 consolidated earnings and profits of
 the group:
  ($18/[$18 + $15] x $3.00)..............................       1.64
  ($15/[$18 + $15] x $3.00)..............................  .........       1.36  .........  .........       3.00
----------------------------------------------------------------------------------------------------------------

    Example 7. Domestic group M, an affiliated group of domestic 
corporations filing a consolidated return under section 1501, makes a 
group election for 1963 with respect to a group consisting of two 
controlled foreign corporations C and D, all of whose one class of stock 
is directly owned by group M, and foreign branch B, a foreign branch of 
a Western Hemisphere trade corporation (as defined in section 921) 
included in group M. No distributions are received for the taxable year 
from corporations C and D, but the foreign group makes a minimum 
distribution by reason of the deemed distribution of all of branch B's 
earnings and profits. Group M complies with the special rules of 
paragraphs (b) and (c) of this section. For 1963, a year for which the 
United States corporate income tax rate is 52 percent, the overall 
limitation under section 904(a)(2) on the foreign tax credit applies. 
All corporations use the calendar year as the taxable year. None of the 
foreign corporations is a less developed country corporation under 
section 902(d) for 1963. The income, and the United States and foreign 
income tax for 1963, are determined as follows, based upon the facts 
assumed:

----------------------------------------------------------------------------------------------------------------
                                                                        Branch       C          D        Total
----------------------------------------------------------------------------------------------------------------
Pretax and predistribution consolidated earnings and profits of the     $100.00     $10.00     $10.00    $120.00
 foreign group (before Western Hemisphere trade corporation
 deduction).........................................................
Western Hemisphere trade corporation deduction ($100 x 0.14/0.52)...      26.92  .........  .........      26.92
Pretax and predistribution consolidated earnings and profits of the       73.08      10.00      10.00      93.08
 foreign group (after Western Hemisphere trade corporation
 deduction).........................................................
Consolidated foreign income taxes (38%, 20%, and zero rate,
 respectively):
  (0.38 x $100).....................................................      38.00
  (0.20 x $10)......................................................  .........       2.00  .........      40.00

[[Page 524]]

 
  Consolidated earnings and profits of the foreign group............      35.08       8.00      10.00      53.08
Effective foreign tax rate ($40/$93.08).............................  .........  .........  .........        43%
Statutory percentage under section 963(b)...........................  .........  .........  .........        40%
Tax which would be paid with respect to a pro rata minimum
 distribution from consolidated earnings and profits of the foreign
 group:
  Pro rata minimum distribution:
    (0.40 x $73.08).................................................      29.23
    (0.40 x $8.00)..................................................  .........       3.20
    (0.40 x $10.00).................................................  .........  .........       4.00      36.43
  Gross-up under section 78: ($3.20/$8.00 x $2).....................  .........        .80  .........        .80
  Taxable income of group M.........................................      29.23       4.00       4.00      37.23
  U.S. tax before foreign tax credit:
    (0.52 x $29.23).................................................      15.20
    (0.54 x $4.00)..................................................  .........       2.16
    (0.54 x $4.00)..................................................  .........  .........       2.16      19.52
  Foreign tax credit ($0.80, as computed under the gross-up above,        15.20        .80  .........      16.00
   plus 40 percent of $38)..........................................
  U.S. tax payable..................................................  .........       1.36       2.16       3.52
  Overall U.S. and foreign income tax with respect to pro rata        .........  .........  .........      43.52
   minimum distribution ($3.52 + $40)...............................
Tentative tax on distribution actually received by group M:
  Taxable income of branch..........................................      73.08  .........  .........      73.08
  U.S. tax before foreign tax credit (0.52 x $73.08)................      38.00  .........  .........      38.00
  Tentative foreign tax credit......................................      38.00  .........  .........      38.00
  Tentative U.S. tax payable........................................  .........  .........  .........          0
Insufficient overall U.S. and foreign income tax (the lesser of       .........  .........  .........       3.52
 $43.52 or $43.56 [0.90 x 0.52 x $93.08] minus $40).................
Reduced foreign tax credit ($38-$3.52)..............................  .........  .........  .........      34.48
U.S. tax payable ($38-$34.48).......................................  .........  .........  .........       3.52
Overall U.S. and foreign income tax ($3.52 + $40.00)................  .........  .........  .........      43.52
Reduction in foreign tax credit for 1963 ($38-$34.48)...............  .........  .........  .........       3.52
Allocation of reduction in foreign tax credit to 1963 undistributed
 consolidated earnings and profits of the foreign group:
  ($8/[$8 + $10] x $3.52)...........................................  .........       1.56
  ($10/[$8 + $10] x $3.52)..........................................  .........  .........       1.96       3.52
----------------------------------------------------------------------------------------------------------------


[T.D. 6759, 29 FR 13335, Sept. 25, 1964; 29 FR 13896, Oct. 8, 1964, as 
amended by T.D. 6767, 29 FR 14878, Nov. 3, 1964; T.D. 7100, 36 FR 5336, 
Mar. 20, 1971]



Sec. 1.963-5  Foreign corporations with variation in foreign tax rate
because of distributions.

    (a) Limited application of section. The rules of this section shall 
apply to a foreign corporation only if--
    (1) Under the laws of a foreign country or possession of the United 
States the foreign income tax of the corporation for the taxable year 
depends upon the extent to which distributions are made by such 
corporation from its earnings and profits for the taxable year, so that 
the rate of such tax for the taxable year on income which is distributed 
differs from the rate of such tax for such year on the income which is 
not distributed, and
    (2) The corporation--
    (i) Is a single first-tier corporation, or
    (ii) Is for the taxable year in a chain or group from which the 
United States shareholder receives a minimum distribution in respect of 
which the minimum overall tax burden is determined in accordance with 
paragraph (a)(1)(ii) of Sec. 1.963-4.
    (b) Foreign income tax determined as though no distributions were 
made. The foreign income tax on the pretax and predistribution earnings 
and profits of the foreign corporation for the taxable year shall 
(solely for the purpose of determining the effective foreign tax rate 
under paragraph (c) of Sec. 1.963-2) be determined as if the foreign 
corporation made no distributions for the taxable year. However, 
notwithstanding the second sentence of paragraph (d)(1) of Sec. 1.963-
2, where the United States shareholder owns the stock (with respect to 
which the election under section 963 is made) in such corporation by 
reason of stock owned through a chain of ownership described in section 
958(a) and the foreign income tax of such corporation for the taxable 
year decreases as distributions are made from its earnings and profits, 
the rule in the preceding

[[Page 525]]

sentence shall not apply if the electing United States shareholder does 
not actually receive for the taxable year its proportionate share of the 
earnings and profits which are actually distributed. In such case, the 
foreign income tax on pretax and predistribution earnings and profits 
shall be the actual foreign income tax of such corporation, computed on 
the basis of the distributions which are made. For example, assume that 
a second-tier foreign corporation in a chain has pretax and 
predistribution earnings of $100 for the taxable year and that foreign 
law imposes on such corporation a foreign income tax of 50 percent of 
the pretax earnings and profits minus dividends for such year and of 20 
percent of such dividends. If the second-tier foreign corporation 
distributes $20 of earnings and profits to a first-tier foreign 
corporation which is part of the same chain, and if the first-tier 
corporation retains the dividend so received, the foreign income tax of 
the second-tier foreign corporation shall be considered to be the tax 
actually paid for the taxable year, that is, $44 (50 percent of $80 plus 
20 percent of $20). If the first-tier foreign corporation distributes 
the dividend so received, the foreign income tax of the second-tier 
foreign corporation shall be considered to be $50 (50 percent of $100). 
For purposes of this paragraph, the principles of paragraph (b)(3) of 
Sec. 1.963-4 shall apply.
    (c) Minimum distribution--(1) Single first-tier corporation. A 
minimum distribution for a taxable year by a single first-tier 
corporation described in paragraph (a)(1) of this section shall be a 
distribution which is equal to--
    (i) The amount resulting from the multiplication of the statutory 
percentage specified in paragraph (b) of Sec. 1.963-2 for such year by 
the United States shareholder's proportionate share of the earnings and 
profits of such corporation, as determined under paragraph (d)(2)(i) of 
Sec. 1.963-2 but without the deduction for foreign income tax provided 
by paragraph (d)(1)(ii) and (iii) of such section, reduced by
    (ii) The foreign income tax on the pretax amount determined under 
subdivision (i) of this subparagraph which would be paid or accrued by 
such corporation by reason of distributing such amount, less such tax, 
for such taxable year.
    (2) Corporation in a chain or group making a pro rata minimum 
distribution. In case of a corporation described in paragraph (a)(2)(ii) 
of this section in a chain or group, such corporation's share of a pro 
rata minimum distribution by the chain or group for the taxable year 
shall be--
    (i) The amount resulting from the multiplication of the statutory 
percentage specified in paragraph (b) of Sec. 1.963-2 for the taxable 
year by the United States shareholder's proportionate share of the 
earnings and profits of such corporation, as determined under paragraph 
(d)(3) of Sec. 1.963-2 but without the deduction for foreign income tax 
provided by paragraph (d)(1)(ii) and (iii) of such section, reduced by
    (ii) The foreign income tax on the pretax amount determined under 
subdivision (i) of this subparagraph which would be paid or accrued by 
such corporation by reason of distributing such amount, less such tax, 
for such taxable year.
    (3) A chain or group making a distribution other than a pro rata 
minimum distribution. If a chain or group contains one or more foreign 
corporations described in paragraph (a)(2)(ii) of this section and such 
chain or group makes a minimum distribution other than a pro rata 
minimum distribution for the taxable year, the amount of such minimum 
distribution to the electing United States shareholder shall be at 
least--
    (i) The amount resulting from the multiplication of the statutory 
percentage specified in paragraph (b) of Sec. 1.963-2 for the taxable 
year by the consolidated earnings and profits of such chain or group 
with respect to such shareholder, as determined under paragraph (d)(3) 
of such section but without any deduction for foreign income tax 
provided by paragraph (d)(1)(ii) and (iii) of such section, reduced by
    (ii) The foreign income tax on the pretax amount determined under 
subdivision (i) of this subparagraph which would be paid or accrued by 
the foreign corporations in the chain or group by

[[Page 526]]

reason of distributing such amount, less such tax, for such taxable 
year.
    (4) Illustrations. The application of this paragraph may be 
illustrated by the following examples:

    Example 1. Domestic corporation M directly owns 80 percent of the 
one class of stock of single first-tier corporation B, which for 1964 
has $100 of pretax earnings and profits on which is imposed a foreign 
income tax of 40 percent of pretax earnings and profits minus dividends 
for the taxable year and of 20 percent of the amount of such dividends. 
Both corporations use the calendar year as the taxable year. The 
effective foreign tax rate applicable to B Corporation, as determined 
under paragraph (c) of Sec. 1.963-2, is 40 percent, and the statutory 
percentage under paragraph (b) of Sec. 1.963-2 for 1964 is 38 percent. 
Corporation M receives a minimum distribution for 1964 if it receives 
from B Corporation's earnings and profits for such year $22.80, that is, 
80 percent of $28.50, the distribution which would be made if there were 
distributed that amount of earnings and profits which, together with the 
foreign income tax at the rate effectively applicable to pretax earnings 
and profits to which such distribution is attributable, equals 38 
percent of $100. Such distribution may be determined by solving for 
``d'' in the following formula:

           d = $38-0.20d-0.40($38-d)
           d = $38-0.20d-$15.20 + 0.40d
           d = $22.80 + 0.20d
     0.80  d = $22.80
           d = $22.80/0.80
           d = $28.50
 

    Example 2. Domestic corporation M directly owns 80 percent of the 
one class of stock of each of controlled foreign corporations A and B, 
which constitute a group and each of which for 1964 has pretax earnings 
and profits of $100. All corporations use the calendar year as the 
taxable year. Corporation A is subject to foreign income tax at a flat 
rate of 40 percent; and B Corporation is subject to a foreign income tax 
of 40 percent of $100 minus dividends for the taxable year and of 20 
percent of the amount of such dividends. The effective foreign tax rate 
with respect to the group, as determined under paragraph (c) of Sec. 
1.963-2, is 40 percent, and the statutory percentage under paragraph (b) 
of Sec. 1.963-2 for 1964 is 38 percent. Corporation B distributes $25 
for 1964 toward a minimum distribution from the group which is not a pro 
rata minimum distribution. The minimum distribution by the group for 
1964 with respect to M Corporation is determined as follows:

M Corporation's proportionate share of B Corporation's            $20.00
 distribution (0.80 x $25).....................................
                                                                --------
Pretax and predistribution consolidated earnings and profits of   160.00
 the group (0.80 x $200).......................................
                                                                --------
Statutory percentage of pretax and predistribution consolidated    60.80
 earnings and profits (0.33 x $160)............................
                                                                --------
Less: portion of such statutory percentage to which the $20        25.00
 dividend received from B Corporation is attributable: Total
 dividend paid by B Corporation
Plus: Foreign income tax on B Corporation's pretax and
 predistribution earnings and profits to which such dividend is
 attributable, letting ``t'' represent such tax:
    t = 0.20 ($25) + 0.40t.....................................
    t = $5 + 0.40t.............................................
  0.60t = $5...................................................
    t = $5/0.60................................................     8.33
                                                                --------
B Corporation's pretax and predistribution earnings and profits    33.33
 to which such dividend is attributable........................
                                                                ========
M Corporation's proportionate share of B Corporation's pretax      26.67
 and predistribution earnings and profits to which the dividend
 is attributable (0.80 x $33.33)...............................
                                                                --------
The statutory percentage of the pretax and predistribution         34.13
 consolidated earnings and profits of the group to which A
 Corporation's distribution must be attributable...............
                                                                ========
Dividend required to be received from A Corporation ($34.13-       20.48
 [0.40 x $34.13])..............................................
                                                                --------
Minimum distribution to M Corporation of the taxable year's        40.48
 consolidated earnings and profits of the group ($20 + $20.48).
                                                                --------
 

    Example 3. The facts are the same as in example 2 except that the 
$25 distribution of earnings and profits is made by A Corporation. The 
amount of the minimum distribution for 1964 is determined as follows:

M Corporation's proportionate share of A Corporation's            $20.00
 distribution (0.80 x $25).....................................
                                                                --------
Pretax and predistribution consolidated earnings and profits of   160.00
 the group (0.80 x $200).......................................
                                                                --------
Statutory percentage of pretax and predistribution consolidated    60.80
 earnings and profits (0.38 x $160)............................
                                                                --------
Less: Portion of such statutory percentage to which the $20        25.00
 dividend received from A Corporation is attributable: Total
 dividend paid by A Corporation................................
Plus: Foreign income tax on A Corporation's pretax and             16.67
 predistribution earnings and profits to which such dividend is
 attributable (0.40 x [$25/0.60])..............................
                                                                --------
A Corporation's pretax and predistribution earnings and profits    41.67
 to which such dividend is attributable........................
                                                                ========
M Corporation's proportionate share of A Corporation's pretax      33.34
 and predistribution earnings and profits to which dividend is
 attributable ($41.67 x 0.80)..................................
                                                                --------
Portion of the statutory percentage of the pretax and              27.46
 predistribution consolidated earnings and profits of the group
 to which B Corporation's distribution must be attributable....
                                                                ========
Dividend received from B Corporation, letting ``d'' represent
 the dividend:
    d = $27.46-0.20d-0.40 ($27.46-d)...........................

[[Page 527]]

 
    d = $27.46-0.20d-$10.98 + 0.40d............................
    d = $16.48 + 0.20d.........................................
  0.80d = $16.48...............................................
    d = $16.48/0.80............................................    20.60
                                                                --------
Minimum distribution to M Corporation of the taxable year's        40.60
 consolidated earnings and profits of the group ($20 + $20.60).
 

    (d) Distributions through a chain or group. In the application of 
paragraph (b)(3)(i) of Sec. 1.963-4, relating to the allocation of 
dividend payments first to income received as a distribution from other 
foreign corporations in the chain or group, if one or more of such other 
foreign corporations is a corporation whose foreign income tax rate 
decreases as the distributions are made, the allocation under such 
paragraph shall be made first to such corporations' distributions.
    (e) Foreign tax credit--(1) Year of minimum distribution. If a 
United States shareholder receives for a taxable year a distribution of 
the earnings and profits for the taxable year of a foreign corporation 
described in paragraph (a) of this section and if for such year such 
corporation is a first-tier corporation, or a second-tier corporation 
described in section 902 (a) or (b), as the case may be, then, in 
applying paragraph (c)(2)(i) of Sec. 1.963-4, only the foreign income 
tax which is effectively applicable to pretax earnings and profits to 
which are attributable the earnings and profits which are distributed 
shall be deemed paid for such year under section 902 (a) or (b), as the 
case may be, and the foreign income tax so paid or accrued by such 
corporation shall not be averaged, for purposes of such section, with 
its foreign income tax paid or accrued for such year on its pretax 
earnings and profits to which are attributable the earnings and profits 
which are not distributed.
    (2) Year of distribution of remaining earnings and profits. If for a 
taxable year a United States shareholder receives a minimum distribution 
from a corporation described in paragraph (a) of this section, the 
pretax and predistribution earnings and profits of such corporation for 
the taxable year to which such minimum distribution is attributable and 
the foreign income tax which is taken into account, in accordance with 
paragraph (c)(2)(i) of Sec. 1.963-4, in determining tax deemed paid 
under section 902 on such pretax and predistribution earnings and 
profits shall not be taken into account in the application of section 
902 when other earnings and profits of such foreign corporation for such 
year are distributed in a subsequent taxable year of such foreign 
corporation to such shareholder.
    (3) Illustration. The application of this paragraph may be 
illustrated by the following examples:

    Example 1. (a) All the income of controlled foreign corporation B, 
wholly owned directly by domestic corporation M, is taxed by foreign 
country Y, the tax laws of which impose at the local level a corporate 
income tax of 10 percent of earnings and profits (before reduction for 
income taxes) and, at the national level, an income tax of 30 percent of 
such earnings and profits reduced by the local tax and by any profits 
which are distributed. Also, at the national level, a tax of 20 percent 
is imposed on B Corporation on the dividends which are paid for the 
taxable year. Both corporations use the calendar year as the taxable 
year. For 1963, B Corporation has earnings and profits (before reduction 
by income taxes) of $100. B Corporation is not a less developed country 
corporation under section 902(d). For 1963, M Corporation makes a first-
tier election with respect to B Corporation and receives a minimum 
distribution. Corporation B has no 1964 earnings and profits, and its 
remaining 1963 earnings and profits are distributed late in 1964. The 
amount of the minimum distribution required to be received by M 
Corporation for 1963 and the United States tax with respect to the 1963 
earnings and profits of B Corporation are determined as follows, 
assuming a United States corporate income tax rate of 52 percent 
(instead of 50 percent) for 1964 and no surtax exemption under section 
11(c) for either year:

                                  1963
Effective foreign tax rate which obtains if no                       37%
 earnings and profits of B Corporation are
 distributed [($100 x 0.10) + ([$100-($100 x 0.10)]
 x 0.30)]/$100......................................
Minimum percentage of earnings and profits required                  68%
 under section 963(b) to be distributed, given a 37
 percent effective foreign tax rate.................
Amount of earnings and profits (before reduction by               $68.00
 foreign income tax) to which minimum distribution
 would be attributable if the effective foreign tax
 rate of 37 percent obtained (0.68 x $100)..........

[[Page 528]]

 
Minimum distribution required to be received by M
 Corporation, i.e., such an amount that is $68 less
 the foreign income tax on such $68, determined by
 letting ``d'' equal the dividend in the algebraic
 equation:
    d = $68 - (0.10 x $68) - 0.30 ($68 - [0.10 x
     $68] - d) - 0.20d..............................
    d = $68 - $6.80 - ($20.40 - $2.04 - 0.30d) -
     0.20d..........................................
    d = $61.20 - $20.40 + $2.04 + 0.30d - 0.20d.....
    d = $42.84 + 0.10d..............................
  0.90d = $42.84....................................
    d = $42.84/0.90, or.............................              $47.60
Gross-up under section 78, using the actual foreign               $20.40
 income tax imposed on pretax profits to which are
 attributable the earnings and profits distributed
 ($6.80 + 0.30 [$61.20-$47.60] + 0.20 [$47.60]).....
Taxable income of M Corporation for 1963 ($47.60 +                $68.00
 $20.40)............................................
U.S. tax before foreign tax credit ($68 x 0.52).....              $35.36
Foreign tax credit ($47.60/$47.60 x $20.40).........              $20.40
U.S. tax payable for 1963 ($35.36- $20.40)..........              $14.96
Overall U.S. and foreign income tax rate [$14.96 +                47.20%
 $20.40 + ($32 x 0.37)]/$100........................
 
                                  1964
 
Dividend received by M Corporation ($32-[0.37 x                   $20.16
 $32])..............................................
Gross-up under section 78, using the foreign income               $11.84
 tax paid or accrued on pretax earnings and profits
 to which are attributable 1963 earnings and profits
 distributed during 1964 ($20.16/$20.16 x [$32 x
 0.37]).............................................
Taxable income of M Corporation for 1964 ($20.16 +                $32.00
 $11.84)............................................
U.S. tax before foreign tax credit ($32 x 0.52).....              $16.64
Foreign tax credit ($20.16/$20.16 x $11.84).........              $11.84
U.S. tax payable ($16.64-$11.84)....................               $4.80
 

    (b) If B Corporation were a less developed country corporation under 
section 902(d), there would be no gross-up under section 78 and the 
foreign tax credit of M Corporation would be $14.28 for 1963 ($47.60/
[47.60 + $20.40] x $20.40), and $7.46 for 1964 ($20.16/ [$20.16 + 
$11.84] x $11.84).
    Example 2. For 1963, domestic corporation M receives a dividend of 
$21 from B Corporation which counts toward a minimum distribution from a 
group, determined by applying the special rules of paragraphs (b) and 
(c) of Sec. 1.963-4. Both corporations use the calendar year as the 
taxable year. Foreign law imposes on B Corporation an income tax of 40 
percent of the year's pretax earnings and profits, less dividends paid 
for such year, and of 20 percent of such dividends. Corporation M 
directly owns 70 percent of the one class of stock of B Corporation, 
which for 1963 has pretax and predistribution earnings and profits of 
$100. Corporation B is not a less developed country corporation under 
section 902(d). In late 1964, M Corporation receives a distribution of 
all of B Corporation's 1964 earnings and profits and of $25.20 from its 
1963 earnings and profits. The foreign income tax of B Corporation 
deemed paid for 1963 by M Corporation under section 902(a) is based on 
the foreign income tax actually paid by B Corporation on an amount of 
pretax earnings and profits which, when reduced by the tax so paid, 
equals the total dividend which is paid. The determination of tax deemed 
paid by M Corporation with respect to distributions from 1963 earnings 
and profits of B Corporation is as follows:

                                  1963
 
Pretax and predistribution earnings and profits of B                $100
 Corporation for 1963..........................................
Total dividend paid by B Corporation in 1963 ($21/0.70)........       30
Total foreign income tax paid by B Corporation for 1963               34
 (0.40[$100- $30] + [0.20 x $30]) or ($28 + $6)................
Foreign income tax, represented by ``t'' in the following
 equation, to be taken into account with respect to total
 dividend in determining tax deemed paid under section 902(a)
 by M Corporation:
    t = (0.20 x $30) + 0.40t...................................
    t = $6 + 0.40t.............................................
  0.60t = $6...................................................
    t = $6/0.60, or............................................      $10
Foreign income tax deemed paid by M Corporation for 1963 ($21/         7
 $30 x $10)....................................................
 
                                  1964
 
Remaining 1963 earnings and profits of B Corporation ([$100-          36
 $34]-$30) or ($66-$30)........................................
Dividend received by M Corporation for 1964 (0.70 x $36).......    25.20
Foreign income tax deemed paid by M Corporation for 1964           16.80
 ($25.20/$36 x [$34-$10]) or ($25.20/$36 x $24)................
 


[T.D. 6759, 29 Sept. 25, 1964; 29 FR 13896, Oct. 8, 1964, as amended by 
T.D. 6767, 29 FR 14879, Nov. 3, 1964]



Sec. 1.963-6  Deficiency distribution.

    (a) In general. Section 963(e)(2) and this section provide a method 
under which, by virtue of a deficiency distribution, a United States 
shareholder may be relieved from the payment of a deficiency in tax for 
any taxable year arising by reason of failure to include subpart F 
income in gross income under section 951(a)(1)(A)(i), when it has been 
determined that such shareholder has failed to receive a minimum 
distribution for such year in respect of which it elected to secure the 
exclusion under section 963. In addition, this section provides rules 
with respect to a credit or refund of part or all of any such deficiency 
which has been paid. Under the method provided, the benefit of the 
exclusion of subpart F income

[[Page 529]]

from gross income of the United States shareholder is allowed 
retroactively for the taxable year in respect of which the election 
under section 963 applied, but only if the subsequent deficiency 
distribution meets the requirements of this section. The benefits of the 
retroactive exclusion will not, however, prevent the assessment of 
interest, additional amounts, and assessable penalties.
    (b) Requirements for deficiency distribution--(1) Distribution made 
on or after date of determination. If--
    (i) A United States shareholder, in making its return of the tax 
imposed by chapter 1 of the Code for any taxable year, elects to secure 
an exclusion under section 963 for such year,
    (ii) It is subsequently determined (within the meaning of paragraph 
(c) of this section) that an exclusion under section 963 of subpart F 
income with respect to stock to which such election relates does not 
apply for such taxable year because of the failure of such shareholder 
to receive a minimum distribution for such year with respect to such 
stock, and
    (iii) Such failure is due to reasonable cause, a deficiency 
distribution which is received by such shareholder with respect to such 
stock from a foreign corporation which was the single first-tier 
corporation, or a corporation in the chain or group, as the case may be, 
with respect to which the election was made, shall count toward a 
minimum distribution under section 963 for such year of election if such 
deficiency distribution is received (except as provided by subparagraph 
(2) of this paragraph) on, or within 90 days after, the date of such 
determination and prior to the filing of a claim under paragraph (d)(1) 
of this section. Such claim must be filed within 120 days after the date 
of such determination, and the deficiency distribution must be a 
dividend of such a nature (except as otherwise provided in this section) 
as would have permitted it to count toward a minimum distribution for 
the taxable year of the election if it had been received by the United 
States shareholder during such year. No distribution shall count as a 
deficiency distribution under this subparagraph unless a claim therefor 
is filed under paragraph (d)(1) of this section.
    (2) Distribution made before date of determination. A deficiency 
distribution may also be received by a United States shareholder at any 
time prior to the date on which the determination required by 
subparagraph (1) of this paragraph is made. A distribution will count as 
a deficiency distribution under this subparagraph--
    (i) To the extent that such distribution otherwise satisfies the 
requirements of this section;
    (ii) If the United States shareholder files within 90 days after 
such distribution but before the determination date an advance claim 
described in paragraph (d)(2) of this section for treatment of such 
distribution as a deficiency distribution;
    (iii) If such shareholder consents in such claim to include such 
deficiency distribution in gross income for the taxable year of the 
election to the extent necessary to complete a minimum distribution for 
such year and under section 6501 to extend the period for the making of 
assessments, and the bringing of distraint or a proceeding in court for 
collection, in respect of a deficiency and all interest, additional 
amounts, and assessable penalties for such taxable year;
    (iv) If, when requested by the district director, such shareholder 
consents under section 6501 in such claim to extend the period for the 
making of assessments, and the bringing of distraint or a proceeding in 
court for collection, in respect of a deficiency and all interest, 
additional amounts and assessable penalties for the year of receipt of 
such distribution; and
    (v) To the extent that such shareholder makes advance payment of tax 
which would result from the inclusion of such distribution in gross 
income as a minimum distribution for the year of such deficiency.


To the extent that such distribution is not necesasry under the 
determination (when made under paragraph (c) of this section) for a 
deficiency distribution, it shall be included in the United States 
shareholder's gross income for the taxable year of receipt of such 
distribution and paragraph (g) of this section shall not apply.

[[Page 530]]

    (3) Earnings and profits of year of election to be first 
distributed. If--
    (i) In the case of a first-tier election, the United States 
shareholder's proportionate share of the earnings and profits of the 
foreign corporation which was the single first-tier corporation, or
    (ii) In the case of a chain or group election, any portion of the 
share of any corporation or corporations (which were in the chain or 
group) of the consolidated earnings and profits with respect to the 
United States shareholder,


for the taxable year of the election has not been distributed on the 
stock with respect to which the election was made, then a distribution, 
in order to be counted toward a deficiency distribution, must be made by 
such corporation or corporations and from such earnings and profits to 
the extent thereof. Once all such earnings and profits of such 
corporation or corporations have been completely distributed, a 
deficiency distribution may be made from other earnings and profits of 
such foreign corporation which was a single first-tier corporation, or 
of such corporation or corporations which were in such chain or group, 
as the case may be.
    (4) Proof of reasonable cause. Reasonable cause for failure to 
receive a minimum distribution shall be deemed to exist, in the absence 
of circumstances demonstrating bad faith, if the electing United States 
shareholder receives, within the period prescribed by paragraph 
(a)(1)(i) of Sec. 1.963-3 with respect to the year of election, at 
least 80 percent of the amount of a minimum distribution (from the 
earnings and profits to which the election for such year relates) which 
if received during such period would have satisfied the conditions for 
the section 963 exclusion to apply to such year. If less than 80 percent 
of the amount of a minimum distribution is received during such period, 
the existence of a reasonable cause for failure to receive a minimum 
distribution must be established by clear and convincing evidence; 
however, the preceding sentence shall not be taken as a limitation on 
the establishment of reasonable cause by any other proof of reasonable 
cause. For example, reasonable cause will exist if a single first-tier 
corporation for its taxable year makes a distribution which would be a 
minimum distribution but for a refund of foreign income tax which it has 
paid in good faith under foreign law but which is found not to be due 
after the United States income tax return of the United States 
shareholder has been filed.
    (c) Nature and details of determination. (1) A determination that 
the section 963 exclusion does not apply to a United States shareholder 
for a taxable year due to its failure to receive a minimum distribution 
for such year shall, for the purposes of this section, be established 
by--
    (i) A decision by the Tax Court or a judgment, decree, or other 
order by any court of competent jurisdiction, which has become final;
    (ii) A closing agreement made under section 7121; or,
    (iii) An agreement which is signed by the district director, or such 
other official to whom authority to sign the agreement is delegated, and 
by, or on behalf of, such shareholder and which relates to the liability 
of such shareholder for the tax under chapter 1 of the Code for such 
year.
    (2) The date of determination by a decision of the Tax Court shall 
be the date upon which such decision becomes final, as prescribed in 
section 7481.
    (3) The date upon which a judgment of a court becomes final shall be 
determined upon the basis of the facts in the particular case. 
Ordinarily, a judgment of a United States district court shall become 
final upon the expiration of the time allowed for taking an appeal, if 
no such appeal is duly taken within such time; and a judgment of the 
United States Court of Claims shall become final upon the expiration of 
the time allowed for filing a petition for certiorari, if no such 
petition is duly filed within such time.
    (4) The date of determination by a closing agreement made under 
section 7121 shall be the date such agreement is approved by the 
Commissioner.
    (5) The date of a determination made by an agreement which is signed 
by the district director, or such other official to whom authority to 
sign the agreement is delegated, shall be the date prescribed by this 
subparagraph. The agreement shall be sent to the United

[[Page 531]]

States shareholder at his last known address by either registered or 
certified mail. For further guidance regarding the definition of last 
known address, see Sec. 301.6212-2 of this chapter. If registered mail 
is used for such purpose, the date of registration shall be treated as 
the date of determination; if certified mail is used for such purpose, 
the date of the postmark on the sender's receipt for such mail shall be 
treated as the date of determination. However, if the deficiency 
distribution is received by such shareholder before such registration or 
postmark date but on or after the date the agreement is signed by the 
district director or such other official to whom authority to sign the 
agreement is delegated, the date of determination shall be the date on 
which the agreement is so signed.
    (6) The determination under this paragraph shall find that, due to 
the United States shareholder's failure to receive a minimum 
distribution, the section 963 exclusion does not apply for the taxable 
year with respect to stock to which the election under such section 
relates. A determination described in subdivision (ii) or (iii) of 
subparagraph (1) of this paragraph shall set forth the amount of the 
deficiency distribution and the amount of additional income tax for 
which the United States shareholder is liable under Chapter 1 of the 
Code by reason of not including in gross income for such year the amount 
of the deficiency distribution. If a determination described in 
subdivision (i) of subparagraph (1) of this paragraph does not establish 
the amount of the deficiency distribution and such amount of additional 
tax, such amounts may be established by an agreement which is signed by 
the district director, or such other official to whom authority to sign 
the agreement is delegated.
    (d) Claim for treatment of distribution as a deficiency 
distribution--(1) Claim filed after date of determination. A claim 
(including any amendments thereof) for treatment of a deficiency 
distribution as counting toward a minimum distribution for the taxable 
year of election shall be filed in duplicate, within 120 days after the 
date of the determination described in paragraph (c) of this section, 
with the requisite declaration prescribed by the Commissioner on the 
appropriate claim form and shall be accompanied by--
    (i) A copy of such determination and a description of how it became 
final;
    (ii) If requested by the district director, or by such other 
official to whom authority to sign the agreement referred to in 
paragraph (c)(1) or (6) of this section is delegated, a consent by the 
United States shareholder under section 6501 to extend the period for 
the making of assessments, and the bringing of distraint or a proceeding 
in court for collection, in respect of a deficiency and all interest, 
additional amounts, and assessable penalties for the taxable year of 
election; and
    (iii) Such other information as may be required by the claim form or 
the district director, or other official, in support of the claim.
    (2) Advance claim. An advance claim for treatment of a deficiency 
distribution as counting toward a minimum distribution for the taxable 
year of election shall be filed in duplicate, within 90 days after such 
distribution but before the date of determination described in paragraph 
(c) of this section, and shall satisfy all requirements of subparagraph 
(1) of this paragraph other than subdivision (i) of such subparagraph. 
However, within 120 days after the date of the determination described 
in paragraph (c) of this section, the advance claim shall be completed 
so that it satisfies all requirements of subparagraph (1) of this 
paragraph.
    (e) Computation of interest on deficiencies in tax. If a United 
States shareholder, for the taxable year of the election under section 
963, completes a minimum distribution for such year by receiving a 
deficiency distribution to which this section applies, the interest on 
the deficiency in tax due by reason of the failure to include the amount 
of such deficiency distribution in such shareholder's gross income for 
such year shall be computed for the period from the last date prescribed 
for payment of the tax for such year to the date such deficiency in tax 
is paid. No interest shall be due by reason of the failure to include 
Subpart F income in gross income for a taxable year in respect of which 
a minimum distribution

[[Page 532]]

under section 963 is completed by a deficiency distribution to which 
this section applies.
    (f) Claim for credit or refund. If a deficiency in tax is asserted 
for any taxable year by reason of failure to include Subpart F income in 
gross income under section 951(a)(1)(A)(i) and the United States 
shareholder has paid any portion of such asserted deficiency, such 
shareholder is entitled to a credit or refund of such payment to the 
extent that such payment constitutes an overpayment of tax as the result 
of the receipt of a deficiency distribution to which this section 
applies. To secure credit or refund of such overpayment of tax, the 
United States shareholder must file a claim for refund in accordance 
with Sec. 301.6402-3, in addition to the claim form required under 
paragraph (d) of this section. No interest shall be allowed on such 
credit or refund. For other rules applicable to the filing of claims for 
credit or refund of an overpayment of tax, see section 6402 and the 
regulations thereunder. For the limitations applicable to the credit or 
refund for an overpayment of tax, see section 6511 and the regulations 
thereunder.
    (g) Effect of deficiency distribution--(1) Allocation of 
distributions. The deficiency distribution shall be allocated, by 
applying the rules of Sec. 1.963-3 (and paragraph (b) of Sec. 1.963-4, 
if applicable for the year of election), as a distribution first from 
the earnings and profits (to the extent thereof) of the foreign 
corporation which was the single first-tier corporation, or of the 
distributing corporation or corporations which were in the chain or 
group, as the case may be, for the taxable year in respect of which the 
election was made, and then from earnings and profits (to the extent 
thereof) described in section 959(c)(3) and determined as provided in 
section 959 for the most recent taxable year and the first, second, 
etc., taxable years preceding such recent taxable years, in that order, 
of the distributing corporation or corporations. In applying the 
preceding sentence to taxable years other than the taxable year in 
respect of which the election was made, the deficiency distribution 
shall first be allocated, in the order of allocation prescribed by such 
sentence, first to taxable years in respect of which no election under 
section 963 was made with respect to the stock on which such 
distribution is received and then to taxable years in respect of which 
an election under such section was made.
    (2) Year of receipt. Any deficiency distribution made with respect 
to a taxable year of the United States shareholder shall be treated, 
except as provided in paragraph (b)(2) of this section, as having been 
received by the shareholder in that year for which such shareholder 
elected to secure an exclusion under section 963; and, for purposes of 
the foreign tax credit under section 901, the foreign income taxes paid 
or accrued, or deemed paid, by the United States shareholder by reason 
of a distribution of any amount treated as a deficiency distribution for 
such year shall be treated as paid or accrued, or deemed paid, for such 
year.
    (3) Year of payment. A distribution counting toward a deficiency 
distribution for a taxable year of election shall, except as provided in 
paragraph (b)(2) of this section, be treated for purposes of applying 
paragraph (a) of Sec. 1.963-3, relating to conditions under which 
earnings and profits are counted toward a minimum distribution, and 
paragraph (b)(3) of Sec. 1.963-4, relating to rules for distributing 
through a chain or group, as if it were distributed during the 
distribution period (as defined in paragraph (g) of Sec. 1.963-3) with 
respect to the distributing corporation and each foreign corporation 
through which such distribution is made to the United States 
shareholder, for the taxable year to which the election under section 
963 applies; and the foreign income taxes paid by any foreign 
corporation by reason of such distribution shall, in the application of 
section 902 and of the special rules of paragraph (c) of Sec. 1.963-4, 
be treated as paid or accrued by such foreign corporation for its 
taxable year to which such election applies. The distribution shall not 
count toward a minimum distribution for any other taxable year.
    (4) Allocation of reduction in tax credit. If any portion of a 
deficiency distribution from a corporation which was in a chain or group 
is paid from earnings and profits of a taxable year other than that in 
respect of which the election

[[Page 533]]

was made, then the minimum distribution toward which such deficiency 
distribution counts may not be treated as a pro rata minimum 
distribution for purposes of Sec. 1.963-4. Moreover, the amount of the 
overall United States and foreign income tax with respect to such 
minimum distribution must satisfy the minimum tax requirements of 
paragraph (a)(1)(i), or paragraph (ii), of Sec. 1.963-4, but, if the 
latter applies, without any reduction and deferral under paragraph 
(c)(3) of such section of the foreign tax credit allowable under section 
901 with respect to the deficiency distribution.

[T.D. 6759, 29 FR 13346, Sept. 25, 1964, as amended by T.D. 6767, 29 FR 
14879, Nov. 3, 1964; T.D. 7410, 41 FR 11020, Mar. 16, 1976; T.D. 8939, 
66 FR 2819, Jan. 12, 2001]



Sec. 1.963-7  Transitional rules for certain taxable years.

    (a) Extension of time for making, revoking, or changing election--
(1) In general. Subparagraphs (2) and (3) of this paragraph provide 
additional rules which apply only to a taxable year of a United States 
shareholder for which the last day prescribed by law for filing its 
return (including any extensions of time under section 6081) occurs on 
or before the 90th day after September 30, 1964.
    (2) Manner of making the election. The election of the United States 
shareholder to secure the exclusion under section 963 and the consent to 
the regulations under such section may be made for the taxable year--
    (i) By filing with the return (or with an amended return filed on or 
before such 90th day) for such taxable year--
    (a) A written statement stating that such election is made for such 
taxable year, and
    (b) The names of the foreign corporations to which such election 
applies, the taxable year, country of incorporation, pretax earnings and 
profits, foreign income taxes, earnings and profits, and outstanding 
capital stock, of each such corporation, and such other information 
relating to the election made as the Commissioner may prescribe, on or 
before the date of filing, by instructions or schedules to support such 
return; or
    (ii) In case of any extension of time under section 6081 with 
respect to such taxable year where the last day prescribed by law for 
filing the return by the electing United States shareholder (not 
including any extensions thereof) occurs on or before September 30, 
1964, by filing with the request for the first such extension of time a 
written statement stating that such election is made for such taxable 
year and setting forth the names of the foreign corporations to which 
each election applies.
    (3) Revocation or change of election. An election made in the manner 
provided by subparagraph (2) of this paragraph may be revoked or 
changed--
    (i) By filing with the return on or before the 90th day after 
September 30, 1964, a written statement that such election is revoked or 
changed, as the case may be, and by setting forth with respect to any 
such modified election the information prescribed by subparagraph 
(2)(i)(b) of this paragraph, or
    (ii) Where the return has been filed on or before such 90th day, by 
filing on or before such 90th day an amended return and an accompanying 
statement that such election is revoked or changed, as the case may be, 
and by setting forth with respect to any such modified election the 
information prescribed by subparagraph (2)(i)(b) of this paragraph.
    (b) Extension of time for making a minimum distribution--(1) In 
general. This paragraph applies only with respect to a taxable year of a 
United States shareholder ending on or before September 30, 1964, for 
which an election to secure an exclusion under section 963 is made 
where, in case of a first-tier election, the distribution period of such 
first-tier corporation with respect to its taxable year to which such 
election applies ends on or before the 90th day after such date, and 
where, in the case of a chain or group election, the distribution period 
ends on or before such 90th day with respect to the taxable year to 
which the election applies of any of the foreign corporations in such 
chain or group.
    (2) Conditions for obtaining extension of time. A distribution on 
stock with respect to which the election under section 963 was made 
which is received by the United States shareholder from a

[[Page 534]]

foreign corporation which was the single first-tier corporation, or a 
corporation in the chain or group, as the case may be, with respect to 
which the election was made, shall count toward a minimum distribution 
under section 963 for such year of election if--
    (i) The distribution is made on or before such 90th day,
    (ii) The shareholder, in a statement attached to its return or 
amended return for such year (which is filed on or before such 90th day) 
indicates the foreign corporation or corporations from which the 
distribution is made and states that, and the extent to which, the 
distribution is to count toward such minimum distribution,
    (iii) The distribution is of such a nature as would have permitted 
it to count toward a minimum distribution for such taxable year of the 
United States shareholder if it had been made on the last day of such 
year, and
    (iv) The United States shareholder includes the distribution in 
gross income as if it were received on the last day of such taxable year 
of election.


The distribution shall be applied against the earnings and profits of 
the single first-tier corporation or the foreign corporations in the 
chain or group for the taxable year of such corporation or corporations 
to which the election applies.
    (3) Year of receipt. To the extent that a distribution counts toward 
a minimum distribution under this paragraph with respect to a taxable 
year of the United States shareholder, it shall be treated as having 
been received by the shareholder in that year for the purpose of 
determining gross income and the assessment of interest, additional 
amounts, and assessable penalties; and, for purposes of the foreign tax 
credit under section 901, the foreign income taxes paid or accrued, or 
deemed paid, by the United States shareholder by reason of a 
distribution of any amount treated as a distribution for such year under 
this paragraph shall be treated as paid or accrued, or deemed paid, for 
such year.
    (4) Year of payment. The distribution shall be treated for purposes 
of applying paragraph (a) of Sec. 1.963-3, relating to conditions under 
which earnings and profits are counted toward a minimum distribution, 
and paragraph (b)(3) of Sec. 1.963-4, relating to rules for 
distributing through a chain or group, as if it were distributed during 
the distribution period (as defined in paragraph (g) of Sec. 1.963-3) 
with respect to the distributing corporation and each foreign 
corporation through which such distribution is made to the United States 
shareholder, for the taxable year to which the election under section 
963 applies; and the foreign income taxes paid by any foreign 
corporation by reason of such distribution shall, in the application of 
section 902 and of the special rules of paragraph (c) of Sec. 1.963-4, 
be treated as paid or accrued by such foreign corporation for its 
taxable year to which such election applies. The distribution shall not 
count toward a minimum distribution for any other taxable year.

[T.D. 6759, 29 FR 13348, Sept. 25, 1964, as amended by T.D. 6767, 29 FR 
14879, Nov. 3, 1964]



Sec. 1.963-8  Determination of minimum distribution during the 
surcharge period.

    (a) Taxable years not wholly within the surcharge period. In the 
case of a taxable year beginning before the surcharge period and ending 
within the surcharge period, or beginning within the surcharge period 
and ending after the surcharge period, or beginning before January 1, 
1970, and ending after December 31, 1969, section 963(b) provides the 
method for determining the required minimum distribution. Under the 
method prescribed in section 963(b) for such years, the required minimum 
distribution is an amount equal to the sums of:
    (1) That portion of the minimum distribution which would be required 
if the provisions of section 963(b)(1) were applicable to the taxable 
year, which the number of days in such taxable year which are within the 
surcharge period and before January 1, 1970, bears to the total number 
of days in such taxable year.
    (2) That portion of the minimum distribution which would be required 
if the provisions of section 963(b)(2) were applicable to such taxable 
year, which the number of days in such taxable year which are within the 
surcharge

[[Page 535]]

period and after December 31, 1969, bears to the total number of days in 
such taxable year, and
    (3) That portion of the minimum distribution which would be required 
if the provisions of section 963(b)(3) were applicable to such taxable 
year, which the number of days in such taxable year which are not within 
the surcharge period bears to the total number of days in such taxable 
year.
    (b) Calendar year 1970. For calendar year 1970, the required minimum 
distribution shall be an amount determined in accordance with the 
following table:

------------------------------------------------------------------------
                                                           The required
                                                              minimum
                                                           distribution
   If the effective foreign tax rate is (percentage)--      of earnings
                                                          and profits is
                                                          (percentage)--
------------------------------------------------------------------------
Under 9.................................................       84.983562
9 or over but less than 10..............................       82.967123
10 or over but less than 18.............................       80.983562
18 or over but less than 19.............................       79.471233
19 or over but less than 26.............................       77.487671
26 or over but less than 27.............................       73.958904
27 or over but less than 32.............................       70.487671
32 or over but less than 33.............................       67.463014
33 or over but less than 36.............................       63.991781
36 or over but less than 37.............................       57.942466
37 or over but less than 39.............................       51.991781
39 or over but less than 40.............................       44.934247
40 or over but less than 41.............................       37.495890
41 or over but less than 42.............................       31.446575
42 or over but less than 43.............................       19.446575
43 or over but less than 44.............................       12.893151
44 or over but less than 45.............................        6.446575
45 or over..............................................               0
------------------------------------------------------------------------

    (c) Surcharge period. For purposes of this section the term 
``surcharge period'' means the period beginning January 1, 1968, and 
ending June 30, 1970.
    (d) Illustration of principles. The application of the rules set 
forth in paragraphs (a), (b), and (c) of this section may be illustrated 
by the following example. It is assumed that all computations are 
carried to sufficient accuracy:

    Example. (a) M, a domestic corporation, and A, its controlled 
corporation (the one class of stock of which is wholly owned by M), both 
have a taxable year beginning December 1, 1969, and ending November 30, 
1970. For such taxable year M makes a first-tier election with respect 
to A corporation. The effective foreign tax rate for such year is 30 
percent.
    (b) Under section 963(b) and paragraph (b) of this section the 
surcharge period ends June 30, 1970. Therefore, of the 365 days in the 
taxable year, 153 days are not within the surcharge period. Of the 
remaining 212 days, 31 are within the surcharge period and before 
January 1, 1970 and 181 days are within the surcharge period and after 
December 31, 1969. If section 963(b)(1) were applicable to the entire 
taxable year, the required minimum distribution of earnings and profits 
would be 75 percent. If section 963(b)(2) were applicable to the entire 
taxable year, the required minimum distribution would be 72 percent. If 
section 963(b)(3) were applicable to the entire taxable year, the 
required minimum distribution would be 69 percent.
    (c) Under section 963(b) and this section the required minimum 
distribution of earnings and profits is 71 percent, computed as follows:

(75% x 31 / 365) + (72% x 181 / 365) + (69% x 153 / 365) = 71%.

[T.D. 7100, 36 FR 5336, Mar. 20, 1971]



Sec. 1.964-1  Determination of the earnings and profits of a foreign
corporation.

    (a)(1) In general. For rules for determining the earnings and 
profits (or deficit in earnings and profits) of a foreign corporation 
for taxable years beginning before January 1, 1987, for purposes of 
sections 951 through 964, see 26 CFR 1.964-1(a) (revised as of April 1, 
2006). For taxable years beginning after December 31, 1986, except as 
otherwise provided in the Code and regulations, the earnings and profits 
(or deficit in earnings and profits) of a foreign corporation for its 
taxable year shall be computed for all Federal income tax purposes 
substantially as if such corporation were a domestic corporation by--
    (i) Preparing a profit and loss statement with respect to such year 
from the books of account regularly maintained by the corporation for 
the purpose of accounting to its shareholders.
    (ii) Making the adjustments necessary to conform such statement to 
the accounting principles described in paragraph (b) of this section; 
and
    (iii) Making the further adjustments necessary to conform such 
statement to the tax accounting standards described in paragraph (c) of 
this section.
    (2) Required adjustments. The computation described in paragraph 
(a)(1) of this section shall be made in the foreign corporation's 
functional currency (determined under section 985 and the regulations 
under that section) and may be made by following the procedures 
described in paragraphs (a)(1)(i)

[[Page 536]]

through (a)(1)(iii) of this section in an order other than the one 
listed, as long as the result so obtained would be the same. In 
determining earnings and profits, or the deficit in earnings and 
profits, of a foreign corporation under section 964, the amount of an 
illegal bribe, kickback, or other payment (within the meaning of section 
162(c), as amended by section 288 of the Tax Equity and Fiscal 
Responsibility Act of 1982 in the case of payments made after September 
3, 1982, and the regulations issued pursuant to section 964) paid after 
November 3, 1976, by or on behalf of the corporation during the taxable 
year of the corporation directly or indirectly to an official, employee, 
or agent in fact of a government shall not be taken into account to 
decrease such earnings and profits or to increase such deficit. No 
adjustment shall be required under paragraph (a)(1)(ii) or (iii) of this 
section unless it is material. Whether an adjustment is material depends 
on the facts and circumstances of the particular case, including the 
amount of the adjustment, its size relative to the general level of the 
corporation's total assets and annual profit or loss, the consistency 
with which the practice has been applied, and whether the item to which 
the adjustment relates is of a recurring or merely a nonrecurring 
nature. For the treatment of earnings and profits whose distribution is 
prevented by restrictions and limitations imposed by a foreign 
government, see section 964(b) and the regulations issued pursuant to 
section 964.
    (3) Translation into dollars. In the case of a foreign corporation 
with a functional currency other than the United States dollar (dollar), 
see sections 986(b) and 989(b) for rules regarding the time and manner 
of translating distributions or inclusions of the foreign corporation's 
earnings and profits into dollars.
    (b) Accounting adjustments--(1) In general. The accounting 
principles to be applied in making the adjustments required by paragraph 
(a)(1)(ii) of this section shall be those accounting principles 
generally accepted in the United States for purposes of reflecting in 
the financial statements of a domestic corporation the operations of its 
foreign affiliates, including the following:
    (i) Clear reflection of income. Any accounting practice designed for 
purposes other than the clear reflection on a current basis of income 
and expense for the taxable year shall not be given effect. For example, 
an adjustment will be required where an allocation is made to an 
arbitrary reserve out of current income.
    (ii) Physical assets, depreciation, etc. All physical assets (as 
defined in paragraph (e)(5)(ii) of this section), including inventory 
when reflected at cost, shall be taken into account at historical cost 
computed either for individual assets or groups of similar assets. The 
historical cost of such an asset shall not reflect any appreciation or 
depreciation in its value or in the relative value of the currency in 
which its cost was incurred. Depreciation, depletion, and amortization 
allowances shall be based on the historical cost of the underlying asset 
and no effect shall be given to any such allowance determined on the 
basis of a factor other than historical cost. For special rules for 
determining historical cost where assets are acquired during a taxable 
year beginning before January 1, 1950, or a majority interest in the 
foreign corporation is acquired after December 31, 1949, but before 
October 27, 1964, see subparagraph (2) of this paragraph.
    (iii) Valuation of assets and liabilities. Any accounting practice 
which results in the systematic undervaluation of assets or 
overvaluation of liabilities shall not be given effect, even though 
expressly permitted or required under foreign law, except to the extent 
allowable under paragraph (c) of this section. For example, an 
adjustment will be required where inventory is written down below market 
value. For the definition of market value, see paragraph (a) of Sec. 
1.471-4.
    (iv) Income equalization. Income and expense shall be taken into 
account without regard to equalization over more than one accounting 
period; and any equalization reserve or similar provision affecting 
income or expense shall not be given effect, even though expressly 
permitted or required under

[[Page 537]]

foreign law, except to the extent allowable under paragraph (c) of this 
section.
    (v) Foreign currency. If transactions effected in a foreign currency 
other than that in which the books of the corporation are kept are 
translated into the foreign currency reflected in the books, such 
translation shall be made in a manner substantially similar to that as 
prescribed in section 988 and the regulations under that section for the 
translation of foreign currency amounts into United States dollars.
    (2) Historical cost. For purposes of this section, the historical 
cost of an asset acquired by the foreign corporation during a taxable 
year beginning before January 1, 1963, shall be determined, if it is so 
elected by or on behalf of such corporation--
    (i) In the event that the foreign corporation became a majority 
owned subsidiary of a United States person (within the meaning of 
section 7701(a)(30)) after December 31, 1949, but before October 27, 
1964, and the asset was held by such foreign corporation at that time, 
as though the asset was purchased on the date during such period the 
foreign corporation first became a majority owned subsidiary at a price 
equal to its then fair market value, or
    (ii) In the event that subdivision (i) of this subparagraph is 
inapplicable but the asset was acquired by the foreign corporation 
during a taxable year beginning before January 1, 1950, as though the 
asset were purchased on the first day of the first taxable year of the 
foreign corporation beginning after December 31, 1949, at a price equal 
to the undepreciated cost (cost or other basis minus book depreciation) 
of that asset as of that date as shown on the books of account of such 
corporation regularly maintained for the purpose of accounting to its 
shareholders.


For purposes of this subparagraph, a foreign corporation shall be 
considered a majority owned subsidiary of a United States person if, 
taking into account only stock acquired by purchase (as defined in 
section 334(b)(3)), the United States person owns (within the meaning of 
section 958(a)) more than 50 percent of the total combined voting power 
of all classes of stock of the foreign corporation entitled to vote. The 
election under this subparagraph shall be made for the first taxable 
year beginning after December 31, 1962, in which the foreign corporation 
is a controlled foreign corporation (within the meaning of section 957), 
or for which it is included in a chain or group under section 
963(c)(2)(B) or (3)(B) (applied as if section 963 had not been repealed 
by the Tax Reduction Act of 1975), or has a deficit in earnings and 
profits sought to be taken into account under section 952(d) or pays a 
dividend that is included in the foreign base company shipping income of 
a controlled foreign corporation under Sec. 1.954-6(f). Once made, such 
an election shall be irrevocable. For the time and manner in which an 
election may be made on behalf of a foreign corporation, see paragraph 
(c)(3) of this section.
    (3) Illustrations. The application of this paragraph may be 
illustrated by the following examples:

    Example 1. Corporation M is a controlled foreign corporation which 
regularly maintains books of account for the purpose of accounting to 
its shareholders in accordance with the accounting practices prevalent 
in country X, the country in which it operates. As a consequence of 
those practices, the profit and loss statement prepared from these books 
of account reflects an allocation to an arbitrary reserve out of current 
income and depreciation allowances based on replacement values which are 
greater than historical cost. Adjustments are necessary to conform such 
statement to accounting principles generally accepted in the United 
States. Assuming these adjustments to be material, the unacceptable 
practices, will have to be eliminated from the statement, an increase in 
the amount of profit (or a decrease in the amount of loss) thereby 
resulting.
    Example 2. In 1973, Corporation N is a foreign corporation which is 
not a controlled foreign corporation but which is included in a chain, 
for minimum distribution purposes, under section 963(c)(2)(B). 
Corporation N regularly maintains books of account for the purpose of 
accounting to its shareholders in accordance with the accounting 
practices of country Y, the country in which it operates. As a 
consequence of those practices, the profit and loss statement prepared 
from these books of account reflects the inclusion in income of stock 
dividends and of corporate distributions representing a return of 
capital. Adjustments are necessary to conform such statement to 
accounting principles generally accepted in the United States. Assuming 
these adjustments to be

[[Page 538]]

material, the unacceptable practices will have to be eliminated from the 
statement, a decrease in the amount of profit (or increase in the amount 
of loss) thereby resulting.

    (c) Tax adjustments--(1) In general. The tax accounting standards to 
be applied in making the adjustments required by paragraph (a)(1)(iii) 
of this section shall be the following:
    (i) Accounting methods. The method of accounting shall reflect the 
provisions of section 446 and the regulations thereunder.
    (ii) Inventories. Inventories shall be taken into account in 
accordance with the provisions of sections 471 and 472 and the 
regulations thereunder.
    (iii) Depreciation. Depreciation shall be computed as follows:
    (a) For any taxable year beginning before July 1, 1972; depreciation 
shall be computed in accordance with section 167 and the regulations 
thereunder.
    (b) If, for any taxable year beginning after June 30, 1972, 20 
percent or more of the gross income from all sources of the corporation 
is derived from sources within the United States, then depreciation 
shall be computed in accordance with the provisions of Sec. 1.312-15.
    (c) If, for any taxable year beginning after June 30, 1972, less 
than 20 percent of the gross income from all sources of the corporation 
is derived from sources within the United States, then depreciation 
shall be computed in accordance with section 167 and the regulations 
thereunder.
    (iv) Elections. Effect shall be given to any election made in 
accordance with an applicable provision of the Code and the regulations 
thereunder and these regulations.
    (v) Taxable years. The period for computation of taxable income and 
earnings and profits known as the taxable year shall reflect the 
provisions of section 441 and the regulations under that section.
    (vi) Applicable requirements. Except as provided in paragraphs 
(c)(2) and (c) (3) of this section, any requirements imposed by the Code 
or applicable regulations with respect to making an election or adopting 
or changing a method of accounting or taxable year must be satisfied by 
or on behalf of the foreign corporation just as though it were a 
domestic corporation if such election or such adoption or change of 
method or taxable year is to be taken into account in the computation of 
its earnings and profits.
    (2) Adoption or change of method or taxable year. For the first 
taxable year of a foreign corporation beginning after April 25, 2006, in 
which such foreign corporation first qualifies as a controlled foreign 
corporation (as defined in section 957 or 953) or a noncontrolled 
section 902 corporation (as defined in section 904(d)(2)(E)), any method 
of accounting or taxable year allowable under this section may be 
adopted, and any election allowable under this section may be made, by 
such foreign corporation or on its behalf notwithstanding that, in 
previous years, its books or financial statements were prepared on a 
different basis, and notwithstanding that such election is required by 
the Code or regulations to be made in a prior taxable year. Any 
allowable methods adopted or elections made shall be reflected in the 
computation of the foreign corporation's earnings and profits for such 
taxable year, prior taxable years, and (unless the Commissioner consents 
to a change) subsequent taxable years. However, see section 898 for the 
rules regarding the taxable year of a specified foreign corporation as 
defined in section 898(b). Any allowable method of accounting or 
election that relates to events that first arise in a subsequent taxable 
year may be adopted or made by or on behalf of the foreign corporation 
for such year. Adjustments to the appropriate separate category (as 
defined in Sec. 1.904-5(a)(1)) of earnings and profits and income of 
the foreign corporation shall be required under section 481 to prevent 
any duplication or omission of amounts attributable to previous years 
that would otherwise result from any change in a method of accounting. 
See paragraph (c)(3) of this section for the manner in which a method of 
accounting or a taxable year may be adopted or changed on behalf of the 
foreign corporation. See paragraph (c)(4) of this section for applicable 
rules if the amount of the foreign corporation's earnings and profits 
became significant for United States tax purposes before a method of 
accounting or taxable year

[[Page 539]]

was adopted by the foreign corporation or on its behalf in accordance 
with the rules of paragraph (c)(3) of this section. See paragraph (c)(6) 
of this section for special rules postponing the time for taking action 
by or on behalf of a foreign corporation until the amount of its 
earnings and profits becomes significant for U.S. tax purposes. See also 
Sec. Sec. 1.985-5, 1.985-6, and 1.985-7 relating to adjustments to 
earnings and profits of a QBU required when the QBU changes its 
functional currency or begins to use the dollar approximate separate 
transactions method of accounting.
    (3) Action on behalf of corporation--(i) In general. An election 
shall be deemed made, or an adoption or change in method of accounting 
or taxable year deemed effectuated, on behalf of the foreign corporation 
only if its controlling domestic shareholders (as defined in paragraph 
(c)(5) of this section)--
    (A) Satisfy for such corporation any requirements imposed by the 
Internal Revenue Code or applicable regulations with respect to such 
election or such adoption or change in method or taxable year (including 
the provisions of sections 442 and 446 and the regulations under those 
sections, as well as any operative provisions), such as the filing of 
forms, the execution of consents, securing the permission of the 
Commissioner, or maintaining books and records in a particular manner. 
For purposes of this paragraph (c)(3)(i)(A), the books of the foreign 
corporation shall be considered to be maintained in a particular manner 
if the controlling domestic shareholders or the foreign corporation 
regularly keep the records and accounts required by section 964(c) and 
the regulations under that section in that manner;
    (B) File the statement described in paragraph (c)(3)(ii) of this 
section, at the time and in the manner prescribed therein; and
    (C) Provide the written notice required by paragraph (c)(3)(iii) of 
this section at the time and in the manner prescribed therein.
    (ii) Statement required to be filed with a tax return. The statement 
required by this paragraph (c)(3)(ii) shall set forth the name, country 
of organization, and U.S. employer identification number (if applicable) 
of the foreign corporation, the name, address, stock interests, and U.S. 
employer identification number of each controlling domestic shareholder 
(or, if applicable, the shareholder's common parent) approving the 
action, and the names, addresses, U.S. employer identification numbers, 
and stock interests of all other domestic shareholders notified of the 
action taken. Such statement shall describe the nature of the action 
taken on behalf of the foreign corporation and the taxable year for 
which made, and identify a designated shareholder who retains a jointly 
executed consent confirming that such action has been approved by all of 
the controlling domestic shareholders and containing the signature of a 
principal officer of each such shareholder (or its common parent). Each 
controlling domestic shareholder (or its common parent) shall file the 
statement with, and on or before the due date (including extensions) of, 
its own tax return (or information return, if applicable) for its 
taxable year with or within which ends the taxable year of the foreign 
corporation for which the election is made or for which the method of 
accounting or taxable year is adopted or changed. In the case of a 
controlling domestic shareholder that is the sole shareholder of a 
controlled foreign corporation, no separate statement need be filed if 
the information described in this paragraph (c)(3)(ii) is included on 
Form 5471 and Form 3115 or 1128, as applicable, filed with respect to 
the controlled foreign corporation with the shareholder's return for 
such taxable year.
    (iii) Notice. On or before the filing date described in paragraph 
(c)(3)(ii) of this section, the controlling domestic shareholders shall 
provide written notice of the election made or the adoption or change of 
method or taxable year effected to all other persons known by them to be 
domestic shareholders who own (within the meaning of section 958(a)) 
stock of the foreign corporation. Such notice shall set forth the name, 
country of organization and U.S. employer identification number (if 
applicable) of the foreign corporation, and the names, addresses, and 
stock interests of the controlling domestic shareholders. Such notice 
shall describe the nature of the action taken

[[Page 540]]

on behalf of the foreign corporation and the taxable year for which 
made, and identify a designated shareholder who retains a jointly 
executed consent confirming that such action has been approved by all of 
the controlling domestic shareholders and containing the signature of a 
principal officer of each such shareholder (or its common parent). 
However, the failure of the controlling domestic shareholders to provide 
such notice to a person required to be notified shall not invalidate the 
election made or the adoption or change of method or taxable year 
effected.
    (4) Effect of action or inaction by controlling domestic 
shareholders--(i) In general. Any election, or adoption or change of 
method of accounting or taxable year made by the controlling domestic 
shareholders on behalf of the foreign corporation pursuant to paragraph 
(c)(3) of this section or any other provision of the regulations (for 
example, Sec. 1.985-2(c)(2) or (3)) shall be reflected in the 
computation of the earnings and profits of such corporation under this 
section to the extent that it bears upon the federal income tax 
liability of the domestic shareholders of the foreign corporation. Any 
such action shall bind both the foreign corporation and its domestic 
shareholders as to the computation of the foreign corporation's earnings 
and profits for the taxable year of the foreign corporation for which 
the election is made or for which the method of accounting or taxable 
year is adopted or changed and in subsequent taxable years unless the 
Commissioner consents to a change. The preceding sentence shall apply 
regardless of--
    (A) When the action was taken;
    (B) Whether the foreign corporation was a controlled foreign 
corporation or a noncontrolled section 902 corporation at the time the 
action was taken;
    (C) When ownership was acquired; or
    (D) Whether the domestic shareholder received the written notice 
required by paragraph (c)(3)(iii) of this section.
    (ii) Inaction or untimely action. In the event that action by or on 
behalf of the foreign corporation is not undertaken by the time 
specified in paragraph (c)(6) of this section and such failure is shown 
to the satisfaction of the Commissioner to be due to reasonable cause, 
such action may be undertaken during any period of at least 30 days 
occurring after such showing is made which the Commissioner may specify 
as appropriate for this purpose. In the event that action by or on 
behalf of the foreign corporation is not undertaken by the time 
specified in paragraph (c)(6) of this section and such failure is not 
shown to the satisfaction of the Commissioner to be due to reasonable 
cause, earnings and profits shall be computed as if no elections had 
been made and any permissible accounting methods not requiring an 
election and reflected in the books of account regularly maintained by 
the foreign corporation for the purpose of accounting to its 
shareholders had been adopted. Accordingly, if the earnings and profits 
of a noncontrolled section 902 corporation became significant for United 
States income tax purposes in a taxable year beginning on or before 
April 25, 2006, the corporation's earnings and profits shall be computed 
as if no elections had been made and any permissible accounting methods 
not requiring an election and reflected in the books of account 
regularly maintained by the foreign corporation for purposes of 
accounting to its shareholders had been adopted. Thereafter, any change 
in a particular accounting method or methods or taxable year may be made 
by, or on behalf of, the foreign corporation only with the 
Commissioner's consent.
    (iii) Computation of earnings and profits by a minority shareholder 
prior to majority election or significant event. A shareholder of a 
foreign corporation may be required to compute the foreign corporation's 
earnings and profits before the foreign corporation or its controlling 
domestic shareholders make, or are required under this section to make, 
an election or adopt a method of accounting for federal income tax 
purposes. In such a case, the shareholder must compute earnings and 
profits in accordance with this section. Such computation shall be made 
as if no elections had been made and any permissible accounting methods 
not requiring an election and reflected in the books of account 
regularly maintained

[[Page 541]]

by the foreign corporation for the purpose of accounting to its 
shareholders had been adopted. However, a later, properly filed, and 
timely election or adoption of method by, or on behalf of, the foreign 
corporation shall not be treated as a change in accounting method.
    (5) Controlling domestic shareholders--(i) Controlled foreign 
corporations. For purposes of this paragraph (c), the controlling 
domestic shareholders of a controlled foreign corporation shall be its 
controlling United States shareholders. The controlling United States 
shareholders of a controlled foreign corporation shall be those United 
States shareholders (as defined in section 951(b) or 953(c)) who, in the 
aggregate, own (within the meaning of section 958(a)) more than 50 
percent of the total combined voting power of all classes of the stock 
of such foreign corporation entitled to vote and who undertake to act on 
its behalf. In the event that the United States shareholders of the 
controlled foreign corporation do not, in the aggregate, own (within the 
meaning of section 958(a)) more than 50 percent of the total combined 
voting power of all classes of the stock of such foreign corporation 
entitled to vote, the controlling United States shareholders of the 
controlled foreign corporation shall be all those United States 
shareholders who own (within the meaning of section 958(a)) stock of 
such corporation.
    (ii) Noncontrolled section 902 corporations. For purposes of this 
paragraph (c), the controlling domestic shareholders of a noncontrolled 
section 902 corporation that is not a controlled foreign corporation 
shall be its majority domestic corporate shareholders. The majority 
domestic corporate shareholders of a noncontrolled section 902 
corporation shall be those domestic corporations that meet the ownership 
requirements of section 902(a) with respect to the noncontrolled section 
902 corporation (or to a first-tier foreign corporation that is a member 
of the same qualified group (as defined in section 902(b)(2)) as the 
noncontrolled section 902 corporation) that, in the aggregate, own 
directly or indirectly more than 50 percent of the combined voting power 
of all of the voting stock of the noncontrolled section 902 corporation 
that is owned directly or indirectly by all domestic corporations that 
meet the ownership requirements of section 902(a) with respect to the 
noncontrolled section 902 corporation (or a relevant first-tier foreign 
corporation).
    (6) Action not required until significant. Notwithstanding any other 
provision of this paragraph, action by or on behalf of a foreign 
corporation (other than a foreign corporation subject to tax under 
section 882) to make an election or to adopt a taxable year or method of 
accounting shall not be required until the due date (including 
extensions) of the return for a controlling domestic shareholder's first 
taxable year with or within which ends the foreign corporation's first 
taxable year in which the computation of its earnings and profits is 
significant for United States tax purposes with respect to its 
controlling domestic shareholders (as defined in Sec. 1.964-1(c)(5)). 
The filing of the information return required by section 6038 shall not 
itself constitute a significant event. For taxable years beginning after 
April 25, 2006, events that cause a foreign corporation's earnings and 
profits to have United States tax significance include, without 
limitation:
    (A) A distribution from the foreign corporation to its shareholders 
with respect to their stock.
    (B) An amount is includible in gross income with respect to such 
corporation under section 951(a).
    (C) An amount is excluded from subpart F income of the foreign 
corporation or another foreign corporation by reason of section 952(c).
    (D) Any event making the foreign corporation subject to tax under 
section 882.
    (E) The use by the foreign corporation's controlling domestic 
shareholders of the tax book value (or alternative tax book value) 
method of allocating interest expense under section 864(e)(4).
    (F) A sale or exchange of the foreign corporation's stock of the 
controlling domestic shareholders that results in the recharacterization 
of gain under section 1248.
    (7) Revocation of election. Notwithstanding any other provision of 
this

[[Page 542]]

section, any election made by or on behalf of a foreign corporation 
(other than a foreign corporation subject to tax under section 882) may 
be modified or revoked by or on behalf of such corporation for the 
taxable year for which made whenever the consent of the Commissioner is 
secured for such modification or revocation, even though such election 
would be irrevocable but for this subparagraph.
    (8) [Reserved]
    (d) Effective/applicability dates. Paragraphs (c)(1)(v) through 
(c)(6) of this section apply to taxable years ending on or after April 
20, 2009. See 26 CFR Sec. Sec. 1.964-1T(c)(1)(v) through (c)(6) 
(revised as of April 1, 2009) for rules applicable to taxable years 
beginning after April 25, 2006, and ending before April 20, 2009. 
However, taxpayers may choose to apply paragraphs (c)(1)(v) through 
(c)(6) of this section in their entirety in lieu of 26 CFR Sec. Sec. 
1.964-1T(c)(1)(v) through (c)(6) for periods covered by the temporary 
regulations, provided that appropriate adjustments are made to eliminate 
duplicate benefits arising from the application of paragraphs (c)(1)(v) 
through (c)(6) of this section to taxable years that are not open for 
assessment.


[T.D. 6764, 29 FR 14628, Oct. 27, 1964]

    Editorial Note: For Federal Register citations affecting Sec. 
1.964-1, see the List of CFR Sections Affected, which appears in the 
Finding Aids section of the printed volume and at www.fdsys.gov.



Sec. 1.964-2  Treatment of blocked earnings and profits.

    (a) General rule. If, in accordance with paragraph (d) of this 
section, it is established to the satisfaction of the district director 
that any amount of the earnings and profits of a controlled foreign 
corporation for the taxable year (determined under Sec. 1.964-1) was 
subject to a currency or other restriction or limitation imposed under 
the laws of any foreign country (within the meaning of paragraph (b) of 
this section) on its distribution to United States shareholders who own 
(within the meaning of section 958(a)) stock of such corporation, such 
amount shall not be included in earnings and profits for purposes of 
sections 952, 955 (as in effect both before and after the enactment of 
the Tax Reduction Act of 1975), and 956 for such taxable year. For rules 
governing the treatment of amounts with respect to which such 
restriction or limitation is removed, see paragraph (c) of this section.
    (b) Rules of application. For purposes of paragraph (a) of this 
section--
    (1) Period of restriction or limitation. An amount of earnings and 
profits of a controlled foreign corporation for any taxable year shall 
not be included in earnings and profits for purposes of sections 952, 
955 (as in effect both before and after the enactment of the Tax 
Reduction Act of 1975), and 956 only if such amount of earnings and 
profits is subject to a currency or other restriction or limitation 
(within the meaning of subparagraph (2) of this paragraph) throughout 
the 150-day period beginning 90 days before the close of the taxable 
year and ending 60 days after the close of such taxable year.
    (2) Restriction or limitation defined. Whether earnings and profits 
of a controlled foreign corporation are subject to a currency or other 
restriction or limitation imposed under the laws of a foreign country 
must be determined on the basis of all the facts and circumstances in 
each case. Generally, such a restriction or limitation must prevent--
    (i) The ready conversion (directly or indirectly) of such currency 
into United States dollars, or into property of a type normally owned by 
such corporation in the operation of its business or other money which 
is readily convertible into United States dollars; or
    (ii) The distribution of dividends by such corporation to its United 
States shareholders.


For purposes of this subparagraph, if a United States shareholder owns 
(within the meaning of section 958(a)), or is considered as owning by 
applying the rules of ownership of section 958(b), 80 percent or more of 
the total combined voting power of all classes of stock of a foreign 
corporation in a chain of ownership described in section 958(a), the 
distribution of dividends by such corporation to such shareholder will 
not be considered prevented solely by reason of the existence of a 
currency or

[[Page 543]]

other restriction or limitation at an intermediate tier in such chain if 
dividends may be distributed directly to such shareholders.
    (3) Foreign laws. A currency or other restriction or limitation on 
the distribution of earnings and profits may be imposed in a foreign 
country by express statutory provisions, executive orders or decrees, 
rules or regulations of a governmental agency, court decisions, the 
actions of appropriate officials who are acting within the scope of 
their authority, or by any similar official action. A currency 
restriction will not be considered to exist unless export restrictions 
are also imposed which prevent the exportation of property of a type 
normally owned by the controlled foreign corporation in the operation of 
its business which could be readily converted into United States 
dollars.
    (4) Voluntary restriction or limitation. A currency or other 
restriction or limitation arising from the voluntary act of the 
controlled foreign corporation or its United States shareholders during 
a taxable year beginning after December 31, 1962, will not be taken into 
account. For example, if a controlled foreign corporation--
    (i) Issues a stock dividend which has the effect of capitalizing 
earnings and profits;
    (ii) Elects to restrict its earnings and profits or to make certain 
investments as a means of avoiding current tax or securing a reduced 
rate of tax; or
    (iii) Allocates earnings and profits to an optional or arbitrary 
reserve; such restriction is voluntary and will not be taken into 
account.
    (5) Treatment of earnings and profits in cases of certain mandatory 
reserves--(i) In general. If a controlled foreign corporation is 
required under the laws of a foreign country to establish a reserve out 
of earnings and profits for the taxable year, such earnings and profits 
shall be considered subject to a restriction or limitation by reason of 
such requirement only to the extent that the amount required to be 
included in such reserve at the close of the taxable year exceeds the 
accumulated earnings and profits (determined in accordance with 
subdivision (ii) of this subparagraph) of such corporation at the close 
of the preceding taxable year.
    (ii) Determination of earnings and profits. For purposes of 
determining the accumulated earnings and profits of a controlled foreign 
corporation under subdivision (i) of this subparagraph, such earnings 
and profits shall not include any amounts which are attributable to--
    (a) Amounts which, for any prior taxable year, have been included in 
the gross income of a United States shareholder under section 951(a) and 
have not been distributed;
    (b) Amounts which, for any prior taxable year, have been included in 
the gross income of a United States shareholder of such foreign 
corporation under section 551(b) and have not been distributed; or
    (c) Amounts which become subject to a voluntary restriction or 
limitation (within the meaning of subparagraph (4) of this paragraph) 
during a taxable year beginning before January 1, 1963.


The rules of this subdivision apply only in determining the accumulated 
earnings and profits of a controlled foreign corporation for purposes of 
this subparagraph. See section 959 and the regulations thereunder for 
limitations on the exclusion from gross income of previously taxed 
earnings and profits.
    (6) Exhaustion of procedures for distributing earnings and profits. 
Earnings and profits of a controlled foreign corporation for a taxable 
year will not be considered subject to a currency or other restriction 
or limitation on their distribution unless the United States 
shareholders of such corporation demonstrate either that the available 
procedures for distributing such earnings and profits have been 
exhausted or that the use of such procedures will be futile. As a 
general rule, such procedures will be considered to have been exhausted 
if the foreign corporation applies for dollars (or foreign currency 
readily convertible into dollars) at the appropriate rate of exchange 
and complies with the applicable laws and regulations governing the 
acquisition and transfer of such currency including submission of the 
necessary documentation to the exchange authority. The fact that 
available procedures for distributing earnings and profits were

[[Page 544]]

exhausted without success with respect to a prior year is not, of 
itself, sufficient evidence that such procedures would not be successful 
with respect to the current taxable year.
    (c) Removal of restriction or limitation--(1) In general. If, during 
any taxable year, a currency or other restriction or limitation (within 
the meaning of paragraph (b) of this section) imposed under the laws of 
a foreign country on the distribution of earnings and profits of a 
controlled foreign corporation to its United States shareholders is 
removed--
    (i) Treatment of deferred income. Each United States shareholder of 
such corporation on the last day in such year that such corporation is a 
controlled foreign corporation shall include in his gross income for 
such taxable year the amounts attributable to such earnings and profits 
which would have been includible in his gross income under section 
951(a) for prior taxable years but for the existence of the currency or 
other restriction or limitation except that the amounts included under 
this subdivision (i) shall not exceed his pro rata share of--
    (a) The earnings and profits upon which the restriction was removed 
determined on the basis of his stock ownership on the last day of the 
immediately preceding taxable year, and
    (b) The applicable limitations under paragraph (c) of Sec. 1.952-1, 
paragraph (b)(2) of Sec. 1.955-1, paragraph (b)(2) of Sec. 1.955A-1, 
or paragraph (b) of Sec. 1.956-1, determined as of the last day of the 
immediately preceding taxable year, taking into account the provisions 
of subdivision (ii) of this subparagraph.
    (ii) Treatment of earnings and profits. For purposes of sections 
952, 955 (as in effect both before and after the enactment of the Tax 
Reduction Act of 1975), and 956, the earnings and profits which are no 
longer subject to a currency or other restriction or limitation shall be 
treated as included in the corporation's earnings and profits for the 
year in which such earnings and profits were derived.


Amounts with respect to which a currency or other restriction or 
limitation is removed shall be translated into United States dollars at 
the appropriate exchange rate for the translation period during which 
such currency or other restriction or limitation is removed. See 
paragraph (d) of Sec. 1.964-1. Amounts with respect to which a currency 
or other restriction or limitation is removed shall not be taken into 
account in determining whether a deficiency distribution (within the 
meaning of Sec. 1.963-6 (applied as if section 963 had not been 
repealed by the Tax Reduction Act of 1975)) is required to be made for 
the year in which such earnings and profits were derived.
    (2) Removal of restriction or limitation defined. An amount of 
earnings and profits shall be considered no longer subject to a 
limitation or restriction if and to the extent that--
    (i) Money or property in such foreign country is readily convertible 
into United States dollars, or into other money or property of a type 
normally owned by such corporation in the operation of its business 
which is readily convertible into United States dollars;
    (ii) Notwithstanding the existence of any laws or regulations 
forbidding the exchange of money or property into United States dollars, 
conversion is actually made into United States dollars, or other money 
or property of a type normally owned by such corporation in the 
operation of its business which is readily convertible into United 
States dollars; or
    (iii) A mandatory reserve requirement (described in paragraph (b)(5) 
of this section) is removed either by a change in law of the foreign 
country imposing such requirement or by an accumulation of earnings and 
profits not subject to such requirement.
    (3) Distribution in foreign country. If, during any taxable year, 
earnings and profits previously subject to a currency or other 
restriction or limitation are distributed in a foreign country to one or 
more United States shareholders of a controlled foreign corporation 
directly, or indirectly through a chain of ownership described in 
section 958(a), such earnings and profits shall be considered no longer 
subject to a restriction or limitation. However, distributed amounts may 
be excluded from such shareholder's gross income for the taxable year of 
receipt if such shareholder elects a method of accounting under which 
the reporting of blocked

[[Page 545]]

foreign income is deferred until the income ceases to be blocked.
    (4) Source of distribution. If, during any taxable year, earnings 
and profits previously subject to a currency or other restriction or 
limitation is distributed to one or more United States shareholders of a 
controlled foreign corporation directly, or indirectly through a chain 
of ownership described in section 958(a), the source of such 
distribution shall be determined in accordance with the rules of Sec. 
1.959-3.
    (5) Illustration. The provisions of this paragraph may be 
illustrated by the following example:

    Example. (a) M, a United States person, owns all of the only class 
of stock of A Corporation, a foreign corporation incorporated under the 
laws of foreign country X on January 1, 1963. Both M and A Corporations 
use the calendar year as a taxable year and A Corporation is a 
controlled foreign corporation throughout the period here involved.
    (b) During 1963, A Corporation derives income of $100,000 all of 
which is subpart F income and has earnings and profits of $100,000. 
Under the laws of X Country, currency cannot be exported without a 
license. During the last 90 days of 1963 and the first 60 days of 1964, 
A Corporation can obtain a license to distribute only an amount 
equivalent to $10,000. M must include $10,000 in his gross income for 
1963 under section 951(a)(1)(A)(i) and $90,000 of A Corporation's 
earnings and profits for 1963 are not taken into account for purposes of 
sections 952, 955, and 956.
    (c) During 1964, A Corporation has no income and no earnings and 
profits. On June 1, 1964, A Corporation converts an amount equivalent to 
$20,000 into property of a type normally owned by such corporation in 
the operation of its business which is readily convertible into United 
States dollars but does not distribute such amount. Corporation A must 
include $20,000 in its earnings and profits for 1963 for purposes of 
sections 952, 955, and 956. M must include $20,000 in his gross income 
for 1964.
    (d) During 1965, A Corporation has no income and no earnings and 
profits. On December 15, 1965, A Corporation distributes an amount 
equivalent to $15,000 to M in X Country. Neither M nor A Corporation can 
obtain a license to export currency from X Country. In his return for 
the taxable year 1965, M elects a method of accounting under which the 
reporting of blocked foreign income is deferred until the income ceases 
to be blocked. Accordingly, M does not include the $15,000 in his gross 
income for 1965.
    (e) During 1966, A Corporation has no income and no earnings and 
profits. On February 1, 1966, notwithstanding the laws and regulations 
of X Country which forbid the exchange of X Country's currency into 
United States dollars, M converts an amount equivalent to $15,000 into a 
currency which is readily convertible into United States dollars. Since 
the income has ceased to be blocked, M must include $15,000 in his gross 
income for 1966.

    (d) Manner of claiming existence of restriction or limitation on 
distribution of earnings and profits. A United States shareholder 
claiming that an amount of the earnings and profits of a controlled 
foreign corporation for the taxable year was subject to a currency or 
other restriction or limitation imposed under the laws of a foreign 
country on its distribution shall file a statement with his return for 
the taxable year with or within which the taxable year of the foreign 
corporation ends which shall include--
    (1) The name and address of the foreign corporation,
    (2) A description of the classes of stock of the foreign corporation 
and a statement of the number of shares of each class owned (within the 
meaning of section 958(a)) or considered as owned (by applying the rules 
of ownership of section 958(b)) by the United States shareholder,
    (3) A description of the currency or other restriction or limitation 
on the distribution of earnings and profits,
    (4) The total earnings and profits of the foreign corporation for 
the taxable year (before any amount is excluded from earnings and 
profits under this section) and the United States shareholder's pro rata 
share of such total earnings and profits,
    (5) The United States shareholder's pro rata share of the amount of 
earnings and profits subject to a restriction or limitation on 
distribution,
    (6) The amounts which would be includible in the United States 
shareholder's gross income under section 951(a) but for the existence of 
the currency or other restriction or limitation,
    (7) A description of the available procedures for distributing 
earnings and profits and a statement setting forth the steps taken to 
exhaust such procedures or a statement setting forth the reasons that 
the use of such procedures would be futile, and

[[Page 546]]

    (8) The amount of distributions made in a foreign country and a 
statement as to whether a method of accounting has been elected under 
which the reporting of blocked income is deferred until such income 
ceases to be blocked, including an identification of the taxable year 
and place of filing of such election.


In addition, such United States shareholder shall furnish to the 
district director such other information as he may require to verify the 
status of a currency or other restriction or limitation.

[T.D. 6892, 31 FR 11142, Aug. 23, 1966, as amended by T.D. 7545, 43 FR 
19652, May 8, 1978; T.D. 7893, 48 FR 22510, May 19, 1983]



Sec. 1.964-3  Records to be provided by United States shareholders.

    (a) Shareholder's responsibility for providing records. For purposes 
of verifying his income tax liability in respect of amounts includible 
in income under section 951 for the taxable year of a controlled foreign 
corporation each United State shareholder (as defined in section 951(b)) 
who owns (within the meaning of section 958(a)) stock of such 
corporation shall, within a reasonable time after demand by the district 
director, provide the district director--
    (1) Such permanent books of account or records as are sufficient to 
satisfy the requirements of section 6001 and section 964(c), or true 
copies thereof, as are reasonably demanded, and
    (2) If such books or records are not maintained in the English 
language, either (i) an accurate English translation of such books or 
records or (ii) the services of a qualified interpreter satisfactory to 
the district director.


If such books or records are being used by another district director, 
the United States shareholder upon whom the district director has made a 
demand to provide such books or records shall file a statement of such 
fact with his district director, indicating the location of such books 
or records. For the length of time the United States shareholder of a 
controlled foreign corporation must cause such books or records as are 
under his control to be retained, see paragraph (e) of Sec. 1.6001-1.
    (b) Records to be provided. Except as otherwise provided in 
paragraph (c) of this section, the requirements of section 6001 and 
section 964(c) for record keeping shall be considered satisfied if the 
books or records produced are sufficient to verify for the taxable 
year--
    (1) The subpart F income of the controlled foreign corporation and, 
if any part of such income is excluded from the income of the United 
States shareholder under section 963 or section 970(a), the application 
of such exclusion,
    (2) The previously excluded subpart F income of such corporation 
withdrawn from investment in less developed countries,
    (3) The previously excluded subpart F income of such corporation 
withdrawn from investment in foreign base company shipping operations,
    (4) The previously excluded export trade income of such corporation 
withdrawn from investment, and
    (5) The increase in earnings invested by such corporation in United 
States property.
    (c) Special rules. Verification of the subpart F income of the 
controlled foreign corporation for the taxable year shall not be 
required if--
    (1) It can be demonstrated to the satisfaction of the district 
director that--
    (i) The locus and nature of such corporation's activities were such 
as to make it unlikely that the foreign base company income of such 
corporation (determined in accordance with paragraph (c)(3) of Sec. 
1.952-3) exceeded 5 percent of its gross income (determined in 
accordance with paragraph (b)(1) of Sec. 1.952-3) for the taxable year. 
(For taxable years to which Sec. 1.952-3 does not apply, such amounts 
shall be determined under 26 CFR Sec. 1.954-1(d)(3)(i) and (ii) 
(Revised as of April 1, 1975))), and
    (ii) If such corporation reinsures or issues insurance or annuity 
contracts in connection with United States risks, the 5-percent minimum 
premium requirement prescribed in paragraph (b) of Sec. 1.953-1 has not 
been exceeded for the taxable year, or
    (2) The United States shareholder's pro rata share of such subpart F 
income is excluded in full from his income under section 963 and the 
books

[[Page 547]]

or records verify the application of such exclusion.

[T.D. 6824, 30 FR 6480, May 11, 1965, as amended by T.D. 7893, 48 FR 
22510, May 19, 1983]



Sec. 1.964-4  Verification of certain classes of income.

    (a) In general. The provisions of this section shall apply for 
purposes of determining when books or records are sufficient for 
purposes of Sec. 1.964-3 to verify the classes of income described in 
such section.
    (b) Subpart F income. Books or records sufficient to verify the 
subpart F income of a controlled foreign corporation must establish for 
the taxable year--
    (1) Its gross income and deductions,
    (2) The income derived from the insurance of United States risks (as 
provided in paragraph (c) of this section),
    (3) The foreign base company income (as provided in paragraph (d) of 
this section), and
    (4) In the case of a United States shareholder claiming the benefit 
of the exclusion provided in section 952(b) or the limitation provided 
in section 952(c)--
    (i) The items of income excluded from subpart F income by paragraph 
(b) of Sec. 1.952-1 as income derived from sources within the United 
States, the United States income tax incurred with respect thereto, and 
the deductions properly allocable thereto and connected therewith, and
    (ii) The earnings and profits, or deficit in earnings and profits, 
of any foreign corporation necessary for the determinations provided in 
paragraphs (c) and (d) of Sec. 1.952-1.
    (c) Income from insurance of United States risks. Books or records 
sufficient to verify the income of a controlled foreign corporation from 
the insurance of United States risks must establish for the taxable 
year--
    (1) That the 5-percent minimum premium requirement prescribed in 
paragraph (b) of Sec. 1.953-1 has not been exceeded, or
    (2) The taxable income, as determined under Sec. 1.953-4 or Sec. 
1.953-5, which is attributable to the reinsuring or the issuing of any 
insurance or annuity contracts in connection with United States risks, 
as defined in Sec. 1.953-2 or Sec. 1.953-3.
    (d) Foreign base company income and exclusions therefrom. Books or 
records sufficient to verify the income of a controlled foreign 
corporation which is foreign base company income must establish for the 
taxable year the following items:
    (1) Foreign personal holding company income. The foreign personal 
holding company income to which section 954(c) and Sec. 1.954-2 apply, 
for which purpose there must be established the gross income from--
    (i) All rents and royalties,
    (ii) Rents and royalties received in the active conduct of a trade 
or business from an unrelated person, as determined under section 
954(c)(3)(A) and paragraph (d)(1) of Sec. 1.954-2,
    (iii) Rents and royalties received from a related person for the use 
of property in the country of incorporation of the controlled foreign 
corporation, as determined under section 954(c)(4)(C) and paragraph 
(e)(3) of Sec. 1.954-2,
    (iv) All dividends, interest, and except where the controlled 
foreign corporation is a regular dealer in stock or securities, all 
gains and losses from the sale or exchange of stock or securities,
    (v) Dividends, interest, and gains from the sale or exchange of 
stock or securities, received in the conduct of a banking, financing, or 
insurance business from an unrelated person, as determined under section 
954(c)(3)(B) and paragraph (d)(2) and (3) of Sec. 1.954-2,
    (vi) Dividends and interest received from a related corporation 
organized in the country of incorporation of the controlled foreign 
corporation, as determined under section 954(c)(4)(A) and paragraph 
(e)(1) of Sec. 1.954-2,
    (vii) Interest received in the conduct of a banking or other 
financing business from a related person, as determined under section 
954(c)(4)(B) and paragraph (e)(2) of Sec. 1.954-2,
    (viii) All annuities,
    (ix) All gains from commodities transactions described in section 
553(a)(3),
    (x) All income from estates and trusts described in section 
553(a)(4),

[[Page 548]]

    (xi) All income from personal service contracts described in section 
553(a)(5), and
    (xii) All compensation for the use of corporate property by 
shareholders described in section 553(a)(6).
    (2) Foreign base company sales income. The foreign base company 
sales income to which section 954(d) and Sec. 1.954-3 apply, for which 
purpose there must be established the gross income from--
    (i) All sales by the controlled foreign corporation of its personal 
property and all purchases or sales of personal property by such 
corporation on behalf of another person,
    (ii) Purchases and/or sales of personal property in connection with 
transactions not involving related persons (as defined in paragraph 
(e)(2) of Sec. 1.954-1),
    (iii) Purchases and/or sales of personal property manufactured, 
produced, etc., in the country of incorporation of the controlled 
foreign corporation, as determined under paragraph (a)(2) of Sec. 
1.954-3,
    (iv) Purchases and/or sales of personal property for use, etc., in 
the country of incorporation of the controlled foreign corporation, as 
determined under paragraph (a)(3) of Sec. 1.954-3, and
    (v) Sales of personal property manufactured or produced by the 
controlled foreign corporation, as determined under paragraph (a)(4) of 
Sec. 1.954-3.


Where an item of income falls within more than one of subdivisions (ii) 
through (v) of this subparagraph, it shall be sufficient to establish 
that it falls within any one of them. If a branch or similar 
establishment is treated as a wholly owned subsidiary corporation 
through the application of section 954(d)(2) and paragraph (b) of Sec. 
1.954-3, the requirements of this subparagraph shall be satisfied 
separately for each branch or similar establishment so treated and for 
the remainder of the controlled foreign corporation.
    (3) Foreign base company services income. The foreign base company 
services income to which section 954(e) and Sec. 1.954-4 apply, for 
which purpose there must be established the gross income from--
    (i) All services performed by the controlled foreign corporation,
    (ii) Services other than those (as determined under paragraph (b) of 
Sec. 1.954-4) performed for, or on behalf of, a related person,
    (iii) Services performed in the country of incorporation of the 
controlled foreign corporation, as determined under paragraph (c) of 
Sec. 1.954-4, and
    (iv) Services performed in connection with the sale or exchange of, 
or with an offer or effort to sell or exchange, personal property 
manufactured, produced, etc., by the controlled foreign corporation, as 
determined under paragraph (d) of Sec. 1.954-4.


Where an item of income falls within more than one of subdivisions (ii) 
through (iv) of this subparagraph, it shall be sufficient to establish 
that it falls within any one of them.
    (4) Foreign base company oil related income. (i) The foreign base 
company oil related income described in section 954(g) and Sec. 1.954-
8, for which purpose there must be established, with respect to each 
foreign country, the gross income derived from--
    (A) The processing of minerals extracted (by the taxpayer or by any 
other person) from oil or gas wells into their primary products, as 
determined under section 907(c)(2)(A),
    (B) The transportation of such minerals or primary products, as 
determined under section 907(c)(2)(B),
    (C) The distribution or sale of such minerals or primary products, 
as determined under section 907(c)(2)(C),
    (D) The disposition of assets used by the taxpayer in a trade or 
business described in subdivision (A), (B) or (C), as determined under 
section 907(c)(2)(D),
    (E) Dividends, interests, partnership distributions, and other 
amounts, as determined under section 907(c)(3).


Where an item of income falls within more than one of the listings in 
paragraphs (d)(4)(i)(A) through (E) of this section, it shall be 
sufficient to establish that it falls within any one of them.
    (ii) If any of the items of income listed in paragraph (d)(4)(i) of 
this section arising from sources within a foreign country relates to 
oil, gas, or a primary product thereof and is described in section 
954(g)(1)(A) or (B) and Sec. 1.954-

[[Page 549]]

8(a)(1)(i) or (ii) (and, hence, is not foreign base company oil related 
income), then there must be established facts sufficient to verify the 
amount of such item of income which is not foreign base company oil 
related income. In this regard, the total quantities of oil, gas and 
primary products thereof which gave rise to such item of income and the 
portions of such quantities which were extracted or sold within the 
foreign country must be established.
    (5) Qualified investments in less developed countries. For rules in 
effect for taxable years of foreign corporations beginning before 
January 1, 1976, see 26 CFR 1.964-4(d)(4) (Revised as of April 1, 1975).
    (6) Income derived from aircraft or ships. For rules in effect for 
taxable years of foreign corporations beginning before January 1, 1976, 
see CFR Sec. 1.964-4(d)(5) (Revised as of April 1, 1975).
    (7) Foreign base company shipping income. The foreign base company 
shipping income to which section 954(f) and Sec. 1.954-6 apply, for 
which purpose there must be established--
    (i) Gross income derived from, or in connection with, the use (or 
hiring or leasing for use) of any aircraft or vessel in foreign 
commerce, as determined under Sec. 1.954-6(c),
    (ii) Gross income derived from, or in connection with, the 
performance of services directly related to the use of any aircraft or 
vessel in foreign commerce, as determined under Sec. 1.954-6(d),
    (iii) Gross income incidental to income described in subdivisions 
(i) and (ii) of this subparagraph, as determined under Sec. 1.954-6(e),
    (iv) Gross income derived from the sale, exchange, or other 
disposition of any aircraft or vessel used (by the seller or by a person 
related to the seller) in foreign commerce,
    (v) Dividends, interest, and gains described in Sec. Sec. 1.954-
6(f) and 1.954(b) (1)(viii),
    (vi) Income described in Sec. 1.954-6(g) (relating to partnerships, 
trusts, etc.), and
    (vii) Exchange gain, to the extent allocable to foreign base company 
shipping income, as determined under Sec. 1.952-2(c)(2)(v)(b).


If the controlled foreign corporation has income derived from or in 
connection with, the use (or hiring or leasing for use) of any aircraft 
or vessel in foreign commerce, or derived from, or in connection with, 
the performance of services directly related to the use of any aircraft 
or vessel in foreign commerce, it shall be necessary to establish, from 
the books and records of the controlled foreign corporation, that such 
aircraft or vessel was used in foreign commerce within the meaning of 
subparagraphs (3) and (4) of Sec. 1.954-6(b).
    (8) Income on which taxes are not substantially reduced. The gross 
income excluded from foreign base company income under section 954(b)(4) 
and paragraph (b)(3) or (4) of Sec. 1.954-1 in the case of a controlled 
foreign corporation not availed of to substantially reduce income taxes, 
the income or similar taxes incurred with respect thereto, and all other 
factors necessary to verify the application of such exclusion.
    (9) Qualified investments in foreign base company shipping 
operations. The foreign base company shipping income that is excluded 
from foreign base company income under section 954(b)(2) and Sec. 
1.954-1(b)(1).
    (10) Special rule for shipping income. The distributions received 
through a chain of ownership described in section 958(a) which are 
excluded from foreign base company income under section 954(b)(6)(B) and 
Sec. 1.954-1(b)(2).
    (11) Deductions. The deductions allocable, under paragraph (c) of 
Sec. 1.954-1, to each of the classes and subclasses of gross income 
described in subparagraphs (1) through (9) of this paragraph.
    (e) Exclusion under section 963. Books or records sufficient to 
verify the application of the exclusion provided by section 963 with 
respect to the subpart F income for the taxable year of a controlled 
foreign corporation must establish that the conditions set forth in 
paragraph (a)(2) of Sec. 1.963-1 have been met.
    (f) Exclusion under section 970(a). Books or records sufficient to 
verify the application for the taxable year of the exclusion provided by 
section 970(a) in respect of export trade income which

[[Page 550]]

is foreign base company income must establish for such year--
    (1) That the controlled foreign corporation is an export trade 
corporation, as defined in section 971(a) and paragraph (a) of Sec. 
1.971-1,
    (2) The export trade income, as determined under section 971(b) and 
paragraph (b) of Sec. 1.971-1, which constitutes foreign base company 
income,
    (3) The export promotion expenses, as determined under section 
971(d) and paragraph (d) of Sec. 1.971-1, which are allocable to the 
excludable export trade income,
    (4) The gross receipts, and the gross amount on which is computed 
compensation included in gross receipts, from property in respect of 
which the excludable export trade income is derived, as described in 
section 970(a)(1)(B) and paragraph (b)(2)(ii) of Sec. 1.970-1, and
    (5) The increase in investments in export trade assets, as 
determined under section 970(c)(2) and paragraph (d)(2) of Sec. 1.970-
1.
    (g-1) Withdrawal of previously excluded subpart F income from 
qualified investment in less developed countries. Books or records 
sufficient to verify the previously excluded subpart F income of the 
controlled foreign corporation withdrawn from investment in less 
developed countries for the taxable year must establish--
    (1) The sum of the amounts of income excluded from foreign base 
company income under section 954(b)(1) and paragraph (b)(1) of Sec. 
1.954-1 (as in effect for taxable years beginning before January 1, 
1976; see 26 CFR 1.954-1(b)(1) (Revised as of April 1, 1975)) for all 
prior taxable years,
    (2) The sum of the amounts of previously excluded subpart F income 
withdrawn from investment in less developed countries for all prior 
taxable years, as determined under section 955(a) (as in effect before 
the enactment of the Tax Reduction Act of 1975) and paragraph (b) of 
Sec. 1.955-1, and
    (3) The amount withdrawn from investment in less developed countries 
for the taxable year as determined under section 955(a) (as in effect 
before the enactment of the Tax Reduction Act of 1975) and paragraph (b) 
of Sec. 1.955-1.
    (g-2) Withdrawal of previously excluded subpart F income from 
investment in foreign base company shipping operations. Books or records 
sufficient to verify the previously excluded subpart F income of the 
controlled foreign corporation withdrawn from investment in foreign base 
company shipping operations for the taxable year must establish--
    (1) The sum of the amounts of income excluded from foreign base 
company income under section 954(b)(2) and paragraph (b)(1) of Sec. 
1.954-1 for all prior taxable years,
    (2) The sum of the amounts of previously excluded subpart F income 
withdrawn from investment in foreign base company shipping operations 
for all prior taxable years, as determined under section 955(a) and 
paragraph (b) of Sec. 1.955A-1,
    (3) The amount withdrawn from investment in foreign base company 
shipping operations for the taxable year as determined under section 
955(a) and paragraph (b) of Sec. 1.955A-1, and
    (4) If the carryover (as described in Sec. 1.955A-1(b)(3)) of 
amounts relating to investments in less developed country shipping 
companies (as described in Sec. 1.995-5(b)) is applicable, (i) the 
amount of the corporation's qualified investments (determined under 
Sec. 1.955-2 other than paragraph (b)(5) thereof) in less developed 
country shipping companies at the close of the last taxable year of the 
corporation beginning before January 1, 1976, and (ii) the amount of the 
limitation with respect to previously excluded subpart F income 
(determined under Sec. 1.955-1(b)(1)(i)(b)) for the first taxable year 
of the corporation beginning after December 31, 1975.
    (h) Withdrawal of previously excluded export trade income from 
investment. Books or records sufficient to verify the previously 
excluded export trade income of the controlled foreign corporation 
withdrawn from investment for the taxable year must establish the United 
States shareholder's proportionate share of--
    (1) The sum of the amounts by which the subpart F income of such 
corporation was reduced for all prior taxable years under section 970(a) 
and paragraph (b) of Sec. 1.970-1,

[[Page 551]]

    (2) The sum of the amounts described in section 970(b)(1)(B),
    (3) The sum of the amounts of previously excluded export trade 
income of such corporation withdrawn from investment under section 
970(b) and paragraph (c) of Sec. 1.970-1 for all prior taxable years, 
and
    (4) The amount withdrawn from investment under section 970(b) and 
paragraph (c) of Sec. 1.970-1 for the taxable year.
    (i) Increase in earnings invested in United States property. Books 
or records sufficient to verify the increase for the taxable year in 
earnings invested by the controlled foreign corporations in United 
States property must establish--
    (1) The amount of such corporation's earnings invested in United 
States property (as defined in section 956(b)(1) and paragraph (a) of 
Sec. 1.956-2) at the close of the current and preceding taxable years, 
as determined under paragraph (b) of Sec. 1.956-1,
    (2) The amount of excluded property described in section 956(b)(2) 
and paragraph (b) of Sec. 1.956-2 held by such corporation at the close 
of such years,
    (3) The earnings and profits, to which section 959(c)(1) and 
paragraph (b)(1) of Sec. 1.959-3 apply, distributed by such corporation 
during the preceding taxable year, and
    (4) The amount of increase in earnings invested by such corporation 
in United States property which is excluded from the United States 
shareholder's gross income for the taxable year under section 959(a)(2) 
and paragraph (c) of Sec. 1.959-1.

[T.D. 6824, 30 FR 6481, May 11, 1965, as amended by T.D. 7211, 37 FR 
21436, Oct. 11, 1972; T.D. 7893, 48 FR 22511, May 19, 1983; T.D. 8331, 
56 FR 2849, Jan. 25, 1991]



Sec. 1.964-5  Effective date of subpart F.

    Sections 951 through 964 and Sec. Sec. 1.951 through 1.964-4 shall 
apply with respect to taxable years of foreign corporations beginning 
after December 31, 1962, and to taxable years of United States 
shareholders within which or with which such taxable years of such 
corporations end.

[T.D. 7120, 36 FR 10862, June 4, 1971]

                        export trade corporations



Sec. 1.970-1  Export trade corporations.

    (a) In general. Sections 970 through 972 provide in general that if 
a controlled foreign corporation is an export trade corporation for any 
taxable year, the subpart F income of such corporation shall, subject to 
limitations provided by section 970(a) and paragraph (b) of this 
section, be reduced by so much of such corporation's export trade income 
as constitutes foreign base company income. To the extent subpart F 
income of an export trade corporation is reduced under section 970 and 
this section, an amount is required by section 970(b) and paragraph (c) 
of this section to be included in gross income of United States 
shareholders of the corporation if there is a subsequent decrease in 
such corporation's investments in export trade assets. See section 
971(a) and paragraph (a) of Sec. 1.971-1 for definition of the term 
``export trade corporation'', section 971(b) and paragraph (b) of Sec. 
1.971-1 for definition of the term ``export trade income'', and section 
971(c) and paragraph (c) of Sec. 1.971-1 for definition of the term 
``export trade assets''.
    (b) Amount by which export trade income shall reduce subpart F 
income--(1) Deductible amount. The subpart F income, determined as 
provided in section 952 and the regulations thereunder but without 
regard to section 970 and this paragraph, of a controlled foreign 
corporation which is an export trade corporation for its taxable year 
shall be reduced by an amount equal to so much of its export trade 
income as constitutes foreign base company income for such taxable year, 
but only to the extent that such amount of export trade income does not 
exceed the limitation determined under subparagraph (2) of this 
paragraph for such taxable year. See section 972 and Sec. 1.972-1 for 
rules relating to the consolidation of export trade corporations for 
purposes of determining the limitations described in subparagraph (2) of 
this paragraph.
    (2) Limitation on the amount of export trade income deductible from 
subpart F income. The amount by which subpart F income of an export 
trade corporation may be reduced for any taxable year

[[Page 552]]

under subparagraph (1) of this paragraph may not exceed whichever of the 
following limitations is the smallest:
    (i) The amount which is equal to 150 percent of the export promotion 
expenses, as defined in section 971(d) and paragraph (d) of Sec. 1.971-
1, of the export trade corporation paid or incurred during the taxable 
year which are properly allocable to the receipt or the production of so 
much of its export trade income as constitutes foreign base company 
income for such taxable year;
    (ii) The amount which is equal to 10 percent of the gross receipts 
(other than from commissions, fees, or other compensation for services), 
plus 10 percent of the gross amount upon the basis of which are computed 
commissions, fees, or other compensation for services included in gross 
receipts, of the export trade corporation received or accrued during the 
taxable year from, or in connection with, the sale, installation, 
operation, maintenance, or use of property in respect of which such 
corporation derives export trade income which constitutes foreign base 
company income for such taxable year; or
    (iii) The amount which bears the same ratio to the increase in 
investments in export trade assets, as defined in section 970(c)(2) and 
paragraph (d)(2) of this section, of the export trade corporation for 
its taxable year as the export trade income which constitutes foreign 
base company income of such corporation for such taxable year bears to 
the entire export trade income of the corporation for such year.


Under subdivision (ii) of this subparagraph, in the case of minimum or 
maximum fee arrangements, the determination shall be made on the basis 
of the actual gross amounts with respect to which such fees are paid, 
rather than on the basis of the amounts upon which such minimum or 
maximum fees are computed. All determinations of limitations under this 
subparagraph shall be made on an aggregate basis and not with respect to 
separate items or categories of income described in paragraph (b)(1) of 
Sec. 1.971-1.
    (3) Determination of export promotion expense limitation. For 
purposes of determining the limitation contained in subparagraph (2)(i) 
of this paragraph for any taxable year of the export trade corporation, 
there shall be taken into account with respect to those items or 
categories of export trade income which constitute foreign base company 
income the entire amount of those export promotion expenses which are 
directly related to such items or categories of income and a ratable 
part of any other export promotion expenses which are indirectly related 
to such items or categories of income, except that no export promotion 
expense shall be allocated to an item or category of income to which it 
clearly does not apply and no deduction allowable to such corporation 
under section 882(c) and the regulations thereunder shall be taken into 
account.
    (4) Application of section 482. The limitations provided in section 
970(a) and subparagraph (2) of this paragraph shall not affect the 
authority of the district director to apply the provisions of section 
482 and the regulations thereunder, relating to allocation of income and 
deductions among taxpayers.
    (5) Illustrations. The application of this paragraph may be 
illustrated by the following examples:

    Example 1. Foreign corporation A is a wholly owned subsidiary of 
domestic corporation M. Both corporations use the calendar year as the 
taxable year. For 1963, A Corporation's subpart F income determined 
under section 952 and the regulations thereunder is $35, the total of 
its gross receipts and gross amounts referred to in subparagraph (2)(ii) 
of this paragraph is $310, its export promotion expenses properly 
allocable to its export trade income which constitutes foreign base 
company income are $18, its increase in investments in export trade 
assets is $32, and its export trade income is $40, of which $30 
constitutes foreign base company income and $10 does not constitute 
foreign base company income. The subpart F income of A Corporation for 
1963 as reduced under section 970(a) is $11, determined as follows:

(i) Subpart F income....................................  ......     $35
(ii) Less: $30 export trade income which constitutes
 foreign base company income, but deduction not to
 exceed the smallest of the following limitations
 (smallest of (a), (b), or (c)):
    (a) 150 percent of allocable export promotion            $27
     expenses referred to in subparagraph (2)(i) of this
     paragraph (150% of $18)............................
    (b) 10 percent of gross receipts and gross amounts       $31
     referred to in subparagraph (2)(ii) of this
     paragraph (10% of $310)............................

[[Page 553]]

 
    (c) Amount which bears to the increase in                $24     $24
     investments in export trade assets ($32) the same
     ratio as the export trade income which constitutes
     foreign base company income ($30) bears to total
     export trade income ($40) (75% [$30/$40] of $32)...
                                                                 =======
(iii) Subpart F income as reduced under section 970(a)..  ......      11
 

    Example 2. The facts are the same as in example 1, except that A 
Corporation's export promotion expenses properly allocable to export 
trade income which constitutes foreign base company income are $14 
instead of $18. The applicable limitation on the amount deductible from 
A Corporation's subpart F income for 1963 is $21 (150% of $14) instead 
of $24. The subpart F income as reduced under section 970(a) is $14 ($35 
less $21).
    Example 3. The facts are the same as in example 1, except that the 
total amount of A Corporation's gross receipts and gross amounts 
referred to in subparagraph (2)(ii) of this paragraph is $200 instead of 
$310. The applicable limitation on the amount deductible from A 
Corporation's subpart F income for 1963 is $20 (10 percent of $200) 
instead of $24. The subpart F income as reduced under section 970(a) is 
$15 ($35 less $20).
    Example 4. The facts are the same as in example 1, except that A 
Corporation derives its export trade income which constitutes foreign 
base company income of $30 in a service arrangement with M Corporation 
under which it receives as a fee 5 percent of the gross receipts from M 
Corporation's sales or a minimum fee of $30. Such gross receipts are 
$220. The gross amounts taken into account in determining the limitation 
under subparagraph (2)(ii) of this paragraph are $220. The applicable 
limitation on the amount deductible from A Corporation's subpart F 
income for 1963 is $22 (10 percent of $220) instead of $24. The subpart 
F income as reduced under section 970(a) is $13 ($35 minus $22).
    Example 5. The facts are the same as in example 1, except that A 
Corporation derives its export trade income which constitutes foreign 
base company income of $30 in a service arrangement with M Corporation 
under which it receives as a fee 9 percent of the gross receipts from M 
Corporation's sales or a maximum fee of $30. Such gross receipts are 
$400. In such instance, the limitation under (ii)(b) of example 1 is $40 
(10 percent of $400) instead of $31. The applicable limitation on the 
amount deductible from A Corporation's subpart F income for 1963 is $24, 
the smallest of the three limitations. The subpart F income as reduced 
under section 970(a) is $11 ($35 less $24).

    (c) Withdrawal of previously excluded export trade income--(1) 
Inclusion of withdrawal in income of United States shareholders. If--
    (i) A controlled foreign corporation was an export trade corporation 
for any taxable year,
    (ii) Such corporation in any such taxable year derived subpart F 
income which, under the provisions of section 970(a) and paragraph (b) 
of this section, was reduced, and
    (iii) Such corporation has in a subsequent taxable year a decrease 
in investments in export trade assets,


every person who is a United States shareholder, as defined in section 
951(b), of such corporation on the last day of such subsequent taxable 
year on which such corporation is a controlled foreign corporation shall 
include in his gross income, under section 951(a)(1)(A)(ii) and the 
regulations thereunder as an amount to which section 955 (as in effect 
before the enactment of the Tax Reduction Act of 1975) applies, his pro 
rata share of the amount of such decrease in investments but only to the 
extent that such pro rata share does not exceed the limitations 
determined under subparagraph (2) of this paragraph. A United States 
shareholder's pro rata share of a controlled foreign corporation's 
decrease for any taxable year in investments in export trade assets 
shall be his pro rata share of such corporation's decrease for such year 
determined under section 970(c)(3) and paragraph (d)(3) of this section.
    (2) Limitations applicable in determining amount includible in 
income--(i) General. A United States shareholder's pro rata share of a 
controlled foreign corporation's decrease in investments in export trade 
assets for any taxable year of such corporation shall, for purposes of 
determining an amount to be included in the gross income for any taxable 
year of such shareholder, not exceed the lesser of the limitations 
determined under (a) and (b) of this subdivision:
    (a) Such shareholder's pro rata share of the sum of the controlled 
foreign corporation's earnings and profits (or deficit in earnings and 
profits) for the taxable year, computed as of the close of the taxable 
year without diminution by reason of any distributions made during the 
taxable year, plus his pro rata share of the sum of its earnings and 
profits (or deficits in earnings and

[[Page 554]]

profits) accumulated for prior taxable years beginning after December 
31, 1962, or
    (b)(1) Such shareholder's pro rata share of the sum of the amounts 
by which the subpart F income of such controlled foreign corporation for 
prior taxable years was reduced under section 970(a) and paragraph (b) 
of this section, plus
    (2) Such shareholder's pro rata share of the sum of the amounts 
which were not included in the subpart F income of such controlled 
foreign corporation for such prior taxable years by reason of the 
application of section 972 and Sec. 1.972-1, minus
    (3) Such shareholder's pro rata share of the sum of the amounts 
which were previously included in his gross income for prior taxable 
years under section 951(a)(1)(A)(ii) by reason of the application of 
section 970(b) and this paragraph with respect to such controlled 
foreign corporation.


The net amount determined under (b) of this subdivision with respect to 
any stock owned by the United States shareholder shall be determined 
without taking into account any amount attributable to a period prior to 
the date on which such shareholder acquired such stock. See section 1248 
and the regulations thereunder for rules governing the treatment of gain 
from sales or exchanges of stock in certain foreign corporations.
    (ii) Treatment of earnings and profits. For purposes of determining 
earnings and profits of a controlled foreign corporation under 
subdivision (i) (a) of this subparagraph, such earnings and profits 
shall be considered not to include any amounts which are attributable 
to--
    (a) Amounts which are, or have been, included in the gross income of 
a United States shareholder of such controlled foreign corporation under 
section 951(a) (other than an amount included in the gross income of a 
United States shareholder under section 951(a)(1)(A)(ii) or section 
951(a)(1)(B) for the taxable year) and have not been distributed, or
    (b)(1) Amounts which for the current taxable year, are included in 
the gross income of a United States shareholder of such controlled 
foreign corporation under section 551(b) or would be so included under 
such section but for the fact that such amounts were distributed to such 
shareholder during the taxable year, or
    (2) Amounts which, for any prior taxable year, have been included in 
the gross income of a United States shareholder of such controlled 
foreign corporation under section 551(b) and have not been distributed.


The rules of this subdivision apply only in determining the limitation 
on a United States shareholder's pro rata share of a controlled foreign 
corporation's decrease in investments in export trade assets. See 
section 959 and the regulations thereunder for limitations on the 
exclusion of previously taxed earnings and profits.
    (iii) Rules of application. The determinations made under 
subdivision (i) of this subparagraph for purposes of determining the 
United States shareholder's pro rata share of a controlled foreign 
corporation's decrease in investments in export trade assets for any 
taxable year shall be made on the basis of the stock such shareholder 
owns, within the meaning of section 958(a) and the regulations 
thereunder, in the controlled foreign corporation on the last day in the 
taxable year on which such corporation is a controlled foreign 
corporation even though such shareholder owned more or less stock in 
such corporation prior to that date. See section 972 and paragraph 
(b)(3) of Sec. 1.972-1 for rules relating to the allocation of a 
decrease in investments in export trade assets of export trade 
corporations in a consolidated chain of such corporations. See section 
951(a)(3) and the regulations thereunder for an additional limitation 
upon the amount of a United States shareholder's pro rata share 
determined under this paragraph.
    (3) Illustrations. The application of this paragraph may be 
illustrated by the following examples:

    Example 1. Foreign corporation A, which has one class of stock 
outstanding, is a wholly owned subsidiary of domestic corporation M 
throughout 1963 and 1964. Both corporations use the calendar year as the 
taxable year. For 1963, A Corporation qualifies as an export trade 
corporation and its subpart F income, determined in accordance with the

[[Page 555]]

provisions of section 952 and the regulations thereunder, is reduced by 
$20 under the provisions of section 970(a) and paragraph (b) of this 
section. Section 972 is assumed not to apply to A Corporation. For 1964, 
A Corporation has a decrease of $8 in investments in export trade 
assets. For 1963 and 1964, A Corporation has earnings and profits of $30 
(determined under the provisions of subparagraph (2) of this paragraph). 
Corporation M's pro rata share of A Corporation's decrease in 
investments in export trade assets for 1964 which is includible in M 
Corporation's gross income for 1964 under section 951(a)(1)(A)(ii) by 
reason of the application of section 970(b) is $8, determined as 
follows:

(i) Corporation M's pro rata share of A              .....  .....     $8
 Corporation's decrease in investments in export
 trade assets for 1964 (100% of $8)................
(ii) Limitation on amount includible in gross
 income of M Corporation for 1964 (smaller of (a)
 or (b)):
  (a) Corporation M's pro rata share of A            .....    $30
   Corporation's earnings and profits for 1963 and
   1964 determined under subparagraph (2) of this
   paragraph (100% of $30).........................
  (b) Corporation M's pro rata share of amounts by     $20
   which the subpart F income of A Corporation for
   1963 was reduced under section 970(a) (100% of
   $20)............................................
  Plus: Corporation M's pro rata share of amounts        0
   which were not included in subpart F income of A
   Corporation for 1963 by reason of the
   application of section 972......................
                                                    -------
      Total........................................     20
  Less: Corporation M's pro rata share of the sum        0     20
   of amounts which were previously included in
   gross income of M Corporation under section
   951(a)(1)(A)(ii) by reason of the application of
   section 970(b) with respect to A Corporation....
                                                    --------------
(iii) Corporation M's pro rata share includible in   .....  .....      8
 gross income for 1964 under section
 951(a)(1)(A)(ii) by reason of the application of
 section 970(b) (smaller of (i) or (ii))...........
 

    Example 2. Assume the same facts as in example 1, except that on 
February 14, 1965, M Corporation sells 25 percent of its stock in A 
Corporation to N Corporation. Corporation N is a domestic corporation 
which also uses the calendar year as a taxable year. For 1965, A 
Corporation has a decrease of $16 in investments in export trade assets. 
Corporation A's earnings and profits for 1963 and 1964 (determined under 
the provisions of subparagraph (2) of this paragraph) are $22 ($30 minus 
$8). Corporation A's earnings and profits for 1965 are $6 (determined 
under the provisions of subparagraph (2) of this paragraph). For 1965, M 
Corporation's pro rata share of A Corporation's decrease in investments 
in export trade assets which is includible in M Corporation's gross 
income under section 951(a)(1)(A)(ii) is $9, and N Corporation's pro 
rata share includible in gross income under such section is $0, 
determined as follows:

                              M Corporation
(i) Corporation M's pro rata share of A              .....  .....    $12
 Corporation's decrease in investments in export
 trade assets for 1965 (75% of $16)................
(ii) Limitation on amount includible in gross
 income of M Corporation for 1965 (smaller of (a)
 or (b)):
  (a) Corporation M's pro rata share of A            .....    $21
   Corporation's earnings and profits for 1963,
   1964, and 1965 determined under subparagraph (2)
   of this paragraph (75% of $28)..................
  (b) Corporation M's pro rata share of amounts by     $15
   which the subpart F income of A Corporation for
   1963 was reduced under section 970(a) (75% of
   $20)............................................
    Plus: Corporation M's pro rata share of amounts      0
     which were not included in subpart F income of
     A Corporation for 1963 and 1964 by reason of
     the application of section 972................
                                                    -------
      Total........................................    $15
  Less: Corporation M's pro rata share of the sum        6      9
   of amounts which were previously included in
   gross income of M Corporation under section
   951(a)(1)(A)(ii) by reason of the application of
   section 970(b) with respect to A Corporation
   (75% of $8).....................................
                                                    -------
(iii) Corporation M's pro rata share includible in   .....  .....      9
 gross income for 1965 under section
 951(a)(1)(A)(ii) by reason of the application of
 section 970(b) (smaller of (i) or (ii))...........
 
                              N Corporation
 
(i) Corporation N's pro rata share of A              .....  .....      0
 Corporation's decrease in investments in export
 trade assets for 1965 (25% of $16)................
(ii) Limitation on amount includible in gross
 income of N Corporation for 1965 (smaller of (a)
 or (b)):
  (a) Corporation N's pro rata share of A            .....     07
   Corporation's earnings and profits for 1963,
   1964, and 1965 determined under subparagraph (2)
   of this paragraph (25% of $28)..................
  (b) Corporation N's pro rata share of amounts by       0
   which the subpart F income of A Corporation for
   1963 was reduced under section 970(a) (amounts
   prior to 2/14/65 not being taken into account)..

[[Page 556]]

 
    Plus: Corporation N's pro rata share of amounts      0
     which were not included in subpart F income of
     A Corporation for 1963 and 1964 by reason of
     the application of section 972 (amounts prior
     to 2/14/65 not being taken into account)......
                                                    -------
      Total........................................      0
  Less: Corporation N's pro rata share of the sum        0      0
   of amounts which were previously included in
   gross income of N Corporation under section
   951(a)(1)(A)(ii) by reason of the application of
   section 970(b) with respect to A Corporation
   (amounts prior to 2/14/65 not being taken into
   account)........................................
(iii) Corporation N's pro rata share includible in   .....  .....      0
 gross income for 1965 under section
 951(a)(1)(A)(ii) by reason of the application of
 section 970(b) (smaller of (i) or (ii))...........
 

    (d) Investments in export trade assets--(1) Amount of investments. 
For purposes of sections 970 through 972 and Sec. Sec. 1.970-1 to 
1.972-1, inclusive, export trade assets shall be taken into account on 
the following bases:
    (i) Working capital. Working capital to which section 971(c)(1) 
applies shall be taken into account at the adjusted basis of current 
assets, determined as of the applicable determination date, less any 
current liabilities (except as provided in subdivision (iii) of this 
subparagraph).
    (ii) Other export trade assets. Inventory to which section 971(c)(2) 
applies, facilities to which section 971(c)(3) applies, and evidences of 
indebtedness to which section 971(c)(4) applies, shall be taken into 
account at their adjusted bases as of the applicable determination date, 
reduced by any liabilities (except as provided in subdivision (iii) of 
this subparagraph) to which such property is subject on such date. To be 
taken into account under this subparagraph, a liability must constitute 
a specific charge against the property involved. Thus, a liability 
evidenced by an open account or a liability secured only by the general 
credit of the controlled foreign corporation will not be taken into 
account. On the other hand, if a liability constitutes a specific charge 
against several items of property and cannot definitely be allocated to 
any single item of property, the liability shall be apportioned against 
each of such items of property in that ratio which the adjusted basis of 
such item on the applicable determination date bears to the adjusted 
basis of all such items on such date. A liability in excess of the 
adjusted basis of the property which is subject to such liability will 
not be taken into account for the purpose of reducing the adjusted basis 
of other property which is not subject to such liability. See paragraph 
(c)(6) of Sec. 1.971-1 for treatment of export trade assets which 
constitute working capital to which section 971(c)(1) applies and which 
also constitute inventory to which section 971(c)(2) applies or 
evidences of indebtedness to which section 971(c)(4) applies.
    (iii) Treatment of certain liabilities. For purposes of subdivisions 
(i) and (ii) of this subparagraph, a current liability, or a specific 
charge created with respect to any item of property, principally for the 
purpose of artificially increasing or decreasing the amount of a 
controlled foreign corporation's investments in export trade assets 
shall be taken into account in such a manner as to properly reflect the 
controlled foreign corporation's investments in export trade assets; 
whether a specific charge or current liability is created principally 
for such purpose will depend upon all the facts and circumstances of 
each case. One of the factors that will be considered in making such a 
determination with respect to a loan is whether the loan is from a 
related person, as defined in section 954(d)(3) and paragraph (e) of 
Sec. 1.954-1.
    (iv) Statement required. If for purposes of this section a United 
States shareholder of a controlled foreign corporation reduces the 
adjusted basis of property which constitutes an export trade asset on 
the ground that such property is subject to a liability, he shall attach 
to his return a statement setting forth the adjusted basis of the 
property before the reduction and the amount and nature of the 
reduction.
    (2) Increase in investments in export trade assets. For purposes of 
section 970(a) and paragraph (b) of this section, the amount of increase 
in investments in export trade assets of a controlled foreign 
corporation for a taxable year shall be, except as provided in Sec. 
1.970-2, the amount by which--

[[Page 557]]

    (i) The amount of its investments in export trade assets at the 
close of such taxable year, exceeds
    (ii) The amount of its investments in export trade assets at the 
close of the preceding taxable year.
    (3) Decrease in investments in export trade assets. For purposes of 
section 970(b) and paragraph (c) of this section, the amount of the 
decrease in investments in export trade assets of a controlled foreign 
corporation for a taxable year shall be, except as provided in Sec. 
1.970-2, the amount by which--
    (i) The amount of its investments in export trade assets at the 
close of the preceding taxable year, minus
    (ii) An amount equal to the excess of recognized losses over 
recognized gains on sales, exchanges, involuntary conversions, assets or 
other dispositions, of export trade during the taxable year, exceeds
    (iii) The amount of its investments in export trade assets at the 
close of the taxable year.


For purposes of subdivision (ii) of this subparagraph, recognized losses 
include a write-down of inventory to lower of cost or market in 
accordance with a method of inventory valuation established or adopted 
by or on behalf of such foreign corporation under paragraph (c) of Sec. 
1.964-1.

[T.D. 6755, 29 FR 12704, Sept. 9, 1964, as amended by T.D. 6795, 30 FR 
947, Jan. 29, 1965; T.D. 6892, 31 FR 11144, Aug. 23, 1966; T.D. 7293, 38 
FR 32802, Nov. 28, 1973; T.D. 7893, 48 FR 22511, May 19, 1983]



Sec. 1.970-2  Elections as to date of determining investments 
in export trade assets.

    (a) Nature of elections--(1) In general. In lieu of determining the 
increase under the provisions of paragraph (d)(2) of Sec. 1.970-1, or 
the decrease under the provisions of paragraph (d)(3) of Sec. 1.970-1, 
in a controlled foreign corporation's investments in export trade assets 
for a taxable year in the manner provided in such provisions, a United 
States shareholder of such corporation may elect, under the provisions 
of section 970(c)(4) and this section, to determine such increase or 
decrease in accordance with the provisions of subparagraph (2) of this 
paragraph or, in the case of export trade assets which are facilities 
described in section 971(c)(3), in accordance with the provisions of 
subparagraph (3) of this paragraph. Separate elections may be made under 
subparagraph (2) and/or (3) of this paragraph with respect to each 
controlled foreign corporation with respect to which a person is a 
United States shareholder, within the meaning of section 951(b).
    (2) Election of 75-day rule. A United States shareholder of a 
controlled foreign corporation may elect with respect to a taxable year 
of such corporation to make the determinations under subparagraphs 
(2)(i) and (3)(iii) of paragraph (d) of Sec. 1.970-1 of the amount of 
such corporation's investments in export trade assets as of the 75th day 
after the close of the taxable year referred to in such subparagraphs of 
paragraph (d) of Sec. 1.970-1. The election provided by this 
subparagraph may be made with respect to export trade assets other than 
facilities described in section 971(c)(3) or with respect to export 
trade assets which are facilities or with respect to both types of 
export trade assets (but the election under this paragraph with respect 
to export trade assets which are facilities or with respect to both 
types of export trade assets may be made only if the election provided 
by subparagraph (3) of this paragraph is not made). If the election 
provided by this subparagraph is made, the amount of export trade assets 
with respect to which such election is made at the close of the 
preceding taxable year which is described in subparagraphs (2)(ii) and 
(3)(i) of paragraph (d) of Sec. 1.970-1 shall be the amount of export 
trade assets which was considered by application of the 75-day rule to 
be the amount of export trade assets at the close of such preceding 
taxable year; except that for the first taxable year of the controlled 
foreign corporation for which the 75-day rule is elected the amount of 
investments in export trade assets with respect to which such election 
is made at the close of such preceding year described in subparagraphs 
(2)(ii) and (3)(i) of paragraph (d) of Sec. 1.970-1 shall be the amount 
of investments in export trade assets at the actual close of such 
preceding year. In the case of a taxable year of such corporation 
beginning after December 31, 1962, and before December 31, 1963, the

[[Page 558]]

amount of investments in export trade assets with respect to which such 
election is made alternatively may be determined by the United States 
shareholder as of the 75th day after the close of the preceding taxable 
year referred to in subparagraphs (2)(ii) and (3)(i) of paragraph (d) of 
Sec. 1.970-1 rather than as of the close of such preceding taxable 
year.
    (3) Election for export trade assets which are facilities. A United 
States shareholder of a controlled foreign corporation may elect with 
respect to a taxable year of such corporation to make the determinations 
under subparagraphs (2)(i) and (3)(iii) of paragraph (d) of Sec. 1.970-
1 of the amount of such corporation's investments in export trade assets 
which are facilities described in section 971(c)(3) as of the close of 
such corporation's taxable year following the taxable year referred to 
in such subparagraphs of paragraph (d) of Sec. 1.970-1. The election 
provided by this subparagraph may be made only if the United States 
shareholder does not elect the 75-day rule of subparagraph (2) of this 
paragraph with respect to export trade assets which are facilities. If 
the election provided by this subparagraph is made, the amount of 
investments in export trade assets which are facilities at the close of 
the preceding taxable year which is described in subparagraphs (2)(ii) 
and (3)(i) of paragraph (d) of Sec. 1.970-1 shall be the amount of 
export trade assets which are facilities which was considered, by reason 
of the application of the following-year rule provided in this 
subparagraph with respect to such preceding taxable year, to be the 
amount of export trade assets which are facilities at the close of such 
preceding taxable year; except that for the first taxable year of the 
controlled foreign corporation for which such following-year rule is 
elected the amount of investments in export trade assets which are 
facilities at the close of the preceding taxable year described in 
subparagraphs (2)(ii) and (3)(i) of paragraph (d) of Sec. 1.970-1 shall 
be the amount of investments in export trade assets which are facilities 
at the actual close of such preceding taxable year.
    (b) Time and manner of making elections--(1) Without consent. A 
United States shareholder may, with respect to any controlled foreign 
corporation, make one or both of the elections described in paragraph 
(a)(2) or (3) of this section without the consent of the Commissioner by 
filing a statement to such effect with his return for his taxable year 
in which or with which ends the first taxable year of such corporation 
in which--
    (i) Such shareholder owns, within the meaning of section 958(a), or 
is considered as owning, by applying the rules of section 958(b), 10 
percent or more of the total combined voting power of all classes of 
stock entitled to vote of such corporation, and
    (ii) Such corporation realizes subpart F income which is reduced 
under section 970(a) and paragraph (b) of Sec. 1.970-1.


The statement shall contain the name and address of the controlled 
foreign corporation, identification of such first taxable year of such 
corporation, and an indication as to which election or elections 
described in paragraph (a) of this section the United States shareholder 
is making. If such return has been filed on or before the 90th day after 
the date these regulations are published in the Federal Register, such 
United States shareholder shall file such statement with the district 
director with which the return was filed on or before such 90th day.
    (2) With consent. A United States shareholder may make one or both 
of the elections described in paragraph (a)(2) or (3) of this section 
with respect to any controlled foreign corporation at any time with the 
consent of the Commissioner. Consent will not be granted unless the 
shareholder and the Commissioner agree to the terms, conditions, and 
adjustments under which the election will be effected. The application 
for consent to elect shall be made by the shareholder's mailing a letter 
for such purpose to the Commissioner of Internal Revenue, Washington, DC 
20224. The application shall be mailed before the close of the first 
taxable year of the controlled foreign corporation with respect to which 
the shareholder desires to determine an exclusion under section 970(a) 
in accordance with one or both of the elections

[[Page 559]]

provided in paragraph (a) of this section. The application shall include 
the following information:
    (i) The name, address, and taxable year of the United States 
shareholder;
    (ii) The name, address, and taxable year of the controlled foreign 
corporation;
    (iii) A statement indicating which of the elections the shareholder 
desires to make;
    (iv) The amount of the foreign corporation's investments in export 
trade assets (by a category which includes export trade assets other 
than facilities and a category which includes only export trade assets 
which are facilities) at the close of its preceding taxable year;
    (v) The shareholder's pro rata share of the sum of the amounts by 
which the subpart F income of the foreign corporation, for all prior 
taxable years during which such shareholder was a United States 
shareholder of such corporation, was reduced under section 970(a) and 
paragraph (b) of Sec. 1.970-1;
    (vi) The shareholder's pro rata share of the sum of the amounts 
which were not included in the subpart F income of the foreign 
corporation, for all prior taxable years during which such shareholder 
was a United States shareholder of such corporation, by reason of the 
application of section 972 and Sec. 1.972-1; and
    (vii) The shareholder's pro rata share of the sum of the amounts 
which were previously included in his gross income, for all prior 
taxable years during which such shareholder was a United States 
shareholder of such corporation, under section 951(a)(1)(A)(ii) by 
reason of the application of section 970(b) and paragraph (b) of Sec. 
1.970-1 to the foreign corporation.
    (c) Effect of elections--(1) In general. Except as provided in 
subparagraphs (3) and (4) of this paragraph, an election made under 
paragraph (a) of this section with respect to a controlled foreign 
corporation shall be binding on the United States shareholder and--
    (i) In the case of the election described in paragraph (a)(2) of 
this section, shall apply to all investments in export trade assets with 
respect to which such election is made acquired, or disposed of, by such 
corporation during the 75-day period following its taxable year for 
which subpart F income is first computed under the election and during 
all succeeding corresponding 75-day periods of such corporation, or
    (ii) In the case of the election described in paragraph (a)(3) of 
this section, shall apply to all investments in export trade assets 
which are facilities acquired, or disposed of, by such corporation 
during the taxable year following its taxable year for which subpart F 
income is first computed under the election and during all succeeding 
corresponding taxable years of such corporation.
    (2) Returns. Any return of a United States shareholder required to 
be filed before the completion of a period with respect to which 
determinations are to be made as to a controlled foreign corporation's 
investments in export trade assets for purposes of computing such 
shareholder's taxable income shall be filed on the basis of an estimate 
of the amount of such corporation's investments in export trade assets 
at the close of the period. If the actual amount of such investments is 
not the same as the amount of the estimate, the shareholder shall 
immediately notify the Commissioner. The Commissioner will thereupon 
redetermine the amount of such shareholder's tax for the year or years 
with respect to which the incorrect amount was taken into account. The 
amount of tax, if any, due upon such redetermination shall be paid by 
the shareholder upon notice and demand by the district director. The 
amount of tax, if any, shown by such redetermination to have been 
overpaid shall be credited or refunded to the shareholder in accordance 
with the provisions of sections 6402 and 6511 and the regulations 
thereunder.
    (3) Revocation--(i) In general--(a) Consent required. Upon 
application by the United States shareholder, an election made under 
paragraph (a) of this section may, subject to the approval of the 
Commissioner, be revoked. Approval will not be granted unless the 
shareholder and the Commissioner agree to the terms, conditions, and 
adjustments under which the revocation will be effected.
    (b) Revocation of 75-day rule. In the case of the revocation of an 
election

[[Page 560]]

described in paragraph (a)(2) of this section, the change in the 
controlled foreign corporation's investments in export trade assets with 
respect to which such election was made for its first taxable year for 
which subpart F income or a decrease in investments in export trade 
assets is computed without regard to the election previously made shall, 
unless the agreement with the Commissioner provides otherwise, be 
considered to be the amount by which--
    (1) Such corporation's investments in export trade assets with 
respect to which such election was made at the close of such taxable 
year exceeds or, if applicable, is exceeded by
    (2) Such corporation's investments in export trade assets with 
respect to which such election was made at the close of the 75th day 
after the close of the preceding taxable year of such corporation.
    (c) Revocation of following-year rule. In the case of the revocation 
of an election described in paragraph (a)(3) of this section, the change 
in the controlled foreign corporation's investments in export trade 
assets which are facilities for its first taxable year for which subpart 
F income or a decrease in investments in export trade assets is computed 
without regard to the election previously made shall, unless the 
agreement with the Commissioner provides otherwise, be considered to be 
zero.
    (ii) Time and manner of applying for consent to revocation--(a) 
Application to Commissioner. The application for consent to revocation 
of an election shall be made by the United States shareholder's mailing 
a letter for such purpose to the Commissioner of Internal Revenue, 
Washington, DC, 20224. The application shall be mailed before the close 
of the first taxable year of the controlled foreign corporation with 
respect to which the shareholder desires to determine an exclusion under 
section 970(a) or an inclusion under section 970(b) without regard to 
such election.
    (b) Information required. The application shall include the 
following information:
    (1) The name, address, and taxable year of the United States 
shareholder;
    (2) The name, address, and taxable year of the controlled foreign 
corporation;
    (3) A statement indicating the election the shareholder desires to 
revoke under this subparagraph;
    (4) The information required under subdivisions (iv) through (vii) 
of paragraph (b)(2) of this section;
    (5) In the case of an application for consent to revocation of an 
election made under paragraph (a)(2) of this section, the amount of the 
foreign corporation's investments in export trade assets with respect to 
which such election was made at the close of the 75th day after the 
close of such corporation's taxable year immediately preceding the 
taxable year of such corporation; and
    (6) The reasons for the request for consent to revocation.
    (4) Transfer of stock--(i) Election of 75-day rule in force. (a) If 
during any taxable year of a controlled foreign corporation--
    (1) A United States shareholder who has made the election described 
in paragraph (a)(2) of this section with respect to such corporation 
sells, exchanges, or otherwise disposes of all or part of his stock in 
such corporation, and
    (2) The foreign corporation is a controlled foreign corporation 
immediately after the sale, exchange, or other disposition,


then, with respect to the stock so sold, exchanged, or disposed of, the 
successor in interest shall consider the controlled foreign 
corporation's change during the first 75 days of such taxable year in 
investments in export trade assets with respect to which such election 
is made to be zero.
    (b) If the United States shareholder's successor in interest makes 
an election under paragraph (a)(2) of this section in order to determine 
an exclusion under section 970(a) for the taxable year of such 
corporation in which the acquires such stock, the amount of the 
controlled foreign corporation's investments in export trade assets with 
respect to which such election is made at the close of its preceding 
taxable year shall be considered, with respect to the stock so acquired, 
to be the amount of

[[Page 561]]

such corporation's investments in export trade assets with respect to 
which such election is made at the close of the 75th day after the close 
of such preceding taxable year.
    (c) If the United States shareholder's successor in interest makes 
an election under paragraph (a)(2) of this section in order to determine 
an exclusion under section 970(a) for a taxable year of such corporation 
subsequent to the taxable year in which he acquired the stock, the 
amount of the controlled foreign corporation's investments in export 
trade assets with respect to which such election is made at the close of 
its taxable year immediately preceding such subsequent taxable year 
shall, with respect to the stock so acquired, be the amount of such 
corporation's investments in such assets at the actual close of such 
preceding taxable year.
    (ii) Election in force with respect to export trade assets which are 
facilities--(a) If during any taxable year of a controlled foreign 
corporation--
    (1) A United States shareholder who has made the election described 
in paragraph (a)(3) of this section with respect to such corporation 
sells, exchanges, or otherwise disposes of all or part of his stock in 
such corporation, and
    (2) The foreign corporation is a controlled foreign corporation 
immediately after the sale, exchange or other disposition,


then, with respect to the stock so sold, exchanged, or disposed of, the 
successor in interest shall consider the controlled foreign 
corporation's change for such taxable year in investments in export 
trade assets which are facilities to be zero.
    (b) If the United States shareholder's successor in interest makes 
an election under paragraph (a)(3) of this section in order to determine 
an exclusion under section 970(a) for the taxable year of such 
corporation in which he acquires such stock, the amount of the 
controlled foreign corporation's investments in export trade assets 
which are facilities at the close of its preceding taxable year shall be 
considered, with respect to the stock so acquired, to be the amount of 
such corporation's investments in export trade assets which are 
facilities at the close of the taxable year in which such stock is 
acquired.
    (c) If the United States shareholder's successor in interest makes 
an election under paragraph (a)(3) of this section in order to determine 
an exclusion under section 970(a) for a taxable year of such corporation 
subsequent to the taxable year in which he acquired the stock, the 
amount of the controlled foreign corporation's investments in export 
trade assets which are facilities at the close of its taxable year 
immediately preceding such subsequent taxable year shall, with respect 
to the stock so acquired, be the amount of such corporation's 
investments in such assets at the actual close of such preceding taxable 
year.
    (d) Illustrations. The principles contained in this section are 
illustrated by the examples set forth in paragraph (d) of Sec. 1.955.3.

[T.D. 6755, 29 FR 12707, Sept. 9, 1964]



Sec. 1.970-3  Effective date of subpart G.

    Sections 970 through 972 and Sec. Sec. 1.970-1 through 1.972-1 
shall apply with respect to taxable years of foreign corporations 
beginning after December 31, 1962, and to taxable years of United States 
shareholders within which or with which such taxable years of such 
corporations end.

[T.D. 6755, 29 FR 12709, Sept. 9, 1964]



Sec. 1.971-1  Definitions with respect to export trade corporations.

    (a) Export trade corporations--(1) In general. For purposes of 
sections 970 through 972 and Sec. Sec. 1.970-1 to 1.972-1, inclusive, 
the term ``export trade corporation'' means a controlled foreign 
corporation which for the period specified in subparagraph (2) of this 
paragraph satisfies the conditions specified in subparagraph (3) of this 
paragraph. However, no controlled foreign corporation may qualify as an 
export trade corporation for any taxable year beginning after October 
31, 1971, unless it qualified as an export trade corporation for any 
taxable year beginning before such date. In addition, if a corporation 
fails to qualify as an export trade corporation for a period of any 3 
consecutive taxable years beginning

[[Page 562]]

after October 31, 1971, then for any taxable year beginning after such 
3-year period, such corporation shall not be included within the term 
``export trade corporation''.
    (2) Three-year period. The period referred to in subparagraph (1) of 
this paragraph is the 3-year period ending with the close of the 
controlled foreign corporation's current taxable year, or such part of 
such 3-year period as occurs on and after the beginning of the 
corporation's first taxable year beginning after December 31, 1962, 
whichever period is shorter.
    (3) Gross income requirements. The conditions referred to in 
subparagraph (1) of this paragraph are that the controlled foreign 
corporation derives--
    (i) 90 percent or more of its gross income from sources without the 
United States, and
    (ii)(a) 75 percent of more of its gross income from transactions, 
activities, or interest described in section 971(b) and paragraph (b) of 
this section, or
    (b) 50 percent or more of its gross income from transactions, 
activities, or interest described in section 971(b) and paragraph (b) of 
this section in respect of agricultural products grown in the United 
States.
    (4) Determination of sources of gross income. The sources of gross 
income of a controlled foreign corporation shall be determined for 
purposes of subparagraph (3)(i) of this paragraph in accordance with the 
rules for determining sources of gross income set forth in sections 861 
through 864 and the regulations thereunder.
    (b) Export trade income--(1) General rule. For purposes of sections 
970 through 972 and Sec. Sec. 1.970-1 to 1.972-1, inclusive, the term 
``export trade income'' means the gross export trade income of a 
controlled foreign corporation derived from transactions, activities, or 
interest described in subdivisions (i) through (vii) of this 
subparagraph, less deductions allowed under subdivision (viii) of this 
subparagraph.
    (i) Sale of export property. Gross export trade income of a 
controlled foreign corporation includes gross income it derives from the 
sale of export property (as defined in paragraph (e) of this section) 
which it purchases, if the sale is made to an unrelated person for use, 
consumption, or disposition outside the United States. See section 
971(b)(1). As a general rule, property will be presumed to have been 
sold for use, consumption, or disposition in the country of destination 
of the sale. However, if at the time of the sale the controlled foreign 
corporation knows, or should have known from the facts and circumstances 
surrounding the sales transaction, that the property will probably be 
used, consumed, or disposed of in the United States, such property will 
be presumed to have been sold for use, consumption, or disposition in 
the United States unless the controlled foreign corporation establishes 
that such property was used, consumed, or disposed of outside the United 
States. For purposes of this subdivision, export property must be sold 
by a controlled foreign corporation in essentially the same form in 
which such property is purchased. Whether export property sold is in 
essentially the same form in which such property is purchased shall be 
determined on the basis of all the facts and circumstances in each case. 
Storage, handling, transportation, packaging, or servicing of property 
will be considered not to alter the form in which property is purchased. 
However, manufacture or production, within the meaning of paragraph 
(a)(4) of Sec. 1.954-3, will be considered to alter the form in which 
property is purchased and no part of the gross income from the sale of 
such property will be treated as export trade income. The application of 
this subdivision may be illustrated by the following example:

    Example. Controlled foreign corporation A, incorporated under the 
laws of foreign country Y, purchases articles manufactured in the United 
States from domestic corporation M and sells them in the form in which 
purchased to foreign corporation B, unrelated to A Corporation, for use 
in foreign countries, X, Y, and Z. The gross income of A Corporation 
from the purchase and sale of the articles constitutes gross export 
trade income.

    (ii) Commissions and other income derived in connection with the 
sale of export property. Gross export trade income of a controlled 
foreign corporation includes gross commissions, fees, compensation, or 
other income derived by such corporation from the performance

[[Page 563]]

for any person of commercial, industrial, financial, technical, 
scientific, managerial, engineering, architectural, skilled, or other 
services in respect of a sale by such corporation in a transaction 
described in subdivision (i) of this subparagraph or in respect of the 
sale by any other person of export property to a person unrelated to the 
controlled foreign corporation for use, consumption, or disposition 
outside the United States. Such gross export trade income includes 
payments received for surveys made prior to, and in connection with, the 
sale of such export property (whether or not such sales are ultimately 
consummated). See section 971(b)(1). The term ``any person'' or ``any 
other person'' as used in this subdivision includes a related person as 
defined in section 954(d)(3) and paragraph (e) of Sec. 1.954-1. The 
application of this subdivision may be illustrated by the following 
examples:

    Example 1. Controlled foreign corporation A, incorporated under the 
laws of foreign country X, receives from M Corporation a commission 
equal to 6 percent of the gross selling price of all personal property 
shipped by M Corporation as a result of services performed by A 
Corporation in soliciting orders in foreign countries X, Y, and Z. In 
fulfillment of such orders, M Corporation ships products manufactured by 
it in the United States. Corporation A does not assume title to the 
property sold. Gross commissions received by A Corporation from M 
Corporation in connection with the sale of such property to persons 
unrelated to A Corporation for use, consumption, or disposition outside 
the United States constitute gross export trade income.
    Example 2. Foreign corporation B, incorporated under the laws of 
foreign country X, is a wholly owned subsidiary of domestic corporation 
N. Corporation N, is engaged in the business of manufacturing heavy duty 
electrical equipment in the United States. By contract, N Corporation 
engages B Corporation for the purpose of conducting engineering, 
technical, and financial studies required by N Corporation in the 
preparation of bids to supply foreign country Y with electrical 
equipment for a construction project to be undertaken by such country. 
Corporation N pays B Corporation a fee for the services, all of which 
are performed in country Y, which is based upon the number of hours of 
work performed without regard to whether a sale is ultimately 
consummated. Corporation N does not receive a contract from country Y on 
its bid to supply equipment. Income derived by B Corporation from 
performance of the service contract constitutes gross export trade 
income.

    (iii) Commissions and other income derived in connection with the 
installation or maintenance of export property. Gross export trade 
income of a controlled foreign corporation includes gross commissions, 
fees, compensation, or other income derived by such corporation from the 
performance for any person of commercial, industrial, financial, 
technical, scientific, managerial, engineering, architectural, skilled, 
or other services in respect of the installation or maintenance of 
export property which has been sold by such corporation in a transaction 
described in subdivision (i) of this subparagraph or by any other person 
to a person unrelated to the controlled foreign corporation for use, 
consumption, or disposition outside the United States. See section 
971(b)(1). The term ``any person'' or ``any other person'' as used in 
this subdivision includes a related person as defined in section 
954(d)(3) and paragraph (e) of Sec. 1.954-1.
    (iv) Commissions and other income derived in connection with the use 
of patents, copyrights, and other like property. Gross export trade 
income of a controlled foreign corporation includes gross commissions, 
fees, compensation, or other income derived by such corporation from the 
performance for any person of commercial, industrial, financial, 
technical, scientific, managerial, engineering, architectural, skilled, 
or other services in connection with the use outside of the United 
States by an unrelated person of patents, copyrights, secret processes 
and formulas, goodwill, trademarks, trade brands, franchises, and other 
like property, including gross income derived from obtaining licensees 
for patents, but only if the patent, copyright, or other like property 
is acquired, or developed, and owned by the manufacturer, producer, 
grower, or extractor of any export property, in respect of which the 
controlled foreign corporation also derives gross export trade income 
within the meaning of subdivision (i), (ii), or (iii) of this 
subparagraph. See section 971(b)(2). The application of this subdivision 
may be illustrated by the following example:


[[Page 564]]


    Example. Foreign corporation A incorporated under the laws of 
foreign country X, is a wholly owned subsidiary of domestic corporation 
M. Corporation M, the owner of a patent registered in foreign country X, 
grants B Corporation, a corporation unrelated to A Corporation, the 
right to use such patent in foreign country Y in exchange for payment of 
a royalty. By a separate contract with B Corporation, A Corporation 
agrees for a gross fee of $100,000 to furnish, by maintaining a staff of 
technical representatives at the offices of B Corporation, technical 
services to B Corporation in connection with B Corporation's use of the 
patent. Corporation A also derives export trade income from the sale of 
export property which it purchases from M Corporation, the manufacturer 
of such property, and sells to C Corporation, an unrelated person, for 
use in country Y by C Corporation. The gross fee of $100,000 received by 
A Corporation for the furnishing of technical services in connection 
with B Corporation's use of M Corporation's patent constitutes gross 
export trade income since the service for which the fee is paid is 
performed in connection with the use outside the United States by an 
unrelated person (B Corporation) of a patent owned by a manufacturer (M 
Corporation) of export property in respect of which the controlled 
foreign corporation (A Corporation) derives gross export trade income 
from the sale to an unrelated person (C Corporation) for use outside the 
United States of export property purchased by it from the manufacturer 
(M Corporation).

    (v) Income attributable to use of export property by an unrelated 
person. Gross export trade income of a controlled foreign corporation 
includes gross commissions, fees, rents, compensation, or other income 
which is received by such corporation from an unrelated person and is 
attributable to the use of export property by such unrelated person. See 
section 971(b)(3). The application of this subdivision may be 
illustrated by the following example:

    Example. Foreign corporation A, incorporated under the laws of 
foreign country X, is a wholly owned subsidiary of domestic corporation 
M. Corporation A acquires by purchase bottling machines manufactured in 
the United States and leases the machines to B Corporation, a 
corporation unrelated to A Corporation, for use by B Corporation in 
foreign country Y. Gross rental income of A Corporation from the lease 
of the machines to B Corporation constitutes gross export trade income.

    (vi) Income attributable to the use of export property in the 
rendition of technical, scientific, or engineering services--(a) 
General. Gross export trade income of a controlled foreign corporation 
includes gross commissions, fees, compensation, or other income which is 
received by such corporation from an unrelated person and is 
attributable to the use of export property in the performance of 
technical, scientific, or engineering services to such unrelated person. 
See section 971(b)(3).
    (b) Rule of apportionment. If a commission, fee, or other income 
received by a controlled foreign corporation from an unrelated person 
under a contract or arrangement for the performance of technical, 
scientific, or engineering services is not solely attributable to the 
use of export property in the performance of such services and the 
amount of the gross income attributable to such use of export property 
cannot be established by reference to transactions between other 
unrelated persons, such gross income shall be an amount which bears the 
same ratio to total gross income from the contract or arrangement as the 
cost of the export property consumed in the performance of such 
services, including a reasonable allowance for depreciation with respect 
to the export property so used, bears to the total costs and expenses 
attributable to the production of income under the contract or 
arrangement.
    (c) Illustration. The application of this subdivision may be 
illustrated by the following example:

    Example. Foreign corporation A, incorporated under the laws of 
foreign country X, is a wholly owned subsidiary of domestic corporation 
M. Corporation A is engaged in the seismograph service business in 
foreign country X. In an effort to establish the probable existence of 
oil in a concession area it owns in foreign country Y, B Corporation 
which is unrelated to A Corporation enters into a contract with A 
Corporation whereby A Corporation is required to make seismographic 
tests of the area in country Y for a fixed fee of $100,000. In 
performance of the contract, A Corporation hires a skilled crew to carry 
out the contract and utilizes equipment and supplies (for example, 
trucks, seismographic equipment, etc.) which constitute export property. 
Corporation A cannot establish by reference to transactions between 
other unrelated persons, the income attributable to the use of the 
export property in the performance of the contract. Corporation

[[Page 565]]

A's total costs and expenses (for example, salaries of the crew, 
administrative expenses, all supplies, total depreciation on property 
used in performance of the contract, etc.) incurred in performance of 
the contract are $80,000. The cost of export property consumed in 
performance of the contract (for example, dynamite, motor oil, and other 
supplies which were produced in the United States, reasonable 
depreciation on trucks and seismographic equipment manufactured in the 
United States and used in performance of the contract, etc.) is $30,000. 
Corporation A's gross export trade income from the contract is $37,500, 
that is, the amount which bears the same ratio to total gross income 
from the contract ($100,000) as the cost of the export property consumed 
in the rendition of the services ($30,000) bears to total costs and 
expenses attributable to the contract ($80,000).

    (vii) Interest from export trade assets. Gross export trade income 
of a controlled foreign corporation includes interest derived by it from 
export trade assets described in section 971(c)(4) and paragraph (c)(5) 
of this section. See section 971(b)(4).
    (viii) Deductions to be taken into account. Export trade income of a 
controlled foreign corporation for any taxable year shall be the amount 
determined by deducting from the items or categories of gross income 
described in subdivisions (i) through (vii) of this subparagraph the 
entire amount of those expenses, taxes, and other deductions properly 
allocable to such items or categories of income. For purposes of this 
section, expenses, taxes, and other deductions shall first be allocated 
to items or categories of gross income to which they directly relate; 
then, expenses, taxes, and other deductions which cannot definitely be 
allocated to some item or category of gross income shall be ratably 
apportioned among all items or categories of gross income, except that 
no expense, tax, or other deduction shall be allocated to an item or 
category of income to which it clearly does not apply and no deduction 
allowable to such controlled foreign corporation under section 882(c) 
and the regulations thereunder shall be taken into account.
    (2) Cross reference. For rules governing the determination of gross 
income and taxable income of a foreign corporation, see Sec. 1.952-2.
    (c) Export trade assets--(1) In general. For purposes of sections 
970 through 972 and Sec. Sec. 1.970-1 to 1.972-1, inclusive, the term 
``export trade assets'' means--
    (i) Working capital reasonably necessary for the production of 
export trade income,
    (ii) Inventory of export property held for use, consumption, or 
disposition outside the United States,
    (iii) Facilities located outside the United States for the storage, 
handling, transportation, packaging, servicing, sale, or distribution of 
export property, and
    (iv) Evidences of indebtedness executed by unrelated persons in 
connection with payment for purchases of export property for use, 
consumption, or disposition outside the United States, or in connection 
with the payment for services described in section 971(b)(2) or (3) and 
paragraph (b)(1)(iv), (v), or (vi) of this section.
    (2) Working capital. For purposes of subparagraph (1)(i) of this 
paragraph, working capital of a controlled foreign corporation is the 
excess of its current assets over its current liabilities. Liabilities 
maturing in one year or less shall be considered current liabilities. A 
determination of the amount of working capital of a controlled foreign 
corporation which is reasonably necessary for the production of export 
trade income will depend upon the nature and volume of the activities of 
the controlled foreign corporation which produce export trade income as 
they exist on the applicable determination date. In determining working 
capital which is reasonably necessary for the production of export trade 
income, the anticipated future needs of the business will be taken into 
account to the extent that such needs relate to the year of the 
controlled foreign corporation following the applicable determination 
date; anticipated future needs relating to a later period will not be 
taken into account unless it is clearly established that such needs are 
reasonably related to the production of export trade income as of the 
applicable determination date.
    (3) Inventory of export property. For purposes of subparagraph 
(1)(ii) of this

[[Page 566]]

paragraph, the inclusion of items in inventory shall be determined in 
accordance with rules applicable to domestic corporations. See 
Sec. Sec. 1.471-1 through 1.471-9. Inventory of export property of a 
controlled foreign corporation includes export property held for use, 
consumption, or disposition outside the United States regardless of 
where it is located on the applicable determination date. Thus, such 
property may be physically located in the United States on such date. 
However, for property physically located in the United States to 
constitute export property, it must have been acquired by the controlled 
foreign corporation with a clear intent that it would dispose of the 
property for use, consumption, or disposition outside the United States. 
As a general rule, if during the year following the applicable 
determination date export property which was physically located in the 
United States on such date is actually exported for use, consumption, or 
disposition outside the United States, such property will be deemed held 
for such purpose on the applicable determination date. On the other 
hand, the indefinite warehousing of export property in the United States 
by the controlled foreign corporation, or the subsequent sale of export 
property by such corporation for use, consumption, or disposition in the 
United States, will evidence a lack of intent by such corporation on the 
applicable determination date to hold such property for use, 
consumption, or disposition outside the United States.
    (4) Facilities located outside the United States--(i) In general. 
For purposes of subparagraph (1)(iii) of this paragraph, a facility, as 
defined in subdivision (ii)(a) of this subparagraph, will be considered 
an export trade asset only--
    (a) If such facility is located outside the United States, and
    (b) To the extent that such facility is used, within the meaning of 
subdivision (ii)(c) of this subparagraph, by the controlled foreign 
corporation for the storage, handling, transportation, packaging, 
servicing, sale, or distribution of export property in essentially the 
same form in which such property is acquired by such corporation.


Thus, a facility in which property is manufactured or produced, even 
though export property is used or consumed in the production or becomes 
a component part of the manufactured article, will not qualify as an 
export trade asset.
    (ii) Special rules--(a) Facility defined. For purposes of 
subdivision (i) of this subparagraph, the term ``facility'' includes any 
asset or group of assets used for the storage, handling, transportation, 
packaging, servicing, sale, or distribution of export property. Thus, 
such term includes warehouse, storage, or sales facilities (for example, 
sales office equipment), transportation equipment (for example, motor 
trucks, vessels, etc.), and machinery and equipment (for example, 
packaging equipment, servicing equipment, cranes, forklift trucks used 
in warehouses, etc.).
    (b) Determination of location of transportation facilities. A 
transportation facility shall be considered to be located outside the 
United States for purposes of subdivision (i)(a) of this subparagraph if 
such property is predominantly located outside the United States. As a 
general rule, on an applicable determination date a transportation 
facility will be considered to be predominantly located outside the 
United States if 70 percent or more of the miles traversed (during the 
12-month period immediately preceding such determination date or for 
such part of such period as such facility is owned by the controlled 
foreign corporation) in the use of such facility are traversed outside 
the United States or if such facility is located outside the United 
States at least 70 percent of the time during such period or such part 
thereof.
    (c) Determination of use. For purposes of subdivision (i)(b) of this 
subparagraph, the extent to which a facility is used in carrying on the 
activities described in such subdivision depends on the use made of the 
facility for the 12-month period immediately preceding the applicable 
determination date or for such part of such period as such facility is 
owned by the controlled foreign corporation. The method of measuring 
such use will depend upon the facts and circumstances in each case. 
However, such determinations of use will generally be made for a 
facility as

[[Page 567]]

a whole and not on the basis of individual items used in the operation 
of a facility. Thus, a determination as to the use of a warehouse 
facility will generally be made with respect to the entire facility and 
not separately for the items used in such warehouse, such as forklift 
trucks, storage bins, etc.
    (5) Evidences of indebtedness. For purposes of subparagraph (1)(iv) 
of this paragraph, the term ``evidence of indebtedness'' shall mean a 
note, installment sales contract, a time bill of exchange evidencing a 
sale on credit, or similar written instrument executed by an unrelated 
person which evidences the obligation of an unrelated person to pay for 
export property which an unrelated person purchases for use, 
consumption, or disposition outside the United States or to pay for 
services described in section 971(b)(2) or (3) and paragraph (b)(1)(iv), 
(v), or (vi) of this section which are performed for an unrelated 
person. Receivables which arise out of the delivery of export property, 
or the performance of services, which are evidenced by invoices, bills 
of lading, bills of exchange which do not evidence a sale on credit, 
sales slips, and similar documents created by the unilateral act of a 
creditor shall not be considered evidences of indebtedness for purposes 
of section 971(c)(4).
    (6) Duplication of treatment and priority of application. No asset 
which constitutes an export trade asset shall be taken into account more 
than once in determining the investments in export trade assets of a 
controlled foreign corporation. Assets which constitute working capital 
and also constitute inventory to which section 971(c)(2) applies or 
evidences of indebtedness to which section 971(c)(4) applies shall be 
taken into account in determining whether the amount of working capital 
of the controlled foreign corporation is reasonably necessary for the 
production of export trade income. However, to the extent that the 
amount of inventory to which section 971(c)(2) applies or evidences of 
indebtedness to which section 971(c)(4) applies is not included in 
working capital to which section 971(c)(1) applies on the ground that 
such amount is not reasonably necessary for the production of export 
trade income, the amount shall be included under section 971(c)(2) or 
971(c)(4), as the case may be, in a controlled foreign corporation's 
investments in export trade assets.
    (d) Export promotion expenses--(1) In general. For purposes of 
sections 970 through 972 and Sec. Sec. 1.970-1 to 1.972-1, inclusive, 
the term ``export promotion expenses'' means, subject to the provisions 
of subparagraph (2) of this paragraph, all the ordinary and necessary 
expenses paid or incurred during the taxable year by the controlled 
foreign corporation which are reasonably allocable to the receipt or 
production of export trade income including--
    (i) A reasonable allowance for salaries or other compensation for 
personal services actually rendered for such purpose,
    (ii) Rentals or other payments for the use of property actually used 
for such purpose, and
    (iii) A reasonable allowance for the exhaustion, wear and tear, or 
obsolescence of property actually used for such purpose.


In determining for purposes of this subparagraph whether expenses are 
reasonably allocable to the receipt or production of export trade 
income, consideration shall be given to the facts and circumstances of 
each case. As a general rule, if export trade income results from the 
sale of export property, export promotion expenses allocable to such 
income shall include warehousing, advertising, selling, billing, 
collection, other administrative, and similar costs properly allocable 
to the marketing activity, but shall not include cost of goods sold, 
income or similar tax, any expense which does not advance the 
distribution or sale of export property for use, consumption, or 
disposition outside the United States, or any expense for which the 
controlled foreign corporation is reimbursed. If export trade income 
results from the rental of export property, export promotion expenses 
allocable to such income shall include a reasonable allowance for 
depreciation and servicing of such property, and the administrative and 
similar costs properly allocable to the rental activity. If export trade 
income results from the performance of services,

[[Page 568]]

export promotion expenses shall include a reasonable allowance for 
compensation of the persons performing services for the controlled 
foreign corporation in the execution of the service contract or 
arrangement and administrative expenses reasonably allocable to the 
service activity. In no case shall income taxes be included in export 
promotion expenses.
    (2) Expenses incurred within the United States. No expense incurred 
within the United States shall be treated as an export promotion expense 
for purposes of section 971(d) and subparagraph (1) of this paragraph 
unless at least--
    (i) 90 percent of all salaries and other personal service 
compensation incurred in the receipt or the production of export trade 
income,
    (ii) 90 percent of rents and other payments for the use of property 
used in the receipt or the production of export trade income,
    (iii) 90 percent of the allowances for the exhaustion, wear and 
tear, or obsolescence of property used in the receipt or the production 
of export trade income, and
    (iv) 90 percent of all other ordinary and necessary expenses 
reasonably allocable to the receipt or the production of export trade 
income,


is incurred outside the United States. For this purpose, personal 
service compensation will be considered incurred at the place where the 
service is performed (for example, salaries will be considered incurred 
at the place where the employee works; payments for art work will be 
considered incurred at the place where the art work is prepared, etc.); 
rent, depreciation, and other expenses related to real or personal 
property will be considered incurred at the place where the property is 
located; and expenses for media advertising will be considered incurred 
at the place where the advertising is consumed. For such purpose, 
newspaper or periodical advertising will be considered consumed where 
the newspaper or periodical is principally distributed, and television 
and radio advertising will be considered consumed at the place where the 
audience is primarily located. Technicalities of contract or payment, 
for example, the place where a contract is executed or the location of a 
bank account from which payment is made, shall not be determinative of 
the place where an expense is incurred.
    (e) Export property. For purposes of sections 970 through 972 and 
Sec. Sec. 1.970-1 to 1.972-1, inclusive, the term ``export property'' 
means property, or any interest in property, which is manufactured, 
produced, grown, or extracted in the United States. Whether property 
will be considered manufactured or produced in the United States will 
depend on the facts and circumstances of each case. As a general rule, 
if--
    (1) The property sold, serviced, used, or rented by the controlled 
foreign corporation is substantially transformed in the United States 
prior to its export from the United States, or
    (2) The operations conducted in the United States with respect to 
the property sold, serviced, used, or rented by the controlled foreign 
corporation, whether performed in the United States by one person or a 
series of persons in a chain of distribution, are substantial in nature 
and are generally considered to constitute the manufacture or production 
of property,


then the property sold, serviced, used, or rented will be considered to 
have been manufactured or produced in the United States. The rules under 
paragraph (a)(4)(ii) of Sec. 1.954-3, relating to the substantial 
transformation of property, and paragraph (a)(4)(iii) of such section, 
dealing with a substantive test for determining whether property will be 
treated as having been manufactured or produced, shall apply for 
purposes of making determinations under this paragraph.
    (f) Unrelated person. For purposes of sections 970 through 972 and 
Sec. Sec. 1.970-1 to 1.972-1, inclusive, the term ``unrelated person'' 
means a person other than a related person as defined in section 
954(d)(3) and paragraph (e) of Sec. 1.954-1.

[T.D. 6755, 29 FR 12710, Sept. 9, 1964, as amended by T.D. 7293, 38 FR 
32802, Nov. 28, 1973; T.D. 7533, 43 FR 6603, Feb. 15, 1978]



Sec. 1.972-1  Consolidation of group of export trade corporations.

    (a) Election to consolidate--(1) In general. One or more United 
States shareholders (as defined in section 951(b)) owning (within the 
meaning of section 958(a)) or who are considered as owning

[[Page 569]]

by applying the rules of ownership of section 958(b) more than 50 
percent of the total combined voting power of all classes of stock 
entitled to vote of an export trade corporation, which is the top-tier 
corporation in a chain (within the meaning of subparagraph (2) of this 
paragraph) of export trade corporations, may, subject to the provisions 
of this section, elect to consolidate such chain for purposes of 
determining--
    (i) The limitations, described in section 970(a) and paragraph 
(b)(2) of Sec. 1.970-1, on the amount by which subpart F income of an 
export trade corporation in such chain shall be reduced as provided in 
section 970(a) and paragraph (b)(1) of Sec. 1.970-1, and
    (ii) The amount includible in gross income of such shareholders 
under section 951(a)(1)(A)(ii) with respect to such a corporation's 
decrease in investments in export trade assets to which section 970(b) 
applies as described in paragraph (c) of Sec. 1.970-1.
    (2) ``Chain'' defined. A chain of export trade corporations shall 
include--
    (i) The top-tier export trade corporation referred to in 
subparagraph (1) of this paragraph which is the first export trade 
corporation in a chain of ownership described in section 958(a);
    (ii) All export trade corporations 80 percent or more of the total 
combined voting power of all classes of stock entitled to vote of which 
is owned directly by such top-tier export trade corporation on the last 
day of its taxable year; and
    (iii) All export trade corporations 80 percent or more of the total 
combined voting power of all classes of stock entitled to vote of which 
is owned directly by the export trade corporations described in 
subdivision (ii) of this subparagraph on the last day of the taxable 
year of the export trade corporation described in subdivision (i) of 
this subparagraph.


For purposes of this section, a reference to a top-tier corporation 
shall mean an export trade corporation described in subdivision (i) of 
this subparagraph, a reference to a second-tier corporation shall mean 
an export trade corporation described in subdivision (ii) of this 
subparagraph, and a reference to a third-tier corporation shall mean an 
export trade corporation described in subdivision (iii) of this 
subparagraph.
    (3) Inclusion requirement. If an election is made by a United States 
shareholder under this paragraph with respect to a chain of export trade 
corporations (as defined in subparagraph (2) of this paragraph), all 
export trade corporations which are included in the chain must be 
included in the consolidation. If such an election is made, the 
determinations under section 970 shall be made on a consolidated basis 
with respect to the entire interest which the electing United States 
shareholder owns in each of the export trade corporations in the chain, 
including any minority interests owned directly or indirectly by such 
shareholder in second-tier and third-tier corporations in the chain. A 
United States shareholder may elect to consolidate his interest in 
export trade corporations in one chain of such corporations without 
electing to consolidate his interest in export trade corporations in 
other chains.
    (4) Conditions for making initial election--(i) Without consent. The 
initial election to consolidate a chain of export trade corporations may 
be made without the consent of the Commissioner only if, immediately 
before the election to consolidate, each of the export trade 
corporations to be included in the consolidation is using the same 
taxable year and has the same elections under section 970(c)(4) and 
Sec. 1.970-2 in force, or not in force, as the case may be. The 
election shall be made by the electing shareholder or shareholders with 
respect to the taxable year in which or with which ends the first 
taxable year of the top-tier corporation to which the election to 
consolidate applies and at the time of filing such shareholders' returns 
for such taxable year or within 90 days after final regulations under 
this section are published in the Federal Register, whichever date 
occurs later. Each United States shareholder making such an election 
shall attach to his return a statement showing:
    (a) The name, address, and taxable year of each export trade 
corporation in the chain of such corporations for which an election is 
made,
    (b) The amount and percentage of each class of stock owned by such

[[Page 570]]

shareholder (within the meaning of section 958), corporation by 
corporation, in each of such export trade corporations, and
    (c) A list of the names and addresses, and a description of the 
ownership interests, of all other United States shareholders, if any, 
who are making the same election to consolidate and a statement that 
such shareholders are also making the election.
    (ii) With consent. If, immediately before the election to 
consolidate, each of the export trade corporations in a chain of such 
corporations does not use the same taxable year or does not have the 
same elections under section 970(c)(4) and Sec. 1.970-2 in force, or 
not in force, as the case may be, the initial election to consolidate 
such chain may be exercised by the electing shareholder or shareholders 
only with the consent of the Commissioner. Consent will not be granted 
unless each electing United States shareholder and the Commissioner 
agree to the terms, conditions, and adjustments under which such 
consolidation is to be effected and unless, subject to such terms, 
conditions, and adjustments as the Commissioner may prescribe, each of 
the export trade corporations in the chain adopts a common taxable year 
and has the same elections under section 970(c)(4) and Sec. 1.970-2 in 
force, or not in force, as the case may be. The application for consent 
to consolidate shall be made by mailing a letter, signed by each of the 
electing United States shareholders, to the Commissioner of Internal 
Revenue, Washington, DC 20224. The application shall be mailed before 
the close of the first taxable year of the top-tier corporation with 
respect to which the electing shareholder or shareholders desire to make 
a consolidation or before the close of the 90th day after final 
regulations under this section are published in the Federal Register, 
whichever date occurs later, and shall include the statement described 
in subdivision (i) of this subparagraph.
    (5) Effect of election. If an election to consolidate a chain of 
export trade corporations is made for a taxable year of a United States 
shareholder, such election shall, except as provided in subparagraph (6) 
of this paragraph, be binding on such shareholder for such taxable year 
and for all succeeding taxable years. If, in a subsequent taxable year 
of the United States shareholder, an export trade corporation for the 
first time qualifies as a second-tier or third-tier corporation in such 
chain on the last day of the taxable year of the top-tier corporation 
which ends in or with the subsequent taxable year of such shareholder, 
the shareholder's interest in such export trade corporation shall be 
included in the consolidation to which the election applies, but only if 
such export trade corporation as of such last day uses the same taxable 
year and has the same elections under section 970(c)(4) and Sec. 1.970-
2 in force, or not in force, as the case may be, as such top-tier 
corporation. The United States shareholder shall, with respect to such 
additional export trade corporation, submit with his return for such 
subsequent taxable year the statement described in subparagraph (4)(i) 
of this paragraph.
    (6) Termination of election. An election under this paragraph to 
consolidate a chain of export trade corporations shall terminate for the 
first taxable year of the foreign corporation which during the period of 
consolidation is a top-tier corporation--
    (i) At the close of which any foreign corporation which was included 
in such consolidation for the preceding taxable year ceases to qualify 
as an export trade corporation or to be eligible under this paragraph 
for inclusion in such chain,
    (ii) At the close of which an export trade corporation for the first 
time qualifies as a second-tier or third-tier corporation in such chain 
but does not as of such close of the year use the same taxable year or 
have the same elections under section 970(c)(4) and Sec. 1.970-2 in 
force, or not in force, as the case may be, as such top-tier 
corporation, or
    (iii)(a) In respect of which the Commissioner, upon application made 
by a United States shareholder who made the election to consolidate, or 
his successor in interest, consents to a termination of the election. 
Approval will not be granted unless the United States shareholder and 
the Commissioner agree to the terms, conditions,

[[Page 571]]

and adjustments under which the termination will be effected.
    (b) The application for consent to termination shall be made by the 
United States shareholder's mailing a letter for such purpose to the 
Commissioner of Internal Revenue, Washington, DC 20224. The application 
shall be mailed before the close of the taxable year of the foreign 
corporations with respect to which the shareholder desires to terminate 
the consolidation and shall include the following information:
    (1) The name, address, and taxable year of each export trade 
corporation in the chain of such corporations for which the election was 
made,
    (2) The amount and percentage of each class of stock owned by such 
shareholder (within the meaning of section 958), corporation by 
corporation, in each of such export trade corporations, and
    (3) A list of the names and addresses, and a description of the 
ownership interests, of all other United States shareholders, if any, 
who participated in making the election with such United States 
shareholder, or their successors in interest, and a statement whether 
such other persons are or are not terminating the election.
    (7) Election subsequent to initial election. If a United States 
shareholder elects under subparagraph (4) of this paragraph to 
consolidate his interest in a chain of export trade corporations and the 
election to consolidate such corporations terminates under the 
provisions of subparagraph (6) of this paragraph, such shareholder may 
not thereafter elect under this section to consolidate his interest in 
any corporation which was in that chain of export trade corporations 
unless he receives the consent of the Commissioner to do so. Application 
to obtain such consent of the Commissioner shall be made by a letter 
mailed to the Commissioner of Internal Revenue, Washington, DC, 20224, 
before the close of the first taxable year of the top-tier corporation 
of the chain of export trade corporations in which the election to 
include such interest is to apply. Such application for consent shall 
include a statement showing:
    (i) With respect to such chain, the information required to be shown 
in the statement described in subparagraph (4)(i) of this paragraph, and
    (ii) The United States shareholder's interest in such chain which 
was previously included in a consolidation, the taxable years of such 
previous consolidation, and the manner in which such previous 
consolidation was terminated.
    (8) Illustration. The application of this paragraph may be 
illustrated by the following example:

    Example. Domestic corporation M owns 60 percent of the only class of 
stock of foreign corporation A, and 100 percent of the only class of 
stock of foreign corporation F, respectively. Corporation A owns 80 
percent of the only class of stock of foreign corporations B and C, 
respectively. Corporation M also owns 20 percent of the stock of B 
Corporation. Corporation B owns 80 percent of the only class of stock of 
foreign corporation D. Corporations B and C each own 50 percent of the 
only class of stock of foreign corporation E. Corporation F owns 100 
percent of the only class of stock of foreign corporation G, which owns 
100 percent of the only class of stock of foreign corporation H. 
Corporation F also owns 20 percent of the stock of C Corporation. 
Domestic corporations N and R own 30 percent and 10 percent, 
respectively, of the stock of A Corporation. All corporations use the 
calendar year as a taxable year, and all foreign corporations qualify as 
export trade corporations for 1963. Corporation M may elect for 1963 to 
consolidate its interest in the chain (the ``A'' chain) of export trade 
corporations which includes corporations A, B, C, D, and E; and 
Corporation M need not, but may, elect to consolidate its interest in 
the chain (the ``F'' chain) of export trade corporations which includes 
corporations F, G, and H. Consolidation of M Corporation's interest in 
the ``A'' chain with its interest in the ``F'' chain is not permitted. 
If M Corporation elects to consolidate the ``A'' chain, M Corporation 
must include in the consolidation its 20 percent directly owned interest 
in B Corporation and its 20 percent indirectly owned (through F 
Corporation) interest in C Corporation. Either N Corporation or R 
Corporation, or both, may join M Corporation in electing to consolidate 
their interests in the ``A'' chain. However, neither N Corporation nor R 
Corporation may elect to consolidate the ``A'' chain unless M 
Corporation also agrees to so elect, because corporations N and R, 
neither jointly nor separately, own more than 50 percent of the total 
combined voting power of all classes of stock entitled to vote of A 
Corporation. If corporations M, N, and R elect to consolidate the ``A'' 
chain, the determinations specified in subparagraph (1) of this 
paragraph will be made on a consolidated basis with respect to

[[Page 572]]

such corporations' respective interest in the chain as shown in the 
following tabulation:

------------------------------------------------------------------------
                                               A %  B %  C %   D %   E %
------------------------------------------------------------------------
M Corporation's interest:
  Direct interest............................   60
  (60% x 80%) + 20% direct interest..........  ...   68
  (60% x 80%) + 20% indirect interest........  ...  ...   68
  (68% x 80%)................................  ...  ...  ...   54.4
  (68% x 50%) + (68% x 50%)..................  ...  ...  ...  .....   68
N Corporation's interest:
  Direct interest............................   30
  (30% x 80%)................................  ...   24
  (30% x 80%)................................  ...  ...   24
  (24% x 80%)................................  ...  ...  ...   19.2
  (24% x 50%) + (24% x 50%)..................  ...  ...  ...  .....   24
R Corporation's interest:
  Direct interest............................   10
  (10% x 80%)................................  ...    8
  (10% x 80%)................................  ...  ...    8
  (8% x 80%).................................  ...  ...  ...    6.4
  (8% x 50%) + (8% x 50%)....................  ...  ...  ...  .....    8
                                              --------------------------
    Total interests to which consolidation     100  100  100     80  100
     applies.................................
------------------------------------------------------------------------

    (b) Effect of consolidation--(1) Determination of subpart F income, 
export trade income, etc. An election under paragraph (a) of this 
section to consolidate export trade corporations in a chain of such 
corporations shall have no effect on the determination of the character 
of income as subpart F income or on the determination of export trade 
income, export trade income which constitutes foreign base company 
income, or earnings and profits of the individual export trade 
corporations in the chain. Thus, the consolidation of export trade 
corporations under this section shall not have the effect of reducing 
earnings and profits of such corporations or of changing the 
characterization of income from that which is, for example, foreign base 
company income to that which is not. The application of this paragraph 
may be illustrated by the following example:

    Example. Corporation A, incorporated under the laws of foreign 
country X, and corporation B, incorporated under the laws of foreign 
country Y, are both wholly owned subsidiaries of domestic corporation M. 
Corporations A and B both qualify under section 971(a) as export trade 
corporations. Corporation A purchases personal property produced in the 
United States from an unrelated person and sells the property to B 
Corporation for use outside of country X. Corporation B resells the 
property to an unrelated person for use in foreign country Z. 
Corporations A and B each derive foreign base company sales income 
described in Sec. 1.954-3 from the purchase and sale transactions. 
Consolidation of Corporations A and B under this section does not result 
in the two transactions being treated as one transaction which is a 
purchase of property from an unrelated person and a sale of property to 
an unrelated person or the nonrecognition of gain on the sale of export 
property by A Corporation to B Corporation.

    (2) Determination of amount by which consolidated subpart F income 
is reduced--(i) In general. In determining the amount by which the 
subpart F income of each export trade corporation includible in a 
consolidation of export trade corporations shall be reduced as provided 
in section 970(a) and paragraph (b)(1) of Sec. 1.970-1 for any taxable 
year of consolidation, the limitations provided by section 970(a) and 
paragraph (b)(2) of Sec. 1.970-1 on such amount for each such export 
trade corporation shall be determined on the basis of such corporation's 
separate share of--
    (a) Amounts included in the total export promotion expense,
    (b) The total gross receipts from the sale, installation, operation, 
maintenance, or use of property in respect of which each such 
corporation derives such export trade income as is properly allocable to 
the export trade income which constitutes foreign base company income, 
and
    (c) The total increase in investments in export trade assets,


of all export trade corporations to which the consolidation applies for 
the taxable year.
    (ii) Limitations not effective. If for any taxable year each of the 
limitations under paragraph (b)(2) of Sec. 1.970-1, determined on a 
consolidated basis, equals or exceeds the total export trade income 
which constitutes foreign base company income of all corporations 
includible in the consolidation of export trade corporations, the 
subpart F income of each includible corporation shall be reduced under 
section 970(a) for such year by its separate export trade income which 
constitutes foreign base company income.
    (iii) Limitation effective. If for any taxable year one of the 
limitations under paragraph (b)(2) of Sec. 1.970-1, determined on a 
consolidated basis, is less than the

[[Page 573]]

total export trade income which constitutes foreign base company income 
of all corporations includible in the consolidation of export trade 
corporations, the amount by which the subpart F income of each 
includible corporation shall be reduced under section 970(a) for such 
year shall be an amount which bears the same ratio to the amount by 
which the subpart F income may be reduced on a consolidated basis as the 
export trade income which constitutes foreign base company income of 
each includible corporation bears to the total export trade income which 
constitutes foreign base company income of all export trade corporations 
includible in the consolidation of export trade corporations.
    (iv) Illustration. The application of this subparagraph may be 
illustrated by the following example:

    Example. (a) Domestic corporation M owns 100 percent of the only 
class of stock of controlled foreign corporation A, which, in turn, owns 
100 percent of the only class of stock of controlled foreign corporation 
B. All corporations use the calendar year as the taxable year, and 
corporations A and B are export trade corporations throughout the period 
here involved. Corporation M elects under this section to consolidate 
corporations A and B for the entire period here involved. Corporation M 
elects under paragraph (a)(2) of Sec. 1.970-2 for 1963 to determine 
both A Corporation's and B Corporation's investments in export trade 
assets as of the close of the 75th day after the close of such 
corporations' taxable year.
    (b) The following amounts are applicable to corporations A and B for 
1964:

------------------------------------------------------------------------
                                                Corporation  Corporation
                                                     A            B
------------------------------------------------------------------------
Subpart F income..............................      $100         $200
Export trade income which constitutes foreign         25           75
 base company income..........................
Other export trade income.....................        10           15
Export promotion expenses allocable to export         10           80
 trade income which constitutes foreign base
 company income...............................
Gross receipts from the sale of property in          400          600
 respect of which export trade income which
 constitutes foreign base company income is
 derived......................................
Increase in investments in export trade assets        35          120
 for period beginning with March 16, 1964, and
 ending with March 16, 1965...................
------------------------------------------------------------------------

    (c) The amount by which subpart F income of corporations A and B is 
reduced for 1964 on a separate-company basis without regard to section 
972 may be determined as set forth in items (i) through (vii) below, and 
the results of the consolidation of corporations A and B for 1964 are 
set forth in items (viii) through (x). Assuming an alternative case in 
which for 1964 the facts are the same as set forth in paragraphs (a) and 
(b) of this example except that B Corporation incurs export promotion 
expenses of $50 (rather than $80) which are allocable to the export 
trade income which constitutes foreign base company income, the results 
of the consolidation of corporations A and B for such year (a case where 
one of the limitations under paragraph (b)(2) of Sec. 1.970-1 is 
effective) are set forth in items (xi) through (xiii):

------------------------------------------------------------------------
                                            A            B
                                       Corporation  Corporation   Total
                                           (1)          (2)        (3)
------------------------------------------------------------------------
(i) Subpart F income.................       $100         $200       $300
                                      ==================================
(ii) Export trade income which                25           75        100
 constitutes foreign base company
 income..............................
(iii) Other export trade income......         10           15         25
                                      ----------------------------------
(iv) Total export trade income.......         35           90        125
                                      ==================================
(v) Limitations under Sec. 1.970-
 1(b)(2):
  (a) Increase in export trade assets
   limitation:
    ($35 x $25/$35)..................         25
    ($120 x $75/$90).................  ...........        100
    ([$35 + $120] x $100/ $125)......  ...........  ...........      124
  (b) Gross receipts limitation:
    (10% of $400)....................         40
    (10% of $600)....................  ...........         60
    (10% of $1,000)..................  ...........  ...........      100
  (c) Export promotion expenses
   limitation:
    (150% of $10)....................         15
    (150% of $80)....................  ...........        120
    (150% of $90)....................  ...........  ...........      135
  (d) Export promotion expenses
   limitation (alternative case):
    (150% of $10)....................         15
    (150% of $50)....................  ...........         75
    (150% of $60)....................  ...........  ...........       90
                                      ----------------------------------
(vi) Reduction in subpart F income on         15           60         75
 a separate company basis determined
 without regard to section 972 (item
 (ii), but not to exceed smallest of
 items (v) (a), (b), and (c), in
 columns (1) and (2))................
                                      ----------------------------------
(vii) Subpart F income as reduced on          85          140        225
 a separate company basis (item (i)
 minus item (vi))....................
                                      ==================================
(viii) Reduction in subpart F income   ...........  ...........      100
 on a consolidated basis determined
 under section 972 (item (ii), but
 not to exceed smallest of items (v)
 (a), (b), and (c), in column (3))...
                                      ----------------------------------

[[Page 574]]

 
(ix) Apportionment of reduction in            25           75        100
 subpart F income (item (ii))........
(x) Subpart F income as reduced on a          75          125        200
 consolidated basis (item (i) minus
 item (ix))..........................
                                      ==================================
 
                            Alternative Case
 
(xi) Reduction in subpart F income on  ...........  ...........        9
 a consolidated basis determined
 under section 972 (item (ii) but not
 to exceed smallest of items (v) (a),
 (b), and (d), in column (3))........
                                                                --------
(xii) Apportionment of reduction in       $22.50
 subpart F income (item (xi) times
 [item (ii) of column (1) over item
 (ii) of column (3)] and item (xi)
 times [item (ii) of column (2) over
 item (ii) of column (3)]); ($90 x
 $25/$100)...........................
  ($90 x $75/$100)...................  ...........     $67.50         90
                                                   ---------------------
(xiii) Subpart F income as reduced on      77.50       132.50        210
 a consolidated basis (item (i) minus
 item (xii)).........................
------------------------------------------------------------------------

    (3) Determination of pro rata share of consolidated withdrawal of 
previously excluded export trade income--(i) In general. If, for any 
taxable year, there is a decrease in investments in export trade assets 
under section 970(b) and paragraph (c)(1) of Sec. 1.970-1, determined 
on a consolidated basis, of export trade corporations includible in a 
consolidated chain of such corporations, each United States shareholder 
who has elected under paragraph (a) of this section to consolidate his 
interest in such chain of corporations shall include in his gross 
income, under section 951(a)(1)(A)(ii) and the regulations thereunder as 
an amount to which section 955 (as in effect before the enactment of the 
Tax Reduction Act of 1975) applies, his pro rata share of the amount of 
such consolidated decrease in investments but only to the extent such 
pro rata share does not exceed the lesser of the limitations provided by 
section 970(b) and paragraph (c)(2) of Sec. 1.970-1 with respect to 
such shareholder determined on a consolidated basis. The consolidated 
decrease in investments and the consolidated limitations shall be 
determined by aggregating the applicable amounts determined under 
paragraph (c) of Sec. 1.970-1 with respect to such shareholder's 
interest in each corporation includible in the consolidation.
    (ii) Allocation of pro rata share of consolidated decrease in 
investments in export trade assets. For purposes of determining the 
amount referred to in paragraph (c)(2)(i)(b)(3) of Sec. 1.970-1 for a 
subsequent taxable year, a United States shareholder's pro rata share of 
a consolidated decrease in investments determined under subdivision (i) 
of this subparagraph for the current taxable year shall be allocated to 
such shareholder's interest in each of the export trade corporations 
includible in the consolidation in that ratio which--
    (a) The net amount determined under paragraph (c)(2)(i)(b) of Sec. 
1.970-1 with respect to such shareholder's interest in such corporation 
for all prior taxable years (whether or not a taxable year occurring 
during the period of consolidation) bears to
    (b) The total of the net amounts determined under paragraph 
(c)(2)(i) (b) of Sec. 1.970-1 with respect to such shareholder's 
interests in all export trade corporations includible in such 
consolidation for all prior taxable years (whether or not a taxable year 
occurring during the period of consolidation).
    (iii) Illustration. The application of this subparagraph may be 
illustrated by the following example:

    Example. (a) Domestic corporation M owns 60 percent of the only 
class of stock of controlled foreign corporation A, which, in turn, owns 
100 percent of the only class of stock of controlled foreign corporation 
B. All corporations use the calendar year as a taxable year, and 
corporations A and B are export trade corporations throughout the period 
here involved. Corporation M elects to consolidate corporations A and B 
for the entire period here involved.
    (b) The following amounts are applicable to corporations A and B for 
1964:

------------------------------------------------------------------------
                                                            Consolidated
                                              A (1)  B (2)       (3)
------------------------------------------------------------------------
(i) Consolidated decrease in investments in   .....  .....       $100
 export trade assets (determined before
 application of Sec. 1.970-1(c)(2)).......
(ii) M Corporation's pro rata share of        .....  .....         60
 consolidated decrease (60%)................
(iii) M Corporation's pro rata share of        $120    $90        210
 earnings and profits for 1963 and 1964
 (Sec. 1.970-1(c) (2)(i)(a)...............

[[Page 575]]

 
(iv) M Corporation's pro rata share of net      180     60        240
 amount determined under Sec. 1.970-
 1(c)(2)(i)(b) for 1963.....................
(v) Amount includible in M Corporation's      .....  .....         60
 gross income for 1964 (smallest of items
 (ii), (iii), and (iv) in column (3)).......
------------------------------------------------------------------------


Corporation M must include $60 in its gross income for 1964 under 
section 951(a)(1)(A)(ii) by reason of the application of section 970(b) 
as its pro rata share of the consolidated decrease in investments in 
export trade assets; and, for purposes of determining the amount under 
paragraph (c)(2)(i)(b)(3) of Sec. 1.970-1 with respect to M 
Corporation's interest in each of corporations A and B for a subsequent 
taxable year, such consolidated decrease for 1964 is allocated as 
follows: to M Corporation's interest in A Corporation, $45 ($60 times 
$180/$240); and to its interest in B Corporation, $15 ($60 times $60/
$240).
    (c) The following amounts are applicable to corporations A and B for 
1965:

------------------------------------------------------------------------
                                                            Consolidated
                                         A(1)       B(2)         (3)
------------------------------------------------------------------------
(i) Consolidated decrease in          .........  .........         $150
 investments in export trade assets
 (determined before application of
 Sec. 1.970-1(c)(2))..............
(ii) M Corporation's pro rata share   .........  .........           90
 of consolidated decrease (60%).....
(iii) M Corporation's pro rata share       $100      ($20)           80
 of earnings and profits (and
 deficits in earnings and profits)
 for 1963, 1964, and 1965 (Sec.
 1.970-1(c)(2)(i)(a))...............
(iv) M Corporation's pro rata share
 of the net amount determined under
 Sec. 1.970-1(c)(2)(i)(b) for 1963
 and 1964...........................
  ($180-$45)........................        135
  ($60-$15).........................  .........         45
    Total...........................  .........  .........          180
(v) Amount includible in M            .........  .........           80
 Corporation's gross income for 1965
 (smallest of items (ii), (iii), and
 (iv) in column (3))................
------------------------------------------------------------------------

Corporation M must include $80 in its gross income for 1965 under 
section 951(a)(1)(A)(ii) by reason of the application of section 970(b) 
as its pro rata share of the consolidated decrease in investments in 
export trade assets; and, for purposes of determining the amount under 
paragraph (c)(2)(i)(b)(3) of Sec. 1.970-1 with respect to M 
Corporation's interest in each of corporations A and B for a subsequent 
taxable year, such consolidated decrease for 1965 is allocated as 
follows: to M Corporation's interest in A Corporation, $60 ($80 times 
$135/$180); and to its interest in B Corporation, $20 ($80 times $45/
$180).
    (d) The following amounts are applicable to corporations A and B for 
1966:

------------------------------------------------------------------------
                                                            Consolidated
                                               A(1)   B(2)       (3)
------------------------------------------------------------------------
(i) Consolidated decrease in investments in   .....  .....       $200
 export trade assets (determined before
 application of Sec. 1.970-1(c)(2)).......
(ii) M Corporation's pro rata share of        .....  .....        120
 consolidated decrease (60%)................
(iii) M Corporation's pro rata share of        $120    $50        170
 earnings and profits (and deficits in
 earnings and profits) for 1963, 1964, 1965,
 and 1966 (Sec. 1.970-1(c)(2)(i)(a))......
(iv) M Corporation's pro rata share of the
 net amount determined under Sec. 1.970-
 1(c)(2)(i)(b) for 1963, 1964, and 1965.....
  ($180 minus [$45 + $60])..................     75
  ($60-[$15 + $20]).........................  .....     25
    Total...................................  .....  .....        100
(v) Amount includible in M Corporation's      .....  .....        100
 gross income for 1966 (smallest of items
 (ii), (iii), and (iv) in column (3)).......
------------------------------------------------------------------------

Corporation M must include $100 in its gross income for 1966 under 
section 951(a)(1)(A)(ii) by reason of the application of section 970(b) 
as its pro rata share of the consolidated decrease in investments in 
export trade assets; and, for purposes of determining the amount under 
paragraph (c)(2)(i)(b)(3) of Sec. 1.970-1 with respect to M 
Corporation's interest in each of corporations A and B for a subsequent 
taxable year, such consolidated decrease for 1966 is allocated as 
follows: to M Corporation's interest in A Corporation, $75 ($100 times 
$75/$100); and to its interest in B Corporation, $25 ($100 times $25/
$100).

[T.D. 6754, 29 FR 12714, Sept. 9, 1964, as amended by T.D. 7893, 48 FR 
22512, May 19, 1983]



Sec. 1.981-0  Repeal of section 981; effective dates.

    The provisions of section 981 are not effective for taxable years 
beginning after December 31, 1976. For the treatment of the community 
income of aliens and their spouses for taxable years beginning after 
December 31, 1976, see section 879 and the regulations thereunder.

[T.D. 7670, 45 FR 6929, Jan. 31, 1980]

[[Page 576]]



Sec. 1.981-1  Foreign law community income for taxable years beginning
after December 31, 1966, and before January 1, 1977.

    (a) Election for special treatment--(1) In general. An individual 
citizen of the United States who meets the requirements of section 
981(a)(1) and subparagraph (2) of this paragraph for any open taxable 
year beginning after December 31, 1966, and before January 1, 1977, may 
make a binding election with his nonresident alien spouse to have 
section 981(b) and paragraph (b) of this section apply to their income 
for such year which is treated as community income under the applicable 
community property laws of a foreign country or countries. Generally, 
the community property laws of a foreign country operate upon land 
situated within its jurisdiction and upon personal property owned by 
spouses domiciled therein. If the election is made for any taxable year, 
it shall also apply for all subsequent open taxable years of such 
citizen and his nonresident alien spouse for which all the requirements 
of section 981(a)(1) and subparagraph (2) of this paragraph are met, 
unless the Director of International Operations consents, in accordance 
with paragraph (c)(2) of this section, to a termination of the election. 
An election under section 981(a) and this section has no effect for any 
taxable year beginning before January 1, 1967, for which a separate 
election, if made, must be made under section 981(c)(1) and Sec. 1.981-
2. For the definition of ``open taxable year'' see section 981(e)(2) and 
paragraph (a) of Sec. 1.981-3. If the citizen and his nonresident alien 
spouse have different taxable years, see paragraph (c) of Sec. 1.981-3. 
If one of the spouses is deceased, see paragraph (d) of Sec. 1.981-3.
    (2) Requirements to be met. In order for a U.S. citizen and his 
nonresident alien spouse to make an election under section 981(a) and 
this section for any taxable year and in order for the election to apply 
for any subsequent taxable year it is required under section 981(a)(1) 
that, for each such taxable year, such citizen be (i) a citizen of the 
United States, (ii) a bona fide resident of a foreign country or 
countries during the entire taxable year, and (iii) married at the close 
of the taxable year to an individual who is (a) a nonresident alien 
during the entire taxable year and (b), in the case of any such 
subsequent taxable year, the same nonresident alien individual to whom 
the citizen was married at the close of the earliest of such taxable 
years. If either spouse dies during a taxable year, the taxable year of 
the surviving spouse shall be treated, solely for purposes of making the 
determination under subdivision (iii) of this subparagraph, as ending on 
the date of such death. A citizen of the United States shall be 
considered as not married at the close of his taxable year if he is 
legally separated from his spouse under a decree of divorce or of 
separate maintenance. However, the mere fact that spouses have not lived 
together during the course of the taxable year shall not cause them to 
be considered as not married at the close of the taxable year. A husband 
and wife who are separated under an interlocutory decree of divorce 
retain the relationship of husband and wife until the decree becomes 
final.
    (3) Determination of residence. The principles of paragraphs (a)(2) 
and (b)(7) of Sec. 1.911-1 (26 CFR 1.911-1 (1978)) shall apply in order 
to determine for purposes of this paragraph whether a U.S. citizen is a 
bona fide resident of a foreign country or countries during the entire 
taxable year. The principles of Sec. Sec. 1.871.2 through 1.871-5 shall 
apply in order to determine whether the alien spouse of a U.S. citizen 
is a nonresident during the entire taxable year.
    (4) Manner of electing. The election under section 981(a) and this 
section shall be made in accordance with the applicable rules set forth 
in paragraph (c) of this section.
    (b) Treatment of community income--(1) In general. Community income 
for any taxable year to which an election under section 981(a) and this 
section applies, and the deductions properly allocable to such income, 
shall be divided between the electing U.S. citizen and nonresident alien 
spouses in accordance with the rules set forth in section 981(b) and 
subparagraphs (2) through (6) of this paragraph. Community income for 
this purpose means all gross income, whether derived from sources within 
or without the United States,

[[Page 577]]

which is treated as community income of the spouses under the community 
property laws of the foreign country having jurisdiction to determine 
the legal ownership of the income. A spouse has ownership of the income 
for this purpose if under the applicable foreign law he has a 
proprietary vested interest in the income.
    (2) Earned income. Wages, salaries, or professional fees, and other 
amounts received as compensation for personal services actually 
performed, which are community income for the taxable year, shall be 
treated as the income of the spouse who actually performed the personal 
services. This subparagraph does not apply, however, to community income 
(i) derived from any trade or business carried on by the husband or the 
wife, (ii) attributable to a spouse's distributive share of the income 
of a partnership to which subparagraph (4) of this paragraph applies, 
(iii) consisting of compensation for personal services rendered to a 
corporation which represents a distribution of the earnings and profits 
of the corporation rather than a reasonable allowance as compensation 
for the personal services actually performed, or (iv) derived from 
property which is acquired as consideration for personal services 
performed.
    (3) Trade or business income. If any income derived from a trade or 
business carried on by the husband or wife is community income for the 
taxable year, all of the gross income, and the deductions attributable 
to such income, shall be treated as the gross income and deductions of 
the husband unless the wife exercises substantially all of the 
management and control of the trade or business, in which case all of 
the gross income and deductions shall be treated as the gross income and 
deductions of the wife. This subparagraph does not apply to any income 
derived from a trade or business carried on by a partnership of which 
both or one of the spouses is a member. For purposes of this 
subparagraph, income derived from a trade or business includes any 
income derived from a trade or business in which both personal services 
and capital are material income producing factors. The term ``management 
and control'' means management and control in fact, not the management 
and control imputed to the husband under the community property laws of 
a foreign country. For example, a wife who operates a beauty parlor 
without any appreciable collaboration on the part of a husband is 
considered as having substantially all of the management and control of 
the business despite the provisions of any community property laws of a 
foreign country vesting in the husband the right of management and 
control of community property; and the income and deductions 
attributable to the operation of the beauty parlor are considered the 
income and deductions of the wife.
    (4) Partnership income. If any portion of a spouse's distributive 
share of the income of a partnership of which such spouse is a member is 
community income for the taxable year, all of that distributive share 
shall be treated as the income of that spouse and shall not be taken 
into account in determining the income of the other spouse. If both 
spouses are members of the same partnership, the distributive share of 
the income of each spouse which is community income shall be treated as 
the income of that spouse. A spouse's distributive share of such income 
of a partnership shall be determined as provided in section 704, and the 
regulations thereunder.
    (5) Income from separate property. Any community income for the 
taxable year, other than income described in section 981(b)(1) or (2) 
and subparagraph (2), (3), or (4) of this paragraph, which is derived 
from the separate property of one of the spouses shall be treated as the 
income of that spouse. The determination of what property is separate 
property for this purpose shall be made in accordance with the laws of 
the foreign country which, in accordance with subparagraph (1) of this 
paragraph, has jurisdiction to determine that the income from such 
property is community income.
    (6) Other community income. Any community income for the taxable 
year, other than income described in section 981(b)(1), (2), or (3), and 
subparagraph (2), (3), (4), or (5) of this paragraph, shall be treated 
as the income of that

[[Page 578]]

spouse who has a proprietary vested interest in that income under the 
laws of the foreign country which, in accordance with subparagraph (1) 
of this paragraph, has jurisdiction to determine that such income is 
community income. Thus, for example, this subparagraph applies to 
community income not described in subparagraph (2), (3), (4), or (5) of 
this paragraph which consists of dividends, interest, rents, royalties, 
or gains, from community property or of the earnings of unemancipated 
minor children.
    (7) Illustrations. The application of this paragraph may be 
illustrated by the following examples:

    Example 1. H, a nonresident alien individual and W, a U.S. citizen, 
each of whose taxable years is the calendar year, were married 
throughout 1967. H and W were residents of, and domiciled in, foreign 
country Z during the entire taxable year. During 1967, H earned $10,000 
from the performance of personal services as an employee. H also 
received $500 in dividend income from stock which under the community 
property laws of country Z is considered to be the separate property of 
H. W had no separate income for 1967. Under the community property laws 
of country Z all income earned by either spouse is considered to be 
community income, and one-half of such income is considered to belong to 
the other spouse. In addition, such laws of country Z provide that all 
income derived from property held separately by either spouse is to be 
treated as community income and treated as belonging one-half to each 
spouse. Thus, under the community property laws of country Z, H and W 
are both considered to have realized income of $5,250 during 1967, even 
though such laws recognize the stock as the separate property of H. If 
the election under this section is in effect for 1967, under the rules 
of subparagraphs (2) and (5) of this paragraph all of the income of 
$10,500 derived during 1967 shall be treated, for U.S. income tax 
purposes, as the income of H.
    Example 2. The facts are the same as in example 1 except that H is 
the sole proprietor of a retail merchandising company and such company 
has a $10,000 profit during 1967. W exercises no management and control 
over the business. In addition, H is a partner in a wholesale 
distributing company, and his distributive share of the partnership 
profit is $5,000. Both of these amounts of income are treated as 
community income under the community property laws of country Z, and 
under such laws both H and W are treated as realizing $7,500 of such 
income. If the election under this section is in effect for 1967, under 
the rule of subparagraphs (3) and (4) of this paragraph all $15,000 of 
such income shall be treated as the income of H for U.S. income tax 
purposes.
    Example 3. The facts are the same as in example 1 except that H also 
received $1,000 in dividends on stock held separately in his name. Under 
the community property laws of country Z the stock is considered to be 
community property; and the dividends, to be community income, one-half 
of such income being treated as the income of each spouse. If the 
election under this section is in effect for 1967, under the rule of 
subparagraph (6) of this paragraph, $500 of the dividend income shall be 
treated, for U.S. income tax purposes, as the income of each spouse.

    (c) Time and manner of making or terminating an election--(1) In 
general. A citizen of the United States and his nonresident alien spouse 
shall, for the first taxable year beginning after December 31, 1966, for 
which an election under section 981(a) and this section is to apply, 
make the election by filing a return, an amended return, or a claim for 
refund, whichever is proper, for such taxable year and attaching thereto 
a statement that the election is being made and that the requirements of 
paragraph (a)(2) of this section are met for such taxable year. The 
statement must show the name, address, and account number, if any, of 
each spouse, the name and address of the executor, administrator, or 
other person making the election for a deceased spouse, the taxable year 
to which the election applies, and the name of the foreign country or 
countries having jurisdiction to determine the ownership of any income 
being treated in accordance with section 981(b) and paragraph (b) of 
this section. The statement must be signed by both persons making the 
election. An election under this section may be made only for a taxable 
year which, on the date of the election, as defined in paragraph (b) of 
Sec. 1.981-3, is open within the meaning of section 981(e)(2) and 
paragraph (a) of Sec. 1.981-3.
    (2) Termination only with consent of Director of International 
Operations--(i) In general. An election under this section for any 
taxable year is binding and may not be revoked. The election shall also 
remain in effect for all subsequent taxable years of the spouses for 
which the requirements of paragraph (a)(2) of this section are met and 
which on the date of the election are open, within

[[Page 579]]

the meaning of paragraph (a) of Sec. 1.981-3, unless the election is 
terminated for any such subsequent taxable year or years in accordance 
with subdivision (ii) of this subparagraph. Any return, amended return, 
or claim for refund in respect of any such subsequent taxable year for 
which the election is in effect shall have attached thereto a copy of 
the statement filed in accordance with subparagraph (1) of this 
paragraph and an additional signed statement that for such subsequent 
taxable year the requirements of paragraph (a)(2) of this section are 
met.
    (ii) Written request to terminate required. A request to terminate 
an election under this section for a subsequent taxable year or years 
shall be made in writing by the persons who made the election and shall 
be addressed to the Director of International Operations, Internal 
Revenue Service, Washington, DC 20225. The request must include the 
name, address, and account number, if any, of each spouse and must be 
signed by the persons making the request. It must specify the taxable 
year or years for which the termination is to be effective and the 
grounds which justify the termination. The request shall be filed not 
later than 90 days before the close of the period for assessing a 
deficiency against the U.S. citizen for the earliest taxable year of 
such citizen for which the termination is to be effective. The Director 
of International Operations may require such other information as may be 
necessary in order to determine whether the termination will be 
permitted. A copy of the consent by the Director of International 
Operations to terminate must be attached to an amended income tax return 
for each taxable year for which the termination is effective and for 
which a return has previously been filed.

(Secs. 913(m) (92 Stat. 3106; 26 U.S.C. 913(m)), and 7805 (68A Stat. 
917; 26 U.S.C. 7805), Internal Revenue Code of 1954)

[T.D. 7330, 39 FR 38372, Oct. 31, 1974, as amended by T.D. 7670, 45 FR 
6929, Jan. 31, 1980; T.D. 7736, 45 FR 76143, Nov. 18, 1980]



Sec. 1.981-2  Foreign law community income for taxable years beginning
before January 1, 1967.

    (a) Election for special treatment--(1) In general. For all open 
taxable years beginning before January 1, 1967, for which an individual 
citizen of the United States meets the requirements of subparagraphs (A) 
and (C) of section 981(a)(1) and subparagraph (2) of this paragraph, 
such citizen and his nonresident alien spouse may make a joint election 
to have section 981(c)(2) and paragraph (b) of this section apply to 
their income which is treated as community income under the applicable 
community property laws of a foreign country or countries. However, if 
the conditions prescribed by section 981(d)(3) and subparagraph (3) of 
this paragraph are met, the nonresident alien spouse is not required to 
join in the election and such citizen may make a separate election to 
have section 981(c)(2) and paragraph (b) of this section apply to such 
income for such taxable years. An election under section 981(c)(1) and 
this section shall apply to every open taxable year of such citizen and 
his nonresident alien spouse beginning before January 1, 1967, for which 
all the requirements of subparagraphs (A) and (C) of section 981(a)(1) 
and subparagraph (2) of this paragraph are met. It is immaterial whether 
such open taxable year is a taxable year subject to the provisions of 
the 1954 Code, the 1939 Code, or any other internal revenue law in 
effect before the 1939 Code. An election under section 981(c)(1) and 
this section has no effect for any taxable year beginning after December 
31, 1966. For the definition of ``open taxable year'' see section 
981(e)(2) and paragraph (a) of Sec. 1.981-3. If the citizen and his 
nonresident alien spouse have different taxable years, see paragraph (c) 
of Sec. 1.981-3. If one of the spouses is deceased, see paragraph (d) 
of Sec. 1.981-3. An election under section 981(c)(1) and this section 
is binding and may not be revoked.
    (2) Requirements to be met. In order for the citizen of the United 
States to make an election under this section, whether required to be 
made jointly with his nonresident alien spouse or permitted to be made 
separately, it is required under section 981(c)(1) that,

[[Page 580]]

for each taxable year to which the election applies, the citizen making 
the election be (i) a citizen of the United States and (ii) married at 
the close of the taxable year to an individual who is (a) a nonresident 
alien during the entire taxable year and (b), in the case of any such 
taxable years subsequent to the first, the same nonresident alien 
individual to whom the citizen was married at the close of such first 
taxable year. The provisions of paragraph (a)(2) of Sec. 1.981-1 apply 
to determine whether a U.S. citizen making an election under section 
981(c)(1) and this section is married at the close of a taxable year to 
an individual who is a nonresident alien during the entire taxable year.
    (3) Cases where joint election is not required. A nonresident alien 
spouse is not required to join in an election under section 981(c)(1) 
and this section if the Director of International Operations determines 
in accordance with paragraph (c)(4) of this section--
    (i) That an election under section 981(c)(1) and this section would 
not affect the liability for Federal income tax of the nonresident alien 
spouse for any taxable year, whether beginning on, before, or after 
January 1, 1967, or
    (ii) That the effect of the election on the liability of the 
nonresident alien spouse for Federal income tax for any such taxable 
year cannot be ascertained and that to deny the election to the U.S. 
citizen spouse would be inequitable and cause undue hardship to the U.S. 
citizen.


If in accordance with this subparagraph the nonresident alien spouse is 
not required to join in the election by the U.S. citizen, the provisions 
of section 981(d)(2) and paragraph (e) of Sec. 1.981-3 shall not apply 
so as to extend the period for assessing deficiencies or filing a claim 
for credit or refund for any taxable year of the nonresident alien 
spouse.
    (4) Manner of electing. The election under section 981(c)(1) and 
this section shall be made in accordance with the applicable rules set 
forth in paragraph (c) of this section.
    (b) Treatment of community income--(1) In general. Community income, 
as defined in paragraph (b)(1) of Sec. 1.981-1, for any taxable year 
beginning before January 1, 1967, to which an election under section 
981(c)(1) and this section applies, and the deductions properly 
allocable to such income, shall be divided between the U.S. citizen and 
his nonresident alien spouse in accordance with the rules set forth in 
section 981(c)(2) and subparagraphs (2) and (3) of this paragraph. The 
income shall be divided in such manner even though the nonresident alien 
spouse is not required, in accordance with paragraph (a)(3) of this 
section, to join in the election by the U.S. citizen.
    (2) Earned income, business income, partnership income, and income 
from separate property. All community income for any taxable year to 
which this paragraph applies which is treated as the income of one of 
the spouses in accordance with section 981(b)(1), (2), or (3) and 
paragraph (b)(2), (3), (4), or (5) of Sec. 1.981-1 shall be treated as 
the income of that spouse for purposes of this paragraph.
    (3) Other community income. All community income for any taxable 
year to which this paragraph applies, other than income described in 
subparagraph (2) of this paragraph, shall be treated as the income of 
the spouse who, for such taxable year, has a greater amount of gross 
income than the other spouse, determined by adding to the amount of 
gross income which is treated as the gross income of that spouse in 
accordance with subparagraph (2) of this paragraph the amount of the 
gross income for the taxable year which is treated as the separate 
income of that spouse under the community property laws of the foreign 
country having jurisdiction to determine the legal ownership of the 
income. If either spouse dies during a taxable year, the taxable year of 
the surviving spouse shall be treated as ending on the date of such 
death for the purpose of determining which spouse has the greater amount 
of gross income for such taxable year. Moreover, if the U.S. citizen and 
his nonresident alien spouse do not have the same taxable year, as 
defined in section 441(b) and the regulations thereunder, the periods 
for which the amounts of gross income are to be compared under this 
subparagraph are (i) the taxable year of the citizen and (ii)

[[Page 581]]

that period falling within the consecutive taxable years of the 
nonresident alien spouse which coincides with the period covered by such 
taxable year of the citizen. See paragraph (c) of Sec. 1.981-3.
    (c) Time and manner of making election--(1) In general. A citizen of 
the United States and his nonresident alien spouse or, if subparagraph 
(4) of this paragraph applies, such citizen alone may make an election 
under section 981(c)(1) and this section at any time on or after 
November 13, 1966, for each and every taxable year beginning before 
January 1, 1967, which on the date of the election, as defined in 
paragraph (b) of Sec. 1.981-3, is open within the meaning of section 
981(e)(2) and paragraph (a) of Sec. 1.981-3. The election shall be made 
by filing a return, an amended return, or a claim for refund, whichever 
is proper, for each taxable year to which the election applies and 
attaching thereto a statement that the election is being made and that 
the requirements of paragraph (a)(2) of this section are met for each 
such taxable year. The statement must also show the information required 
by subparagraph (2) of this paragraph and must, where applicable, be 
signed by both persons making the election.
    (2) Information required. The statement described in subparagraph 
(1) of this paragraph must show--
    (i) The name, address, and account number, if any, of each spouse,
    (ii) The name and address of the executor, administrator, or other 
person making the election for a deceased spouse,
    (iii) The taxable years to which the election applies,
    (iv) The office of the district director, or the service center, 
where the return or returns, if any, for such taxable year or years were 
filed,
    (v) The dates on which such return or returns, if any, were filed 
and on which the tax for such taxable year or years was paid, if the tax 
has been paid, and
    (vi) The name of the foreign country or countries having 
jurisdiction to determine the ownership of any income being treated in 
accordance with section 981(c)(2) and paragraph (b) of this section.
    (3) Place for filing. Any return, amended return, or claim for 
refund filed under subparagraph (1) of this paragraph in respect of any 
taxable year shall be filed with the Director of International 
Operations, Internal Revenue Service, Washington, DC 20225. (See Sec. 
1.6091-3.)
    (4) Determination that joint election is not required. A U.S. 
citizen spouse entitled to make an election under section 981(c)(1) and 
this section for open taxable years beginning before January 1, 1967, 
may apply to the Director of International Operations for a 
determination under section 981(d)(3) that the nonresident alien spouse 
is not required to join in the election by such citizen. This 
application shall be made by filing with the Director of International 
Operations, Internal Revenue Service, Washington, DC 20225, a statement 
setting forth the same information required by subparagraph (2) of this 
paragraph and such other information as is required by the Director of 
International Operations to justify a claim that the requirements of 
section 981(d)(3) and paragraph (a)(3) of this section are met. The 
Director of International Operations shall notify the U.S. citizen by 
letter of his determination with respect to the application. If the 
determination is that the nonresident alien spouse is not required to 
join in the election, a copy of the letter of determination shall be 
attached to each return, amended return, or claim for refund, to be 
filed pursuant to subparagraph (1) of this paragraph.

[T.D. 7330, 39 FR 38373, Oct. 31, 1974]



Sec. 1.981-3  Definitions and other special rules.

    (a) Open taxable years. (1) For purposes of paragraph (a) of Sec. 
1.981-1, and paragraph (a) of Sec. 1.981-2, a taxable year of the U.S. 
citizen, and the taxable year or years of his nonresident alien spouse 
ending or beginning within such taxable year of such citizen, shall be 
treated as open if the period prescribed by section 6501(a) (or section 
6501(c)(4) if the period is extended by agreement) for assessing a 
deficiency against the citizen for his taxable year has not expired 
before the date of the election, determined under paragraph (b) of this 
section. Thus, for example, a taxable

[[Page 582]]

year of a U.S. citizen beginning before January 1, 1967, is open for 
purposes of this subparagraph if, before the election under section 
981(c)(1) and Sec. 1.981-2, such citizen has never filed a return for 
such year and a return was required under section 6012 without reference 
to section 981. For example, if a U.S. citizen spouse on a calendar year 
basis who has never filed a return for 1960 decides in 1975 that he 
wishes to make the election under section 981(c)(1) and Sec. 1.981-2 in 
order to avoid being subject to tax for 1960 on his share of the 
community income for that year, he may in 1975 elect the benefits of 
section 981(c)(2) by filing an election in accordance with paragraph (c) 
of Sec. 1.981-2. In such case, a taxable year or years of the 
nonresident alien spouse of such citizen ending or beginning within 1960 
shall be treated in 1975 as an open taxable year.
    (2) Subparagraph (1) of this paragraph shall apply even though the 
period prescribed by section 6501 for assessing a deficiency against the 
nonresident alien spouse for his taxable year or years ending or 
beginning within the taxable year of the U.S. citizen has expired before 
the election is made.
    (3) If either spouse dies during a taxable year to which an election 
under Sec. 1.981-1 or Sec. 1.981-2 applies, the taxable year of the 
decedent and the surviving spouse shall be determined under this 
paragraph without regard to section 981(e)(4), relating to death of 
spouse during the taxable year. See paragraph (a)(2) of Sec. 1.443-1.
    (4) For definition of the term ``taxable year'', see section 441(b) 
and the regulations thereunder.
    (b) Date of election. (1) For purposes of Sec. 1.981-1 and this 
section the date of an election made under section 981(a) and Sec. 
1.981-1 is the date on which the return, amended return, or claim for 
refund required by paragraph (c)(1) of Sec. 1.981-1 is filed.
    (2) For purposes of Sec. 1.981-2 and this section the date of an 
election made under section 981(c)(1) and Sec. 1.981-2 is the date on 
which the returns, amended returns, or claims for refund, required by 
paragraph (c)(1) of Sec. 1.981-2 are filed.
    (3) For provisions treating timely mailing as timely filing, see 
section 7502 and the regulations thereunder.
    (c) Spouses with different taxable years. If the U.S. citizen and 
his nonresident alien spouse do not have the same taxable year, as 
defined in section 441(b) and the regulations thereunder, the election 
under Sec. 1.981-1 or Sec. 1.981-2 shall apply to each taxable year of 
such citizen in respect of which the election is made and to that period 
falling within the consecutive taxable years of the nonresident alien 
spouse which coincides with the period covered by such taxable year of 
the citizen.
    (d) Election on behalf of deceased spouse. Any election, statement, 
or request, required to be made under paragraph (c) of Sec. 1.981-1, or 
paragraph (c) of Sec. 1.981-2, by one of the spouses may, if such 
spouse is deceased, be made by the executor, administrator, or other 
person charged with the property of such deceased spouse.
    (e) Extension of period of limitations on assessment or refund--(1) 
Assessment of deficiency. Except as provided in subparagraph (3) of this 
paragraph, if an election under section 981(a) and Sec. 1.981-1, or 
under section 981(c)(1) and Sec. 1.981-2, is properly made, the period 
within which a deficiency may be assessed for any taxable year to which 
the election applies shall, to the extent the deficiency is attributable 
to the application of such election, not expire before one year after 
the date of the election, determined under paragraph (b) of this 
section.
    (2) Refund of tax. Except as provided in subparagraph (3) of this 
paragraph, if an election under section 981(a) and Sec. 1.981-1, or 
under section 981(c)(1) and Sec. 1.981-2, is properly made, the period 
within which a claim for credit or refund of an overpayment for any 
taxable year to which the election applies may be filed shall, to the 
extent the overpayment is attributable to the application of the 
election, not expire before one year after the date of the election, 
determined under paragraph (b) of this section.
    (3) Exception in case of nonelecting alien. Subparagraphs (1) and 
(2) of this paragraph shall not apply to any taxable year of a 
nonresident alien spouse who, in accordance with paragraph

[[Page 583]]

(a)(3) of Sec. 1.981-2, is not required to join in the election by the 
U.S. citizen spouse under section 981(c)(1) and Sec. 1.981-2.
    (f) Payment of interest for extension period. To the extent that an 
overpayment or deficiency for any taxable year is attributable to an 
election made under Sec. 1.981-1 or Sec. 1.981-2, no interest shall be 
allowed or paid for any period ending with the day before the date which 
is one year after the date of the election, determined under paragraph 
(b) of this section.

[T.D. 7330, 39 FR 38374, Oct. 31, 1974]



Sec. 1.985-0  Outline of regulation.

    This section lists the paragraphs contained in Sec. Sec. 1.985-1 
through 1.985-6.

                   Sec. 1.985-1 Functional currency.

    (a) Applicability and effective date.
    (b) Dollar functional currency.
    (c) Functional currency of a QBU that is not required to use the 
dollar.
    (d) Single functional currency for a foreign corporation.
    (e) Translation of nonfunctional currency transactions.
    (f) Examples.

Sec. 1.985-2 Election to use the United States dollar as the functional 
                           currency of a QBU.

    (a) Background and scope.
    (b) Eligible QBU.
    (c) Time and manner for dollar election.
    (d) Effect of dollar election.

  Sec. 1.985-3 United States dollar approximate separate transactions 
                                 method.

    (a) Scope and effective date.
    (b) Statement of method.
    (c) Translation into United States dollars.
    (d) Computation of DASTM gain or loss.
    (e) Effect of DASTM gain or loss on gross income, taxable income, or 
earnings and profits.

                   Sec. 1.985-4 Method of accounting.

    (a) Adoption or election.
    (b) Condition for changing functional currencies.
    (c) Relationship to certain other sections of the Code.

 Sec. 1.985-5 Adjustments required upon change in functional currency.

    (a) In general.
    (b) Step 1--Taking into account exchange gain or loss on certain 
section 988 transactions.
    (c) Step 2--Determining the new functional currency basis of 
property and the new functional currency amount of liabilities and any 
other relevant items.
    (d) Step 3A--Additional adjustments that are necessary when a branch 
changes functional currency.
    (e) Step 3B--Additional adjustments that are necessary when a 
taxpayer changes functional currency.
    (f) Examples.

    Section 1.985-6 Transition rules for a QBU that uses the dollar 
  approximate separate transactions method for its first taxable year 
                           beginning in 1987.

    (a) In general.
    (b) Certain controlled foreign corporations.
    (c) All other foreign corporations.
    (d) Pre-1987 section 902 amounts.
    (e) Net worth branch.
    (f) Profit and loss branch.

[T.D. 8263, 54 FR 38653, Sept. 20, 1989, as amended by T.D. 8464, 58 FR 
232, Jan. 5, 1993; T.D. 8556, 59 FR 37672, July 25, 1994]



Sec. 1.985-1  Functional currency.

    (a) Applicability and effective date--(1) Purpose and scope. These 
regulations provide guidance with respect to defining the functional 
currency of a taxpayer and each qualified business unit (QBU), as 
defined in section 989(a). Generally, a taxpayer and each QBU must make 
all determinations under subtitle A of the Code (relating to income 
taxes) in its respective functional currency. This section sets forth 
rules for determining when the functional currency is the United States 
dollar (dollar) or a currency other than the dollar. Section 1.985-2 
provides an election to use the dollar as the functional currency for 
certain QBUs that absent the election would have a functional currency 
that is a hyperinflationary currency, and explains the effect of making 
the election. Section 1.985-3 sets forth the dollar approximate separate 
transactions method that certain QBUs must use to compute their income 
or loss or earnings and profits. Section 1.985-4 provides that the 
adoption of a functional currency is a method of accounting and sets 
forth conditions for a change in functional currency. Section 1.985-5 
provides adjustments that are required to be made upon a change in 
functional currency. Finally, Sec. 1.985-6 provides transition rules 
for a QBU that uses the dollar approximate separate transactions method 
for its first

[[Page 584]]

taxable year beginning after December 31, 1986.
    (2) Effective date. These regulations apply to taxable years 
beginning after December 31, 1986. However, any taxpayer desiring to 
apply temporary Income Tax Regulations Sec. 1.985-0T through Sec. 
1.985-4T in lieu of these regulations to all taxable years beginning 
after December 31, 1986, and on or before October 20, 1989 may (on a 
consistent basis) so choose. For the text of the temporary regulations, 
see 53 FR 20308 (1988).
    (b) Dollar functional currency--(1) In general. The dollar shall be 
the functional currency of a taxpayer or QBU described in paragraph 
(b)(1)(i) through (v) of this section regardless of the currency used in 
keeping its books and records (as defined in Sec. 1.989(a)-1(d)). The 
dollar shall be the functional currency of--
    (i) A taxpayer that is not a QBU (e.g., an individual);
    (ii) A QBU that conducts its activities primarily in dollars. A QBU 
conducts its activities primarily in dollars if the currency of the 
economic environment in which the QBU conducts its activities is 
primarily the dollar. The facts and circumstances test set forth in 
paragraph (c)(2) of this section shall apply in making this 
determination;
    (iii) Except as otherwise provided by ruling or administrative 
pronouncement, a QBU that has the United States, or any possession or 
territory of the United States where the dollar is the standard 
currency, as its residence (as defined in section 988(a)(3)(B));
    (iv) A QBU that does not keep books and records in the currency of 
any economic environment in which a significant part of its activities 
is conducted. Whether a QBU keeps such books and records is determined 
in accordance with paragraph (c)(3) of this section; or
    (v) A QBU that produces income or loss that is, or is treated as, 
effectively connected with the conduct of a trade or business within the 
United States.
    (2) QBUs operating in a hyperinflationary environment--(i) Taxable 
years beginning on or before August 24, 1994. For taxable years 
beginning on or before August 24, 1994, see Sec. 1.985-2 with respect 
to a QBU that elects to use, or is otherwise required to use, the dollar 
as its functional currency.
    (ii) Taxable years beginning after August 24, 1994--(A) In general. 
For taxable years beginning after August 24, 1994, except as otherwise 
provided in paragraph (b)(2)(ii)(B) of this section, any QBU that 
otherwise would be required to use a hyperinflationary currency as its 
functional currency must use the dollar as its functional currency and 
compute income or loss or earnings and profits under the rules of Sec. 
1.985-3.
    (B) Exceptions--(1)--Certain QBU branches. The functional currency 
of a QBU that otherwise would be required to use a hyperinflationary 
currency as its functional currency and that is a branch of a foreign 
corporation having a non-dollar functional currency that is not 
hyperinflationary shall be the functional currency of the foreign 
corporation. Such QBU's income or loss or earnings and profits shall be 
determined under Sec. 1.985-3 by substituting the functional currency 
of the foreign corporation for the dollar.
    (2) Corporation that is not a controlled foreign corporation. A 
foreign corporation (or its QBU branch) operating in a hyperinflationary 
environment is not required to use the dollar as its functional currency 
pursuant to paragraph (b)(2)(ii)(A) of this section if that foreign 
corporation is not a controlled foreign corporation as defined in 
section 957 or 953(c)(1)(B). However, a noncontrolled section 902 
corporation, as defined in section 904(d)(2)(E), may elect to use the 
dollar (or, if appropriate, the currency specified in paragraph 
(b)(2)(ii)(B)(1) of this section) as its (or its QBU branch's) 
functional currency under the procedures set forth in Sec. 1.985-
2(c)(3).
    (C) Change in functional currency--(1) In general. If a QBU is 
required to change its functional currency to the dollar under paragraph 
(b)(2)(ii)(A) of this section, or chooses or is required to change its 
functional currency to the dollar for any open taxable year (and all 
subsequent taxable years) under Sec. 1.985-3(a)(2)(ii), the change is 
considered to be made with the consent of the Commissioner for purposes 
of Sec. 1.985-4. A QBU changing functional currency must make 
adjustments described in Sec. 1.985-7 if the year of change

[[Page 585]]

(as defined in Sec. 1.481-1(a)(1)) begins after 1987, or the 
adjustments described in Sec. 1.985-6 if the year of change begins in 
1987. No adjustments under section 481 are required solely because of a 
change in functional currency described in this paragraph (b)(2)(ii)(C).
    (2) Effective date. This paragraph (b)(2)(ii)(C) applies to taxable 
years beginning after April 6, 1998. However, a taxpayer may choose to 
apply this paragraph (b)(2)(ii)(C) to all open years after December 31, 
1986, provided each person, and each QBU branch of a person, that is 
related (within the meaning of Sec. 1.985-2(d)(3)) also applies to this 
paragraph (b)(2)(ii)(C).
    (D) Hyperinflationary currency. For purposes of sections 985 through 
989, the term hyperinflationary currency means the currency of a country 
in which there is cumulative inflation during the base period of at 
least 100 percent as determined by reference to the consumer price index 
of the country listed in the monthly issues of the ``International 
Financial Statistics'' or a successor publication of the International 
Monetary Fund. If a country's currency is not listed in the monthly 
issues of ``International Financial Statistics,'' a QBU may use any 
other reasonable method consistently applied for determining the 
country's consumer price index. Base period means, with respect to any 
taxable year, the thirty-six calendar months immediately preceding the 
first day of the current calendar year. For this purpose, the cumulative 
inflation rate for the base period is based on compounded inflation 
rates. Thus, if for 1991, 1992, and 1993, a country's annual inflation 
rates are 29 percent, 25 percent, and 30 percent, respectively, the 
cumulative inflation rate for the three-year base period is 110 percent 
[((1.29 x 1.25 x 1.3)-1.0 x 1.10) x 100 = 110%] and the currency of the 
country for the QBU's 1994 year is considered hyperinflationary. In 
making the determination whether a currency is hyperinflationary, the 
determination for purposes of United States generally accepted 
accounting principles may be used for income tax purposes provided the 
determination is based on criteria that is substantially similar to the 
rules previously set forth in this paragraph (b)(2)(ii)(D), the method 
of determination is applied consistently from year to year, and the same 
method is applied to all related persons as defined in Sec. 1.985-
3(e)(2)(vi).
    (E) Change in functional currency when currency ceases to be 
hyperinflationary--(1) In general. A QBU that has been required to use 
the dollar as its functional currency under paragraph (b)(2) of this 
section, or has elected to use the dollar as its functional currency 
under paragraph (b)(2)(ii)(B)(2) of this section or Sec. 1.985-2, must 
change its functional currency as of the first day of the first taxable 
year that follows three consecutive taxable years in which the currency 
of its economic environment, determined under paragraph (c)(2) of this 
section, is not a hyperinflationary currency. The functional currency of 
the QBU for such year shall be determined in accordance with paragraph 
(c) of this section. For purposes of Sec. 1.985-4, the change is 
considered to be made with the consent of the Commissioner. See Sec. 
1.985-5 for adjustments that are required upon a change in functional 
currency.
    (2) Effective Date. This paragraph (b)(2)(ii)(E) of this section 
applies to taxable years beginning after April 6, 1998.
    (c) Functional currency of a QBU that is not required to use the 
dollar--(1) General rule. The functional currency of a QBU that is not 
required to use the dollar under paragraph (b) of this section shall be 
the currency of the economic environment in which a significant part of 
the QBU's activities is conducted, if the QBU keeps, or is presumed 
under paragraph (c)(3) of this section to keep, its books and records in 
such currency.
    (2) Economic environment. For purposes of section 985 and the 
regulations thereunder, the economic environment in which a significant 
part of a QBU's activities is conducted shall be determined by taking 
into account all the facts and circumstances.
    (i) Facts and circumstances. The facts and circumstances that are 
considered in determining the economic environment in which a 
significant part of a QBU's activities is conducted include, but are not 
limited to, the following:

[[Page 586]]

    (A) The currency of the country in which the QBU is a resident as 
determined under section 988(a)(3)(B);
    (B) The currencies of the QBU's cash flows;
    (C) The currencies in which the QBU generates revenues and incurs 
expenses;
    (D) The currencies in which the QBU borrows and lends;
    (E) The currencies of the QBU's sales markets;
    (F) The currencies in which pricing and other financial decisions 
are made;
    (G) The duration of the QBU's business operations; and
    (H) The significance and/or volume of the QBU's independent 
activities.
    (ii) Rate of inflation. The rate of inflation (regardless of how it 
is determined) shall not be a factor used to determine a QBU's economic 
environment.
    (iii) Consistency. A taxpayer must consistently apply the facts and 
circumstances test set forth in this paragraph (c)(2) in evaluating the 
economic environment of its QBUs, e.g., its branches, that engage in the 
same or similar trades or businesses.
    (3) Books and records presumption. A QBU shall be presumed to keep 
books and records in the currency of the economic environment in which a 
significant part of its activities are conducted. The presumption may be 
overcome only if the QBU can demonstrate to the satisfaction of the 
district director that a substantial nontax purpose exists for not 
keeping any books and records in such currency. A taxpayer may not use 
this presumption affirmatively in determining a QBU's functional 
currency.
    (4) Multiple currencies. If a QBU has more than one currency that 
satisfies the requirements of paragraph (c)(1) of this section, the QBU 
may choose any such currency as its functional currency.
    (5) Relationship of United States accounting principles. In making 
the functional currency determination under this paragraph (c), the 
currency of the QBU for purposes of United States generally accepted 
accounting principles (GAAP) will ordinarily be accepted as the 
functional currency of the QBU for income tax purposes, provided that 
the GAAP determination is based on facts and circumstances substantially 
similar to those set forth in paragraph (c)(2) of this section.
    (6) Effect of changed circumstances. Regardless of any change in 
circumstances, a QBU may change its functional currency determined under 
this paragraph (c) only if the QBU complies with Sec. 1.985-4 or the 
Commissioner's consent is considered to have been granted under Sec. 
1.985-2(d)(4) or Sec. 1.985-3(a)(2)(ii). For special rules relating to 
the conversion to the euro, see Sec. 1.985-8.
    (d) Single functional currency for a foreign corporation--(1) 
General rule. This paragraph (d) applies to a foreign corporation that 
has two or more QBUs that do not have the same functional currency. The 
foreign corporation shall be treated as having a single functional 
currency for the corporation as a whole that is different from the 
functional currency of one or more of its QBUs. The determination of a 
foreign corporation's functional currency shall be made by first 
applying paragraph (d)(1)(i) and then paragraph (d)(l)(ii) of this 
section.
    (i) Step 1. Each QBU of the foreign corporation determines its 
functional currency in accordance with the rules set forth in paragraphs 
(b) and (c) of this section and Sec. 1.985-2.
    (ii) Step 2. The foreign corporation determines its functional 
currency applying the principles of paragraphs (b) and (c) of this 
section to the corporation's activities as a whole. Thus, if a foreign 
corporation has two branches, the corporation shall determine its 
functional currency by applying the principles of paragraphs (b) and (c) 
of this section to the combined activities of the corporation and the 
branches. For purposes of this paragraph (d)(1), if a QBU of a foreign 
corporation has the dollar as its functional currency under paragraph 
(b)(2) of this section, the QBU's activities shall be considered dollar 
activities of the corporation.
    (2) Translation of income or loss of QBUs having different 
functional currencies than the foreign corporation as a whole. Where the 
functional currency of a foreign corporation as a whole differs from the 
functional currency of one or more of its QBUs, each such

[[Page 587]]

QBU shall determine the amount of its income or loss or earnings and 
profits (or deficit in earnings and profits) in its functional currency 
under the principles of section 987 (relating to branch transactions). 
The amount of income or loss or earnings and profits (or deficit in 
earnings and profits) of each QBU in its functional currency shall then 
be translated into the foreign corporation's functional currency using 
the appropriate exchange rate as defined in section 989(b)(4) for 
purposes of determining the corporation's income or loss or earnings and 
profits (or deficit in earnings and profits).
    (e) Translation of nonfunctional currency transactions. Except for a 
QBU using the dollar approximate separate transactions method described 
in Sec. 1.985-3, see section 988 and the regulations thereunder for the 
treatment of nonfunctional currency transactions.
    (f) Examples. The provisions of this section are illustrated by the 
following examples:

    Example 1. P, a domestic corporation, operates exclusively through 
foreign branch X in Country A. X is a QBU within the meaning of section 
989(a) and its residence is Country A as determined under section 988 
(a)(3)(B). The currency of Country A is the LC. All of X's purchases, 
sales, and expenses are in the LC. The laws of A require X to keep books 
and records in the LC. It is determined that the LC is the currency of X 
under United States generally accepted accounting principles. This 
determination is based on facts and circumstances substantially similar 
to those set forth in paragraph (c)(2) of this section. Under these 
facts, while the functional currency of P is the dollar since its 
residence is the United States, the functional currency of X is the LC.
    Example 2. P, a publicly-held domestic regulated investment company 
(as defined under section 851), operates exclusively through foreign 
branch B in Country R. B is a QBU within the meaning of section 989(a) 
and its residence is Country R as determined under section 988(a)(3)(B). 
The currency of Country R is the LC. B's principal activities consist of 
purchasing and selling stock and securities of Country R companies and 
securities issued by Country R. It is determined that the dollar is the 
currency of B under United States generally accepted accounting 
principles. This determination is not based on facts and circumstances 
substantially similar to those set forth in paragraph (c)(2) of this 
section. Under these facts, while the functional currency of P is the 
dollar since its residence is the United States, B may choose the LC as 
its functional currency because it has significant activities in the LC 
provided it keeps books and records in the LC. The fact that the dollar 
is the currency of B under generally accepted accounting principles is 
irrelevant for purposes of determining B's functional currency because 
the GAAP determination was not based on factors similar to those set 
forth in paragraph (c)(2) of this section.
    Example 3. P, a domestic bank, operates through foreign branch X in 
Country R. X is a QBU within the meaning of section 989(a) and its 
residence is Country R as determined under section 988(a)(3)(B). The 
currency of Country R is the LC. The laws of R require X to keep books 
and records in the LC. The branch customarily loans dollars and LCs. In 
the case of its LC loans, X ordinarily fixes the terms of the loans by 
reference to a contemporary London Inter-Bank Offered Rate (LIBOR) on 
dollar deposits. For instance, the interest on the amount of the 
outstanding LC loan principal might equal LIBOR plus 2 percent and the 
amount of the outstanding LC loan principal would be adjusted to reflect 
changes in the dollar value of the LC. X is primarily funded with 
dollar-denominated funds borrowed from related and unrelated parties. 
X's only LC activities are paying local taxes, employee wages, and local 
expenses such as rent and electricity. Under these facts, X's activities 
are primarily conducted in dollars. Thus, although X keeps its books and 
records in LCs, X's functional currency is the dollar.
    Example 4. S, a foreign corporation organized in Country U, is 
wholly-owned by P, a domestic corporation. The currency of Country U is 
the LC. S's sole function is acting as a financing vehicle for P and 
domestic corporations that are affiliated with P. All borrowing and 
lending transactions between S and P and its domestic affiliates are in 
dollars. Furthermore, primarily all of S's other borrowings are dollar-
denominated or based on a dollar index. S's only LC activities are 
paying local taxes, employee wages, and local expenses such as rent and 
electricity. S keeps its books and records in the LC. Under these facts, 
S's activities are primarily conducted in dollars. Thus, although S 
keeps its books and records in LCs, S's functional currency is the 
dollar.
    Example 5. D is a domestic corporation whose primary activity is the 
extraction of natural gas and oil through foreign branch X in Country Y. 
X is a QBU within the meaning of section 989(a) and its residence is 
Country Y as determined under section 988(a)(3)(B). The currency of 
Country Y is the LC. X bills a significant amount of its natural gas and 
oil sales in dollars and a significant amount in LCs. X also incurs 
significant LC and dollar expenses and liabilities. The laws of Country 
Y require X to keep its books and records in the LC. It is determined 
that the

[[Page 588]]

LC is the currency of X under United States generally accepted 
accounting principles. This determination is based on facts and 
circumstances substantially similar to those set forth in paragraph 
(c)(2) of this section. Absent other factors indicating that X primarily 
conducts its activities in the dollar, D could choose either the dollar 
or the LC as X's functional currency because X has significant 
activities in both the dollar and the LC, provided the books and records 
requirement is satisfied. If, instead, X's activities were determined to 
be primarily in the dollar, then X would have to use the dollar as its 
functional currency.
    Example 6. S, a foreign corporation organized in Country U, is 
wholly-owned by P, a domestic corporation. The currency of U is the LC. 
S purchases the products it sells from related and unrelated parties, 
including P. These purchases are made in the LC. In addition, most of 
S's gross receipts are generated by transactions denominated in the LC. 
S attempts to determine its LC price for goods sold in such a manner as 
to obtain an LC equivalent of a certain dollar amount after reduction 
for all LC costs. However, local market conditions sometimes result in 
pricing adjustments. Thus, changes in the LC-dollar exchange rate from 
period to period generally result in corresponding changes in the LC 
price of S's products. S pays local taxes, employee wages, and other 
local expenses in the LC. It is determined that the dollar is the 
currency of S under United States generally accepted accounting 
principles. This determination is not based on facts and circumstances 
substantially similar to those set forth in paragraph (c)(2) of this 
section. Under these facts, S could choose either the dollar or the LC 
as its functional currency because S has significant activities in both 
the dollar and the LC, provided that the books and records requirement 
is satisfied.
    Example 7. S, a foreign corporation organized in Country X, is 
wholly-owned by P, a domestic corporation. S conducts all of its 
operations through two branches. Branch A is located in Country F and 
branch B is located in Country G. S, A, and B are QBUs within the 
meaning of section 989(a). Branch A's and branch B's residences are 
Country F and Country G respectively as determined under section 
988(a)(3)(B). The currency of Country F is the FC and the currency of 
Country G is the LC. The functional currencies of S, A, and B are 
determined in a two step procedure.
    Step 1: The functional currency of branches A and B. Branch A and 
branch B both conduct all activities in their respective local 
currencies. The FC is the currency of branch A and the LC is the 
currency of branch B under United States generally accepted accounting 
principles. This determination is based on facts and circumstances 
substantially similar to those set forth in paragraph (c)(2) of this 
section. Under these facts, the functional currency of branch A is the 
FC and the functional currency of branch B is the LC.
    Step 2: The functional currency of S. S's functional currency is 
determined by disregarding the fact that A and B are branches. When A's 
activities and B's activities are viewed as a whole, S determines that 
it only conducts significant activities in the LC. Therefore, S's 
functional currency is the LC. See Examples 9, 10, and 11 for how the 
earnings and profits of a foreign corporation, which has branches with 
different functional currencies, are determined.
    Example 8. Assume the same facts as in Example 7, except that S does 
not exist and P conducts all of its operations through branch A and 
branch B. In this instance P's functional currency in Step 2 is the 
dollar, regardless of the fact that its branches' activities viewed as a 
whole are in the LC, because P is a taxpayer whose residence is the 
United States under section 988(a)(3)(B)(i). Therefore, while the 
functional currency of branch A is the FC and the functional currency of 
branch B is the LC, the functional currency of P is the dollar because 
its residence is the United States.
    Example 9. The facts are the same as in Example 7. ln addition, 
assume that in 1987 branch A has earnings of 100 FC and branch B has 
earnings of 100 LC as determined under section 987. The weighted average 
exchange rate for the year is 1 FC/2 LC. Branch A's earnings are 
translated into 200 LC for purposes of computing S's earnings and 
profits in 1987. Thus, the total earnings and profits of S from branch A 
and branch B for 1987 is 300 LC.
    Example 10. (i) X, a foreign corporation organized in Country W, is 
wholly-owned by P, a domestic corporation. Both X and P are calendar 
year taxpayers that began business during 1987. X operates exclusively 
through two branches, A and B both of which are located outside of 
Country W. The functional currency of X and A is the LC, while the 
functional currency of B is the DC as determined under section 985 and 
Sec. 1.985-1. The earnings of B must be computed under section 987, 
relating to branch transactions. In 1987, A earns 900 LCs of nonsubpart 
F income and B earns 200 DCs of nonsubpart F income. Under section 
904(d)(2), A's income is financial service income and B's income is 
general limitation income. In order to determine X's earnings and 
profits, B's income must be translated into LCs (the functional currency 
of X). The weighted average exchange rate for 1987 is 1 LC/2 DC. Thus, 
in 1987 X's current earnings and profits (and its post-1986 
undistributed earnings) are 1000 LCs consisting of 900 LCs of financial 
services income earned by A and 100 LCs (200 DC/2) of

[[Page 589]]

general limitation income earned by B. Neither A nor B makes any 
remittances during 1987.
    (ii) In 1988, neither A nor B earns any income or generates any 
loss. On December 31, 1988, A remits 50 LCs directly to P. The 
remittance to P is considered to be remitted by A to X and then 
immediately distributed by X as a dividend. The 50 LC remittance does 
not result in an exchange gain or loss under section 987 to X because 
the functional currency of X and A is the LC. See section 987(3). Under 
section 904(d)(3)(D), the 50 LC dividend is treated as income in a 
separate category to the extent of the dividend's pro rata share of X's 
earnings and profits in each separate limitation category. Thus, 90 
percent, or 45 LCs, is treated as financial services income, and 10 
percent, or 5 LCs, is treated as general limitation income. After the 
dividend distribution, X has 950 LCs of accumulated earnings and profits 
(and post-1986 undistributed earnings) consisting of 855 LCs of 
financial service limitation income and 95 LCs of general limitation 
income.
    Example 11. The facts are the same as in Example 10, except that A 
makes no remittance during 1988 but B remits 120 DCs to X on December 
31, 1988, which X immediately converts into LCs, and X makes no dividend 
distribution during 1988. Assume that the appropriate exchange rate for 
the remittance is 1 LC/3 DCs. B's remittance triggers exchange loss to 
X. See section 987(3). Under section 987, the exchange loss on the 
remittance is 20 LCs calculated as follows: 40 LCs, which is the LC 
value of the 120 DC remittance (120 DCs/3), less 60 LCs, their LC basis 
(120 DCs/2). This loss is sourced and characterized under section 987 
and regulations thereunder.
    Example 12. F, a foreign corporation, has gain from the disposition 
of a United States real property interest (as defined in section 
897(c)). The gain is taken into account as if F were engaged in a trade 
or business within the United States during the taxable year and as if 
such gain were effectively connected with such trade or business. F's 
disposition activity shall be treated as a separate QBU with a dollar 
functional currency because such activity produced income that is 
treated as effectively connected with a trade or business within the 
United States. Therefore, F must compute its gain from the disposition 
by giving the United States real property interest an historic dollar 
basis.

[T.D. 8263, 54 FR 38653, Sept. 20, 1989, as amended by T.D. 8556, 59 FR 
37672, July 25, 1994; T.D. 8765, 63 FR 10774, Mar. 5, 1998; 63 FR 15760, 
Apr. 1, 1998; T.D. 8776, 63 FR 40368, July 29, 1998; T.D. 8927, 66 FR 
2216, Jan. 11, 2001]



Sec. 1.985-2  Election to use the United States dollar as the functional
currency of a QBU.

    (a) Background and scope--(1) In general. This section permits an 
eligible QBU to elect to use the dollar as its functional currency for 
taxable years beginning on or before August 24, 1994. An election to use 
a dollar functional currency is not permitted for a QBU other than an 
eligible QBU. Paragraph (b) of this section defines an eligible QBU. 
Paragraph (c) of this section describes the time and manner for making 
the dollar election and paragraph (d) of this section describes the 
effect of making the election. For the definition of a QBU, see section 
989(a). See Sec. 1.985-1(b)(2)(ii) for rules requiring a QBU to use the 
dollar as its functional currency in taxable years beginning after 
August 24, 1994.
    (2) Exception. Pursuant to Sec. 1.985-1(b)(2)(ii)(B)(2), the rules 
of paragraph (c)(3) of this section shall apply with respect to the 
procedure required to be followed by a noncontrolled section 902 
corporation as defined in section 904(d)(2)(E) to elect the dollar as 
its (or its QBU branch's) functional currency and the application of 
Sec. 1.985-3.
    (b) Eligible QBU--(1) In general. The term ``eligible QBU'' means a 
QBU that could have used a hyperinflationary currency as its functional 
currency absent the dollar election. See Sec. 1.985-1 for how a QBU 
determines its functional currency absent the dollar election.
    (2) Hyperinflationary currency. See Sec. 1.985-1(b)(2)(ii)(D) for 
the definition of hyperinflationary currency.
    (c) Time and manner for dollar election--(1) QBUs that are branches 
of United States persons--(i) Rule. If an eligible QBU is a branch of a 
United States person, the dollar election shall be made by attaching a 
completed Form 8819 to the United States person's timely filed (taking 
extensions into account) tax return for the first taxable year for which 
the election is to be effective.
    (ii) Procedure prior to the issuance of Form 8819. In the absence of 
Form 8819, the election shall be made in accordance with Sec. 1.985-
2T(c)(1). Failure to file an amended return within the time period 
prescribed in Sec. 1.985-2T(c)(1) shall not invalidate the dollar 
election if it

[[Page 590]]

is established to the satisfaction of the district director that 
reasonable cause existed for such failure. A subsequent election for 
1988 will not prejudice the taxpayer with respect to such reasonable 
cause determination. Nevertheless, each United States person making an 
election under the Sec. 1.985-2T(c)(1) must file a Form 8819 in the 
time and manner provided in the Form's instructions.
    (2) Eligible QBUs that are controlled foreign corporations or 
branches of controlled foreign corporations--(i) Rule. If an eligible 
QBU is a controlled foreign corporation (as described in section 957), 
or a branch of a controlled foreign corporation, the election may be 
made either by the foreign corporation or by the controlling United 
States shareholders on behalf of the foreign corporation by--
    (A) Filing a completed Form 8819 in the time and manner provided in 
the Form's instructions, and
    (B) Providing the written notice required by paragraph (c)(2)(ii) of 
this section at the time and in the manner prescribed therein.


The term controlling United States shareholders means those United 
States shareholders (as defined in section 951(b)) who, in the 
aggregate, own (within the meaning of section 958(a)) greater than 50 
percent of the total combined voting power of all classes of stock of 
the foreign corporation entitled to vote. If the foreign corporation is 
a controlled foreign corporation (as described in section 957) but the 
United States shareholders do not, in the aggregate, own the requisite 
voting power, the term ``controlling United States shareholders'' means 
all the United States shareholders (as defined in section 951(b)) who 
own (within the meaning of section 958(a)) stock of the controlled 
foreign corporation.
    (ii) Notice. Prior to filing Form 8819, the controlling United 
States shareholders (or the foreign corporation, if the dollar election 
is made by the corporation) shall provide written notice that the dollar 
election will be made to all United States persons known to be 
shareholders who own (within the meaning of section 958(a)) stock of the 
foreign corporation. Such notice shall also include all information 
required in Form 8819.
    (iii) Reasonable cause exception. Failure of the controlling United 
States shareholders (or the foreign corporation, if the dollar election 
is made by the corporation) to timely file Form 8819 or provide written 
notice to a United States person required to be notified by paragraph 
(c)(2)(ii) of this section shall not invalidate the dollar election, if 
it is established to the satisfaction of the district director that 
reasonable cause existed for such failure.
    (iv) Procedure prior to the issuance of Form 8819. In the absence of 
Form 8819, an eligible QBU described in paragraph (c)(2)(i) of this 
section shall make the dollar election in accordance with Sec. 1.985-
2T(c)(2). Nevertheless, the person or persons that made such election 
must file a Form 8819 in the time and manner provided in the Form's 
instructions.
    (3) Eligible QBUs that are noncontrolled foreign corporations or 
branches of noncontrolled foreign corporations--(i) Rule. If an eligible 
QBU is a noncontrolled foreign corporation (a foreign corporation not 
described in section 957), or a branch of a noncontrolled foreign 
corporation, the dollar election must be made by the corporation or the 
majority domestic corporate shareholders on behalf of the corporation by 
applying the rules provided in paragraph (c)(2)(i)(A) and (B), (ii), 
(iii), and (iv) of this section substituting ``majority domestic 
corporate shareholders'' for ``controlling United States shareholders'' 
wherever it appears therein. The term ``majority domestic corporate 
shareholders'' means those domestic corporate shareholders (as described 
in section 902(a)) who, in the aggregate, own (within the meaning of 
section 958(a)) greater than 50 percent of the total combined voting 
stock of all classes of stock of the noncontrolled foreign corporation 
entitled to vote that is owned (within the meaning of section 958(a)) by 
all the domestic corporate shareholders.
    (ii) Procedure prior to the issuance of Form 8819. In the absence of 
Form 8819, an eligible QBU described in paragraph (c)(3)(i) of this 
section shall make the dollar election in accordance with

[[Page 591]]

Sec. 1.985-2T(c)(3). Nevertheless, the person or persons that made such 
election must file a Form 8819 in the time and manner provided in the 
Form's instructions.
    (4) Others. Any other person making a dollar election under this 
section shall elect by filing Form 8819 and fulfilling any other notice 
requirements that may be required by the Commissioner.
    (d) Effect of dollar election--(1) General rule. If a dollar 
election is made (or considered made under paragraph (d)(3) of this 
section) by or on behalf of an eligible QBU, the QBU shall be deemed to 
have the dollar as its functional currency. Each United States person 
that owns (within the meaning of section 958(a)) stock of a foreign 
corporation which has the dollar as its functional currency under Sec. 
1.985-2 must make all of its federal income tax calculations with 
respect to the foreign corporation using the dollar as the corporation's 
functional currency (regardless of when ownership was acquired or 
whether the United States person received the written notice required by 
paragraph (c)(2)(i)(B) of this section).
    (2) Computation--(i) In general. Except as provided in paragraph 
(d)(2)(ii) of this section, any eligible QBU that pursuant to this Sec. 
1.985-2 has a dollar functional currency must compute income or loss or 
earnings and profits (or deficit in earnings and profits) in dollars 
using the dollar approximate separate transactions method described in 
Sec. 1.985-3.
    (ii) Alternative method. An eligible QBU that has a dollar 
functional currency pursuant to this Sec. 1.985-2 may use a method 
other than the dollar approximate separate transactions method described 
in Sec. 1.985-3 only if the QBU demonstrates to the satisfaction of the 
Commissioner that it can properly employ such method. Generally, the QBU 
must show that it could compute foreign currency gain or loss under the 
principles of section 988 with respect to each of its section 988 
transactions. If subsequently the QBU can no longer demonstrate to the 
satisfaction of the district director that it can properly employ such 
an alternative method, then the QBU will be deemed to have changed its 
method of accounting to the dollar approximate separate transactions 
method described in Sec. 1.985-3. This change in accounting will be 
treated as having been made with the consent of the Commissioner. No 
adjustments under either Sec. 1.985-5T (or any succeeding final 
regulation) or section 481(a) shall be required solely because of the 
change. Rather the QBU shall begin accounting for its operations under 
Sec. 1.985-3 based on its dollar books and records as of the time of 
the change.
    (3) Conformity--(i) General rule. If a dollar election is made under 
this Sec. 1.985-2 for an eligible QBU (``electing QBU''), then the 
dollar shall be the functional currency of any related person 
(regardless of when such person became related to the electing QBU) that 
is an eligible QBU, or any branch of any such related person that is an 
eligible QBU. For purposes of the preceding sentence, the term ``related 
person'' means any person with a relationship defined in section 267 (b) 
to the electing QBU (or to the United States or foreign person of which 
the electing QBU is a part). In determining whether two or more 
corporations are members of the same controlled group under section 
267(b)(3), a person is considered to own stock owned directly by such 
person, stock owned with the application of section 1563(e)(1), and 
stock owned with the application of section 267(c).
    (ii) Branches of United States and foreign persons. If a dollar 
election is made for a QBU branch of any person, each eligible QBU 
branch of such person shall have the dollar as its functional currency.
    (4) Required adjustments. If an eligible QBU's functional currency 
changes due to a dollar election, or due to the conformity requirements 
of paragraph (d)(3) of this section, such change shall be deemed for 
purposes of Sec. 1.9B5-4 to be consented to by the Commissioner. No 
adjustments under section 481(a) shall be required solely because of the 
change. However, the QBU must make those adjustments required by Sec. 
1.985-5T (or any succeeding final regulation).
    (5) Taxable year conformity required. Generally, the adjustments 
required by paragraph (d)(4) of this section shall be made for a related 
person's taxable year--

[[Page 592]]

    (i) That includes the date in which the electing QBU made the dollar 
election if the person was related to such electing QBU at any time 
during the QBU's taxable year that includes such date, or
    (ii) During which the person first becomes related to any electing 
QBU, in all other cases.


For purposes of this paragraph (d)(5), the date in which the electing 
QBU makes the dollar election shall be the last day of the electing 
QBU's taxable year. The district director may permit the related party 
to make such adjustments beginning one taxable year later if, in the 
district director's sole judgment, reasonable cause exists for the 
related party not being able to make the required adjustments for the 
earlier year.
    (6) Availability of election. A dollar election may be made by or on 
behalf of a QBU, or considered made under the conformity rule of 
paragraph (d)(3), in any year in which the QBU is an eligible QBU. If a 
dollar election is not made by or on behalf of a QBU for its first 
taxable year beginning after December 31, 1986 in which it is an 
eligible QBU, then any dollar election made by or on behalf of the QBU, 
or considered made under the conformity rules of paragraph (d)(3) of 
this section, that results in a change in the QBU's functional currency 
shall be treated as having been made with the consent of the 
Commissioner. In such a case, however, the taxpayer must make those 
adjustments required by Sec. 1.985-5T (or any succeeding final 
regulation).
    (7) Effect of changed circumstances. Regardless of any change in 
circumstances (e.g., a currency ceases to qualify as hyperinflationary), 
a QBU whose functional currency is the dollar under this section may 
change its functional currency only if the QBU complies with Sec. 
1.985-4.
    (8) Examples. The provisions of this section are illustrated by the 
following examples.

    Example 1. X is a calendar year domestic corporation that in 1987 
establishes a branch, A, in Country Z. A's functional currency under 
sections 985(b)(1) and (2) and Sec. 1.985-1 is the ``h'', the currency 
of Country Z. The cumulative inflation in Country Z exceeds 100 percent 
for the thirty-six months prior to January 1987, as measured by the 
consumer price index of Country Z listed in the monthly issues of the 
``International Financial Statistics''. Accordingly, A is an eligible 
QBU in 1987 because the h is a hyperinflationary currency. Thus, X may 
elect the dollar as the functional currency of A for 1987.
    Example 2. The facts are the same as in Example (1). X does not 
elect the dollar as the functional currency of A for 1987. Rather, X 
elects the dollar as the functional currency of A for l991, a year A is 
an eligible QBU. The election constitutes a change in A's functional 
currency that is made with the consent of the Commissioner. However, A 
must make the adjustments required under Sec. 1.985-5T (or any 
succeeding final regulation).
    Example 3. X is a domestic corporation that establishes A, an 
eligible QBU branch. X is wholly owned by domestic corporation Y. Y has 
an eligible QBU branch, B. Both X and Y are calendar year taxpayers. X 
makes a dollar election for A in 1987. Thus, A is an electing QBU. X and 
Y are related persons as defined in section 267(b) (i.e., Y has a 
relationship under section 267(b)(3) to X, the corporation of which A is 
a part). Therefore, the dollar election by X for A in 1987 results in B, 
the eligible QBU branch of Y, also having the dollar as its functional 
currency for 1987.
    Example 4. The facts are the same as in Example 3, except that Y 
does not have an eligible QBU branch but owns all the stock of C, a 
calendar year controlled foreign corporation, which is not itself an 
eligible QBU but which has an eligible QBU branch, D. X and C are 
related persons as defined in section 267(b) (i.e., C has a relationship 
under section 267(b)(3) to X, the corporation of which A is a part). 
Therefore, the dollar election by X for A in 1987 results in D, the 
eligible QBU branch of C, also having the dollar as its functional 
currency for 1987.
    Example 5. X, whose taxable year ends September 30, is an eligible 
QBU that does not use the dollar as its functional currency. X is 
wholly-owned by domestic corporation W. On January 1, 1989, X acquires 
all the stock of Y, an unrelated eligible QBU that made the dollar 
election under Sec. 1.985-2. Y is a calendar year taxpayer. After the 
stock purchase, X and Y are related persons as defined in section 
267(b). Under Sec. Sec. 1.985-2(d)(3) and (5), the dollar shall be the 
functional currency of X, any person related to X, and any branch of 
such related person that is an eligible QBU beginning with the taxable 
year that includes December 31, 1989. Thus, X must change to the dollar 
for its taxable year beginning October 1, 1988. However, the district 
director may allow X to change to the dollar for its taxable year 
beginning October 1, 1989, provided reasonable cause exists. Those

[[Page 593]]

QBUs changing to the dollar as their functional currency as the result 
of the conformity requirements must make the adjustments required under 
Sec. 1.985-5T (or any succeeding final regulation).
    Example 6. The facts are the same as in Example 5, except that 
before X purchased the Y stock, X made the dollar election under Sec. 
1.985-2 but Y did not use the dollar as its functional currency. Under 
Sec. Sec. 1.985-2(d)(3) and (5) the dollar shall be the functional 
currency of Y, any person related to Y, and any branch of such related 
person that is an eligible QBU beginning with the taxable year that 
includes September 30, 1989. Thus, Y must change to the dollar for its 
taxable year beginning January 1, 1989. However the district director 
may allow Y to change to the dollar for its taxable year beginning 
January 1, 1990, provided reasonable cause exists. Those QBUs changing 
to the dollar as their functional currency as the result of the 
conformity requirements must make the adjustments required under Sec. 
1.985-5T (or any succeeding final regulation).

[T.D. 8263, 54 FR 38656, Sept. 20, 1989, as amended by T.D. 8556, 59 FR 
37673, July 25, 1994]



Sec. 1.985-3  United States dollar approximate separate transactions
method.

    (a) Scope and effective date--(1) Scope. This section describes the 
United States dollar (dollar) approximate separate transactions method 
of accounting (DASTM). For all purposes of subtitle A, this method of 
accounting must be used to compute the gross income, taxable income or 
loss, or earnings and profits (or deficit in earnings and profits) of a 
QBU (as defined in section 989(a)) that has the dollar as its functional 
currency pursuant to Sec. 1.985-1(b)(2).
    (2) Effective date--(i) In general. This section is effective for 
taxable years beginning after August 24, 1994.
    (ii) DASTM prior-year election. A taxpayer may elect to apply this 
section to any open taxable year beginning after December 31, 1986 
(whether or not DASTM has been previously elected for some or all of 
those years). In order to make this election, the taxpayer must apply 
Sec. 1.985-3 to that year and all subsequent years. In addition, each 
person that is related (within the meaning of Sec. 1.985-3(e)(2)(vi)) 
to the taxpayer on the last day of any taxable year for which the 
election is effective and that would have been eligible to elect DASTM 
must also apply these rules to that year and all subsequent years. A 
taxpayer that has not previously elected to apply DASTM to its prior 
taxable years may make the DASTM election for the pertinent years by 
filing amended returns and complying with the applicable election 
procedures of Sec. 1.985-2. Form 8819 shall be attached to the return 
for the first year for which the election is to be effective. A taxpayer 
that has elected DASTM for prior taxable years and applied the rules 
under Sec. 1.985-3 (as contained in the April 1, 1994 edition of 26 CFR 
part 1 (1.908 to 1.1000)) may amend its returns to apply the rules of 
this Sec. 1.985-3. In either case, the DASTM election for prior taxable 
years shall be deemed to be made with the consent of the Commissioner.
    (b) Statement of method. Under DASTM, income or loss or earnings and 
profits (or a deficit in earnings and profits) of a QBU for its taxable 
year shall be determined in dollars by--
    (1) Preparing an income or loss statement from the QBU's books and 
records (within the meaning of Sec. 1.989(a)-1(d)) as recorded in the 
QBU's hyperinflationary currency (as defined in Sec. 1.985-
1(b)(2)(ii)(D));
    (2) Making the adjustments necessary to conform such statement to 
United States generally accepted accounting principles and tax 
accounting principles (including reversing monetary correction 
adjustments required by local accounting principles);
    (3) Translating the amounts of hyperinflationary currency as shown 
on such adjusted statement into dollars in accordance with paragraph (c) 
of this section; and
    (4) Adjusting the resulting dollar income or loss or earnings and 
profits (or deficit in earnings and profits) and, where necessary, 
particular items of gross income, deductible expense or other amounts, 
in accordance with paragraph (e) of this section to reflect the amount 
of DASTM gain or loss as determined under paragraph (d) of this section.
    (c) Translation into United States dollars--(1) In general. Except 
as otherwise provided in this paragraph (c), the amounts shown on the 
income or loss statement, as adjusted under paragraph (b)(2) of this 
section, shall be

[[Page 594]]

translated into dollars at the exchange rate (as defined in paragraph 
(c)(6) of this section) for the translation period (as defined in 
paragraph (c)(7) of this section) to which they relate. However, if the 
QBU previously changed its functional currency to the dollar, and the 
rules of Sec. 1.985-5 (or, if applicable, Sec. 1.985-5T, as contained 
in the April 1, 1993 edition of 26 CFR part 1 (1.908 to 1.1000)) applied 
in translating its balance sheet amounts into dollars, then the spot 
exchange rate applied under those rules shall be used to translate any 
amount that would otherwise be translated at a rate determined by 
reference to a translation period prior to the change in functional 
currency. For example, depreciation with respect to an asset acquired 
while the QBU had a nondollar functional currency shall be translated 
into dollars at the spot rate on the last day of the taxable year before 
the year of change to a dollar functional currency, rather than at the 
rate for the period in which the asset was acquired.
    (2) Cost of goods sold. The dollar value of cost of goods sold shall 
equal the sum of the dollar values of beginning inventory and purchases 
less the dollar value of closing inventory as these amounts are 
determined under paragraph (c)(3) of this section.
    (3) Beginning inventory, purchases, and closing inventory--(i) 
Beginning inventory. Amounts representing beginning inventory shall be 
translated so as to obtain the same amount of dollars which represented 
such items in the closing inventory balance for the preceding taxable 
year.
    (ii) Purchases. Amounts representing items purchased or otherwise 
first included in inventory during the taxable year shall be translated 
at the exchange rate for the translation period in which the cost of 
such items was incurred.
    (iii) Closing inventory--(A) In general. Amounts representing items 
included in the closing inventory balance shall be translated at the 
exchange rate for the translation period in which the cost of such items 
was incurred. However, if amounts representing items included in the 
closing inventory balance are either valued at market or written down to 
market value, they shall be translated at the exchange rate existing on 
the last day of the taxable year. For purposes of determining lower of 
cost or market, items of inventory included in the closing inventory 
balance shall be translated into dollars at the exchange rate for the 
translation period in which the cost of such items was incurred and 
compared with market as determined in the QBU's hyperinflationary 
currency translated into dollars at the exchange rate existing on the 
last day of the taxable year.
    (B) Determination of translation period. The method used to 
determine the translation period of amounts representing items of 
closing inventory for purposes of paragraph (c)(3)(iii)(A) of this 
section may be based upon reasonable approximations and averages, 
including rates of turnover, provided that the method is used 
consistently from year to year.
    (4) Depreciation, depletion, and amortization. Amounts representing 
allowances for depreciation, depletion, or amortization shall be 
translated at the exchange rate for the translation period in which the 
cost of the underlying asset was incurred, except as provided in 
paragraph (c)(1) of this section.
    (5) Prepaid expenses or income. Amounts representing expense or 
income paid or received in a prior taxable year shall be translated at 
the exchange rate for the translation period during which they were paid 
or received.
    (6) Exchange rate. The exchange rate for a translation period may be 
determined under any reasonable method, provided that the method is 
consistently applied to all translation periods and conforms to the 
taxpayer's method of financial accounting. Reasonable methods include 
the average of beginning and ending exchange rates for the translation 
period and the spot rate on the last day of the translation period. Once 
chosen, a method for determining an exchange rate can be changed only 
with the consent of the district director.
    (7) Translation period--(i) In general. Except as provided in 
paragraphs (c)(3)(iii)(B) and (c)(7)(ii) of this section, a translation 
period shall be each month within a QBU's taxable year.

[[Page 595]]

    (ii) Exception. A taxpayer may divide its taxable year into 
translation periods of equal length (with not more than one short period 
annually) that are less than one month. Once such a translation period 
is established, it may not be changed without the consent of the 
district director.
    (8) Dollar transactions--(i) In general. Except as provided in 
paragraph (c)(8)(ii) of this section, no DASTM gain or loss is realized 
with respect to dollar transactions since the dollar is the functional 
currency of the QBU. Thus, the amount of any payment or receipt of 
dollars shall be reflected in the income or loss statement by the amount 
of such dollars. Also, the income or loss attributable to any 
transaction in which the amount that a QBU is entitled to receive (or is 
required to pay) by reason of such transaction is denominated in terms 
of the dollar, or is determined by reference to the value of the dollar, 
must be computed transaction by transaction. For example, if a foreign 
corporation lends 20 LC when 20 LC = $20 and is entitled to receive the 
LC equivalent of $20 at maturity plus a market rate of interest in 
dollars (or its LC equivalent), the loan is a dollar transaction. 
Similarly, this paragraph applies to any transaction that is determined 
to be a dollar transaction under section 988.
    (ii) Non-dollar functional currency. If pursuant to Sec. 1.985-
1(b)(2)(ii)(B)(1), a QBU is required to use a functional currency other 
than the dollar, then that currency shall be substituted for the dollar 
in applying paragraph (c)(8)(i) of this section.
    (9) Third currency transactions. A taxpayer may use any reasonable 
method of accounting for transactions described in sections 988(c)(1)(B) 
and (C) that are denominated in, or determined by reference to, a 
currency other than the QBU's hyperinflationary currency or the dollar 
(third currency transactions) so long as such method is consistent with 
its method of financial accounting.
    (10) Examples. The provisions of this paragraph (c) are illustrated 
by the following examples:

    Example 1. S is an accrual basis QBU that is required to use the 
dollar as its functional currency for its first taxable year beginning 
in 1994. S's hyperinflationary currency is the ``h.'' During 1994, S 
accrues 100 dollars attributable to dollar-denominated sales. Because 
this is a dollar transaction under paragraph (c)(8) of this section, S's 
income or loss for 1994 shall reflect the 100 dollars (not the 
hyperinflationary value of such dollars when accrued).
    Example 2. (i) S is an accrual basis QBU that is required to use the 
dollar as its functional currency for its first taxable year beginning 
in 1994. S's hyperinflationary currency is the ``h.'' During 1994, S's 
sales amounted to 240,000,000h, its currently deductible expenses were 
26,000,000h, and its total inventory purchases amounted to 100,000,000h. 
During January and February of 1994, S purchased depreciable assets for 
80,000,000h and was allowed depreciation of 4,000,000h. At the end of 
1994, S's closing inventory was 23,000,000h. No election to use a 
translation period other than the month is made, S had no transactions 
described in paragraph (c)(8) or (c)(9) of this section, and S's closing 
inventory was computed on the first-in, first-out inventory method. S's 
adjusted income or loss statement for 1994 is translated into dollars as 
follows:

----------------------------------------------------------------------------------------------------------------
                                                                  Hyperinflationary   Exchange    United States
                                                                       currency         rate         dollars
----------------------------------------------------------------------------------------------------------------
                              Sales
 
(Jan.-Feb.).....................................................       10,000,000h     \1\ 20:1        $500,000
(Mar.-Apr.).....................................................        20,000,000         21:1         952,381
(May.-June.)....................................................        50,000,000         22:1       2,272,727
(July)..........................................................        50,000,000         23:1       2,173,913
(August)........................................................        20,000,000         26:1         769,231
(Sept.).........................................................        20,000,000         28:1         714,286
(Oct.)..........................................................        20,000,000         29:1         689,655
(Nov.)..........................................................        20,000,000         30:1         666,667
(Dec.)..........................................................        30,000,000         31:1         967,742
                                                                 -------------------            ----------------
      Total.....................................................      240,000,000h   ..........       9,706,602
 
                       Cost of Goods Sold
 
Opening Inventory Purchases:                                                     0   ..........               0
    (Jan.-Feb.).................................................       15,000,000h         20:1         750,000
    (Mar.-Apr.).................................................        10,000,000         21:1         476,190
    (May-June)..................................................        30,000,000         22:1       1,363,636

[[Page 596]]

 
    (July)......................................................        20,000,000         23:1         869,565
    (August)....................................................        10,000,000         26:1         384,615
    (Sept.).....................................................         5,000,000         28:1         178,571
    (Oct.)......................................................         5,000,000         29:1         172,414
    (Nov.)......................................................         2,500,000         30:1          83,333
    (Dec.)......................................................         2,500,000         31:1          80,645
Less Closing Inventory..........................................      (23,000,000)        (\2\)        (822,655)
                                                                 -------------------            ----------------
                                                                       77,000,000h   ..........       3,536,314
----------------------------------------------------------------------------------------------------------------
\1\ Where multiple months are indicated, the exchange rate applies for all months.
\2\ See paragraph (ii) of this Example.

    (ii) Since S uses the first-in, first-out inventory method, the 
closing inventory is assumed to consist of purchases made during the 
most recent translation period as follows:

----------------------------------------------------------------------------------------------------------------
                                                               Hyperinflationary                   United States
                                                                    currency       Exchange rate      dollars
----------------------------------------------------------------------------------------------------------------
December.....................................................        2,500,000h             31:1         $80,645
November.....................................................         2,500,000             30:1          83,333
October......................................................         5,000,000             29:1         172,414
September....................................................         5,000,000             28:1         178,571
August.......................................................         8,000,000             26:1         307,692
                                                              -------------------                ---------------
      Total..................................................       23,000,000h   ..............         822,655
                                                              ===================                ===============
 
                   Non-Capitalized Expenses
 
(Jan.-Feb.)..................................................        4,000,000h             20:1         200,000
(Mar.-Apr.)..................................................         2,500,000             21:1         119,048
(May-June)...................................................         2,500,000             22:1         113,636
(July).......................................................         2,000,000             23:1          86,957
(August).....................................................         3,000,000             26:1         115,385
(Sept.)......................................................         3,000,000             28:1         107,143
(Oct.).......................................................         2,000,000             29:1          68,966
(Nov.).......................................................         3,000,000             30:1         100,000
(Dec.).......................................................         4,000,000             31:1         129,032
                                                              -------------------                ---------------
      Total..................................................       26,000,000h   ..............       1,040,167
Depreciation.................................................        4,000,000h             20:1         200,000
      Total Cost & Expenses..................................      107,000,000h   ..............       4,776,481
                                                              -------------------                ---------------
Operating Profit.............................................      133,000,000h   ..............       4,930,121
                                                              ===================                ===============
----------------------------------------------------------------------------------------------------------------

    (d) Computation of DASTM gain or loss--(1) Rule. DASTM gain or loss 
of a QBU equals--
    (i) The net worth of the QBU (as determined under paragraph (d)(2) 
of this section) at the end of the taxable year minus the net worth of 
the QBU at the end of the preceding taxable year; plus
    (ii) The dollar amount of the items described in paragraph (d)(3) of 
this section and minus the dollar amount of the items described in 
paragraph (d)(4) of this section; minus
    (iii) The amount of dollar income or earnings and profits (or plus 
the amount of any dollar loss or deficit in earnings and profits) as 
determined for the taxable year pursuant to paragraphs (b)(1) through 
(b)(3) of this section.
    (2) Net worth. Net worth of a QBU at the end of any taxable year 
equals the aggregate dollar amount representing assets on the QBU's 
balance sheet at the end of the taxable year less the aggregate dollar 
amount representing liabilities on the balance sheet. Notwithstanding 
any other provision in this paragraph (d)(2), the district director may 
adjust the amount of any asset or liability if a purpose for acquiring 
(or disposing of) the asset or incurring (or discharging) the liability 
is to manipulate the composition of the balance sheet for any period 
during the taxable

[[Page 597]]

year in order to avoid tax. The taxpayer shall determine net worth by--
    (i) Preparing a balance sheet as of the end of the taxable year from 
the QBU's books and records (within the meaning of Sec. 1.989(a)-1(d)) 
as recorded in the QBU's hyperinflationary currency;
    (ii) Making adjustments necessary to conform such balance sheet to 
United States generally accepted accounting principles and tax 
accounting principles (including reversing monetary correction 
adjustments required by local accounting principles); and
    (iii) Translating the asset and liability amounts shown on the 
balance sheet into United States dollars in accordance with paragraph 
(d)(5) of this section.
    (3) Positive adjustments--(i) In general. The items described in 
this paragraph (d)(3) are dividend distributions for the taxable year 
and any items that decrease net worth for the taxable year but that 
generally do not affect income or loss or earnings and profits (or a 
deficit in earnings and profits). Such items include a transfer to the 
home office of a QBU branch and a return of capital.
    (ii) Translation. Except as provided by ruling or administrative 
pronouncement, items described in paragraph (d)(3)(i) of this section 
shall be translated into dollars as follows:
    (A) If the item giving rise to the adjustment would be translated 
under paragraph (d)(5) of this section at the exchange rate for the last 
translation period of the taxable year if it were shown on the QBU's 
year-end balance sheet, such item shall be translated at the exchange 
rate on the date the item is transferred.
    (B) If the item giving rise to the adjustment would be translated 
under paragraph (d)(5) of this section at the exchange rate for the 
translation period in which the cost of the item was incurred if it were 
shown on the QBU's year-end balance sheet, such item shall be translated 
at the same historical rate.
    (iii) Effective date. Paragraph (d)(3)(ii) of this section is 
applicable for any transfer, dividend, or distribution that is a return 
of capital that is made after March 8, 2005, and that gives rise to an 
adjustment under this paragraph (d)(3).
    (4) Negative adjustments. The items described in this paragraph 
(d)(4) are items that increase net worth for the taxable year but that 
generally do not affect income or loss or earnings and profits (or a 
deficit in earnings and profits). Such items include a capital 
contribution or a transfer from a home office to a QBU branch. Except as 
otherwise provided by ruling or administrative pronouncement, if the 
contribution or transfer is not in dollars, the amount of a capital 
contribution or transfer shall be translated into dollars at the 
exchange rate on the date made.
    (5) Translation of balance sheet. Asset and liability amounts shown 
on the balance sheet in hyperinflationary currency (adjusted pursuant to 
paragraph (d)(2)(ii) of this section) shall be translated into dollars 
as provided in this paragraph (d)(5). However, if the QBU previously 
changed its functional currency to the dollar and the rules of Sec. 
1.985-5 (or, if applicable, Sec. 1.985-5T, as contained in the April 1, 
1993 edition of 26 CFR part 1 (1.908 to 1.1000)) applied in translating 
its balance sheet amounts into dollars, then the spot exchange rate 
applied under those rules shall be used to translate any amount that 
would otherwise be translated at a rate determined by reference to a 
translation period prior to the change in functional currency. For 
example, the basis of real property acquired while the QBU had a 
nondollar functional currency shall be translated into dollars at the 
spot rate on the last day of the taxable year before the year of change 
to a dollar functional currency, rather than at the rate for the period 
in which the cost was incurred.
    (i) Closing inventory. Amounts representing items of inventory 
included in the closing inventory balance shall be translated in 
accordance with paragraph (c)(3)(iii) of this section.
    (ii) Bad debt reserves. Amounts representing bad debt reserves shall 
be translated at the exchange rate for the last translation period for 
the taxable year.

[[Page 598]]

    (iii) Prepaid income or expense. Amounts representing expenses or 
income paid or received in a prior taxable year shall be translated in 
accordance with paragraph (c)(5) of this section.
    (iv) Hyperinflationary currency. Amounts of the hyperinflationary 
currency and hyperinflationary demand deposit balances shall be 
translated at the exchange rate for the last translation period of the 
taxable year.
    (v) Certain assets--(A) In general. Amounts representing plant, real 
property, equipment, goodwill, and patents and other intangibles shall 
be translated at the exchange rate for the translation period in which 
the cost of the asset was incurred.
    (B) Adjustment to certain assets. Amounts representing depreciation, 
depletion, and amortization reserves shall be translated in accordance 
with paragraph (c)(4) of this section.
    (vi) Hyperinflationary debt obligations. Except as provided in 
paragraph (d)(5)(vii) of this section, amounts representing a 
hyperinflationary debt obligation (including accounts receivable and 
payable) shall be translated at the exchange rate for the last 
translation period for the taxable year.
    (vii) Accrued foreign income taxes. Amounts representing an accrued 
but unpaid foreign income tax shall be translated at the exchange rate 
on the last day of the last translation period of the taxable year of 
accrual.
    (viii) Certain hyperinflationary financial instruments. Amounts 
representing any item described in section 988(c)(1)(B)(iii) (relating 
to forward contracts, futures contracts, options, or similar financial 
instruments) denominated in or determined by reference to the 
hyperinflationary currency shall be translated at the exchange rate for 
the last translation period for the taxable year.
    (ix) Other assets and liabilities. Amounts representing assets and 
liabilities, other than those described in paragraphs (d)(5)(i) through 
(viii) of this section, shall be translated at the exchange rate for the 
translation period in which the cost of the asset or the amount of the 
liability was incurred.
    (6) Dollar transactions. Notwithstanding any other provisions of 
this paragraph (d), where the amount representing an item shown on the 
balance sheet reflects a dollar transaction (described in paragraph 
(c)(8) of this section), the transaction shall be taken into account in 
accordance with that paragraph.
    (7) Third currency transactions. A taxpayer may use any reasonable 
method of accounting for transactions described in section 988(c)(1)(B) 
and (C) that are denominated in, or determined by reference to, a 
currency other than the QBU's hyperinflationary currency or the dollar 
(third currency transactions), so long as such method is consistent with 
its method of financial accounting.
    (8) Character. The amount of DASTM gain or loss determined under 
paragraph (d)(1) of this section shall be ordinary income or loss.
    (9) Example. The provisions of this paragraph (d) are illustrated by 
the following example:

    Example. (i) S, an accrual method calendar year foreign corporation, 
uses DASTM. S's hyperinflationary currency is the ``h.'' S's net worth 
at December 31, 1993 was $3,246,495. For 1994, S's operating profit is 
81,340,000h, or $2,038,200. S made a 5,000,000h distribution in April 
and again in December of 1994. S's translation period is the month. None 
of S's assets or liabilities reflect a dollar or third currency 
transaction described in paragraph (c)(8) or (c)(9) of this section, 
respectively. The exchange rate for each month in 1994 is as follows:

        January..........................  32h:$1
        Feb.-Mar.........................  33:1
        April-May........................  34:1
        June.............................  35:1
        July.............................  36:1
        Aug.-Sept........................  37:1
        Oct..............................  38:1
        Nov..............................  39:1
        Dec..............................  40:1
 

    (ii) At the end of 1994, S's assets and liabilities, as adjusted and 
translated pursuant to paragraphs (d)(2) and (d)(5) of this section, are 
as follows:

----------------------------------------------------------------------------------------------------------------
                                                                     Hyperin-
                                                                    flationary     Exchange rate    U.S. dollar
----------------------------------------------------------------------------------------------------------------
Hyperinflationary cash on hand..................................         40,000h            40:1          $1,000
  Checking account..............................................         400,000            40:1          10,000

[[Page 599]]

 
Accounts Receivable- 30 Day Accounts............................      20,000,000        \1\ 40:1         500,000
    60 Day Accounts.............................................      25,000,000            40:1         625,000
Inventory.......................................................      65,000,000           (\2\)       2,500,000
Fixed assets--Property..........................................      90,000,000            27:1       3,333,333
    Plant.......................................................     190,000,000           (\3\)       6,785,714
        Accumulated Depreciation................................       (600,000)           (\3\)        (21,428)
    Equipment...................................................      10,000,000           (\4\)         340,000
        Accumulated Depreciation................................       (400,000)           (\4\)        (13,333)
Common Stock--Stock A...........................................         500,000            34:1          14,706
      Stock B...................................................         400,000            26:1          15,385
Preferred Stock.................................................       1,000,000            32:1          31,250
C.D.s...........................................................       5,000,000            40:1         125,000
      Total Assets..............................................     406,340,000  ..............      14,246,627
Accounts Payable Long-term liabilities:                               35,000,000            40:1         875,000
    Liability A.................................................     150,000,000            40:1       3,750,000
    Liability B.................................................      80,000,000            40:1       2,000,000
    Liability C.................................................      30,000,000            40:1         750,000
                                                                 ----------------                ---------------
      Total Liabilities.........................................    295,000,000h  ..............      $7,375,000
----------------------------------------------------------------------------------------------------------------
\1\ S ages its accounts receivable and groups them into two categories--those outstanding for 30 days and those
  outstanding for 60 days.
\2\ Translated the same as closing inventory under paragraph (c)(3)(iii).
\3\ The cost of S's plant was incurred in several translation periods. Therefore, the dollar cost and dollar
  depreciation reflect several translation rates.
\4\ S has a variety of equipment. Therefore, S's dollar basis represents the sum of the hyperinflationary cost
  of each, translated according to the exchange rate for the translation period incurred.

    (iii) The DASTM gain of S for 1994 is computed as follows:

Net worth--1994.........................  ..............      $6,871,627
Less--Net worth--1993...................  ..............      $3,246,495
Plus--1994 Dividends:...................
  April.................................        $149,254
  December..............................     \1\ 126,582         275,836
Less Operating Profit--1994.............  ..............       2,038,200
DASTM Gain..............................  ..............      $1,862,768
                                                         ===============
 
\1\ The exchange rates on the date of the April and December dividends
  were 33.5h:$1 and 39.5h:$1, respectively.

    (iv) Thus, total profit = $2,038,200 + $1,862,768 = $3,900,968

    (e) Effect of DASTM gain or loss on gross income, taxable income, or 
earnings and profits--(1) In general. For all purposes of subtitle A, 
the amount of DASTM gain or loss of a QBU determined under paragraph (d) 
of this section is taken into account by the QBU for purposes of 
determining the amount of its gross income, taxable income or loss, 
earnings and profits (or deficit in earnings and profits), and, where 
necessary, particular items of income, expense or other amounts. DASTM 
gain or loss is allocated under one of two methods. Certain small QBUs 
may elect the small QBU DASTM allocation described in paragraph (e)(2) 
of this section. All other QBUs must use the 9-step procedure described 
in paragraph (e)(3) of this section.
    (2) Small QBU DASTM allocation--(i) Election threshold. A taxpayer 
may elect to use the small QBU DASTM allocation described in paragraph 
(e)(2)(iv) of this section with respect to a QBU that has an adjusted 
basis in assets (translated as provided in paragraph (d)(5) of this 
section) of $10 million or less at the end of any taxable year. In 
calculating the $10 million threshold, a QBU shall be treated as owning 
all of the assets of each related QBU (as defined in paragraph 
(e)(2)(vi) of this section) having its residence (as defined in section 
988(a)(3)(B)) in the QBU's country of residence (related same- country 
QBU). For this purpose, appropriate adjustment shall be made to 
eliminate the double counting of assets created in transactions between 
related QBUs resident in the same country. For example, assume QBU-1, 
resident in country X, sells inventory to related QBU-2, also resident 
in country X, in exchange for an account receivable. For purposes of 
determining the assets of QBU-1 under this paragraph (e)(2)(i), the 
taxpayer shall take into account either the inventory shown on the books 
of QBU-2 or QBU-1's receivable from QBU-2 (but not both).
    (ii) Consent to election. The election of the small QBU DASTM 
allocation or subsequent application of the rules of paragraph (e)(3) of 
this section due to an increase in the adjusted basis of the

[[Page 600]]

QBU's assets shall be deemed to have been made with the consent of the 
Commissioner. Once the election under paragraph (e)(2)(iii) of this 
section is made, it shall apply for all years in which the adjusted 
basis of the assets of the QBU (and any related same-country QBU) is $10 
million or less, unless revoked with the Commissioner's consent. If the 
adjusted basis of the assets of the QBU (and any related same- country 
QBU) exceeds $10 million at the end of any taxable year, the rules of 
paragraph (e)(3) of this section shall apply to that QBU (and any 
related same-country QBU) for such year and each subsequent year unless 
such QBU again qualifies, and applies for and obtains the Commissioner's 
consent, to use the small QBU DASTM allocation. However, if a QBU 
acquires assets with a principal purpose of avoiding the application of 
paragraph (e)(2)(iv) of this section, the Commissioner may disregard the 
acquisition of such assets.
    (iii) Manner of making election--(A) QBUs that are branches of 
United States persons. For the first year in which this election is 
effective, in the case of a QBU branch of a United States person, a 
statement shall be attached to the United States person's timely filed 
Federal income tax return (taking extensions into account). The 
statement shall identify the QBU (or QBUs) for which the election is 
being made by describing its business and its country of residence, 
state the adjusted basis of the assets of the QBU (and any related same-
country QBUs) to which the election applies, and include a statement 
that the election is being made pursuant to Sec. 1.985-3(e)(2).
    (B) Other QBUs. In the case of a QBU other than one described in 
paragraph (e)(2)(iii)(A) of this section, an election must be made in 
the manner prescribed in Sec. 1.964-1. The statement filed with the 
Internal Revenue Service as required under Sec. 1.964-1 must include 
the information required under paragraph (e)(2)(iii)(A) of this section.
    (iv) Effect of election. If a taxpayer elects under this paragraph 
(e)(2) to use the small QBU DASTM allocation, DASTM gain or loss, as 
determined under paragraph (d) of this section, of a small QBU shall be 
allocated ratably to all items of the QBU's gross income (determined 
prior to adjustment for DASTM gain or loss). Therefore, for purposes of 
the foreign tax credit, DASTM gain or loss shall be allocated on the 
basis of the relative amounts of gross income in each separate category 
as defined in Sec. 1.904-5(a)(1). In the case of a controlled foreign 
corporation (within the meaning of section 957 or 953(c)(1)(B)), for 
purposes of section 952, DASTM gain or loss shall be allocated to 
subpart F income in a separate category in the same ratio that the gross 
subpart F income in that category for the taxable year bears to its 
total gross income in that category for the taxable year.
    (v) Conformity. If a person (or a QBU of such person) makes an 
election under this paragraph (e)(2) to use the small QBU DASTM 
allocation, then each QBU of any related person (as defined in paragraph 
(e)(2)(vi) of this section) that satisfies the threshold requirement of 
paragraph (e)(2)(i) of this section (after application of the 
aggregation rule of paragraph (e)(2)(i) of this section) shall be deemed 
to have made the election.
    (vi) Related person. The term related person means any person with a 
relationship to the QBU (or to the United States or foreign person of 
which the electing QBU is a part) that is defined in section 267(b) or 
section 707(b).
    (3) DASTM 9-step procedure--(i) Step 1--prepare balance sheets. The 
taxpayer shall prepare an opening and a closing balance sheet for the 
QBU for each balance sheet period during the taxable year. The balance 
sheet period is the most frequent period for which balance sheet data 
are reasonably available (but in no event less frequently than 
quarterly). The balance sheet period may not be changed without the 
consent of the district director. The balance sheets must be prepared 
under the principles of paragraph (d)(2) of this section.
    (ii) Step 2--identify certain assets and liabilities. The taxpayer 
shall identify each item on the balance sheet that is described in 
section 988(c)(1)(B) or (C) and that would have been translated under 
paragraph (d)(5) of this section into dollars at the exchange rate for 
the last translation period for the taxable year (or the exchange rate 
on the

[[Page 601]]

last day of the last translation period of the taxable year in the case 
of an accrued foreign income tax liability).
    (iii) Step 3--characterize the assets. The taxpayer shall 
characterize and group the assets identified in paragraph (e)(3)(ii) of 
this section (Step 2) according to the source and the type of income 
that they generate, have generated, or may reasonably be expected to 
generate by applying the principles of Sec. 1.861-9T(g)(3) or its 
successor regulation (relating to characterization of assets for 
purposes of interest expense allocation). If a purpose for a taxpayer's 
business practices is to manipulate asset characterization or groupings, 
the district director may allocate or apportion DASTM gain or loss 
attributable to the assets. Thus, if a taxpayer that previously did not 
separately state interest on accounts receivable begins to impose an 
interest charge and a purpose for the change was to manipulate tax 
characterizations or groupings, then the district director may require 
that none of the DASTM gain or loss attributable to those receivables be 
allocated or apportioned to interest income.
    (iv) Step 4--determine DASTM gain or loss attributable to certain 
assets--(A) General rule. The taxpayer shall determine the dollar amount 
of DASTM gain or loss attributable to assets in each group identified in 
paragraph (e)(3)(iii) of this section (Step 3) as follows:
[GRAPHIC] [TIFF OMITTED] TC09OC91.062

where

bb = the hyperinflationary currency adjusted basis of the assets in the 
          group at the beginning of the balance sheet period.
eb = the hyperinflationary currency adjusted basis of the assets in the 
          group at the end of the balance sheet period.
er = one dollar divided by the number of hyperinflationary currency 
          units that equal one dollar at the end of the balance sheet 
          period.
br = one dollar divided by the number of hyperinflationary currency 
          units that equal one dollar at the beginning of the balance 
          sheet period.

    (B) Weighting to prevent distortion. If averaging the adjusted basis 
of assets in a group at the beginning and end of a balance sheet period 
results in an allocation of DASTM gain or loss that does not clearly 
reflect income, as might be the case in the event of a purchase or 
disposition of an asset that is not in the normal course of business, 
the taxpayer must use a weighting method that reflects the time the 
assets are held by the QBU during the translation period.
    (C) Example. The provisions of this paragraph (e)(3)(iv) are 
illustrated by the following example:

    Example. S is a foreign corporation that operates in the 
hyperinflationary currency ``h'' and computes its income or loss or 
earnings and profits under DASTM. S's adjusted basis in a group of 
assets described in section 988(c)(1)(B) or (C) that generate general 
limitation foreign source income (as characterized under paragraph 
(e)(3)(iii) of this section) at the beginning of the balance sheet 
period is 750,000h. S's basis in such assets at the end of the balance 
sheet period is 1,250,000h. The exchange rate at the beginning of the 
balance sheet period is $1 = 200h. The exchange rate at the end of the 
balance sheet period is $1 = 500h. The DASTM loss attributable to the 
assets described above is $3,000, determined as follows:

[(750,000h + 1,250,000h) / 2] x [($1 / 500h) - ($1 / 200h)] = ($3000)

    (v) Step 5--adjust dollar gross income by DASTM gain or loss from 
assets. The taxpayer shall adjust the dollar amount of the QBU's gross 
income (computed under paragraphs (b)(1) through (b)(3) of this section) 
generated by each group of assets characterized in paragraph (e)(3)(iii) 
of this section (Step 3) by the amount of DASTM gain or loss 
attributable to those assets computed under paragraph (e)(3)(iv) of this 
section (Step 4). Thus, if a group of assets, such as accounts 
receivable, generates both a category of income described in section 
904(d)(1)(I) (relating to general limitation income) that is not foreign 
base company income as defined in section 954 and a DASTM loss under 
paragraph (e)(3)(iv) of this section (Step 4), the amount of the DASTM 
loss would reduce the amount of the QBU's gross income in that category. 
Similarly, if a group of assets, such as short-term bank deposits, 
generates both foreign personal holding company income that is passive 
income (described in sections 954(c)(1)(A) and 904(d)(1)(A)) and a DASTM 
loss under paragraph (e)(3)(iv)

[[Page 602]]

of this section (Step 4), the amount of the DASTM loss would reduce the 
amount of the QBU's foreign personal holding company income and passive 
income. See section 904(f) and the regulations thereunder in the case 
where that section would apply and DASTM loss attributable to a group of 
assets exceeds the income generated by such assets.
    (vi) Step 6--determine DASTM gain or loss attributable to 
liabilities--(A) General rule. The taxpayer shall determine the dollar 
amount of DASTM gain or loss attributable to liabilities identified in 
paragraph (e)(3)(ii) of this section (Step 2), and described in 
paragraph (e)(3)(vi)(B) of this section as follows:
[GRAPHIC] [TIFF OMITTED] TC09OC91.063

where

bl = the hyperinflationary currency amount of liabilities at the 
          beginning of the balance sheet period.
el = the hyperinflationary currency amount of liabilities at the end of 
          the balance sheet translation period.
br = one dollar divided by the number of hyperinflationary currency 
          units that equal one dollar at the beginning of the balance 
          sheet period.
er = one dollar divided by the number of hyperinflationary currency 
          units that equal one dollar at the end of the balance sheet 
          period.

    (B) Separate calculation. The calculation shall be made separately 
for interest-bearing liabilities described in paragraph (e)(3)(vii) of 
this section (Step 7) and for each of the classes of non-interest-
bearing liabilities described in paragraph (e)(3)(viii) of this section 
(Step 8).
    (C) Weighting to prevent distortion. Where a distortion would result 
from averaging the amount of liabilities at the beginning and end of a 
balance sheet period, as might be the case where a taxpayer incurs or 
retires a substantial liability, the taxpayer must use a different 
method that more clearly reflects the average amount of liabilities 
weighted to reflect the time the liability was outstanding during the 
balance sheet period.
    (vii) Step 7--adjust dollar income and expense by DASTM gain or loss 
from interest-bearing liabilities--(A) In general. The taxpayer shall 
apply the amount of DASTM gain on interest-bearing liabilities computed 
under paragraph (e)(3)(vi) of this section (Step 6) to reduce interest 
expense generated by such liabilities (e.g., prior to the application of 
Sec. 1.861-9T or its successor regulation). To the extent DASTM gain on 
such liabilities exceeds interest expense, it shall be sourced or 
otherwise classified in the same manner that interest expense is 
allocated and apportioned under Sec. 1.861-9T or its successor 
regulation. The amount of DASTM loss on interest-bearing liabilities 
computed under paragraph (e)(3)(vi) of this section (Step 6) shall be 
allocated and apportioned in the same manner that interest expense is 
allocated and apportioned under Sec. 1.861-9T or its successor 
regulation (without regard to the exceptions to fungibility in Sec. 
1.861-10T or its successor regulation). For purposes of this section, an 
interest-bearing liability is a liability that requires payment of 
periodic interest (whether fixed or variable), has original issue 
discount, or would have interest imputed under subtitle A.
    (B) Allocation of DASTM gain or loss from interest-bearing 
liabilities that generate related person interest expense. DASTM gain or 
loss from interest-bearing liabilities that generate related person 
interest expense (as provided in section 954(b)(5)) shall be allocated 
for purposes of subtitle A (including sections 904 and 952) in the same 
manner that the related person interest expense of that debt is required 
to be allocated under the rules of section 954(b)(5) and Sec. 1.904-
5(c)(2).
    (C) Modified gross income method. In applying the modified gross 
income method described in Sec. 1.861-9T(j) or its successor 
regulation, gross income shall be adjusted for any DASTM gain or loss 
from assets as provided in paragraph (e)(3)(v) of this section (Step 5) 
and any DASTM gain or loss with respect to short-term, non-interest-
bearing trade payables as provided in paragraph (e)(3)(viii)(A) of this 
section.
    (viii) Step 8--adjust dollar income and expense by DASTM gain or 
loss from non-interest bearing liabilities--(A) Short-term, non-
interest-bearing trade payables. The taxpayer shall allocate DASTM gain 
or loss on short-term non-interest-bearing trade payables for purposes

[[Page 603]]

of subtitle A (including sections 904 and 952) to the same category or 
type of gross income as the cost or expense to which the trade payable 
relates. For this purpose, a short-term, non-interest-bearing trade 
payable is a non-interest-bearing liability with a term of 183 days or 
less that is incurred to purchase property or services to be used by the 
obligor in an active trade or business.
    (B) Excise tax payables. The taxpayer shall allocate DASTM gain or 
loss on excise tax payables for purposes of subtitle A (including 
sections 904 and 952) to the same category or type of gross income as 
would be derived from the activity to which the excise tax relates.
    (C) Other non-interest-bearing liabilities--(1) In general. Except 
as provided in paragraphs (e)(3)(viii)(A), (e)(3)(viii)(B), and 
(e)(3)(viii)(C)(2) of this section, DASTM gain or loss on non-interest-
bearing liabilities shall be allocated under paragraph (e)(3)(ix) of 
this section (Step 9).
    (2) Tracing if substantial distortion of income. DASTM gains and 
losses on liabilities described in paragraph (e)(3)(viii)(C)(1) of this 
section may be attributed to the same section 904(d) separate category 
or subpart F category as the transaction to which the liability relates 
if the taxpayer demonstrates to the satisfaction of the district 
director, or it is determined by the district director, that application 
of paragraph (e)(3)(viii)(C)(1) of this section results in a substantial 
distortion of income.
    (ix) Step 9--allocate residual DASTM gain or loss. If there is a 
difference between the net DASTM gain or loss determined under 
paragraphs (e)(3)(i) through (viii) of this section (Steps 1 through 8) 
and the DASTM gain or loss determined under paragraph (d) of this 
section, the amount of the difference must be allocated for purposes of 
subtitle A (including sections 904 and 952) to the QBU's gross income 
(computed under paragraphs (b)(1) through (3) of this section, as 
adjusted under paragraphs (e)(3)(i) through (viii) of this section 
(Steps 1 through 8)) on the basis of the relative amounts of each 
category or type of gross income.

[T.D. 8556, 59 FR 37673, July 25, 1994, as amended by T.D. 9320, 72 FR 
15044, Mar. 30, 2007]



Sec. 1.985-4  Method of accounting.

    (a) Adoption of election. The adoption of, or the election to use, a 
functional currency shall be treated as a method of accounting. The 
functional currency shall be used for the year of adoption (or election) 
and for all subsequent taxable years unless permission to change is 
granted, or considered to be granted under Sec. 1.985-2 or Sec. 1.985-
8, by the Commissioner.
    (b) Condition for changing functional currencies. Generally, 
permission to change functional currencies shall not be granted unless 
significant changes in the facts and circumstances of the QBU's economic 
environment occur. If the determination of the functional currency of 
the QBU for purposes of United States generally accepted accounting 
principles (GAAP) is based on facts and circumstances substantially 
similar to those set forth in Sec. 1.985-1(c)(2), then ordinarily the 
Commissioner will grant a taxpayer's request to change its functional 
currency (or the functional currency of its branch that is a QBU) to a 
new functional currency only if the taxpayer (or its QBU) also changes 
to the new functional currency for purposes of GAAP. However, permission 
to change will not necessarily be granted merely because the new 
functional currency will conform to the taxpayer's GAAP functional 
currency.
    (c) Relationship to certain other sections of the Code. Nothing in 
this section shall be construed to override the provisions of any other 
sections of the Code of regulations that require the use of consistent 
accounting methods. Such provisions must be independently satisfied 
separate and apart from the identification of a functional currency. For 
instance, while separate geographical divisions of a taxpayer's trade or 
business may have different functional currencies, such geographical 
divisions may nevertheless

[[Page 604]]

be required to consistently use other methods of accounting.

[T.D. 8263, 54 FR 38661, Sept. 20, 1989, as amended by T.D. 8776, 63 FR 
40368, July 29, 1998; T.D. 8927, Jan. 11, 2001]



Sec. 1.985-5  Adjustments required upon change in functional currency.

    (a) In general. This section applies in the case of a QBU that 
changes from one functional currency (old functional currency) to 
another functional currency (new functional currency). A taxpayer or QBU 
subject to the rules of this section shall make the adjustments set 
forth in the 3-step procedure described in paragraphs (b) through (e) of 
this section. The adjustments shall be made on the last day of the 
taxable year ending before the year of change as defined in Sec. 1.481-
1(a)(1). Gain or loss required to be recognized under paragraphs (b), 
(d)(2), and (e)(2) of this section is not subject to section 481 and, 
therefore, the full amount of the gain or loss must be included in 
income or earnings and profits on the last day of the taxable year 
ending before the year of change. Except as provided in Sec. 1.985-6, a 
QBU with a functional currency for its first taxable year beginning in 
1987 that is different from the currency in which it had kept its books 
and records for United States accounting and tax accounting purposes for 
its prior taxable year shall apply the principles of this Sec. 1.985-5 
for purposes of computing the relevant functional currency items, such 
as earnings and profits, basis of an asset, and amount of a liability, 
as of the first day of a taxpayer's first taxable year beginning in 
1987. However, a QBU that changes to the dollar pursuant to Sec. 1.985-
1(b)(2) after 1987 shall apply Sec. 1.985-7.
    (b) Step 1--Taking into account exchange gain or loss on certain 
section 988 transactions. The QBU shall recognize or otherwise take into 
account for all purposes of the Code the amount of any unrealized 
exchange gain or loss attributable to a section 988 transaction (as 
defined in section 988(c)(1)(A), (B), and (C)) that, after applying 
section 988(d), is denominated in terms of or determined by reference to 
the new functional currency. The amount of such gain or loss shall be 
determined without regard to the limitations of section 988(b) (i.e., 
whether any gain or loss would be realized on the transaction as a 
whole). The character and source of such gain or loss shall be 
determined under section 988.
    (c) Step 2--Determining the new functional currency basis of 
property and the new functional currency amount of liabilities and any 
other relevant items. The new functional currency adjusted basis of 
property and the new functional currency amount of liabilities and any 
other relevant items (e.g., items described in section 
988(c)(1)(B)(iii)) shall equal the product of the amount of the old 
functional currency adjusted basis or amount multiplied by the new 
functional currency/old functional currency spot exchange rate on the 
last day of the taxable year ending before the year of change (spot 
rate).
    (d) Step 3A--Additional adjustments that are necessary when a branch 
changes functional currency--(1) Branch changing to a functional 
currency other than the taxpayer's functional currency--(i) Rule. If a 
QBU that is a branch of a taxpayer changes to a functional currency 
other than the taxpayer's functional currency, the branch shall make the 
adjustments set forth in either paragraph (d)(1)(ii) or (d)(1)(iii) of 
this section for purposes of section 987. See Sec. 1.987-5(d) for rules 
for computing the branch's equity pool and basis pool.
    (ii) Where prior to the change the branch and taxpayer had different 
functional currencies. If the branch and the taxpayer had different 
functional currencies prior to the change, the branch's new functional 
currency equity pool shall equal the product of the old functional 
currency amount of the equity pool multiplied by the spot rate. No 
adjustment to the basis pool is necessary.
    (iii) Where prior to the change the branch and taxpayer had the same 
functional currency. If the branch and the taxpayer had the same 
functional currency prior to the change, the branch's basis pool shall 
equal the difference between the branch's total old functional currency 
basis of its assets and its total old functional currency amount of its 
liabilities. The branch's equity pool shall equal the product of the 
basis pool multiplied by the spot rate.

[[Page 605]]

    (2) Branch changing to the taxpayer's functional currency. If a 
branch changes its functional currency to the taxpayer's functional 
currency, the branch shall be treated as if it terminated on the last 
day of the taxable year ending before the year of change. In such a 
case, the taxpayer shall realize gain or loss attributable to the 
branch's equity pool under the principles of section 987.
    (e) Step 3B--Additional adjustments that are necessary when a 
taxpayer changes functional currency--(1) Corporations. The amount of a 
corporation's new functional currency earnings and profits and the 
amount of its new functional currency paid-in capital shall equal the 
product of the old functional currency amounts of such items multiplied 
by the spot rate. The foreign income taxes and accumulated profits or 
deficits in accumulated profits of a foreign corporation that were 
maintained in foreign currency for purposes of section 902 and that are 
attributable to taxable years of the foreign corporation beginning 
before January 1, 1987, also shall be translated into the new functional 
currency at the spot rate.
    (2) Collateral consequences to a United States shareholder of a 
corporation changing to the United States dollar as its functional 
currency. A United States shareholder (within the meaning of section 
951(b) or section 953(c)(1)(A)) of a controlled foreign corporation 
(within the meaning of section 957 or section 953(c)(1)(B)) changing its 
functional currency to the dollar shall recognize foreign currency gain 
or loss computed under section 986(c) as if all previously taxed 
earnings and profits, if any, (including amounts attributable to pre-
1987 taxable years that were translated from dollars into functional 
currency in the foreign corporation's first post-1986 taxable year) were 
distributed immediately prior to the change. Such a shareholder shall 
also recognize gain or loss attributable to the corporation's paid-in 
capital to the same extent, if any, that such gain or loss would be 
recognized under the regulations under section 367(b) if the corporation 
was liquidated completely.
    (3) Taxpayers that are not corporations. [Reserved]
    (4) Adjustments to a branch's accounts when a taxpayer changes 
functional currency--(i) Taxpayer changing to a functional currency 
other than the branch's functional currency. If a taxpayer changes to a 
functional currency that differs from the functional currency of a 
branch of the taxpayer, the branch shall adjust its basis pool in the 
manner prescribed in paragraph (d)(1)(ii) of this section for adjusting 
the equity pool, if the taxpayer's old functional currency was different 
from the branch's functional currency. If the taxpayer's old functional 
currency was the same as the branch's functional currency, the branch 
shall determine its equity pool and basis pool in the manner set forth 
in paragraph (d)(1)(iii) of this section for determining the basis pool 
and equity pool, respectively.
    (ii) Taxpayer changing to the same functional currency as the 
branch. If a taxpayer changes to the same functional currency as a 
branch of the taxpayer, the taxpayer shall realize gain or loss as set 
forth in paragraph (d)(2) of this section.
    (f) Examples. The provisions of this section are illustrated by the 
following examples.

    Example 1. S, a calendar year foreign corporation, is wholly owned 
by domestic corporation P. The Commissioner granted permission to change 
S's functional currency from the LC to the FC beginning January 1, 1993. 
The LC/FC exchange rate on December 31, 1992 is 1 LC/2 FC. The following 
shows how S must convert the items on its balance sheet from the LC to 
the FC.

------------------------------------------------------------------------
                                                            1:2
                                                 -----------------------
                                                      LC          FC
------------------------------------------------------------------------
Assets:
  Cash on hand..................................      40,000      80,000
  Accounts Receivable...........................      10,000      20,000
  Inventory.....................................     100,000     200,000
  100,000 FC Bond (100,000 LC historical basis).   \1\50,000     100,000
  Fixed assets:
    Property....................................     200,000     400,000
    Plant.......................................     500,000   1,000,000
      Accumulated Depreciation..................   (200,000)   (400,000)
    Equipment...................................   1,000,000   2,000,000
      Accumulated Depreciation..................   (400,000)   (800,000)
                                                 -----------------------
    Total Assets................................   1,300,000   2,600,000
                                                 =======================
Liabilities:
  Accounts Payable..............................      50,000     100,000
  Long-term Liabilities.........................     400,000     800,000

[[Page 606]]

 
  Paid-in-Capital...............................     800,000   1,600,000
  Retained Earnings.............................  \2\ 50,000     100,000
                                                 -----------------------
    Total Liabilities and Equity................   1,300,000   2,600,000
------------------------------------------------------------------------
\1\ Under Sec. 1.985-5(b), S will recognize a 50,000 LC loss (100,000
  LC basis-50,000 LC value) on the bond resulting from the change in
  functional currency. Thus, immediately before the change, S's basis in
  the FC bond (taking into account the loss) is 50,000 LC.
\2\ The amount of S's LC retained earnings reflects the 50,000 LC loss
  on the bond.

    Example 2. P, a domestic corporation, operates a foreign branch, S. 
The Commissioner granted permission to change S's functional currency 
from the LC to the FC beginning January 1, 1993. As of December 31, 
1992, S's equity pool was 2,000 LC and its basis pool was $4,000. The 
LC/FC exchange rate on December 31, 1992 is 1 LC/2 FC. On January 1, 
1993, the new functional currency amount of S's equity pool is 4,000 FC. 
The basis pool is not affected.

[T.D. 8464, 58 FR 233, Jan. 5, 1993; 58 FR 11099, Feb. 23, 1993, as 
amended by T.D. 8765, 63 FR 10774, Mar. 5, 1998]



Sec. 1.985-6  Transition rules for a QBU that uses the dollar
approximate separate transactions method for its first taxable
year beginning in 1987.

    (a) In general. This section sets forth transition rules for a QBU 
that used the dollar approximate separate transactions method of 
accounting set forth in Sec. 1.985-3 or Sec. 1.985-3T (as contained in 
the April 1, 1989 edition of 26 CFR part 1 (1.908 to 1.1000)) for its 
first taxable year beginning in 1987 (DASTM QBU). A DASTM QBU must 
determine the dollar and hyperinflationary currency basis of its assets 
and the dollar and hyperinflationary currency amount of its liabilities 
that were acquired or incurred in taxable years beginning before January 
1, 1987. In addition, a DASTM QBU must determine its net worth, 
including its retained earnings, at the end of the QBU's last taxable 
year beginning before January 1, 1987. This section provides rules for 
controlled foreign corporations (as defined in section 957 or section 
953(c)(1)(B)), other foreign corporations, and branches of United States 
persons that must make these determinations.
    (b) Certain controlled foreign corporations. If a DASTM QBU was a 
controlled foreign corporation for its last taxable year beginning 
before January 1, 1987, and it had a significant event as described in 
Sec. 1.964-1(c)(6) in a taxable year beginning before January 1, 1987, 
then the rules of this paragraph (b) shall apply.
    (1) Basis in assets and amount of liabilities. The hyperinflationary 
currency adjusted basis of the QBU's assets and the hyperinflationary 
currency amount of the QBU's liabilities acquired or incurred by the QBU 
in a taxable year beginning before January 1, 1987, shall be the basis 
or the amount as determined under Sec. 1.964-1(e) prior to translation 
under Sec. 1.964-1(e)(4). The dollar adjusted basis of such assets and 
the dollar amount of such liabilities shall be the adjusted basis or the 
amount as determined under the rules of Sec. 1.964-1(e) after 
translation under Sec. 1.964-1(e)(4).
    (2) Retained earnings. The dollar amount of the QBU's retained 
earnings at the end of its last taxable year beginning before January 1, 
1987, shall be the dollar amount determined under Sec. 1.964-1(e)(3).
    (c) All other foreign corporations. If a foreign corporation is a 
DASTM QBU that is not described in paragraph (b) of this section, then 
the hyperinflationary currency and dollar adjusted basis in the QBU's 
assets acquired in taxable years beginning before January 1, 1987, the 
hyperinflationary currency and dollar amount of the QBU's liabilities 
acquired or incurred in taxable years beginning before January 1, 1987, 
and the dollar amount of the QBU's net worth, including its retained 
earnings, at the end of its last taxable year beginning before January 
1, 1987, shall be determined by applying the principles of Sec. 1.985-
3T or Sec. 1.985-3. Thus, for example, the dollar basis of plant and 
equipment shall be determined using the appropriate historical exchange 
rate.
    (d) Pre-1987 section 902 amounts--(1) Translation of pre-1987 
section 902 accumulated profits and taxes into United States dollars. 
The foreign income taxes and accumulated profits or deficits in 
accumulated profits of a foreign corporation that were maintained in 
foreign currency for purposes of section 902 and that are attributable 
to taxable years of the foreign corporation beginning before January 1, 
1987, shall be

[[Page 607]]

translated into dollars at the spot exchange rate on the first day of 
its first taxable year beginning after December 31, 1986. Once 
translated into dollars, these accumulated profits and taxes shall 
(absent a change in functional currency) remain in dollars for all 
federal income tax purposes.
    (2) Carryforward of accumulated deficits in accumulated profits from 
pre-1987 taxable years to post-1986 taxable years. For purposes of 
sections 902 and 960, the post-1986 undistributed earnings of a foreign 
corporation that is subject to the rules of this section shall be 
reduced by the dollar amount of the corporation's deficit in accumulated 
profits, if any, determined under section 902 and the regulations 
thereunder, that was accumulated at the end of the corporation's last 
taxable year beginning before January 1, 1987. The dollar amount of the 
accumulated deficit shall be determined by multiplying the foreign 
currency amount of such deficit by the spot exchange rate on the last 
day of the corporation's last taxable year beginning before January 1, 
1987, and shall be taken into account on the first day of the 
corporation's first taxable year beginning after December 31, 1986. 
Post-1986 undistributed earnings may not be reduced by the dollar amount 
of a pre-1987 deficit in retained earnings determined under Sec. 1.964-
1(e).
    (e) Net worth branch. If a DASTM QBU is a branch of a United States 
person and the QBU used a net worth method of accounting for its last 
taxable year beginning before January 1, 1987, then the rules of this 
paragraph (e) shall apply. A net worth method of accounting is any 
method of accounting under which the taxpayer calculates the taxable 
income of a QBU based on the net change in the dollar value of the QBU's 
equity (assets minus liabilities) during the course of a taxable year, 
taking into account any contributions or remittances made during the 
year. See, e.g., Rev. Rul. 75-106, 1975-1 C.B. 31. (See Sec. 
601.601(d)(2)(ii)(b) of this chapter).
    (1) Basis in assets and amount of liabilities--(i) Hyperinflationary 
amounts. For the first taxable year beginning in 1987, the 
hyperinflationary currency adjusted basis of a QBU's assets or the 
hyperinflationary currency amounts of its liabilities acquired or 
incurred in a taxable year beginning before January 1, 1987 is the 
hyperinflationary currency basis or amount at the date when acquired or 
incurred, as adjusted according to United States generally accepted 
accounting and tax accounting principles. If a hyperinflationary 
currency basis or amount was not determined at such date, the dollar 
basis or amount, as adjusted according to United States generally 
accepted accounting and tax accounting principles, shall be translated 
into hyperinflationary currency at the spot exchange rate on the date 
when the asset or liability was acquired or incurred.
    (ii) Dollar amounts. For the first taxable year beginning in 1987, 
the dollar adjusted basis of the QBU's assets and the amounts of its 
liabilities shall be those amounts reflected on the QBU's dollar books 
and records at the end of the taxpayer's last taxable year beginning 
before January 1, 1987, after adjusting the books and records according 
to United States generally accepted accounting and tax accounting 
principles.
    (2) Ending net worth. The dollar amount of the QBU's net worth at 
the end of its last taxable year beginning before January 1, 1987 shall 
equal the QBU's net worth at that date as determined under paragraph 
(e)(1)(ii) of this section.
    (f) Profit and loss branch. If a DASTM QBU is a branch of a United 
States person and the QBU used a profit and loss method of accounting 
for its last taxable year beginning before January 1, 1987, then the 
United States person shall first apply the transition rules of Sec. 
1.987-5 in order to determine the beginning amount and dollar basis of 
the branch's EQ pool, the hyperinflationary currency basis of the 
branch's assets, and the hyperinflationary currency amounts of its 
liabilities. A profit and loss method of accounting is any method of 
accounting under which the taxpayer calculates the profits of a QBU by 
computing the QBU's profits in its functional currency and translating 
the net result into dollars. See e.g., Rev. Rul. 75-107, 1975-1 C.B. 32. 
(See Sec. 601.601(d)(2)(ii)(b) of this chapter). The

[[Page 608]]

QBU and the taxpayer must then make the adjustments required by Sec. 
1.985-5, e.g., the QBU must take into account unrealized exchange gain 
or loss on dollar-denominated section 988 transactions, the taxpayer 
must account for the deemed termination of the branch, and the taxpayer 
must translate the QBU's balance sheet items from hyperinflationary 
currency into dollars at the spot rate.

[T.D. 8464, 58 FR 234, Jan. 5, 1993]



Sec. 1.985-7  Adjustments required in connection with a change to DASTM.

    (a) In general. If a QBU begins to use the dollar approximate 
separate transactions method of accounting set forth in Sec. 1.985-3 
(DASTM) in a taxable year beginning after April 6, 1998, adjustments 
shall be made as provided by this section. For the rules with respect to 
foreign corporations, see paragraph (b) of this section. For the rules 
with respect to adjustments to the income of United States shareholders 
of controlled foreign corporations, see paragraph (c) of this section. 
For the rules with respect to adjustments relating to QBU branches, see 
paragraph (d) of this section. For the effective date of this section, 
see paragraph (e). For purposes of applying this section, the look-back 
period shall be the period beginning with the first taxable year after 
the transition date and ending on the last day prior to the taxable year 
of change. The term transition date means the later of the last day of 
the last taxable year ending before the base period as defined in Sec. 
1.985-1(b)(2)(ii)(D) or the last day of the taxable year in which the 
QBU last applied DASTM. The taxable year of change shall mean the 
taxable year of change as defined in Sec. 1.481-1(a)(1). The 
application of this paragraph may be illustrated by the following 
examples:

    Example 1. A calendar year QBU that has not previously used DASTM 
operates in a country in which the functional currency of the country is 
hyperinflationary as defined under Sec. 1.985-1(b)(2)(ii)(D) for the 
QBU's 1999 tax year. The look-back period is the period from January 1, 
1996 through December 31, 1998, the transition date is December 31, 
1995, and the taxable year of change is the taxable year beginning 
January 1, 1999.
    Example 2. A QBU that has not previously used DASTM with a taxable 
year ending June 30, operates in a country in which the functional 
currency of the country is hyperinflationary for the QBU's tax year 
beginning July 1, 1999 as defined under Sec. 1.985-1(b)(2)(ii)(D) 
(where the base period is the thirty-six calendar months immediately 
preceding the first day of the current calendar year 1999). The look-
back period is the period from July 1, 1995 through June 30, 1999, the 
transition date is June 30, 1995, and the taxable year of change is the 
taxable year beginning July 1, 1999.

    (b) Adjustments to foreign corporations--(1) In general. In the case 
of a foreign corporation, the corporation shall make the adjustments set 
forth in paragraphs (b)(2) through (4) of this section. The adjustments 
shall be made on the first day of the taxable year of change.
    (2) Treatment of certain section 988 transactions--(i) Exchange gain 
or loss from section 988 transactions unrealized as of the transition 
date. A foreign corporation shall adjust earnings and profits by the 
amount of any unrealized exchange gain or loss that was attributable to 
a section 988 transaction (as defined in sections 988(c)(1)(A), (B), and 
(C)) that was denominated in terms of (or determined by reference to) 
the dollar and was held by the corporation on the transition date. Such 
gain or loss shall be computed as if recognized on the transition date 
and shall be reduced by any gain and increased by any loss recognized by 
the corporation with respect to such transaction during the look-back 
period. The amount of such gain or loss shall be determined without 
regard to the limitations of section 988(b) (i.e., whether any gain or 
loss would be realized on the transaction as a whole). The character and 
source of such gain or loss shall be determined under section 988. 
Proper adjustments shall be made to account for gain or loss taken into 
account by reason of this paragraph (b)(2). See Sec. 1.985-5(f) Example 
1, footnote 1.
    (ii) Treatment of a section 988 transaction entered into and 
terminated during the look-back period. A foreign corporation shall 
reduce earnings and profits by the amount of any gain, and increase 
earnings and profits by the

[[Page 609]]

amount of any loss, that was recognized with respect to any dollar 
denominated section 988 transactions entered into and terminated during 
the look-back period.
    (3) Opening balance sheet. The opening balance sheet of a foreign 
corporation for the taxable year of change shall be determined as if the 
corporation had changed its functional currency to the dollar by 
applying Sec. 1.985-5(c) on the transition date and had translated its 
assets and liabilities acquired and incurred during the look-back period 
under Sec. 1.985-3.
    (4) Earnings and profits adjustments--(i) Pre-1987 accumulated 
profits. The foreign income taxes and accumulated profits or deficits in 
accumulated profits of a foreign corporation that are attributable to 
taxable years beginning before January 1, 1987, as stated on the 
transition date, and that were maintained for purposes of section 902 in 
the old functional currency, shall be translated into dollars at the 
spot rate in effect on the transition date. The applicable accumulated 
profits shall be reduced on a last-in, first-out basis by the aggregate 
dollar amount (translated from functional currency in accordance with 
the rules of section 989(b)) attributable to earnings and profits that 
were distributed (or treated as distributed) during the look-back period 
to the extent such amounts distributed exceed the earnings and profits 
calculated under (b)(4)(ii) or (b)(4)(iii), as applicable. See Sec. 
1.902-1(b)(2)(ii). Once translated into dollars, these pre-1987 taxes 
and accumulated profits or deficits in accumulated profits shall (absent 
a change in functional currency) remain in dollars for all federal 
income tax purposes.
    (ii) Post-1986 undistributed earnings of a CFC. In the case of a 
controlled foreign corporation (within the meaning of section 957 or 
section 953(c)(1)(B))(CFC) or a foreign corporation subject to the rules 
of Sec. 1.904-6(a)(2), the corporation's post-1986 undistributed 
earnings in each separate category as defined in Sec. 1.904-5(a)(1) as 
of the first day of the taxable year of change (and prior to adjustment 
under paragraph (c)(1) of this section) shall equal the sum of--
    (A) The corporation's post-1986 undistributed earnings and profits 
(or deficit in earnings and profits) in each separate category as 
defined in Sec. 1.904-5(a)(1) as stated on the transition date 
translated into dollars at the spot rate in effect on the transition 
date; and
    (B) The sum of the earnings and profits (or deficit in earnings and 
profits) in each separate category determined under Sec. 1.985-3 for 
each post-transition date taxable year prior to the taxable year of 
change.
    Such amount shall be reduced by the aggregate dollar amount 
(translated from functional currency in accordance with the rules of 
section 989(b)) attributable to earnings and profits that were 
distributed (or treated as distributed) during the look-back period out 
of post-1986 earnings and profits in such separate category. For 
purposes of applying this paragraph (b)(4)(ii)(B), the opening balance 
sheet for calculating earnings and profits under Sec. 1.985-3 for the 
first post-transition year shall be translated into dollars pursuant to 
Sec. 1.985-5(c).
    (iii) Post-1986 undistributed earnings of other foreign 
corporations. In the case of a foreign corporation that is not a CFC or 
subject to the rules of Sec. 1.904-6(a)(2), the corporation's post-1986 
undistributed earnings shall equal the sum of--
    (A) The corporation's post-1986 undistributed earnings (or deficit) 
on the transition date translated into dollars at the spot rate in 
effect on the transition date; and
    (B) The sum of the earnings and profits (or deficit in earnings and 
profits) determined under Sec. 1.985-3 for each post-transition date 
taxable year (or such later year determined under section 902(c)(3)(A)) 
prior to the taxable year of change.
    Such amount shall be reduced by the aggregate dollar amount 
(translated from functional currency in accordance with the rules of 
section 989(b)) that was distributed (or treated as distributed) during 
the look-back period out of post-1986 earnings and profits. For purposes 
of applying this paragraph (b)(4)(iii)(B), the opening balance sheet for 
calculating earnings and profits under Sec. 1.985-3 for the first post-
transition year shall be translated into dollars pursuant to Sec. 
1.985-5(c).

[[Page 610]]

    (c) United States shareholders of controlled foreign corporations--
(1) In general. A United States shareholder (within the meaning of 
section 951(b) or section 953(c)(1)(B)) of a CFC that changes to DASTM 
shall make the adjustments set forth in paragraphs (c) (2) through (5) 
of this section on the first day of the taxable year of change. 
Adjustments under this section shall be taken into account by the 
shareholder (or such shareholder s successor in interest) ratably over 
four taxable years beginning with the taxable year of change. Similar 
rules shall apply in determining adjustments to income of United States 
persons who have made an election under section 1295 to treat a passive 
foreign investment company as a qualified electing fund.
    (2) Treatment under subpart F of income recognized on section 988 
transactions. The character of amounts taken into account under 
paragraph (b)(2) of this section for purposes of sections 951 through 
964, shall be determined on the transition date and to the extent 
characterized as subpart F income shall be taken into account in 
accordance with the rules of paragraph (c)(1) of this section. Such 
amounts shall retain their character for all federal income tax purposes 
(including sections 902, 959, 960, 961, 1248, and 6038).
    (3) Recognition of foreign currency gain or loss on previously taxed 
earnings and profits on the transition date. Gain or loss is recognized 
under section 986(c) as if all previously taxed earnings and profits as 
determined on the transition date, if any, were distributed on such 
date. Such gain or loss shall be reduced by any foreign currency gain 
and increased by any foreign currency loss that was recognized under 
section 986(c) with respect to distributions of previously taxed 
earnings and profits during the look-back period. Such amount shall be 
characterized in accordance with section 986(c) and taken into account 
in accordance with the rules of paragraph (c)(1) of this section.
    (4) Subpart F income adjustment. Subpart F income in a separate 
category shall be determined under Sec. 1.985-3 for each look-back 
year. For this purpose, the opening DASTM balance sheet shall be 
determined under Sec. 1.985-5. The sum of the difference (positive or 
negative) between the amount computed pursuant to Sec. 1.985-3 and 
amount that was included in income for each year shall be taken into 
account in the taxable year of change pursuant to paragraph (c)(1) of 
this section. Such amounts shall retain their character for all federal 
income tax purposes (including sections 902, 959, 960, 961, 1248, and 
6038). For rules applicable if an adjustment under this section results 
in a loss for the taxable year in a separate category, see section 
904(f) and the regulations thereunder. The amount of previously taxed 
earnings and profits as determined under section 959(c)(2) shall be 
adjusted (positively or negatively) by the amount taken into account 
under this paragraph (c)(4) as of the first day of the taxable year of 
change.
    (5) Foreign tax credit. A United States shareholder of a CFC shall 
compute an amount of foreign taxes deemed paid under section 960 with 
respect to any positive adjustments determined under paragraph (c) of 
this section. The amount of foreign tax deemed paid shall be computed 
with reference to the full amount of the adjustment and to the post-1986 
undistributed earnings determined under paragraph (b)(4) (i) and (ii) of 
this section and the post-1986 foreign income taxes of the CFC on the 
first day of the taxable year of change (i.e., without taking into 
account earnings and taxes for the taxable year of change). For purposes 
of section 960, the associated taxes in each separate category shall be 
allocated pro rata among, and deemed paid in, the shareholder's taxable 
years in which the income is taken into account. (No adjustment to 
foreign taxes deemed paid in prior years is required solely by reason of 
a negative adjustment to income under paragraph (c)(1) of this section).
    (d) QBU branches--(1) In general. In the case of a QBU branch, the 
taxpayer shall make the adjustments set forth in paragraphs (d)(2) 
through (d)(4) of this section. Adjustments under this section shall be 
taken into account by the taxpayer ratably over four taxable years 
beginning with the taxable year of change.
    (2) Treatment of certain section 988 transactions--(i) Exchange gain 
or loss from section 988 transactions unrealized

[[Page 611]]

as of the transition date. A QBU branch shall adjust income by the 
amount of any unrealized exchange gain or loss that was attributable to 
a section 988 transaction (as defined in sections 988(c)(1) (A), (B), 
and (C)) that was denominated in terms of (or determined by reference 
to) the dollar and was held by the QBU branch on the transition date. 
Such gain or loss shall be computed as if recognized on the transition 
date and shall be reduced by any gain and increased by any loss 
recognized by the QBU branch with respect to such transaction during the 
look-back period. The amount of such gain or loss shall be determined 
without regard to the limitations of section 988(b) (i.e., whether any 
gain or loss would be realized on the transaction as a whole). The 
character and source of such gain or loss shall be determined under 
section 988. Proper adjustments shall be made to account for gain or 
loss taken into account by reason of this paragraph (d)(2). See Sec. 
1.985-5(f) Example 1, footnote 1.
    (ii) Treatment of a section 988 transaction entered into and 
terminated during the look-back period. A QBU branch shall reduce income 
by the amount of any gain, and increase income by the amount of any 
loss, that was recognized with respect to any dollar denominated section 
988 transactions entered into and terminated during the look-back 
period.
    (3) Deemed termination income adjustment. The taxpayer shall realize 
gain or loss attributable to the QBU branch's equity pool (as stated on 
the transition date) under the principles of section 987, computed as if 
the branch terminated on the transition date. Such amount shall be 
reduced by section 987 gain and increased by section 987 loss that was 
recognized by such taxpayer with respect to remittances during the look-
back period.
    (4) Branch income adjustment. Branch income in a separate category 
shall be determined under Sec. 1.985-3 for each look-back year. For 
this purpose, the opening DASTM balance sheet shall be determined under 
Sec. 1.985-5. The sum of the difference (positive or negative) between 
the amount computed pursuant to Sec. 1.985-3 and amount taken into 
account for each year shall be taken into account in the taxable year of 
change pursuant to paragraph (d)(1) of this section. Such amounts shall 
retain their character for all federal income tax purposes.
    (5) Opening balance sheet. The opening balance sheet of a QBU branch 
for the taxable year of change shall be determined as if the branch had 
changed its functional currency to the dollar by applying Sec. 1.985-
5(c) on the transition date and had translated its assets and 
liabilities acquired and incurred during the look-back period under 
Sec. 1.985-3.
    (e) Effective date. This section is effective for taxable years 
beginning after April 6, 1998. However, a taxpayer may choose to apply 
this section to all open taxable years beginning after December 31, 
1986, provided each person, and each QBU branch of a person, that is 
related (within the meaning of Sec. 1.985-2(d)(3)) to the taxpayer also 
applies this section.

[T.D. 8765, 63 FR 10774, Mar. 5, 1998]



Sec. 1.985-8  Special rules applicable to the European Monetary Union
(conversion to euro).

    (a) Definitions--(1) Legacy currency. A legacy currency is the 
former currency of a Member State of the European Community which is 
substituted for the euro in accordance with the Treaty establishing the 
European Community signed February 7, 1992. The term legacy currency 
shall also include the European Currency Unit.
    (2) Conversion rate. The conversion rate is the rate at which the 
euro is substituted for a legacy currency.
    (b) Operative rules--(1) Initial adoption. A QBU (as defined in 
Sec. 1.989(a)-1(b)) whose first taxable year begins after the euro has 
been substituted for a legacy currency may not adopt a legacy currency 
as its functional currency.
    (2) QBU with a legacy currency as its functional currency--(i) 
Required change. A QBU with a legacy currency as its functional currency 
is required to change its functional currency to the euro beginning the 
first day of the first taxable year--
    (A) That begins on or after the day that the euro is substituted for 
that legacy currency (in accordance with the Treaty on European Union); 
and

[[Page 612]]

    (B) In which the QBU begins to maintain its books and records (as 
described in Sec. 1.989(a)-1(d)) in the euro.
    (ii) Notwithstanding paragraph (b)(2)(i) of this section, a QBU with 
a legacy currency as its functional currency is required to change its 
functional currency to the euro no later than the last taxable year 
beginning on or before the first day such legacy currency is no longer 
valid legal tender.
    (3) QBU with a non-legacy currency as its functional currency--(i) 
In general. A QBU with a non-legacy currency as its functional currency 
may change its functional currency to the euro pursuant to this Sec. 
1.985-8 if--
    (A) Under the rules set forth in Sec. 1.985-1(c), the euro is the 
currency of the economic environment in which a significant part of the 
QBU's activities are conducted;
    (B) After conversion, the QBU maintains its books and records (as 
described in Sec. 1.989(a)-1(d)) in the euro; and
    (C) The QBU is not required to use the dollar as its functional 
currency under Sec. 1.985-1(b).
    (ii) Time period for change. A QBU with a non-legacy currency as its 
functional currency may change its functional currency to the euro under 
this section only if it does so within the period set forth in paragraph 
(b)(2) of this section as if the functional currency of the QBU was a 
legacy currency.
    (4) Consent of Commissioner. A change made pursuant to paragraph (b) 
of this section shall be deemed to be made with the consent of the 
Commissioner for purposes of Sec. 1.985-4. A QBU changing its 
functional currency to the euro pursuant to paragraph (b)(2) of this 
section must make adjustments as provided in paragraph (c) of this 
section. A QBU changing its functional currency to the euro pursuant to 
paragraph (b)(3) must make adjustments as provided in Sec. 1.985-5.
    (5) Statement to file upon change. With respect to a QBU that 
changes its functional currency to the euro under paragraph (b) of this 
section, an affected taxpayer shall attach to its return for the taxable 
year of change a statement that includes the following: ``TAXPAYER 
CERTIFIES THAT A QBU OF THE TAXPAYER HAS CHANGED ITS FUNCTIONAL CURRENCY 
TO THE EURO PURSUANT TO TREAS. REG. Sec. 1.985-8.'' For purposes of 
this paragraph (b)(5), an affected taxpayer shall be in the case where 
the QBU is: a QBU of an individual U.S. resident (as a result of the 
activities of such individual), the individual; a QBU branch of a U.S. 
corporation, the corporation; a controlled foreign corporation (as 
described in section 957)(or QBU branch thereof), each United States 
shareholder (as described in section 951(b)); a partnership, each 
partner separately; a noncontrolled section 902 corporation (as 
described in section 904(d)(2)(E)) (or branch thereof), each domestic 
shareholder as described in Sec. 1.902-1(a)(1); or a trust or estate, 
the fiduciary of such trust or estate.
    (c) Adjustments required when a QBU changes its functional currency 
from a legacy currency to the euro pursuant to paragraph (b)(2) of this 
section--(1) In general. A QBU that changes its functional currency from 
a legacy currency to the euro pursuant to paragraph (b)(2) of this 
section must make the adjustments described in paragraphs (c)(2) through 
(5) of this section. Section 1.985-5 shall not apply.
    (2) Determining the euro basis of property and the euro amount of 
liabilities and other relevant items. The euro basis in property and the 
euro amount of liabilities and other relevant items shall equal the 
product of the legacy functional currency adjusted basis or amount of 
liabilities multiplied by the applicable conversion rate.
    (3) Taking into account exchange gain or loss on legacy currency 
section 988 transactions--(i) In general. Except as provided in 
paragraphs (c)(3)(iii) and (iv) of this section, a legacy currency 
denominated section 988 transaction (determined after applying section 
988(d)) outstanding on the last day of the taxable year immediately 
prior to the year of change shall continue to be treated as a section 
988 transaction after the change and the principles of section 988 shall 
apply.
    (ii) Examples. The application of this paragraph (c)(3) may be 
illustrated by the following examples:

    Example 1. X, a calendar year QBU on the cash method of accounting, 
uses the deutschmark as its functional currency. X is

[[Page 613]]

not described in section 1281(b). On July 1, 1998, X converts 10,000 
deutschmarks (DM) into Dutch guilders (fl) at the spot rate of fl1 = DM1 
and loans the 10,000 guilders to Y (an unrelated party) for one year at 
a rate of 10% with principal and interest to be paid on June 30, 1999. 
On January 1, 1999, X changes its functional currency to the euro 
pursuant to this section. Assume that the euro/deutschmark conversion 
rate is set by the European Council at [euro]1= DM2. Assume further that 
the euro/guilder conversion rate is set at [euro]1 = fl2.25. 
Accordingly, under the terms of the note, on June 30, 1999, X will 
receive [euro]4444.44 (fl10,000/2.25) of principal and [euro]444.44 
(fl1,000/2.25) of interest. Pursuant to this paragraph (c)(3), X will 
realize an exchange loss on the principal computed under the principles 
of Sec. 1.988-2(b)(5). For this purpose, the exchange rate used under 
Sec. 1.988-2(b)(5)(i) shall be the guilder/euro conversion rate. The 
amount under Sec. 1.988-2(b)(5)(ii) is determined by translating the 
fl10,000 at the guilder/deutschmark spot rate on July 1, 1998, and 
translating that deutschmark amount into euros at the deutschmark/euro 
conversion rate. Thus, X will compute an exchange loss for 1999 of 
[euro]555.56 determined as follows: [[euro]4444.44 (fl10,000/2.25)-5000 
((fl10,000/1)/2) = -[euro]555.56]. Pursuant to this paragraph (c)(3), 
the character and source of the loss are determined pursuant to section 
988 and regulations thereunder. Because X uses the cash method of 
accounting for the interest on this debt instrument, X does not realize 
exchange gain or loss on the receipt of that interest.
    Example 2. (i) X, a calendar year QBU on the accrual method of 
accounting, uses the deutschmark as its functional currency. On February 
1, 1998, X converts 12,000 deutschmarks into Dutch guilders at the spot 
rate of fl1 = DM1 and loans the 12,000 guilders to Y (an unrelated 
party) for one year at a rate of 10% with principal and interest to be 
paid on January 31, 1999. In addition, assume the average rate 
(deutschmark/guilder) for the period from February 1, 1998, through 
December 31, 1998 is fl1.07 = DM1. Pursuant to Sec. 1.988-
2(b)(2)(ii)(C), X will accrue eleven months of interest on the note and 
recognize interest income of DM1028.04 (fl1100/1.07) in the 1998 taxable 
year.
    (ii) On January 1, 1999, the euro will replace the deutschmark as 
the national currency of Germany pursuant to the Treaty on European 
Union signed February 7, 1992. Assume that on January 1, 1999, X changes 
its functional currency to the euro pursuant to this section. Assume 
that the euro/deutschmark conversion rate is set by the European Council 
at [euro]1 = DM2. Assume further that the euro/guilder conversion rate 
is set at [euro]1 = fl2.25. In 1999, X will accrue one month of interest 
equal to [euro]44.44 (fl100/2.25). On January 31, 1999, pursuant to the 
note, X will receive interest denominated in euros of [euro]533.33 
(fl1200/2.25). Pursuant to this paragraph (c)(3), X will realize an 
exchange loss in the 1999 taxable year with respect to accrued interest 
computed under the principles of Sec. 1.988-2(b)(3). For this purpose, 
the exchange rate used under Sec. 1.988-2(b)(3)(i) is the guilder/euro 
conversion rate and the exchange rate used under Sec. 1.988-2(b)(3)(ii) 
is the deutschmark/euro conversion rate. Thus, with respect to the 
interest accrued in 1998, X will realize exchange loss of [euro]25.13 
under Sec. 1.988-2(b)(3) as follows: [[euro]488.89 (fl1100/2.25) - 
[euro]514.02 (DM1028.04/2) = -[euro]25.13]. With respect to the one 
month of interest accrued in 1999, X will realize no exchange gain or 
loss since the exchange rate when the interest accrued and the spot rate 
on the payment date are the same.
    (iii) X will realize exchange loss of [euro]666.67 on repayment of 
the loan principal computed in the same manner as in Example 1 
[[euro]5333.33 (fl12,000/2.25) - [euro]6000 fl12,000/1)/2)]. The losses 
with respect to accrued interest and principal are characterized and 
sourced under the rules of section 988.

    (iii) Special rule for legacy nonfunctional currency. The QBU shall 
realize or otherwise take into account for all purposes of the Internal 
Revenue Code the amount of any unrealized exchange gain or loss 
attributable to nonfunctional currency (as described in section 
988(c)(1)(C)(ii)) that is denominated in a legacy currency as if the 
currency were disposed of on the last day of the taxable year 
immediately prior to the year of change. The character and source of the 
gain or loss are determined under section 988.
    (iv) Legacy currency denominated accounts receivable and payable--
(A) In general. A QBU may elect to realize or otherwise take into 
account for all purposes of the Internal Revenue Code the amount of any 
unrealized exchange gain or loss attributable to a legacy currency 
denominated item described in section 988(c)(1)(B)(ii) as if the item 
were terminated on the last day of the taxable year ending prior to the 
year of change.
    (B) Time and manner of election. With respect to a QBU that makes an 
election described in paragraph (c)(3)(iv)(A) of this section, an 
affected taxpayer (as described in paragraph (b)(5) of this section) 
shall attach a statement to its tax return for the taxable year ending 
immediately prior to the year of change which includes the following: 
``TAXPAYER CERTIFIES THAT A QBU OF THE TAXPAYER HAS

[[Page 614]]

ELECTED TO REALIZE CURRENCY GAIN OR LOSS ON LEGACY CURRENCY DENOMINATED 
ACCOUNTS RECEIVABLE AND PAYABLE UPON CHANGE OF FUNCTIONAL CURRENCY TO 
THE EURO.'' A QBU making the election must do so for all legacy currency 
denominated items described in section 988(c)(1)(B)(ii).
    (4) Adjustments when a branch changes its functional currency to the 
euro--(i) Branch changing from a legacy currency to the euro in a 
taxable year during which taxpayer's functional currency is other than 
the euro. If a branch changes its functional currency from a legacy 
currency to the euro for a taxable year during which the taxpayer's 
functional currency is other than the euro, the branch's euro equity 
pool shall equal the product of the legacy currency amount of the equity 
pool multiplied by the applicable conversion rate. No adjustment to the 
basis pool is required.
    (ii) Branch changing from a legacy currency to the euro in a taxable 
year during which taxpayer's functional currency is the euro. If a 
branch changes its functional currency from a legacy currency to the 
euro for a taxable year during which the taxpayer's functional currency 
is the euro, the taxpayer shall realize gain or loss attributable to the 
branch's equity pool under the principles of section 987, computed as if 
the branch terminated on the last day prior to the year of change. 
Adjustments under this paragraph (c)(4)(ii) shall be taken into account 
by the taxpayer ratably over four taxable years beginning with the 
taxable year of change.
    (5) Adjustments to a branch's accounts when a taxpayer changes to 
the euro--(i) Taxpayer changing from a legacy currency to the euro in a 
taxable year during which a branch's functional currency is other than 
the euro. If a taxpayer changes its functional currency to the euro for 
a taxable year during which the functional currency of a branch of the 
taxpayer is other than the euro, the basis pool shall equal the product 
of the legacy currency amount of the basis pool multiplied by the 
applicable conversion rate. No adjustment to the equity pool is 
required.
    (ii) Taxpayer changing from a legacy currency to the euro in a 
taxable year during which a branch's functional currency is the euro. If 
a taxpayer changes its functional currency from a legacy currency to the 
euro for a taxable year during which the functional currency of a branch 
of the taxpayer is the euro, the taxpayer shall take into account gain 
or loss as determined under paragraph (c)(4)(ii) of this section.
    (6) Additional adjustments that are necessary when a corporation 
changes its functional currency to the euro. The amount of a 
corporation's euro currency earnings and profits and the amount of its 
euro paid-in capital shall equal the product of the legacy currency 
amounts of these items multiplied by the applicable conversion rate. The 
foreign income taxes and accumulated profits or deficits in accumulated 
profits of a foreign corporation that were maintained in foreign 
currency for purposes of section 902 and that are attributable to 
taxable years of the foreign corporation beginning before January 1, 
1987, also shall be translated into the euro at the conversion rate.
    (d) Treatment of legacy currency section 988 transactions with 
respect to a QBU that has the euro as its functional currency--(1) In 
general. This Sec. 1.985-8(d) applies to a QBU that has the euro as its 
functional currency and that holds a section 988 transaction denominated 
in, or determined by reference to, a currency that is substituted by the 
euro. For example, this paragraph (d) will apply to a German QBU with 
the euro as its functional currency if the QBU is holding Country X 
currency or other section 988 transactions denominated in such currency 
on the day in the year 2005 when the euro is substituted for the Country 
X currency.
    (2) Principles of paragraph (c)(3) of this section shall apply. With 
respect to a QBU described in paragraph (d) of this section, the 
principles of paragraph (c)(3) of this section shall apply. For example, 
if a German QBU with the euro as its functional currency is holding a 
Country X currency denominated debt instrument on the day in the year 
2005 when the euro is substituted for the Country X currency, the 
instrument shall continue to be treated as a section 988 transaction 
pursuant to the

[[Page 615]]

principles of paragraph (c)(3)(i) of this section. However, if such QBU 
holds Country X currency, the QBU shall take into account any unrealized 
exchange gain or loss pursuant to the principles of paragraph 
(c)(3)(iii) of this section as if the currency was disposed of on the 
day prior to the day the euro is substituted for the Country X currency. 
Similarly, if the QBU makes an election under the principles of 
paragraph (c)(3)(iv) of this section, the QBU shall take into account 
for all purposes of the Internal Revenue Code the amount of any 
unrealized exchange gain or loss attributable to a legacy currency 
denominated item described in section 988(c)(1)(B)(ii) as if the item 
were terminated on the day prior to the day the euro is substituted for 
the Country X currency.
    (e) Effective date. This section applies to tax years ending after 
July 29, 1998.

[T.D. 8927, 66 FR 2216, Jan. 11, 2001; T.D. 8927, 66 FR 21447, Apr. 30, 
2001]



Sec. 1.987-1  Profit and loss method of accounting for a qualified
business unit of a taxpayer having a different functional currency
from the taxpayer. 
          [Reserved]



Sec. 1.987-2  Accounting for gain or loss on certain transfers
of property. [Reserved]



Sec. 1.987-3  Termination. [Reserved]



Sec. 1.987-4  Special rules relating to QBU branches of foreign
taxpayers. [Reserved]



Sec. 1.987-5  Transition rules for certain qualified business units
using a profit and loss method of accounting for taxable years
beginning before January 1, 1987.

    (a) Applicability--(1) In general. This section applies to qualified 
business unit (QBU) branches of United States persons, whose functional 
currency (as defined in section 985 of the Code and the regulations 
thereunder) is other than the United States dollar (dollar) and that 
used a profit and loss method of accounting for their last taxable year 
beginning before January 1, 1987. Generally, a profit and loss method of 
accounting is any method of accounting under which the taxpayer 
calculates the profits of a QBU branch in its functional currency and 
translates the net result into dollars. For all taxable years beginning 
after December 31, 1986, such QBU branches must use the profit and loss 
method of accounting as described in section 987, except to the extent 
otherwise provided in regulations under section 985 or any other 
provision of the Code. See Sec. 1.989(c)-1 regarding transition rules 
for QBU branches of United States persons that have a nondollar 
functional currency and that used a net worth method of accounting for 
their last taxable year beginning before January 1, 1987.
    (2) Insolvent QBU branches. A taxpayer may apply the principles of 
this section to a QBU branch that used a profit and loss method of 
accounting for its last taxable year beginning before January 1, 1987, 
whose $E pool (as defined in paragraph (d)(3)(i) of this section) is 
negative. For taxable years beginning on or after October 25, 1991, the 
principles of this section shall apply to insolvent QBU branches.
    (b) General rules. Generally, section 987 gain or loss occurs when a 
QBU branch makes a remittance. A remittance is considered to be made 
from one or more functional currency pools under rules provided in 
paragraph (c) of this section. In general, the amount of section 987 
gain or loss from a remittance equals the difference between the dollar 
value of the functional currency adjusted basis of the property remitted 
and the portion of the dollar basis in the applicable pool. Section 987 
gain or loss is calculated under a 4-step procedure described in 
paragraph (d) of this section. Section 987 gain or loss attributable to 
a remittance is realized and must be recognized in the taxable year of 
the remittance except to the extent otherwise provided in regulations.
    (c) Determining the pool(s) from which a remittance is made--(1) 
Remittances made during taxable years beginning after December 31, 1986, 
and before October 25, 1991. A remittance made during taxable years 
beginning after December 31, 1986 and before October 25, 1991, first 
represents an amount of the QBU branch's post-86 profits pool (including 
functional currency profits for the current taxable year determined 
without regard to remittances made during the

[[Page 616]]

current year). To the extent the functional currency amount of the 
remittance exceeds the post-86 profits pool, it is considered to come 
out of the EQ pool. Paragraph (d)(2) of this section describes the EQ 
pool and the post-86 profits pool.
    (2) Remittances made in taxable years beginning on or after October 
25, 1991. For remittances made in taxable years beginning on or after 
October 25, 1991, the post-86 profits and EQ pools are combined into one 
pool called the equity pool. Therefore, remittances made during those 
taxable years will only come from the equity pool. The dollar basis of, 
and section 987 gain or loss on, such remittances shall be calculated 
utilizing the principles set forth in paragraphs (d)(4) and (5) of this 
section.
    (d) Calculation of section 987 gain or loss--(1) In general. This 
paragraph (d) describes the 4-step procedure for calculating section 987 
gain or loss.
    (2) Step 1--Calculate the amount of the functional currency pools--
(i) EQ pool--(A) Beginning pool. The beginning amount of the EQ pool is 
equal to the functional currency adjusted bases of a QBU branch's assets 
less the functional currency amount of the QBU branch's liabilities at 
the end of the taxpayer's last taxable year beginning before January 1, 
1987, as these amounts are determined under the rules of paragraphs (e) 
and (f) of the section. The district director may allow for additional 
adjustments to the beginning amount of the EQ pool to prevent the 
recognition of section 987 gain or loss due to factors unrelated to the 
movement of exchange rates.
    (B) Adjusting the EQ pool. The EQ pool is increased by the 
functional currency amount of any transfer (as determined under section 
987) to the QBU branch made during the current taxable year or any prior 
taxable year beginning after December 31, 1986. If the transfer is made 
in a nonfunctional currency, this amount is translated into the QBU 
branch's functional currency at the spot rate (determined under the 
principles of section 988 and the regulations thereunder) on the date of 
the transfer. The method for determining the rate must be applied 
consistently each quarter. The EQ pool is decreased by the functional 
currency amount of any remittance (as determined under section 987) made 
during a prior taxable year beginning after December 31, 1986, that is 
considered remitted from the EQ pool under paragraph (c) of this 
section. The EQ pool must also be decreased by any transfer from the QBU 
branch that is not a remittance.
    (ii) Post-86 profits pool. The amount of a QBU branch's post-86 
profits pool is calculated at the end of each taxable year beginning 
after December 31, 1986. The opening balance of the post-86 profits pool 
at the beginning of the first taxable year beginning after December 31, 
1986, is zero. The post-86 profits pool is increased by the functional 
currency amount of the QBU branch's profits (determined under section 
987) for the taxable year. The post-86 profits pool is decreased by the 
functional currency amount of the QBU branch's losses (determined under 
section 987) for the taxable year and the amount of any remittances by 
the QBU branch during the taxable year from the post-86 profits pool as 
provided under paragraph (c) of this section.
    (iii) Adjustments to the equity pool. For remittances made in 
taxable years beginning on or after October 25, 1991 under paragraph 
(c)(2) of this section, the post-86 profits and EQ pools are combined 
into one pool called the equity pool. Additions to and subtractions from 
the equity pool shall be made utilizing the principles of paragraphs 
(d)(2)(i)(B) and (ii) of this section. For example, remittances shall 
reduce the equity pool.
    (3) Step 2--Calculate the dollar basis of the pools--(i) Dollar 
basis of the EQ pool--(A) Beginning dollar basis. The beginning dollar 
basis of the EQ pool (hereinafter referred to as the $E pool) equals:
    (1) The dollar amount of all the QBU branch's profits reported on 
the taxpayer's income tax returns for taxable years beginning before 
January 1, 1987, plus the total dollar amount of all transfers to the 
QBU branch during that period (properly reflected on the taxpayer's 
books), less
    (2) The dollar amount of all the QBU branch's losses reported on the 
taxpayer's income tax returns for such years, and the total dollar basis 
of all

[[Page 617]]

remittances and all transfers made by the QBU branch during that period 
(properly reflected on the taxpayer's books).


A QBU branch's profits and losses shall be properly adjusted for foreign 
taxes of the QBU branch.
    (B) Adjusting the $E pool. The $E pool is increased by the dollar 
amount of any transfers to the QBU branch made during the current 
taxable year or any prior taxable year beginning after December 31, 
1986. If a transfer is made in a currency other than the dollar, the 
amount of the currency is translated into dollars at the spot rate 
(determined under the principles of section 988 and the regulations 
thereunder) on the date of the transfer. The $E pool is decreased by the 
dollar basis of any remittance made during a prior taxable year 
beginning after December 31, 1986, that is considered remitted from the 
$E pool under paragraphs (c) and (d)(4) of these section. The $E pool is 
also reduced by the amount of a transfer (other than a remittance) from 
the QBU branch translated into dollars at the spot rate (determined 
under the principles of section 988 and the regulations thereunder) on 
the date of the transfer. The method for determining the spot rate must 
be applied consistently to all transfers to and from a QBU branch.
    (ii) Dollar basis of the post-86 profits pool. The amount of a QBU 
branch's dollar basis in the post-86 profits pool (the $P pool) is 
calculated at the end of each taxable year beginning after December 31, 
1986. The opening balance of the $P pool at the beginning of the first 
taxable year beginning after December 31, 1986, is zero. The $P pool is 
increased by the functional currency amount of the QBU branch's profits 
(determined under section 987) for the taxable year translated into 
dollars at the weighted average exchange rate (as defined in Sec. 1.989 
(b)-1) for the year. The $P pool is decreased by the functional currency 
amount of the QBU branch's losses (determined under section 987) for the 
taxable year translated into dollars at the weighted average exchange 
rate for the year and by the dollar basis of any remittances made by the 
QBU branch during the taxable year from the post-86 profits pool under 
paragraph (c)(1) of this section.
    (iii) Combination of the $E and the $P pools. For taxable years 
beginning on or after October 25, 1991 the $P and the $E pools are 
combined into one pool called the basis pool. Additions to and 
subtractions from the basis pool shall be made utilizing the principles 
set forth in paragraphs (d)(3)(i) and (ii) of this section.
    (4) Step 3--Calculation of the dollar basis of a remittance. For all 
taxable years beginning after December 31, 1986, the dollar basis of a 
remittance is calculated using the following formula:
[GRAPHIC] [TIFF OMITTED] TC09OC91.064

    (5) Step 4--Calculation of the section 987 gain or loss on a 
remittance. Section 987 gains or loss equals the difference between--
    (i) The dollar amount of the remittance, and
    (ii) The dollar basis of the remittance as calculated under 
paragraph (d)(4) of this section.
    (e) Functional currency adjusted basis of QBU branch assets acquired 
in taxable years beginning before January 1, 1987--(1) Basis of asset. 
For taxable years beginning after December 31, 1986, the functional 
currency adjusted basis of a QBU branch asset acquired in a taxable year 
beginning before January 1, 1987, is the functional currency basis of 
the asset at the date of acquisition, as adjusted according to United 
States tax principles. The functional currency adjusted basis of an 
asset for which a

[[Page 618]]

functional currency basis was not determined at the date of acquisition 
is the nonfunctional currency basis of the asset at the date of 
acquisition multiplied by the spot exchange rate on the date of 
acquisition, as adjusted according to United States tax principles.
    (2) Adjustment to basis of asset. Any future adjustments to the 
functional currency adjusted basis of such an asset are determined with 
respect to the appropriate functional currency adjusted basis of the 
asset as determined under this paragraph (e).
    (f) Functional currency amount of QBU branch liabilities acquired in 
taxable years beginning before January 1, 1987. For the first taxable 
year beginning after December 31, 1986, the amount of a QBU branch 
liability incurred in a taxable year beginning before January 1, 1987, 
is the functional currency amount of the liability at the date incurred, 
as adjusted according to United States tax principles. The functional 
currency amount of a liability for which a functional currency amount 
was not determined at the date incurred is the nonfunctional currency 
amount of the liability at the date incurred multiplied by the spot 
exchange rate on the date incurred, as adjusted according to the United 
States tax principles.
    (g) Examples. The provisions of this section are illustrated by the 
following examples.

    Example 1: (i) Facts. U.S. is a domestic corporation. B, a QBU 
branch of U.S., operates in country X and was established in 1985. B's 
functional currency is the FC. U.S. is on a calendar taxable year and, 
prior to January 1, 1987, accounted for the operations of B by the 
profit and loss method of accounting as set forth in Rev. Rul. 75-107, 
1975-1 C.B. 32. B's books and records were kept according to United 
States tax principles. B received a transfer of $2,000 in 1985, and had 
profits of $3,000 in 1985 and $5,000 in 1986. B made a remittance in 
1986, the dollar basis of which was $1,000. As of December 31, 1986, the 
adjusted basis of B's functional currency assets exceeded the functional 
currency amount of its liabilities by 15,000 FC (the beginning pool of 
EQ). Under section 987, B has profits of 8,000 FC in 1987, which are 
worth $1,000 when translated at the weighted average exchange rate for 
1987 as required by sections 987(2) and 989(b)(4). B has no profits or 
loss in 1988. There are no transfers to B in 1987 and 1988. B remits 
18,000 FC in 1988. Under section 987, the appropriate exchange rate for 
the 1988 remittance is 10 FC/$1.
    (ii) Calculation of section 987 loss on remittance--(A) Post-86 
profits. Under paragraph (c)(i) of this section, the 18,000 FC 
remittance comes first out of the post-86 profits pool (8,000 FC) and 
second out of EQ (10,000 FC). The loss on the 1988 remittance out of the 
post-86 profits pool equals:

Dollar value of post-86 profits remitted - Dollar basis of post-86 
          profits remitted =
(8,000 FC x 10 FC / $1) - $1,000 = $800 - $1,000 = 
          <=$200loss.

    (B) EQ. Under paragraph (d) of this section, U.S. calculates 987 
gain or loss on the 10,000 FC remittance of EQ from B as follows:
    Step 1. The total EQ pool equals 15,000 FC (the functional currency 
adjusted bases of its assets less the functional currency amount of its 
liabilities as of December 31, 1986). There are no adjustments necessary 
under paragraph (d)(2)(i)(B) of this section.
    Step 2. The $E pool is $9,000 (the $2,000 transfer in 1985 plus 
profits of $3,000 in 1985 and $5,000 in 1986 and less than $1,000 basis 
of the 1986 remittance). There are no adjustments necessary under 
paragraph (d)(3)(i)(B) of this section.
    Step 3. The entire 10,000 FC remittance is deemed to come out of EQ.
    Step 4. The dollar basis of the EQ remitted equals: N x $E 
determined under paragraph (d)(3)(i)=
[GRAPHIC] [TIFF OMITTED] TC09OC91.065


Where:
[GRAPHIC] [TIFF OMITTED] TC09OC91.066

    Step 5. Section 987 loss of U.S. on remittance equals:

Dollar value of the EQ remitted - Dollar basis of the EQ remitted = 
          (10,000 FC x 10 FC / $1) - $6,000 = $1,000 - $6,000 = 
          <=$5,000loss.


[[Page 619]]


    (C) Total loss on remittance. The total combined loss on the 
remittance is <=$5,200. The total of amounts determined in 
paragraphs (ii)(A) and (B) of this Example 1.
    Example 2: (i) Facts. D is a domestic corporation. B, a QBU branch 
of D, operates in country X. B's functional currency is the FC. At the 
end of B's last taxable year beginning before October 25, 1991, B's EQ 
pool equals 15,000 FC and B's post-86 profits pool equals 8,000 FC. B's 
$E amount equals $9,000, and the $P pool equals $1,000. In B's first 
taxable year beginning on or after October 25, 1991, B remits 18,000 FC. 
Under section 987, the appropriate exchange rate for this remittance is 
10FC:$1.
    (ii) Computation of the equity pool.
15,000 FC (EQ pool) + 8,000 FC (post-86 profits pool) = 23,000 FC 
          (equity pool)
    (iii) Computation of the basis pool.
    [GRAPHIC] [TIFF OMITTED] TC09OC91.067
    
    (iv) Dollar basis in remittance.
    [GRAPHIC] [TIFF OMITTED] TC09OC91.068
    
    (v) Computation of section 987 loss by U.S. on remittance.
    [GRAPHIC] [TIFF OMITTED] TC09OC91.069
    
    (h) Character and source of section 987 gain or loss. Section 987 
gain or loss is sourced and characterized as provided by section 987 and 
regulations issued under that section.

[T.D. 8367, 56 FR 48434, Sept. 25, 1991; 56 FR 65684, Dec. 18, 1991]



Sec. 1.988-0  Taxation of gain or loss from a section 988 transaction;
Table of Contents.

    This section lists captioned paragraphs contained in Sec. Sec. 
1.988-1 through 1.988-6.

          Sec. 1.988-1 Certain definitions and special rules.

    (a) Section 988 transaction.
    (1) In general.
    (2) Description of transactions.
    (3)-(5) [Reserved]
    (6) Examples.
    (7) Special rules for regulated futures contracts and non-equity 
options.
    (8) Special rules for qualified funds.
    (9) Exception for certain transactions entered into by an 
individual.
    (10) Intra-taxpayer transactions.
    (11) Authority of Commissioner to include or exclude transactions 
from section 988.
    (b) Spot contract.
    (c) Nonfunctional currency.
    (d) Spot rate.
    (1) In general.
    (2) Consistency required in valuing transactions subject to section 
988.
    (3) Use of certain spot rate conventions for payables and 
receivables denominated in nonfunctional currency.
    (4) Currency where an official government established rate differs 
from a free market rate.
    (e) Exchange gain or loss.
    (f) Hyperinflationary currency.
    (g) Fair market value.
    (h) Interaction with sections 1092 and 1256 in examples.
    (i) Effective date.

   Sec. 1.988-2 Recognition and computation of exchange gain or loss.

    (a) Disposition of nonfunctional currency.
    (1) Recognition of exchange gain or loss.
    (2) Computation of exchange gain or loss.
    (b) Translation of interest income or expense and determination of 
exchange gain or loss with respect to debt instruments.

[[Page 620]]

    (1) Translation of interest income received with respect to a 
nonfunctional currency demand account.
    (2) Translation of nonfunctional currency interest income or expense 
received or paid with respect to a debt instrument described in Sec. 
1.988-1(a)(1)(ii) and (2)(i).
    (3) Exchange gain or loss recognized by the holder with respect to 
accrued interest income.
    (4) Exchange gain or loss recognized by the obligor with respect to 
accrued interest expense.
    (5) Exchange gain or loss recognized by the holder of a debt 
instrument with respect to principal.
    (6) Exchange gain or loss recognized by the obligor of a debt 
instrument with respect to principal.
    (7) Payment ordering rules.
    (8) Limitation of exchange gain or loss on payment or disposition of 
a debt instrument.
    (9) Examples.
    (10) Treatment of bond premium.
    (11) Market discount.
    (12) Tax exempt bonds.
    (13) Nonfunctional currency debt exchanged for stock of obligor.
    (14) [Reserved]
    (15) Debt instruments and deposits denominated in hyperinflationary 
currencies.
    (16) Coordination with section 267 regarding debt instruments.
    (17) Coordination with installment method under section 453.
    (18) Interaction of section 988 and Sec. 1.1275-2(g).
    (c) Item of expense or gross income or receipts which is to be paid 
or received after the date accrued.
    (1) In general.
    (2) Determination of exchange gain or loss with respect to an item 
of gross income or receipts.
    (3) Determination of exchange gain or loss with respect to an item 
of expense.
    (4) Examples.
    (d) Exchange gain or loss with respect to forward contracts, futures 
contracts and option contracts.
    (1) Scope.
    (2) Realization of exchange gain or loss.
    (3) Recognition of exchange gain or loss.
    (4) Determination of exchange gain or loss.
    (5) Hyperinflationary contracts.
    (e) Currency swaps and notional principal contracts.
    (1) Notional principal contract denominated in a single 
nonfunctional currency.
    (2) Special rules for currency swaps.
    (3) Amortization of swap premium or discount in the case of off 
market swaps.
    (4) Treatment of taxpayer disposing of a currency swap.
    (5) Examples.
    (6) Special effective date for rules regarding currency swaps.
    (7) Special rules for currency swap contracts in hyperinflationary 
currencies.
    (f) Substance over form.
    (1) In general.
    (2) Example.
    (g) Effective date.
    (h) Timing of income and deductions from notional principal 
contracts.

            Sec. 1.988-3 Character of exchange gain or loss.

    (a) In general.
    (b) Election to characterize exchange gain or loss on certain 
identified forward contracts, futures contracts and option contracts as 
capital gain or loss.
    (1) In general.
    (2) Special rule for contracts that become part of a straddle after 
the election is made.
    (3) Requirements for making the election.
    (4) Verification.
    (5) Independent verification.
    (6) Effective date.
    (c) Exchange gain or loss treated as interest.
    (1) In general.
    (2) Exchange loss realized by the holder on nonfunctional currency 
tax exempt bonds.
    (d) Effective date.

     Sec. 1.988-4 Source of gain or loss realized on a section 988 
                              transaction.

    (a) In general.
    (b) Qualified business unit.
    (1) In general.
    (2) Proper reflection on the books of the taxpayer or qualified 
business unit.
    (c) Effectively connected exchange gain or loss.
    (d) Residence.
    (1) In general.
    (2) Exception.
    (3) Partner in a partnership not engaged in a U.S. trade or business 
under section 864(b)(2).
    (e) Special rule for certain related party loans.
    (1) In general.
    (2) United States person.
    (3) Loans by related person.
    (4) 10 percent owned foreign corporation.
    (f) Exchange gain or loss treated as interest under Sec. 1.988-3.
    (g) Exchange gain or loss allocated in the same manner as interest 
under Sec. 1.861-9T.
    (h) Effective date.

           Sec. 1.988-5 Section 988(d) hedging transactions.

    (a) Integration of a nonfunctional currency debt instrument and a 
Sec. 1.988-5(a) hedge.
    (1) In general.
    (2) Exception.
    (3) Qualifying debt instrument.
    (4) Section 1.988-5(a) hedge.
    (5) Definition of integrated economic transaction.

[[Page 621]]

    (6) Special rules for legging in and legging out of integrated 
treatment.
    (7) Transactions part of a straddle.
    (8) Identification requirements.
    (9) Taxation of qualified hedging transactions.
    (10) Transition rules and effective dates.
    (b) Hedged executory contracts.
    (1) In general.
    (2) Definitions.
    (3) Identification rules.
    (4) Effect of hedged executory contract.
    (5) References to this paragraph (b).
    (c) Hedges of period between trade date and settlement date on 
purchase or sale of publicly traded stock or security.
    (d) [Reserved]
    (e) Advance rulings regarding net hedging and anticipatory hedging 
systems.
    (f) [Reserved]
    (g) General effective date.

Sec. 1.988-6 Nonfunctional Currency Contingent Payment Debt Instruments

    (a) In general.
    (1) Scope.
    (2) Exception for hyperinflationary currencies.
    (b) Instruments described in paragraph (a)(1)(i) of this section.
    (1) In general.
    (2) Application of noncontingent bond method.
    (3) Treatment and translation of amounts determined under 
noncontingent bond method.
    (4) Determination of gain or loss not attributable to foreign 
currency.
    (5) Determination of foreign currency gain or loss.
    (6) Source of gain or loss.
    (7) Basis different from adjusted issue price.
    (8) Fixed but deferred contingent payments.
    (c) Examples.
    (d) Multicurrency debt instruments.
    (1) In general.
    (2) Determination of denomination currency.
    (3) Issuer/holder consistency.
    (4) Treatment of payments in currencies other than the denomination 
currency.
    (e) Instruments issued for nonpublicly traded property.
    (1) Applicability.
    (2) Separation into components.
    (3) Treatment of components consisting of one or more noncontingent 
payments in the same currency.
    (4) Treatment of components consisting of contingent payments.
    (5) Basis different from adjusted issue price.
    (6) Treatment of holder on sale, exchange, or retirement.
    (f) Rules for nonfunctional currency tax exempt obligations 
described in Sec. 1.1275-4(d).
    (g) Effective date.

[T.D. 8400, 57 FR 9177, Mar. 17, 1992, as amended by T.D. 8860, 65 FR 
2028, Jan. 13, 2000; T.D. 9157, 69 FR 52818, Aug. 30, 2004]



Sec. 1.988-1  Certain definitions and special rules.

    (a) Section 988 transaction--(1) In general. The term ``section 988 
transaction'' means any of the following transactions--
    (i) A disposition of nonfunctional currency as defined in paragraph 
(c) of this section;
    (ii) Any transaction described in paragraph (a)(2) of this section 
if any amount which the taxpayer is entitled to receive or is required 
to pay by reason of such transaction is denominated in terms of a 
nonfunctional currency or is determined by reference to the value of one 
or more nonfunctional currencies.


A transaction described in this paragraph (a) need not require or permit 
payment with a nonfunctional currency as long as any amount paid or 
received is determined by reference to the value of one or more 
nonfunctional currencies. The acquisition of nonfunctional currency is 
treated as a section 988 transaction for purposes of establishing the 
taxpayer's basis in such currency and determining exchange gain or loss 
thereon.
    (2) Description of transactions. The following transactions are 
described in this paragraph (a)(2).
    (i) Debt instruments. Acquiring a debt instrument or becoming an 
obligor under a debt instrument. The term ``debt instrument'' means a 
bond, debenture, note, certificate or other evidence of indebtedness.
    (ii) Payables, receivables, etc. Accruing, or otherwise taking into 
account, for purposes of subtitle A of the Internal Revenue Code, any 
item of expense or gross income or receipts which is to be paid or 
received after the date on which so accrued or taken into account. A 
payable relating to cost of goods sold, or a payable or receivable 
relating to a capital expenditure or receipt, is within the meaning of 
this paragraph (a)(2)(ii). Generally, a payable relating to foreign 
taxes (whether

[[Page 622]]

or not claimed as a credit under section 901) is within the meaning of 
this paragraph (a)(2)(ii). However, a payable of a domestic person 
relating to accrued foreign taxes of its qualified business unit (QBU 
branch) is not within the meaning of this paragraph (a)(2)(ii) if the 
QBU branch's functional currency is the U.S. dollar and the foreign 
taxes are claimed as a credit under section 901.
    (iii) Forward contract, futures contract, option contract, or 
similar financial instrument. Except as otherwise provided in this 
paragraph (a)(2)(iii) and paragraph (a)(4)(i) of this section, entering 
into or acquiring any forward contract, futures contract, option, 
warrant, or similar financial instrument.
    (A) Limitation for certain derivative instruments. A forward 
contract, futures contract, option, warrant, or similar financial 
instrument is within this paragraph (a)(2)(iii) only if the underlying 
property to which the instrument ultimately relates is a nonfunctional 
currency or is otherwise described in paragraph (a)(1)(ii) of this 
section. Thus, if the underlying property of an instrument is another 
financial instrument (e.g., an option on a futures contract), then the 
underlying property to which such other instrument (e.g., the futures 
contract) ultimately relates must be a nonfunctional currency. For 
example, a forward contract to purchase wheat denominated in a 
nonfunctional currency, an option to enter into a forward contract to 
purchase wheat denominated in a nonfunctional currency, or a warrant to 
purchase stock denominated in a nonfunctional currency is not described 
in this paragraph (a)(2)(iii). On the other hand, a forward contract to 
purchase a nonfunctional currency, an option to enter into a forward 
contract to purchase a nonfunctional currency, an option to purchase a 
bond denominated in or the payments of which are determined by reference 
to the value of a nonfunctional currency, or a warrant to purchase 
nonfunctional currency is described in this paragraph (a)(2)(iii).
    (B) Nonfunctional currency notional principal contracts--(1) In 
general. The term ``similar financial instrument'' includes a notional 
principal contract only if the payments required to be made or received 
under the contract are determined with reference to a nonfunctional 
currency.
    (2) Definition of notional principal contract. The term ``notional 
principal contract'' means a contract (e.g., a swap, cap, floor or 
collar) that provides for the payment of amounts by one party to another 
at specified intervals calculated by reference to a specified index upon 
a notional principal amount in exchange for specified consideration or a 
promise to pay similar amounts. For this purpose, a ``notional principal 
contract'' shall only include an instrument where the underlying 
property to which the instrument ultimately relates is money (e.g., 
functional currency), nonfunctional currency, or property the value of 
which is determined by reference to an interest rate. Thus, the term 
``notional principal contract'' includes a currency swap as defined in 
Sec. 1.988-2(e)(2)(ii), but does not include a swap referenced to a 
commodity or equity index.
    (C) Effective date with respect to certain contracts. This paragraph 
(a)(2)(iii) does not apply to any forward contract, futures contract, 
option, warrant, or similar financial instrument entered into or 
acquired on or before October 21, 1988, if such instrument would have 
been marked to market under section 1256 if held on the last day of the 
taxable year.
    (3)-(5) [Reserved]
    (6) Examples. The following examples illustrate the application of 
paragraph (a) of this section. The examples assume that X is a U.S. 
corporation on an accrual method with the calendar year as its taxable 
year. Because X is a U.S. corporation the U.S. dollar is its functional 
currency under section 985. The examples also assume that section 988(d) 
does not apply.

    Example 1. On January 1, 1989, X acquires 10,000 Canadian dollars. 
On January 15, 1989, X uses the 10,000 Canadian dollars to purchase 
inventory. The acquisition of the 10,000 Canadian dollars is a section 
988 transaction for purposes of establishing X's basis in such Canadian 
dollars. The disposition of the 10,000 Canadian dollars is a section 988 
transaction pursuant to paragraph (a)(1) of this section.
    Example 2. On January 1, 1989, X acquires 10,000 Canadian dollars. 
On January 15, 1989, X converts the 10,000 Canadian dollars to

[[Page 623]]

U.S. dollars. The acquisition of the 10,000 Canadian dollars is a 
section 988 transaction for purposes of establishing X's basis in such 
Canadian dollars. The conversion of the 10,000 Canadian dollars to U.S. 
dollars is a section 988 transaction pursuant to paragraph (a)(1) of 
this section.
    Example 3. On January 1, 1989, X borrows 100,000 British pounds 
([pound]) for a period of 10 years and issues a note to the lender with 
a face amount of [pound]100,000. The note provides for payments of 
interest at an annual rate of 10% paid quarterly in pounds and has a 
stated redemption price at maturity of [pound]100,000. X's becoming the 
obligor under the note is a section 988 transaction pursuant to 
paragraphs (a)(1)(ii) and (2)(i) of this section. Because X is an 
accrual basis taxpayer, the accrual of interest expense under X's note 
is a section 988 transaction pursuant to paragraphs (a)(1)(ii) and 
(2)(ii) of this section. In addition, the acquisition of the British 
pounds to make payments under the note is a section 988 transaction for 
purposes of establishing X's basis in such pounds, and the disposition 
of such pounds is a section 988 transaction under paragraph (a)(1)(i) of 
this section. See Sec. 1.988-2(b) with respect to the translation of 
accrued interest expense and the determination of exchange gain or loss 
upon payment of accrued interest expense.
    Example 4. On January 1, 1989, X purchases an original issue for 
74,621.54 British pounds ([pound]) a 3-year bond maturing on December 
31, 1991, at a stated redemption price of [pound]100,000. The bond 
provides for no stated interest. The bond has a yield to maturity of 10% 
compounded semiannually and has [pound]25,378.46 of original issue 
discount. The acquisition of the bond is a section 988 transaction as 
provided in paragraphs (a)(1)(ii) and (2)(i) of this section. The 
accrual of original issue discount with respect to the bond is a section 
988 transaction under paragraphs (a)(1)(ii) and (2)(ii) of this section. 
See Sec. 1.988-2(b) with respect to the translation of original issue 
discount and the determination of exchange gain or loss upon receipt of 
such amounts.
    Example 5. On January 1, 1989, X sells and delivers inventory to Y 
for 10,000,000 Italian lira for payment on April 1, 1989. Under X's 
method of accounting, January 1, 1989 is the accrual date. Because X is 
an accrual basis taxpayer, the accrual of a nonfunctional currency 
denominated item of gross receipts on January 1, 1989, for payment after 
the date of accrual is a section 988 transaction under paragraphs 
(a)(1)(ii) and (2)(ii) of this section.
    Example 6. On January 1, 1989, X agrees to purchase a machine from Y 
for delivery on March 1, 1990 for 1,000,000 yen. The agreement calls for 
X to pay Y for the machine on June 1, 1990. Under X's method of 
accounting, the expenditure for the machine does not accrue until 
delivery on March 1, 1990. The agreement to purchase the machine is not 
a section 988 transaction. In particular, the agreement to purchase the 
machine is not described in paragraph (a)(2)(ii) of this section because 
the agreement is not an item of expense taken into account under 
subtitle A (but rather is an agreement to purchase a capital asset in 
the future). However, the payable that will arise on the delivery date 
is a section 988 transaction under paragraphs (a)(1)(ii) and (2)(ii) of 
this section even though the payable relates to a capital expenditure. 
In addition, the disposition of yen to satisfy the payable on June 1, 
1990, is a section 988 transaction under paragraph (a)(1)(i) of this 
section.
    Example 7. On January 1, 1989, X purchases and takes delivery of 
inventory for 10,000 French francs with payment to be made on April 1, 
1989. Under X's method of accounting, the expense accrues on January 1, 
1989. On January 1, 1989, X also enters into a forward contract with a 
bank to purchase 10,000 French francs for $2,000 on April 1, 1989. 
Because X is an accrual basis taxpayer, the accrual of a nonfunctional 
currency denominated item of expense on January 1, 1989, for payment 
after the date of accrual is a section 988 transaction under paragraphs 
(a)(1)(ii) and (2)(ii) of this section. Entering into the forward 
contract to purchase the 10,000 French francs is a section 988 
transaction under paragraphs (a)(1)(ii) and (2)(iii) of this section.
    Example 8. On January 1, 1989, X acquires 100,000 Norwegian krone. 
On January 15, 1989, X purchases and takes delivery of 1,000 shares of 
common stock with the 100,000 krone acquired on January 1, 1989. On 
August 1, 1989, X sells the 1,000 shares of common stock and receives 
120,000 krone in payment. On August 30, 1989, X converts the 120,000 
krone to U.S. dollars. The acquisition of the 100,000 krone on January 
1, 1989, and the acquisition of the 120,000 krone on August 1, 1989, are 
section 988 transactions for purposes of establishing the basis of such 
krone. The disposition of the 100,000 krone on January 15, 1989, and the 
120,000 krone on August 30, 1989, are section 988 transactions as 
provided in paragraph (a)(1)(i) of this section. Neither the acquisition 
on January 15, 1989, nor the disposition on August 1, 1989, of the stock 
is a section 988 transaction.
    Example 9. On May 11, 1989, X purchases a one year note at original 
issue for its issue price of $1,000. The note pays interest in dollars 
at the rate of 4 percent compounded semiannually. The amount of 
principal received by X upon maturity is equal to $1,000 plus the 
equivalent of the excess, if any, of (a) the Financial Times One Hundred 
Stock Index (an index of stocks traded on the London Stock Exchange 
hereafter referred to as the FT100) determined and translated into 
dollars on the last business day prior to the maturity date, over (b) 
[pound]2,150, the ``stated value'' of the FT100, which is equal to 110%

[[Page 624]]

of the average value of the index for the six months prior to the issue 
date, translated at the exchange rate of [pound]1 = $1.50. The purchase 
by X of the instrument described above is not a section 988 transaction 
because the index used to compute the principal amount received upon 
maturity is determined with reference to the value of stock and not 
nonfunctional currency.
    Example 10. On April 9, 1989, X enters into an interest rate swap 
that provides for the payment of amounts by X to its counterparty based 
on 4% of a 10,000 yen principal amount in exchange for amounts based on 
yen LIBOR rates. Pursuant to paragraphs (a)(1)(ii) and (2)(iii) of this 
section, this yen for yen interest rate swap is a section 988 
transaction.
    Example 11. On August 11, 1989, X enters into an option contract for 
sale of a group of stocks traded on the Japanese Nikkei exchange. The 
contract is not a section 988 transaction within the meaning of Sec. 
1.988-1(a)(2)(iii) because the underlying property to which the option 
relates is a group of stocks and not nonfunctional currency.

    (7) Special rules for regulated futures contracts and non-equity 
options--(i) In general. Except as provided in paragraph (a)(7)(ii) of 
this section, paragraph (a)(2)(iii) of this section shall not apply to 
any regulated futures contract or non-equity option which would be 
marked to market under section 1256 if held on the last day of the 
taxable year.
    (ii) Election to have paragraph (a)(2)(iii) of this section apply. 
Notwithstanding paragraph (a)(7)(i) of this section, a taxpayer may 
elect to have paragraph (a)(2)(iii) of this section apply to regulated 
futures contracts and non-equity options as provided in paragraphs 
(a)(7)(iii) and (iv) of this section.
    (iii) Procedure for making the election. A taxpayer shall make the 
election provided in paragraph (a)(7)(ii) of this section by sending to 
the Internal Revenue Service Center, Examination Branch, Stop Number 92, 
Kansas City, MO 64999 a statement titled ``Election to Treat Regulated 
Futures Contracts and Non-Equity Options as Section 988 Transactions 
Under Section 988 (c)(1)(D)(ii)'' that contains the following:
    (A) The taxpayer's name, address, and taxpayer identification 
number;
    (B) The date the notice is mailed or otherwise delivered to the 
Internal Revenue Service Center;
    (C) A statement that the taxpayer (including all members of such 
person's affiliated group as defined in section 1504 or in the case of 
an individual all persons filing a joint return with such individual) 
elects to have section 988(c)(1)(D)(i) and Sec. 1.988-1(a)(7)(i) not 
apply;
    (D) The date of the beginning of the taxable year for which the 
election is being made;
    (E) If the election is filed after the first day of the taxable 
year, a statement regarding whether the taxpayer has previously held a 
contract described in section 988(c)(1)(D)(i) or Sec. 1.988-1(a)(7)(i) 
during such taxable year, and if so, the first date during the taxable 
year on which such contract was held; and
    (F) The signature of the person making the election (in the case of 
individuals filing a joint return, the signature of all persons filing 
such return).


The election shall be made by the following persons: in the case of an 
individual, by such individual; in the case of a partnership, by each 
partner separately; effective for taxable years beginning after March 
17, 1992, in the case of tiered partnerships, each ultimate partner; in 
the case of an S corporation, by each shareholder separately; in the 
case of a trust (other than a grantor trust) or estate, by the fiduciary 
of such trust or estate; in the case of any corporation other than an S 
corporation, by such corporation (in the case of a corporation that is a 
member of an affiliated group that files a consolidated return, such 
election shall be valid and binding only if made by the common parent, 
as that term is used in Sec. 1.1502-77(a)); in the case of a controlled 
foreign corporation, by its controlling United States shareholders under 
Sec. 1.964-1(c)(3). With respect to a corporation (other than an S 
corporation), the election, when made by the common parent, shall be 
binding on all members of such corporation's affiliated group as defined 
in section 1504 that file a consolidated return. The election shall be 
binding on any income or loss derived from the partner's share 
(determined under the principles of section 702(a)) of all contracts 
described in section 988(c)(1)(D)(i) or paragraph (a)(7)(i) of this 
section in

[[Page 625]]

which the taxpayer holds a direct interest or indirect interest through 
a partnership or S corporation; however, the election shall not apply to 
any income or loss of a partnership for any taxable year if such 
partnership made an election under section 988(c)(1)(E)(iii)(V) for such 
year or any preceding year. Generally, a copy of the election must be 
attached to the taxpayer's income tax return for the first year it is 
effective. It is not required to be attached to subsequent returns. 
However, in the case of a partner, a copy of the election must be 
attached to the taxpayer's income tax return for every year during which 
the taxpayer is a partner in a partnership that engages in a transaction 
that is subject to the election.
    (iv) Time for making the election--(A) In general. Unless the 
requirements for making a late election described in paragraph 
(a)(7)(iv)(B) of this section are satisfied, an election under section 
988 (c)(1)(D)(ii) and paragraph (a)(7)(ii) of this section for any 
taxable year shall be made on or before the first day of the taxable 
year or, if later, on or before the first day during such taxable year 
on which the taxpayer holds a contract described in section 
988(c)(1)(D)(ii) and paragraph (a)(7)(ii) of this section. The election 
under section 988(c)(1)(D)(ii) and paragraph (a)(7)(ii) of this section 
shall apply to contracts entered into or acquired after October 21, 
1988, and held on or after the effective date of the election. The 
election shall be effective as of the beginning of the taxable year and 
shall be binding with respect to all succeeding taxable years unless 
revoked with the prior consent of the Commissioner. In determining 
whether to grant revocation of the election, recapture of the tax 
benefit derived from the election in previous taxable years will be 
considered.
    (B) Late elections. A taxpayer may make an election under section 
988(c)(1)(D)(ii) and paragraph (a)(7)(ii) of this section within 30 days 
after the time prescribed in the first sentence of paragraph 
(a)(7)(iv)(A) of this section. Such a late election shall be effective 
as of the beginning of the taxable year; however, any losses recognized 
during the taxable year with respect to contracts described in section 
988(c)(1)(D)(ii) or paragraph (a)(7)(ii) of this section which were 
entered into or acquired after October 21, 1988, and held on or before 
the date on which the late election is mailed or otherwise delivered to 
the Internal Revenue Service Center shall not be treated as derived from 
a section 988 transaction. A late election must comply with the 
procedures set forth in paragraph (a)(7)(iii) of this section.
    (v) Transition rule. An election made prior to September 21, 1989 
which satisfied the requirements of Notice 88-124, 1988-51 I.R.B. 6, 
shall be deemed to satisfy the requirements of paragraphs (a)(7)(iii) 
and (iv) of this section.
    (vi) General effective date provision. This paragraph (a)(7) shall 
apply with respect to futures contracts and options entered into or 
acquired after October 21, 1988.
    (8) Special rules for qualified funds--(i) Definition of qualified 
fund. The term ``qualified fund'' means any partnership if--
    (A) At all times during the taxable year (and during each preceding 
taxable year to which an election under section 988(c)(1)(E)(iii)(V) 
applied) such partnership has at least 20 partners and no single partner 
owns more than 20 percent of the interests in the capital or profits of 
the partnership;
    (B) The principa1 activity of such partnership for such taxable year 
(and each such preceding taxable year) consists of buying and selling 
options, futures, or forwards with respect to commodities;
    (C) At least 90 percent of the gross income of the partnership for 
the taxable year (and each such preceding year) consists of income or 
gains described in subparagraph (A), (B), or (G) of section 7704(d)(1) 
or gain from the sale or disposition of capital assets held for the 
production of interest or dividends;
    (D) No more than a de minimis amount of the gross income of the 
partnership for the taxable year (and each such preceding taxable year) 
was derived from buying and selling commodities; and
    (E) An election under section 988 (c)(1)(E)(iii)(V) as provided in 
paragraph (a)(8)(iv) of this section applies to the taxable year.

[[Page 626]]

    (ii) Special rules relating to paragraph (a)(8)(i)(A) of this 
section--(A) Certain general partners. The interest of a general partner 
in the partnership shall not be treated as failing to meet the 20 
percent ownership requirement of paragraph (a)(8)(i)(A) of this section 
for any taxable year of the partnership if, for the taxable year of the 
partner in which such partnership's taxable year ends, such partner (and 
each corporation filing a consolidated return with such partner) had no 
ordinary income or loss from a section 988 transaction (other than 
income from the partnership) which is exchange gain or loss (as the case 
may be).
    (B) Treatment of incentive compensation. For purposes of paragraph 
(a)(8)(i)(A) of this section, any income allocable to a general partner 
as incentive compensation based on profits rather than capital shall not 
be taken into account in determining such partner's interest in the 
profits of the partnership.
    (C) Treatment of tax exempt partners. The interest of a partner in 
the partnership shall not be treated as failing to meet the 20 percent 
ownership requirements of paragraph (a)(5)(8)(A) of this section if none 
of the income of such partner from such partnership is subject to tax 
under chapter 1 of subtitle A of the Internal Revenue Code (whether 
directly or through one or more pass-through entities).
    (D) Look-through rule. In determining whether the 20 percent 
ownership requirement of paragraph (a)(8)(i)(A) of this section is met 
with respect to any partnership, any interest in such partnership held 
by another partnership shall be treated as held proportionately by the 
partners in such other partnership.
    (iii) Other special rules--(A) Related persons. Interests in the 
partnership held by persons related to each other (within the meaning of 
section 267(b) or 707(b)) shall be treated as held by one person.
    (B) Predecessors. Reference to any partnership shall include a 
reference to any predecessor thereof.
    (C) Treatment of certain debt instruments. Solely for purposes of 
paragraph (a)(8)(i)(D) of this section, any debt instrument which is 
described in both paragraphs (a)(1)(ii) and (2)(i) of this section shall 
be treated as a commodity.
    (iv) Procedure for making the election provided in section 
988(c)(1)(E)(iii)(V). A partnership shall make the election provided in 
section 988(c)(1)(E)(iii)(V) by sending to the Internal Revenue Service 
Center, Examination Branch, Stop Number 92, Kansas City, MO 64999 a 
statement titled ``QUALIFIED FUND ELECTION UNDER SECTION 
988(c)(1)(E)(iii)(V)'' that contains the following:
    (A) The partnership's name, address, and taxpayer identification 
number;
    (B) The name, address and taxpayer identification number of the 
general partner making the election on behalf of the partnership;
    (C) The date the notice is mailed or otherwise delivered to the 
Internal Revenue Service Center;
    (D) A brief description of the activity of the partnership;
    (E) A statement that the partnership is making the election provided 
in section 988(c)(1)(E)(iii)(V);
    (F) The date of the beginning of the taxable year for which the 
election is being made;
    (G) If the election is filed after the first day of the taxable 
year, then a statement regarding whether the partnership previously held 
an instrument referred to in section 988(c)(1)(E)(i) during such taxable 
year and, if so, the first date during the taxable year on which such 
contract was held; and
    (H) The signature of the general partner making the election.


The election shall be made by a general partner with management 
responsibility of the partnership's activities and a copy of such 
election shall be attached to the partnership's income tax return (Form 
1065) for the first taxable year it is effective. It is not required to 
be attached to subsequent returns.
    (v) Time for making the election. The election under section 
988(c)(1)(E)(iii)(V) for any taxable year shall be made on or before the 
first day of the taxable year or, if later, on or before the first day 
during such year on which the partnership holds an instrument described 
in section 988(c)(1)(E)(i). The election under section 
988(c)(1)(E)(iii)(V) shall apply to

[[Page 627]]

the taxable year for which made and all succeeding taxable years. Such 
election may only be revoked with the consent of the Commissioner. In 
determining whether to grant revocation of the election, recapture by 
the partners of the tax benefit derived from the election in previous 
taxable years will be considered.
    (vi) Operative rules applicable to qualified funds--(A) In general. 
In the case of a qualified fund, any bank forward contract or any 
foreign currency futures contract traded on a foreign exchange which is 
not otherwise a section 1256 contract shall be treated as a section 1256 
contract for purposes of section 1256.
    (B) Gains and losses treated as short-term. In the case of any 
instrument treated as a section 1256 contract under paragraph 
(a)(8)(vi)(A) of this section, subparagraph (A) of section 1256(a)(3) 
shall be applied by substituting ``100 percent'' for ``40 percent'' (and 
subparagraph (B) of such section shall not apply).
    (vii) Transition rule. An election made prior to September 21, 1989, 
which satisfied the requirements of Notice 88-124, 1988-51 I.R.B. 6, 
shall be deemed to satisfy the requirements of Sec. 1.988-1(a)(8)(iv) 
and (v).
    (viii) General effective date rules--(A) The requirements of 
subclause (IV) of section 988(c)(1)(E)(iii) shall not apply to contracts 
entered into or acquired on or before October 21, 1988.
    (B) In the case of any partner in an existing partnership, the 20 
percent ownership requirements of subclause (I) of section 
988(c)(1)(E)(iii) shall be treated as met during any period during which 
such partner does not own a percentage interest in the capital or 
profits of such partnership greater than 33\1/3\ percent (or, if lower, 
the lowest such percentage interest of such partner during any period 
after October 21, 1988, during which such partnership is in existence). 
For purposes of the preceding sentence, the term ``existing 
partnership'' means any partnership if--
    (1) Such partnership was in existence on October 21, 1988, and 
principally engaged on such date in buying and selling options, futures, 
or forwards with respect to commodities; or
    (2) A registration statement was filed with respect to such 
partnership with the Securities and Exchange Commission on or before 
such date and such registration statement indicated that the principal 
activity of such partnership will consist of buying and selling 
instruments referred to in paragraph (a)(8)(viii)(B)(1) of this section.
    (9) Exception for certain transactions entered into by an 
individual--(i) In general. A transaction entered into by an individual 
which otherwise qualifies as a section 988 transaction shall be 
considered a section 988 transaction only to the extent expenses 
properly allocable to such transaction meet the requirements of section 
162 or 212 (other than the part of section 212 dealing with expenses 
incurred in connection with taxes).
    (ii) Examples. The following examples illustrate the application of 
paragraph (a)(9) of this section.

    Example 1. X is a U.S. citizen who therefore has the U.S. dollar as 
his functional currency. On January 1, 1990, X enters into a spot 
contract to purchase 10,000 British pounds ([pound]) for $15,000 for 
delivery on January 3, 1990. Immediately upon delivery, X acquires at 
original issue a pound denominated bond with an issue price of 
[pound]10,000. The bond matures on January 3, 1993, pays interest in 
pounds at a rate of 10% compounded semiannually, and has no original 
issue discount. Assume that all expenses properly allocable to these 
transactions would meet the requirements of section 212. Under Sec. 
1.988-2(d)(1)(ii), entering into the spot contract on January 1, 1990, 
is not a section 988 transaction. The acquisition of the pounds on 
January 3, 1990, under the spot contract is a section 988 transaction 
for purposes of establishing X's basis in the pounds. The disposition of 
the pounds and the acquisition of the bond by X are section 988 
transactions. These transactions are not excluded from the definition of 
a section 988 transaction under paragraph (a)(9) of this section because 
expenses properly allocable to such transactions meet the requirements 
of section 212.
    Example 2. X is a U.S. citizen who therefore has the dollar as his 
functional currency. In preparation for X's vacation, X purchases 1,000 
British pounds ([pound]) from a bank on June 1, 1989. During the period 
of X's vacation in the United Kingdom beginning June 10, 1989, and 
ending June 20, 1989, X spends [pound]500 for hotel rooms, [pound]300 
for food and [pound]200 for miscellaneous vacation expenses. The 
expenses properly allocable to such dispositions do not meet the 
requirements of section 162 or 212. Thus, the disposition of the pounds 
by X

[[Page 628]]

on his vacation are not section 988 transactions.

    (10) Intra-taxpayer transactions--(i) In general. Except as provided 
in paragraph (a)(10)(ii) of this section, transactions between or among 
the taxpayer and/or qualified business units of that taxpayer (``intra-
taxpayer transactions'') are not section 988 transactions. See section 
987 and the regulations thereunder.
    (ii) Certain transfers. Exchange gain or loss with respect to 
nonfunctional currency or any item described in paragraph (a)(2) of this 
section entered into with another taxpayer shall be realized upon an 
intra-taxpayer transfer of such currency or item where as the result of 
the transfer the currency or other such item--
    (A) Loses its character as nonfunctional currency or an item 
described in paragraph (a)(2) of this section; or
    (B) Where the source of the exchange gain or loss could be altered 
absent the application of this paragraph (a)(10)(ii).


Such exchange gain or loss shall be computed in accordance with Sec. 
1.988-2 (without regard to Sec. 1.988-2(b)(8)) as if the nonfunctional 
currency or item described in paragraph (a)(2) of this section had been 
sold or otherwise transferred at fair market value between unrelated 
taxpayers. For purposes of the preceding sentence, a taxpayer must use 
the translation rate that it uses for purposes of computing section 987 
gain or loss with respect to the QBU branch that makes the transfer. In 
the case of a gain or loss incurred in a transaction described in this 
paragraph (a)(10)(ii) that does not have a significant business purpose, 
the Commissioner, may defer such gain or loss.
    (iii) Example. The following example illustrates the provisions of 
this paragraph (a)(10).

    Example. (A) X, a corporation with the U.S. dollar as its functional 
currency, operates through foreign branches Y and Z. Y and Z are 
qualified business units as defined in section 989(a) with the LC as 
their functional currency. X computes Y's and Z's income under section 
987 (relating to branch transactions). On November 12, 1988, Y transfers 
$25 to the home office of X when the fair market value of such amount 
equals LC120. Y has a basis of LC100 in the $25. Under paragraph 
(a)(10)(ii) of this section, Y realizes foreign source exchange gain of 
LC20 (LC120--LC100) as the result of the $25 transfer. For purposes of 
determining whether the transfer is a remittance resulting in additional 
gain or loss, see section 987 and the regulations thereunder.
    (B) If instead Y transfers the $25 to Z, exchange gain is not 
realized because the $25 is nonfunctional currency with respect to Z and 
if Z were to immediately convert the $25 into LCs, the gain would be 
foreign source. For purposes of determining whether the transfer is a 
remittance resulting in additional gain or loss, see section 987 and the 
regulations thereunder.

    (11) Authority to include or exclude transactions from section 988--
(i) In general. The Commissioner may recharacterize a transaction (or 
series of transactions) in whole or in part as a section 988 transaction 
if the effect of such transaction (or series of transactions) is to 
avoid section 988. In addition, the Commissioner may exclude a 
transaction (or series of transactions) which in form is a section 988 
transaction from the provisions of section 988 if the substance of the 
transaction (or series of transactions) indicates that it is not 
properly considered a section 988 transaction.
    (ii) Example. The following example illustrates the provisions of 
this paragraph (a)(11).

    Example. B is an individual with the U.S. dollar as its functional 
currency. B holds 500,000 Swiss francs which have a basis of $100,000 
and a fair market value of $400,000 as of October 15, 1989. On October 
16, 1989, B transfers the 500,000 Swiss francs to a newly formed U.S. 
corporation, X, with the dollar as its functional currency. On October 
16, 1989, B sells the stock of X for $400,000. Assume the transfer to X 
qualified for nonrecognition under section 351. Because the sale of the 
stock of X is a substitute for the disposition of an asset subject to 
section 988, the Commissioner may recharacterize the sale of the stock 
as a section 988 transaction. The same result would obtain if B 
transferred the Swiss francs to a partnership and then sold the 
partnership interest.

    (b) Spot contract. A spot contract is a contract to buy or sell 
nonfunctional currency on or before two business days following the date 
of the execution of the contract. See Sec. 1.988-2 (d)(1)(ii) for 
operative rules regarding spot contracts.
    (c) Nonfunctional currency. The term ``nonfunctional currency'' 
means with

[[Page 629]]

respect to a taxpayer or a qualified business unit (as defined in 
section 989 (a)) a currency (including the European Currency Unit) other 
than the taxpayer's or the qualified business unit's functional currency 
as defined in section 985 and the regulations thereunder. For rules 
relating to nonrecognition of exchange gain or loss with respect to 
certain dispositions of nonfunctional currency, see Sec. 1.988-2 
(a)(1)(iii).
    (d) Spot rate--(1) In general. Except as otherwise provided in this 
paragraph, the term ``spot rate'' means a rate demonstrated to the 
satisfaction of the District Director or the Assistant Commissioner 
(International) to reflect a fair market rate of exchange available to 
the public for currency under a spot contract in a free market and 
involving representative amounts. In the absence of such a 
demonstration, the District Director or the Assistant Commissioner 
(International), in his or her sole discretion, shall determine the spot 
rate from a source of exchange rate information reflecting actual 
transactions conducted in a free market. For example, the taxpayer or 
the District Director or the Assistant Commissioner (International) may 
determine the spot rate by reference to exchange rates published in the 
pertinent monthly issue of ``International Financial Statistics'' or a 
successor publication of the International Monetary Fund; exchange rates 
published by the Board of Governors of the Federal Reserve System 
pursuant to 31 U.S.C. section 5151; exchange rates published in 
newspapers, financial journals or other daily financial news sources; or 
exchange rates quoted by electronic financial news services.
    (2) Consistency required in valuing transactions subject to section 
988. If the use of inconsistent sources of spot rate quotations results 
in the distortion of income, the District Director or the Assistant 
Commissioner (International) may determine the appropriate spot rate.
    (3) Use of certain spot rate conventions for payables and 
receivables denominated in nonfunctional currency. If consistent with 
the taxpayer's financial accounting, a taxpayer may utilize a spot rate 
convention determined at intervals of one quarter year or less for 
purposes of computing exchange gain or loss with respect to payables and 
receivables denominated in a nonfunctional currency that are incurred in 
the ordinary course of business with respect to the acquisition or sale 
of goods or the obtaining or performance of services. For example, if 
consistent with the taxpayer's financial accounting, a taxpayer may 
accrue all payables and receivables incurred during the month of January 
at the spot rate on December 31 or January 31 (or at an average of any 
spot rates occurring between these two dates) and record the payment or 
receipt of amounts in satisfaction of such payables and receivables 
consistent with such convention. The use of a spot rate convention 
cannot be changed without the consent of the Commissioner.
    (4) Currency where an official government established rate differs 
from a free market rate--(i) In general. If a currency has an official 
government established rate that differs from a free market rate, the 
spot rate shall be the rate which most clearly reflects the taxpayer's 
income. Generally, this shall be the free market rate.
    (ii) Examples. The following examples illustrate the application of 
this paragraph (d)(4).

    Example 1. X is an accrual method U.S. corporation with the dollar 
as its functional currency. X owns all the stock of a Country L 
subsidiary, CFC. CFC has the currency of Country L, the LC, as its 
functional currency. Country L imposes restrictions on the remittance of 
dividends. On April 1, 1990, CFC pays a dividend to X in the amount of 
LC100. Assume that the official governnent established rate is $1 = LC1 
and the free market rate, which takes into account the remittance 
restrictions and which is the rate that most clearly reflects income, is 
$1 = LC4. On April 1, 1990, X donates the LC100 in a transaction that 
otherwise qualifies as a charitable contribution under section 170 (c). 
Both the amount of the dividend income and the deduction under section 
170 is $25 (LC100 x the free market rate, $.25).
    Example 2. X, a corporation with the U.S. dollar as its functional 
currency, operates in foreign country L through branch Y. Y is a 
qualified business unit as defined in section 989 (a). X computes Y's 
income under the dollar approximate separate transactions method as 
described in Sec. 1.985-3. The currency of L is the LC. X can purchase 
legally United

[[Page 630]]

States dollars ($) in L only from the L government. In order to take 
advantage of an arbitrage between the official and secondary dollar to 
LC exchange rates in L:
    (i) X purchases LC100 for $60 in L on the secondary market when the 
official exchange rate is S1 = LC1;
    (ii) X transfers the LC100 to Y;
    (iii) Y purchases $100 for LC100; and
    (iv) Y transfers $65 ($100 less an L tax withheld of $35 on the 
transfer) to the home office of X.


Under paragraph (a)(7) of this section, the transfer of the LC100 by X 
to Y is a realization event. X has a basis of $60 in the LC100. Under 
these facts, the appropriate dollar to LC exchange rate for computing 
the amount realized by X is the official exchange rate. Therefore, X 
realizes $40 ($100-$60) of U.S. source gain from the transfer to Y. The 
same result would obtain if Y rather than X purchased the LC100 on the 
secondary market in L with $60 supplied by X, because the substance of 
this transaction is that X is performing the arbitrage.

    (e) Exchange gain or loss. The term ``exchange gain or loss'' means 
the amount of gain or loss realized as determined in Sec. 1.988-2 with 
respect to a section 988 transaction. Except as otherwise provided in 
these regulations (e.g., Sec. 1.98B-5), the amount of exchange gain or 
loss from a section 988 transaction shall be separately computed for 
each section 988 transaction, and such amount shall not be integrated 
with gain or loss recognized on another transaction (whether or not such 
transaction is economically related to the section 988 transaction). See 
Sec. 1.988-2 (b)(8) for a special rule with respect to debt 
instruments.
    (f) Hyperinflationary currency--(1) Definition--(i) General rule. 
For purposes of section 988, a hyperinflationary currency means a 
currency described in Sec. 1.985-1(b)(2)(ii)(D). Unless otherwise 
provided, the currency in any example used in Sec. Sec. 1.988-1 through 
1.988-5 is not a hyperinflationary currency.
    (ii) Special rules for determining base period. In determining 
whether a currency is hyperinflationary under Sec. 1.985-1(b)(2)(ii)(D) 
for purposes of this paragraph (f), the following rules will apply:
    (A) The base period means the thirty-six calendar month period 
ending on the last day of the taxpayer's (or qualified business unit's) 
current taxable year. Thus, for example, if for 1996, 1997, and 1998, a 
country's annual inflation rates are 6 percent, 11 percent, and 90 
percent, respectively, the cumulative inflation rate for the three-year 
base period is 124% [((1.06 x 1.11 x 1.90) - 1.0 = 1.24) x 100 = 124%]. 
Accordingly, assuming the QBU has a calendar year as its taxable year, 
the currency of the country is hyperinflationary for the 1998 taxable 
year. This change in the Sec. 1.985-1(b)(2)(ii)(D) base period shall 
not apply to any section 988 transaction of an entity described in 
section 851 (regulated investment company (RIC)) or section 856 (real 
estate investment trust (REIT)). The Service may, by notice, provide 
that the foregoing change in the Sec. 1.985-1(b)(2)(ii)(D) base period 
does not apply to any section 988 transaction of an entity with 
distribution requirements similar to a RIC or REIT.
    (B) The last sentence of Sec. 1.985-1(b)(2)(ii)(D) shall not apply 
to alter the base period for purposes of this paragraph (f) in 
determining whether a currency is hyperinflationary for purposes of 
section 988. Accordingly, generally accepted accounting principles may 
not apply to alter the base period for purposes of this paragraph (f).
    (2) Effective date. Paragraph (f)(1) of this section shall apply to 
transactions entered into after February 14, 2000.
    (g) Fair market value. The fair market value of an item shall, where 
relevant, reflect an appropriate premium or discount for the time value 
of money (e.g., the fair market value of a forward contract to buy or 
sell nonfunctional currency shall reflect the present value of the 
difference between the units of nonfunctional currency times the market 
forward rate at the time of valuation and the units of nonfunctional 
currency times the forward rate set forth in the contract). However, if 
consistent with the taxpayer's method of financial accounting (and 
consistently applied from year to year), the preceding sentence shall 
not apply to a financial instrument that matures within one year from 
the date of issuance or acquisition. Unless otherwise provided, the fair 
market value given in any example used in Sec. Sec. 1.988-1 through 
1.988-5 is deemed to reflect appropriately the time value of money. If

[[Page 631]]

the use of inconsistent sources of forward or other market rate 
quotations results in the distortion of income, the District Director or 
the Assistant Commissioner (International) may determine the appropriate 
rate.
    (h) Interaction with sections 1092 and 1256. Unless otherwise 
provided, it is assumed for purposes of Sec. Sec. 1.988-1 through 
1.988-5 that any contract used in any example is not a section 1256 
contract and is not part of a straddle as defined in section 1092. No 
inference is intended regarding the application of section 1092 or 1256 
unless expressly stated.
    (i) Effective date. Except as otherwise provided in this section, 
this section shall be effective for taxable years beginning after 
December 31, 1986. Thus, except as otherwise provided in this section, 
any payments made or received with respect to a section 988 transaction 
in taxable years beginning after December 31, 1986, are subject to this 
section.

[T.D. 8400, 57 FR 9178, Mar. 17, 1992, as amended by T.D. 8914, 66 FR 
280, Jan. 3, 2001]



Sec. 1.988-2  Recognition and computation of exchange gain or loss.

    (a) Disposition of nonfunctional currency--(1) Recognition of 
exchange gain or loss--(i) In general. Except as otherwise provided in 
this section, Sec. 1.988-1(a)(7)(ii), and Sec. 1.988-5, the 
recognition of exchange gain or loss upon the sale or other disposition 
of nonfunctional currency shall be governed by the recognition 
provisions of the Internal Revenue Code which apply to the sale or 
disposition of property (e.g., section 1001 or, to the extent provided 
in regulations, section 1092). The disposition of nonfunctional currency 
in settlement of a forward contract, futures contract, option contract, 
or similar financial instrument is considered to be a sale or 
disposition of the nonfunctional currency for purposes of the preceding 
sentence.
    (ii) Clarification of section 1031. An amount of one nonfunctional 
currency is not ``property of like kind'' with respect to an amount of a 
different nonfunctional currency.
    (iii) Coordination with section 988(c)(1)(C)(ii). No exchange gain 
or loss is recognized with respect to the following transactions--
    (A) An exchange of units of nonfunctional currency for different 
units of the same nonfunctional currency;
    (B) The deposit of nonfunctional currency in a demand or time 
deposit or similar instrument (including a certificate of deposit) 
issued by a bank or other financial institution if such instrument is 
denominated in such currency;
    (C) The withdrawal of nonfunctional currency from a demand or time 
deposit or similar instrument issued by a bank or other financial 
institution if such instrument is denominated in such currency;
    (D) The receipt of nonfunctional currency from a bank or other 
financial institution from which the taxpayer purchased a certificate of 
deposit or similar instrument denominated in such currency by reason of 
the maturing or other termination of such instrument; and
    (E) The transfer of nonfunctional currency from a demand or time 
deposit or similar instrument issued by a bank or other financial 
institution to another demand or time deposit or similar instrument 
denominated in the same nonfunctional currency issued by a bank or other 
financial institution.


The taxpayer's basis in the units of nonfunctional currency or other 
property received in the transaction shall be the adjusted basis of the 
units of nonfunctional currency or other property transferred. See 
paragraph (b) of this section with respect to the timing of interest 
income or expense and the determination of exchange gain or loss 
thereon.
    (iv) Example. The following example illustrates the provisions of 
paragraph (a)(1)(iii) of this section.

    Example. X is a corporation on the accrual method of accounting with 
the U.S. dollar as its functional currency. On January 1, 1989, X 
acquires 1,500 British pounds ([pound]) for $2,250 ([pound]1 = $1.50). 
On January 3, 1989, when the spot rate is [pound]1 = $1.49, X deposits 
the [pound]1,500 with a British financial institution in a non-interest 
bearing demand account. On February 1, 1989, when the spot rate is 
[pound]1 = $1.45, X withdraws the [pound]1,500. On February 5, 1989, 
when the spot rate is [pound]1 = $1.42, X purchases inventory in the 
amount of [pound]1,500. Pursuant to

[[Page 632]]

paragraph (a)(1)(iii) of this section, no exchange loss is realized 
until February 5, 1989, when X disposes of the [pound]1,500 for 
inventory. At that time, X realizes exchange loss in the amount of $120 
computed under paragraph (a)(2) of this section. The loss is not an 
adjustment to the cost of the inventory.

    (2) Computation of gain or loss--(i) In general. Exchange gain 
realized from the sale or other disposition of nonfunctional currency 
shall be the excess of the amount realized over the adjusted basis of 
such currency, and exchange loss realized shall be the excess of the 
adjusted basis of such currency over the amount realized.
    (ii) Amount realized--(A) In general. The amount realized from the 
disposition of nonfunctional currency shall be determined under section 
1001(b). A taxpayer that uses a spot rate convention under Sec. 1.988-
1(d)(3) to determine exchange gain or loss with respect to a payable 
shall determine the amount realized upon the disposition of 
nonfunctional currency paid in satisfaction of the payable in a manner 
consistent with such convention.
    (B) Exchange of nonfunctional currency for property. For purpose of 
paragraph (a)(2) of this section, the exchange of nonfunctional currency 
for property (other than nonfunctional currency) shall be treated as--
    (1) An exchange of the units of nonfunctional currency for units of 
functional currency at the spot rate on the date of the exchange, and
    (2) The purchase or sale of the property for such units of 
functional currency.
    (C) Example. The following example illustrates the provisions of 
paragraph (a)(2)(ii)(B) of this section.

    Example. G is a U.S. corporation with the U.S. dollar as its 
functional currency. On January 1, 1989, G enters into a contract to 
purchase a paper manufacturing machine for 10,000,000 British pounds 
([pound]) for delivery on January 1, 1991. On January 1, 1991, when G 
exchanges [pound]10,000,000 (which G purchased for $12,000,000) for the 
machine, the fair market value of the machine is [pound]17,000,000. On 
January 1, 1991, the spot exchange rate is [pound]1 = $1.50. Under 
paragraph (a)(2)(ii)(B) of this section, the transaction is treated as 
an exchange of [pound]10,000,000 for $15,000,000 and the purchase of the 
machine for $15,000,000. Accordingly, in computing G's exchange gain of 
$3,000,000 on the disposition of the [pound]10,000,000, the amount 
realized is $15,000,000. G's basis in the machine is $15,000,000. No 
gain is recognized on the bargain purchase of the machine.

    (iii) Adjusted basis--(A) In general. Except as provided in 
paragraph (a)(2)(iii)(B) of this section, the adjusted basis of 
nonfunctional currency is determined under the applicable provisions of 
the Internal Revenue Code (e.g., sections 1011 through 1023). A taxpayer 
that uses a spot rate convention under Sec. 1.988-1 (d)(3) to determine 
exchange gain or loss with respect to a receivable shall determine the 
basis of nonfunctional currency received in satisfaction of such 
receivable in a manner consistent with such convention.
    (B) Determination of the basis of nonfunctional currency withdrawn 
from an account with a bank or other financial institution--(1) In 
general. The basis of nonfunctional currency withdrawn from an account 
with a bank or other financial institution shall be determined under any 
reasonable method that is consistently applied from year to year by the 
taxpayer to all accounts denominated in a nonfunctional currency. For 
example, a taxpayer may use a first in first out method, a last in first 
out method, a pro rata method (as illustrated in the example below), or 
any other reasonable method that is consistently applied. However, a 
method that consistently results in units of nonfunctional currency with 
the highest basis being withdrawn first shall not be considered 
reasonable.
    (2) Example. The following example illustrates the provisions of 
this paragraph (a)(2)(iii)(B).

    Example. (i) X, a cash basis individual with the dollar as his 
functional currency, opens a demand account with a Swiss bank. Assume 
expenses associated with the demand account are deductible under section 
212. The following chart indicates Swiss franc deposits to the account, 
Swiss franc interest credited to the account, the dollar basis of each 
deposit, and the determination of the aggregate dollar basis of all 
Swiss francs in the account. Assume that the taxpayer has properly 
translated all the amounts specified in the chart and that all 
transactions are subject to section 988.

[[Page 633]]



----------------------------------------------------------------------------------------------------------------
                                                                                                      Aggregate
               Date                  Swiss francs deposited       Interest received     U.S. dollar  U.S. dollar
                                                                                           basis        basis
----------------------------------------------------------------------------------------------------------------
1/01/89..........................  1000 Sf                    ........................         $500         $500
3/31/89..........................  .........................  50 Sf                              25          525
6/30/89..........................  .........................  50 Sf                              24          549
9/30/89..........................  .........................  50 Sf                              25          574
12/31/89.........................  .........................  50 Sf                              26          600
----------------------------------------------------------------------------------------------------------------

    (ii) On January 1, 1990, X withdraws 500 Swiss francs from the 
account. X may determine his basis in the Swiss francs by multiplying 
the aggregate U.S. dollar basis of Swiss francs in the account by a 
fraction the numerator of which is the number of Swiss francs withdrawn 
from the account and the denominator is the total number of Swiss francs 
in the account. Under this method, X's basis in the 500 Swiss francs is 
$250 computed as follows:
[GRAPHIC] [TIFF OMITTED] TC09OC91.070

    (iii) X's basis in the Swiss francs remaining in the account is $350 
($600-$250). X must use this method consistently from year to year with 
respect to withdrawals of nonfunctional currency from all of X's 
accounts.
    (iv) Purchase and sale of stock or securities traded on an 
established securities market by cash basis taxpayer--
    (A) Amount realized. If stock or securities traded on an established 
securities market are sold by a cash basis taxpayer for nonfunctional 
currency, the amount realized with respect to the stock or securities 
(as determined on the trade date) shall be computed by translating the 
units of nonfunctional currency received into functional currency at the 
spot rate on the settlement date of the sale. This rule applies 
notwithstanding that the stock or securities are treated as disposed of 
on a date other than the settlement date under another section of the 
Code. See section 453(k).
    (B) Basis. If stock or securities traded on an established 
securities market are purchased by a cash basis taxpayer for 
nonfunctional currency, the basis of the stock or securities shall be 
determined by translating the units of nonfunctional currency paid into 
functional currency at the spot rate on the settlement date of the 
purchase.

    (C) Example. The following example illustrates the provisions of 
this paragraph (a)(2)(iv).

    Example. On November 1, 1989 (the trade date), X, a calendar year 
cash basis U.S. individual, purchases stock for [pound]100 for 
settlement on November 5, 1989. On November 1, 1989, the spot value of 
the [pound]100 is $140. On November 5, 1989, X purchases [pound]100 for 
$141 which X uses to pay for the stock. X's basis in the stock is $141. 
On December 30, 1990 (the trade date), X sells the stock for [pound]110 
for settlement on January 5, 1991. On December 30, 1990, the spot value 
of [pound]110 is $165. On January 5, 1991, X transfers the stock and 
receives [pound]110 which, translated at the spot rate, equal $166. 
Under section 453(k), the stock is considered disposed of on December 
30, 1990. The amount realized with respect to such disposition is the 
value of the [pound]110 on January 5, 1991 ($166). Accordingly, X's gain 
realized on December 30, 1990, from the disposition of the stock is $25 
($166 amount realized less $141 basis). X's basis in the [pound]110 
received from the sale of the stock is $166.

    (v) Purchase and sale of stock or securities traded on an 
established securities market by accrual basis taxpayer. For taxable 
years beginning after March 17, 1992, an accrual basis taxpayer may 
elect to apply the rules of paragraph (a)(2)(iv) of this section. The 
election shall be made by filing a statement with the taxpayer's first 
return in which the election is effective clearly indicating that the 
election has been made. A method so elected must be applied consistently 
from year to year and cannot be changed without the consent of the 
Commissioner.
    (b) Translation of interest income or expense and determination of 
exchange gain or loss with respect to debt instruments--(1) Translation 
of interest income received with respect to a nonfunctional currency 
demand account. Interest income received with respect to a demand 
account with a bank or other financial institution which is denominated 
in (or the payments of which are determined by reference to) a 
nonfunctional currency shall be translated into functional currency at 
the spot rate on the date received or accrued or pursuant to any 
reasonable spot rate convention consistently applied by the taxpayer to 
all taxable years and to all accounts denominated in nonfunctional 
currency in the same financial institution. For

[[Page 634]]

example, a taxpayer may translate interest income received with respect 
to a demand account on the last day of each month of the taxable year, 
on the last day of each quarter of the taxable year, on the last day of 
each half of the taxable year, or on the last day of the taxable year. 
No exchange gain or loss is realized upon the receipt or accrual of 
interest income with respect to a demand account subject to this 
paragraph (b)(1).
    (2) Translation of nonfunctional currency interest income or expense 
received or paid with respect to a debt instrument described in Sec. 
1.988-1(a)(1)(ii) and (2)(i)--(i) Scope--(A) In general. Paragraph (b) 
of this section only applies to debt instruments described in Sec. 
1.988-1(a)(1)(ii) and (2)(i) where all payments are denominated in, or 
determined with reference to, a single nonfunctional currency. Except as 
provided in paragraph (b)(2)(i)(B) of this section, this paragraph (b) 
shall not apply to contingent payment debt instruments.
    (B) Nonfunctional currency contingent payment debt instruments--(1) 
Operative rules. See Sec. 1.988-6 for rules applicable to contingent 
payment debt instruments for which one or more payments are denominated 
in, or determined by reference to, a nonfunctional currency.
    (2) Certain instruments are not contingent payment debt instruments. 
For purposes of sections 163(e) and 1271 through 1275 and the 
regulations thereunder, a debt instrument does not provide for 
contingent payments merely because the instrument is denominated in, or 
all payments of which are determined with reference to, a single 
nonfunctional currency. See Sec. 1.988-6 for the treatment of 
nonfunctional currency contingent payment debt instruments.
    (ii) Determination and translation of interest income or expense--
(A) In general. Interest income or expense on a debt instrument 
described in paragraph (b)(2)(i) of this section (including original 
issue discount determined in accordance with sections 1271 through 1275 
and 163(e) as adjusted for acquisition premium under section 1272(a)(7), 
and acquisition discount determined in accordance with sections 1281 
through 1283) shall be determined in units of nonfunctional currency and 
translated into functional currency as provided in paragraphs 
(b)(2)(ii)(B) and (C) of this section. For purposes of sections 483, 
1273(b)(5) and 1274, the nonfunctional currency in which an instrument 
is denominated (or by reference to which payments are determined) shall 
be considered money.
    (B) Translation of interest income or expense that is not required 
to be accrued prior to receipt or payment. With respect to an instrument 
described in paragraph (b)(2)(i) of this section, interest income or 
expense received or paid that is not required to be accrued by the 
taxpayer prior to receipt or payment shall be translated at the spot 
rate on the date of receipt or payment. No exchange gain or loss is 
realized with respect to the receipt or payment of such interest income 
or expense (other than the exchange gain or loss that might be realized 
under paragraph (a) of this section upon the disposition of the 
nonfunctional currency so received or paid).
    (C) Translation of interest income or expense that is required to be 
accrued prior to receipt or payment. With respect to an instrument 
described in paragraph (b)(2)(i) of this section, interest income or 
expense that is required to be accrued prior to receipt or payment 
(e.g., under section 1272, 1281 or 163(e) or because the taxpayer uses 
an accrual method of accounting) shall be translated at the average rate 
(or other rate specified in paragraph (b)(2)(iii)(B) of this section) 
for the interest accrual period or, with respect to an interest accrual 
period that spans two taxable years, at the average rate (or other rate 
specified in paragraph (b)(2)(iii)(B) of this section) for the partial 
period within the taxable year. See paragraphs (b)(3) and (4) of this 
section for the determination of exchange gain or loss on the receipt or 
payment of accrued interest income or expense.
    (iii) Determination of average rate or other accrual convention--(A) 
In general. For purposes of this paragraph (b), the average rate for an 
accrual period (or partial period) shall be a simple average of the spot 
exchange rates for each business day of such period or other average 
exchange rate for the period reasonably derived and consistently applied 
by the taxpayer.

[[Page 635]]

    (B) Election to use spot accrual convention. For taxable years 
beginning after March 17, 1992, a taxpayer may elect to translate 
interest income and expense at the spot rate on the last day of the 
interest accrual period (and in the case of a partial accrual period, 
the spot rate on the last day of the taxable year). If the last day of 
the interest accrual period is within five business days of the date of 
receipt or payment, the taxpayer may translate interest income or 
expense at the spot rate on the date of receipt or payment. The election 
shall be made by filing a statement with the taxpayer's first return in 
which the election is effective clearly indicating that the election has 
been made. A method so elected must be applied consistently to all debt 
instruments from year to year and cannot be changed without the consent 
of the Commissioner.
    (3) Exchange gain or loss recognized by the holder with respect to 
accrued interest income. The holder of a debt instrument described in 
paragraph (b)(2)(i) of this section shall realize exchange gain or loss 
with respect to accrued interest income on the date such accrued 
interest income is received or the instrument is disposed of (including 
a deemed disposition under section 1001 that results from a material 
change in terms of the instrument). Except as otherwise provided in this 
paragraph (b) (e.g., paragraph (b)(8) of this section), exchange gain or 
loss realized with respect to accrued interest income shall be 
recognized in accordance with the applicable recognition provisions of 
the Internal Revenue Code. The amount of exchange gain or loss so 
realized with respect to accrued interest income is determined for each 
accrual period by--
    (i) Translating the units of nonfunctional currency interest income 
received with respect to such accrual period (as determined under the 
ordering rules of paragraph (b)(7) of this section) into functional 
currency at the spot rate on the date the interest income is received or 
the instrument is disposed of (or deemed disposed of), and
    (ii) Subtracting from such amount the amount computed by translating 
the units of nonfunctional currency interest income accrued with respect 
to such income received at the average rate (or other rate specified in 
paragraph (b)(2)(iii)(B) of this section) for the accrual period.
    (4) Exchange gain or loss recognized by the obligor with respect to 
accrued interest expense. The obligor under a debt instrument described 
in paragraph (b)(2)(i) of this section shall realize exchange gain or 
loss with respect to accrued interest expense on the date such accrued 
interest expense is paid or the obligation to make payments is 
transferred or extinguished (including a deemed disposition under 
section 1001 that results from a material change in terms of the 
instrument). Except as otherwise provided in this paragraph (b) (e.g., 
paragraph (b)(8) of this section), exchange gain or loss realized with 
respect to accrued interest expense shall be recognized in accordance 
with the applicable recognition provisions of the Internal Revenue Code. 
The amount of exchange gain or loss so realized with respect to accrued 
interest expense is determined for each accrual period by--
    (i) Translating the units of nonfunctional currency interest expense 
accrued with respect to the amount of interest paid into functional 
currency at the average rate (or other rate specified in paragraph 
(b)(2)(iii)(B) of this section) for such accrual period; and
    (ii) Subtracting from such amount the amount computed by translating 
the units of nonfunctional currency interest paid (or, if the obligation 
to make payments is extinguished or transferred, the units accrued) with 
respect to such accrual period (as determined under the ordering rules 
in paragraph (b)(7) of this section) into functional currency at the 
spot rate on the date payment is made or the obligation is transferred 
or extinguished (or deemed extinguished).
    (5) Exchange gain or loss recognized by the holder of a debt 
instrument with respect to principal. The holder of a debt instrument 
described in paragraph (b)(2)(i) of this section shall realize exchange 
gain or loss with respect to the principal amount of such instrument on 
the date principal (determined under the ordering rules of paragraph 
(b)(7) of this section) is received from

[[Page 636]]

the obligor or the instrument is disposed of (including a deemed 
disposition under section 1001 that results from a material change in 
terms of the instrument). For purposes of computing exchange gain or 
loss, the principal amount of a debt instrument is the holder's purchase 
price in units of nonfunctional currency. See paragraph (b)(10) of this 
section for rules regarding the amortization of that part of the 
principal amount that represents bond premium and the computation of 
exchange gain or loss thereon. If, however, the holder acquired the 
instrument in a transaction in which exchange gain or loss was realized 
but not recognized by the transferor, the nonfunctional currency 
principal amount of the instrument with respect to the holder shall be 
the same as that of the transferor. Except as otherwise provided in this 
paragraph (b) (e.g., paragraph (b)(8) of this section), exchange gain or 
loss realized with respect to such principal amount shall be recognized 
in accordance with the applicable recognition provisions of the Internal 
Revenue Code. The amount of exchange gain or loss so realized by the 
holder with respect to principal is determined by--
    (i) Translating the units of nonfunctional currency principal at the 
spot rate on the date payment is received or the instrument is disposed 
of (or deemed disposed of); and
    (ii) Subtracting from such amount the amount computed by translating 
the units of nonfunctional currency principal at the spot rate on the 
date the holder (or a transferor from whom the nonfunctional principal 
amount is carried over) acquired the instrument (is deemed to acquire 
the instrument).
    (6) Exchange gain or loss recognized by the obligor of a debt 
instrument with respect to principal. The obligor under a debt 
instrument described in paragraph (b)(2)(i) of this section shall 
realize exchange gain or loss with respect to the principal amount of 
such instrument on the date principal (determined under the ordering 
rules of paragraph (b)(7) of this section) is paid or the obligation to 
make payments is transferred or extinguished (including a deemed 
disposition under section 1001 that results from a material change in 
terms of the instrument). For purposes of computing exchange gain or 
loss, the principal amount of a debt instrument is the amount received 
by the obligor for the debt instrument in units of nonfunctional 
currency. See paragraph (b)(10) of this section for rules regarding the 
amortization of that part of the principal amount that represents bond 
premium and the computation of exchange gain or loss thereon. If, 
however, the obligor became the obligor in a transaction in which 
exchange gain or loss was realized but not recognized by the transferor, 
the nonfunctional currency principal amount of the instrument with 
respect to such obligor shall be the same as that of the transferor. 
Except as otherwise provided in this paragraph (b) (e.g., paragraph 
(b)(8) of this section), exchange gain or loss realized with respect to 
such principal shall be recognized in accordance with the applicable 
recognition provisions of the Internal Revenue Code. The amount of 
exchange gain or loss so realized by the obligor is determined by--
    (i) Translating the units of nonfunctional currency principal at the 
spot rate on the date the obligor (or a transferor from whom the 
principal amount is carried over) became the obligor (or is deemed to 
have become the obligor); and
    (ii) Subtracting from such amount the amount computed by translating 
the units of nonfunctional currency principal at the spot rate on the 
date payment is made or the obligation is transferred or extinguished 
(or deemed extinguished).
    (7) Payment ordering rules--(i) Debt instruments subject to the 
rules of sections 163(e), or 1271 through 1288. In the case of a debt 
instrument described in paragraph (b)(2)(i) of this section that is 
subject to the rules of sections 163(e), or 1272 through 1288, units of 
nonfunctional currency (or an amount determined with reference to 
nonfunctional currency) received or paid with respect to such debt 
instrument shall be treated first as a receipt or payment of periodic 
interest under the principles of section 1273 and the regulations 
thereunder, second as a receipt or payment of original issue discount to 
the extent accrued as of the date of the receipt or payment, and finally 
as a receipt or

[[Page 637]]

payment of principal. Units of nonfunctional currency (or an amount 
determined with reference to nonfunctional currency) treated as a 
receipt or payment of original issue discount under the preceding 
sentence are attributed to the earliest accrual period in which original 
issue discount has accrued and to which prior receipts or payments have 
not been attributed. No portion thereof shall be treated as prepaid 
interest. These rules are illustrated by Example 10 of paragraph (b)(9) 
of this section.
    (ii) Other debt instruments. In the case of a debt instrument 
described in paragraph (b)(2)(i) of this section that is not subject to 
the rules of section 163(e) or 1272 through 1288, whether units of 
nonfunctional currency (or an amount determined with reference to 
nonfunctional currency) received or paid with respect to such debt 
instrument are treated as interest or principal shall be determined 
under section 163 or other applicable section of the Code.
    (8) Limitation of exchange gain or loss on payment or disposition of 
a debt instrument. When a debt instrument described in paragraph 
(b)(2)(i) of this section is paid or disposed of, or when the obligation 
to make payments thereunder is satisfied by another person, or 
extinguished or assumed by another person, exchange gain or loss is 
computed with respect to both principal and any accrued interest 
(including original issue discount), as provided in paragraph (b)(3) 
through (7) of this section. However, pursuant to section 988(b)(1) and 
(2), the sum of any exchange gain or loss with respect to the principal 
and interest of any such debt instrument shall be realized only to the 
extent of the total gain or loss realized on the transaction. The gain 
or loss realized shall be recognized in accordance with the general 
principles of the Code. See Examples 3, 4 and 6 of paragraph (b)(9) of 
this section.
    (9) Examples. The preceding provisions are illustrated in the 
following examples. The examples assume that any transaction involving 
an individual is a section 988 transaction.

    Example 1. (i) X is an individual on the cash method of accounting 
with the dollar as his functional currency. On January 1, 1992, X 
converts $13,000 to 10,000 British pounds ([pound]) at the spot rate of 
[pound]1 = $1.30 and loans the [pound]10,000 to Y for 3 years. The terms 
of the loan provide that Y will make interest payments of [pound]1,000 
on December 31 of 1992, 1993, and 1994, and will repay X's [pound]10,000 
principal on December 31, 1994. Assume the spot rates for the pertinent 
dates are as follows:

------------------------------------------------------------------------
                                                              Spot rate
                            Date                              (pounds to
                                                               dollars)
------------------------------------------------------------------------
Jan. 1, 1992...............................................   [pound]1 =
                                                                   $1.30
Dec. 31, 1992..............................................   [pound]1 =
                                                                   $1.35
Dec. 31, 1993..............................................   [pound]1 =
                                                                   $1.40
Dec. 31, 1994..............................................   [pound]1 =
                                                                   $1.45
------------------------------------------------------------------------

    (ii) Under paragraph (b)(2)(ii)(B) of this section, X will trans1ate 
the [pound]1,000 interest payments at the spot rate on the date 
received. Accordingly, X will have interest income of $1,350 in 1992, 
$1,400 in 1993, and $1,450 in 1994. Because X is a cash basis taxpayer, 
X does not realize exchange gain or loss on the receipt of interest 
income.
    (iii) Under paragraph (b)(5) of this section, X will realize 
exchange gain upon repayment of the [pound]10,000 principal amount 
determined by translating the [pound]10,000 at the spot rate on the date 
it is received ([pound]10,000 x $1.45 = $14,500) and subtracting from 
such amount, the amount determined by translating the [pound]10,000 at 
the spot rate on the date the loan was made ([pound]10,000 x $1.30 = 
$13,000). Accordingly, X will realize an exchange gain of $1,500 on the 
repayment of the loan on December 31, 1994.
    Example 2. (i) Assume the same facts as in Example 1 except that X 
is an accrual method taxpayer and that average rates are as follows:

------------------------------------------------------------------------
                                               Average rate (pounds to
              Accrual period                          dollars)
------------------------------------------------------------------------
1992......................................  [pound]1 = $1.32
1993......................................  [pound]1 = $1.37
1994......................................  [pound]1 = $1.42
------------------------------------------------------------------------

    (ii) Under paragraph (b)(2)(ii)(C) of this section, X will accrue 
the [pound]1,000 interest payments at the average rate for the accrual 
period. Accordingly, X will have interest income of $1,320 in 1992, 
$1,370 in 1993, and $1,420 in 1994. Because X is an accrual basis 
taxpayer, X determines exchange gain or loss for each interest accrual 
period by translating the units of nonfunctional currency interest 
income received with respect to such accrual period at the spot rate on 
the date received and subtracting the amounts of interest income accrued 
for such period. Thus, X will realize $90 of exchange gain with respect 
to interest received under the loan, computed as follows:

[[Page 638]]



------------------------------------------------------------------------
                                            Spot     Accrued
                                           value     interest    Exch.
                  Year                    interest  @ average     gain
                                          received     rate
------------------------------------------------------------------------
1992...................................     $1,350     $1,320        $30
1993...................................      1,400      1,370         30
1994...................................      1,450      1,420         30
                                                              ----------
  Total................................  .........  .........        $90
------------------------------------------------------------------------

    (iii) Under paragraph (b)(5) of this section, X will realize 
exchange gain upon repayment of the [pound]10,000 loan principal 
determined in the same manner as in Example 1. Accordingly, X will 
realize an exchange gain of $1,500 on the repayment of the loan 
principal on December 31, 1994.
    Example 3. Assume the same facts as in Example 1 except that X is a 
calendar year taxpayer on the accrual method of accounting that elects 
to use a spot rate convention to translate interest income as provided 
in Sec. 1.988-2(b)(2)(iii)(B). Interest income is received by X on the 
last day of each accrual period. Under paragraph (b)(2)(ii)(C), X will 
translate the interest income at the spot rate on the last day of each 
interest accrual period. Accordingly, X will have interest income of 
$1,350 in 1992, and $1,400 in 1993, $1,450 in 1994. Because the rate at 
which the interest income is translated is the same as the rate on the 
day of receipt, X will not realize any exchange gain or loss with 
respect to the interest income. Under paragraph (b)(5) of this section, 
X will realize exchange gain upon repayment of the [pound]10,000 loan 
principal determined in the same manner as in Example 1. Accordingly, X 
will realize an exchange gain of $1,500 on the repayment of the loan 
principal on December 31, 1994.
    Example 4. Assume the same facts as in Example 1 except that on 
December 31, 1993, X sells Y's note for 9,821.13 British pounds 
([pound]) after the interest payment. Under paragraph (b)(8) of this 
section, X will compute exchange gain on the [pound]10,000 principal. 
The exchange gain is $1,000 [([pound]10,000 x $1.40)-([pound]10,000 x 
$1.30)]. This exchange gain, however, is only realized to the extent of 
the total gain on the disposition. X's total gain is $749.58 
[([pound]9,821.13 x $1.40)-([pound]10,000 x $1.30)]. Thus, X will 
realize $749.58 of exchange gain (and will realize no market loss).
    Example 5. (i) The facts are the same as in Example 1 except that Y 
becomes insolvent and fails to repay the full [pound]10,000 principal 
when due. Instead, X and Y agree to compromise the debt for a payment of 
[pound]8,000 on December 31, 1994. Under paragraph (b)(8) of this 
section, X will compute exchange gain on the [pound]10,000 originally 
booked. The exchange gain is $1,500 [([pound]10,000 x $1.45)-
([pound]10,000 x $1.30) = $1,500]. This exchange gain, however, is only 
realized to the extent of the total gain on the disposition. X realizes 
an overall loss on the disposition of $1,400 [([pound]8,000 x $1.45)-
([pound]10,000 x $1.30) = ($1,400)]. Thus, X will realize no exchange 
gain (and a $1400 market loss).
    (ii) If the exchange rate on December 31, 1994, were [pound]1 = 
$1.25, rather than [pound]1 = $1.45, X would compute exchange loss under 
paragraph (b)(8) of this section, on the [pound]10,000 originally 
booked. The exchange loss would be $500 [([pound]10,000 x $1.25)-
([pound]10,000 x $1.30) = ($500)]. X's total loss on the disposition 
would be $3,000 [([pound]8,000 x $1.25)-([pound]10,000 x $1.30) = 
($3,000)]. Thus, X would realize $500 of exchange loss and a $2,500 
market loss on the disposition.
    Example 6. (i) X is an individual with the dollar as his functional 
currency. X is on the cash method of accounting. On January 1, 1989, X 
borrows 10,000 British pounds ([pound]) from Y, an unrelated person. The 
terms of the loan provide that X will make interest payments of 
[pound]1,200 on December 31 of 1989 and 1990 and will repay Y's 
[pound]10,000 principal on December 31, 1990. The spot rates for the 
pertinent dates are as follows:

------------------------------------------------------------------------
                                                              Spot rate
                            Date                                 \1\
------------------------------------------------------------------------
Jan. 1, 1989...............................................    1 = $1.50
Dec. 31, 1989..............................................     1 = 1.60
Dec. 31, 1990..............................................     1 = 1.70
------------------------------------------------------------------------
\1\ Pounds to dollars.


Assume that the basis of the [pound]1,200 paid as interest by X on 
December 31, 1989, is $2,000, the basis of the [pound]1,200 paid as 
interest by X on December 31, 1990, is $2,020 and the basis of the 
[pound]10,000 principal paid by X on December 31, 1990, is $16,000.
    (ii) Under paragraph (b)(2)(ii)(B) of this section, X translates the 
[pound]1,200 interest payments at the spot rate on the day paid. Thus, X 
paid $1,920 ([pound]1,200 x $1.60) of interest on December 31, 1989, and 
$2,040 ([pound]1,200 x $1.70) of interest on December 31, 1990. In 
addition, X will realize exchange gain or loss on the disposition of the 
[pound]1,200 on December 31, 1989 and 1990, under paragraph (a) of this 
section. Pursuant to paragraph (a)(2) of this section, X will realize an 
exchange loss of $80 [([pound]1,200 x $1.60)-$2,000] on December 31, 
1989, and exchange gain of $20 [([pound]1,200 x $1.70)-$2,020] on 
December 31, 1990.
    (iii) Under paragraph (b)(6) of this section, X will realize 
exchange loss on December 31, 1990, upon repayment of the [pound]10,000 
principal amount determined by translating the [pound]10,000 received at 
the spot rate on January 1, 1989 ([pound]10,000 x $1.50 = $15,000) and 
subtracting from such amount, the amount determined by translating the 
[pound]10,000 paid at the spot rate on December 31, 1990 ([pound]10,000 
x $1.70 = $17,000). Thus, under paragraph (b)(6) of this section, X has 
an exchange loss with respect to the [pound]10,000 principal of $2,000. 
Further, under paragraph (a)(2) of this section, X will realize an 
exchange gain upon disposition of the [pound]10,000 on December 31, 
1990. Under paragraph (a)(2) of this section, X will

[[Page 639]]

subtract his adjusted basis in the [pound]10,000 ($16,000) from the 
amount realized upon the disposition of the [pound]10,000 ([pound]10,000 
x $1.70 = $17,000) resulting in a gain of $1,000. Accordingly, X's 
combined exchange gain and loss realized on December 31, 1990, with 
respect to the repayment of the [pound]10,000 is a $1,000 exchange loss.
    Example 7. (i) X is a calendar year corporation on the accrual 
method of accounting and with the dollar as its functional currency. On 
January 1, 1989, X purchases at original issue for 82.64 Canadian 
dollars (C$) M corporation's 2 year note maturing on December 31, 1990, 
at a stated redemption price of C$100. The yield to maturity in Canadian 
dollars is 10 percent and the accrual period is the one year period 
beginning January 1 and ending December 31. The note has C$17.36 of 
original issue discount. Assume that the spot rates are as follows: C$1 
= U.S.$.72 on January 1, 1989; C$1 = U.S.$.80 on January 1, 1990; C$1 = 
U.S.$ .82 on December 31, 1990. Assume further that the average rate for 
1989 is C$1 = U.S.$ .76 and for 1990 is C$1 = U.S. $.81.
    (ii) Under paragraph (b)(2)(ii)(A) of this section, X will determine 
its interest income in Canadian dollars. Accordingly, under section 
1272, X must take into account original issue discount in the amount of 
C$8.26 on December 31, 1989, and C$9.10 on December 31, 1990. Pursuant 
to paragraph (b)(2)(ii)(C) of this section, X will translate these 
amounts into U.S. dollars at the average exchange rate for the relevant 
accrual period. Thus, the amount of interest income taken into account 
in 1989 is U.S.$6.28 (C$8.26 x U.S.$.76) and in 1990 is U.S.$7.37 
(C$9.10 x U.S.$.81). Pursuant to paragraph (b)(3)(ii) of this section, X 
will realize exchange gain or loss with respect to the accrued interest 
determined for each accrual period by translating the Canadian dollars 
received with respect to such accrual period into U.S. dollars at the 
spot rate on the date the interest is received and subtracting from that 
amount the amount accrued in U.S. dollars. Thus, the amount of exchange 
gain realized on December 31, 1990, is U.S.$.58 (U.S.$.49 from 1989 + 
U.S.$.09 from 1990). Pursuant to paragraph (b)(5) of this section, X 
shall realize exchange gain or loss with respect to the principal 
(C$82.64) on December 31, 1990, computed by translating the C$82.64 at 
the spot rate on December 31, 1990 (U.S.$67.76) and subtracting the 
C$82.64 translated at the spot rate on January 1, 1989 (U.S.$59.50) for 
an exchange gain of U.S.$8.26. Thus, X's combined exchange gain is 
U.S.$8.84 (U.S.$.49 + U.S.$.09 + U.S.$8.26).
    (iii) Assume instead that on January 1, 1990, X sells the note for 
C$86.95, which it immediately converts to U.S. dollars. X's exchange 
gain is computed under paragraph (b)(8) of this section with reference 
to the nonfunctional currency denominated principal amount (C$82.64) and 
the nonfunctional currency denominated accrued original issue discount 
(C$8.26). X will compute an exchange gain of U.S.$6.61 with respect to 
the issue price [(C$82.64 x U.S.$.80)-(C$82.64 x U.S.$.72)] and an 
exchange gain of U.S.$.33 with respect to the accrued original issue 
discount [(C$8.26 x U.S.$.80)- (C$8.26 x U.S.$ .76)]. Accordingly, prior 
to the application of paragraph (b)(8) of this section, X's total 
exchange gain is U.S.$6.94 (U.S.$6.61 + U.S.$.33), and X's market loss 
is U.S.$3.16 [(C$90.90-C$86.95) x U.S.$.80]. Pursuant to paragraph 
(b)(8) of this section, however, X's market loss on the note of 
U.S.$3.16 is netted against X's exchange gain of U.S.$6.94, resulting in 
a realized exchange gain of U.S.$3.78 and no market loss.
    Example 8. (i) The facts are the same as in Example 7 (i) except 
that on January 1, 1990, X contributes the M corporation note to Y, a 
wholly-owned U.S. subsidiary of X with the dollar as its functional 
currency, and Y collects C$100 from M corporation at maturity on 
December 31, 1990, when the spot rate is C$1 = U.S.$.82. The transfer of 
the note from X to Y qualifies for nonrecognition of gain under section 
351(a). On December 31, 1990, Y includes C$9.10 of accrued interest in 
income which translated at the average exchange rate of C$1 = U.S.$.81 
for the year results in U.S.$7.37 of interest income.
    (ii) Y's exchange gain is computed under paragraph (b)(3) of this 
section with respect to accrued interest income and paragraph (b)(5) of 
this section with respect to the nonfunctional currency principal 
amount. Under paragraph (b)(3) of this section, Y will realize exchange 
gain or loss for each accrual period computed by translating the units 
of nonfunctional currency interest income received with respect to such 
accrual period at the spot rate on the day received and subtracting the 
amounts of interest income accrued for such period. Thus, Y will realize 
$.49 of exchange gain with respect to original issue discount accrued in 
1989 [(C$8.26 x U.S.$.82)-(C$8.26 x U.S.$.76) = U.S. $.49] and $.09 of 
exchange gain with respect to original issue discount accrued in 1990 
[(C$9.10 x U.S.$.82)-(C$9.10 x U.S.$.81) = $.09].
    (iii) Pursuant to paragraph (b)(5) of this section, the 
nonfunctional currency principal amount of the M bond in the hands of Y 
is C$82.64, the amount carried over from X, the transferor. Y's exchange 
gain with respect to the nonfunctional currency principal amount is 
$8.26 [(C$82.64 x U.S.$.82)- (C$82.64 x U.S.$.72) = U.S. $8.26]. 
Accordingly, Y's combined exchange gain is U.S. $8.84 ($.49 + $.09 + 
$8.26). Because the amount realized in Canadian dollars equals the 
adjusted issue price (C$100) on retirement of the M note, there is no 
market loss, and the netting rule of paragraph (b)(8) of this section 
does not limit realization of the exchange gain.
    Example 9. (i) X is a calendar year corporation on the accrual 
method of accounting

[[Page 640]]

and with the dollar as its functional currency. X elects to use the spot 
rate convention to translate interest income as provided in paragraph 
(b)(2)(iii)(B) of this section. On January 31, 1992, X loans [pound]1000 
to Y, an unrelated person. Under the terms of the loan, Y will pay X 
interest of [pound]50 on July 31, 1992, and January 31, 1993, and will 
repay the [pound]1000 principal on January 31, 1993. Assume the 
following spot exchange rates:

------------------------------------------------------------------------
                                                              Spot rate
                            Date                                 \1\
------------------------------------------------------------------------
Jan. 31, 1992..............................................   [pound]1 =
                                                                   $1.50
July 31, 1992..............................................   [pound]1 =
                                                                    1.55
Dec. 31, 1992..............................................   [pound]1 =
                                                                    1.60
Jan. 31, 1993..............................................   [pound]1 =
                                                                    1.61
------------------------------------------------------------------------
\1\ Pounds to dollars.

    (ii) Under paragraph (b)(2)(ii)(C) of this section, X will translate 
the interest income at the spot rate on the last day of each interest 
accrual period (and in the case of a partial accrual period, at the spot 
rate on the last day of the taxable year). Accordingly, X will have 
interest income of $77.50 ([pound]50 x $1.55) on July 31, 1992. Assuming 
under X's method of accounting that interest is accrued daily, X will 
accrue $66.50 (153 / 184 x [pound]50) x $1.60) of interest income on 
December 31, 1992. On January 31, 1993, X will have interest income of 
$13.60 ((31/184 x [pound]50) x $1.61). Because the rate at which the 
interest income is translated is the same as the rate on the day of 
receipt, X will not realize any exchange gain or loss with respect to 
the interest income received on July 31, 1992. However, X will realize 
exchange gain on the [pound]41.50 (153/184 x [pound]50) of accrued 
interest income of $.41 [([pound]41.50 x $1.61) - ([pound]41.50 x $1.60) 
= $.41].
    (iii) Under paragraph (b)(5) of this section, X will realize 
exchange gain upon repayment of the [pound]100 principal amount 
determined by translating the [pound]100 at the spot rate on the date it 
is received ([pound]100 x $1.61 = $161.00) and subtracting from such 
amount, the amount determined by translating the [pound]100 at the spot 
rate on the date the loan was made ([pound]100 x $1.50 = $150.00). 
Accordingly, X will realize an exchange gain of $11 on the repayment of 
the loan on January 31, 1993.
    Example 10. (i) X, a cash basis taxpayer with the dollar as its 
functional currency, has the calendar year as its taxable year. On 
January 1, 1992, X purchases at original issue for 65.88 British pounds 
([pound]) M corporation's 5-year bond maturing on December 31, 1996, 
having a stated redemption price at maturity of [pound]100. The bond 
provides for annual payments of interest in pounds of 1 pound per year 
on December 31 of each year. The bond has 34.12 British pounds of 
original issue discount. The yield to maturity is 10 percent in British 
pounds and the accrual period is the one year period beginning January 1 
and ending December 31 of each calendar year. The amount of original 
issue discount is determined in pounds for each accrual period by 
multiplying the adjusted issue price expressed in pounds by the yield 
and subtracting from such amount the periodic interest payments 
expressed in pounds for such period. The periodic interest payments are 
translated at the spot rate on the payment date (December 31 of each 
year). The original issue discount is translated at the average rate for 
the accrual period (January 1 through December 31). The following chart 
describes the determination of interest income with respect to the facts 
presented and provides other pertinent information.

                                                     Table 1
----------------------------------------------------------------------------------------------------------------
                                                                                  Original
                                                                    Periodic        issue
                                                                    interest     discount in    Total
                Periodic  Original             Assumed   Assumed   payments in     pounds     interest
                interest    issue     Issue     spot     average     pounds      multiplied    income
                payments  discount  price or   rate on  rate for   multiplied      by the        in     Adjusted
Year (Dec. 31)     in        in     adjusted   Dec. 31   accrual  by spot rate  average rate   dollars    issue
                 pounds    pounds     issue    (pounds   period    on the date     for the     (column  price in
                 for the   for the  price in     to      (pounds   of payment      accrual     7 plus    dollars
                 accrual   accrual   pounds   dollars)     to       (column 2      period      column
                 period    period                       dollars)  times column    (column 3      8)
                                                                       5)       times column
                                                                                     6)
1                      2         3         4         5         6             7             8         9       10
----------------------------------------------------------------------------------------------------------------
Issue Date:
                ........  ........     65.88       1 =  ........  ............  ............  ........   $79.06
                                                 $1.20
1992                   1      5.59     71.47  1 = 1.30       1 =         $1.30         $6.99     $8.29    86.05
                                                           $1.25
1993                   1      6.15     77.62  1 = 1.40  1 = 1.35          1.40          8.30      9.70    94.35
1994                   1      6.76     84.38  1 = 1.50  1 = 1.45          1.50          9.80     11.30   104.15
1995                   1      7.44     91.82  1 = 1.60  1 = 1.55          1.60         11.53     13.13   115.68
1996                   1      8.18    100.00  1 = 1.70  1 = 1.65          1.70         13.50     15.20   129.18
----------------------------------------------------------------------------------------------------------------

    (ii) Because X is a cash basis taxpayer, X does not realize exchange 
gain or loss on the receipt of the [pound]1 periodic interest payments. 
However, X will realize exchange gain on December 31, 1996 totaling 
$7.88 with respect to the original issue discount. Exchange gain is 
determined for each interest accrual period by translating the units of 
nonfunctional currency interest income received with respect to such 
accrual period at the spot rate on the date received and subtracting 
from such amount, the amount computed by

[[Page 641]]

translating the units of nonfunctional currency interest income accrued 
for such period at the average rate for the period. The following chart 
illustrates this computation:

                                                     Table 2
----------------------------------------------------------------------------------------------------------------
                                                                                           IOD in
                                                                Interest                   pounds
                                                   Assumed      received     Assumed     times the
                                    OID accrued   spot rate    times spot    average      average      Exchange
                                     in pounds     on date    rate on the    rate for     rate for     gain or
               Year                   for each     payment        date       accrual    the accrual   loss (col.
                                      accrual      received     received      period       period    4 less col.
                                       period     (pounds to    (col. 2     (pounds to    (col. 2         6)
                                                   dollars)    times col.    dollars)    times col.
                                                                   3)                        5)
1                                             2            3            4            5            6            7
----------------------------------------------------------------------------------------------------------------
1992..............................         5.59    1 = $1.70        $9.50    1 = $1.25        $6.99        $2.51
1993..............................         6.15     1 = 1.70        10.46     1 = 1.35         8.30         2.16
1994..............................         6.76     1 = 1.70        11.49     1 = 1.45         9.80         1.69
1995..............................         7.44     1 = 1.70        12.65     1 = 1.55        11.53         1.12
1996..............................         8.18     1 = 1.70        13.90     1 = 1.65        13.50          .40
                                                                                                    ------------
  Total...........................  ...........  ...........  ...........  ...........  ...........        $7.88
----------------------------------------------------------------------------------------------------------------

    (iii) X will also realize exchange gain with respect to the 
principal of the loan (i.e., the issue price of 65.88 British pounds) on 
December 31, 1996 computed by translating the units of nonfunctional 
currency principal received at the spot rate on the date principal is 
received (65.88 British pounds x $1.70 = $112.00) and subtracting from 
such amount, the units of nonfunctional currency principal received 
translated at the spot rate on the date the instrument was acquired 
(65.88 British pounds x $1.20 = $79.06). Accordingly, X's exchange gain 
on the principal is $32.94 and X's total exchange gain with respect to 
the accrued interest and principal is $40.82. It should be noted that, 
under this fact pattern, the total exchange gain may be determined in an 
alternative fashion. Exchange gain may be computed by subtracting the 
adjusted issue price in dollars at maturity ($129.18--see column 10 of 
Table 1) from the amount computed by multiplying the stated redemption 
price at maturity in pounds times the spot rate on the maturity date 
([pound]100 x $1.70 = $170), which equals $40.82.
    Example 11. (i) The facts are the same as in Example 10 except that 
X makes an election under paragraph (b)(2)(iii) of this section to 
translate accrued interest on the last day of the accrual period. 
Accordingly, columns 8, 9 and 10 in Table 1 would change as follows:

------------------------------------------------------------------------
                                     Original
                                      issue
                                   discount in     Total
                                      pounds      interest
                                    multiplied   income in     Adjusted
          Year (Dec. 31)           by the spot    dollars    issue price
                                     rate on     (column 7    in dollars
                                   last day of  plus column
                                     accrual         8)
                                      period
                                    (Dec. 31)
1                                            8            9           10
------------------------------------------------------------------------
                                                                  $79.06
1992.............................        $7.27        $8.57        87.63
1993.............................         8.61        10.01        97.64
1994.............................        10.14        11.64       109.28
1995.............................        11.90        13.50       122.78
1996.............................        13.91        15.61       138.39
------------------------------------------------------------------------

    (ii) Because X is a cash basis taxpayer, X does not realize exchange 
gain or loss on the receipt of the [pound]1 periodic interest payments. 
However, X will realize exchange gain on December 31, 1993 totaling 
$6.18 with respect to the original issue discount. Exchange gain is 
determined for each interest accrual period by translating the units of 
nonfunctional currency interest income received with respect to such 
accrual period at the spot rate on the date received and subtracting 
from such amount, the amount computed by translating the units of 
nonfunctional currency interest income accrued for such period at the 
spot rate on the last day of the accrual period. Accordingly, columns 5, 
6 and 7 of Table 2 would change as follows:

------------------------------------------------------------------------
                                                   OID in
                                                   pounds
                                                 times the
                                    Spot rate    spot rate     Exchange
                                   on last day  on the last    gain or
               Year                 of accrual   day of the   loss (col.
                                      period      accrual    4 less col.
                                                period (col       6)
                                                  2 times
                                                  col. 3)
1                                            5            6            7
------------------------------------------------------------------------
1992.............................        $1.30        $7.27        $2.23
1993.............................         1.40         8.61         1.85
1994.............................         1.50        10.14         1.35
1995.............................         1.60        11.90         0.75

[[Page 642]]

 
1996.............................         1.70        13.90         0.00
                                                            ------------
                                                                    6.18
------------------------------------------------------------------------

    (iii) X will realize exchange gain with respect to the principal 
amount of the loan as provided in the preceding example.
    Example 12. (i) C is a corporation that is a calendar year accrual 
method taxpayer with the dollar as its functional currency. On January 
1, 1989, C lends 100 British pounds ([pound]) in exchange for a note 
under the terms of which C will receive two equal payments of 
[pound]57.62 on December 31, 1989, and December 31, 1990. Each payment 
of [pound]57.62 represents the annual payment necessary to amortize the 
[pound]100 principal amount at a rate of 10% compounded annually over a 
two year period. The following tables reflect the amounts of principal 
and interest that compose each payment and assumptions as to the 
relevant exchange rates:

------------------------------------------------------------------------
                     Date                        Principal     Interest
------------------------------------------------------------------------
Dec. 31, 1989.................................  [pound]47.6  [pound]10.0
                                                          2            0
Dec. 12, 1990.................................  [pound]52.3  [pound]5.24
                                                          8
------------------------------------------------------------------------


------------------------------------------------------------------------
                                                               Average
                     Date                        Spot rate     rate for
                                                 [pound]1=   year ending
------------------------------------------------------------------------
Jan. 1, 1989..................................        $1.30
Dec. 31, 1989.................................         1.40         1.35
Dec. 31, 1990.................................         1.50         1.45
------------------------------------------------------------------------

    (ii) Because each interest payment is equal to the product of the 
outstanding principal balance of the obligation and a single fixed rate 
of interest, each stated interest payment constitutes periodic interest 
under the principles of section 1273. Accordingly, there is no original 
issue discount.
    (iii) Because C is an accrual basis taxpayer, C will translate the 
interest income at the average rate for the annual accrual period 
pursuant to paragraph (b)(2)(ii)(C) of this section. Thus, C's interest 
income is $13.50 ([pound]10.00 x $1.35) in 1989, and $7.60 ([pound]5.24 
x $1.45) in 1990. C will realize exchange gain or loss upon receipt of 
accrued interest computed in accordance with paragraph (b)(3) of this 
section. Thus, C will realize exchange gain in the amount of $.50 
[([pound]10.00 x $1.40)-$13.50] in 1989, and $.26 [([pound]5.24 x 
$1.50)-$7.60] in 1990.
    (iv) In addition, C will realize exchange gain or loss upon the 
receipt of principal each year computed under paragraph (b)(5) of this 
section. Thus, C will realize exchange gain in the amount of $4.76 
[([pound]47.62 x $1.40)-([pound]47.62 x $1.30)] in 1989, and $10.48 
[([pound]52.38 x $1.50)-([pound]52.38 x $1.30)] in 1990.

    (10) Treatment of bond premium--(i) In general. Amortizable bond 
premium on a bond described in paragraph (b)(2)(i) of this section shall 
be computed in the units of nonfunctional currency in which the bond is 
denominated (or in which the payments are determined). Amortizable bond 
premium properly taken into account under section 171 or Sec. 1.61-12 
(or the successor provision thereof) shall reduce interest income or 
expense in units of nonfunctional currency. Exchange gain or loss is 
realized with respect to bond premium described in the preceding 
sentence by treating the portion of premium amortized with respect to 
any period as a return of principal. With respect to a holder that does 
not elect to amortize bond premium under section 171, the amount of bond 
premium will constitute a market loss when the bond matures. See 
paragraph (b)(8) of this section. The principles set forth in this 
paragraph (b)(10) shall apply to determine the treatment of acquisition 
premium described in section 1272(a)(7).
    (ii) Example. The following example illustrates the provisions of 
this paragraph (b)(10).

    Example. (A) X is an individual on the cash method of accounting 
with the dollar as his functional currency. On January 1, 1989, X 
purchases Y corporation's note for 107.99 British pounds ([pound]) from 
Z, an unrelated party. The note has an issue price of [pound]100, a 
stated redemption price at maturity of [pound]100, pays interest in 
pounds at the rate of 10% compounded annually, and matures on December 
31, 1993. X elects to amortize the bond premium of [pound]7.99 under the 
rules of section 171. Pursuant to paragraph (b)(10)(i) of this section, 
bond premium is determined and amortized in British pounds. Assume the 
amortization schedule is as follows:

------------------------------------------------------------------------
                                                Unamortized
                                       Bond       premium
        Year ending 12/31            premium        plus       Interest
                                    amortized    principal
------------------------------------------------------------------------
                                                [pound]107.
                                                         99
1989.............................  [pound]1.36  [pound]106.  [pound]8.64
                                                         63
1990.............................  [pound]1.47  [pound]105.  [pound]8.53
                                                         16
1991.............................  [pound]1.59  [pound]103.  [pound]8.41
                                                         57
1992.............................  [pound]1.71  [pound]101.  [pound]8.29
                                                         86
1993.............................  [pound]1.85  [pound]100.  [pound]8.15
                                                         00
------------------------------------------------------------------------

    (B) The bond premium reduces X's pound interest income under the 
note. For example, the [pound]10 stated interest payment made in 1989

[[Page 643]]

is reduced by [pound]1.36 of bond premium, and the resulting [pound]8.64 
interest income is translated into dollars at the spot rate on December 
31, 1989. Exchange gain or loss is realized on the [pound]1.36 bond 
premium based on the difference between the spot rates on January 1, 
1989, the date the premium is paid to acquire the bond, and December 31, 
1989, the date the bond premium is returned as part of the stated 
interest. The [pound]1.36 bond premium reduces the unamortized premium 
plus principal to [pound]106.63 ([pound]107.99-[pound]1.36). On December 
31, 1993, when the bond matures and the [pound]7.99 of bond premium has 
been fully amortized, X will realize exchange gain or loss with respect 
to the remaining purchase price of [pound]100.

    (11) Market discount--(i) In general. Market discount as defined in 
section 1278(a)(2) shall be determined in units of nonfunctional 
currency in which the market discount bond is denominated (or in which 
the payments are determined). Accrued market discount (other than market 
discount currently included in income pursuant to section 1278(b)) shall 
be translated into functional currency at the spot rate on the date the 
market discount bond is disposed of. No part of such accrued market 
discount is treated as exchange gain or loss. Accrued market discount 
currently includible in income pursuant to section 1278(b) shall be 
translated into functional currency at the average exchange rate for the 
accrual period. Exchange gain or loss with respect to accrued market 
discount currently includible in income under section 1278(b) shall be 
determined in accordance with paragraph (b)(3) of this section relating 
to accrued interest income.
    (ii) Example. The following example illustrates the provisions of 
this paragraph (b)(11).

    Example. (A) X is a calendar year corporation with the U.S. dollar 
as its functional currency. On January 1, 1990, X purchases a bond of M 
corporation for 96,530 British pounds ([pound]). The bond, which was 
issued on January 1, 1989, has an issue price of [pound]100,000, a 
stated redemption price at maturity of [pound]100,000, and provides for 
annual pound payments of interest at 8 percent. The bond matures on 
December 31, 1991. X purchased the bond at a market discount of 3,470 
pounds and did not elect to include the market discount currently in 
income under section 1278(b). X holds the bond to maturity and on 
December 31, 1991, receives payment of [pound]100,000 (plus [pound]8,000 
interest) when the exchange rate is [pound]1 = $1.50.
    (B) Pursuant to paragraph (b)(11) of this section, X computes market 
discount in units of nonfunctional currency. Thus, the market discount 
as defined under section 1278(a)(2) is [pound]3,470. Accrued market 
discount (other than market discount currently included in income 
pursuant to section 1278(b)) is translated at the spot rate on the date 
the market discount bond is disposed of. Accordingly, X will translate 
the accrued market discount of [pound]3,470 at the spot rate on December 
31, 1991 ([pound]3,470 x $1.50 = $5,205). No exchange gain or loss is 
realized with respect to the [pound]3,470 of accrued market discount. 
See paragraphs (b)(3) and (5) of this section for the realization and 
recognition of exchange gain or loss with respect to accrued interest 
and principal.

    (12) Tax exempt bonds. See Sec. 1.988-3(c)(2), which characterizes 
exchange loss realized with respect to a nonfunctional currency tax 
exempt bond as a reduction of interest income.
    (13) Nonfunctional currency debt exchanged for stock of obligor--(i) 
In general. Notwithstanding any other section of the Code other than 
section 267, 1091 or 1092, exchange gain or loss shall be realized and 
recognized by the holder and the obligor in accordance with the rules of 
paragraphs (b)(3) through (7) of this section with respect to the 
principal and accrued interest of a debt instrument described in 
paragraph (b)(2)(i) of this section that is acquired by the obligor in 
exchange for its stock, provided however, that such gain or loss shall 
be recognized only to the extent of the total gain or loss on the 
exchange (regardless of whether such gain or loss would otherwise be 
recognized). This rule shall apply whether the debt instrument is 
converted into stock according to its terms or exchanged pursuant to a 
separate agreement between the obligor and the holder. A debt instrument 
that is acquired by the obligor from a shareholder as a contribution to 
capital shall be treated for purposes of this section as exchanged for 
stock, whether or not additional stock is issued.
    (ii) Coordination with section 108. Section 988 and this section 
shall apply before section 108. Exchange gain realized by the obligor on 
an exchange described in paragraph (b)(13)(i) of this section shall not 
be treated as discharge of indebtedness income, but shall be considered 
to reduce the amount of the liability for purposes of

[[Page 644]]

computing the obligor's income on the exchange under section 108(e)(4), 
section 108(e)(6) or section 108(e)(10).
    (iii) Effective date. This paragraph (b)(13) shall be effective for 
exchanges of debt for stock effected after September 21, 1989.
    (iv) Examples. The following examples illustrate the operation of 
this paragraph (b)(13). In each such example, assume that sections 267, 
1091 and 1092 do not apply.

    Example 1. (i) X is a calendar year U.S. corporation with the U.S. 
dollar as its functional currency. On January 1, 1990 (the issue date), 
X acquired a convertible bond maturing on December 31, 1998, issued by Y 
corporation, a U.K. corporation with the British pound ([pound]) as its 
functional currency. The issue price of the bond is [pound]100,000, the 
stated redemption price at maturity is [pound]100,000, and the bond 
provides for annual pound interest payments at the rate of 10%. The 
terms of the bond also provide that at any time prior to December 31, 
1998, the holder may surrender all of his interest in the bond in 
exchange for 20 shares of Y common stock. On January 1, 1994, X 
surrenders his interest in the bond for 20 shares of Y common stock. 
Assume the following: (a) The spot rate on January 1, 1990, is [pound]1 
= $1.30, (b) The spot rate on January 1, 1994, is [pound]1 = $1.50, and 
(c) The 20 shares of Y common stock have a market value of 
[pound]200,000 on January 1, 1994.
    (ii) Pursuant to paragraph (b)(13) of this section, X will realize 
and recognize exchange gain with respect to the issue price 
([pound]100,000) of the bond on January 1, 1994, when the bond is 
converted to stock. X will compute exchange gain pursuant to paragraph 
(b)(5) of this section by translating the issue price at the spot rate 
on the conversion date ([pound]100.000 x $1.50 = $150,000) and 
subtracting from such amount the issue price translated at the spot rate 
on the date X acquired the bond ([pound]100,000 x $1.30 = $130,000). 
Thus, X will realize and recognize $20,000 of exchange gain. X's basis 
in the 20 shares of Y common stock is $150,000 ($130,000 substituted 
basis + $20,000 recognized gain).
    Example 2. (i) X, a foreign corporation with the British pound 
([pound]) as its functional currency, lends [pound]100 at a market rate 
of interest to Y, its wholly-owned U.S. subsidiary, on January 1, 1990, 
on which date the spot exchange rate is [pound]1 = $1. Y's functional 
currency is the U.S. dollar. On January 1, 1992, when the spot exchange 
rate is [pound]1 = $.50, X cancels the debt as a contribution to 
capital. Pursuant to paragraph (b)(13) of this section, Y will realize 
and recognize exchange gain with respect to the [pound]100 issue price 
of the debt instrument on January 1, 1992. Y will compute exchange gain 
pursuant to paragraph (b)(6) of this section by translating the issue 
price at the spot rate on the date Y became the obligor ([pound]100 x $1 
= $100) and subtracting from such amount the issue price translated at 
the spot rate on the date of extinguishment ([pound]100 x $.50 = $50). 
Thus, Y will realize and recognize $50 of exchange gain.
    (ii) Under section 108(e)(6), on the acquisition of its indebtedness 
from X as a contribution to capital Y is treated as having satisfied the 
debt with an amount of money equal to X's adjusted basis in the debt 
([pound]100). For purposes of section 108(e)(6), X's adjusted basis is 
translated into United States dollars at the spot rate on the date Y 
acquires the debt ([pound]1 = $.50). Therefore, Y is treated as having 
satisfied the debt for $50. Pursuant to paragraph (b)(13) of this 
section, for purposes of section 108 the amount of the indebtedness is 
considered to be reduced by the exchange gain from $100 to $50. 
Accordingly, Y recognizes $50 of exchange gain and no discharge of 
indebtedness income on the extinguishment of its debt to X.
    (iii) If X were a United States taxpayer with a dollar functional 
currency and a $100 basis in Y's obligation. X would realize and 
recognize an exchange loss of $50 under paragraph (b)(5) of this section 
on the contribution of the debt to Y. The recognized loss would reduce 
X's adjusted basis in the debt from $100 to $50, so that for purposes of 
applying section 108(e)(6) Y is treated as having satisfied the debt for 
$50. Accordingly, under these facts as well Y would recognize $50 of 
exchange gain and no discharge of indebtedness income.
    Example 3. (i) X and Y are unrelated calendar year U.S. corporations 
with the U.S. dollar as their functional currency. On January 1, 1990 
(the issue date), X acquires Y's bond maturing on December 31, 1999. The 
issue price of the bond is [pound]100,000, the stated redemption price 
at maturity is [pound]100,000, and the bond provides for annual pound 
interest payments at the rate of 10%. On January 1, 1994, X and Y agree 
that Y will redeem its bond from X in exchange for 20 shares of Y common 
stock. Assume the following:
    (a) The spot rate on January 1, 1990, is [pound]1 = $1.00,
    (b) The spot rate on January 1, 1994, is [pound]1 = $.50,
    (c) Interest rates on equivalent bonds have increased so that as of 
January 1, 1994, the value of Y's bond has declined to [pound]90,000, 
and
    (d) The 20 shares of Y common stock have a market value of 
[pound]90,000 as of January 1, 1994.
    (ii) Pursuant to paragraph (b)(13) of this section, X will realize 
and recognize exchange loss with respect to the issue price 
([pound]100,000) of the bond on January 1, 1994, when the bond is 
exchanged for stock. X will compute exchange loss pursuant to paragraph 
(b)(5) of this section by translating the issue price at the spot rate 
on the exchange date ([pound]100,000 x $.50 = $50,000) and subtracting

[[Page 645]]

from such amount the issue price translated at the spot rate on the date 
X acquired the bond ([pound]100,000 x $1.00 = $100,000). Thus, X will 
compute $50,000 of exchange loss, all of which will be realized and 
recognized because it does not exceed the total $55,000 realized loss on 
the exchange ($45,000 worth of stock received less $100,000 basis in the 
exchanged bond).
    (iii) Pursuant to paragraph (b)(13) of this section, Y will realize 
and recognize exchange gain with respect to the issue price, computed 
under paragraph (b)(6) of this section by translating the issue price at 
the spot rate on the date Y became the obligor ([pound]100,000 x $1.00 = 
$100,000) and subtracting from such amount the issue price translated at 
the spot rate on the exchange date ([pound]100,000 x $.50 = $50,000). 
Thus, Y will realize and recognize $50,000 of exchange gain. Under 
section 108(e)(10), on the transfer of stock to X in satisfaction of its 
indebtedness Y is treated as having satisfied the indebtedness with an 
amount of money equal to the fair market value of the stock 
([pound]90,000 x $.50 = $45,000). Pursuant to paragraph (b)(13) of this 
section, for purposes of section 108 the amount of the indebtedness is 
considered to be reduced by the recognized exchange gain from $100,000 
to $50,000. Accordingly, Y recognizes an additional $5,000 of discharge 
of indebtedness income on the exchange.
    Example 4. (i) The facts are the same as in Example 3 except that 
interest rates on equivalent bonds have declined, rather than increased, 
so that the value of Y's bond on January 1, 1994, has risen to 
[pound]112,500; and X and Y agree that Y will redeem its bond from X on 
that date in exchange for 25 shares of Y common stock worth 
[pound]112,500. Pursuant to paragraphs (b)(13) and (b)(5) of this 
section, X will compute $50,000 of exchange loss on the exchange with 
respect to the [pound]100,000 issue price of the bond. See Example 3. 
However, because X's total loss on the exchange is only $43,750 ($56,250 
worth of stock received less $100,000 basis in the exchanged bond), 
under the netting rule of paragraph (b)(13) of this section the realized 
exchange loss is limited to $43,750.
    (ii) Pursuant to paragraphs (b)(13) and (b)(6) of this section, Y 
will compute $50,000 of exchange gain with respect to the issue price. 
See Example 3. Under section 108(e)(10), Y is treated as having 
satisfied the $100,000 indebtedness with an amount of money equal to the 
fair market value of the stock ([pound]112,500 x $.50 = $56,250), 
resulting in a total gain on the exchange of $43,750. Accordingly, under 
paragraph (b)(13) of this section Y's realized (and recognized) exchange 
gain on the exchange is limited to $43,750. Also pursuant to paragraph 
(b)(13) of this section, for purposes of section 108 the amount of the 
indebtedness is considered to be reduced by the recognized exchange gain 
from $100,000 to $56,250. Accordingly, Y recognizes no discharge of 
indebtedness income on the exchange.

    (14) [Reserved]
    (15) Debt instruments and deposits denominated in hyperinflationary 
currencies--(i) In general. If a taxpayer issues, acquires, or otherwise 
enters into or holds a hyperinflationary debt instrument (as defined in 
paragraph (b)(15)(vi)(A) of this section) or a hyperinflationary deposit 
(as defined in paragraph (b)(15)(vi)(B) of this section) on which 
interest is paid or accrued that is denominated in (or determined by 
reference to) a nonfunctional currency of the taxpayer, then the 
taxpayer shall realize exchange gain or loss with respect to such 
instrument or deposit for its taxable year determined by reference to 
the change in exchange rates between--
    (A) The later of the first day of the taxable year, or the date the 
instrument was entered into (or an amount deposited); and
    (B) The earlier of the last day of the taxable year, or the date the 
instrument (or deposit) is disposed of or otherwise terminated.
    (ii) Only exchange gain or loss is realized. No gain or loss is 
realized under paragraph (b)(15)(i) by reason of factors other than 
movement in exchange rates, such as the creditworthiness of the debtor.
    (iii) Special rule for synthetic, non-hyperinflationary currency 
debt instruments--(A) General rule. Paragraph (b)(15)(i) does not apply 
to a debt instrument that has interest and principal payments that are 
to be made by reference to a currency or item that does not reflect 
hyperinflationary conditions in a country (within the meaning of Sec. 
1.988-1(f)).
    (B) Example. Paragraph (b)(15)(iii)(A) is illustrated by the 
following example:

    Example. When the Turkish lira (TL) is a hyperinflationary currency, 
A, a U.S. corporation with the U.S. dollar as its functional currency, 
makes a 5 year, 100,000 TL-denominated loan to B, an unrelated 
corporation, at a 10% interest rate when 1,000 TL equals $1. Under the 
terms of the debt instrument, B must pay interest annually to A in 
amount of Turkish lira that is equal to $100. Also under the terms of 
the debt instrument, B must pay A upon maturity of the debt instrument 
an amount of Turkish lira

[[Page 646]]

that is equal to $1,000. Although the principal and interest are payable 
in a hyperinflationary currency, the debt instrument is a synthetic 
dollar debt instrument and is not subject to paragraph (b)(15)(i) of 
this section.

    (iv) Source and character of gain or loss--(A) General rule for 
hyperinflationary conditions. The rules of this paragraph (b)(15)(iv)(A) 
shall apply to any taxpayer that is either an issuer of (or obligor 
under) a hyperinflationary debt instrument or deposit and has currency 
gain on such debt instrument or deposit, or a holder of a 
hyperinflationary debt instrument or deposit and has currency loss on 
such debt instrument or deposit. For purposes of subtitle A of the 
Internal Revenue Code, any exchange gain or loss realized under 
paragraph (b)(15)(i) of this section is directly allocable to the 
interest expense or interest income, respectively, from the debt 
instrument or deposit (computed under this paragraph (b)), and therefore 
reduces or increases the amount of interest income or interest expense 
paid or accrued during that year with respect to that instrument or 
deposit. With respect to a debt instrument or deposit during a taxable 
year, to the extent exchange gain realized under paragraph (b)(15)(i) of 
this section exceeds interest expense of an issuer, or exchange loss 
realized under paragraph (b)(15)(i) of this section exceeds interest 
income of a holder or depositor, the character and source of such excess 
amount shall be determined under Sec. Sec. 1.988-3 and 1.988-4.
    (B) Special rule for subsiding hyperinflationary conditions. If the 
taxpayer is an issuer of (or obligor under) a hyperinflationary debt 
instrument or deposit and has currency loss, or if the taxpayer is a 
holder of a hyperinflationary debt instrument or deposit and has 
currency gain, then for purposes of subtitle A of the Internal Revenue 
Code, the character and source of the currency gain or loss is 
determined under Sec. Sec. 1.988-3 and 1.988-4. Thus, if an issuer has 
both interest expense and currency loss, the currency loss is sourced 
and characterized under section 988, and does not affect the 
determination of interest expense.
    (v) Adjustment to principal or basis. Any exchange gain or loss 
realized under paragraph (b)(15)(i) of this section is an adjustment to 
the functional currency principal amount of the issuer, functional 
currency basis of the holder, or the functional currency amount of the 
deposit. This adjusted amount or basis is used in making subsequent 
computations of exchange gain or loss, computing the basis of assets for 
purposes of allocating interest under Sec. Sec. 1.861-9T through 1.861-
12T and 1.882-5, or making other determinations that may be relevant for 
computing taxable income or loss.
    (vi) Definitions--(A) Hyperinflationary debt instrument. A 
hyperinflationary debt instrument is a debt instrument that provides 
for--
    (1) Payments denominated in or determined by reference to a currency 
that is hyperinflationary (as defined in Sec. 1.988-1(f)) at the time 
the taxpayer enters into or otherwise acquires the debt instrument; or
    (2) Payments denominated in or determined by reference to a currency 
that is hyperinflationary (as defined in Sec. 1.988-1(f)) during the 
taxable year, and the terms of the instrument provide for the adjustment 
of principal or interest payments in a manner that reflects 
hyperinflation. For example, a debt instrument providing for a variable 
interest rate based on local conditions and generally responding to 
changes in the local consumer price index will reflect hyperinflation.
    (B) Hyperinflationary deposit. A hyperinflationary deposit is a 
demand or time deposit or similar instrument issued by a bank or other 
financial institution that provides for--
    (1) Payments denominated in or determined by reference to a currency 
that is hyperinflationary (as defined in Sec. 1.988-1(f)) at the time 
the taxpayer enters into or otherwise acquires the deposit; or
    (2) Payments denominated in or determined by reference to a currency 
that is hyperinflationary (as defined in Sec. 1.988-1(f)) during the 
taxable year, and the terms of the deposit provide for the adjustment of 
the deposit amount or interest payments in a manner that reflects 
hyperinflation.

[[Page 647]]

    (vii) Interaction with other provisions--(A) Interest allocation 
rules. In determining the amount of interest expense, this paragraph 
(b)(15) applies before Sec. Sec. 1.861-9T through 1.861-12T, and 1.882-
5.
    (B) DASTM. With respect to a qualified business unit that uses the 
United States dollar approximate separate transactions method of 
accounting described in Sec. 1.985-3, paragraph (b)(15)(i) of this 
section does not apply.
    (C) Interaction with section 988(a)(3)(C). Section 988(a)(3)(C) does 
not apply to a debt instrument subject to the rules of paragraph 
(b)(15)(i) of this section.
    (D) Hedging rules. To the extent Sec. 1.446-4 or 1.988-5 apply, the 
rules of paragraph (b)(15)(i) of this section will not apply. This 
paragraph (b)(15)(vii)(D) does not apply if the application of Sec. 
1.988-5 results in hyperinflationary debt instrument or deposit 
described in paragraph (b)(15)(vi)(A) or (B) of this section.
    (viii) Effective date. This paragraph (b)(15) applies to 
transactions entered into after February 14, 2000.
    (16) Coordination with section 267 regarding debt instruments--(i) 
Treatment of a creditor. For rules applicable to a corporation included 
in a controlled group that is a creditor under a debt instrument see 
Sec. 1.267(f)-1(h).
    (ii) Treatment of a debtor. [Reserved]
    (17) Coordination with installment method under section 453. 
[Reserved]
    (18) Interaction of section 988 and Sec. 1.1275-2(g)--(i) In 
general. If a principal purpose of structuring a debt instrument subject 
to section 988 and any related hedges is to achieve a result that is 
unreasonable in light of the purposes of section 163(e), section 988, 
sections 1271 through 1275, or any related section of the Internal 
Revenue Code, the Commissioner can apply or depart from the regulations 
under the applicable sections as necessary or appropriate to achieve a 
reasonable result. For example, if this paragraph (b)(18) applies to a 
multicurrency debt instrument and a hedge or hedges, the Commissioner 
can wholly or partially integrate transactions or treat portions of the 
debt instrument as separate instruments where appropriate. See also 
Sec. 1.1275-2(g).
    (ii) Unreasonable result. Whether a result is unreasonable is 
determined based on all the facts and circumstances. In making this 
determination, a significant fact is whether the treatment of the debt 
instrument is expected to have a substantial effect on the issuer's or a 
holder's U.S. tax liability. Another significant fact is whether the 
result is obtainable without the application of Sec. 1.988-6 and any 
related provisions (e.g., if the debt instrument and the contingency 
were entered into separately). A result will not be considered 
unreasonable, however, in the absence of an expected substantial effect 
on the present value of a taxpayer's tax liability.
    (iii) Effective date. This paragraph (b)(18) shall apply to debt 
instruments issued on or after October 29, 2004.
    (c) Item of expense or gross income or receipts which is to be paid 
or received after the date accrued--(1) In general. Except as provided 
in Sec. 1.988-5, exchange gain or loss with respect to an item 
described in Sec. 1.988-1(a)(1)(ii) and (2)(ii) (other than accrued 
interest income or expense subject to paragraph (b) of this section) 
shall be realized on the date payment is made or received. Except as 
provided in the succeeding sentence, such exchange gain or loss shall be 
recognized in accordance with the applicable recognition provisions of 
the Internal Revenue Code. If the taxpayer's right to receive income, or 
obligation to pay an expense, is transferred or modified in a 
transaction in which gain or loss would otherwise be recognized, 
exchange gain or loss shall be realized and recognized only to the 
extent of the total gain or loss on the transaction.
    (2) Determination of exchange gain or loss with respect to an item 
of gross income or receipts. Exchange gain or loss realized on an item 
of gross income or receipts described in paragraph (c)(1) of this 
section shall be determined by multiplying the units of nonfunctional 
currency received by the spot rate on the payment date, and subtracting 
from such amount the amount determined by multiplying the units of 
nonfunctional currency received by the spot rate on the booking date. 
The term ``spot rate on the payment date'' means the spot rate 
determined under

[[Page 648]]

Sec. 1.988-1(d) on the date payment is received or otherwise taken into 
account. Pursuant to Sec. 1.988-1(d)(3), a taxpayer may use a spot rate 
convention for purposes of determining the spot rate on the payment 
date. The term ``spot rate on the booking date'' means the spot rate 
determined under Sec. 1.988-1(d) on the date the item of gross income 
or receipts is accrued or otherwise taken into account. Pursuant to 
Sec. 1.988-1(d)(3), a taxpayer may use a spot rate convention for 
purposes of determining the spot rate on the booking date.
    (3) Determination of exchange gain or loss with respect to an item 
of expense. Exchange gain or loss realized on an item of expense 
described in paragraph (c)(1) of this section shall be determined by 
multiplying the units of nonfunctional currency paid by the spot rate on 
the booking date and subtracting from such amount the amount determined 
by multiplying the units of nonfunctional currency paid by the spot rate 
on the payment date. The term ``spot rate on the booking date'' means 
the spot rate determined under Sec. 1.988-1(d) on the date the item of 
expense is accrued or otherwise taken into account. Pursuant to Sec. 
1.988-1(d)(3), a taxpayer may use a spot rate convention for purposes of 
determining the spot rate on the booking date. The term ``spot rate on 
the payment date'' means the spot rate determined under Sec. 1.988-1(d) 
on the date payment is made or otherwise taken into account. Pursuant to 
Sec. 1.988-1(d)(3), a taxpayer may use a spot rate convention for 
purposes of determining the spot rate on the date.
    (4) Examples. The following examples illustrate the application of 
paragraph (c) of this section.

    Example 1. X is a calendar year corporation with the dollar as its 
functional currency. X is on the accrual method of accounting. On 
January 15, 1989, X sells inventory for 10,000 Canadian dollars (C$). 
The spot rate on January 15, 1989, is C$1 = U.S. $.55. On February 23, 
1989, when X receives payment of the C$10,000, the spot rate is C$1 = 
U.S. $.50. On February 23, 1989, X will realize exchange loss. X's loss 
is computed by multiplying the C$10,000 by the spot rate on the date the 
C$10,000 are received (C$10,000 x .50 = U.S. $5,000) and subtracting 
from such amount, the amount computed by multiplying the C$10,000 by the 
spot rate on the booking date (C$10,000 x .55 = U.S. $5,500). Thus, X's 
exchange loss on the transaction is U.S. $500 (U.S. $5,000-U.S. $5,500).
    Example 2. The facts are the same as in Example 1 except that X uses 
a spot rate convention to determine the spot rate as provided in Sec. 
1.988-1(d)(3). Pursuant to X's spot rate convention, the spot rate at 
which a payable or receivable is booked is determined monthly for each 
nonfunctional currency payable or receivable by adding the spot rate at 
the beginning of the month and the spot rate at the end of the month and 
dividing by two. All payables and receivables in a nonfunctional 
currency booked during the month are translated into functional currency 
at the rate described in the preceding sentence. Further, the 
translation of nonfunctional currency paid with respect to a payable, 
and nonfunctional currency received with respect to a receivable, is 
also performed pursuant to the spot rate convention. Assume the spot 
rate determined under the spot rate convention for the month of January 
is C$1 = U.S. $.54 and for the month of February is C$1 = U.S. $.51. On 
the last date in February, X will realize exchange loss. X's loss is 
computed by multiplying the C$10,000 by the spot rate convention for the 
month of February (C$10,000 x U.S. $.51 = U.S. $5,100) and subtracting 
from such amount, the amount computed by multiplying the C$10,000 by the 
spot rate convention for the month of January (C$10,000 x U.S. $.54 = 
$5,400). Thus, X's exchange loss on the transaction is U.S. $300 (U.S. 
$5,100-U.S. $5,400). X's basis in the C$10,000 is U.S. $5,400.
    Example 3. The facts are the same as in Example 2 except that X has 
a standing order with X's bank for the bank to convert any nonfunctional 
currency received in satisfaction of a receivable into U.S. dollars on 
the day received and to deposit those U.S. dollars in X's U.S. dollar 
bank account. X may use its convention to translate the amount booked 
into U.S. dollars, but must use the U.S. dollar amounts received from 
the bank with respect to such receivables to determine X's exchange gain 
or loss. Thus, if X receives payment of the C$10,000 on February 23, 
1989, when the spot rate is C$1 = U.S.$ .50, X determines exchange gain 
or loss by subtracting the amount booked under X's convention 
(U.S.$5,400) from the amount of U.S. dollars received from the bank 
under the standing conversion order (assume $5,000). X's exchange loss 
is U.S.$400.

    (d) Exchange gain or loss with respect to forward contracts, futures 
contracts and option contracts--(1) Scope--(i) In general. This 
paragraph (d) applies to forward contracts, futures contracts and option 
contracts described in Sec. 1.988-1(a)(1)(ii) and (2)(iii). For rules

[[Page 649]]

applicable to currency swaps and notional principal contracts described 
in Sec. 1.988-1(a) (1)(ii) and (2)(iii), see paragraph (e) of this 
section.
    (ii) Treatment of spot contracts. Solely for purposes of this 
paragraph (d), a spot contract as defined in Sec. 1.988-1(b) to buy or 
sell nonfunctional currency is not considered a forward contract or 
similar transaction described in Sec. 1.988-1(a)(2)(iii) unless such 
spot contract is disposed of (or otherwise terminated) prior to making 
or taking delivery of the currency. For example, if a taxpayer with the 
dollar as its functional currency enters into a spot contract to 
purchase British pounds, and takes delivery of such pounds under the 
contract, the delivery of the pounds is not a realization event under 
section 988(c)(5) and paragraph (e)(4)(ii) of this section because the 
contract is not considered a forward contract or similar transaction 
described in Sec. 1.988-1(a)(2)(iii). However, if the taxpayer sells or 
otherwise terminates the contract before taking delivery of the pounds, 
exchange gain or loss shall be realized and recognized in accordance 
with paragraphs (d)(2) and (3) of this section.
    (2) Realization of exchange gain or loss--(i) In general. Except as 
provided in Sec. 1.988-5, exchange gain or loss on a contract described 
in Sec. 1.988-2(d)(1) shall be realized in accordance with the 
applicable realization section of the Internal Revenue Code (e.g., 
sections 1001, 1092, and 1256). See also section 988(c)(5). For purposes 
of determining the timing of the realization of exchange gain or loss, 
sections 1092 and 1256 shall take precedence over section 988(c)(5).
    (ii) Realization by offset--(A) In general. Except as provided in 
paragraphs (d)(2)(ii)(B) and (C) of this section, exchange gain or loss 
with respect to a transaction described in Sec. 1.988-1(a)(1)(ii) and 
(2)(iii) shall not be realized solely because such transaction is offset 
by another transaction (or transactions).
    (B) Exception where economic benefit is derived. If a transaction 
described in Sec. 1.988-1(a)(1)(ii) and (2)(iii) is offset by another 
transaction or transactions, exchange gain shall be realized to the 
extent the taxpayer derives, by pledge or otherwise, an economic benefit 
(e.g., cash, property or the proceeds from a borrowing) from any gain 
inherent in such offsetting positions. Proper adjustment shall be made 
in the amount of any gain or loss subsequently realized for gain taken 
into account by reason of the preceding sentence. This paragraph 
(d)(2)(ii)(B) shall apply to transactions creating an offset after 
September 21, 1989.
    (C) Certain contracts traded on an exchange. If a transaction 
described in Sec. 1.988-1(a)(1)(ii) and (2)(iii) is traded on an 
exchange and it is the general practice of the exchange to terminate 
offsetting contracts, entering into an offsetting contract shall be 
considered a termination of the contract being offset.
    (iii) Clarification of section 988(c)(5). If the delivery date of a 
contract subject to section 988(c)(5) and paragraph (d)(4)(ii) of this 
section is different than the date the contract expires, then for 
purposes of determining the date exchange gain or loss is realized, the 
term delivery date shall mean expiration date.
    (iv) Examples. The following examples illustrate the rules of this 
paragraph (d)(1) and (2).

    Example 1. On August 1, 1989, X, a calendar year corporation with 
the dollar as its functional currency, enters into a forward contract 
with Bank A to buy 100 New Zealand dollars for $80 for delivery on 
January 31, 1990. (The forward purchase contract is not a section 1256 
contract.) On November 1, 1989, the market price for the purchase of 100 
New Zealand dollars for delivery on January 31, 1990, is $76. On 
November 1, 1989, X cancels its obligation under the forward purchase 
contract and pays Bank A $3.95 (the present value of $4 discounted at 
12% for the period) in cancellation of such contract. Under section 1001 
(a), X realizes an exchange loss of $3.95 on November 1, 1989, because 
cancellation of the forward purchase contract for cash results in the 
termination of X's contract.
    Example 2. X is a corporation with the dollar as its functional 
currency. On January 1, 1989, X enters into a currency swap contract 
with Bank A under which X is obligated to make a series of Japanese yen 
payments in exchange for a series of dollar payments. On February 21, 
1992, X has a gain of $100,000 inherent in such contract as a result of 
interest rate and exchange rate movements. Also on February 21, 1992, X 
enters into an offsetting swap with Bank A to lock in such gain.

[[Page 650]]

If on February 21, 1992, X pledges the gain inherent in such offsetting 
positions as collateral for a loan, X's initial swap contract is treated 
as being terminated on February 21, 1992, under paragraph (d)(2)(ii)(B) 
of this section. Proper adjustment is made in the amount of any gain or 
loss subsequently realized for the gain taken into account by reason of 
paragraph (d)(2)(ii)(B) of this section.
    Example 3. X is a calendar year corporation with the dollar as its 
functional currency. On October 1, 1989, X enters into a forward 
contract to buy 100,000 Swiss francs (Sf) for delivery on March l, 1990, 
for $51,220. Assume that the contract is a section 1256 contract under 
section 1256(g)(2) and that section 1256(e) does not apply. Pursuant to 
section 1256(a)(1), the forward contract is treated as sold for its fair 
market value on December 31, 1989. Assume that the fair market value of 
the contract is $1,000 determined under Sec. 1.988-1(g). Thus X will 
realize an exchange gain of $1,000 on December 31, 1989. Such gain is 
subject to the character rules of Sec. 1.988-3 and the source rules of 
Sec. 1.988-4.

    (v) Extension of the maturity date of certain contracts. An 
extension of time for making or taking delivery under a contract 
described in paragraph (d)(1) of this section (e.g., a historical rate 
rollover as defined in Sec. 1.988-5(b)(2)(iii)(C)) shall be considered 
a sale or exchange of the contract for its fair market value on the date 
of the extension and the establishment of a new contract on such date. 
If, under the terms of the extension, the time value of any gain or loss 
recognized pursuant to the preceding sentence adjusts the price of the 
currency to be bought or sold under the new contract, the amount 
attributable to such time value shall be treated as interest income or 
expense for all purposes of the Code. However, the preceding sentence 
shall not apply and the amount attributable to the time value of any 
gain or loss recognized shall be treated as exchange gain or loss if the 
period beginning on the first date the contract is rolled over and 
ending on the date payment is ultimately made or received with respect 
to such contract does not exceed 183 days.
    (3) Recognition of exchange gain or loss. Except as provided in 
Sec. 1.988-5 (relating to section 988 hedging transactions), exchange 
gain or loss realized with respect to a contract described in paragraph 
(d)(1) of this section shall be recognized in accordance with the 
applicable recognition provisions of the Internal Revenue Code. For 
example, a loss realized with respect to a contract described in 
paragraph (d)(1) of this section which is part of a straddle shall be 
recognized in accordance with the provisions of section 1092 to the 
extent such section is applicable.
    (4) Determination of exchange gain or loss--(i) In general. Exchange 
gain or loss with respect to a contract described in Sec. 1.988-2(d)(1) 
shall be determined by subtracting the amount paid (or deemed paid), if 
any, for or with respect to the contract (including any amount paid upon 
termination of the contract) from the amount received (or deemed 
received), if any, for or with respect to the contract (including any 
amount received upon termination of the contract). Any gain or loss 
determined according to the preceding sentence shall be treated as 
exchange gain or loss.
    (ii) Special rules where taxpayer makes or takes delivery. If the 
taxpayer makes or takes delivery in connection with a contract described 
in paragraph (d)(1) of this section, any gain or loss shall be realized 
and recognized in the same manner as if the taxpayer sold the contract 
(or paid another person to assume the contract) on the date on which he 
took or made delivery for its fair market value on such date. See 
paragraph (d)(2)(iii) of this section regarding the definition of the 
term ``delivery date.'' This paragraph (d)(4)(ii) shall not apply in any 
case in which the taxpayer makes or takes delivery before June 11, 1987.
    (iii) Examples. The following examples illustrate the application of 
paragraph (d)(4) of this section.

    Example 1. X is a calendar year corporation with the dollar as its 
functional currency. On October 1, 1989, when the six month forward rate 
is $.4907, X enters into a forward contract to buy 100,000 New Zealand 
dollars (NZD) for delivery on March 1, 1990. On March 1, 1990, when X 
takes delivery of the 100,000 NZD, the spot rate is 1NZD equals $.48. 
Pursuant to section 988(c)(5) and paragraph (d)(4)(ii) of this section, 
a taxpayer that takes delivery of nonfunctional currency under a forward 
contract that is subject to section 988 is treated as if the taxpayer 
sold the contract for its fair market value on the date delivery is 
taken. If X sold the contract on March 1, 1990, the transferee would 
require a payment of $1,070 [($.48 x

[[Page 651]]

100,000NZD)-($.4907 x 100,000NZD)] to compensate him for the loss in 
value of the 100,000NZD. Therefore, X realizes an exchange loss of 
$1,070. X has a basis in the 100,000NZD of $48,000.
    Example 2. Assume the same facts as in Example 1 except that the 
contract is for Swiss francs and is a section 1256 contract. Assume 
further that on December 31, 1989, the value to X of the contract as 
marked to market is $1,000. Pursuant to section 1256(a), X realizes an 
exchange gain of $1,000. Such gain, however, is characterized as 
ordinary income under Sec. 1.988-3 and will be sourced under Sec. 
1.988-4.
    Example 3. X is a calendar year corporation with the dollar as its 
functional currency. On May 2, 1989, X enters into an option contract 
with Bank A to purchase 50,000 Canadian dollars (C$) for U.S. $42,500 
(C$1 = U.S. $.85) for delivery on or before September 18, 1989. X pays a 
$285 premium to Bank A to obtain the option contract. On September 18, 
1989, when X exercises the option and takes delivery of the C$50,000, 
the spot rate is C$1 equals U.S. $.90. Pursuant to section 988(c)(5) and 
paragraph (d)(4)(ii) of this section, a taxpayer that takes delivery 
under an option contract that is subject to section 988 is treated as if 
the taxpayer sold the contract for its fair market value on the date 
delivery is taken. If X sold the contract for its fair market value on 
September 18, 1989, X would receive U.S. $2,500 [(C$50,000 x U.S. $.90)-
(C$50,000 x U.S. $.85)]. Accordingly, X is deemed to have received U.S. 
$2,500 on the sale of the contract at its fair market value. X will 
realize U.S. $2,215 ($2,500 deemed received less $285 paid) of exchange 
gain with respect to the delivery of Canadian dollars under the option 
contract. X's basis in the 50,000 Canadian dollars is U.S. $45,000.

    (5) Hyperinflationary contracts--(i) In general. If a taxpayer 
acquires or otherwise enters into a hyperinflationary contract (as 
defined in paragraph (d)(5)(ii) of this section) that has payments to be 
made or received that are denominated in (or determined by reference to) 
a nonfunctional currency of the taxpayer, then the taxpayer shall 
realize exchange gain or loss with respect to such contract for its 
taxable year determined by reference to the change in exchange rates 
between--
    (A) The later of the first day of the taxable year, or the date the 
contract was acquired or entered into; and
    (B) The earlier of the last day of the taxable year, or the date the 
contract is disposed of or otherwise terminated.
    (ii) Definition of hyperinflationary contract. A hyperinflationary 
contract is a contract described in paragraph (d)(1) of this section 
that provides for payments denominated in or determined by reference to 
a currency that is hyperinflationary (as defined in Sec. 1.988-1(f)) at 
the time the taxpayer acquires or otherwise enters into the contract.
    (iii) Interaction with other provisions--(A) DASTM. With respect to 
a qualified business unit that uses the United States dollar approximate 
separate transactions method of accounting described in Sec. 1.985-3, 
this paragraph (d)(5) does not apply.
    (B) Hedging rules. To the extent Sec. 1.446-4 or 1.988-5 apply, 
this paragraph (d)(5) does not apply.
    (C) Adjustment for subsequent transactions. Proper adjustments must 
be made in the amount of any gain or loss subsequently realized for gain 
or loss taken into account by reason of this paragraph (d)(5).
    (iv) Effective date. This paragraph (d) (5) is applicable to 
transactions acquired or otherwise entered into after February 14, 2000.
    (e) Currency swaps and other notional principal contracts--(1) In 
general. Except as provided in paragraph (e)(2) of this section or in 
Sec. 1.988-5, the timing of income, deduction and loss with respect to 
a notional principal contract that is a section 988 transaction shall be 
governed by section 446 and the regulations thereunder. Such income, 
deduction and loss is characterized as exchange gain or loss (except as 
provided in another section of the Internal Revenue Code (or regulations 
thereunder), Sec. 1.988-5, or in paragraph (f) of this section).
    (2) Special rules for currency swaps--(i) In general. Except as 
provided in paragraph (e)(2)(iii)(B) of this section, the provisions of 
this paragraph (e)(2) shall apply solely for purposes of determining the 
realization, recognition and amount of exchange gain or loss with 
respect to a currency swap contract, and not for purposes of determining 
the source of such gain or loss, or characterizing such gain or loss as 
interest. Except as provided in Sec. 1.988-3(c), any income or loss 
realized with respect to a currency swap contract shall be characterized 
as exchange gain or loss (and not as interest income or expense). Any

[[Page 652]]

exchange gain or loss realized in accordance with this paragraph (e)(2) 
shall be recognized unless otherwise provided in an applicable section 
of the Code. For purposes of this paragraph (e)(2), a currency swap 
contract is a contract defined in paragraph (e)(2)(ii) of this section. 
With respect to a contract which requires the payment of swap principal 
prior to maturity of such contract, see paragraph (f) of this section. 
For purposes of this paragraph (e), the rules of paragraph (d)(2)(ii) of 
this section (regarding realization by offset) apply. See Example 2 of 
paragraph (d)(2)(iv) of this section.
    (ii) Definition of currency swap contract--(A) In general. A 
currency swap contract is a contract involving different currencies 
between two or more parties to--
    (1) Exchange periodic interim payments, as defined in paragraph 
(e)(2)(ii)(C) of this section, on or prior to maturity of the contract; 
and
    (2) Exchange the swap principal amount upon maturity of the 
contract.


A currency swap contract may also require an exchange of the swap 
principal amount upon commencement of the agreement.
    (B) Swap principal amount. The swap principal amount is an amount of 
two different currencies which, under the terms of the currency swap 
contract, is used to determine the periodic interim payments in each 
currency and which is exchanged upon maturity of the contract. If such 
amount is not clearly set forth in the contract, the Commissioner may 
determine the swap principal amount.
    (C) Exchange of periodic interim payments. An exchange of periodic 
interim payments is an exchange of one or more payments in one currency 
specified by the contract for one or more payments in a different 
currency specified by the contract where the payments in each currency 
are computed by reference to an interest index applied to the swap 
principal amount. A currency swap contract must clearly indicate the 
periodic interim payments, or the interest index used to compute the 
periodic interim payments, in each currency.
    (iii) Timing and computation of periodic interim payments--(A) In 
general. Except as provided in paragraph (e)(2)(iii)(B) of this section 
and Sec. 1.988-5, the timing and computation of the periodic interim 
payments provided in a currency swap agreement shall be determined by 
treating--
    (1) Payments made under the swap as payments made pursuant to a 
hypothetical borrowing that is denominated in the currency in which 
payments are required to be made (or are determined with reference to) 
under the swap, and
    (2) Payments received under the swap as payments received pursuant 
to a hypothetical loan that is denominated in the currency in which 
payments are received (or are determined with reference to) under the 
swap.


Except as provided in paragraph (e)(2)(v) of this section, the 
hypothetical issue price of such hypothetical borrowing and loan shall 
be the swap principal amount. The hypothetical stated redemption price 
at maturity is the total of all payments (excluding any exchange of the 
swap principal amount at the inception of the contract) provided under 
the hypothetical borrowing or loan other than periodic interest payments 
under the principles of section 1273. For purposes of determining 
economic accrual under the currency swap, the number of hypothetical 
interest compounding periods of such hypothetical borrowing and loan 
shall be determined pursuant to a semiannual compounding convention 
unless the currency swap contract indicates otherwise. For purposes of 
determining the timing and amount of the periodic interim payments, the 
principles regarding the amortization of interest (see generally, 
sections 1272 through 1275 and 163(e)) shall apply to the hypothetical 
interest expense and income of such hypothetical borrowing and loan. 
However, such principles shall not apply to determine the time when 
principal is deemed to be paid on the hypothetical borrowing and loan. 
See paragraph (d)(2)(iii) of this section and Example 2 of paragraph 
(d)(5) of this section with respect to the time when principal is deemed 
to be paid. With respect to the translation and computation of exchange 
gain or loss on any hypothetical interest income or expense, see Sec. 
1.988-2(b). The amount treated as exchange gain or loss by the

[[Page 653]]

taxpayer with respect to the periodic interim payments for the taxable 
year shall be the amount of hypothetical interest income and exchange 
gain or loss attributable to such interest income from the hypothetical 
borrowing and loan for such year less the amount of hypothetical 
interest expense and exchange gain or loss attributable to the interest 
expense from such hypothetical borrowing and loan for such year.
    (B) Effect of prepayment for purposes of section 956. For purposes 
of section 956, the Commissioner may treat any prepayment of a currency 
swap as a loan.
    (iv) Timing and determination of exchange gain or loss with respect 
to the swap principal amount. Exchange gain or loss with respect to the 
swap principal amount shall be realized on the day the units of swap 
principal in each currency are exchanged. (See paragraph 
(e)(2)(ii)(A)(2) of this section which requires that the entire swap 
principal amount be exchanged upon maturity of the contract.) Such gain 
or loss shall be determined on the date of the exchange by subtracting 
the value (on such date) of the units of swap principal paid from the 
value of the units of swap principal received. This paragraph (e)(2)(iv) 
does not apply to an equal exchange of the swap principal amount at the 
commencement of the agreement at a market exchange rate.
    (v) Anti-abuse rules--(A) Method of accounting does not clearly 
reflect income. If the taxpayer's method of accounting for income, 
expense, gain or loss attributable to a currency swap does not clearly 
reflect income, or if the present value of the payments to be made is 
not equivalent to that of the payments to be received (including the 
swap premium or discount, as defined in paragraph (e)(3)(ii) of this 
section) on the day the taxpayer enters into or acquires the contract, 
the Commissioner may apply principles analogous to those of section 1274 
or such other rules as the Commissioner deems appropriate to clearly 
reflect income. For example, in order to clearly reflect income the 
Commissioner may determine the hypothetical issue price, the 
hypothetical stated redemption price at maturity, and the amounts 
required to be taken into account within a taxable year. Further, if the 
present value of the payments to be made is not equivalent to that of 
the payments to be received (including the swap premium or discount, as 
defined in paragraph (e)(3)(ii) of this section) on the day the taxpayer 
enters into or acquires the contract, the Commissioner may integrate the 
swap with another transaction (or transactions) in order to clearly 
reflect income.
    (B) Terms must be clearly stated. If the currency swap contract does 
not clearly set forth the swap principal amount in each currency, and 
the periodic interim payments in each currency (or the interest index 
used to compute the periodic interim payments in each currency), the 
Commissioner may defer any income, deduction, gain or loss with respect 
to such contract until termination of the contract.
    (3) Amortization of swap premium or discount in the case of off-
market currency swaps--(i) In general. An ``off-market currency swap'' 
is a currency swap contract under which the present value of the 
payments to be made is not equal to that of the payments to be received 
on the day the taxpayer enters into or acquires the contract (absent the 
swap premium or discount, as defined in paragraph (e)(3)(ii) of this 
section). Generally, such present values may not be equal if the swap 
exchange rate (as defined in paragraph (e)(3)(iii) of this section) is 
not the spot rate, or the interest indices used to compute the periodic 
interim payments do not reflect current values, on the day the taxpayer 
enters into or acquires the currency swap.
    (ii) Treatment of taxpayer entering into or acquiring an off-market 
currency swap. If a taxpayer that enters into or acquires a currency 
swap makes a payment (that is, the taxpayer pays a premium, ``swap 
premium,'' to enter into or acquire the currency swap) or receives a 
payment (that is, the taxpayer enters into or acquires the currency swap 
at a discount, ``swap discount'') in order to make the present value of 
the amounts to be paid equal the amounts to be received, such payment 
shall be amortized in a manner which

[[Page 654]]

places the taxpayer in the same position it would have been in had the 
taxpayer entered into a currency swap contract under which the present 
value of the amounts to be paid equal the amounts to be received (absent 
any swap premium or discount). Thus, swap premium or discount shall be 
amortized as follows--
    (A) The amount of swap premium or discount that is attributable to 
the difference between the swap exchange rate (as defined in paragraph 
(e)(3)(iii) of this section) and the spot rate on the date the contract 
is entered into or acquired shall be taken into account as income or 
expense on the date the swap principal amounts are taken into account; 
and
    (B) The amount of swap premium or discount attributable to the 
difference in values of the periodic interim payments shall be amortized 
in a manner consistent with the principles of economic accrual. Cf., 
section 171.


Any amount taken into account pursuant to this paragraph (e)(3)(ii) 
shall be treated as exchange gain or loss.
    (iii) Definition of swap exchange rate. The swap exchange rate is 
the single exchange rate set forth in the contract at which the swap 
principal amounts are determined. If the swap exchange rate is not 
clearly set forth in the contract, the Commissioner may determine such 
rate.
    (iv) Coordination with Sec. 1.446-3(g)(4) regarding swaps with 
significant nonperiodic payments. The rules of Sec. 1.446-3(g)(4) apply 
to any currency swap with a significant nonperiodic payment. Section 
1.446-3(g)(4) applies before this paragraph (e)(3). Thus, if Sec. 
1.446-3(g)(4) applies, currency gain or loss may be realized on the 
loan. This paragraph (e)(3)(iv) applies to transactions entered into 
after February 14, 2000.
    (4) Treatment of taxpayer disposing of a currency swap. Any gain or 
loss realized on the disposition or the termination of a currency swap 
is exchange gain or loss.
    (5) Examples. The following examples illustrate the application of 
this paragraph (e).

    Example 1. (i) C is an accrual method calendar year corporation with 
the dollar as its functional currency. On January 1, 1989, C enters into 
a currency swap with J with the following terms:
    (1) the principal amount is $150 and 100 British pounds ([pound]) 
(the equivalent of $150 on the effective date of the contract assuming a 
spot rate of [pound]1 = $1.50 on January 1, 1989);
    (2) C will make payments equal to 10% of the dollar principal amount 
on December 31, 1989, and December 31, 1990;
    (3) J will make payments equal to 12% of the pound principal amount 
on December 31, 1989, and December 31, 1990; and
    (4) on December 31, 1990, C will pay to J the $150 principal amount 
and J will pay to C the [pound]100 principal amount.


Assume that the spot rate is [pound]1 = $1.50 on January 1, 1989, 
[pound]1 = $1.40 on December 31, 1989, and [pound]1 = $1.30 on December 
31, 1990. Assume further that the average rate for 1989 is [pound]1 = 
$1.45 and for 1990 is [pound]1 = $1.35.
    (ii) Solely for determining the realization of gain or loss in 
accordance with paragraph (e)(2) of this section (and not for purposes 
of determining whether any payments are treated as interest), C will 
treat the dollar payments made by C as payments made pursuant to a 
dollar borrowing with an issue price of $150, a stated redemption price 
at maturity of $150, and yield to maturity of 10%. C will treat the 
pound payments received as payments received pursuant to a pound loan 
with an issue price of [pound]100, a stated redemption price at maturity 
of [pound]100, and a yield of 12% to maturity. Pursuant to Sec. 1.988-
2(b), C is required to compute hypothetical accrued pound interest 
income at the average rate for the accrual period and then determine 
exchange gain or loss on the day payment is received with respect to 
such accrued amount. Accordingly, C will accrue $17.40 ([pound]12 x 
$1.45) in 1989 and $16.20 ([pound]12 x $1.35) in 1990. C also will 
compute hypothetical exchange loss of $.60 on December 31, 1989 
[([pound]12 x $1.40)-([pound]12 x $1.45)] and hypothetical exchange loss 
of $.60 on December 31, 1990 [([pound]12 x $1.30)-([pound]12 x $1.35)]. 
All such hypothetical interest income and exchange loss are 
characterized and sourced as exchange gain and loss. Further, C is 
treated as having paid $15 ($150 x 10%) of hypothetical interest on 
December 31, 1989, and again on December 31, 1990. Such hypothetical 
interest expense is characterized and sourced as exchange loss. Thus, C 
will have a net exchange gain of $1.80 ($17.40-$.60-$15.00) with respect 
to the periodic interim payments in 1989 and a net exchange gain of $.60 
($16.20-$.60-$15.00) with respect to the periodic interim payments in 
1990. Finally, C will realize an exchange loss on December 31, 1990, 
with respect to the exchange of the swap principal amount. This loss is 
determined by subtracting the value of the units of swap principal paid 
($150) from the value of the units of swap principal received 
([pound]100

[[Page 655]]

x $1.30 = $130) resulting in a $20 exchange loss.
    Example 2. (i) C is an accrual method calendar year corporation with 
the dollar as its functional currency. On January 1, 1989, when the spot 
rate is [pound]1 = $1.50, C enters into a currency swap contract with J 
under which C agrees to make and receive the following payments:

------------------------------------------------------------------------
                     Date                          C pays       J pays
------------------------------------------------------------------------
December 31, 1989.............................       $15.00  [pound]12.0
                                                                       0
December 31, 1990.............................        41.04        12.00
December 31, 1991.............................         0.00        12.00
December 31, 1992.............................       150.00       112.00
------------------------------------------------------------------------

    (ii) Under paragraph (e)(2)(iii) of this section, C must treat the 
dollar periodic interim payments under the swap as made pursuant to a 
hypothetical dollar borrowing. The hypothetical issue price is $150 and 
the stated redemption price at maturity is $206.04. The amount of 
hypothetical interest expense must be amortized in accordance with 
economic accrual. Thus J must include and C must deduct periodic interim 
payment amounts as follows:

------------------------------------------------------------------------
                                                   Amount
                                                 taken into    Adjusted
                                                  account    issue price
------------------------------------------------------------------------
December 31, 1989.............................       $15.00       150.00
December 31, 1990.............................       $15.00       123.96
December 31, 1991.............................       $12.40       136.36
December 31, 1992.............................       $13.64
------------------------------------------------------------------------

    (iii) Gain or loss with respect to the periodic interim payments of 
the currency swap is determined under paragraph (e)(2)(iii)(A) of this 
section with respect to the dollar cash flow amortized as set forth 
above and the corresponding pound cash flow as stated in the currency 
swap contract. Gain or loss with respect to the principal payments 
(i.e., $150 and [pound]100) exchanged on December 31, 1992, is 
determined under paragraph (e)(2)(iv) of this section on December 31, 
1992, notwithstanding that under the principles regarding amortization 
of interest $26.04 would have been regarded as a payment of principal on 
December 31, 1990.
    Example 3. (i) X is a corporation on the accrual method of 
accounting with the dollar as its functional currency and the calendar 
year as its taxable year. On January 1, 1989, X enters into a three year 
currency swap contract with Y with the following terms. The swap 
principal amount is $100 and the Swiss franc (Sf) equivalent of such 
amount which equals Sf200 translated at the swap exchange rate of $1 = 
Sf2. There is no initial exchange of the swap principal amount. The 
interest rates used to compute the periodic interim payments are 10% 
compounded annually for U.S. dollar payments and 5% compounded annually 
for Swiss franc payments. Thus, under the currency swap, X agrees to pay 
Y $10 (10% x $100) on December 31st of 1989, 1990 and 1991 and to pay Y 
the swap principal amount of $100 on December 31, 1991. Y agrees to pay 
X Sf10 (5% x Sf200) on December 31st of 1989, 1990 and 1991 and to pay X 
the swap principal amount of Sf200 on December 31, 1991. Assume that the 
average rate for 1989 and the spot rate on December 31, 1989, is $1 = 
Sf2.5.
    (ii) Under paragraph (e)(2)(iii) of this section, on December 31, 
1989, X will realize an exchange loss of $6 (the sum of $10 of loss by 
reason of the $10 periodic interim payment paid to Y and $4.00 of gain, 
the value of Sf10 on December 31, 1989, from the receipt of Sf10 on such 
date).
    (iii) On January 1, 1990, X transfers its rights and obligations 
under the swap contract to Z, an unrelated corporation. Z has the dollar 
as its functional currency, is on the accrual method of accounting, and 
has the calendar year as its taxable year. On January 1, 1990, the 
exchange rate is $1 = Sf2.50. The relevant dollar interest rate is 8% 
compounded annually and the relevant Swiss franc interest rate is 5% 
compounded annually. Because of the movement in exchange and interest 
rates, the agreement between X and Z to transfer the currency swap 
requires X to pay Z $23.56 (the swap discount as determined under 
paragraph (e)(3) of this section).
    (iv) Pursuant to paragraph (e)(4) of this section, X may deduct the 
loss of $23.56 in 1990. The loss is characterized under Sec. 1.988-3 
and sourced under Sec. 1.988-4.
    (v) Pursuant to paragraph (e)(3)(ii) of this section, Z is required 
to amortize the $23.56 received as follows. The amount of the $23.56 
payment that is attributable to movements in exchange rates ($20) is 
taken into account on December 31, 1991, the date the swap principal 
amounts are exchanged, under paragraph (e)(3)(ii)(A) of this section. 
This amount is the present value (discounted at 10%, the rate under the 
currency swap contract used to compute the dollar periodic interim 
payments) of the financial asset required to compensate Z for the loss 
in value of the hypothetical Swiss franc loan resulting from movements 
in exchange rates between January 1, 1989, and January 1, 1990. This 
amount is determined by assuming that interest rates did not change from 
the date the swap originally was entered into (January 1, 1989), but 
that the exchange rate is $1 = Sf2.50. Under this assumption, a taxpayer 
undertaking the obligation to pay dollars under the currency swap on 
January 1, 1990, would only agree to pay $8 for Sf10 on December 31, 
1990, and $88 for Sf210 on December 31, 1991, because the exchange rates 
have moved from $1 = Sf2 to $1 = Sf2.50. Thus, Z requires $2 on December 
31, 1990, and $22 on December 31, 1991, to compensate for the amount of 
dollar payments Z is required to make in exchange for the Swiss francs 
received on December 31, 1990 and 1991. The

[[Page 656]]

present value of $2 on December 31, 1990, and $22 on December 31, 1991, 
discounted at the rate for U.S. dollar payments of 10% is $20 ($1.82 + 
$18.18). This amount is discounted at the rate for U.S. dollar payments 
(i.e., at the historic rate) because the amount of the $23.56 payment 
received by Z that is attributable to movements in interest rates is 
computed and amortized separately as provided in the following 
paragraph.
    (vi) Pursuant to paragraph (e)(3)(ii)(B) of this section, Z is 
required to amortize the portion of the $23.56 payment attributable to 
movements in interest rates under principles of economic accrual over 
the term of the currency swap agreement. The amount of the $23.56 
payment that is attributable to movements in interest rates (assuming 
that exchange rates have not changed) is the present value ($3.56) of 
the excess ($2.00 in 1990 and $2.00 in 1991) of the periodic interim 
payments Z is required to pay under the currency swap agreement ($10 in 
1990 and $10 in 1991) over the amount Z would be required to pay if the 
currency swap agreement reflected current interest rates on the day Z 
acquired the swap contract ($8 in 1990 and $8 in 1991) discounted at the 
appropriate dollar interest rate on January 1, 1990. Thus, under 
principles of economic accrual (e.g., see section 171 of the Code), Z 
will include in income $1.72 on December 31, 1990, the amount that, when 
added to the interest ($.28) on the $3.56 computed at the 8% rate on the 
date Z acquired the currency swap contract, will equal the $2.00 needed 
to compensate Z for the movement in interest rates between January 1, 
1989, and January 1, 1990. Z also will include in income $1.85 on 
December 31, 1991, the amount that, when added to the interest ($.15) on 
the $1.85 (the remaining balance of the $3.56 payment) computed at the 
8% rate on the date Z acquired the currency swap contract, will equal 
the $2.00 needed to compensate Z for the movement in interest rates 
between January 1, 1990, and January 1, 1991. This amount is computed 
assuming exchange rates have not changed because the amount attributable 
to movements in exchange rates is computed and amortized separately 
under the preceding paragraph.

    (6) Special effective date for rules regarding currency swaps. 
Paragraph (e)(3) of this section regarding amortization of swap premium 
or discount in the case of off-market currency swaps shall be effective 
for transactions entered into after September 21, 1989, unless such swap 
premium or discount was paid or received pursuant to a binding contract 
with an unrelated party that was entered into prior to such date. For 
transactions entered into prior to this date, see Notice 89-21, 1989-8 
I.R.B. 23.
    (7) Special rules for currency swap contracts in hyperinflationary 
currencies--(i) In general. If a taxpayer enters into a 
hyperinflationary currency swap (as defined in paragraph (e)(7)(iv) of 
this section), then the taxpayer realizes exchange gain or loss for its 
taxable year with respect to such instrument determined by reference to 
the change in exchange rates between--
    (A) The later of the first day of the taxable year, or the date the 
instrument was entered into (by the taxpayer); and
    (B) The earlier of the last day of the taxable year, or the date the 
instrument is disposed of or otherwise terminated.
    (ii) Adjustment to principal or basis. Proper adjustments are made 
in the amount of any gain or loss subsequently realized for gain or loss 
taken into account by reason of this paragraph (e)(7).
    (iii) Interaction with DASTM. With respect to a qualified business 
unit that uses the United States dollar approximate separate 
transactions method of accounting described in Sec. 1.985-3, this 
paragraph (e)(7) does not apply.
    (iv) Definition of hyperinflationary currency swap contract. A 
hyperinflationary currency swap contract is a currency swap contract 
that provides for--
    (A) Payments denominated in or determined by reference to a currency 
that is hyperinflationary (as defined in Sec. 1.988-1(f)) at the time 
the taxpayer enters into or otherwise acquires the currency swap; or
    (B) Payments that are adjusted to take into account the fact that 
the currency is hyperinflationary (as defined in Sec. 1.988-1(f)) 
during the current taxable year. A currency swap contract that provides 
for periodic payments determined by reference to a variable interest 
rate based on local conditions and generally responding to changes in 
the local consumer price index is an example of this latter type of 
currency swap contract.
    (v) Special effective date for nonfunctional hyperinflationary 
currency swap contracts. This paragraph (e)(7) applies

[[Page 657]]

to transactions entered into after February 14, 2000.
    (f) Substance over form--(1) In general. If the substance of a 
transaction described in Sec. 1.988-1(a)(1) differs from its form, the 
timing, source, and character of gains or losses with respect to such 
transaction may be recharacterized by the Commissioner in accordance 
with its substance. For example, if a taxpayer enters into a transaction 
that it designates a ``currency swap contract'' that requires the 
prepayment of all payments to be made or to be received (but not both), 
the Commissioner may recharacterize the contract as a loan. In applying 
the substance over form principle, separate transactions may be 
integrated where appropriate. See also Sec. 1.861-9T(b)(1).
    (2) Example. The following example illustrates the provisions of 
this paragraph (f).

    Example. (i) On January 1, 1990, X, a U.S. corporation with the 
dollar as its functional currency, enters into a contract with Y under 
which X will pay Y $100 and Y will pay X LC100 on January 1, 1990, and X 
will pay Y LC109.3 and Y will pay X $133 on December 31, 1992. On 
January 1, 1990, the spot exchange rate is LC1 = $1 and the 3 year 
forward rate is LC1 = $.8218. X's cash flows are summarized below:

------------------------------------------------------------------------
                         Date                            Dollar     LC
------------------------------------------------------------------------
1/1/90................................................    (100)      100
12/31/90..............................................        0        0
12/31/91..............................................        0        0
12/31/92..............................................      133  (109.3)
------------------------------------------------------------------------

    (ii) X and Y designate this contract as a ``currency swap.'' 
Notwithstanding this designation, for purposes of determining the 
timing, source, and character with respect to the transaction, the 
transaction is characterized by the Commissioner in accordance with its 
substance. Thus, the January 1, 1990, exchange by X of $100 for LC 100 
is treated as a spot purchase of LCs by X and the December 31, 1992, 
exchange by X at 109.3LC for $133 is treated as a forward sale of LCs by 
X. Under such treatment there would be no tax consequences to X under 
paragraph (e)(2) of this section in 1990, 1991, and 1992 with respect to 
this transaction other than the realization of exchange gain or loss on 
the sale of the LC109.3 on December 31, 1992. Calculation of such gain 
or loss would be governed by the rules of paragraph (d) of this section.

    (g) Effective date. Except as otherwise provided in this section, 
this section shall be effective for taxable years beginning after 
December 31, 1986. Thus, except as otherwise provided in this section, 
any payments made or received with respect to a section 988 transaction 
in taxable years beginning after December 31, 1986, are subject to this 
section.
    (h) Timing of income and deductions from notional principal 
contracts. Except as otherwise provided (e.g., in Sec. 1.988-5 or Sec. 
1.446-3(g)), income or loss from a notional principal contract described 
in Sec. 1.988-1(a)(2)(iii)(B) (other than a currency swap) is exchange 
gain or loss. For the rules governing the timing of income and 
deductions with respect to notional principal contracts, see Sec. 
1.446-3. See paragraph (e)(2) of this section with respect to currency 
swaps.

[T.D. 8400, 57 FR 9183, Mar. 17, 1992, as amended by T.D. 8491, 58 FR 
53135, Oct. 14, 1993; T.D. 8860, 65 FR 2028, Jan. 13, 2000; T.D. 9157, 
69 FR 52819, Aug. 30, 2004]



Sec. 1.988-3  Character of exchange gain or loss.

    (a) In general. The character of exchange gain or loss recognized on 
a section 988 transaction is governed by section 988 and this section. 
Except as otherwise provided in section 988(c)(1)(E), section 1092, 
Sec. 1.988-5 and this section, exchange gain or loss realized with 
respect to a section 988 transaction (including a section 1256 contract 
that is also a section 988 transaction) shall be characterized as 
ordinary gain or loss. Accordingly, unless a valid election is made 
under paragraph (b) of this section, any section providing special rules 
for capital gain or loss treatment, such as sections 1233, 1234, 1234A, 
1236 and 1256(f)(3), shall not apply.
    (b) Election to characterize exchange gain or loss on certain 
identified forward contracts, futures contracts and option contracts as 
capital gain or loss--(1) In general. Except as provided in paragraph 
(b)(2) of this section, a taxpayer may elect, subject to the 
requirements of paragraph (b)(3) of this section, to treat any gain or 
loss recognized on a contract described in Sec. 1.988-2(d)(1) as 
capital gain or loss, but only if the contract--
    (i) Is a capital asset in the hands of the taxpayer;

[[Page 658]]

    (ii) Is not part of a straddle within the meaning of section 1092(c) 
(without regard to subsections (c)(4) or (e)); and
    (iii) Is not a regulated futures contract or nonequity option with 
respect to which an election under section 988(c)(1)(D)(ii) is in 
effect.


If a valid election under this paragraph (b) is made with respect to a 
section 1256 contract, section 1256 shall govern the character of any 
gain or loss recognized on such contract.
    (2) Special rule for contracts that become part of a straddle after 
an election is made. If a contract which is the subject of an election 
under paragraph (b)(1) of this section becomes part of a straddle within 
the meaning of section 1092(c) (without regard to subsections (c)(4) or 
(e)) after the date of the election, the election shall be invalid with 
respect to gains from such contract and the Commissioner, in his sole 
discretion, may invalidate the election with respect to losses.
    (3) Requirements for making the election. A taxpayer elects to treat 
gain or loss on a transaction described in paragraph (b)(1) of this 
section as capital gain or loss by clearly identifying such transaction 
on its books and records on the date the transaction is entered into. No 
specific language or account is necessary for identifying a transaction 
referred to in the preceding sentence. However, the method of 
identification must be consistently applied and must clearly identify 
the pertinent transaction as subject to the section 988(a)(1)(B) 
election. The Commissioner, in his sole discretion, may invalidate any 
purported election that does not comply with the preceding sentence.
    (4) Verification. A taxpayer that has made an election under Sec. 
1.988-3(b)(3) must attach to his income tax return a statement which 
sets forth the following:
    (i) A description and the date of each election made by the taxpayer 
during the taxpayer's taxable year;
    (ii) A statement that each election made during the taxable year was 
made before the close of the date the transaction was entered into;
    (iii) A description of any contract for which an election was in 
effect and the date such contract expired or was otherwise sold or 
exchanged during the taxable year;
    (iv) A statement that the contract was never part of a straddle as 
defined in section 1092; and
    (v) A statement that all transactions subject to the election are 
included on the statement attached to the taxpayer's income tax return.


In addition to any penalty that may otherwise apply, the Commissioner, 
in his sole discretion, may invalidate any or all elections made during 
the taxable year under Sec. 1.988-3(b)(1) if the taxpayer fails to 
verify each election as provided in this Sec. 1.988-3(b)(4). The 
preceding sentence shall not apply if the taxpayer's failure to verify 
each election was due to reasonable cause or bona fide mistake. The 
burden of proof to show reasonable cause or bona fide mistake made in 
good faith is on the taxpayer.
    (5) Independent verification--(i) Effect of independent 
verification. If the taxpayer receives independent verification of the 
election in paragraph (b)(3) of this section, the taxpayer shall be 
presumed to have satisfied the requirements of paragraphs (b)(3) and (4) 
of this section. A contract that is a part of a straddle as defined in 
section 1092 may not be independently verified and shall be subject to 
the rules of paragraph (b)(2) of this section.
    (ii) Requirements for independent verification. A taxpayer receives 
independent verification of the election in paragraph (b)(3) of this 
section if--
    (A) The taxpayer establishes a separate account(s) with an unrelated 
broker(s) or dealer(s) through which all transactions to be 
independently verified pursuant to this paragraph (b)(5) are conducted 
and reported.
    (B) Only transactions entered into on or after the date the taxpayer 
establishes such account may be recorded in the account.
    (C) Transactions subject to the election of paragraph (b)(3) of this 
section are entered into such account on the date such transactions are 
entered into.
    (D) The broker or dealer provides the taxpayer a statement detailing 
the transactions conducted through such account and includes on such 
statement the following: ``Each transaction

[[Page 659]]

identified in this account is subject to the election set forth in 
section 988(a)(1)(B).''
    (iii) Special effective date for independent verification. The rules 
of this paragraph (b)(5) shall be effective for transactions entered 
into after March 17, 1992.
    (6) Effective date. Except as otherwise provided, this paragraph (b) 
is effective for taxable years beginning on or after September 21, 1989. 
For prior taxable years, any reasonable contemporaneous election meeting 
the requirements of section 988(a)(1)(B) shall satisfy this paragraph 
(b).
    (c) Exchange gain or loss treated as interest--(1) In general. 
Except as provided in this paragraph (c)(1), exchange gain or loss 
realized on a section 988 transaction shall not be treated as interest 
income or expense. Exchange gain or loss realized on a section 988 
transaction shall be treated as interest income or expense as provided 
in paragraph (c)(2) of this section with regard to tax exempt bonds, 
Sec. 1.988-2(e)(2)(ii)(B), Sec. 1.988-5, and in administrative 
pronouncements. See Sec. 1.861-9T(b), providing rules for the 
allocation of certain items of exchange gain or loss in the same manner 
as interest expense.
    (2) Exchange loss realized by the holder on nonfunctional currency 
tax exempt bonds. Exchange loss realized by the holder of a debt 
instrument the interest on which is excluded from gross income under 
section 103(a) or any similar provision of law shall be treated as an 
offset to and reduce total interest income received or accrued with 
respect to such instrument. Therefore, to the extent of total interest 
income, no exchange loss shall be recognized. This paragraph (c)(2) 
shall be effective with respect to debt instruments acquired on or after 
June 24, 1987.
    (d) Effective date. Except as otherwise provided in this section, 
this section shall be effective for taxable years beginning after 
December 31, 1986. Thus, except as otherwise provided in this section, 
any payments made or received with respect to a section 988 transaction 
in taxable years beginning after December 31, 1986, are subject to this 
section. Thus, for example, a payment made prior to January 1, 1987, 
under a forward contract that results in the deferral of a loss under 
section 1092 to a taxable year beginning after December 31, 1986, is not 
characterized as an ordinary loss by virtue of paragraph (a) of this 
section because payment was made prior to January 1, 1987.

[T.D. 8400, 57 FR 9197, Mar. 17, 1992]



Sec. 1.988-4  Source of gain or loss realized on a section 988 
transaction.

    (a) In general. Except as otherwise provided in Sec. 1.988-5 and 
this section, the source of exchange gain or loss shall be determined by 
reference to the residence of the taxpayer. This rule applies even if 
the taxpayer has made an election under Sec. 1.988-3(b) to characterize 
exchange gain or loss as capital gain or loss. This section takes 
precedence over section 865.
    (b) Qualified business unit--(1) In general. The source of exchange 
gain or loss shall be determined by reference to the residence of the 
qualified business unit of the taxpayer on whose books the asset, 
liability, or item of income or expense giving rise to such gain or loss 
is properly reflected.
    (2) Proper reflection on the books of the taxpayer or qualified 
business unit--(i) In general. Whether an asset, liability, or item of 
income or expense is properly reflected on the books of a qualified 
business unit is a question of fact.
    (ii) Presumption if booking practices are inconsistent. It shall be 
presumed that an asset, liability, or item of income or expense is not 
properly reflected on the books of the qualified business unit if the 
taxpayer and its qualified business units employ inconsistent booking 
practices with respect to the same or similar assets, liabilities, or 
items of income or expense. If not properly reflected on the books, the 
Commissioner may allocate any asset, liability, or item of income or 
expense between or among the taxpayer and its qualified business units 
to properly reflect the source (or realization) of exchange gain or 
loss.
    (c) Effectively connected exchange gain or loss. Notwithstanding 
paragraphs (a) and (b) of this section, exchange gain or loss that under 
principles similar to those set forth in Sec. 1.864-4(c) arises from 
the conduct of a United States

[[Page 660]]

trade or business shall be sourced in the United States and such gain or 
loss shall be treated as effectively connected to the conduct of a 
United States trade or business for purposes of sections 871(b) and 882 
(a)(1).
    (d) Residence--(1) In general. Except as otherwise provided in this 
paragraph (d), for purposes of sections 985 through 989, the residence 
of any person shall be--
    (i) In the case of an individual, the country in which such 
individual's tax home (as defined in section 911(d)(3)) is located;
    (ii) In the case of a corporation, partnership, trust or estate 
which is a United States person (as defined in section 7701(a)(30)), the 
United States; and
    (iii) In the case of a corporation, partnership, trust or estate 
which is not a United States person, a country other than the United 
States.


If an individual does not have a tax home (as defined in section 
911(d)(3)), the residence of such individual shall be the United States 
if such individual is a United States citizen or a resident alien and 
shall be a country other than the United States if such individual is 
not a United States citizen or resident alien. If the taxpayer is a U.S. 
person and has no principal place of business outside the United States, 
the residence of the taxpayer is the United States. Notwithstanding 
paragraph (d)(1)(ii) of this section, if a partnership is formed or 
availed of to avoid tax by altering the source of exchange gain or loss, 
the source of such gain or loss shall be determined by reference to the 
residence of the partners rather than the partnership.
    (2) Exception. In the case of a qualified business unit of any 
taxpayer (including an individual), the residence of such unit shall be 
the country in which the principal place of business of such qualified 
business unit is located.
    (3) Partner in a partnership not engaged in a U.S. trade or business 
under section 864(b)(2). The determination of residence shall be made at 
the partner level (without regard to whether the partnership is a 
qualified business unit of the partners) in the case of partners in a 
partnership that are not engaged in a U.S. trade or business by reason 
of section 864(b)(2).
    (e) Special rule for certain related party loans--(1) In general. In 
the case of a loan by a United States person or a related person to a 10 
percent owned foreign corporation, or a corporation that meets the 80 
percent foreign business requirements test of section 861(c)(1), other 
than a corporation subject to Sec. 1.861-11T(e)(2)(i), which is 
denominated in, or determined by reference to, a currency other than the 
U.S. dollar and bears interest at a rate at least 10 percentage points 
higher than the Federal mid-term rate (as determined under section 
1274(d)) at the time such loan is entered into, the following rules 
shall apply--
    (i) For purposes of section 904 only, such loan shall be marked to 
market annually on the earlier of the last business day of the United 
States person's (or related person's) taxable year or the date the loan 
matures; and
    (ii) Any interest income earned with respect to such loan for the 
taxable year shall be treated as income from sources within the United 
States to the extent of any notional loss attributable to such loan 
under paragraph (d)(1)(i) of this section.
    (2) United States person. For purposes of this paragraph (e), the 
term ``United States person'' means a person described in section 
7701(a)(30).
    (3) Loans by related foreign persons--(i) In general. [Reserved]
    (ii) Definition of related person. For purposes of this paragraph 
(e), the term ``related person'' has the meaning given such term by 
section 954(d)(3) except that such section shall be applied by 
substituting ``United States person'' for ``controlled foreign 
corporation'' each place such term appears.
    (4) 10 percent owned foreign corporation. For purposes of this 
paragraph (e), the term ``10 percent owned foreign corporation'' means 
any foreign corporation in which the United States person owns directly 
or indirectly (within the meaning of section 318(a)) at least 10 percent 
of the voting stock.
    (f) Exchange gain or loss treated as interest under Sec. 1.988-3. 
Notwithstanding the provisions of this section, any gain or loss 
realized on a section 988 transaction that is treated as interest income 
or expense under Sec. 1.988-3(c)(1)

[[Page 661]]

shall be sourced or allocated and apportioned pursuant to section 
861(a)(1), 862(a)(1), or 864(e) as the case may be.
    (g) Exchange gain or loss allocated in the same manner as interest 
under Sec. 1.861-9T. The allocation and apportionment of exchange gain 
or loss under Sec. 1.861-9T shall not affect the source of exchange 
gain or loss for purposes of sections 871(a), 881, 1441, 1442 and 6049.
    (h) Effective date. This section shall be effective for taxable 
years beginning after December 31, 1986. Thus, any payments made or 
received with respect to a section 988 transaction in taxable years 
beginning after December 31, 1986, are subject to this section.

[T.D. 8400, 57 FR 9199, Mar. 17, 1992]



Sec. 1.988-5  Section 988(d) hedging transactions.

    (a) Integration of a nonfunctional currency debt instrument and a 
Sec. 1.988-5(a) hedge--(1) In general. This paragraph (a) applies to a 
qualified hedging transaction as defined in this paragraph (a)(1). A 
qualified hedging transaction is an integrated economic transaction, as 
provided in paragraph (a)(5) of this section, consisting of a qualifying 
debt instrument as defined in paragraph (a)(3) of this section and a 
Sec. 1.988-5(a) hedge as defined in paragraph (a)(4) of this section. 
If a taxpayer enters into a transaction that is a qualified hedging 
transaction, no exchange gain or loss is recognized by the taxpayer on 
the qualifying debt instrument or on the Sec. 1.988-5(a) hedge for the 
period that either is part of a qualified hedging transaction, and the 
transactions shall be integrated as provided in paragraph (a)(9) of this 
section. However, if the qualified hedging transaction results in a 
synthetic nonfunctional currency denominated debt instrument, such 
instrument shall be subject to the rules of Sec. 1.988-2(b).
    (2) Exception. This paragraph (a) does not apply with respect to a 
qualified hedging transaction that creates a synthetic asset or 
liability denominated in, or determined by reference to, a currency 
other than the U.S. dollar if the rate that approximates the Federal 
short-term rate in such currency is at least 20 percentage points higher 
than the Federal short term rate (determined under section 1274(d)) on 
the date the taxpayer identifies the transaction as a qualified hedging 
transaction.
    (3) Qualifying debt instrument--(i) In general. A qualifying debt 
instrument is a debt instrument described in Sec. 1.988-1(a)(2)(i), 
regardless of whether denominated in, or determined by reference to, 
nonfunctional currency (including dual currency debt instruments, multi-
currency debt instruments and contingent payment debt instruments). A 
qualifying debt instrument does not include accounts payable, accounts 
receivable or similar items of expense or income.
    (ii) Special rule for debt instrument of which all payments are 
proportionately hedged. If a debt instrument satisfies the requirements 
of paragraph (a)(3)(i) of this section, and all principal and interest 
payments under the instrument are hedged in the same proportion, then 
for purposes of this paragraph (a), that portion of the instrument that 
is hedged is eligible to be treated as a qualifying debt instrument, and 
the rules of this paragraph (a) shall apply separately to such 
qualifying debt instrument. See Example 8 in paragraph (a)(9)(iv) of 
this section.
    (4) Section 1.988-5(a) hedge--(i) In general. A Sec. 1.988-5(a) 
hedge (hereinafter referred to in this paragraph (a) as a ``hedge'') is 
a spot contract, futures contract, forward contract, option contract, 
notional principal contract, currency swap contract, similar financial 
instrument, or series or combination thereof, that when integrated with 
a qualifying debt instrument permits the calculation of a yield to 
maturity (under principles of section 1272) in the currency in which the 
synthetic debt instrument is denominated (as determined under paragraph 
(a)(9)(ii)(A) of this section).
    (ii) Retroactive application of definition of currency swap 
contract. A taxpayer may apply the definition of currency swap contract 
set forth in Sec. 1.988-2(e)(2)(ii) in lieu of the definition of swap 
agreement in section 2(e)(5) of Notice 87-11, 1987-1 C.B. 423 to 
transactions entered into after December 31, 1986 and before September 
21, 1989.
    (5) Definition of integrated economic transaction. A qualifying debt 
instrument and a hedge are an integrated

[[Page 662]]

economic transaction if all of the following requirements are 
satisfied--
    (i) All payments to be made or received under the qualifying debt 
instrument (or amounts determined by reference to a nonfunctional 
currency) are fully hedged on the date the taxpayer identifies the 
transaction under paragraph (a) of this section as a qualified hedging 
transaction such that a yield to maturity (under principles of section 
1272) in the currency in which the synthetic debt instrument is 
denominated (as determined under paragraph (a)(9)(ii)(A) of this 
section) can be calculated. Any contingent payment features of the 
qualifying debt instrument must be fully offset by the hedge such that 
the synthetic debt instrument is not classified as a contingent payment 
debt instrument. See Examples 6 and 7 of paragraph (a)(9)(iv) of this 
section.
    (ii) The hedge is identified in accordance with paragraph (a)(8) of 
this section on or before the date the acquisition of the financial 
instrument (or instruments) constituting the hedge is settled or closed.
    (iii) None of the parties to the hedge are related. The term 
``related'' means the relationships defined in section 267(b) or section 
707(b).
    (iv) In the case of a qualified business unit with a residence, as 
defined in section 988(a)(3)(B), outside of the United States, both the 
qualifying debt instrument and the hedge are properly reflected on the 
books of such qualified business unit throughout the term of the 
qualified hedging transaction.
    (v) Subject to the limitations of paragraph (a)(5) of this section, 
both the qualifying debt instrument and the hedge are entered into by 
the same individual, partnership, trust, estate, or corporation. With 
respect to a corporation, the same corporation must enter into both the 
qualifying debt instrument and the hedge whether or not such corporation 
is a member of an affiliated group of corporations that files a 
consolidated return.
    (vi) With respect to a foreign person engaged in a U.S. trade or 
business that enters into a qualifying debt instrument or hedge through 
such trade or business, all items of income and expense associated with 
the qualifying debt instrument and the hedge (other than interest 
expense that is subject to Sec. 1.882-5), would have been effectively 
connected with such U.S. trade or business throughout the term of the 
qualified hedging transaction had this paragraph (a) not applied.
    (6) Special rules for legging in and legging out of integrated 
treatment--(i) Legging in. ``Legging in'' to integrated treatment under 
this paragraph (a) means that a hedge is entered into after the date the 
qualifying debt instrument is entered into or acquired, and the 
requirements of this paragraph (a) are satisfied on the date the hedge 
is entered into (``leg in date''). If a taxpayer legs into integrated 
treatment, the following rules shall apply--
    (A) Exchange gain or loss shall be realized with respect to the 
qualifying debt instrument determined solely by reference to changes in 
exchange rates between--
    (1) The date the instrument was acquired by the holder, or the date 
the obligor assumed the obligation to make payments under the 
instrument; and
    (2) The leg in date.
    (B) The recognition of such gain or loss will be deferred until the 
date the qualifying debt instrument matures or is otherwise disposed of.
    (C) The source and character of such gain or loss shall be 
determined on the leg in date as if the qualifying debt instrument was 
actually sold or otherwise terminated by the taxpayer.
    (ii) Legging out. With respect to a qualifying debt instrument and 
hedge that are properly identified as a qualified hedging transaction, 
``legging out'' of integrated treatment under this paragraph (a) means 
that the taxpayer disposes of or otherwise terminates all or any portion 
of the qualifying debt instrument or the hedge before maturity of the 
qualified hedging transaction. For purposes of the preceding sentence, 
if the taxpayer changes a material term of the qualifying debt 
instrument (for example, exercises an option to change the interest rate 
or index, or the maturity date) or the hedge (for example, changes the 
interest or exchange rates underlying the hedge, or the expiration date) 
before maturity of the qualified hedging

[[Page 663]]

transaction, the taxpayer will be deemed to have disposed of or 
otherwise terminated all or any portion of the qualifying debt 
instrument or the hedge, as applicable. A taxpayer that disposes of or 
terminates a qualified hedging transaction (that is, disposes of or 
terminates both the qualifying debt instrument and the hedge in their 
entirety on the same day) is considered to have disposed of or otherwise 
terminated the synthetic debt instrument rather than legging out. See 
paragraph (a)(9)(iv) of this section, Example 10 for an illustration of 
this rule. If a taxpayer legs out of integrated treatment, the following 
rules apply:
    (A) The transaction will be treated as a qualified hedging 
transaction during the time the requirements of this paragraph (a) were 
satisfied.
    (B) If all of the instruments comprising the hedge (each such 
instrument, a component) are disposed of or otherwise terminated, the 
qualifying debt instrument is treated as sold or otherwise terminated by 
the taxpayer for its fair market value on the date the hedge is disposed 
of or otherwise terminated (the leg-out date), and any gain or loss 
(including gain or loss resulting from factors other than movements in 
exchange rates) from the identification date to the leg-out date is 
realized and recognized on the leg-out date. The spot rate on the leg-
out date is used to determine exchange gain or loss on the debt 
instrument for the period beginning on the leg-out date and ending on 
the date such instrument matures or is disposed of or otherwise 
terminated. Proper adjustment must be made to reflect any gain or loss 
taken into account. The netting rule of Sec. 1.988-2(b)(8) applies. See 
paragraph (a)(9)(iv) of this section, Example 4 and Example 5 for an 
illustration of this rule.
    (C) If a hedge has more than one component (and such components have 
been properly identified as being part of the qualified hedging 
transaction) and at least one but not all of the components that 
comprise the hedge has been disposed of or otherwise terminated, or if 
part of any component of the hedge has been terminated (whether a hedge 
consists of a single or multiple components), the date such component 
(or part thereof) is disposed of or terminated is considered the leg-out 
date and the qualifying debt instrument is treated as sold or otherwise 
terminated by the taxpayer for its fair market value in accordance with 
the rules of paragraph (a)(6)(ii)(B) of this section on such leg-out 
date. In addition, all of the remaining components (or parts thereof) 
that have not been disposed of or otherwise terminated are treated as 
sold by the taxpayer for their fair market value on the leg-out date, 
and any gain or loss from the identification date to the leg-out date is 
realized and recognized on the leg-out date. To the extent relevant, the 
spot rate on the leg-out date is used to determine exchange gain or loss 
on the remaining components (or parts thereof) for the period beginning 
on the leg-out date and ending on the date such components (or parts 
thereof) are disposed of or otherwise terminated. See paragraph 
(a)(9)(iv) of this section, Example 11 for an illustration of this rule.
    (D) If the qualifying debt instrument is disposed of or otherwise 
terminated in whole or in part, the date of such disposition or 
termination is considered the leg-out date. Accordingly, the hedge 
(including all components making up the hedge in their entirety) that is 
part of the qualified hedging transaction is treated as sold by the 
taxpayer for its fair market value on the leg-out date, and any gain or 
loss from the identification date to the leg-out date is realized and 
recognized on the leg-out date. To the extent relevant, the spot rate on 
the leg-out date is used to determine exchange gain or loss on the hedge 
(including all components thereof) for the period beginning on the leg-
out date and ending on the date such hedge is disposed of or otherwise 
terminated.
    (E) Except as provided in paragraph (a)(8)(iii) of this section 
(regarding identification by the Commissioner), the part of the 
qualified hedging transaction that has not been disposed of or otherwise 
terminated (that is, the remaining debt instrument in its entirety even 
if partially hedged, or the remaining components of the hedge) cannot be 
part of a qualified hedging transaction for any period after the leg-out 
date.

[[Page 664]]

    (F) If a taxpayer legs out of a qualified hedging transaction and 
realizes a net gain with respect to the debt instrument that is disposed 
of or otherwise terminated, then paragraph (a)(6)(ii)(B), (C), and (D) 
of this section, as appropriate, will not apply if during the period 
beginning 30 days before the leg-out date and ending 30 days after that 
date the taxpayer enters into another transaction that, taken together 
with any remaining components of the hedge, hedges at least 50 percent 
of the remaining currency flow with respect to the qualifying debt 
instrument that was part of the qualified hedging transaction or, if 
appropriate, an equivalent amount under the hedge (or any remaining 
components thereof) that was part of the qualified hedging transaction. 
Similarly, in a case in which a hedge has multiple components that are 
part of a qualified hedging transaction, if the taxpayer legs out of a 
qualified hedging transaction by terminating one such component or a 
part of one or more such components and realizes a net gain with respect 
to the terminated component, components, or portions thereof, then 
paragraphs (a)(6)(ii)(B), (C), and (D) of this section, as appropriate, 
will not apply if the remaining components of the hedge (including parts 
thereof) by themselves hedge at least 50 percent of the remaining 
currency flow with respect to the qualifying debt instrument that was 
part of the qualified hedging transaction. See paragraph (a)(9)(iv) of 
this section, Example 11 for an illustration of this rule.
    (7) Transactions part of a straddle. At the discretion of the 
Commissioner, a transaction shall not satisfy the requirements of 
paragraph (a)(5) of this section if the debt instrument making up the 
qualified hedging transaction is part of a straddle as defined in 
section 1092(c) prior to the time the qualified hedging transaction is 
identified.
    (8) Identification requirements--(i) Identification by the taxpayer. 
A taxpayer must establish a record and before the close of the date the 
hedge is entered into, the taxpayer must enter into the record for each 
qualified hedging transaction the following information--
    (A) The date the qualifying debt instrument and hedge were entered 
into;
    (B) The date the qualifying debt instrument and the hedge are 
identified as constituting a qualified hedging transaction;
    (C) The amount that must be deferred, if any, under paragraph (a)(6) 
of this section and the source and character of such deferred amount;
    (D) A description of the qualifying debt instrument and the hedge; 
and
    (E) A summary of the cash flow resulting from treating the 
qualifying debt instrument and the hedge as a qualified hedging 
transaction.
    (ii) Identification by trustee on behalf of beneficiary. A trustee 
of a trust that enters into a qualified hedging transaction may satisfy 
the identification requirements described in paragraph (a)(8)(i) of this 
section on behalf of a beneficiary of such trust.
    (iii) Identification by the Commissioner. If--
    (A) A taxpayer enters into a qualifying debt instrument and a hedge 
but fails to comply with one or more of the requirements of this 
paragraph (a), and
    (B) On the basis of all the facts and circumstances, the 
Commissioner concludes that the qualifying debt instrument and the hedge 
are, in substance, a qualified hedging transaction,


then the Commissioner may treat the qualifying debt instrument and the 
hedge as a qualified hedging transaction. The Commissioner may identify 
a qualifying debt instrument and a hedge as a qualified hedging 
transaction regardless of whether the qualifying debt instrument and the 
hedge are held by the same taxpayer.
    (9) Taxation of qualified hedging transactions--(i) In general--(A) 
General rule. If a transaction constitutes a qualified hedging 
transaction, the qualifying debt instrument and the hedge are integrated 
and treated as a single transaction with respect to the taxpayer that 
has entered into the qualified hedging transaction during the period 
that the transaction qualifies as a qualified hedging transaction. 
Neither the qualifying debt instrument nor the hedge that makes up the 
qualified hedging transaction shall be subject to section 263(g), 1092 
or 1256 for the period such transactions are integrated.

[[Page 665]]

However, the qualified hedging transaction may be subject to section 
263(g) or 1092 if such transaction is part of a straddle.
    (B) Special rule for income or expense of foreign persons 
effectively connected with a U.S. trade or business. Interest income of 
a foreign person resulting from a qualified hedging transaction entered 
into by such foreign person that satisfies the requirements of paragraph 
(a)(5)(vii) of this section shall be treated as effectively connected 
with a U.S. trade or business. Interest expense of a foreign person 
resulting from a qualified hedging transaction entered into by such 
foreign person that satisfies the requirements of paragraph (a)(5)(vii) 
of this section shall be allocated and apportioned under Sec. 1.882-5 
of the regulations.
    (C) Special rule for foreign persons that enter into qualified 
hedging transactions giving rise to U.S. source income not effectively 
connected with a U.S. trade or business. If a foreign person enters into 
a qualified hedging transaction that gives rise to U.S. source interest 
income (determined under the source rules for synthetic asset 
transactions as provided in this section) not effectively connected with 
a U.S. trade or business of such foreign person, for purposes of 
sections 871(a), 881, 1441, 1442 and 6049, the provisions of this 
paragraph (a) shall not apply and such sections of the Internal Revenue 
Code shall be applied separately to the qualifying debt instrument and 
the hedge. To the extent relevant to any foreign person, if the 
requirements of this paragraph (a) are otherwise met, the provisions of 
this paragraph (a) shall apply for all other purposes of the Internal 
Revenue Code (e.g., for purposes of calculating the earnings and profits 
of a controlled foreign corporation that enters into a qualified hedging 
transaction through a qualified business unit resident outside the 
United States, income or expense with respect to such qualified hedging 
transaction shall be calculated under the provisions of this paragraph 
(a)).
    (ii) Income tax effects of integration. The effect of integrating 
and treating a transaction as a single transaction is to create a 
synthetic debt instrument for income tax purposes, which is subject to 
the original issue discount provisions of sections 1272 through 1288 and 
163(e), the terms of which are determined as follows:
    (A) Denomination of synthetic debt instrument. In the case where the 
qualifying debt instrument is a borrowing, the denomination of the 
synthetic debt instrument is the same as the currency paid under the 
terms of the hedge to acquire the currency used to make payments under 
the qualifying debt instrument. In the case where the qualifying debt 
instrument is a lending, the denomination of the synthetic debt 
instrument is the same as the currency received under the terms of the 
hedge in exchange for amounts received under the qualifying debt 
instrument. For example, if the hedge is a forward contract to acquire 
British pounds for dollars, and the qualifying debt instrument is a 
borrowing denominated in British pounds, the synthetic debt instrument 
is considered a borrowing in dollars.
    (B) Term and accrual periods. The term of the synthetic debt 
instrument shall be the period beginning on the identification date and 
ending on the date the qualifying debt instrument matures or such 
earlier date that the qualifying debt instrument or hedge is disposed of 
or otherwise terminated. Unless otherwise clearly indicated by the 
payment interval under the hedge, the accrual period shall be a six 
month period which ends on the dates determined under section 
1272(a)(5).
    (C) Issue price. The issue price of the synthetic debt instrument is 
the adjusted issue price of the qualifying debt instrument translated 
into the currency in which the synthetic debt instrument is denominated 
at the spot rate on the identification date.
    (D) Stated redemption price at maturity. In the case where the 
qualifying debt instrument is a borrowing, the stated redemption price 
at maturity shall be determined under section 1273(a)(2) on the 
identification date by reference to the amounts to be paid under the 
hedge to acquire the currency necessary to make interest and principal 
payments on the qualifying debt instrument. In

[[Page 666]]

the case where the qualifying debt instrument is a lending, the stated 
redemption price at maturity shall be determined under section 
1273(a)(2) on the identification date by reference to the amounts to be 
received under the hedge in exchange for the interest and principal 
payments received pursuant to the terms of the qualifying debt 
instrument.
    (iii) Source of interest income and allocation of expense. Interest 
income from a synthetic debt instrument described in paragraph 
(a)(9)(ii) of this section shall be sourced by reference to the source 
of income under sections 861 (a)(1) and 862(a)(1) of the qualifying debt 
instrument. The character for purposes of section 904 of interest income 
from a synthetic debt instrument shall be determined by reference to the 
character of the interest income from qualifying debt instrument. 
Interest expense from a synthetic debt instrument described in paragraph 
(a)(9)(ii) of this section shall be allocated and apportioned under 
Sec. Sec. 1.861-8T through 1.861-12T or the successor sections thereof 
or under Sec. 1.882-5.
    (iv) Examples. The following examples illustrate the application of 
this paragraph (a)(9).

    Example 1. (i) K is a U.S. corporation with the U.S. dollar as its 
functional currency. On December 24, 1989, K agrees to close the 
following transaction on December 31, 1989. K will borrow from an 
unrelated party on December 31, 1989, 100 British pounds ([pound]) for 3 
years at a 10 percent rate of interest, payable annually, with no 
principal payment due until the final installment. K will also enter 
into a currency swap contract with an unrelated counterparty under the 
terms of which--
    (a) K will swap, on December 31, 1989, the [pound]100 obtained from 
the borrowing for $100; and
    (b) K will exchange dollars for pounds pursuant to the following 
table in order to obtain the pounds necessary to make payments on the 
pound borrowing:

------------------------------------------------------------------------
                                                    U.S.
                     Date                         dollars       Pounds
------------------------------------------------------------------------
December 31, 1990.............................            8           10
December 31, 1991.............................            8           10
December 31, 1992.............................          108          110
------------------------------------------------------------------------

    (ii) The interest rate on the borrowing is set and the exchange 
rates on the swap are fixed on December 24, 1989. On December 31, 1989, 
K borrows the [pound]100 and swaps such pounds for $100. Assume x has 
satisfied the identification requirements of paragraph (a)(8) of this 
section.
    (iii) The pound borrowing (which constitutes a qualifying debt 
instrument under paragraph (a)(3) of this section) and the currency swap 
contract (which constitutes a hedge under paragraph (a)(4) of this 
section) are a qualified hedging transaction as defined in paragraph 
(a)(1) of this section. Accordingly, the pound borrowing and the swap 
are integrated and treated as one transaction with the following 
consequences:
    (A) The integration of the pound borrowing and the swap results in a 
synthetic dollar borrowing with an issue price of $100 under section 
1273(b)(2).
    (B) The total amount of interest and principal of the synthetic 
dollar borrowing is equal to the dollar payments made by K under the 
currency swap contract (i.e., $8 in 1990, $8 in 1991, and $108 in 1992).
    (C) The stated redemption price at maturity (defined in section 
1273(a)(2)) is $100. Because the stated redemption price equals the 
issue price, there is no OID on the synthetic dollar borrowing.
    (D) K may deduct the annual interest payments of $8 under section 
163(a) (subject to any limitations on deductibility imposed by other 
provisions of the Code) according to its regular method of accounting. K 
has also paid $100 as a return of principal in 1992.
    (E) K must allocate and apportion its interest expense with respect 
to the synthetic dollar borrowing under the rules of Sec. Sec. 1.861-8T 
through 1.861-12T.
    Example 2. (i) K, a U.S. corporation, has the U.S. dollar as its 
functional currency. On December 24, 1989, when the spot rate for Swiss 
francs (Sf) is Sf1 = $1, K enters into a forward contract to purchase 
Sf100 in exchange for $100.04 for delivery on December 31, 1989. The 
Sf100 are to be used for the purchase of a franc denominated debt 
instrument on December 31, 1989. The instrument will have a term of 3 
years, an issue price of Sf100, and will bear interest at 6 percent, 
payable annually, with no repayment of principal until the final 
installment. On December 24, 1989, K also enters into a series of 
forward contracts to sell the franc interest and principal payments that 
will be received under the terms of the franc denominated debt 
instrument for dollars according to the following schedule:

------------------------------------------------------------------------
                                                    U.S.
                     Date                         dollars       Francs
------------------------------------------------------------------------
December 31, 1990.............................         6.12            6
December 31, 1991.............................         6.23            6
December 31, 1992.............................       112.16          106
------------------------------------------------------------------------

    (ii) On December 31, 1989, K takes delivery of the Sf100 and 
purchases the franc denominated debt instrument. Assume K satisfies the 
identification requirements of paragraph (a)(8) of this section. The 
purchase of the franc debt instrument (which constitutes a

[[Page 667]]

qualifying debt instrument under paragraph (a)(3) of this section) and 
the series of forward contracts (which constitute a hedge under 
paragraph (a)(4) of this section) are a qualified hedging transaction 
under paragraph (a)(1) of this section. Accordingly, the franc debt 
instrument and all the forward contracts are integrated and treated as 
one transaction with the following consequences:
    (A) The integration of the franc debt instrument and the forward 
contracts results in a synthetic dollar debt instrument in an amount 
equal to the dollars exchanged under the forward contract to purchase 
the francs necessary to acquire the franc debt instrument. Accordingly, 
the issue price is $100.04 (section 1273(b)(2) of the Code).
    (B) The total amount of interest and principal received by K with 
respect to the synthetic dollar debt instrument is equal to the dollars 
received under the forward sales contracts (i.e., $6.12 in 1990, $6.23 
in 1991, and $112.16 in 1992).
    (C) The synthetic dollar debt instrument is an installment 
obligation and its stated redemption price at maturity is $106.15 (i.e., 
$6.12 of the payments in 1990, 1991, and 1992 are treated as periodic 
interest payments under the principles of section 1273). Because the 
stated redemption price at maturity exceeds the issue price, under 
section 1273(a)(1) the synthetic dollar debt instrument has OID of 
$6.11.
    (D) The yield to maturity of the synthetic dollar debt instrument is 
8.00 percent, compounded annually. Assuming K is a calendar year 
taxpayer, it must include interest income of $8.00 in 1990 (of which 
$1.88 constitutes OID), $8.15 in 1991 (of which $2.03 constitutes OID), 
and $8.32 in 1992 (of which $2.20 constitutes OID). The amount of the 
final payment received by K in excess of the interest income includible 
is a return of principal and a payment of previously accrued OID.
    (E) The source of the interest income shall be determined by 
applying sections 861(a)(1) and 862(a)(1) with reference to the franc 
interest income that would have been received had the transaction not 
been integrated.
    Example 3. (i) K is an accrual method U.S. corporation with the U.S. 
dollar as its functional currency. On January 1, 1992, K borrows 100 
British pounds ([pound]) for 3 years at a 10% rate of interest payable 
on December 31 of each year with no principal payment due until the 
final installment. The spot rate on January 1, 1992, is [pound]1 = 
$1.50. On January 1, 1993, when the spot rate is [pound]1 = $1.60, K 
enters into a currency swap contract with an unrelated counterparty 
under the terms of which K will exchange dollars for pounds pursuant to 
the following table in order to obtain the pounds necessary to make the 
remaining payments on the pound borrowing:

------------------------------------------------------------------------
                                                    U.S.
                     Date                         dollars       Pounds
------------------------------------------------------------------------
December 31, 1993.............................        12.80           10
December 31, 1994.............................        12.80           10
December 31, 1994.............................       160.00          100
------------------------------------------------------------------------

    (ii) Assume that British pound interest rates are still 10% and that 
K properly identifies the pound borrowing and the currency swap contract 
as a qualified hedging transaction as provided in paragraph (a)(8) of 
this section. Under paragraph (a)(6)(i) of this section, K must realize 
exchange gain or loss with respect to the pound borrowing determined 
solely by reference to changes in exchange rates between January 1, 1992 
and January 1, 1993. (Thus, gain or loss from other factors such as 
movements in interest rates or changes in credit quality of K are not 
taken into account). Recognition of such gain or loss is deferred until 
K terminates its pound borrowing. Accordingly, K must defer exchange 
loss in the amount of $10 [([pound]100 x 1.50)-([pound]100 x 1.60)].
    (iii) Additionally, the qualified hedging transaction is treated as 
a synthetic U.S. dollar debt instrument with an issue date of January 1, 
1993, and a maturity date of December 31, 1994. The issue price of the 
synthetic debt instrument is $160 ([pound]100 x 1.60, the spot rate on 
January 1, 1993) and the total amount of interest and principal is 
$185.60. The accrual period is the one year period beginning on January 
1 and ending December 31 of each year. The stated redemption price at 
maturity is $160. Thus, K is treated as paying $12.80 of interest in 
1993, $12.80 of interest in 1994, and $160 of principal in 1994. The 
interest expense from the synthetic instrument is allocated and 
apportioned in accordance with the rules of Sec. Sec. 1.861-8T through 
1.861-12T. Sections 263(g), 1092, and 1256 do not apply to the positions 
comprising the synthetic dollar borrowing.
    Example 4. (i) K is an accrual method U.S. corporation with the U.S. 
dollar as its functional currency. On January 1, 2013, K borrows 100 
British pounds ([pound]) for 3 years at a 10% rate of interest payable 
on December 31 of each year with no principal payment due until the 
final installment. The spot rate on January 1, 2013, is [pound]1 = 
$1.50. Also on January 1, 2013, K enters into a currency swap contract 
with an unrelated counterparty under the terms of which K will exchange 
dollars for pounds pursuant to the following table in order to obtain 
the pounds necessary to make the remaining payments on the pound 
borrowing:

------------------------------------------------------------------------
                                                    U.S.
                     Date                         dollars       Pounds
------------------------------------------------------------------------
December 31, 2013.............................        12.00           10
December 31, 2014.............................        12.00           10
December 31, 2015.............................       162.00          110
------------------------------------------------------------------------


[[Page 668]]

    (ii) Assume that K properly identifies the pound borrowing and the 
currency swap contract as a qualified hedging transaction as provided in 
paragraph (a)(1) of this section.
    (iii) The pound borrowing (which constitutes a qualifying debt 
instrument under paragraph (a)(3) of this section) and the currency swap 
contract (which constitutes a hedge under paragraph (a)(4) of this 
section) are a qualified hedging transaction as defined in paragraph 
(a)(1) of this section. Accordingly, the pound borrowing and the swap 
are integrated and treated as one transaction with the following 
consequences:
    (A) The integration of the pound borrowing and the swap results in a 
synthetic dollar borrowing with an issue price of $150 under section 
1273(b)(2).
    (B) The total amount of interest and principal of the synthetic 
dollar borrowing is equal to the dollar payments made by K under the 
currency swap contract (i.e., $12 in 2013, $12 in 2014, and $162 in 
2015).
    (C) The stated redemption price at maturity (defined in section 
1273(a)(2)) is $150. Because the stated redemption price equals the 
issue price, there is no OID on the synthetic dollar borrowing.
    (D) K may deduct the annual interest payments of $12 under section 
163(a) (subject to any limitations on deductibility imposed by other 
provisions of the Code) according to its regular method of accounting. K 
has also paid $150 as a return of principal in 2015.
    (E) K must allocate and apportion its interest expense from the 
synthetic instrument under the rules of Sec. Sec. 1.861-8T through 
1.861-12T.
    (iv) Assume that on January 1, 2014, the spot exchange rate is 
[pound]1 = $1.60, interest rates have not changed since January 1, 2013, 
(accordingly, assume that the market value of K's bond in pounds has not 
changed) and that K transfers its rights and obligations under the 
currency swap contract in exchange for $10. Under Sec. 1.988-
2(e)(3)(iii), K will include in income as exchange gain $10 on January 
1, 2014. Pursuant to paragraph (a)(6)(ii) of this section, the pound 
borrowing and the currency swap contract are treated as a qualified 
hedging transaction for 2013. The loss inherent in the pound borrowing 
from January 1, 2013, to January 1, 2014, is realized and recognized on 
January 1, 2014. Such loss is exchange loss in the amount of $10.00 
[([pound]100 x $1.50, the spot rate on January 1, 2013)-([pound]100 x 
$1.60, the spot rate on January 1, 2014)]. For purposes of determining 
exchange gain or loss on the [pound]100 principal amount of the debt 
instrument for the period January 1, 2014, to December 31, 2015, the 
spot rate on January 1, 2014 is used rather than the spot rate on the 
issue date. Thus, assuming that the spot rate on December 31, 2015, the 
maturity date, is [pound]1 = $1.80, K realizes exchange loss in the 
amount of $20 [([pound]100 x $1.60)-([pound]100 x $1.80)]. Except as 
provided in paragraph (a)(8)(iii) (regarding identification by the 
Commissioner), the pound borrowing cannot be part of a qualified hedging 
transaction for any period subsequent to the leg out date.
    Example 5. (i) K, a U.S. corporation, has the U.S. dollar as its 
functional currency. On January 1, 2013, when the spot rate for Swiss 
francs (Sf) is Sf1 = $.50, K converts $100 to Sf200 and purchases a 
franc denominated debt instrument. The instrument has a term of 3 years, 
an adjusted issue price of Sf200, and will bear interest at 5 percent, 
payable annually, with no repayment of principal until the final 
installment. The U.S. dollar interest rate on an equivalent instrument 
is 8% on January 1, 2013, compounded annually. On January 1, 2013, K 
also enters into a series of forward contracts to sell the franc 
interest and principal payments that will be received under the terms of 
the franc denominated debt instrument for dollars according to the 
following schedule:

------------------------------------------------------------------------
                                                    U.S.
                     Date                         dollars       Francs
------------------------------------------------------------------------
December 31, 2013.............................         5.14           10
December 31, 2014.............................         5.29           10
December 31, 2015.............................       114.26          210
------------------------------------------------------------------------

    (ii) Assume K satisfies the identification requirements of paragraph 
(a)(8) of this section. Assume further that on January 1, 2014, the spot 
exchange rate is Sf1 = U.S.$.5143, the U.S. dollar interest rate is 10%, 
compounded annually, and the Swiss franc interest rate is the same as on 
January 1, 2013 (5%, compounded annually). On January 1, 2014, K 
disposes of the forward contracts that were to mature on December 31, 
2014, and December 31, 2015 and incurs a loss of $3.62 (the present 
value of $.10 with respect to the 2014 contract and $4.27 with respect 
to the 2015 contract).
    (iii) The purchase of the franc debt instrument (which constitutes a 
qualifying debt instrument under paragraph (a)(3) of this section) and 
the series of forward contracts (which constitute a hedge under 
paragraph (a)(4) of this section) are a qualified hedging transaction 
under paragraph (a)(1) of this section. Accordingly, the franc debt 
instrument and all the forward contracts are integrated for the period 
beginning January 1, 2013, and ending January 1, 2014.
    (A) The integration of the franc debt instrument and the forward 
contracts results in a synthetic dollar debt instrument with an issue 
price of $100.
    (B) The total amount of interest and principal to be received by K 
with respect to the synthetic dollar debt instrument is equal to the 
dollars to be received under the forward sales contracts (i.e., $5.14 in 
2013, $5.29 in 2014, and $114.26 in 2015).
    (C) The synthetic dollar debt instrument is an installment 
obligation and its stated redemption price at maturity is $109.27 (i.e., 
$5.14 of the payments in 2013, 2014, and 2015 is treated as periodic 
interest payments under

[[Page 669]]

the principles of section 1273). Because the stated redemption price at 
maturity exceeds the issue price, under section 1273(a)(1) the synthetic 
dollar debt instrument has OID of $9.27.
    (D) The yield to maturity of the synthetic dollar debt instrument is 
8.00 percent, compounded annually. Assuming K is a calendar year 
taxpayer, it must include interest income of $8.00 in 2013 (of which 
$2.86 constitutes OID).
    (E) The source of the interest income is determined by applying 
sections 861(a)(1) and 862(a)(1) with reference to the franc interest 
income that would have been received had the transaction not been 
integrated.
    (iv) Because K disposed of the forward contracts on January 1, 2014, 
the rules of paragraph (a)(6)(ii) of this section shall apply. 
Accordingly, the $3.62 loss from the disposition of the forward 
contracts is realized and recognized on January 1, 2014. Additionally, K 
is deemed to have sold the franc debt instrument for $102.86, its fair 
market value in dollars on January 1, 2014. K will compute gain or loss 
with respect to the deemed sale of the franc debt instrument by 
subtracting its adjusted basis in the instrument ($102.86--the value of 
the Sf200 issue price at the spot rate on the identification date plus 
$2.86 of original issue discount accrued on the synthetic dollar debt 
instrument for 2013) from the amount realized on the deemed sale of 
$102.86. Thus K realizes and recognizes no gain or loss from the deemed 
sale of the debt instrument. The dollar amount used to determine 
exchange gain or loss with respect to the franc debt instrument is the 
Sf200 issue price on January 1, 2014, translated into dollars at the 
spot rate on January 1, 2014, of Sf1 = U.S.$.5143. Except as provided in 
paragraph (a)(8)(iii) of this section (regarding identification by the 
Commissioner), the franc borrowing cannot be part of a qualified hedging 
transaction for any period subsequent to the leg out date.
    Example 6. (i) K is a U.S. corporation with the dollar as its 
functional currency. On January 1, 1992, K issues a debt instrument with 
the following terms: the issue price is $1,000, the instrument pays 
interest annually at a rate of 8% on the $1,000 principal amount, the 
instrument matures on December 31, 1996, and the amount paid at maturity 
is the greater of zero or $2,000 less the U.S. dollar value (determined 
on December 31, 1996) of 150,000 Japanese yen.
    (ii) Also on January 1, 1992, K enters into the following hedges 
with respect to the instrument described in the preceding paragraph: a 
forward contract under which K will sell 150,000 yen for $1,000 on 
December 31, 1996 (note that this forward rate assumes that interest 
rates in yen and dollars are equal); and an option contract that expires 
on December 31, 1996, under which K has the right (but not the 
obligation) to acquire 150,000 yen for $2,000. K will pay for the option 
by making payments to the writer of the option equal to $5 each December 
31 from 1992 through 1996.
    (iii) The net economic effect of these transactions is that K has 
created a liability with a principal amount and amount paid at maturity 
of $1,000, with an interest cost of 8.5% (8% on debt instrument, 0.5% 
option price) compounded annually. For example, if on December 31, 1996, 
the spot exchange rate is $1 = 100 yen, K pays $500 on the bond [$2,000-
(150,000 yen/$100)], and $500 in satisfaction of the forward contract 
[$1,000-(150,000 yen/$100)]. If instead the spot exchange rate on 
December 31, 1996 is $1 = 200 yen, K pays $1,250 on the bond [$2,000-
(150,000 yen/$200)] and K receives $250 in satisfaction of the forward 
contract [$1,000-(150,000 yen/$200)]. Finally, if the spot exchange rate 
on December 31, 1996 is $1 = 50 yen, K pays $0 on the bond [$2,000-
(150,000 yen/$50), but the bond holder is not required under the terms 
of the instrument to pay additional principal]; K exercises the option 
to buy 150,000 yen for $2,000; and K then delivers the 150,000 yen as 
required by the forward contract in exchange for $1,000.
    (iv) Assume K satisfies the identification requirements of paragraph 
(a)(8) of this section. The debt instrument described in paragraph (i) 
of this Example 6 (which constitutes a qualifying debt instrument under 
paragraph (a)(3) of this section) and the forward contract and option 
contract described in paragraph (ii) of this example (which constitute a 
hedge under paragraph (a)(4) of this section and are collectively 
referred to hereafter as ``the contracts'') together are a qualified 
hedging transaction under paragraph (a)(1) of this section. Accordingly, 
with respect to K, the debt instrument and the contracts are integrated, 
resulting in a synthetic dollar debt instrument with an issue price of 
$1000, a stated redemption price at maturity of $1000 and a yield to 
maturity of 8.5% compounded annually (with no original issue discount). 
K must allocate and apportion its annual interest expense of $85 under 
the rules of Sec. Sec. 1.861-8T through 1.861-12T.
    Example 7. (i) R is a U.S. corporation with the dollar as its 
functional currency. On January 1, 1995, R issues a debt instrument with 
the following terms: the issue price is 504 British pounds ([pound]), 
the instrument pays interest at a rate of 3.7% (compounded semi-
annually) on the [pound]504 principal amount, the instrument matures on 
December 31, 1999, with a repayment at maturity of the [pound]504 
principal plus the proportional gain, if any, in the ``Financial Times'' 
100 Stock Exchange (FTSE) index (determined by the excess of the value 
of the FTSE index on the maturity date over the value of the FTSE on the 
issue date, divided by the value of the FTSE index on the issue date, 
multiplied by

[[Page 670]]

the number of FTSE index contracts that could be purchased on the issue 
date for [pound]504).
    (ii) Also on January 1, 1995, R enters into a contract with a bank 
under which on January 1, 1995, R will swap the [pound]504 for $1,000 
(at the current spot rate). R will make U.S. dollar payments to the bank 
equal to 8.15% on the notional principal amount of $1,000 (compounded 
semi-annually) for the period beginning January 1, 1995 and ending 
December 31, 1999. R will receive pound payments from the bank equal to 
3.7% on the notional principal amount of [pound]504 (compounded semi-
annually) for the period beginning January 1, 1995 and ending December 
31, 1999. On December 31, 1999, R will swap with the bank $1,000 for 
[pound]504 plus the proportional gain, if any, in the FTSE index 
(computed as provided above).
    (iii) Economically, both the indexed debt instrument and the hedging 
contract are hybrid instruments with the following components. The 
indexed debt instrument is composed of a par pound debt instrument that 
is assumed to have a 10.85% coupon (compounded semi-annually) plus an 
embedded FTSE equity index option for which the investor pays a premium 
of 7.15% (amortized semi-annually) on the pound principal amount. The 
combined effect is that the premium paid by the investor partially 
offsets the coupon payments resulting in a return of 3.7% (10.85%-
7.15%). Similarly, the dollar payments under the hedging contract to be 
made by R are computed by multiplying the dollar notional principal 
amount by an 8.00% rate (compounded semi-annually) which the facts 
assume would be the rate paid on a conventional currency swap plus a 
premium of 0.15% (amortized semi-annually) on the dollar notional 
principal amount for an embedded FTSE equity index option.
    (iv) Assume R satisfies the identification requirements of paragraph 
(a)(8) of this section. The indexed debt instrument described in 
paragraph (i) of this Example 7 constitutes a qualifying debt instrument 
under paragraph (a)(3) of this section. The hedging contract described 
in paragraph (ii) of this Example 7 constitutes a hedge under paragraph 
(a)(4) of this section. Since both the pound exposure of the indexed 
debt instrument and the exposure to movements of the FTSE embedded in 
the indexed debt instrument are hedged such that a yield to maturity can 
be determined in dollars, the transaction satisfies the requirement of 
paragraph (a)(5)(i) of this section. Assuming the transactions satisfy 
the other requirements of paragraph (a)(5) of this section, the indexed 
debt instrument and hedge are a qualified hedging transaction under 
paragraph (a)(1) of this section. Accordingly, with respect to R, the 
debt instrument and the contracts are integrated, resulting in a 
synthetic dollar debt instrument with an issue price of $1000, a stated 
redemption price at maturity of $1000 and a yield to maturity of 8.15% 
compounded semi-annually (with no original issue discount). K must 
allocate and apportion its interest expense from the synthetic 
instrument under the rules Sec. Sec. 1.861-8T through 1.861-12T.
    Example 8. (i) K is a U.S. corporation with the U.S. dollar as its 
functional currency. On December 24, 1992, K agrees to close the 
following transaction on December 31, 1992. K will borrow from an 
unrelated party on December 31, 1992, 200 British pounds ([pound]) for 3 
years at a 10 percent rate of interest, payable annually, with no 
principal payment due until the final installment. K will also enter 
into a currency swap contract with an unrelated counterparty under the 
terms of which--
    (A) K will swap, on December 31, 1992, [pound]100 obtained from the 
borrowing for $100; and
    (B) K will exchange dollars for pounds pursuant to the following 
table:

------------------------------------------------------------------------
                                                    U.S.
                     Date                         dollars       Pounds
------------------------------------------------------------------------
December 31, 1993.............................            8           10
December 31, 1994.............................            8           10
December 31, 1995.............................          108          110
------------------------------------------------------------------------

    (ii) The interest rate on the borrowing is set and the exchange 
rates on the swap are fixed on December 24, 1992. On December 31, 1992, 
K borrows the [pound]200 and swaps [pound]100 for $100. Assume K has 
satisfied the identification requirements of paragraph (a)(8) of this 
section.
    (iii) The [pound]200 debt instrument satisfies the requirements of 
paragraph (a)(3)(i) of this section. Because all principal and interest 
payments under the instrument are hedged in the same proportion (50% of 
all interest and principal payments are hedged), 50% of the payments 
under the [pound]200 instrument (principal amount of [pound]100 and 
annual interest of [pound]10) are treated as a qualifying debt 
instrument for purposes of paragraph (a) of this section. Thus, the 
distinct [pound]100 borrowing and the currency swap contract (which 
constitutes a hedge under paragraph (a)(4) of this section) are a 
qualified hedging transaction as defined in paragraph (a)(1) of this 
section. Accordingly, [pound]100 of the pound borrowing and the swap are 
integrated and treated as one synthetic dollar transaction with the 
following consequences:
    (A) The integration of [pound]100 of the pound borrowing and the 
swap results in a synthetic dollar borrowing with an issue price of $100 
under section 1273(b)(2).
    (B) The total amount of interest and principal of the synthetic 
dollar borrowing is equal to the dollar payments made by K under the 
currency swap contract (i.e., $8 in 1993, $8 in 1994, and $108 in 1995).
    (C) The stated redemption price at maturity (defined in section 
1273(a)(2)) is $100. Because the stated redemption price equals the

[[Page 671]]

issue price, there is no OID on the synthetic dollar borrowing.
    (D) K may deduct the annual interest payments of $8 under section 
163(a) (subject to any limitations on deductibility imposed by other 
provisions of the Code) according to its regular method of accounting. K 
has also paid $100 as a return of principal in 1995.
    (E) K must allocate and apportion its interest expense from the 
synthetic instrument under the rules of Sec. Sec. l.861-8T through 
1.861-12T.


That portion of the [pound]200 pound debt instrument that is not hedged 
(i.e., [pound]100) is treated as a separate debt instrument subject to 
the rules of Sec. 1.988-2 (b) and Sec. Sec. l.861-8T through 1.861-
12T.
    Example 9. (i) K is an accrual method U.S. corporation with the U.S. 
dollar as its functional currency. On January 1, 1992, K borrows 100 
British pounds ([pound]) for 3 years at a 10% rate of interest payable 
on December 31 of each year with no principal payment due until the 
final installment. On the same day, K enters into a currency swap 
agreement with an unrelated bank under which K agrees to the following:
    (A) On January 1, 1992, K will exchange the [pound]100 borrowed for 
$150.
    (B) For the period beginning January 1, 1992 and ending December 31, 
1994, K will pay at the end of each month an amount determined by 
multiplying $150 by one month LIBOR less 65 basis points and receive 
from the bank on December 31st of 1992, 1993, and 1994, [pound]10.
    (C) On December 31, 1994, K will exchange $150 for [pound]100.


Assume K satisfies the identification requirements of paragraph (a)(8) 
of this section.
    (ii) The pound borrowing (which constitutes a qualifying debt 
instrument under paragraph (a)(3) of this section) and the currency swap 
contract (which constitutes a hedge under paragraph (a)(4) of this 
section) are a qualified hedging transaction as defined in paragraph 
(a)(1) of this section. Accordingly, the pound borrowing and the swap 
are integrated and treated as one transaction with the following 
consequences:
    (A) The integration of the pound borrowing and the swap results in a 
synthetic dollar borrowing with an issue price of $150 under section 
1273(b)(2).
    (B) The total amount of interest and principal of the synthetic 
dollar borrowing is equal to the dollar payments made by K under the 
currency swap contract.
    (C) The stated redemption price at maturity (defined in section 
1273(a)(2)) is $150. Because the stated redemption price equals the 
issue price, there is no OID on the synthetic dollar borrowing.
    (D) K may deduct the monthly variable interest payments under 
section 163(a) (subject to any limitations on deductibility imposed by 
other provisions of the Code) according to its regular method of 
accounting. K has also paid $150 as a return of principal in 1994.
    (E) K must allocate and apportion its interest expense from the 
synthetic instrument under the rules of Sec. Sec. 1.861-8T through 
1.861-12T.
    Example 10. (i) K is an accrual method U.S. corporation with the 
U.S. dollar as its functional currency. On January 1, 1992, K loans 100 
British pounds ([pound]) for 3 years at a 10% rate of interest payable 
on December 31 of each year with no principal payment due until the 
final installment. The spot rate on January 1, 1992, is [pound]1 = 
$1.50. Also on January 1, 1992, K enters into a currency swap contract 
with an unrelated counterparty under the terms of which K will exchange 
pounds for dollars pursuant to the following table:

------------------------------------------------------------------------
                     Date                          Pounds      Dollars
------------------------------------------------------------------------
December 31, 1992.............................           10           12
December 31, 1993.............................           10           12
December 31, 1994.............................          110          162
------------------------------------------------------------------------

    (ii) Assume that K properly identifies the pound borrowing and the 
currency swap contract as a qualified hedging transaction as provided in 
paragraph (a)(1) of this section.
    (iii) The pound loan (which constitutes a qualifying debt instrument 
under paragraph (a)(3) of this section) and the currency swap contract 
(which constitutes a hedge under paragraph (a)(4) of this section) are a 
qualified hedging transaction as defined in paragraph (a)(1) of this 
section. Accordingly, the pound loan and the swap are integrated and 
treated as one transaction with the following consequences:
    (A) The integration of the pound loan and the swap results in a 
synthetic dollar loan with an issue price of $150 under section 
1273(b)(2).
    (B) The total amount of interest and principal of the synthetic 
dollar loan is equal to the dollar payments received by K under the 
currency swap contract (i.e., $12 in 1992, $12 in 1993, and $162 in 
1994).
    (C) The stated redemption price at maturity (defined in section 
1273(a)(2)) is $150. Because the stated redemption price equals the 
issue price, there is no OID on the synthetic dollar loan.
    (D) K must include in income as interest $12 in 1992, 1993, and 
1994.
    (E) The source of the interest income shall be determined by 
applying sections 861(a)(1) and 862(a)(1) with reference to the pound 
interest income that would have been received had the transaction not 
been integrated.
    (iv) On January 1, 1993, K transfers both the pound loan and the 
currency swap to B, its wholly owned U.S. subsidiary, in exchange for B 
stock in a transfer that satisfies the requirements of section 351. 
Under paragraph (a)(6) of this section, the transfer

[[Page 672]]

of both instruments is not ``legging out.'' Rather, K is considered to 
have transferred the synthetic dollar loan to B in a transaction in 
which gain or loss is not recognized. B's basis in the loan under 
section 362 is $100.
    Example 11. (i) K is a domestic corporation with the U.S. dollar as 
its functional currency. On January 1, 2013, K borrows 100 British 
pounds ([pound]) for two years at a 10% rate of interest payable on 
December 31 of each year with no principal payment due until maturity on 
December 31, 2014. Assume that the spot rate on January 1, 2013, is 
[pound]1=$1. On the same date, K enters into two swap contracts with an 
unrelated counterparty that economically results in the transformation 
of the fixed rate [pound]100 borrowing to a floating rate dollar 
borrowing. The terms of the swaps are as follows:
    (A) Swap 1, Currency swap. On January 1, 2013, K will exchange 
[pound]100 for $100.
    (1) On December 31 of both 2013 and 2014, K will exchange $8 for 
[pound]10;
    (2) On December 31, 2014, K will exchange $100 for [pound]100.
    (B) Swap 2, Interest rate swap. On December 31 of both 2013 and 
2014, K will pay LIBOR times a notional principal amount of $100 and 
will receive 8% times the same $100 notional principal amount.
    (ii) Assume that K properly identifies the pound borrowing and the 
swap contracts as a qualified hedging transaction as provided in 
paragraph (a)(8)(i) of this section and that the other relevant 
requirements of paragraph (a) of this section are satisfied.
    (iii) On January 1, 2014, the spot exchange rate is [pound]1=$2; the 
U.S. dollar LIBOR rate of interest is 9%; the market value of K's note 
in pounds has not changed; and K terminates swap 2. Because interest 
rates have increased from 8% to 9%, K will incur a loss of ($.92) (the 
present value of the ($1) difference between the 8% and 9% interest 
payments discounted at the current interest rate of 9%) with respect to 
the termination of such swap on January 1, 2014. Pursuant to paragraph 
(a)(6)(ii)(C) of this section, K must treat swap 1 as having been sold 
for its fair market value on the leg-out date, which is the date swap 2 
is terminated. K must realize and recognize gain of $100.92 (the present 
value of [pound]110 discounted in pounds to equal [pound]100 x $2 ($200) 
less the present value of $108 ($99.08)). The loss inherent in the pound 
borrowing from January 1, 2013 to January 1, 2014 is realized and 
recognized on January 1, 2014. Such loss is exchange loss in the amount 
of $100 (the present value of [pound]110 that was to be paid at the end 
of the year discounted at pound interest rates to equal [pound]100 times 
the change in exchange rates: ([pound]100 x $1, the spot rate on January 
1, 2013)-([pound]100 x $2, the spot rate on January 1, 2014)). Pursuant 
to paragraph (a)(6)(ii)(E) of this section, except as provided in 
paragraph (a)(8)(iii) of this section (regarding identification by the 
Commissioner), the pound borrowing and currency swap cannot be part of a 
qualified hedging transaction for any period after the leg-out date.
    (iv) Assume the facts are the same as in paragraph (iii) of this 
Example except that on January 1, 2014, the U.S. dollar LIBOR rate of 
interest is 7% rather than 9%. When K terminates swap 2, K will realize 
gain of $0.93 (the present value of the ($1) difference between the 8% 
and 7% interest payments discounted at the current interest rate of 7%) 
received with respect to the termination on January 1, 2014. Fifty 
percent or more of the remaining pound cash flow of the pound borrowing 
remains hedged after the termination of swap 2. Accordingly, under 
paragraph (a)(6)(ii)(F) of this section, paragraphs (a)(6)(ii)(B) and 
(C) of this section do not apply, and the gain on swap 1 and the loss 
on the qualifying debt instrument are not taken into account. Thus, K 
will include in income $0.93 realized from the termination of swap 2.

    (10) Transition rules and effective dates for certain provisions--
(i) Coordination with Notice 87-11. Any transaction entered into prior 
to September 21, 1989, which satisfied the requirements of Notice 87-11, 
1987-1 C.B. 423, shall be deemed to satisfy the requirements of 
paragraph (a) of this section.
    (ii) Prospective application to contingent payment debt instruments. 
In the case of a contingent payment debt instrument, the definition of 
qualifying debt instrument set forth in paragraph (a)(3)(i) of this 
section applies to transactions entered into after March 17, 1992.
    (iii) Prospective application of partial hedging rule. Paragraph 
(a)(3)(ii) of this section is effective for transactions entered into 
after March 17, 1992.
    (iv) Effective/applicability dates for legging in and legging out 
rules. (A) The rules of paragraph (a)(6)(i) of this section are 
effective for qualified hedging transactions that are legged into after 
March 17, 1992.
    (B) The rules of paragraph (a)(6)(ii) and Example 11 of paragraph 
(a)(9)(iv) of this section apply to leg-outs that occur on or after 
September 6, 2012.
    (b) Hedged executory contracts--(1) In general. If the taxpayer 
enters into a hedged executory contract as defined in paragraph (b)(2) 
of this section, the executory contract and the hedge shall be 
integrated as provided in paragraph (b)(4) of this section.

[[Page 673]]

    (2) Definitions--(i) Hedged executory contract. A hedged executory 
contract is an executory contract as defined in paragraph (b)(2)(ii) of 
this section that is the subject of a hedge as defined in paragraph 
(b)(2)(iii) of this section, provided that the following requirements 
are satisfied--
    (A) The executory contract and the hedge are identified as a hedged 
executory contract as provided in paragraph (b)(3) of this section.
    (B) The hedge is entered into (i.e., settled or closed, or in the 
case of nonfunctional currency deposited in an account with a bank or 
other financial institution, such currency is acquired and deposited) on 
or after the date the executory contract is entered into and before the 
accrual date as defined in paragraph (b)(2)(iv) of this section.
    (C) The executory contract is hedged in whole or in part throughout 
the period beginning with the date the hedge is identified in accordance 
with paragraph (b)(3) of this section and ending on or after the accrual 
date.
    (D) None of the parties to the hedge are related. The term related 
means the relationships defined in section 267(b) and section 707(c)(1).
    (E) In the case of a qualified business unit with a residence, as 
defined in section 988(a)(3)(B), outside of the United States, both the 
executory contract and the hedge are properly reflected on the books of 
the same qualified business unit.
    (F) Subject to the limitations of paragraph (b)(2)(i)(E) of this 
section, both the executory contract and the hedge are entered into by 
the same individual, partnership, trust, estate, or corporation. With 
respect to a corporation, the same corporation must enter into both the 
executory contract and the hedge whether or not such corporation is a 
member of an affiliated group of corporations that files a consolidated 
return.
    (G) With respect to a foreign person engaged in a U.S. trade or 
business that enters into an executory contract or hedge through such 
trade or business, all items of income and expense associated with the 
executory contract and the hedge would have been effectively connected 
with such U.S. trade or business throughout the term of the hedged 
executory contract had this paragraph (b) not applied.
    (ii) Executory contract--(A) In general. Except as provided in 
paragraph (b)(2)(ii)(B) of this section, an executory contract is an 
agreement entered into before the accrual date to pay nonfunctional 
currency (or an amount determined with reference thereto) in the future 
with respect to the purchase of property used in the ordinary course of 
the taxpayer's business, or the acquisition of a service (or services), 
in the future, or to receive nonfunctional currency (or an amount 
determined with reference thereto) in the future with respect to the 
sale of property used or held for sale in the ordinary course of the 
taxpayer's business, or the performance of a service (or services), in 
the future. Notwithstanding the preceding sentence, a contract to buy or 
sell stock shall be considered an executory contract. (Thus, for 
example, a contract to sell stock of an affiliate is an executory 
contract for this purpose.) On the accrual date, such agreement ceases 
to be considered an executory contract and is treated as an account 
payable or receivable.
    (B) Exceptions. An executory contract does not include a section 988 
transaction. For example, a forward contract to purchase nonfunctional 
currency is not an executory contract. An executory contract also does 
not include a transaction described in paragraph (c) of this section.
    (C) Effective date for contracts to buy or sell stock. That part of 
paragraph (b)(2)(ii)(A) of this section which provides that a contract 
to buy or sell stock shall be considered an executory contract applies 
to contracts to buy or sell stock entered into on or after March 17, 
1992.
    (iii) Hedge--(A) In general. For purposes of this paragraph (b), the 
term hedge means a deposit of nonfunctional currency in a hedging 
account (as defined paragraph (b)(3)(iii)(D) of this section), a forward 
or futures contract described in Sec. 1.988-1(a)(1)(ii) and (2)(iii), 
or combination thereof, which reduces the risk of exchange rate 
fluctuations by reference to the taxpayer's functional currency with 
respect to nonfunctional currency payments made or received under an 
executory

[[Page 674]]

contract. The term hedge also includes an option contract described in 
Sec. 1.988-1(a)(1)(ii) and (2)(iii), but only if the option's 
expiration date is on or before the accrual date. The premium paid for 
an option that lapses shall be integrated with the executory contract.
    (B) Special rule for series of hedges. A series of hedges as defined 
in paragraph (b)(3)(iii)(A) of this section shall be considered a hedge 
if the executory contract is hedged in whole or in part throughout the 
period beginning with the date the hedge is identified in accordance 
with paragraph (b)(3)(i) of this section and ending on or after the 
accrual date. A taxpayer that enters into a series of hedges will be 
deemed to have satisfied the preceding sentence if the hedge that 
succeeds a hedge that has been terminated is entered into no later than 
the business day following such termination.
    (C) Special rules for historical rate rollovers--(1) Definition. A 
historical rate rollover is an extension of the maturity date of a 
forward contract where the new forward rate is adjusted on the rollover 
date to reflect the taxpayer's gain or loss on the contract as of the 
rollover date plus the time value of such gain or loss through the new 
maturity date.
    (2) Certain historical rate rollovers considered a hedge. A 
historical rate rollover is considered a hedge if the rollover date is 
before the accrual date.
    (3) Treatment of time value component of certain historical rate 
rollovers that are hedges. Interest income or expense determined under 
Sec. 1.988-2(d)(2)(v) with respect to a historical rate rollover shall 
be considered part of a hedge if the period beginning on the first date 
a hedging contract is rolled over and ending on the date payment is made 
or received under the executory contract does not exceed 183 days. Such 
interest income or expense shall not be recognized and shall be an 
adjustment to the income from, or expense of, the services performed or 
received under the executory contract, or to the amount realized or 
basis of the property sold or purchased under the executory contract. 
For the treatment of such interest income or expense that is not 
considered part of a hedge, see Sec. 1.988-2(d)(2)(v).
    (D) Special rules regarding deposits of nonfunctional currency in a 
hedging account. A hedging account is an account with a bank or other 
financial institution used exclusively for deposits of nonfunctional 
currency used to hedge executory contracts. For purposes of determining 
the basis of units in such account that comprise the hedge, only those 
units in the account as of the accrual date shall be taken into 
consideration. A taxpayer may adopt any reasonable convention 
(consistently applied to all hedging accounts) to determine which units 
comprise the hedge as of the accrual date and the basis of the units as 
of such date.
    (E) Interest income on deposit of nonfunctional currency in a 
hedging account. Interest income on a deposit of nonfunctional currency 
in a hedging account may be taken into account for purposes of 
determining the amount of a hedge if such interest is accrued on or 
before the accrual date. However, such interest income shall be included 
in income as provided in section 61. For example, if a taxpayer with the 
dollar as its functional currency enters into an executory contract for 
the purchase and delivery of a machine in one year for 100 British 
pounds ([pound]), and on such date deposits [pound]90.91 in a properly 
identified bank account that bears interest at the rate of 10%, the 
interest that accrues prior to the accrual date shall be included in 
income and may be considered a hedge.
    (iv) Accrual date. The accrual date is the date when the item of 
income or expense (including a capital expenditure) that relates to an 
executory contract is required to be accrued under the taxpayer's method 
of accounting.
    (v) Payment date. The payment date is the date when payment is made 
or received with respect to an executory contract or the subsequent 
corresponding account payable or receivable.
    (3) Identification rules--(i) Identification by the taxpayer. A 
taxpayer must establish a record and before the close of the date the 
hedge is entered into, the taxpayer must enter into the

[[Page 675]]

record a clear description of the executory contract and the hedge and 
indicate that the transaction is being identified in accordance with 
paragraph (b)(3) of this section.
    (ii) Identification by the Commissioner. If a taxpayer enters into 
an executory contract and a hedge but fails to satisfy one or more of 
the requirements of paragraph (b) of this section and, based on the 
facts and circumstances, the Commissioner concludes that the executory 
contract in substance is hedged, then the Commissioner may apply the 
provisions of paragraph (b) of this section as if the taxpayer had 
satisfied all of the requirements therein, and may make appropriate 
adjustments. The Commissioner may apply the provisions of paragraph (b) 
of this section regardless of whether the executory contract and the 
hedge are held by the same taxpayer.
    (4) Effect of hedged executory contract--(i) In general. If a 
taxpayer enters into a hedged executory contract, amounts paid or 
received under the hedge by the taxpayer are treated as paid or received 
by the taxpayer under the executory contract, or any subsequent account 
payable or receivable, or that portion to which the hedge relates. Also, 
the taxpayer recognizes no exchange gain or loss on the hedge. If an 
executory contract, on the accrual date, becomes an account payable or 
receivable, the taxpayer recognizes no exchange gain or loss on such 
payable or receivable for the period covered by the hedge.
    (ii) Partially hedged executory contracts. The effect of integrating 
an executory contract and a hedge that partially hedges such contract is 
to treat the amounts paid or received under the hedge as paid or 
received under the portion of the executory contract being hedged, or 
any subsequent account payable or receivable. The income or expense of 
services performed or received under the executory contract, or the 
amount realized or basis of property sold or purchased under the 
executory contract, that is attributable to that portion of the 
executory contract that is not hedged shall be translated into 
functional currency on the accrual date. Exchange gain or loss shall be 
realized when payment is made or received with respect to any payable or 
receivable arising on the accrual date with respect to such unhedged 
amount.
    (iii) Disposition of a hedge or executory contract prior to the 
accrual date--(A) In general. If a taxpayer identifies an executory 
contract as part of a hedged executory contract as defined in paragraph 
(b)(2) of this section, and disposes of (or otherwise terminates) the 
executory contract prior to the accrual date, the hedge shall be treated 
as sold for its fair market value on the date the executory contract is 
disposed of and any gain or loss shall be realized and recognized on 
such date. Such gain or loss shall be an adjustment to the amount 
received or expended with respect to the disposition or termination, if 
any. The spot rate on the date the hedge is treated as sold shall be 
used to determine subsequent exchange gain or loss on the hedge. If a 
taxpayer identifies a hedge as part of a hedged executory contract as 
defined in paragraph (b)(2) of this section, and disposes of the hedge 
prior to the accrual date, any gain or loss realized on such disposition 
shall not be recognized and shall be an adjustment to the income from, 
or expense of, the services performed or received under the executory 
contract, or to the amount realized or basis of the property sold or 
purchased under the executory contract.
    (B) Certain events in a series of hedges treated as a termination of 
the hedged executory contract. If the rules of paragraph (b)(2)(iii)(B) 
of this section are not satisfied, the hedged executory contract shall 
be terminated and the provisions of paragraph (b)(4)(iii)(A) of this 
section shall apply to any gain or loss previously realized with respect 
to such hedge. Any subsequent hedging contracts entered into to reduce 
the risk of exchange rate movements with respect to such executory 
contract shall not be considered a hedge as defined in paragraph 
(b)(2)(iii) of this section.
    (C) Executory contracts between related persons. If an executory 
contract is between related persons as defined in sections 267(b) and 
707(b), and the taxpayer disposes of the hedge or terminates the 
executory contract prior to the accrual date, the Commissioner may 
redetermine the timing, source,

[[Page 676]]

and character of gain or loss from the hedge or the executory contract 
if he determines that a significant purpose for disposing of the hedge 
or terminating the executory contract prior to the accrual date was to 
affect the timing, source, or character of income, gain, expense, or 
loss for Federal income tax purposes.
    (iv) Disposition of a hedge on or after the accrual date. If a 
taxpayer identifies a hedge as part of a hedged executory contract as 
defined in paragraph (b)(2) of this section, and disposes of the hedge 
on or after the accrual date, no gain or loss is recognized on the hedge 
and the booking date as defined in Sec. 1.988-2(c)(2) of the payable or 
receivable for purposes of computing exchange gain or loss shall be the 
date such hedge is disposed of. See Example 3 of paragraph (b)(4)(iv) of 
this section.
    (v) Sections 263(g), 1092, and 1256 do not apply. Sections 263(g), 
1092, and 1256 do not apply with respect to an executory contract or 
hedge which comprise a hedged executory contract as defined in paragraph 
(b)(2) of this section. However, sections 263(g), 1092 and 1256 may 
apply to the hedged executory contract if such transaction is part of a 
straddle.
    (vi) Examples. The principles set forth in paragraph (b) of this 
section are illustrated in the following examples. The examples assume 
that K is an accrual method, calendar year U.S. corporation with the 
dollar as its functional currency.

    Example 1. (i) On January 1, 1992, K enters into a contract with 
JPF, a Swiss machine manufacturer, to pay 500,000 Swiss francs for 
delivery of a machine on June 1, 1993. Also on January 1, 1992, K enters 
into a foreign currency forward agreement to purchase 500,000 Swiss 
francs for $250,000 for delivery on June 1, 1993. K properly identifies 
the executory contract and the hedge in accordance with paragraph 
(b)(3)(i) of this section. On June 1, 1993, K takes delivery of the 
500,000 Swiss francs (in exchange for $250,000) under the forward 
contract and makes payment of 500,000 Swiss francs to JPF in exchange 
for the machine. Assume that the accrual date is June 1, 1993.
    (ii) Under paragraph (b)(1) of this section, the hedge is integrated 
with the executory contract. Therefore, K is deemed to have paid 
$250,000 for the machine and there is no exchange gain or loss on the 
foreign currency forward contract. K's basis in the machine is $250,000. 
Section 1256 does not apply to the forward contract.
    Example 2. (i) On January 1, 1992, K enters into a contract with S, 
a Swiss machine manufacturer, to pay 500,000 Swiss francs for delivery 
of a machine on June 1, 1993. Under the contract, K is not obligated to 
pay for the machine until September 1, 1993. On February 1, 1992, K 
enters into a foreign currency forward agreement to purchase 500,000 
Swiss francs for $250,000 for delivery on September 1, 1993. K properly 
identifies the executory contract and the hedge in accordance with 
paragraph (b)(3) of this section. On June 1, 1993, K takes delivery of 
machine. Assume that under K's method of accounting the delivery date is 
the accrual date. On September 1, 1993, K takes delivery of the 500,000 
Swiss francs (in exchange for $250,000) under the forward contract and 
makes payment of 500,000 Swiss francs to S.
    (ii) Under paragraph (b)(1) of this section, the hedge is integrated 
with the executory contract. Therefore K is deemed to have paid $250,000 
for the machine and there is no exchange gain or loss on the foreign 
currency forward contract. Thus K's basis in the machine is $250,000. In 
addition, no exchange gain or loss is recognized on the payable in 
existence from June 1, 1993, to September 1, 1993. Section 1256 does not 
apply to the forward contract.
    Example 3. The facts are the same as in Example 2 except that K 
disposed of the forward contract on August 1, 1993 for $10,000. Pursuant 
to paragraph (b)(4)(iv) of this section, K does not recognize the 
$10,000 gain. K's basis in the machine is $250,000 (the amount fixed by 
the forward contract), regardless of the amount in dollars that K 
actually pays to acquire the Sf500,000 when K pays for the machine. K 
has a payable with a booking date of August 1, 1993, payable on 
September 1, 1993 for 500,000 Swiss francs. Thus, K will realize 
exchange gain or loss on the difference between the amount booked on 
August 1, 1993 and the amount paid on September 1, 1993 under Sec. 
1.988-2(c).
    Example 4. (i) On January 1, 1992, K enters into a contract with S, 
a Swiss machine repair firm, to pay 500,000 Swiss francs for repairs to 
be performed on June 1, 1992. Under the contract, K is not obligated to 
pay for the repairs until September 1, 1992. On February 1, 1992, K 
enters into a foreign currency forward agreement to purchase 500,000 
Swiss francs for $250,000 for delivery on August 1, 1992. K properly 
identifies the executory contract and the hedge in accordance with 
paragraph (b)(3) of this section. On June 1, 1992, S performs the repair 
services. Assume that under K's method of accounting this date is the 
accrual date. On August 1, 1992, K takes delivery of the 500,000 Swiss 
francs (in exchange for $250,000) under the forward contract. On the 
same day, K deposits the Sf500,000 in a separate account with a

[[Page 677]]

bank and properly identifies the transaction as a continuation of the 
hedged executory contract. On September 1, 1992, K makes payment of the 
Sf500,000 in the account to S.
    (ii) Under paragraph (b)(1) of this section, the hedge is integrated 
with the executory contract. Therefore K is deemed to have paid $250,000 
for the services and there is no exchange gain or loss on the foreign 
currency forward contract or on the disposition of Sf500,000 in the 
account. Any interest on the Swiss francs in the account is included in 
income but is not considered part of the hedge (because the amount paid 
for the services must be set on or before the accrual date). In 
addition, no exchange gain or loss is recognized on the payable in 
existence from June 1, 1992, to September 1, 1992. Section 1256 does not 
apply to the forward contract.
    Example 5. (i) On January 1, 1992, K enters into a contract with S, 
a Swiss machine manufacturer, to pay 500,000 Swiss francs for delivery 
of a machine on June 1, 1993. Under the contract, K is not obligated to 
pay for the machine until September 1, 1993. On February 1, 1992, K 
enters into a foreign currency forward agreement to purchase 250,000 
Swiss francs for $125,000 for delivery on September 1, 1993. K properly 
identifies the executory contract and the hedge in accordance with 
paragraph (b)(3) of this section. On June 1, 1993, K takes delivery of 
the machine. Assume that under K's method of accounting the delivery 
date is the accrual date. Assume further that the exchange rate is Sf1 = 
$.50 on June 1, 1993. On August 30, 1993, K purchases Sf250,000 for 
$135,000. On September 1, 1993, K takes delivery of the 250,000 Swiss 
francs (in exchange for $125,000) under the forward contract and makes 
payment of 500,000 Swiss francs (the Sf250,000 received under the 
contract plus the Sf250,000 purchased on August 30, 1993) to S. Assume 
the spot rate on September 1, 1993, is 1 Sf = $.5420 (Sf250,000 equal 
$135,500).
    (ii) Under paragraph (b)(1) of this section, the partial hedge is 
integrated with the executory contract. K is deemed to have paid 
$250,000 for the machine [$125,000 on the hedged portion of the 
Sf500,000 and $125,000 ($.50, the spot rate on June 1, 1993, times 
Sf250,000) on the unhedged portion of the Sf500,000]. K's basis in the 
machine therefore is $250,000. K recognizes no exchange gain or loss on 
the foreign currency forward contract but K will realize exchange gain 
of $500 on the disposition of the Sf250,000 purchased on August 30, 1993 
under Sec. 1.988-2(a). In addition, exchange loss is realized on the 
unhedged portion of the payable in existence from June 1, 1993, to 
September 1, 1993. Thus, K will realize exchange loss of $10,500 
($125,000 booked less $135,500 paid) under Sec. 1.988-2(c) on the 
payable. Section 1256 does not apply to the forward contract.
    Example 6. (i) On January 1, 1990, K enters into a contract with S, 
a Swiss steel manufacturer, to buy steel for 1,000,000 Swiss francs (Sf) 
for delivery and payment on December 31, 1990. On January 1, 1990, the 
spot rate is Sf1 = $.50, the U.S. dollar interest rate is 10% compounded 
annually, and the Swiss franc rate is 5% compounded annually. Under K's 
method of accounting, the delivery date is the accrual date.
    (ii) Assume that on January 1, 1990, K enters into a foreign 
currency forward contract to buy Sf1,000,000 for $523,800 for delivery 
on December 31, 1990. K properly identifies the executory contract and 
the hedge in accordance with paragraph (b)(3) of this section. Pursuant 
to paragraph (b)(2)(iii) of this section, the forward contract 
constitutes a hedge. Assuming that the requirements of paragraph 
(b)(2)(i) of this section are satisfied, the executory contract to buy 
steel and the forward contract are integrated under paragraph (b)(1) of 
this section. Thus, K is deemed to have paid $523,800 for the steel and 
will have a basis in the steel of $523,800. No gain or loss is realized 
with respect to the forward contract and section 1256 does not apply to 
such contract.
    (iii) Assume instead that on January 1, 1990, K enters into a 
foreign currency forward contract to buy Sf1,000,000 for $512,200 for 
delivery on July 1, 1990. K properly identifies the executory contract 
and the hedge in accordance with paragraph (b)(3) of this section. On 
July 1, 1990, when the spot rate is Sf1 = $.53, K cancels the forward 
contract in exchange for $17,800 ($530,000-$512,200). On July 1, 1990, K 
enters into a second forward agreement to buy Sf1,000,000 for $542,900 
for delivery on December 31, 1990. K properly identifies the second 
forward agreement as a hedge in accordance with paragraph (b)(3) of this 
section. Pursuant to paragraph (b)(2)(iii) of this section, the forward 
contract entered into on January 1, 1990, and the forward contract 
entered into on July 1, 1990, constitute a hedge. Assuming that the 
requirements of paragraph (b)(2)(i) of this section are satisfied, the 
executory contract to buy steel and the forward agreements are 
integrated under paragraph (b)(1) of this section. Thus, K is deemed to 
have paid $525,100 for the steel (the forward price in the second 
forward agreement of $542,900 less the gain on the first forward 
agreement of $17,800) and will have a basis in the steel of $525,100. No 
gain is realized with respect to the forward contracts and section 1256 
does not apply to such contracts.
    (iv) Assume instead that on January 1, 1990, K enters into a foreign 
currency forward contract to buy Sf1,000,000 for $512,200 for delivery 
on July 1, 1990. K properly identifies the executory contract and the 
hedge in accordance with paragraph (b)(3) of this section. On July 1, 
1990, when the spot rate is Sf1 = $.53, K enters into a historical rate 
rollover of its $17,800 gain ($530,000-$512,200) on the forward 
agreement. Thus, K enters into a

[[Page 678]]

second foreign currency forward agreement to buy Sf1,000,000 for 
$524,210 for delivery on December 31, 1990. (The forward price of 
$524,210 is the market forward price on July 1, 1990, for the purchase 
of Sf1,000,000 for delivery on December 31, 1990, of $542,900 less the 
$17,800 gain on January 1, 1990, contract and less the time value of 
such gain of $890.) K properly identifies the second forward agreement 
as a hedge in accordance with paragraph (b)(3) of this section. On 
December 31, 1990, when the spot rate is Sf1 = $.54, K takes delivery of 
the Sf1,000,000 (in exchange for $524,210) and purchases the steel for 
Sf1,000,000. Pursuant to paragraph (b)(2)(iii) of this section, the 
forward contract entered into on January 1, 1990, and the forward 
contract entered into on July 1, 1990, which incorporates the rollover 
of K's gain on the January 1, 1990, contract, constitute a hedge. 
Assuming that the requirements of paragraph (b)(2)(i) of this section 
are satisfied, the executory contract to buy steel and the forward 
agreements are integrated under paragraph (b)(1) of this section. 
Because the period from the rollover date to the date payment is made 
under the executory contract does not exceed 183 days, the $890 of 
interest income is considered part of the hedge and is not recognized. 
Thus, K is deemed to have paid $524,210 for the steel and will have a 
basis in the steel of $524,210. No gain is realized with respect to the 
forward contracts and section 1256 does not apply to such contracts.
    (v) Assume instead that on January 1, 1990, K purchases Sf952,380.95 
(the present value of Sf1,000,000 to be paid on December 31, 1990) for 
$476,190.48 and on the same day deposits the Swiss francs in a separate 
bank account that bears interest at a rate of 5%, compounded annually. K 
properly identifies the transaction as a hedged executory contract. Over 
the period beginning January 1, 1990, and ending December 31, 1990, K 
receives Sf47,619.05 in interest on the account that is included in 
income and that has a basis of $25,714.29. (Assume that under Sec. 
1.988-2(b)(1), K uses the spot rate of Sf1 = $.54 to translate the 
interest income). On December 31, 1990, K makes payment of the 
Sf1,000,000 principal and accrued interest in the account to S. Pursuant 
to paragraph (b)(2)(iii) of this section, the principal in the bank 
account and the interest constitute a hedge. Under paragraph (b)(1) of 
this section, the hedge is integrated with the executory contract. 
Therefore K is deemed to have paid $501,904.77 (the basis of the 
principal deposited plus the basis of the interest) for the steel and 
there is no exchange gain or loss on the disposition of the Sf1,000,000. 
K's basis in the steel therefore is $501,904.77.

    (5) References to this paragraph (b). If the rules of this paragraph 
(b) are referred to in another paragraph of this section (e.g., 
paragraph (c) of this section), then the rules of this paragraph (b) 
shall be applied for purposes of such other paragraph by substituting 
terms appropriate for such other paragraph. For example, paragraph 
(c)(2) of this section refers to the identification rules of paragraph 
(b)(3) of this section. Accordingly, for purposes of paragraph (c)(2), 
the rules of paragraph (b)(3) will be applied by substituting the term 
``stock or security'' for ``executory contract''.
    (c) Hedges of period between trade date and settlement date on 
purchase or sale of publicly traded stock or security. If a taxpayer 
purchases or sells stocks or securities which are traded on an 
established securities market and--
    (1) Hedges all or part of such purchase or sale for any part of the 
period beginning on the trade date and ending on the settlement date; 
and
    (2) Identifies the hedge and the underlying stock or securities as 
an integrated transaction under the rules of paragraph (b)(3) of this 
section;


then any gain or loss on the hedge shall be an adjustment to the amount 
realized or the adjusted basis of the stock or securities sold or 
purchased (and shall not be taken into account as exchange gain or 
loss). The term hedge means a deposit of nonfunctional currency in a 
hedging account (within the meaning of paragraph (b)(2)(iii)(D) of this 
section), or a forward or futures contract described in Sec. 1.988-
1(a)(1)(ii) and (2)(iii), or combination thereof, which reduces the risk 
of exchange rate fluctuations for any portion of the period beginning on 
the trade date and ending on the settlement date. The provisions of 
paragraphs (b)(2)(i)(D) through (G), and (b)(2)(iii)(D) and (E) of this 
section shall apply. Sections 263(g), 1092, and 1256 do not apply with 
respect to stock or securities and a hedge which are subject to this 
paragraph (c).
    (d) [Reserved]
    (e) Advance rulings regarding net hedging and anticipatory hedging 
systems. In his sole discretion, the Commissioner may issue an advance 
ruling addressing the income tax consequences of a taxpayer's system of 
hedging either its net

[[Page 679]]

nonfunctional currency exposure or anticipated nonfunctional currency 
exposure. The ruling may address the character, source, and timing of 
both the section 988 transaction(s) making up the hedge and the 
underlying transactions being hedged. The procedures for obtaining a 
ruling shall be governed by such pertinent revenue procedures and 
revenue rulings as the Commissioner may provide. The Commissioner will 
not issue a ruling regarding hedges of a taxpayer's investment in a 
foreign subsidiary.
    (f) [Reserved]
    (g) General effective date. Except as otherwise provided in this 
section, the rules of this section shall apply to qualified hedging 
transactions, hedged executory contracts and transactions described in 
paragraph (c) of this section entered into on or after September 21, 
1989. This section shall apply even if the transaction being hedged 
(e.g., the debt instrument) was entered into or acquired prior to such 
date. The effective date regarding advance rulings for net and 
anticipatory hedging shall be governed by such revenue procedures that 
the Commissioner may publish.

[T.D. 8400, 57 FR 9199, Mar. 17, 1992, as amended at T.D. 9598, 77 FR 
54809, Sept. 6, 2012; T.D. 9736, 80 FR 53733, 53735, Sept. 8, 2015]



Sec. 1.988-6  Nonfunctional currency contingent payment debt 
instruments.

    (a) In general--(1) Scope. This section determines the accrual of 
interest and the amount, timing, source, and character of any gain or 
loss on nonfunctional currency contingent payment debt instruments 
described in this paragraph (a)(1) and to which Sec. 1.1275-4(a) would 
otherwise apply if the debt instrument were denominated in the 
taxpayer's functional currency. Except as provided by the rules in this 
section, the rules in Sec. 1.1275-4 (relating to contingent payment 
debt instruments) apply to the following instruments--
    (i) A debt instrument described in Sec. 1.1275-4(b)(1) for which 
all payments of principal and interest are denominated in, or determined 
by reference to, a single nonfunctional currency and which has one or 
more non-currency related contingencies;
    (ii) A debt instrument described in Sec. 1.1275-4(b)(1) for which 
payments of principal or interest are denominated in, or determined by 
reference to, more than one currency and which has no non-currency 
related contingencies;
    (iii) A debt instrument described in Sec. 1.1275-4(b)(1) for which 
payments of principal or interest are denominated in, or determined by 
reference to, more than one currency and which has one or more non-
currency related contingencies; and
    (iv) A debt instrument otherwise described in paragraph (a)(1)(i), 
(ii) or (iii) of this section, except that the debt instrument is 
described in Sec. 1.1275-4(c)(1) rather than Sec. 1.1275-4(b)(1) 
(e.g., the instrument is issued for non-publicly traded property).
    (2) Exception for hyperinflationary currencies--(i) In general. 
Except as provided in paragraph (a)(2)(ii) of this section, this section 
shall not apply to an instrument described in paragraph (a)(1) of this 
section if any payment made under such instrument is determined by 
reference to a hyperinflationary currency, as defined in Sec. 1.985-
1(b)(2)(ii)(D). In such case, the amount, timing, source and character 
of interest, principal, foreign currency gain or loss, and gain or loss 
relating to a non-currency contingency shall be determined under the 
method that reflects the instrument's economic substance.
    (ii) Discretion as to method. If a taxpayer does not account for an 
instrument described in paragraph (a)(2)(i) of this section in a manner 
that reflects the instrument's economic substance, the Commissioner may 
apply the rules of this section to such an instrument or apply the 
principles of Sec. 1.988-2(b)(15), reasonably taking into account the 
contingent feature or features of the instrument.
    (b) Instruments described in paragraph (a)(1)(i) of this section--
(1) In general. Paragraph (b)(2) of this section provides rules for 
applying the noncontingent bond method (as set forth in Sec. 1.1275-
4(b)) in the nonfunctional currency in which a debt instrument described 
in paragraph (a)(1)(i) of this section is denominated, or by reference 
to which its payments are determined

[[Page 680]]

(the denomination currency). Paragraph (b)(3) of this section describes 
how amounts determined in paragraph (b)(2) of this section shall be 
translated from the denomination currency of the instrument into the 
taxpayer's functional currency. Paragraph (b)(4) of this section 
describes how gain or loss (other than foreign currency gain or loss) 
shall be determined and characterized with respect to the instrument. 
Paragraph (b)(5) of this section describes how foreign currency gain or 
loss shall be determined with respect to accrued interest and principal 
on the instrument. Paragraph (b)(6) of this section provides rules for 
determining the source and character of any gain or loss with respect to 
the instrument. Paragraph (b)(7) of this section provides rules for 
subsequent holders of an instrument who purchase the instrument for an 
amount other than the adjusted issue price of the instrument. Paragraph 
(c) of this section provides examples of the application of paragraph 
(b) of this section. See paragraph (d) of this section for the 
determination of the denomination currency of an instrument described in 
paragraph (a)(1)(ii) or (iii) of this section. See paragraph (e) of this 
section for the treatment of an instrument described in paragraph 
(a)(1)(iv) of this section.
    (2) Application of noncontingent bond method--(i) Accrued interest. 
Interest accruals on an instrument described in paragraph (a)(1)(i) of 
this section are initially determined in the denomination currency of 
the instrument by applying the noncontingent bond method, set forth in 
Sec. 1.1275-4(b), to the instrument in its denomination currency. 
Accordingly, the comparable yield, projected payment schedule, and 
comparable fixed rate debt instrument, described in Sec. 1.1275-
4(b)(4), are determined in the denomination currency. For purposes of 
applying the noncontingent bond method to instruments described in this 
paragraph, the applicable Federal rate described in Sec. 1.1275-
4(b)(4)(i) shall be the rate described in Sec. 1.1274-4(d) with respect 
to the denomination currency.
    (ii) Net positive and negative adjustments. Positive and negative 
adjustments, and net positive and net negative adjustments, with respect 
to an instrument described in paragraph (a)(1)(i) of this section are 
determined by applying the rules of Sec. 1.1275-4(b)(6) (and Sec. 
1.1275-4(b)(9)(i) and (ii), if applicable) in the denomination currency. 
Accordingly, a net positive adjustment is treated as additional interest 
(in the denomination currency) on the instrument. A net negative 
adjustment first reduces interest that otherwise would be accrued by the 
taxpayer during the current tax year in the denomination currency. If a 
net negative adjustment exceeds the interest that would otherwise be 
accrued by the taxpayer during the current tax year in the denomination 
currency, the excess is treated as ordinary loss (if the taxpayer is a 
holder of the instrument) or ordinary income (if the taxpayer is the 
issuer of the instrument). The amount treated as ordinary loss by a 
holder with respect to a net negative adjustment is limited, however, to 
the amount by which the holder's total interest inclusions on the debt 
instrument (determined in the denomination currency) exceed the total 
amount of the holder's net negative adjustments treated as ordinary loss 
on the debt instrument in prior taxable years (determined in the 
denomination currency). Similarly, the amount treated as ordinary income 
by an issuer with respect to a net negative adjustment is limited to the 
amount by which the issuer's total interest deductions on the debt 
instrument (determined in the denomination currency) exceed the total 
amount of the issuer's net negative adjustments treated as ordinary 
income on the debt instrument in prior taxable years (determined in the 
denomination currency). To the extent a net negative adjustment exceeds 
the current year's interest accrual and the amount treated as ordinary 
loss to a holder (or ordinary income to the issuer), the excess is 
treated as a negative adjustment carryforward, within the meaning of 
Sec. 1.1275-4(b)(6)(iii)(C), in the denomination currency.
    (iii) Adjusted issue price. The adjusted issue price of an 
instrument described in paragraph (a)(1)(i) of this section is 
determined by applying the rules of Sec. 1.1275-4(b)(7) in the 
denomination currency. Accordingly, the adjusted issue price is equal to 
the debt instrument's

[[Page 681]]

issue price in the denomination currency, increased by the interest 
previously accrued on the debt instrument (determined without regard to 
any net positive or net negative adjustments on the instrument) and 
decreased by the amount of any noncontingent payment and the projected 
amount of any contingent payment previously made on the instrument. All 
adjustments to the adjusted issue price are calculated in the 
denomination currency.
    (iv) Adjusted basis. The adjusted basis of an instrument described 
in paragraph (a)(1)(i) of this section is determined by applying the 
rules of Sec. 1.1275-4(b)(7) in the taxpayer's functional currency. In 
accordance with those rules, a holder's basis in the debt instrument is 
increased by the interest previously accrued on the debt instrument 
(translated into functional currency), without regard to any net 
positive or net negative adjustments on the instrument (except as 
provided in paragraph (b)(7) or (8) of this section, if applicable), and 
decreased by the amount of any noncontingent payment and the projected 
amount of any contingent payment previously made on the instrument to 
the holder (translated into functional currency). See paragraph 
(b)(3)(iii) of this section for translation rules.
    (v) Amount realized. The amount realized by a holder and the 
repurchase price paid by the issuer on the scheduled or unscheduled 
retirement of a debt instrument described in paragraph (a)(1)(i) of this 
section are determined by applying the rules of Sec. 1.1275-4(b)(7) in 
the denomination currency. For example, with regard to a scheduled 
retirement at maturity, the holder is treated as receiving the projected 
amount of any contingent payment due at maturity, reduced by the amount 
of any negative adjustment carryforward. For purposes of translating the 
amount realized by the holder into functional currency, the rules of 
paragraph (b)(3)(iv) of this section shall apply.
    (3) Treatment and translation of amounts determined under 
noncontingent bond method--(i) Accrued interest. The amount of accrued 
interest, determined under paragraph (b)(2)(i) of this section, is 
translated into the taxpayer's functional currency at the average 
exchange rate, as described in Sec. 1.988-2(b)(2)(iii)(A), or, at the 
taxpayer's election, at the appropriate spot rate, as described in Sec. 
1.988-2(b)(2)(iii)(B).
    (ii) Net positive and negative adjustments--(A) Net positive 
adjustments. A net positive adjustment, as referenced in paragraph 
(b)(2)(ii) of this section, is translated into the taxpayer's functional 
currency at the spot rate on the last day of the taxable year in which 
the adjustment is taken into account under Sec. 1.1275-4(b)(6), or, if 
earlier, the date the instrument is disposed of or otherwise terminated.
    (B) Net negative adjustments. A net negative adjustment is treated 
and, where necessary, is translated from the denomination currency into 
the taxpayer's functional currency under the following rules:
    (1) The amount of a net negative adjustment determined in the 
denomination currency that reduces the current year's interest in that 
currency shall first reduce the current year's accrued but unpaid 
interest, and then shall reduce the current year's interest which was 
accrued and paid. No translation is required.
    (2) The amount of a net negative adjustment treated as ordinary 
income or loss under Sec. 1.1275-4(b)(6)(iii)(B) first is attributable 
to accrued but unpaid interest accrued in prior taxable years. For this 
purpose, the net negative adjustment shall be treated as attributable to 
any unpaid interest accrued in the immediately preceding taxable year, 
and thereafter to unpaid interest accrued in each preceding taxable 
year. The amount of the net negative adjustment applied to accrued but 
unpaid interest is translated into functional currency at the same rate 
used, in each of the respective prior taxable years, to translate the 
accrued interest.
    (3) Any amount of the net negative adjustment remaining after the 
application of paragraphs (b)(3)(ii)(B)(1) and (2) of this section is 
attributable to interest accrued and paid in prior taxable years. The 
amount of the net negative adjustment applied to such amounts is 
translated into functional currency at the spot rate on the date the 
debt instrument was issued or, if later, acquired.

[[Page 682]]

    (4) Any amount of the net negative adjustment remaining after 
application of paragraphs (b)(3)(ii)(B)(1), (2) and (3) of this section 
is a negative adjustment carryforward, within the meaning of Sec. 
1.1275-4(b)(6)(iii)(C). A negative adjustment carryforward is carried 
forward in the denomination currency and is applied to reduce interest 
accruals in subsequent years. In the year in which the instrument is 
sold, exchanged or retired, any negative adjustment carryforward not 
applied to interest reduces the holder's amount realized on the 
instrument (in the denomination currency). An issuer of a debt 
instrument described in paragraph (a)(1)(i) of this section who takes 
into income a negative adjustment carryforward (that is not applied to 
interest) in the year the instrument is retired, as described in Sec. 
1.1275-4(b)(6)(iii)(C), translates such income into functional currency 
at the spot rate on the date the instrument was issued.
    (iii) Adjusted basis--(A) In general. Except as otherwise provided 
in this paragraph and paragraph (b)(7) or (8) of this section, a holder 
determines and maintains adjusted basis by translating the denomination 
currency amounts determined under Sec. 1.1275-4(b)(7)(iii) into 
functional currency as follows:
    (1) The holder's initial basis in the instrument is determined by 
translating the amount paid by the holder to acquire the instrument (in 
the denomination currency) into functional currency at the spot rate on 
the date the instrument was issued or, if later, acquired.
    (2) An increase in basis attributable to interest accrued on the 
instrument is translated at the rate applicable to such interest under 
paragraph (b)(3)(i) of this section.
    (3) Any noncontingent payment and the projected amount of any 
contingent payments determined in the denomination currency that 
decrease the holder's basis in the instrument under Sec. 1.1275-
4(b)(7)(iii) are translated as follows:
    (i) The payment first is attributable to the most recently accrued 
interest to which prior amounts have not already been attributed. The 
payment is translated into functional currency at the rate at which the 
interest was accrued.
    (ii) Any amount remaining after the application of paragraph 
(b)(3)(iii)(A)(3)(i) of this section is attributable to principal. Such 
amounts are translated into functional currency at the spot rate on the 
date the instrument was issued or, if later, acquired.
    (B) Exception for interest reduced by a negative adjustment 
carryforward. Solely for purposes of this Sec. 1.988-6, any amounts of 
accrued interest income that are reduced as a result of a negative 
adjustment carryforward shall be treated as principal and translated at 
the spot rate on the date the instrument was issued or, if later, 
acquired.
    (iv) Amount realized--(A) Instrument held to maturity--(1) In 
general. With respect to an instrument held to maturity, a holder 
translates the amount realized by separating such amount in the 
denomination currency into the component parts of interest and principal 
that make up adjusted basis prior to translation under paragraph 
(b)(3)(iii) of this section, and translating each of those component 
parts of the amount realized at the same rate used to translate the 
respective component parts of basis under paragraph (b)(3)(iii) of this 
section. The amount realized first shall be translated by reference to 
the component parts of basis consisting of accrued interest during the 
taxpayer's holding period as determined under paragraph (b)(3)(iii) of 
this section and ordering such amounts on a last in first out basis. Any 
remaining portion of the amount realized shall be translated by 
reference to the rate used to translate the component of basis 
consisting of principal as determined under paragraph (b)(3)(iii) of 
this section.
    (2) Subsequent purchases at discount and fixed but deferred 
contingent payments. For purposes of this paragraph (b)(3)(iv) of this 
section, any amount which is required to be added to adjusted basis 
under paragraph (b)(7) or (8) of this section shall be treated as 
additional interest which was accrued on the date the amount was added 
to adjusted basis. To the extent included in amount realized, such 
amounts shall be translated into functional currency at the same rates 
at which they were

[[Page 683]]

translated for purposes of determining adjusted basis. See paragraphs 
(b)(7)(iv) and (b)(8) of this section for rules governing the rates at 
which the amounts are translated for purposes of determining adjusted 
basis.
    (B) Sale, exchange, or unscheduled retirement--(1) Holder. In the 
case of a sale, exchange, or unscheduled retirement, application of the 
rule stated in paragraph (b)(3)(iv)(A) of this section shall be as 
follows. The holder's amount realized first shall be translated by 
reference to the principal component of basis as determined under 
paragraph (b)(3)(iii) of this section, and then to the component of 
basis consisting of accrued interest as determined under paragraph 
(b)(3)(iii) of this section and ordering such amounts on a first in 
first out basis. Any gain recognized by the holder (i.e., any excess of 
the sale price over the holder's basis, both expressed in the 
denomination currency) is translated into functional currency at the 
spot rate on the payment date.
    (2) Issuer. In the case of an unscheduled retirement of the debt 
instrument, any excess of the adjusted issue price of the debt 
instrument over the amount paid by the issuer (expressed in denomination 
currency) shall first be attributable to accrued unpaid interest, to the 
extent the accrued unpaid interest had not been previously offset by a 
negative adjustment, on a last-in-first-out basis, and then to 
principal. The accrued unpaid interest shall be translated into 
functional currency at the rate at which the interest was accrued. The 
principal shall be translated at the spot rate on the date the debt 
instrument was issued.
    (C) Effect of negative adjustment carryforward with respect to the 
issuer. Any amount of negative adjustment carryforward treated as 
ordinary income under Sec. 1.1275-4(b)(6)(iii)(C) shall be translated 
at the exchange rate on the day the debt instrument was issued.
    (4) Determination of gain or loss not attributable to foreign 
currency. A holder of a debt instrument described in paragraph (a)(1)(i) 
of this section shall recognize gain or loss upon sale, exchange, or 
retirement of the instrument equal to the difference between the amount 
realized with respect to the instrument, translated into functional 
currency as described in paragraph (b)(3)(iv) of this section, and the 
adjusted basis in the instrument, determined and maintained in 
functional currency as described in paragraph (b)(3)(iii) of this 
section. The amount of any gain or loss so determined is characterized 
as provided in Sec. 1.1275-4(b)(8), and sourced as provided in 
paragraph (b)(6) of this section.
    (5) Determination of foreign currency gain or loss--(i) In general. 
Other than in a taxable disposition of the debt instrument, foreign 
currency gain or loss is recognized with respect to a debt instrument 
described in paragraph (a)(1)(i) of this section only when payments are 
made or received. No foreign currency gain or loss is recognized with 
respect to a net positive or negative adjustment, as determined under 
paragraph (b)(2)(ii) of this section (except with respect to a positive 
adjustment described in paragraph (b)(8) of this section). As described 
in this paragraph (b)(5), foreign currency gain or loss is determined in 
accordance with the rules of Sec. 1.988-2(b).
    (ii) Foreign currency gain or loss attributable to accrued interest. 
The amount of foreign currency gain or loss recognized with respect to 
payments of interest previously accrued on the instrument is determined 
by translating the amount of interest paid or received into functional 
currency at the spot rate on the date of payment and subtracting from 
such amount the amount determined by translating the interest paid or 
received into functional currency at the rate at which such interest was 
accrued under the rules of paragraph (b)(3)(i) of this section. For 
purposes of this paragraph, the amount of any payment that is treated as 
accrued interest shall be reduced by the amount of any net negative 
adjustment treated as ordinary loss (to the holder) or ordinary income 
(to the issuer), as provided in paragraph (b)(2)(ii) of this section. 
For purposes of determining whether the payment consists of interest or 
principal, see the payment ordering rules in paragraph (b)(5)(iv) of 
this section.
    (iii) Principal. The amount of foreign currency gain or loss 
recognized with

[[Page 684]]

respect to payment or receipt of principal is determined by translating 
the amount paid or received into functional currency at the spot rate on 
the date of payment or receipt and subtracting from such amount the 
amount determined by translating the principal into functional currency 
at the spot rate on the date the instrument was issued or, in case of 
the holder, if later, acquired. For purposes of determining whether the 
payment consists of interest or principal, see the payment ordering 
rules in paragraph (b)(5)(iv) of this section.
    (iv) Payment ordering rules--(A) In general. Except as provided in 
paragraph (b)(5)(iv)(B) of this section, payments with respect to an 
instrument described in paragraph (a)(1)(i) of this section shall be 
treated as follows:
    (1) A payment shall first be attributable to any net positive 
adjustment on the instrument that has not previously been taken into 
account.
    (2) Any amount remaining after applying paragraph (b)(5)(iv)(A)(1) 
of this section shall be attributable to accrued but unpaid interest, 
remaining after reduction by any net negative adjustment, and shall be 
attributable to the most recent accrual period to the extent prior 
amounts have not already been attributed to such period.
    (3) Any amount remaining after applying paragraphs (b)(5)(iv)(A)(1) 
and (2) of this section shall be attributable to principal. Any interest 
paid in the current year that is reduced by a net negative adjustment 
shall be considered a payment of principal for purposes of determining 
foreign currency gain or loss.
    (B) Special rule for sale or exchange or unscheduled retirement. 
Payments made or received upon a sale or exchange or unscheduled 
retirement shall first be applied against the principal of the debt 
instrument (or in the case of a subsequent purchaser, the purchase price 
of the instrument in denomination currency) and then against accrued 
unpaid interest (in the case of a holder, accrued while the holder held 
the instrument).
    (C) Subsequent purchaser that has a positive adjustment allocated to 
a daily portion of interest. A positive adjustment that is allocated to 
a daily portion of interest pursuant to paragraph (b)(7)(iv) of this 
section shall be treated as interest for purposes of applying the 
payment ordering rule of this paragraph (b)(5)(iv).
    (6) Source of gain or loss. The source of foreign currency gain or 
loss recognized with respect to an instrument described in paragraph 
(a)(1)(i) of this section shall be determined pursuant to Sec. 1.988-4. 
Consistent with the rules of Sec. 1.1275-4(b)(8), all gain (other than 
foreign currency gain) on an instrument described in paragraph (a)(1)(i) 
of this section is treated as interest income for all purposes. The 
source of an ordinary loss (other than foreign currency loss) with 
respect to an instrument described in paragraph (a)(1)(i) of this 
section shall be determined pursuant to Sec. 1.1275-4(b)(9)(iv). The 
source of a capital loss with respect to an instrument described in 
paragraph (a)(1)(i) of this section shall be determined pursuant to 
Sec. 1.865-1(b)(2).
    (7) Basis different from adjusted issue price--(i) In general. The 
rules of Sec. 1.1275-4(b)(9)(i), except as set forth in this paragraph 
(b)(7), shall apply to an instrument described in paragraph (a)(1)(i) of 
this section purchased by a subsequent holder for more or less than the 
instrument's adjusted issue price.
    (ii) Determination of basis. If an instrument described in paragraph 
(a)(1)(i) of this section is purchased by a subsequent holder, the 
subsequent holder's initial basis in the instrument shall equal the 
amount paid by the holder to acquire the instrument, translated into 
functional currency at the spot rate on the date of acquisition.
    (iii) Purchase price greater than adjusted issue price. If the 
purchase price of the instrument (determined in the denomination 
currency) exceeds the adjusted issue price of the instrument, the holder 
shall, consistent with the rules of Sec. 1.1275-4(b)(9)(i)(B), 
reasonably allocate such excess to the daily portions of interest 
accrued on the instrument or to a projected payment on the instrument. 
To the extent attributable to interest, the excess shall be reasonably 
allocated over the remaining term of the instrument to the daily 
portions of interest accrued and shall be a negative adjustment on the 
dates the daily

[[Page 685]]

portions accrue. On the date of such adjustment, the holder's adjusted 
basis in the instrument is reduced by the amount treated as a negative 
adjustment under this paragraph (b)(7)(iii), translated into functional 
currency at the rate used to translate the interest which is offset by 
the negative adjustment. To the extent related to a projected payment, 
such excess shall be treated as a negative adjustment on the date the 
payment is made. On the date of such adjustment, the holder's adjusted 
basis in the instrument is reduced by the amount treated as a negative 
adjustment under this paragraph (b)(7)(iii), translated into functional 
currency at the spot rate on the date the instrument was acquired.
    (iv) Purchase price less than adjusted issue price. If the purchase 
price of the instrument (determined in the denomination currency) is 
less than the adjusted issue price of the instrument, the holder shall, 
consistent with the rules of Sec. 1.1275-4(b)(9)(i)(C), reasonably 
allocate the difference to the daily portions of interest accrued on the 
instrument or to a projected payment on the instrument. To the extent 
attributable to interest, the difference shall be reasonably allocated 
over the remaining term of the instrument to the daily portions of 
interest accrued and shall be a positive adjustment on the dates the 
daily portions accrue. On the date of such adjustment, the holder's 
adjusted basis in the instrument is increased by the amount treated as a 
positive adjustment under this paragraph (b)(7)(iv), translated into 
functional currency at the rate used to translate the interest to which 
it relates. For purposes of determining adjusted basis under paragraph 
(b)(3)(iii) of this section, such increase in adjusted basis shall be 
treated as an additional accrual of interest during the period to which 
the positive adjustment relates. To the extent related to a projected 
payment, such difference shall be treated as a positive adjustment on 
the date the payment is made. On the date of such adjustment, the 
holder's adjusted basis in the instrument is increased by the amount 
treated as a positive adjustment under this paragraph (b)(7)(iv), 
translated into functional currency at the spot rate on the date the 
adjustment is taken into account. For purposes of determining the amount 
realized on the instrument in functional currency under paragraph 
(b)(3)(iv) of this section, amounts attributable to the excess of the 
adjusted issue price of the instrument over the purchase price of the 
instrument shall be translated into functional currency at the same rate 
at which the corresponding adjustments are taken into account under this 
paragraph (b)(7)(iv) for purposes of determining the adjusted basis of 
the instrument.
    (8) Fixed but deferred contingent payments. In the case of an 
instrument with a contingent payment that becomes fixed as to amount 
before the payment is due, the rules of Sec. 1.1275-4(b)(9)(ii) shall 
be applied in the denomination currency of the instrument. For this 
purpose, foreign currency gain or loss shall be recognized on the date 
payment is made or received with respect to the instrument under the 
principles of paragraph (b)(5) of this section. Any increase or decrease 
in basis required under Sec. 1.1275-4(b)(9)(ii)(D) shall be taken into 
account at the same exchange rate as the corresponding net positive or 
negative adjustment is taken into account.
    (c) Examples. The provisions of paragraph (b) of this section may be 
illustrated by the following examples. In each example, assume that the 
instrument described is a debt instrument for federal income tax 
purposes. No inference is intended, however, as to whether the 
instrument is a debt instrument for federal income tax purposes. The 
examples are as follows:

    Example 1. Treatment of net positive adjustment. (i) Facts. On 
December 31, 2004, Z, a calendar year U.S. resident taxpayer whose 
functional currency is the U.S. dollar, purchases from a foreign 
corporation, at original issue, a zero-coupon debt instrument with a 
non-currency contingency for [pound]1000. All payments of principal and 
interest with respect to the instrument are denominated in, or 
determined by reference to, a single nonfunctional currency (the British 
pound). The debt instrument would be subject to Sec. 1.1275-4(b) if it 
were denominated in dollars. The debt instrument's comparable yield, 
determined in British pounds under paragraph (b)(2)(i) of this section 
and Sec. 1.1275-4(b), is 10 percent, compounded annually, and the 
projected payment schedule, as constructed under the rules of Sec. 
1.1275-4(b), provides for a

[[Page 686]]

single payment of [pound]1210 on December 31, 2006 (consisting of a 
noncontingent payment of [pound]975 and a projected payment of 
[pound]235). The debt instrument is a capital asset in the hands of Z. Z 
does not elect to use the spot-rate convention described in Sec. 1.988-
2(b)(2)(iii)(B). The payment actually made on December 31, 2006, is 
[pound]1300. The relevant pound/dollar spot rates over the term of the 
instrument are as follows:

------------------------------------------------------------------------
                Date                     Spot rate (pounds to dollars)
------------------------------------------------------------------------
Dec. 31, 2004.......................  [pound]1.00 = $1.00
Dec. 31, 2005.......................  [pound]1.00 = $1.10
Dec. 31, 2006.......................  [pound]1.00 = $1.20
------------------------------------------------------------------------


------------------------------------------------------------------------
           Accrual period              Average rate (pounds to dollars)
------------------------------------------------------------------------
2005................................  [pound]1.00 = $1.05
2006................................  [pound]1.00 = $1.15
------------------------------------------------------------------------

    (ii) Treatment in 2005--(A) Determination of accrued interest. Under 
paragraph (b)(2)(i) of this section, and based on the comparable yield, 
Z accrues [pound]100 of interest on the debt instrument for 2005 (issue 
price of [pound]1000 x 10 percent). Under paragraph (b)(3)(i) of this 
section, Z translates the [pound]100 at the average exchange rate for 
the accrual period ($1.05 x [pound]100 = $105). Accordingly, Z has 
interest income in 2005 of $105.
    (B) Adjusted issue price and basis. Under paragraphs (b)(2)(iii) and 
(iv) of this section, the adjusted issue price of the debt instrument 
determined in pounds and Z's adjusted basis in dollars in the debt 
instrument are increased by the interest accrued in 2005. Thus, on 
January 1, 2006, the adjusted issue price of the debt instrument is 
[pound]1100. For purposes of determining Z's dollar basis in the debt 
instrument, the $1000 basis ($1.00 x [pound]1000 original cost basis) is 
increased by the [pound]100 of accrued interest, translated at the rate 
at which interest was accrued for 2005. See paragraph (b)(3)(iii) of 
this section. Accordingly, Z's adjusted basis in the debt instrument as 
of January 1, 2006, is $1105.
    (iii) Treatment in 2006--(A) Determination of accrued interest. 
Under paragraph (b)(2)(i) of this section, and based on the comparable 
yield, Z accrues [pound]110 of interest on the debt instrument for 2006 
(adjusted issue price of [pound]1100 x 10 percent). Under paragraph 
(b)(3)(i) of this section, Z translates the [pound]110 at the average 
exchange rate for the accrual period ($1.15 x [pound]110 = $126.50). 
Accordingly, Z has interest income in 2006 of $126.50.
    (B) Effect of net positive adjustment. The payment actually made on 
December 31, 2006, is [pound]1300, rather than the projected 
[pound]1210. Under paragraph (b)(2)(ii) of this section, Z has a net 
positive adjustment of [pound]90 on December 31, 2006, attributable to 
the difference between the amount of the actual payment and the amount 
of the projected payment. Under paragraph (b)(3)(ii)(A) of this section, 
the [pound]90 net positive adjustment is treated as additional interest 
income and is translated into dollars at the spot rate on the last day 
of the year ($1.20 x [pound]90 = $108). Accordingly, Z has a net 
positive adjustment of $108 resulting in a total interest inclusion for 
2006 of $234.50 ($126.50 + $108 = $234.50).
    (C) Adjusted issue price and basis. Based on the projected payment 
schedule, the adjusted issue price of the debt instrument immediately 
before the payment at maturity is [pound]1210 ([pound]1100 plus 
[pound]110 of accrued interest for 2006). Z's adjusted basis in dollars, 
based only on the noncontingent payment and the projected amount of the 
contingent payment to be received, is $1231.50 ($1105 plus $126.50 of 
accrued interest for 2006).
    (D) Amount realized. Even though Z receives [pound]1300 at maturity, 
for purposes of determining the amount realized, Z is treated under 
paragraph (b)(2)(v) of this section as receiving the projected amount of 
the contingent payment on December 31, 2006. Therefore, Z is treated as 
receiving [pound]1210 on December 31, 2006. Under paragraph (b)(3)(iv) 
of this section, Z translates its amount realized into dollars and 
computes its gain or loss on the instrument (other than foreign currency 
gain or loss) by breaking the amount realized into its component parts. 
Accordingly, [pound]100 of the [pound]1210 (representing the interest 
accrued in 2005) is translated at the rate at which it was accrued 
([pound]1 = $1.05), resulting in an amount realized of $105; [pound]110 
of the [pound]1210 (representing the interest accrued in 2006) is 
translated into dollars at the rate at which it was accrued ([pound]1 = 
$1.15), resulting in an amount realized of $126.50; and [pound]1000 of 
the [pound]1210 (representing a return of principal) is translated into 
dollars at the spot rate on the date the instrument was purchased 
([pound]1 = $1), resulting in an amount realized of $1000. Z's total 
amount realized is $1231.50, the same as its basis, and Z recognizes no 
gain or loss (before consideration of foreign currency gain or loss) on 
retirement of the instrument.
    (E) Foreign currency gain or loss. Under paragraph (b)(5) of this 
section Z recognizes foreign currency gain under section 988 on the 
instrument with respect to the consideration actually received at 
maturity (except for the net positive adjustment), [pound]1210. The 
amount of recognized foreign currency gain is determined based on the 
difference between the spot rate on the date the instrument matures and 
the rates at which the principal and interest were taken into account. 
With respect to the portion of the payment attributable to interest 
accrued in 2005, the foreign currency gain is $15 [[pound]100 x ($1.20-
$1.05)]. With respect to interest accrued in 2006, the foreign currency 
gain equals $5.50 [[pound]110 x ($1.20-$1.15)]. With respect to 
principal, the foreign currency gain

[[Page 687]]

is $200 [[pound]1000 x ($1.20-$1.00)]. Thus, Z recognizes a total 
foreign currency gain on December 31, 2006, of $220.50.
    (F) Source. Z has interest income of $105 in 2005, interest income 
of $234.50 in 2006 (attributable to [pound]110 of accrued interest and 
the [pound]90 net positive adjustment), and a foreign currency gain of 
$220.50 in 2006. Under paragraph (b)(6) of this section and section 
862(a)(1), the interest income is sourced by reference to the residence 
of the payor and is therefore from sources without the United States. 
Under paragraph (b)(6) of this section and Sec. 1.988-4, Z's foreign 
currency gain of $220.50 is sourced by reference to Z's residence and is 
therefore from sources within the United States.
    Example 2. Treatment of net negative adjustment. (i) Facts. Assume 
the same facts as in Example 1, except that Z receives [pound]975 at 
maturity instead of [pound]1300.
    (ii) Treatment in 2005. The treatment of the debt instrument in 2005 
is the same as in Example 1. Thus, Z has interest income in 2005 of 
$105. On January 1, 2006, the adjusted issue price of the debt 
instrument is [pound]1100, and Z's adjusted basis in the instrument is 
$1105.
    (iii) Treatment in 2006--(A) Determination of accrued interest. 
Under paragraph (b)(2)(i) of this section and based on the comparable 
yield, Z's accrued interest for 2006 is [pound]110 (adjusted issue price 
of [pound]1100 x 10 percent). Under paragraph (b)(3)(i) of this section, 
the [pound]110 of accrued interest is translated at the average exchange 
rate for the accrual period ($1.15 x [pound]110 = $126.50).
    (B) Effect of net negative adjustment. The payment actually made on 
December 31, 2006, is [pound]975, rather than the projected [pound]1210. 
Under paragraph (b)(2)(ii) of this section, Z has a net negative 
adjustment of [pound]235 on December 31, 2006, attributable to the 
difference between the amount of the actual payment and the amount of 
the projected payment. Z's accrued interest income of [pound]110 in 2006 
is reduced to zero by the net negative adjustment. Under paragraph 
(b)(3)(ii)(B)(1) of this section the net negative adjustment which 
reduces the current year's interest is not translated into functional 
currency. Under paragraph (b)(2)(ii) of this section, Z treats the 
remaining [pound]125 net negative adjustment as an ordinary loss to the 
extent of the [pound]100 previously accrued interest in 2005. This 
[pound]100 ordinary loss is attributable to interest accrued but not 
paid in the preceding year. Therefore, under paragraph (b)(3)(ii)(B)(2) 
of this section, Z translates the loss into dollars at the average rate 
for such year ([pound]1 = $1.05). Accordingly, Z has an ordinary loss of 
$105 in 2006. The remaining [pound]25 of net negative adjustment is a 
negative adjustment carryforward under paragraph (b)(2)(ii) of this 
section.
    (C) Adjusted issue price and basis. Based on the projected payment 
schedule, the adjusted issue price of the debt instrument immediately 
before the payment at maturity is [pound]1210 ([pound]1100 plus 
[pound]110 of accrued interest for 2006). Z's adjusted basis in dollars, 
based only on the noncontingent payments and the projected amount of the 
contingent payments to be received, is $1231.50 ($1105 plus $126.50 of 
accrued interest for 2006).
    (D) Amount realized. Even though Z receives [pound]975 at maturity, 
for purposes of determining the amount realized, Z is treated under 
paragraph (b)(2)(v) of this section as receiving the projected amount of 
the contingent payment on December 31, 2006, reduced by the amount of 
Z's negative adjustment carryforward of [pound]25. Therefore, Z is 
treated as receiving [pound]1185 ([pound]1210-[pound]25) on December 31, 
2006. Under paragraph (b)(3)(iv) of this section, Z translates its 
amount realized into dollars and computes its gain or loss on the 
instrument (other than foreign currency gain or loss) by breaking the 
amount realized into its component parts. Accordingly, [pound]100 of the 
[pound]1185 (representing the interest accrued in 2005) is translated at 
the rate at which it was accrued ([pound]1 = $1.05), resulting in an 
amount realized of $105; [pound]110 of the [pound]1185 (representing the 
interest accrued in 2006) is translated into dollars at the rate at 
which it was accrued ([pound]1 = $1.15), resulting in an amount realized 
of $126.50; and [pound]975 of the [pound]1185 (representing a return of 
principal) is translated into dollars at the spot rate on the date the 
instrument was purchased ([pound]1 = $1), resulting in an amount 
realized of $975. Z's amount realized is $1206.50 ($105 + $126.50 + $975 
= $1206.50), and Z recognizes a capital loss (before consideration of 
foreign currency gain or loss) of $25 on retirement of the instrument 
($1206.50-$1231.50 = -$25).
    (E) Foreign currency gain or loss. Z recognizes foreign currency 
gain with respect to the consideration actually received at maturity, 
[pound]975. Under paragraph (b)(5)(ii) of this section, no foreign 
currency gain or loss is recognized with respect to unpaid accrued 
interest reduced to zero by the net negative adjustment resulting in 
2006. In addition, no foreign currency gain or loss is recognized with 
respect to unpaid accrued interest from 2005, also reduced to zero by 
the ordinary loss. Accordingly, Z recognizes foreign currency gain with 
respect to principal only. Thus, Z recognizes a total foreign currency 
gain on December 31, 2006, of $195 [[pound]975 x ($1.20-$1.00)].
    (F) Source. In 2006, Z has an ordinary loss of $105, a capital loss 
of $25, and a foreign currency gain of $195. Under paragraph (b)(6) of 
this section and Sec. 1.1275-4(b)(9)(iv), the $105 ordinary loss 
generally reduces Z's foreign source passive income under section 904(d) 
and the regulations thereunder. Under paragraph (b)(6) of this section 
and Sec. 1.865-1(b)(2), the $25 capital loss is sourced by reference to 
how interest income on the instrument would have been sourced. 
Therefore, the $25 capital loss generally reduces Z's foreign

[[Page 688]]

source passive income under section 904(d) and the regulations 
thereunder. Under paragraph (b)(6) of this section and Sec. 1.988-4, 
Z's foreign currency gain of $195 is sourced by reference to Z's 
residence and is therefore from sources within the United States.
    Example 3. Negative adjustment and periodic interest payments. (i) 
Facts. On December 31, 2004, Z, a calendar year U.S. resident taxpayer 
whose functional currency is the U.S. dollar, purchases from a foreign 
corporation, at original issue, a two-year debt instrument with a non-
currency contingency for [pound]1000. All payments of principal and 
interest with respect to the instrument are denominated in, or 
determined by reference to, a single nonfunctional currency (the British 
pound). The debt instrument would be subject to Sec. 1.1275-4(b) if it 
were denominated in dollars. The debt instrument's comparable yield, 
determined in British pounds under Sec. Sec. 1.988-2(b)(2) and 1.1275-
4(b), is 10 percent, compounded semiannually. The debt instrument 
provides for semiannual interest payments of [pound]30 payable each June 
30, and December 31, and a contingent payment at maturity on December 
31, 2006, which is projected to equal [pound]1086.20 (consisting of a 
noncontingent payment of [pound]980 and a projected payment of 
[pound]106.20) in addition to the interest payable at maturity. The debt 
instrument is a capital asset in the hands of Z. Z does not elect to use 
the spot-rate convention described in Sec. 1.988-2(b)(2)(iii)(B). The 
payment actually made on December 31, 2006, is [pound]981.00. The 
relevant pound/dollar spot rates over the term of the instrument are as 
follows:

------------------------------------------------------------------------
                Date                     Spot rate (pounds to dollars)
------------------------------------------------------------------------
Dec. 31, 2004.......................  [pound]1.00 = $1.00
June 30, 2005.......................  [pound]1.00 = $1.20
Dec. 31, 2005.......................  [pound]1.00 = $1.40
June 30, 2006.......................  [pound]1.00 = $1.60
Dec. 31, 2006.......................  [pound]1.00 = $1.80
------------------------------------------------------------------------


------------------------------------------------------------------------
           Accrual period              Average rate (pounds to dollars)
------------------------------------------------------------------------
Jan.-June 2005......................  [pound]1.00 = $1.10
July-Dec. 2005......................  [pound]1.00 = $1.30
Jan.-June 2006......................  [pound]1.00 = $1.50
July-Dec. 2006......................  [pound]1.00 = $1.70
------------------------------------------------------------------------

    (ii) Treatment in 2005--(A) Determination of accrued interest. Under 
paragraph (b)(2)(i) of this section, and based on the comparable yield, 
Z accrues [pound]50 of interest on the debt instrument for the January-
June accrual period (issue price of [pound]1000 x 10 percent/2). Under 
paragraph (b)(3)(i) of this section, Z translates the [pound]50 at the 
average exchange rate for the accrual period ($1.10 x [pound]50 = 
$55.00). Similarly, Z accrues [pound]51 of interest in the July-December 
accrual period [([pound]1000 + [pound]50-[pound]30) x 10 percent/2], 
which is translated at the average exchange rate for the accrual period 
($1.30 x [pound]51 = $66.30). Accordingly, Z accrues $121.30 of interest 
income in 2005.
    (B) Adjusted issue price and basis--(1) January-June accrual period. 
Under paragraphs (b)(2)(iii) and (iv) of this section, the adjusted 
issue price of the debt instrument determined in pounds and Z's adjusted 
basis in dollars in the debt instrument are increased by the interest 
accrued, and decreased by the interest payment made, in the January-June 
accrual period. Thus, on July 1, 2005, the adjusted issue price of the 
debt instrument is [pound]1020 ([pound]1000 + [pound]50 - [pound]30 = 
[pound]1020). For purposes of determining Z's dollar basis in the debt 
instrument, the $1000 basis is increased by the [pound]50 of accrued 
interest, translated, under paragraph (b)(3)(iii) of this section, at 
the rate at which interest was accrued for the January-June accrual 
period ($1.10 x [pound]50 = $55). The resulting amount is reduced by the 
[pound]30 payment of interest made during the accrual period, 
translated, under paragraph (b)(3)(iii) of this section and Sec. 1.988-
2(b)(7), at the rate applicable to accrued interest ($1.10 x [pound]30 = 
$33). Accordingly, Z's adjusted basis as of July 1, 2005, is $1022 
($1000 + $55 - $33).
    (2) July-December accrual period. Under paragraphs (b)(2)(iii) and 
(iv) of this section, the adjusted issue price of the debt instrument 
determined in pounds and Z's adjusted basis in dollars in the debt 
instrument are increased by the interest accrued, and decreased by the 
interest payment made, in the July-December accrual period. Thus, on 
January 1, 2006, the adjusted issue price of the instrument is 
[pound]1041 ([pound]1020 + [pound]51 - [pound]30 = [pound]1041). For 
purposes of determining Z's dollar basis in the debt instrument, the 
$1022 basis is increased by the [pound]51 of accrued interest, 
translated, under paragraph (b)(3)(iii) of this section, at the rate at 
which interest was accrued for the July-December accrual period ($1.30 x 
[pound]51 = $66.30). The resulting amount is reduced by the [pound]30 
payment of interest made during the accrual period, translated, under 
paragraph (b)(3)(iii) of this section and Sec. 1.988-2(b)(7), at the 
rate applicable to accrued interest ($1.30 x [pound]30 = $39). 
Accordingly, Z's adjusted basis as of January 1, 2006, is $1049.30 
($1022 + $66.30 - $39).
    (C) Foreign currency gain or loss. Z will recognize foreign currency 
gain on the receipt of each [pound]30 payment of interest actually 
received during 2005. The amount of foreign currency gain in each case 
is determined, under paragraph (b)(5)(ii) of this section, by reference 
to the difference between the spot rate on the date the [pound]30 
payment was made and the average exchange rate for the accrual period 
during which the interest accrued. Accordingly, Z recognizes $3 of 
foreign currency gain on the January-June interest payment [[pound]30 x 
($1.20 - $1.10)], and $3 of foreign currency gain on the July-December 
interest payment [[pound]30 x ($1.40 - $1.30)]. Z recognizes in 2005 a 
total of $6 of foreign currency gain.

[[Page 689]]

    (D) Source. Z has interest income of $121.30 and a foreign currency 
gain of $6. Under paragraph (b)(6) of this section and section 
862(a)(1), the interest income is sourced by reference to the residence 
of the payor and is therefore from sources without the United States. 
Under paragraph (b)(6) of this section and Sec. 1.988-4, Z's foreign 
currency gain of $6 is sourced by reference to Z's residence and is 
therefore from sources within the United States.
    (iii) Treatment in 2006--(A) Determination of accrued interest. 
Under paragraph (b)(2)(i) of this section, and based on the comparable 
yield, Z's accrued interest for the January-June accrual period is 
[pound]52.05 (adjusted issue price of [pound]1041 x 10 percent/2). Under 
paragraph (b)(3)(i) of this section, Z translates the [pound]52.05 at 
the average exchange rate for the accrual period ($1.50 x [pound]52.05 = 
$78.08). Similarly, Z accrues [pound]53.15 of interest in the July-
December accrual period [([pound]1041 + [pound]52.05-[pound]30) x 10 
percent/2], which is translated at the average exchange rate for the 
accrual period ($1.70 x [pound]53.15 = $90.35). Accordingly, Z accrues 
[pound]105.20, or $168.43, of interest income in 2006.
    (B) Effect of net negative adjustment. The payment actually made on 
December 31, 2006, is [pound]981.00, rather than the projected 
[pound]1086.20. Under paragraph (b)(2)(ii)(B) of this section, Z has a 
net negative adjustment of [pound]105.20 on December 31, 2006, 
attributable to the difference between the amount of the actual payment 
and the amount of the projected payment. Z's accrued interest income of 
[pound]105.20 in 2006 is reduced to zero by the net negative adjustment. 
Elimination of the 2006 accrued interest fully utilizes the net negative 
adjustment.
    (C) Adjusted issue price and basis--(1) January-June accrual period. 
Under paragraphs (b)(2)(iii) and (iv) of this section, the adjusted 
issue price of the debt instrument determined in pounds and Z's adjusted 
basis in dollars in the debt instrument are increased by the interest 
accrued, and decreased by the interest payment made, in the January-June 
accrual period. Thus, on July 1, 2006, the adjusted issue price of the 
debt instrument is [pound]1063.05 ([pound]1041 + [pound]52.05 - 
[pound]30 = [pound]1063.05). For purposes of determining Z's dollar 
basis in the debt instrument, the $1049.30 adjusted basis is increased 
by the [pound]52.05 of accrued interest, translated, under paragraph 
(b)(3)(iii) of this section, at the rate at which interest was accrued 
for the January-June accrual period ($1.50 x [pound]52.05 = $78.08). The 
resulting amount is reduced by the [pound]30 payment of interest made 
during the accrual period, translated, under paragraph (b)(3)(iii) of 
this section and Sec. 1.988-2(b)(7), at the rate applicable to accrued 
interest ($1.50 x [pound]30 = $45). Accordingly, Z's adjusted basis as 
of July 1, 2006, is $1082.38 ($1049.30 + $78.08 - $45).
    (2) July-December accrual period. Under paragraphs (b)(2)(iii) and 
(iv) of this section, the adjusted issue price of the debt instrument 
determined in pounds and Z's adjusted basis in dollars in the debt 
instrument are increased by the interest accrued, and decreased by the 
interest payment made, in the July-December accrual period. Thus, 
immediately before maturity on December 31, 2006, the adjusted issue 
price of the instrument is [pound]1086.20 ([pound]1063.05 + [pound]53.15 
- [pound]30 = [pound]1086.20). For purposes of determining Z's dollar 
basis in the debt instrument, the $1082.38 adjusted basis is increased 
by the [pound]53.15 of accrued interest, translated, under paragraph 
(b)(3)(iii) of this section, at the rate at which interest was accrued 
for the July-December accrual period ($1.70 x [pound]53.15 = $90.36). 
The resulting amount is reduced by the [pound]30 payment of interest 
made during the accrual period, translated, under paragraph (b)(3)(iii) 
of this section and Sec. 1.988-2(b)(7), at the rate applicable to 
accrued interest ($1.70 x [pound]30 = $51). Accordingly, Z's adjusted 
basis on December 31, 2006, immediately prior to maturity is $1121.74 
($1082.38 + $90.36 - $51).
    (D) Amount realized. Even though Z receives [pound]981.00 at 
maturity, for purposes of determining the amount realized, Z is treated 
under paragraph (b)(2)(v) of this section as receiving the projected 
amount of the contingent payment on December 31, 2006. Therefore, Z is 
treated as receiving [pound]1086.20 on December 31, 2006. Under 
paragraph (b)(3)(iv) of this section, Z translates its amount realized 
into dollars and computes its gain or loss on the instrument (other than 
foreign currency gain or loss) by breaking the amount realized into its 
component parts. Accordingly, [pound]20 of the [pound]1086.20 
(representing the interest accrued in the January-June 2005 accrual 
period, less [pound]30 interest paid) is translated into dollars at the 
rate at which it was accrued ([pound]1 = $1.10), resulting in an amount 
realized of $22; [pound]21 of the [pound]1086.20 (representing the 
interest accrued in the July-December 2005 accrual period, less 
[pound]30 interest paid) is translated into dollars at the rate at which 
it was accrued ([pound]1 = $1.30), resulting in an amount realized of 
$27.30; [pound]22.05 of the [pound]1086.20 (representing the interest 
accrued in the January-June 2006 accrual period, less [pound]30 interest 
paid) is translated into dollars at the rate at which it was accrued 
([pound]1 = $1.50), resulting in an amount realized of $33.08; 
[pound]23.15 of the [pound]1086.20 (representing the interest accrued in 
the July 1-December 31, 2006 accrual period, less the [pound]30 interest 
payment) is translated into dollars at the rate at which it was accrued 
([pound]1 = $1.70), resulting in an amount realized of $39.36; and 
[pound]1000 (representing principal) is translated into dollars at the 
spot rate on the date the instrument was purchased ([pound]1 = $1), 
resulting in an amount realized of $1000. Accordingly, Z's total amount 
realized is $1121.74 ($22 + $27.30 + $33.08 + $39.36 + $1000), the same 
as its basis, and Z recognizes no gain or loss (before consideration of 
foreign

[[Page 690]]

currency gain or loss) on retirement of the instrument.
    (E) Foreign currency gain or loss. Z recognizes foreign currency 
gain with respect to each [pound]30 payment actually received during 
2006. These payments, however, are treated as payments of principal for 
this purpose because all 2006 accrued interest is reduced to zero by the 
net negative adjustment. See paragraph (b)(5)(iv)(A)(3) of this section. 
The amount of foreign currency gain in each case is determined, under 
paragraph (b)(5)(iii) of this section, by reference to the difference 
between the spot rate on the date the [pound]30 payment is made and the 
spot rate on the date the debt instrument was issued. Accordingly, Z 
recognizes $18 of foreign currency gain on the January-June 2006 
interest payment [[pound]30 x ($1.60 - $1.00)], and $24 of foreign 
currency gain on the July-December 2006 interest payment [[pound]30 x 
($1.80 - $1.00)]. Z separately recognizes foreign currency gain with 
respect to the consideration actually received at maturity, 
[pound]981.00. The amount of such gain is determined based on the 
difference between the spot rate on the date the instrument matures and 
the rates at which the principal and interest were taken into account. 
With respect to the portion of the payment attributable to interest 
accrued in January-June 2005 (other than the [pound]30 payments), the 
foreign currency gain is $14 [[pound]20 x ($1.80 - $1.10)]. With respect 
to the portion of the payment attributable to interest accrued in July-
December 2005 (other than the [pound]30 payments), the foreign currency 
gain is $10.50 [[pound]21 x ($1.80 - $1.30)]. With respect to the 
portion of the payment attributable to interest accrued in 2006 (other 
than the [pound]30 payments), no foreign currency gain or loss is 
recognized under paragraph (b)(5)(ii) of this section because such 
interest was reduced to zero by the net negative adjustment. With 
respect to the portion of the payment attributable to principal, the 
foreign currency gain is $752 [[pound]940 x ($1.80 - $1.00)]. Thus, Z 
recognizes a foreign currency gain of $42 on receipt of the two 
[pound]30 payments in 2006, and $776.50 ($14 + $10.50 + $752) on receipt 
of the payment at maturity, for a total 2006 foreign currency gain of 
$818.50.
    (F) Source. Under paragraph (b)(6) of this section and Sec. 1.988-
4, Z's foreign currency gain of $818.50 is sourced by reference to Z's 
residence and is therefore from sources within the United States.
    Example 4. Purchase price greater than adjusted issue price. (i) 
Facts. On July 1, 2005, Z, a calendar year U.S. resident taxpayer whose 
functional currency is the U.S. dollar, purchases a debt instrument with 
a non-currency contingency for [pound]1405. All payments of principal 
and interest with respect to the instrument are denominated in, or 
determined by reference to, a single nonfunctional currency (the British 
pound). The debt instrument would be subject to Sec. 1.1275-4(b) if it 
were denominated in dollars. The debt instrument was originally issued 
by a foreign corporation on December 31, 2003, for an issue price of 
[pound]1000, and matures on December 31, 2006. The debt instrument's 
comparable yield, determined in British pounds under Sec. Sec. 1.988-
2(b)(2) and 1.1275-4(b), is 10.25 percent, compounded semiannually, and 
the projected payment schedule for the debt instrument (determined as of 
the issue date under the rules of Sec. 1.1275-4(b)) provides for a 
single payment at maturity of [pound]1349.70 (consisting of a 
noncontingent payment of [pound]1000 and a projected payment of 
[pound]349.70). At the time of the purchase, the adjusted issue price of 
the debt instrument is [pound]1161.76, assuming semiannual accrual 
periods ending on June 30 and December 31 of each year. The increase in 
the value of the debt instrument over its adjusted issue price is due to 
an increase in the expected amount of the contingent payment. The debt 
instrument is a capital asset in the hands of Z. Z does not elect to use 
the spot-rate convention described in Sec. 1.988-2(b)(2)(iii)(B). The 
payment actually made on December 31, 2006, is [pound]1400. The relevant 
pound/dollar spot rates over the term of the instrument are as follows:

------------------------------------------------------------------------
                Date                     Spot rate (pounds to dollars)
------------------------------------------------------------------------
July 1, 2005........................  [pound]1.00 = $1.00
Dec. 31, 2006.......................  [pound]1.00 = $2.00
------------------------------------------------------------------------


------------------------------------------------------------------------
           Accrual period              Average rate (pounds to dollars)
------------------------------------------------------------------------
July 1-Dec. 31, 2005................  [pound]1.00 = $1.50
Jan. 1-June 30, 2006................  [pound]1.00 = $1.50
July 1-Dec. 31, 2006................  [pound]1.00 = $1.50
------------------------------------------------------------------------

    (ii) Initial basis. Under paragraph (b)(7)(ii) of this section, Z's 
initial basis in the debt instrument is $1405, Z's purchase price of 
[pound]1405, translated into functional currency at the spot rate on the 
date the debt instrument was purchased ([pound]1 = $1).
    (iii) Allocation of purchase price differential. Z purchased the 
debt instrument for [pound]1405 when its adjusted issue price was 
[pound]1161.76. Under paragraph (b)(7)(iii) of this section, Z allocates 
the [pound]243.24 excess of purchase price over adjusted issue price to 
the contingent payment at maturity. This allocation is reasonable 
because the excess is due to an increase in the expected amount of the 
contingent payment and not, for example, to a decrease in prevailing 
interest rates.
    (iv) Treatment in 2005--(A) Determination of accrued interest. Under 
paragraph (b)(2)(i) of this section, and based on the comparable yield, 
Z accrues [pound]59.54 of interest on the debt instrument for the July-
December 2005 accrual period (issue price of [pound]1161.76 x 10.25 
percent/2). Under paragraph (b)(3)(i) of this section, Z translates the 
[pound]59.54 of interest at

[[Page 691]]

the average exchange rate for the accrual period ($1.50 x [pound]59.54 = 
$89.31). Accordingly, Z has interest income in 2005 of $89.31.
    (B) Adjusted issue price and basis. Under paragraphs (b)(2)(iii) and 
(iv) of this section, the adjusted issue price of the debt instrument 
determined in pounds and Z's adjusted basis in dollars in the debt 
instrument are increased by the interest accrued in July-December 2005. 
Thus, on January 1, 2006, the adjusted issue price of the debt 
instrument is [pound]1221.30 ([pound]1161.76 + [pound]59.54). For 
purposes of determining Z's dollar basis in the debt instrument on 
January 1, 2006, the $1405 basis is increased by the [pound]59.54 of 
accrued interest, translated at the rate at which interest was accrued 
for the July-December 2005 accrual period. Paragraph (b)(3)(iii) of this 
section. Accordingly, Z's adjusted basis in the instrument, as of 
January 1, 2006, is $1494.31 [$1405 + ([pound]59.54 x $1.50)].
    (v) Treatment in 2006--(A) Determination of accrued interest. Under 
paragraph (b)(2)(i) of this section, and based on the comparable yield, 
Z accrues [pound]62.59 of interest on the debt instrument for the 
January-June 2006 accrual period (issue price of [pound]1221.30 x 10.25 
percent/2). Under paragraph (b)(3)(i) of this section, Z translates the 
[pound]62.59 of accrued interest at the average exchange rate for the 
accrual period ($1.50 x [pound]62.59 = $93.89). Similarly, Z accrues 
[pound]65.80 of interest in the July-December 2006 accrual period 
[([pound]1221.30 + [pound]62.59) x 10.25 percent/2], which is translated 
at the average exchange rate for the accrual period ($1.50 x 
[pound]65.80 = $98.70). Accordingly, Z accrues [pound]128.39, or 
$192.59, of interest income in 2006.
    (B) Effect of positive and negative adjustments--(1) Offset of 
positive adjustment. The payment actually made on December 31, 2006, is 
[pound]1400, rather than the projected [pound]1349.70. Under paragraph 
(b)(2)(ii) of this section, Z has a positive adjustment of [pound]50.30 
on December 31, 2006, attributable to the difference between the amount 
of the actual payment and the amount of the projected payment. Under 
paragraph (b)(7)(iii) of this section, however, Z also has a negative 
adjustment of [pound]243.24, attributable to the excess of Z's purchase 
price for the debt instrument over its adjusted issue price. 
Accordingly, Z will have a net negative adjustment of [pound]192.94 
([pound]50.30-[pound]243.24 = [pound]192.94) for 2006.
    (2) Offset of accrued interest. Z's accrued interest income of 
[pound]128.39 in 2006 is reduced to zero by the net negative adjustment. 
The net negative adjustment which reduces the current year's interest is 
not translated into functional currency. Under paragraph (b)(2)(ii) of 
this section, Z treats the remaining [pound]64.55 net negative 
adjustment as an ordinary loss to the extent of the [pound]59.54 
previously accrued interest in 2005. This [pound]59.54 ordinary loss is 
attributable to interest accrued but not paid in the preceding year. 
Therefore, under paragraph (b)(3)(ii)(B)(2) of this section, Z 
translates the loss into dollars at the average rate for such year 
([pound]1 = $1.50). Accordingly, Z has an ordinary loss of $89.31 in 
2006. The remaining [pound]5.01 of net negative adjustment is a negative 
adjustment carryforward under paragraph (b)(2)(ii) of this section.
    (C) Adjusted issue price and basis--(1) January-June accrual period. 
Under paragraph (b)(2)(iii) of this section, the adjusted issue price of 
the debt instrument on July 1, 2006, is [pound]1283.89 ([pound]1221.30 + 
[pound]62.59 = [pound]1283.89). Under paragraphs (b)(2)(iv) and 
(b)(3)(iii) of this section, Z's adjusted basis as of July 1, 2006, is 
$1588.20 ($1494.31 + $93.89).
    (2) July-December accrual period. Based on the projected payment 
schedule, the adjusted issue price of the debt instrument immediately 
before the payment at maturity is [pound]1349.70 ([pound]1283.89 + 
[pound]65.80 accrued interest for July-December). Z's adjusted basis in 
dollars, based only on the noncontingent payments and the projected 
amount of the contingent payments to be received, is $1686.90 ($1588.20 
plus $98.70 of accrued interest for July-December).
    (3) Adjustment to basis upon contingent payment. Under paragraph 
(b)(7)(iii) of this section, Z's adjusted basis in the debt instrument 
is reduced at maturity by [pound]243.24, the excess of Z's purchase 
price for the debt instrument over its adjusted issue price. For this 
purpose, the adjustment is translated into functional currency at the 
spot rate on the date the instrument was acquired ([pound]1 = $1). 
Accordingly, Z's adjusted basis in the debt instrument at maturity is 
$1443.66 ($1686.90-$243.24).
    (D) Amount realized. Even though Z receives [pound]1400 at maturity, 
for purposes of determining the amount realized, Z is treated under 
paragraph (b)(2)(v) of this section as receiving the projected amount of 
the contingent payment on December 31, 2006, reduced by the amount of 
Z's negative adjustment carryforward of [pound]5.01. Therefore, Z is 
treated as receiving [pound]1344.69 ([pound]1349.70-[pound]5.01) on 
December 31, 2006. Under paragraph (b)(3)(iv) of this section, Z 
translates its amount realized into dollars and computes its gain or 
loss on the instrument (other than foreign currency gain or loss) by 
breaking the amount realized into its component parts. Accordingly, 
[pound]59.54 of the [pound]1344.69 (representing the interest accrued in 
2005) is translated at the rate at which it was accrued ([pound]1 = 
$1.50), resulting in an amount realized of $89.31; [pound]62.59 of the 
[pound]1344.69 (representing the interest accrued in January-June 2006) 
is translated into dollars at the rate at which it was accrued ([pound]1 
= $1.50), resulting in an amount realized of $93.89; [pound]65.80 of the 
[pound]1344.69 (representing the interest accrued in July-December 2006) 
is translated into dollars at the rate at which it was accrued ([pound]1 
= $1.50), resulting in an amount realized of $98.70; and [pound]1156.76 
of the [pound]1344.69

[[Page 692]]

(representing a return of principal) is translated into dollars at the 
spot rate on the date the instrument was purchased ([pound]1 = $1), 
resulting in an amount realized of $1156.76. Z's amount realized is 
$1438.66 ($89.31 + $93.89 + $98.70 + $1156.76), and Z recognizes a 
capital loss (before consideration of foreign currency gain or loss) of 
$5 on retirement of the instrument ($1438.66 - $1443.66 = -$5).
    (E) Foreign currency gain or loss. Z recognizes foreign currency 
gain under section 988 on the instrument with respect to the entire 
consideration actually received at maturity, [pound]1400. While foreign 
currency gain or loss ordinarily would not have arisen with respect to 
[pound]50.30 of the [pound]1400, which was initially treated as a 
positive adjustment in 2006, the larger negative adjustment in 2006 
reduced this positive adjustment to zero. Accordingly, foreign currency 
gain or loss is recognized with respect to the entire [pound]1400. Under 
paragraph (b)(5)(ii) of this section, however, no foreign currency gain 
or loss is recognized with respect to unpaid accrued interest reduced to 
zero by the net negative adjustment resulting in 2006, and no foreign 
currency gain or loss is recognized with respect to unpaid accrued 
interest from 2005, also reduced to zero by the ordinary loss. 
Therefore, the entire [pound]1400 is treated as a return of principal 
for the purpose of determining foreign currency gain or loss, and Z 
recognizes a total foreign currency gain on December 31, 2001, of $1400 
[[pound]1400 x ($2.00-$1.00)].
    (F) Source. Z has an ordinary loss of $89.31, a capital loss of $5, 
and a foreign currency gain of $1400. Under paragraph (b)(6) of this 
section and Sec. 1.1275-4(b)(9)(iv), the $89.31 ordinary loss generally 
reduces Z's foreign source passive income under section 904(d) and the 
regulations thereunder. Under paragraph (b)(6) of this section and Sec. 
1.865-1(b)(2), the $5 capital loss is sourced by reference to how 
interest income on the instrument would have been sourced. Therefore, 
the $5 capital loss generally reduces Z's foreign source passive income 
under section 904(d) and the regulations thereunder. Under paragraph 
(b)(6) of this section and Sec. 1.988-4, Z's foreign currency gain of 
$1400 is sourced by reference to Z's residence and is therefore from 
sources within the United States.
    Example 5. Sale of an instrument with a negative adjustment 
carryforward. (i) Facts. On December 31, 2003, Z, a calendar year U.S. 
resident taxpayer whose functional currency is the U.S. dollar, 
purchases at original issue a debt instrument with non-currency 
contingencies for [pound]1000. All payments of principal and interest 
with respect to the instrument are denominated in, or determined by 
reference to, a single nonfunctional currency (the British pound). The 
debt instrument would be subject to Sec. 1.1275-4(b) if it were 
denominated in dollars. The debt instrument's comparable yield, 
determined in British poundsunder Sec. Sec. 1.988-2(b)(2) and 1.1275-
4(b), is 10 percent, compounded annually, and the projected payment 
schedule for the debt instrument provides for payments of [pound]310 on 
December 31, 2005 (consisting of a noncontingent payment of [pound]50 
and a projected amount of [pound]260) and [pound]990 on December 31, 
2006 (consisting of a noncontingent payment of [pound]940 and a 
projected amount of [pound]50). The debt instrument is a capital asset 
in the hands of Z. Z does not elect to use the spot-rate convention 
described in Sec. 1.988-2(b)(2)(iii)(B). The payment actually made on 
December 31, 2005, is [pound]50. On December 30, 2006, Z sells the debt 
instrument for [pound]940. The relevant pound/dollar spot rates over the 
term of the instrument are as follows:

------------------------------------------------------------------------
                Date                     Spot rate (pounds to dollars)
------------------------------------------------------------------------
Dec. 31, 2003.......................  [pound]1.00 = $1.00
Dec. 31, 2005.......................  [pound]1.00 = $2.00
Dec. 30, 2006.......................  [pound]1.00 = $2.00
------------------------------------------------------------------------


------------------------------------------------------------------------
           Accrual period              Average rate (pounds to dollars)
------------------------------------------------------------------------
Jan. 1-Dec. 31, 2004................  [pound]1.00 = $2.00
Jan. 1-Dec. 31, 2005................  [pound]1.00 = $2.00
Jan. 1-Dec. 31, 2006................  [pound]1.00 = $2.00
------------------------------------------------------------------------

    (ii) Treatment in 2004--(A) Determination of accrued interest. Under 
paragraph (b)(2)(i) of this section, and based on the comparable yield, 
Z accrues [pound]100 of interest on the debt instrument for 2004 (issue 
price of [pound]1000 x 10 percent). Under paragraph (b)(3)(i) of this 
section, Z translates the [pound]100 at the average exchange rate for 
the accrual period ($2.00 x [pound]100 = $200). Accordingly, Z has 
interest income in 2004 of $200.
    (B) Adjusted issue price and basis. Under paragraphs (b)(2)(iii) and 
(iv) of this section, the adjusted issue price of the debt instrument 
determined in pounds and Z's adjusted basis in dollars in the debt 
instrument are increased by the interest accrued in 2004. Thus, on 
January 1, 2005, the adjusted issue price of the debt instrument is 
[pound]1100. For purposes of determining Z's dollar basis in the debt 
instrument, the $1000 basis ($1.00 x [pound]1000 original cost basis) is 
increased by the [pound]100 of accrued interest, translated at the rate 
at which interest was accrued for 2004. See paragraph (b)(3)(iii) of 
this section. Accordingly, Z's adjusted basis in the debt instrument as 
of January 1, 2005, is $1200 ($1000 + $200).
    (iii) Treatment in 2005--(A) Determination of accrued interest. 
Under paragraph (b)(2)(i) of this section, and based on the comparable 
yield, Z's accrued interest for 2005 is [pound]110 (adjusted issue price 
of [pound]1100 x 10 percent). Under paragraph (b)(3)(i) of this section, 
the [pound]110 of accrued interest is translated at the average exchange 
rate for the accrual period ($2.00 x [pound]110 = $220).

[[Page 693]]

    (B) Effect of net negative adjustment. The payment actually made on 
December 31, 2005, is [pound]50, rather than the projected [pound]310. 
Under paragraph (b)(2)(ii) of this section, Z has a net negative 
adjustment of [pound]260 on December 31, 2005, attributable to the 
difference between the amount of the actual payment and the amount of 
the projected payment. Z's accrued interest income of [pound]110 in 2005 
is reduced to zero by the net negative adjustment. Under paragraph 
(b)(3)(ii)(B)(1) of this section, the net negative adjustment which 
reduces the current year's interest is not translated into functional 
currency. Under paragraph (b)(2)(ii) of this section, Z treats the 
remaining [pound]150 net negative adjustment as an ordinary loss to the 
extent of the [pound]100 previously accrued interest in 2004. This 
[pound]100 ordinary loss is attributable to interest accrued but not 
paid in the preceding year. Therefore, under paragraph (b)(3)(ii)(B)(2) 
of this section, Z translates the loss into dollars at the average rate 
for such year ([pound]1 = $2.00). Accordingly, Z has an ordinary loss of 
$200 in 2005. The remaining [pound]50 of net negative adjustment is a 
negative adjustment carryforward under paragraph (b)(2)(ii) of this 
section.
    (C) Adjusted issue price and basis. Based on the projected payment 
schedule, the adjusted issue price of the debt instrument on January 1, 
2006 is [pound]900, i.e., the adjusted issue price of the debt 
instrument on January 1, 2005 ([pound]1100), increased by the interest 
accrued in 2005 ([pound]110), and decreased by the projected amount of 
the December 31, 2005, payment ([pound]310). See paragraph (b)(2)(iii) 
of this section. Z's adjusted basis on January 1, 2006 is Z's adjusted 
basis on January 1, 2005 ($1200), increased by the functional currency 
amount of interest accrued in 2005 ($220), and decreased by the amount 
of the payments made in 2005, based solely on the projected payment 
schedule, ([pound]310). The amount of the projected payment is first 
attributable to the interest accrued in 2005 ([pound]110), and then to 
the interest accrued in 2004 ([pound]100), and the remaining amount to 
principal ([pound]100). The interest component of the projected payment 
is translated into functional currency at the rates at which it was 
accrued, and the principal component of the projected payment is 
translated into functional currency at the spot rate on the date the 
instrument was issued. See paragraph (b)(3)(iii) of this section. 
Accordingly, Z's adjusted basis in the debt instrument, following the 
increase of adjusted basis for interest accrued in 2005 ($1200 + $220 = 
$1420), is decreased by $520 ($220 + $200 + $100 = $520). Z's adjusted 
basis on January 1, 2006 is therefore, $900.
    (D) Foreign currency gain or loss. Z will recognize foreign currency 
gain on the receipt of the [pound]50 payment actually received on 
December 31, 2005. Based on paragraph (b)(5)(iv) of this section, the 
[pound]50 payment is attributable to principal since the accrued unpaid 
interest was completely eliminated by the net negative adjustment. The 
amount of foreign currency gain is determined, under paragraph 
(b)(5)(iii) of this section, by reference to the difference between the 
spot rate on the date the [pound]50 payment was made and the spot rate 
on the date the debt instrument was issued. Accordingly, Z recognizes 
$50 of foreign currency gain on the [pound]50 payment. [($2.00--$1.00) x 
[pound]50 = $50]. Under paragraph (b)(6) of this section and Sec. 
1.988-4, Z's foreign currency gain of $50 is sourced by reference to Z's 
residence and is therefore from sources within the United States.
    (iv) Treatment in 2006--(A) Determination of accrued interest. Under 
paragraph (b)(2)(i) of this section, and based on the comparable yield, 
Z accrues [pound]90 of interest on the debt instrument for 2006 
(adjusted issue price of [pound]900 x 10 percent). Under paragraph 
(b)(3)(i) of this section, Z translates the [pound]90 at the average 
exchange rate for the accrual period ($2.00 x [pound]90 = $180). 
Accordingly, prior to taking into account the 2005 negative adjustment 
carryforward, Z has interest income in 2006 of $180.
    (B) Effect of net negative adjustment. The [pound]50 negative 
adjustment carryforward from 2005 is a negative adjustment for 2006. 
Since there are no other positive or negative adjustments, there is a 
[pound]50 negative adjustment in 2006 which reduces Z's accrued interest 
income by [pound]50. Accordingly, after giving effect to the [pound]50 
negative adjustment carryforward, Z will accrue $80 of interest income. 
[([pound]90-[pound]50) x $2.00 = $80]
    (C) Adjusted issue price. Under paragraph (b)(2)(iii) of this 
section, the adjusted issue price of the debt instrument determined in 
pounds is increased by the interest accrued in 2006 (prior to taking 
into account the negative adjustment carryforward). Thus, on December 
30, 2006, the adjusted issue price of the debt instrument is [pound]990.
    (D) Adjusted basis. For purposes of determining Z's dollar basis in 
the debt instrument, Z's $900 adjusted basis on January 1, 2006, is 
increased by the accrued interest, translated at the rate at which 
interest was accrued for 2006. See paragraph (b)(3)(iii)(A) of this 
section. Note, however, that under paragraph (b)(3)(iii)(B) of this 
section the amount of accrued interest which is reduced as a result of 
the negative adjustment carryforward, i.e., [pound]50, is treated for 
purposes of this section as principal, and is translated at the spot 
rate on the date the instrument was issued, i.e., [pound]1.00 = $1.00. 
Accordingly, Z's adjusted basis in the debt instrument as of December 
30, 2006, is $1030 ($900 + $50 + $80).
    (E) Amount realized. Z's amount realized in denomination currency is 
[pound]940, i.e., the amount of pounds Z received on the sale of the 
debt instrument. Under paragraph (b)(3)(iv)(B)(1) of this section, Z's 
amount realized is first translated by reference to the principal 
component of basis (including the

[[Page 694]]

amount which is treated as principal under paragraph (b)(3)(iii)(B) of 
this section) and then the remaining amount realized, if any, is 
translated by reference to the accrued unpaid interest component of 
adjusted basis. Thus, [pound]900 of Z's amount realized is translated by 
reference to the principal component of adjusted basis. The remaining 
[pound]40 of Z's amount realized is treated as principal under paragraph 
(b)(3)(iii)(B) of this section, and is also translated by reference to 
the principal component of adjusted basis. Accordingly, Z's amount 
realized in functional currency is $940. (No part of Z's amount realized 
is attributable to the interest accrued on the debt instrument.) Z 
realizes a loss of $90 on the sale of the debt instrument ($1030 basis-
$940 amount realized). Under paragraph (b)(4) of this section and Sec. 
1.1275-4(b)(8), $80 of the loss is characterized as ordinary loss, and 
the remaining $10 of loss is characterized as capital loss. Under 
Sec. Sec. 1.988-6(b)(6) and 1.1275-4(b)(9)(iv) the $80 ordinary loss is 
treated as a deduction that is definitely related to the interest income 
accrued on the debt instrument. Similarly, under Sec. Sec. 1.988-
6(b)(6) and 1.865-1(b)(2) the $10 capital loss is also allocated to the 
interest income from the debt instrument.
    (F) Foreign currency gain or loss. Z recognizes foreign currency 
gain with respect to the [pound]940 he received on the sale of the debt 
instrument. Under paragraph (b)(5)(iv) of this section, the [pound]940 Z 
received is attributable to principal (and the amount which is treated 
as principal under paragraph (b)(3)(iii)(B) of this section). Thus, Z 
recognizes foreign currency gain on December 31, 2006, of $940. [($2.00-
$1.00) x [pound]940]. Under paragraph (b)(6) of this section and Sec. 
1.988-4, Z's foreign currency gain of $940 is sourced by reference to 
Z's residence and is therefore from sources within the United States.

    (d) Multicurrency debt instruments--(1) In general. Except as 
provided in this paragraph (d), a multicurrency debt instrument 
described in paragraph (a)(1)(ii) or (iii) of this section shall be 
treated as an instrument described in paragraph (a)(1)(i) of this 
section and shall be accounted for under the rules of paragraph (b) of 
this section. Because payments on an instrument described in paragraph 
(a)(1)(ii) or (iii) of this section are denominated in, or determined by 
reference to, more than one currency, the issuer and holder or holders 
of the instrument are required to determine the denomination currency of 
the instrument under paragraph (d)(2) of this section before applying 
the rules of paragraph (b) of this section.
    (2) Determination of denomination currency--(i) In general. The 
denomination currency of an instrument described in paragraph (a)(1)(ii) 
or (iii) of this section shall be the predominant currency of the 
instrument. Except as otherwise provided in paragraph (d)(2)(ii) of this 
section, the predominant currency of the instrument shall be the 
currency with the greatest value determined by comparing the functional 
currency value of the noncontingent and projected payments denominated 
in, or determined by reference to, each currency on the issue date, 
discounted to present value (in each relevant currency), and translated 
(if necessary) into functional currency at the spot rate on the issue 
date. For this purpose, the applicable discount rate may be determined 
using any method, consistently applied, that reasonably reflects the 
instrument's economic substance. If a taxpayer does not determine a 
discount rate using such a method, the Commissioner may choose a method 
for determining the discount rate that does reflect the instrument's 
economic substance. The predominant currency is determined as of the 
issue date and does not change based on subsequent events (e.g., changes 
in value of one or more currencies).
    (ii) Difference in discount rate of greater than 10 percentage 
points. This Sec. 1.988-6(d)(2)(ii) applies if no currency has a value 
determined under paragraph (d)(2)(i) of this section that is greater 
than 50% of the total value of all payments. In such a case, if the 
difference between the discount rate in the denomination currency 
otherwise determined under (d)(2)(i) of this section and the discount 
rate determined under paragraph (d)(2)(i) of this section with respect 
to any other currency in which payments are made (or determined by 
reference to) pursuant to the instrument is greater than 10 percentage 
points, then the Commissioner may determine the predominant currency 
under any reasonable method.
    (3) Issuer/holder consistency. The issuer determines the 
denomination currency under the rules of paragraph (d)(2) of this 
section and provides this information to the holders of the instrument 
in a manner consistent with the issuer disclosure rules of Sec. 1.1275-

[[Page 695]]

2(e). If the issuer does not determine the denomination currency of the 
instrument, or if the issuer's determination is unreasonable, the holder 
of the instrument must determine the denomination currency under the 
rules of paragraph (d)(2) of this section. A holder that determines the 
denomination currency itself must explicitly disclose this fact on a 
statement attached to the holder's timely filed federal income tax 
return for the taxable year that includes the acquisition date of the 
instrument.
    (4) Treatment of payments in currencies other than the denomination 
currency. For purposes of applying the rules of paragraph (b) of this 
section to debt instruments described in paragraph (a)(1)(ii) or (iii) 
of this section, payments not denominated in (or determined by reference 
to) the denomination currency shall be treated as non-currency-related 
contingent payments. Accordingly, if the denomination currency of the 
instrument is determined to be the taxpayer's functional currency, the 
instrument shall be accounted for under Sec. 1.1275-4(b) rather than 
under this section.
    (e) Instruments issued for nonpublicly traded property--(1) 
Applicability. This paragraph (e) applies to debt instruments issued for 
nonpublicly traded property that would be described in paragraph 
(a)(1)(i), (ii), or (iii) of this section, but for the fact that such 
instruments are described in Sec. 1.1275-4(c)(1) rather than Sec. 
1.1275-4(b)(1). For example, this paragraph (e) generally applies to a 
contingent payment debt instrument denominated in a nonfunctional 
currency that is issued for non-publicly traded property. Generally the 
rules of Sec. 1.1275-4(c) apply except as set forth by the rules of 
this paragraph (e).
    (2) Separation into components. An instrument described in this 
paragraph (e) is not accounted for using the noncontingent bond method 
of Sec. 1.1275-4(b) and paragraph (b) of this section. Rather, the 
instrument is separated into its component payments. Each noncontingent 
payment or group of noncontingent payments which is denominated in a 
single currency shall be considered a single component treated as a 
separate debt instrument denominated in the currency of the payment or 
group of payments. Each contingent payment shall be treated separately 
as provided in paragraph (e)(4) of this section.
    (3) Treatment of components consisting of one or more noncontingent 
payments in the same currency. The issue price of each component treated 
as a separate debt instrument which consists of one or more 
noncontingent payments is the sum of the present values of the 
noncontingent payments contained in the separate instrument. The present 
value of any noncontingent payment shall be determined under Sec. 
1.1274-2(c)(2), and the test rate shall be determined under Sec. 
1.1274-4 with respect to the currency in which each separate instrument 
is considered denominated. No interest payments on the separate debt 
instrument are qualified stated interest payments (within the meaning of 
Sec. 1.1273-1(c)) and the de minimis rules of section 1273(a)(3) and 
Sec. 1.1273-1(d) do not apply to the separate debt instrument. Interest 
income or expense is translated, and exchange gain or loss is recognized 
on the separate debt instrument as provided in Sec. 1.988-2(b)(2), if 
the instrument is denominated in a nonfunctional currency.
    (4) Treatment of components consisting of contingent payments--(i) 
General rule. A component consisting of a contingent payment shall 
generally be treated in the manner provided in Sec. 1.1275-4(c)(4). 
However, except as provided in paragraph (e)(4)(ii) of this section, the 
test rate shall be determined by reference to the U.S. dollar unless the 
dollar does not reasonably reflect the economic substance of the 
contingent component. In such case, the test rate shall be determined by 
reference to the currency which most reasonably reflects the economic 
substance of the contingent component. Any amount received in 
nonfunctional currency from a component consisting of a contingent 
payment shall be translated into functional currency at the spot rate on 
the date of receipt. Except in the case when the payment becomes fixed 
more than six months before the payment is due, no foreign currency gain 
or loss shall be recognized on a contingent payment component.
    (ii) Certain delayed contingent payments--(A) Separate debt 
instrument relating to the fixed component. The rules

[[Page 696]]

of Sec. 1.1275-4(c)(4)(iii) shall apply to a contingent component the 
payment of which becomes fixed more than 6 months before the payment is 
due. For this purpose, the denomination currency of the separate debt 
instrument relating to the fixed payment shall be the currency in which 
payment is to be made and the test rate for such separate debt 
instrument shall be determined in the currency of that instrument. If 
the separate debt instrument relating to the fixed payment is 
denominated in nonfunctional currency, the rules of Sec. 1.988-2(b)(2) 
shall apply to that instrument for the period beginning on the date the 
payment is fixed and ending on the payment date.
    (B) Contingent component. With respect to the contingent component, 
the issue price considered to have been paid by the issuer to the holder 
under Sec. 1.1275-4(c)(4)(iii)(A) shall be translated, if necessary, 
into the functional currency of the issuer or holder at the spot rate on 
the date the payment becomes fixed.
    (5) Basis different from adjusted issue price. The rules of Sec. 
1.1275-4(c)(5) shall apply to an instrument subject to this paragraph 
(e).
    (6) Treatment of a holder on sale, exchange, or retirement. The 
rules of Sec. 1.1275-4(c)(6) shall apply to an instrument subject to 
this paragraph (e).
    (f) Rules for nonfunctional currency tax exempt obligations 
described in Sec. 1.1275-4(d)--(1) In general. Except as provided in 
paragraph (f)(2) of this section, section 1.988-6 shall not apply to a 
debt instrument the interest on which is excluded from gross income 
under section 103(a).
    (2) Operative rules. [Reserved]
    (g) Effective date. This section shall apply to debt instruments 
issued on or after October 29, 2004.

[T.D. 9157, 69 FR 52819, Aug. 30, 2004]



Sec. 1.989(a)-1  Definition of a qualified business unit.

    (a) Applicability--(1) In general. This section provides rules 
relating to the definition of the term ``qualified business unit'' (QBU) 
within the meaning of section 989.
    (2) Effective date. These rules shall apply to taxable years 
beginning after December 31, 1986. However, any person may apply on a 
consistent basis Sec. 1.989(a)-1T (c) of the Temporary Income Tax 
Regulations in lieu of Sec. 1.989(a)-1 (c) to all taxable years 
beginning after December 31, 1986, and on or before February 5, 1990. 
For the text of the temporary regulation, see 53 FR 20612 (June 8, 
1988).
    (b) Definition of a qualified business unit--(1) In general. A QBU 
is any separate and clearly identified unit of a trade or business of a 
taxpayer provided that separate books and records are maintained.
    (2) Application of the QBU definition--(i) Persons. A corporation is 
QBU. An individual is not a QBU. A partnership, trust, or estate is a 
QBU of a partner or beneficiary.
    (ii) Activities. Activities of a corporation, partnership, trust, 
estate, or individual qualify as a QBU if--
    (A) The activities constitute a trade or business; and
    (B) A separate set of books and records is maintained with respect 
to the activities.
    (3) Special rule. Any activity (wherever conducted and regardless of 
its frequency) that produces income or loss that is, or is treated as, 
effectively connected with the conduct of a trade or business within the 
United States shall be treated as a separate QBU, provided the books and 
records requirement of paragraph (d)(2) of this section is satisfied.
    (c) Trade or business. The determination as to whether activities 
constitute a trade or business is ultimately dependent upon an 
examination of all the facts and circumstances. Generally, a trade or 
business for purposes of section 989(a) is a specific unified group of 
activities that constitutes (or could constitute) an independent 
economic enterprise carried on for profit, the expenses related to which 
are deductible under section 162 or 212 (other than that part of section 
212 dealing with expenses incurred in connection with taxes). To 
constitute a trade or business, a group of activities must ordinarily 
include every operation which forms a part of, or a step in, a process 
by which an enterprise may earn income or profit. Such group of 
activities must ordinarily include the collection of income and the 
payment of expenses.

[[Page 697]]

It is not necessary that the activities carried out by a QBU constitute 
a different trade or business from those carried out by other QBUs of 
the taxpayer. A vertical, functional, or geographic division of the same 
trade or business may be a trade or business for this purpose provided 
that the activities otherwise qualify as trade or business under this 
paragraph (c). However, activities that are merely ancillary to a trade 
or business will not constitute a trade or business under this paragraph 
(c). Activities of an individual as an employee are not considered by 
themselves to constitute a trade or business under this paragraph (c).
    (d) Separate books and records--(1) General rule. Except as provided 
in paragraph (d)(2) of this section, a separate set of books and records 
shall include books of original entry and ledger accounts, both general 
and subsidiary, or similar records. For example, in the case of a 
taxpayer using the cash receipts and disbursements method of accounting, 
the books of original entry include a cash receipts and disbursements 
journal where each receipt and each disbursement is recorded. Similarly, 
in the case of a taxpayer using an accrual method of accounting, the 
books of original entry include a journal to record sales (accounts 
receivable) and a journal to record expenses incurred (accounts 
payable). In general, a journal represents a chronological account of 
all transactions entered into by an entity for an accounting period. A 
ledger account, on the other hand, chronicles the impact during an 
accounting period of the specific transactions recorded in the journal 
for that period upon the various items shown on the entity's balance 
sheet (i.e., assets, liabilities, and capital accounts) and income 
statement (i.e., revenues and expenses).
    (2) Special rule. For purposes of paragraph (b)(3) of this section, 
books and records include books and records used to determine income or 
loss that is, or is treated as, effectively connected with the conduct 
of a trade or business within the United States.
    (e) Examples. The provisions of this section may be illustrated by 
the following examples:

    Example 1. Corporation X is a domestic corporation. Corporation X 
manufactures widgets in the U.S. for export. Corporation X sells widgets 
in the United Kingdom through a branch office in London. The London 
office has its own employees and solicits and processes orders. 
Corporation X maintains in the U.S. a separate set of books and records 
for all transactions conducted by the London office. Corporation X is a 
QBU under paragraph (b)(2)(i) of this section because of its corporate 
status. The London branch office is a QBU under paragraph (b)(2)(ii) of 
this section because (1) the sale of widgets is a trade or business as 
defined in paragraph (c) of this section; and (2) a complete and 
separate set of books and records (as described in paragraph (d) of this 
section) is maintained with respect to its sales operations.
    Example 2. A domestic corporation incorporates a wholly-owned 
subsidiary in Switzerland. The domestic corporation is a manufacturer 
that markets its product abroad primarily through the Swiss subsidiary. 
To facilitate sales of the parent's product in Europe, the Swiss 
subsidiary has branch offices in France and West Germany that are 
responsible for all marketing operations in those countries. Each branch 
has its own employees, solicits and processes orders, and maintains a 
separate set of books and records. The domestic corporation and the 
Swiss subsidiary are both QBUs under paragraph (b)(2)(i) of this section 
because of their corporate status. The French and West German branches 
are QBUs of the Swiss subsidiary. They satisfy paragraph (b)(2)(ii) 
because each constitutes a trade or business (as defined in paragraph 
(c) of this section) and because separate sets of books and records (as 
described in paragraph (d) of this section) of their respective 
operations is maintained. Each branch is considered to have a trade or 
business although each is a geographical division of the same trade or 
business.
    Example 3. W is a domestic corporation that manufactures product X 
in the United States for sale worldwide. All of W's sales functions are 
conducted exclusively in the United States. W employs individual Q to 
work in France. Q's sole function is to act as a courier to deliver 
sales documents to customers in France. With respect to Q's activities 
in France, a separate set of books and records as described in paragraph 
(d) is maintained. Under paragraph (c) of this section, Q's activities 
in France do not constitute a QBU since they are merely ancillary to W's 
manufacturing and selling business. Q is not considered to have a QBU 
because an individual's activities as an employee are not considered to 
constitute a trade or business of the individual under paragraph (c).
    Example 4. The facts are the same as in example (3) except that the 
courier function is the sole activity of a wholly-owned French

[[Page 698]]

subsidiary of W. Under paragraph (b)(2)(i) of this section, the French 
subsidiary is considered to be a QBU.
    Example 5. A corporation incorporated in the Netherlands is a 
subsidiary of a domestic corporation and a holding company for the stock 
of one or more subsidiaries incorporated in other countries. The Dutch 
corporation's activities are limited to paying its directors and its 
administrative expenses, receiving capital contributions from its United 
States parent corporation, contributing capital to its subsidiaries, 
receiving dividend distributions from its subsidiaries, and distributing 
dividends to its domestic parent corporation. Under paragraph (b)(2)(i) 
of this section, the Netherlands corporation is considered to be a QBU.
    Example 6. Taxpayer A, an individual resident of the United States, 
is engaged in a trade or business wholly unrelated to any type of 
investment activity. A also maintains a portfolio of foreign currency-
denominated investments through a foreign broker. The broker is 
responsible for all activities necessary to the management of A's 
investments and maintains books and records as described in paragraph 
(d) of this section, with respect to all investment activities of A. A's 
investment activities qualify as a QBU under paragraph (b)(2)(ii) of 
this section to the extent the activities engaged in by A generate 
expenses that are deductible under section 212 (other than that part of 
section 212 dealing with expenses incurred in connection with taxes).
    Example 7. Taxpayer A, an individual resident of the United States, 
is the sole shareholder of foreign corporation (FC) whose activities are 
limited to trading in stocks and securities. FC is a QBU under paragraph 
(b)(2)(i) of this section.
    Example 8. Taxpayer A, an individual resident of the United States, 
markets and sells in Spain and in the United States various products 
produced by other United States manufacturers. A has an office and 
employs a salesman to manage A's activities in Spain, maintains a 
separate set of books and records with respect to his activities in 
Spain, and is engaged in a trade or business as defined in paragraph (c) 
of this section. Therefore, under paragraph (b)(2)(ii) of this section, 
the activities of A in Spain are considered to be a QBU.
    Example 9. Foreign corporation FX is incorporated in Mexico and is 
wholly owned by a domestic corporation. The domestic corporation elects 
to treat FX as a domestic corporation under section 1504(d). FX operates 
entirely in Mexico and maintains a separate set of books and records 
with respect to its activities in Mexico. FX is a QBU under paragraph 
(b)(2)(i) of this section. The activities of FX in Mexico also 
constitute a QBU under paragraph (b)(2)(ii) of this section.
    Example 10. F, a foreign corporation, computes a gain of $100 from 
the disposition of a United States real property interest (as defined in 
section 897(c)). The gain is taken into account as if F were engaged in 
a trade or business in the United States and as if such gain were 
effectively connected with such trade or business. F is a QBU under 
paragraph (b)(2)(i) of this section because of its corporate status. F's 
disposition activity constitutes a separate QBU under paragraph (b)(3) 
of this section.

[T.D. 8279, 55 FR 284, Jan. 4, 1990]



Sec. 1.989(b)-1  Definition of weighted average exchange rate.

    For purposes of section 989(b)(3) and (4), the term ``weighted 
average exchange rate'' means the simple average of the daily exchange 
rates (determined by reference to a qualified source of exchange rates 
described in Sec. 1.988-1(d)(1)), excluding weekends, holidays and any 
other nonbusiness days for the taxable year.

[T.D. 8263, 54 FR 38664, Sept. 20, 1989. Redesignated by T.D. 8367, 56 
FR 48437, Sept. 25, 1991; 57 FR 6060, Feb. 18, 1992; T.D. 9452, 74 FR 
27890, June 11, 2009]



Sec. 1.989(c)-1  Transition rules for certain branches of United States
persons using a net worth method of accounting for taxable years
beginning before January 1, 1987.

    (a) Applicability--(1) In general. This section applies to qualified 
business units (QBU) branches of United States persons, whose functional 
currency (as defined in section 985 of the Code and regulations issued 
thereunder) is other than the United States dollar (dollar) and that 
used a net worth method of accounting for their last taxable year 
beginning before January 1, 1987. Generally, a net worth method of 
accounting is any method of accounting under which the taxpayer 
calculates the taxable income of a QBU branch based on the net change in 
the dollar value of the QBU branch's equity over the course of a taxable 
year, taking into account any remittance made during the year. QBU 
branch equity is the excess of QBU branch assets over QBU branch 
liabilities. For all taxable years beginning after December 31, 1986, 
such QBU branches must use the profit and loss method of accounting as 
described

[[Page 699]]

in section 987, except to the extent otherwise provided in regulations 
under section 985 or any other provision of the Code.
    (2) Insolvent QBU branches. A taxpayer may apply the principles of 
this section to a QBU branch that used a net worth method of accounting 
for its last taxable year beginning before January 1, 1987, whose $E 
pool (as defined in paragraph (d)(3)(i) of this section) is negative. 
For taxable years beginning on or after October 25, 1991, the principles 
of this section shall apply to insolvent QBU branches.
    (b) General rules. For the general rules, see Sec. 1.987-5(b).
    (c) Determining the pool(s) from which a remittance is made. To 
determine from which pool(s) a remittance is made, see Sec. 1.987-5(c).
    (d) Calculation of section 987 gain or loss--(1) In general. See 
Sec. 1.987-5(d)(1) for rules to make this calculation.
    (2) Step 1--Calculate the amount of the functional currency pools. 
For calculation of the amount of the functional currency pools, see 
Sec. 1.987-5(d)(2).
    (3) Step 2--Calculate the dollar basis pools--(i) Dollar basis of 
the EQ pool--(A) Beginning dollar basis. The beginning dollar basis of 
the EQ pool (hereinafter referred to as the $E pool) equals the final 
net worth of the QBU branch. Final net worth of the QBU branch equals 
the QBU branch's equity value (assets less liabilities) measured in 
dollars at the end of the taxpayer's last taxable year beginning before 
January 1, 1987, determined on the basis of the QBU branch's books and 
records as adjusted according to United States tax principles.
    (B) Adjusting the $E pool. For adjustments to be made to the $E 
pool, see Sec. 1.987-5(d)(3)(i)(B).
    (ii) Dollar basis of the post-86 profits pool. To calculate the 
dollar basis of the post-86 profits pool, see Sec. 1.987-5(d)(3)(ii).
    (iii) Dollar basis of the equity pool. To calculate the dollar basis 
of the equity pool, see Sec. 1.987-5(d)(3)(iii).
    (4) Step 3--Calculation of the dollar basis of a remittance. To 
calculate the dollar basis of the EQ remitted, see Sec. 1.987-5(d)(4).
    (5) Step 4--Calculation of the section 987 gain or loss on a 
remittance. To calculate 987 gain or loss determined on a remittance, 
see Sec. 1.987-5(d)(5).
    (e) Functional currency adjusted basis of QBU branch assets acquired 
in taxable years beginning before January 1, 1987. To determine the 
functional currency adjusted basis of QBU branch assets acquired in 
taxable years beginning before January 1, 1987, see Sec. 1.987-5(e).
    (f) Functional currency amount of QBU branch liabilities acquired in 
taxable years beginning before January 1, 1987. To determine the 
functional currency amount of QBU branch liabilities acquired in taxable 
years beginning before January 1, 1987, see Sec. 1.987-5(f).

[T.D. 8367, 56 FR 48437, Sept. 25, 1991]

                Domestic International Sales Corporations



Sec. 1.991-1  Taxation of a domestic international sales corporation.

    (a) In general. A corporation which is a DISC for a taxable year is 
not subject to any tax imposed by subtitle A of the Code (sections 1 
through 1564) for such taxable year, except for the tax imposed by 
chapter 5 thereof (sections 1491 through 1494) on certain transfers to 
avoid tax. Thus, for example, a corporation which is a DISC for a 
taxable year is not subject for such year to the corporate income tax 
(section 11), the minimum tax on tax preferences (sections 56 through 
58), or the accumulated earnings tax (sections 531 through 537). A DISC 
is liable for the payment of all taxes payable by corporations under 
other subtitles of the Code, such as, for example, income taxes withheld 
at the source and other employment taxes under subtitle C and the 
interest equalization tax and other miscellaneous excise taxes imposed 
by subtitle D. In addition, a DISC is subject to the provisions of 
chapter 3 of subtitle A (including section 1461), relating to 
withholding of tax on nonresident aliens and foreign corporations and 
tax-free covenant bonds. See Sec. 1.992-1 for the definition of the 
term ``DISC.''
    (b) Determination of taxable income--(1) In general. Although a DISC 
is not subject to tax under subtitle A of the Code (other than chapter 5 
thereof), a DISC's taxable income shall be determined for each taxable 
year in order to

[[Page 700]]

determine, for example, the amount deemed distributed for that taxable 
year to its shareholders pursuant to Sec. 1.995-2. Except as otherwise 
provided in the Code and the regulations thereunder, the taxable income 
of a DISC shall be determined in the same manner as if the DISC were a 
domestic corporation which had not elected to be treated as a DISC. 
Thus, for example, a DISC chooses its method of depreciation, inventory 
method, and annual accounting period in the same manner as if it were a 
corporation which had not elected to be treated as a DISC. Any elections 
affecting the determination of taxable income shall be made by the DISC. 
Thus, as a further example, a DISC which makes an installment sale 
described in section 453 is able to avail itself of the benefits of 
section 453: Provided, The DISC complies with the election requirements 
of such section. See Sec. 1.995-2(e) and Sec. 1.996-8 and the 
regulations thereunder for rules relating to the application for a 
taxable year of a DISC of a deduction under section 172 for a net 
operating loss carryback or carryover or of a capital loss carryback or 
carryover under section 1212.
    (2) Choice of method of accounting. A DISC may, generally, choose 
any method of accounting permissible under section 446(c) and the 
regulations thereunder. However, if a DISC is a member of a controlled 
group (as defined in Sec. 1.993-1(k)), the DISC may not choose a method 
of accounting which, when applied to transactions between the DISC and 
other members of the controlled group, will result in a material 
distortion of the income of the DISC or any other member of the 
controlled group. Such a material distortion of income would occur, for 
example, if a DISC chooses to use the cash method of accounting where 
the DISC acts as commission agent in a substantial volume of sales of 
property by a related corporation which uses the accrual method of 
accounting and which customarily pays commissions to the DISC more than 
2 months after such sales. As a further example, a material distortion 
of income would occur if a DISC chooses to use the accrual method of 
accounting where the DISC leases a substantial amount of property from a 
related corporation which uses the cash method of accounting, if the 
DISC customarily accrues any portion of the rent on such property more 
than 2 months before the rent is paid. Changes in the method of 
accounting of a DISC are subject to the requirements of section 446(e) 
and the regulations thereunder.
    (3) Choice of annual accounting period--(i) In general. A DISC may 
choose its annual accounting period without regard to the annual 
accounting period of any of its stockholders. In general, changes in the 
annual accounting period of a DISC are subject to the requirements of 
section 442 and the regulations thereunder.
    (ii) Transition rule for change in taxable year in order to become a 
DISC. A corporation may, without the consent of the Commissioner, change 
its annual accounting period and adopt a new taxable year beginning on 
the first day of any month in 1972: Provided, That--
    (a) Such change has the effect of accelerating the time as of which 
such corporation can become a DISC,
    (b) The Commissioner is notified of such change by means of a 
statement filed (with the regional service center with which such 
corporation files its election to be treated as a DISC) not later than 
the end of the period during which such corporation may file an election 
to be treated as a DISC for such new taxable year, and
    (c) The short period required to effect such change is not a taxable 
year in which such corporation has a net operating loss as defined in 
section 172.


Thus, for example, if a corporation which uses the calendar year for its 
taxable year does not complete arrangements to become a DISC until May 
15, 1972, such corporation can, pursuant to this subdivision, change its 
annual accounting period and adopt a taxable year beginning on the first 
day of any month in 1972 after May. A change to a new annual accounting 
period made pursuant to this subdivision is effective only if the 
corporation which makes such change qualifies as a DISC for such new 
period. A corporation may change its annual accounting period and adopt 
a new taxable year pursuant to this subdivision without regard to the 
provisions of Sec. 1.1502-76

[[Page 701]]

(relating to the taxable year of members of a group). A copy of the 
statement described in (b) of this subdivision shall be attached to the 
return of a corporation for the new taxable year to which such 
corporation changes pursuant to this subdivision. A corporation which 
changes its annual accounting period pursuant to this subparagraph will 
not be permitted under section 442 to change its annual accounting 
period at any time before 1982, except with the consent of the 
Commissioner as provided in Sec. 1.442-1(b)(1) or pursuant to 
subparagraph (4) of this paragraph.
    (4) Transition rule for change of taxable year of certain DISC's. In 
the case of a DISC all of the shares of which are held by a single 
shareholder or by members of a group who file a consolidated return, 
such DISC may (without the consent of the Commissioner) change its 
annual accounting period and adopt a taxable year beginning in 1972 
which is the same as the taxable year of such shareholder or the members 
of such group. A change to a new annual accounting period may be made by 
a DISC pursuant to this subparagraph even if such DISC has changed its 
annual accounting period pursuant to subparagraph (3)(ii) of this 
paragraph.
    (5) Transition rule for beginning of first taxable year of certain 
corporations. If a corporation organized before January 1, 1972, neither 
acquires assets (other than cash or other property acquired as 
consideration for the issuance of stock) nor begins doing business prior 
to January 1, 1972, the first taxable year of such corporation is deemed 
to begin at the time such corporation acquires any asset (other than 
cash or other property acquired as consideration for the issuance of 
stock) or begins doing business, whichever is earlier: Provided, That 
such corporation is a DISC for such first taxable year. For purposes of 
Sec. 1.6012-2(a), such corporation is treated as not coming into 
existence until the beginning of such first taxable year.
    (c) Effective date. The provisions of this section and the 
regulations under sections 992 through 997 apply with respect to taxable 
years ending after December 31, 1971, except that a corporation may not 
be a DISC for any taxable year beginning before January 1, 1972.
    (d) Related statutes. For rules relating to the transfer, during a 
taxable year beginning before January 1, 1976, to a DISC of assets of an 
export trade corporation (as defined in section 971), where a parent 
owns all the outstanding stock of both such DISC and such export trade 
corporation, see section 505(b) of the Revenue Act of 1971 (85 Stat. 
551). For rules regarding limitations on the qualification of a 
corporation as an export trade corporation for any taxable year 
beginning after October 31, 1971, see section 971(a)(3).

[T.D. 7323, 39 FR 34402, Sept. 25, 1974, as amended by T.D. 7854, 47 FR 
51738, Nov. 17, 1982]



Sec. 1.992-1  Requirements of a DISC.

    (a) ``DISC'' defined. The term ``DISC'' refers to a domestic 
international sales corporation. The term ``DISC'' means a corporation 
which, for a taxable year--
    (1) Is duly incorporated and existing under the laws of any State or 
the District of Columbia,
    (2) Satisfies the gross receipts test described in paragraph (b) of 
this section,
    (3) Satisfies the assets test described in paragraph (c) of this 
section,
    (4) Satisfies the capitalization requirement described in paragraph 
(d) of this section,
    (5) Satisfies the requirement that an election to be treated as a 
DISC be in effect for such year, as described in paragraph (e) of this 
section,
    (6) [Reserved]
    (7) Maintains separate books and records, and
    (8) Is not an ineligible corporation described in paragraph (f) of 
this section.


A corporation which satisfies the requirements described in 
subparagraphs (1) through (8) of this paragraph for a taxable year is 
treated as a separate corporation for Federal tax purposes and qualifies 
as a DISC, even though such corporation would not be treated (if it were 
not a DISC) as a corporate entity for Federal income tax purposes. An 
association cannot qualify as a DISC even if such association is taxable 
as a corporation pursuant to section 7701(a)(3). In addition, a 
corporation created or organized in, or under

[[Page 702]]

the law of, a possession of the United States cannot qualify as a DISC. 
The rules contained in this paragraph constitute a relaxation of the 
general rules of corporate substance otherwise applicable under the 
Code. The separate incorporation of a DISC is required under section 
992(a)(1) to make it possible to keep a better record of the income 
which is subject to the special treatment provided by sections 991 
through 996, but this does not necessitate in all other respects the 
separate relationships which otherwise would be required between a 
parent corporation and its subsidiary. However, this relaxation of the 
general rules of corporate substance does not apply with respect to 
other corporations in other contexts. In the case of a transaction 
between a DISC and a person related to such DISC for purposes of section 
482, see Sec. 1.993-1(l) for rules for determining whether income is 
income of a DISC to which the intercompany pricing rules authorized by 
section 994 apply.
    (b) Gross receipts test. In order for a corporation described in 
paragraph (a)(1) of this section to be a DISC for a taxable year, 95 
percent or more of its gross receipts (as defined in Sec. 1.993-6) for 
such year must consist of qualified export receipts (as defined in Sec. 
1.993-1). Gross receipts for a taxable year are determined in accordance 
with the method of accounting adopted by the corporation pursuant to 
Sec. 1.991-1(b)(2). However, for rules regarding gross receipts in the 
case of a commission sale by such corporation, see Sec. 1.993-6.
    (c) Assets test--(1) In general. In order for a corporation 
described in paragraph (a)(1) of this section to be a DISC for a taxable 
year, the adjusted basis (determined under section 1011) of its 
qualified export assets at the close of such year must equal or exceed 
95 percent of the sum of the adjusted bases (determined under section 
1011) of all assets of such corporation at the close of such year.
    (2) Assets acquired to meet assets test. For purposes of determining 
whether the requirements of subparagraph (1) of this paragraph are 
satisfied by a corporation at the end of a taxable year, an asset which 
is a qualified export asset is treated as not being an asset of such 
corporation at such time if such asset is held for a total of 60 days or 
less and is acquired directly or indirectly through borrowing, unless 
the acquisition of such asset is established to the satisfaction of the 
Commissioner or his delegate to have been for bona fide purposes. Such 
acquisition is deemed to have been for bona fide purposes if, for 
example, it is made in the usual course of the corporation's trade or 
business.
    (d) Capitalization requirement--(1) In general. To qualify as a DISC 
for a taxable year, a corporation must have, on each day of that taxable 
year, only one class of stock. The par value (or, in the case of stock 
without par value, the stated value) of the corporation's outstanding 
stock must be on each day of the taxable year at least $2,500. In the 
case of a corporation which elects to be treated as a DISC for its first 
taxable year, the requirements of this paragraph (d)(1) are satisfied if 
the corporation has no more than one class of stock at any time during 
the year and if the par value (or, in the case of stock without par 
value, the stated value) of the corporation's outstanding stock is at 
least $2,500 on the last day of the period within which the election 
must be made and on each succeeding day of the year. For purposes of 
this paragraph (d)(1), the stated value of shares is the aggregate 
amount of the consideration paid for such shares which is not allotted 
to paid in surplus, or other surplus. The law of the State of 
incorporation of the DISC determines what consideration may be used to 
capitalize the DISC. A corporation will not be a qualified DISC unless 
at least $2,500 of valid consideration was used for this purpose. If a 
corporation has a realized or unrealized loss during a taxable year 
which results in the impairment of all or part of the capital required 
under this paragraph (d)(1), that impairment does not result in 
disqualification under this paragraph (d)(1), provided that the 
corporation does not take any legal or formal action under State law to 
reduce capital for that year below the amount required under this 
paragraph (d)(1).
    (2) Treatment of debt payable to shareholders--(i) In general. 
Purported debt of a DISC payable to any person,

[[Page 703]]

whether or not such person is a shareholder or a member of a controlled 
group (as defined in Sec. 1.993-1(k)) of which such DISC is a member, 
is treated as debt for all purposes of the Code, provided that such 
purported debt--
    (a) Would qualify as debt for purposes of the Code if the DISC were 
a corporation which did not qualify as a DISC,
    (b) Qualifies under subdivision (ii) of this subparagraph, or
    (c) Are trade accounts payable described in subdivision (iii) of 
this subparagraph.


Such debt is not treated as stock, and interest payable by the DISC on 
such debt is treated as interest by both the DISC and the holder of such 
debt. Payment of the principal of such debt by a DISC does not 
constitute the payment of a dividend by such DISC. The provisions of 
this subparagraph apply for a taxable year of a DISC, even though debt 
described in this subparagraph would be treated as stock of the 
corporation if such corporation did not qualify as a DISC for such year.
    (ii) Safe harbor rule. Purported debt of a DISC will in no event be 
treated as other than debt for purposes of subdivision (i) of this 
subparagraph if--
    (a) It is a written obligation to pay a sum certain on or before a 
fixed maturity date,
    (b) Interest is payable on such purported debt at an arm's length 
interest rate (as determined under Sec. 1.482-2(a)(2)), expressed as a 
fixed dollar amount or a fixed percentage of principal,
    (c) Such purported debt is not convertible into stock or into other 
purported debt unless such other purported debt qualifies under this 
subparagraph as debt of the DISC,
    (d) Such purported debt does not confer voting rights upon its 
holder, except in the event of default thereon, and
    (e) Interest and principal are paid in accordance with the terms of 
such purported debt or with any modification of such terms consistent 
with (a) through (d) of this subdivision.


The determination of whether purported debt of a DISC constitutes debt 
described in this subdivision is made without regard to the proportion 
of debt of the DISC held by any of its shareholders, to the ratio of the 
outstanding debt of the DISC to its equity, or to the amount of 
outstanding debt of such DISC. The provisions of (e) of this subdivision 
do not prevent the modification of the terms of debt of a DISC where, 
for example, a DISC becomes unable to make timely payments of principal 
required under such terms, provided that such modification is consistent 
with (a) through (d) of this subdivision.
    (iii) Trade accounts payable. Trade accounts payable of a DISC which 
arise in the normal course of its trade or business (such as in 
consideration for inventory or supplies) constitute debt of the DISC 
(whether or not such accounts payable are debt described in subdivision 
(i) (a) or (b) of this subparagraph), provided that such accounts are 
payable within 15 months after they arise. If such accounts are payable 
more than 15 months after they arise, they are debt of such DISC only if 
they are debt described in subdivision (i) (a) or (b) of this 
subparagraph.
    (iv) Relation of subparagraph to other corporations. The provisions 
of this subparagraph generally constitute a relaxation of the ordinary 
rules used in determining whether purported debt of a corporation is 
debt or equity. This relaxation is in recognition of the principle that 
a corporation may qualify as a DISC even though it has relatively little 
capital. This relaxation does not apply with respect to purported debt 
of other corporations in other contexts. The provisions of subdivisions 
(i), (ii), and (iii) of this subparagraph apply only for taxable years 
for which a corporation qualifies (or is treated) as a DISC.
    (3) Classes of stock. [Reserved]
    (e) Election in effect. In order for a corporation to be a DISC for 
a taxable year, an election to be treated as a DISC must be made by such 
corporation pursuant to Sec. 1.992-2 and must be in effect for such 
taxable year. A corporation does not become or remain a DISC solely by 
making such an election. A corporation is a DISC for a taxable year only 
if such an election is in effect for that year and the corporation also 
satisfies the requirements of paragraphs (a) through (d) of this 
section.

[[Page 704]]

See Sec. 1.992-2 for rules regarding the time and manner of making such 
an election.
    (f) Ineligible corporations. The following corporations shall not be 
eligible to be treated as a DISC--
    (1) A corporation exempt from tax by reason of section 501,
    (2) A personal holding company (as defined in section 542),
    (3) A financial institution to which section 581 or 593 applies,
    (4) An insurance company subject to the tax imposed by subchapter L,
    (5) A regulated investment company (as defined in section 851(a)),
    (6) A China Trade Act corporation receiving the special deduction 
provided in section 941(a), or
    (7) An electing small business corporation (as defined in section 
1371(b)).
    (g) Status as DISC after having filed return as a DISC. Under 
section 992(a)(2), notwithstanding the failure of a corporation to meet 
the requirements of paragraph (a) of this section for a taxable year, 
such corporation will be treated as a DISC for purposes of the Code for 
such taxable year (and, thus, will not be able to claim that it is not 
eligible to be a DISC) if--
    (1) Such corporation files a return as a DISC for such taxable year,
    (2) Such corporation does not notify the district director, more 
than 30 days before the expiration of the period of limitation 
(including extensions thereof) on assessment for underpayment of tax for 
such taxable year (as determined under section 6501 and the regulations 
thereunder), that it is not a DISC for such taxable year, and
    (3) The Internal Revenue Service has not issued, within such period 
of limitation (including extensions thereof) on assessment for 
underpayment of tax for such taxable year, a notice of deficiency based 
on a determination that such corporation is not a DISC for such taxable 
year.


A corporation is treated as a DISC, for all purposes, pursuant to the 
provisions of this paragraph for any taxable year for which it meets the 
requirements of this paragraph, even if such corporation is an 
ineligible corporation described in paragraph (f) of this section for 
such taxable year. Thus, for example, a corporation which is treated as 
a DISC for a taxable year pursuant to this paragraph is treated as a 
DISC for that taxable year for purposes of Sec. 1.992-2(e)(3) (relating 
to the termination of a DISC election if a corporation is not a DISC for 
each of any 5 consecutive taxable years). If a corporation is treated as 
a DISC for a taxable year pursuant to this paragraph, persons who held 
stock of such corporation at any time during such taxable year are 
treated, with respect to such stock, as holders of stock in a DISC for 
the period or periods during which they held such stock within such 
taxable year.
    (h) Definition of ``former DISC''. Under section 992(a)(3), the term 
``former DISC'' refers to a corporation which is not a DISC for a 
taxable year but which was (or was treated as) a DISC for a prior 
taxable year. However, a corporation is not a former DISC for a taxable 
year unless such corporation has, at the beginning of such taxable year, 
undistributed previously taxed income (as defined in Sec. 1.996-3(c) or 
accumulated DISC income (as defined in Sec. 1.996-3(b)). A corporation 
which is a former DISC for a taxable year is a former DISC for all 
purposes of the Code.

(Secs. 385 and 7805 of the Internal Revenue Code of 1954 (83 Stat. 613 
and 68A Stat. 917; 26 U.S.C. 385 and 7805))

[T.D. 7323, 39 FR 34403, Sept. 25, 1974, as amended by T.D. 7420, 41 FR 
20654, May 20, 1976; 41 FR 22267, June 2, 1976; T.D. 7747, 45 FR 86459, 
Dec. 31, 1980; T.D. 7920, 48 FR 50712, Nov. 3, 1983; T.D. 8371, 56 FR 
55234, Oct. 25, 1991]



Sec. 1.992-2  Election to be treated as a DISC.

    (a) Manner and time of election--(1) Manner--(i) In general. A 
corporation can elect to be treated as a DISC for a taxable year 
beginning after December 31, 1971. Except as provided in paragraph 
(a)(1)(ii) of this section, the election is made by the corporation 
filing Form 4876 with the service center with which it would file its 
income tax return if it were subject for such taxable year to all the 
taxes imposed by subtitle A of the Internal Revenue Code of 1954. The 
form shall be signed by any person authorized to sign a corporation 
return under section 6062, and shall

[[Page 705]]

contain the information required by such form. Except as provided in 
paragraphs (b)(3) and (c) of this section, such election to be treated 
as a DISC shall be valid only if the consent of every person who is a 
shareholder of the corporation as of the beginning of the first taxable 
year for which such election is effective is on or attached to such Form 
4876 when filed with the service center.
    (ii) Transitional rule for corporations electing during 1972. If the 
first taxable year for which an election by a corporation to be treated 
as a DISC is a taxable year beginning after December 31, 1971, and on or 
before December 31, 1972, such election may be made either in the manner 
prescribed in subdivision (i) of this subparagraph or by filing, at the 
place prescribed in subdivision (i) of this subparagraph, a statement 
captioned ``Election to be Treated as a DISC.'' Such statement of 
election shall be valid only if the consent of each shareholder is filed 
with the service center in the form, and at the time, prescribed in 
paragraph (b) of this section. Such statement shall be signed by any 
person authorized to sign a corporation return under section 6062 and 
shall include the name, address, and employer identification number (if 
known) of the corporation, the beginning date of the first taxable year 
for which the election is effective, the number of shares of stock of 
the corporation issued and outstanding as of the earlier of the 
beginning of the first taxable year for which the election is effective 
or the time the statement is filed, the number of shares held by each 
shareholder as of the earlier of such dates, and the date and place of 
incorporation. As a condition of the election being effective, a 
corporation which elects to become a DISC by filing a statement in 
accordance with this subdivision must furnish (to the service center 
with which the statement was filed) such additional information as is 
required by Form 4876 by March 31, 1973.
    (2) Time of making election--(i) In general. In the case of a 
corporation making an election to be treated as a DISC for its first 
taxable year, such election shall be made within 90 days after the 
beginning of such taxable year. In the case of a corporation which makes 
an election to be treated as a DISC for any taxable year beginning after 
March 31, 1972 (other than the first taxable year of such corporation), 
the election shall be made during the 90-day period immediately 
preceding the first day of such taxable year.
    (ii) Transitional rules for certain corporations electing during 
1972. In the case of a corporation which makes an election to be treated 
as a DISC for a taxable year beginning after December 31, 1971, and on 
or before March 31, 1972 (other than its first taxable year), the 
election shall be made within 90 days after the beginning of such 
taxable year.
    (b) Consent by shareholders--(1) In general--(i) Time and manner of 
consent. Under paragraph (a)(1)(i) of this section, subject to certain 
exceptions, the election to be treated as a DISC is not valid unless 
each person who is a shareholder as of the beginning of the first 
taxable year for which the election is effective signs either the 
statement of consent on Form 4876 or a separate statement of consent 
attached to such form. A shareholder's consent is binding on such 
shareholder and all transferees of his shares and may not be withdrawn 
after a valid election is made by the corporation. In the case of a 
corporation which files an election to become a DISC for a taxable year 
beginning after December 31, 1972, if a person who is a shareholder as 
of the beginning of the first taxable year for which the election is 
effective does not consent by signing the statement of consent set forth 
on Form 4876, such election shall be valid (except in the case of an 
extension of the time for filing granted under the provisions of 
subparagraph (3) of this paragraph or paragraph (c) of this section) 
only if the consent of such shareholder is attached to the Form 4876 
upon which such election is made.
    (ii) Form of consent. A consent other than the statement of consent 
set forth on Form 4876 shall be in the form of a statement which is 
signed by the shareholder and which sets forth (a) the name and address 
of the corporation and of the shareholder and (b) the number of shares 
held by each such shareholder as of the time the consent

[[Page 706]]

is made and (if the consent is made after the beginning of the 
corporation's taxable year for which the election is effective) as of 
the beginning of such year. If the consent is made by a recipient of 
transferred shares pursuant to paragraph (c) of this section, the 
statement of consent shall also set forth the name and address of the 
person who held such shares as of the beginning of such taxable year and 
the number of such shares. Consent shall be made in the following form: 
``I (insert name of shareholder), a shareholder of (insert name of 
corporation seeking to make the election) consent to the election of 
(insert name of corporation seeking to make the election) to be treated 
as a DISC under section 992(b) of the Internal Revenue Code. The consent 
so made by me is irrevocable and is binding upon all transferees of my 
shares in (insert name of corporation seeking to make the election).'' 
The consents of all shareholders may be incorporated in one statement.
    (iii) Who may consent. Where stock of the corporation is owned by a 
husband and wife as community property (or the income from such stock is 
community property), or is owned by tenants in common, joint tenants, or 
tenants by the entirety, each person having a community interest in such 
stock or the income therefrom and each tenant in common, joint tenant, 
and tenant by the entirety must consent to the election. The consent of 
a minor shall be made by his legal guardian or by his natural guardian 
if no legal guardian has been appointed. The consent of an estate shall 
be made by the executor or administrator thereof. The consent of a trust 
shall be made by the trustee thereof. The consent of an estate or trust 
having more than one executor, administrator, or trustee, may be made by 
any executor, administrator, or trustee, authorized to make a return of 
such estate or trust pursuant to section 6012(b)(5). The consent of a 
corporation or partnership shall be made by an officer or partner 
authorized pursuant to section 6062 or 6063, as the case may be, to sign 
the return of such corporation or partnership. In the case of a foreign 
person, the consent may be signed by any individual (whether or not a 
U.S. person) who would be authorized under sections 6061 through 6063 to 
sign the return of such foreign person if he were a U.S. person.
    (2) Transitional rule for corporations electing during 1972. In the 
case of a corporation which files an election to be treated as a DISC 
for a taxable year beginning after December 31, 1971, and on or before 
December 31, 1972, such election shall be valid only if the consent of 
each person who is a shareholder as of the beginning of the first 
taxable year for which such election is effective is filed with the 
service center with which the election was filed within 90 days after 
the first day of such taxable year or within the time granted for an 
extension of time for filing such consent. The form of such consent 
shall be the same as that prescribed in subparagraph (1) of this 
paragraph. Such consent shall be attached to the statement of election 
or shall be filed separately (with such service center) with a copy of 
the statement of election. An extension of time for filing a consent may 
be granted in the manner, and subject to the conditions, described in 
subparagraph (3) of this paragraph.
    (3) Extension of time to consent. An election which is timely filed 
and would be valid except for the failure to attach the consent of any 
shareholder to the Form 4876 upon which the election was made or to 
comply with the 90-day requirement in subparagraph (2) of this paragraph 
or paragraph (c)(1) of this section, as the case may be, will not be 
invalid for such reason if it is shown to the satisfaction of the 
service center that there was reasonable cause for the failure to file 
such consent, and if such shareholder files a proper consent to the 
election within such extended period of time as may be granted by the 
Internal Revenue Service. In the case of a late filing of a consent, a 
copy of the Form 4876 or statement of election shall be attached to such 
consent and shall be filed with the same service center as the election. 
The form of such consent shall be the same as that set forth in 
paragraph (b)(1)(ii) of this section. In no event can any consent be 
made pursuant to this paragraph on or after the last day of the first 
taxable year for which a corporation elects to be treated as a DISC.

[[Page 707]]

    (c) Consent by holder of transferred shares--(1) In general. If a 
shareholder of a corporation transfers--
    (i) Prior to the first day of the first taxable year for which such 
corporation elects to be treated as a DISC, some or all of the shares 
held by him without having consented to such election, or
    (ii) On or before the 90th day after the first day of the first 
taxable year for which such corporation elects to be treated as a DISC, 
some or all of the shares held by him as of the first day of such year 
(or if later, held by him as of the time such shares are issued) without 
having consented to such election, then consent may be made by any 
recipient of such shares on or before the 90th day after the first day 
of such first taxable year. If such recipient fails to file his consent 
on or before such 90th day, an extension of time for filing such consent 
may be granted in the manner, and subject to the conditions, described 
in paragraph (b)(3) of this section. In addition, if the transfer occurs 
more than 90 days after the first day of such taxable year, an extension 
of time for filing such consent may be granted to such recipient only if 
it is determined under paragraph (b)(3) of this section that an 
extension of time would have been granted the transferor for the filing 
of such consent if the transfer had not occurred. A consent which is not 
attached to the original Form 4876 or statement of election (as the case 
may be) shall be filed with the same service center as the original Form 
4876 or statement of election and shall have attached a copy of such 
original form or statement of election. The form of such consent shall 
be the same as that set forth in paragraph (b)(1)(ii) of this section. 
For the purposes of this paragraph, a transfer of shares includes any 
sale, exchange, or other disposition, including a transfer by gift or at 
death.
    (2) Requirement for the filing of an amended Form 4876 or statement 
of election. In any case in which a consent to a corporation's election 
to be treated as a DISC is made pursuant to subparagraph (1) of this 
paragraph, such corporation must file an amended Form 4876 or statement 
of election (as the case may be) reflecting all changes in ownership of 
shares. Such form must be filed with the same service center with which 
the original Form 4876 or statement of election was filed by such 
corporation.
    (d) Effect of election--(1) Effect on corporation. A valid election 
to be treated as a DISC remains in effect (without regard to whether the 
electing corporation qualifies as a DISC for a particular year) until 
terminated by any of the methods provided in paragraph (e) of this 
section. While such election is in effect, the electing corporation is 
subject to sections 991 through 997 and other provisions of the Code 
applicable to DISC's for any taxable year for which it qualifies as a 
DISC (or is treated as qualifying as a DISC pursuant to Sec. 1.992-
1(g)). Such corporation is also subject to such provisions for any 
taxable year for which it is treated as a former DISC as a result of 
qualifying or being treated as a DISC for any taxable year for which 
such election was in effect.
    (2) Effect on shareholders. A valid election by a corporation to be 
treated as a DISC subjects the shareholders of such corporation to the 
provisions of section 995 (relating to the taxation of the shareholders 
of a DISC or former DISC) and to all other provisions of the Code 
relating to the shareholders of a DISC or former DISC. Such provisions 
of the Code apply to any person who is a shareholder of a DISC or former 
DISC whether or not such person was a shareholder at the time the 
corporation elected to become a DISC.
    (e) Termination of election--(1) In general. An election to be 
treated as a DISC is terminated only as provided in subparagraph (2) or 
(3) of this paragraph.
    (2) Revocation of election--(i) Manner of revocation. An election by 
a corporation to be treated as a DISC may be revoked by the corporation 
for any taxable year of the corporation after the first taxable year for 
which the election is effective. Such revocation shall be made by the 
corporation filing a statement that the corporation revokes its election 
under section 992(b) to be treated as a DISC. Such statement shall 
indicate the corporation's name, address, employer identification 
number, and the first taxable year of

[[Page 708]]

the corporation for which the revocation is to be effective. The 
statement shall be signed by any person authorized to sign a corporation 
return under section 6062. Such revocation shall be filed with the 
service center with which the corporation filed its election, except 
that, if it filed an annual information return under section 6011(e)(2), 
the revocation shall be filed with the service center with which it 
filed its last such return.
    (ii) Years for which revocation is effective. If a corporation files 
a statement revoking its election to be treated as a DISC during the 
first 90 days of a taxable year (other than the first taxable year for 
which such election is effective), such revocation will be effective for 
such taxable year and all taxable years thereafter. If the corporation 
files a statement revoking its election to be treated as a DISC after 
the first 90 days of a taxable year, the revocation will be effective 
for all taxable years following such taxable year.
    (3) Continued failure to be a DISC. If a corporation which has 
elected to be treated as a DISC does not qualify as a DISC (and is not 
treated as a DISC pursuant to Sec. 1.992-1(g)) for each of any 5 
consecutive taxable years, such election terminates and will not be 
effective for any taxable year after such fifth taxable year. Such 
termination will be effective automatically, without notice to such 
corporation or to the Internal Revenue Service. If, during any 5-year 
period for which an election is effective, the corporation should 
qualify as a DISC (or be treated as a DISC pursuant to Sec. 1.992-1(g)) 
for a taxable year, a new 5-year period shall automatically start at the 
beginning of the following taxable year.
    (4) Election after termination. If a corporation has made a valid 
election to be treated as a DISC and such election terminates in either 
manner described in subparagraph (2) or (3) of this paragraph, such 
corporation is eligible to reelect to be treated as a DISC at any time 
by following the procedures described in paragraphs (a) through (c) of 
this section. If a corporation terminates its election and subsequently 
reelects to be treated as a DISC, the corporation and its shareholders 
continue to be subject to sections 995 and 996 with respect to the 
period during which its first election was in effect. Thus, for example, 
distributions upon disqualification includible in the gross incomes of 
shareholders of a corporation pursuant to section 995(b)(2) continue to 
be so includible for taxable years for which a second election of such 
corporation is in effect without regard to the second election.

[T.D. 7323, 39 FR 34405, Sept. 25, 1974, as amended by T.D. 7420, 41 FR 
20655, May 20, 1976]



Sec. 1.992-3  Deficiency distributions to meet qualification
requirements.

    (a) In general. A corporation which meets the requirements described 
in Sec. 1.992-1 for treatment as a DISC for a taxable year, other than 
the 95 percent of gross receipts test described in Sec. 1.992-1(b) or 
the 95-percent assets test described in Sec. 1.992-1(c), or both tests, 
may nevertheless qualify as a DISC for such year by making deficiency 
distributions (attributable to its gross receipts other than qualified 
export receipts and its assets other than qualified export assets) if 
all of the following requirements are satisfied:
    (1) The corporation distributes the amount determined under 
paragraph (b) of this section as a deficiency distribution. The amount 
of a deficiency distribution is determined without regard to the amount 
by which the corporation fails to meet either test.
    (2) The reasonable cause requirements prescribed in paragraph (c)(1) 
of this section are satisfied with respect to both the corporation's 
failure to meet either test and its failure to make a deficiency 
distribution prior to the time the distribution is made.
    (3) The corporation makes such deficiency distribution pro rata to 
all its shareholders.
    (4) The corporation designates the distribution, at the time of the 
distribution, as a deficiency distribution, pursuant to section 992(c), 
to meet the qualification requirements to be a DISC. Such designation 
shall be in the form of a communication sent at the time of such 
distribution to each shareholder and to the service center with which 
the corporation has filed or will file its return for the taxable year 
to

[[Page 709]]

which the distribution relates. A corporation may not retroactively 
designate a prior distribution as a deficiency distribution to meet 
qualification requirements. Subject to the limitation described in 
paragraph (c)(3) of this section, a corporation may make a deficiency 
distribution with respect to a taxable year at any time after the close 
of such taxable year or, in the case of a deficiency distribution made 
on or before September 29, 1975, at any time during or after such 
taxable year.


See sections 246(d), 904(f), 995, and 996 for rules regarding the 
treatment of a deficiency distribution to meet qualification 
requirements by the shareholders and the corporation.
    (b) Amount of deficiency distribution--(1) In general. In order to 
meet the requirements of paragraph (a) of this section, the amount of a 
deficiency distribution must be, if the corporation fails to meet--
    (i) The 95 percent of gross receipts test, the amount determined in 
subparagraph (2) of this paragraph,
    (ii) The 95-percent assets test, the amount determined in 
subparagraph (3) of this paragraph, and
    (iii) Both such tests, except as provided in subparagraph (4) of 
this paragraph, the sum of the amounts determined in subparagraphs (2) 
and (3) of this paragraph.
    (2) Computation of deficiency distribution to meet 95 percent of 
gross receipts test--(i) In general. If a corporation fails to meet the 
95 percent of gross receipts test described in Sec. 1.992-1(b) for its 
taxable year, the amount of the deficiency distribution required by this 
subparagraph is an amount equal to the sum of its taxable income (if 
any) from each transaction giving rise to gross receipts (as defined in 
Sec. 1.993-6) which are not qualified export receipts (as defined in 
Sec. 1.993-1). A corporation's taxable income from a transaction shall 
be the amount of such gross receipts from such transaction reduced only 
by (a) its cost of goods sold attributable to such gross receipts, and 
by (b) its expenses, losses, and other deductions properly apportioned 
or allocated thereto in a manner consistent with the rules set forth in 
Sec. 1.861-8. For purposes of this subdivision, however, any expenses, 
losses, or other deductions which cannot definitely be allocated to some 
item or class of gross income in such manner shall not reduce such gross 
receipts. If the corporation is a commission agent for a principal in a 
transaction, the corporation's taxable income is the amount of the 
commission from such transaction reduced only by the amounts described 
in (b) of this subdivision.
    (ii) Example. The provisions of this subparagraph may be illustrated 
by the following example:

    Example. (a) X and Y are calendar year taxpayers. X, a domestic 
manufacturing company, owns all the stock of Y, which seeks to qualify 
as a DISC for 1973. During 1973, X manufactures a machine which is 
eligible to be export property as defined in Sec. 1.993-3. Y is made a 
commission agent with respect to exporting such machine. Thereafter, 
during 1973 Y is considered to receive gross receipts of $100,000, as 
determined under section 993(f), attributable to X's sale of the machine 
in a manner which causes the gross receipts to be excluded receipts 
pursuant to section 993(a)(2) and, therefore, not qualified export 
receipts. Y's total gross receipts for 1973 are $1 million of which 
$900,000 (i.e., 90 percent) are qualified export receipts. Therefore, Y 
does not satisfy the 95 percent of gross receipts test for 1973 because 
less than 95 percent of its gross receipts are qualified export 
receipts. Y has $9,000 of expenses properly apportioned or allocated to 
its gross income from such sale and $1,000 of other expenses which 
cannot definitely be allocated to some item or class of gross income, 
determined in a manner consistent with the rules set forth in Sec. 
1.861-8. In order to satisfy the 95 percent of gross receipts test for 
1973, if the commission due from X to Y were $15,000, Y must make a 
deficiency distribution of $6,000 computed as follows:

Y's commission (gross income) from the transaction.........      $15,000
Less: Y's expenses apportioned or allocated to its gross           9,000
 income from the transaction...............................
                                                            ------------
Required deficiency distribution by reason of $100,000 of          6,000
 gross receipts which are not qualified export receipts....
 

    (b) If the commission due from X to Y were $9,400, resulting in a 
net loss of $600 to Y ($9,400 to $10,000), Y must make a deficiency 
distribution of $400 computed as follows:

Y's commissions (gross income) from the transaction........       $9,400
Less: Y's expenses apportioned or allocated to its gross           9,000
 income from the transaction...............................
                                                            ------------
Required deficiency distribution by reason of $100,000 of            400
 gross receipts which are not qualified export receipts....
 


[[Page 710]]

    (c) If the commission due from X to Y were $8,500, Y would not be 
required to make a deficiency distribution since, under this 
subparagraph, there would be no taxable income attributable to gross 
receipts from the sale.

    (3) Computation of deficiency distribution to meet 95 percent assets 
test--(i) In general. If a corporation fails to meet the 95 percent 
assets test described in Sec. 1.992-1(c) for its taxable year, the 
amount of the deficiency distribution required by this subparagraph is 
an amount equal to the fair market value as of the last day of such 
taxable year of the assets which are not qualified export assets held by 
such corporation on such last day.
    (ii) Asset held for more than 1 year. In the case of a corporation 
which holds continuously an asset which is not a qualified export asset 
at the close of more than 1 taxable year, it must distribute an amount 
equal to its fair market value (or, if greater, the amount determined 
under subparagraph (4) of this paragraph) only once if, at the close of 
the first such taxable year, such corporation reasonably believed that 
such asset was a qualified export asset. This subdivision shall not 
apply for any taxable year beginning after the date the corporation 
knows (or a reasonable man would have known) that an asset is not a 
qualified export asset and in order to qualify for each such year, the 
corporation must distribute the fair market value of such asset for each 
such year.
    (4) Computation in the case of a failure to meet both tests as a 
result of a single transaction. If a corporation fails to meet both the 
95 percent of gross receipts test and the 95 percent assets test for a 
taxable year, and if the corporation holds at the end of such year 
assets (other than cash or qualified export assets) which were received 
as proceeds of a sale or exchange during such year which resulted in 
gross receipts other than qualified export receipts, then the amount of 
the deficiency distribution required by this paragraph with respect to 
such sale or exchange and assets held is the larger of the amount 
required by subparagraph (2) of this paragraph with respect to the sale 
or exchange or the amount required by subparagraph (3) of this paragraph 
with respect to such assets held. Thus, for example, if a corporation 
sells property which is not a qualified export asset for $100, receives 
$85 in cash and a note for $15, and derives $25 of taxable income from 
the sale as determined under subparagraph (2) of this paragraph, it must 
distribute $25. If the provisions of this subparagraph are applied with 
respect to assets of a DISC (other than qualified export assets), such 
provisions do not apply to any property received as proceeds from a sale 
or exchange of such assets.
    (c) Reasonable cause for failure--(1) In general. If for a taxable 
year, a corporation has failed to meet the 95 percent of gross receipts 
test, the 95 percent assets test, or both tests, such corporation may 
satisfy any such test for such year by means of a deficiency 
distribution in the amount determined under paragraph (b) of this 
section only if the reasonable cause requirements of this subparagraph 
are satisfied. Such reasonable cause requirements are satisfied if--
    (i) There is reasonable cause (as determined in accordance with 
subparagraph (2) of this paragraph) for such corporation's failure to 
satisfy such test and to make such distribution prior to the date on 
which it was made, the time limit in subparagraph (3) of this paragraph 
for making the distribution is satisfied, and interest (if required) is 
paid in the amount and in the manner prescribed by subparagraph (4) of 
this paragraph, or
    (ii) The time and ``70-percent'' requirements of the reasonable 
cause test of paragraph (d) of this section are satisfied.
    (2) Determination of reasonable cause. In general, whether a 
corporation's failure to meet the 95 percent of gross receipts test, the 
95 percent assets test, or both tests for a taxable year and its failure 
to make a pro rata distribution prior to the date on which it was made 
will be considered for reasonable cause where the action or inaction 
which resulted in such failure occurred in good faith, such as failure 
to meet the 95 percent assets test resulting from blocked currency or 
expropriation, or failure to meet either test because of reasonable 
uncertainty as to what constitutes a qualified export receipt or a

[[Page 711]]

qualified export asset. For further examples, if a corporation's 
reasonable determination of the percentage of its total gross receipts 
that are qualified export receipts is subsequently redetermined to be 
less than 95 percent as a result of a price adjustment by the Internal 
Revenue Service under section 482, or if the corporation has a casualty 
loss for which it receives an unanticipated insurance recovery which 
causes its qualified export receipts to be less than 95 percent of its 
total gross receipts, then the failure to satisfy the 95 percent of 
gross receipts test is considered to be due to reasonable cause.
    (3) Time limit for deficiency distribution. Except as otherwise 
provided in this subparagraph, the time limit prescribed by this 
subparagraph for making a deficiency distribution is satisfied if the 
amount of the distribution required by paragraph (b) of this section is 
made within 90 days from the date of the first written notification to 
the corporation by the Internal Revenue Service that it had not 
satisfied the 95 percent of gross receipts test or the 95 percent assets 
test or both tests, for a taxable year. Upon a showing by the 
corporation that an extension of the 90-day time limit is reasonable and 
necessary, the Commissioner may grant such extension of such time limit. 
In any case in which a corporation contests the decision of the Internal 
Revenue Service that such corporation has not met the 95 percent of 
gross receipts test, the 95 percent assets test, or both tests, an 
extension of the 90-day time limit will be allowed until 30 days after 
the final determination of such contest. The date of the final 
determination of such contest shall, for purposes of section 992(c), be 
established in the manner specified in subdivisions (i) through (iv) of 
this subparagraph:
    (i) The date of final determination by a decision of the United 
States Tax Court is the date upon which such decision becomes final, as 
prescribed in section 7481.
    (ii) The date of final determination in a case which is contested in 
a court (and upon which there is a judgment) other than the Tax Court is 
the date upon which the judgment becomes final and will be determined on 
the basis of the facts and circumstances of each particular case. For 
example, ordinarily a judgment of a United States district court becomes 
final upon the expiration of the time allowed for taking an appeal, if 
no such appeal is duly taken within such time; and a judgment of the 
United States Court of Claims becomes final upon the expiration of the 
time allowed for filing a petition for certiorari if no such petition is 
duly filed within such time.
    (iii) The date of a final determination by a closing agreement, made 
under section 7121, is the date such agreement is approved by the 
Commissioner.
    (iv) A final determination under section 992(c) may be made by an 
agreement signed by the district director or director of the service 
center with which the corporation files its annual return or by such 
other official to which authority to sign has been delegated, and by or 
on behalf of the taxpayer. The agreement shall set forth the total 
amount of the deficiency distribution to be paid to the shareholders of 
the DISC for the taxable year or years. An agreement under this 
subdivision shall be sent to the taxpayer at his last known address by 
either registered or certified mail. For further guidance regarding the 
definition of last known address, see Sec. 301.6212-2 of this chapter. 
If registered mail is used for such purpose, the date of registration is 
considered the date of final determination; if certified mail is used 
for such purpose, the date of postmark on the sender's receipt for such 
mail is considered the date of final determination. If the corporation 
makes a deficiency distribution before such registration or postmark 
date but on or after the date the district director or director of the 
service center or other official has signed the agreement, the date of 
signature by the district director or director of the service center or 
other official is considered the date of final determination. If the 
corporation makes a deficiency distribution before the district director 
or director of the service center or other official signs the agreement, 
the date of final determination is considered to be the date of the 
making of the deficiency distribution. During any extension of time the

[[Page 712]]

interest charge provided in subparagraph (4) of this paragraph will 
continue to accrue at the rate provided for in such subparagraph.
    (4) Payment of interest for delayed distribution--(i) In general. If 
a corporation makes a deficiency distribution after the 15th day of the 
ninth month after the close of the taxable year with respect to which 
such distribution is made, such distribution will not be deemed to 
satisfy the 95 percent of gross receipts test or the 95 percent assets 
test for such year unless such corporation pays to the Internal Revenue 
Service a charge determined by multiplying (a) an amount equal to 4\1/2\ 
percent of such distribution by (b) the number of its taxable years 
which begin (1) after the taxable year with respect to which the 
distribution is made and (2) before such distribution is made. Such 
charge must be paid, within the 30-day period beginning with the day on 
which such distribution is made, to the service center with which the 
corporation files its annual information return for its taxable year in 
which the distribution is made. For purposes of the Internal Revenue 
Code, such charge is considered interest.
    (ii) Example. The provisions of subdivision (i) of this subparagraph 
may be illustrated by the following example:

    Example. X corporation, which uses the calendar year as its taxable 
year, meets the 95 percent assets test but fails to meet the 95 percent 
of gross receipts test for 1972 and does not by September 15, 1973, make 
the deficiency distribution required by reason of its failure to meet 
such test. Assume that reasonable cause exists for the corporation's 
failure to meet the 95 percent of gross receipts test and failure to 
make the required deficiency distribution. If X makes the required 
deficiency distribution, in the amount of $10,000, on April 1, 1976, X 
must pay on or before April 30, 1976, to the service center with which 
it files its annual information return a charge of $1,800, computed as 
follows:

Deficiency distribution made by X..........................      $10,000
Multiplied by 4\1/2\ percent...............................         .045
                                                            ------------
Intermediate product.......................................          450
Multiplied by: Number of X's taxable years beginning after             4
 1972 and before April 1, 1976.............................
                                                            ------------
Charge to be paid service center because of late deficiency        1,800
 distribution (which is considered interest)...............
 

    (d) Certain distributions deemed for reasonable cause. If a 
corporation makes a distribution in the amount required by paragraph (b) 
of this section with respect to a taxable year on or before the 15th day 
of the ninth month after the close of such year, it will be deemed to 
have acted with reasonable cause with respect to its failure to satisfy 
the 95 percent of gross receipts test, the 95 percent assets test, or 
both tests, for such year and its failure to make such distribution 
prior to the date on which the distribution was made if--
    (1) At least 70 percent of the gross receipts of such corporation 
for such taxable year consist of qualified export receipts, and
    (2) The sum of the adjusted bases of the qualified export assets 
held by such corporation on the last day of each month of the taxable 
year equals or exceeds 70 percent of the sum of the adjusted bases of 
all assets held by the corporation on each such day.

[T.D. 7323, 39 FR 34407, Sept. 25, 1974; 39 FR 36009, Oct. 7, 1974, as 
amended by T.D. 7420, 41 FR 20655, May 20, 1976; T.D. 7854, 47 FR 51739, 
Nov. 17, 1982; T.D. 8939, 66 FR 2819, Jan. 12, 2001]



Sec. 1.992-4  Coordination with personal holding company provisions
in case of certain produced film rents.

    (a) In general. Section 992(d)(2) provides that a personal holding 
company is not eligible to be treated as a DISC. Section 543(a)(5)(B) 
provides that, for purposes of section 543, the term ``produced film 
rents'' means payments received with respect to an interest in a film 
for the use of, or the right to use, such film, but only to the extent 
that such interest was acquired before substantial completion of 
production of such film. Under section 992(e), if such produced film 
rents are included in the ordinary gross income (as defined in section 
543(b)(1)) of a qualified subsidiary for a taxable year of such 
subsidiary, and such interest was acquired by such subsidiary from its 
parent, such interest is deemed (for purposes of the application of 
sections 541, 543(b)(1), and 992(d)(2), and Sec. 1.992-1(f) for such 
taxable year) to have been acquired by such subsidiary at the time

[[Page 713]]

such interest was acquired by such parent. Thus, for example, if a 
parent acquires an interest in a film before it is substantially 
completed, then substantially completes such film prior to transferring 
an interest in such motion picture to a qualified subsidiary, the 
qualified subsidiary is considered as having acquired such interest 
prior to substantial completion of such motion picture for purposes of 
determining whether payments from the rental of such motion picture will 
be classified as produced film rents of such subsidiary. The provisions 
of section 992(e) and this section are not applicable in determining 
whether payments received with respect to an interest in a film are 
included in the ordinary gross income of a parent or a qualified 
subsidiary. Thus, even though a qualified subsidiary is treated pursuant 
to this section as having acquired an interest in a film at the time 
such interest was acquired by such subsidiary's parent, payments 
received by such parent with respect to such interest prior to the 
transfer of such interest to such subsidiary are includible in the 
ordinary gross income of such parent and not includible in the ordinary 
gross income of such subsidiary.
    (b) Definitions--(1) Qualified subsidiary. For purposes of this 
section, a corporation is a qualified subsidiary for a taxable year if--
    (i) Such corporation was established for the purpose of becoming a 
DISC,
    (ii) Such corporation would qualify (or be treated) as a DISC for 
such taxable year if it is not a personal holding company, and
    (iii) On every day of such taxable year on which shares of such 
corporation are outstanding, at least 80 percent of such shares are held 
directly by a second corporation.
    (2) Parent. For purposes of this section, the term ``parent'' means 
a second corporation referred to in subparagraph (1)(iii) of this 
paragraph.

[T.D. 7323, 39 FR 34409, Sept. 25, 1974]



Sec. 1.993-1  Definition of qualified export receipts.

    (a) In general. For a corporation to qualify as a DISC, at least 95 
percent of its gross receipts for a taxable year must consist of 
qualified export receipts. Under section 993(a), the term ``qualified 
export receipts'' means any of the eight amounts described in paragraphs 
(b) through (i) of this section, except to the extent that any of the 
eight amounts is an excluded receipt within the meaning of paragraph (j) 
of this section. For purposes of this section and Sec. Sec. 1.993-2 
through 1.993-6--
    (1) DISC. All references to a DISC mean a DISC, except when the 
context indicates that such term means a corporation in the process of 
meeting the conditions necessary for that corporation to become a DISC, 
or a corporation being tested as to whether it qualifies as a DISC.
    (2) Sale, lease, and license. The term ``sale'' includes an exchange 
or other disposition and the term ``lease'' includes a rental or a 
sublease. The term ``license'' includes a sublicense. All rules under 
this section and Sec. Sec. 1.993-2 through 1.993-6 applicable to leases 
of export property apply in the same manner to licenses of export 
property. See Sec. 1.993-3(f)(3) for a description of intangible 
property which cannot be export property.
    (3) Gross receipts. The term ``gross receipts'' is defined by 
section 993(f) and Sec. 1.993-6.
    (4) Qualified export assets. The term ``qualified export assets'' is 
defined by section 993(b) and Sec. 1.993-2.
    (5) Export property. The term ``export property'' is defined by 
section 993(c) and Sec. 1.993-3.
    (6) Related person. The term ``related person'' means a person who 
is related to another person if either immediately before or after a 
transaction--
    (i) The relationship between such persons would result in a 
disallowance of losses under section 267 (relating to disallowance of 
losses, etc., between related taxpayers), or section 707(b) (relating to 
losses disallowed, etc., between partners and controlled partnerships), 
and the regulations thereunder, or
    (ii) Such persons are members of the same controlled group of 
corporations, as defined in section 1563(a) (relating to definition of 
controlled group of corporations), except that (a) ``more than 50 
percent'' shall be substituted for ``at least 80 percent'' each place it 
appears in section 1563(a) and the regulations

[[Page 714]]

thereunder, and (b) the provisions of section 1563(b) shall not apply in 
determining whether such persons are members of the same controlled 
group.
    (7) Related supplier. The term ``related supplier'' is defined by 
Sec. 1.994-1(a)(3)(ii).
    (8) Controlled group. The term ``controlled group'' is defined by 
paragraph (k) of this section.
    (b) Sales of export property. Qualified export receipts of a DISC 
include gross receipts from the sale of export property by such DISC, or 
by any principal for whom such DISC acts as a commission agent (whether 
or not such principal is a related supplier), pursuant to the terms of a 
contract entered into with a purchaser by such DISC or by such principal 
at any time or by any other person and assigned to such DISC or such 
principal at any time prior to the shipment of such property to the 
purchaser. Any agreement, oral or written, which constitutes a contract 
at law, satisfies the contractual requirement of this paragraph. Gross 
receipts from the sale of export property, whenever received, do not 
constitute qualified export receipts unless the seller (or the 
corporation acting as commission agent for the seller) is a DISC at the 
time of the shipment of such property to the purchaser. For example, if 
a corporation which sells export property under the installment method 
is not a DISC for the taxable year in which the property is shipped to 
the purchaser, gross receipts from such sale do not constitute qualified 
export receipts for any taxable year of the corporation.
    (c) Leases of export property--(1) In general. Qualified export 
receipts of a DISC include gross receipts from the lease of export 
property provided that--
    (i) Such property is held by such DISC (or by a principal for whom 
such DISC acts as commission agent with respect to the lease) either as 
an owner or lessee at the beginning of the term of such lease, and
    (ii) Such DISC qualified (or was treated) as a DISC for its taxable 
year in which the term of such lease began.
    (2) Prepayment of lease receipts. If part or all of the gross 
receipts from a lease of property are prepaid, then--
    (i) All such prepaid gross receipts are qualified export receipts of 
a DISC if it is reasonably expected at the time of such prepayment that 
throughout the term of such lease they would be qualified export 
receipts if received not as a prepayment; or
    (ii) If it is reasonably expected at the time of such prepayment 
that throughout the term of such lease they would not be qualified 
export receipts if received not as a prepayment, then only those prepaid 
receipts, for the taxable years of the DISC for which they would be 
qualified export receipts, are qualified export receipts.


Thus, for example, if a lessee makes a prepayment of the first and last 
years' rent, and it is reasonably expected that the leased property will 
be export property for the first half of the lease period but not the 
second half of such period, the amount of the prepayment which 
represents the first year's rent will be considered qualified export 
receipts if it would otherwise qualify, whereas the amount of the 
prepayment which represents the last year's rent will not be considered 
qualified export receipts.
    (d) Related and subsidiary services--(1) In general. Qualified 
export receipts of a DISC include gross receipts from services furnished 
by such DISC which are related and subsidiary to any sale or lease (as 
described in paragraph (b) or (c) of this section) of export property by 
such DISC or with respect to which such DISC acts as a commission agent, 
provided that such DISC derives qualified export receipts from such sale 
or lease. Such services may be performed within or without the United 
States.
    (2) Services furnished by DISC. Services are considered to be 
furnished by a DISC for purposes of this paragraph if such services are 
provided by--
    (i) The person who sold or lease the export property to which such 
services are related and subsidiary, provided that the DISC acts as a 
commission agent with respect to the sale or lease of such property and 
with respect to such services,
    (ii) The DISC as principal, or any other person pursuant to a 
contract between such person and such DISC, provided the DISC acted as 
principal or

[[Page 715]]

commission agent with respect to the sale or lease of such property, or
    (iii) A member of the same controlled group as the DISC where the 
sale or lease of the export property is made by another member of such 
controlled group provided, however, that the DISC act as principal or 
commission agent with respect to such sale or lease and as commission 
agent with respect to such services.
    (3) Related services. A service is related to a sale or lease of 
export property if--
    (i) Such service is of the type customarily and usually furnished 
with the type of transaction in the trade or business in which such sale 
or lease arose and
    (ii) The contract to furnish such service--
    (a) Is expressly provided for in or is provided for by implied 
warranty under the contract of sale or lease,
    (b) Is entered into on or before the date which is 2 years after the 
date on which the contract under which such sale or lease was entered 
into, provided that the person described in subparagraph (2) of this 
paragraph which is to furnish such service delivers to the purchaser or 
lessor a written offer or option to furnish such services on or before 
the date on which the first shipment of goods with respect to which the 
service is to be performed is delivered, or
    (c) Is a renewal of the services contract described in (a) or (b) of 
this subdivision. Services which may be related to a sale or lease of 
export property include but are not limited to warranty service, 
maintenance service, repair service, and installation service. 
Transportation (including insurance related to such transportation) may 
be related to a sale or lease of export property, provided that the cost 
of such transportation is included in the sale price or rental of the 
property or, if such cost is separately stated, is paid by the DISC (or 
its principal) which sold or leased the property to the person 
furnishing the transportation service. Financing or the obtaining of 
financing for a sale or lease is not a related service for purposes of 
this paragraph.
    (4) Subsidiary services--(i) In general. Services related to a sale 
or lease of export property are subsidiary to such sale or lease only if 
it is reasonably expected at the time of such sale or lease that the 
gross receipts from all related services furnished by the DISC (as 
defined in subparagraphs (2) and (3) of this paragraph) will not exceed 
50 percent of the sum of (a) the gross receipts from such sale or lease 
and (b) the gross receipts from related services furnished by the DISC 
(as described in subparagraph (2) of this paragraph). In the case of a 
sale, reasonable expectations at the time of the sale are based on the 
gross receipts from all related services which may reasonably be 
expected to be performed at any time before the end of the 10-year 
period following the date of such-sale. In the case of a lease, 
reasonable expectations at the time of the lease are based on the gross 
receipts from all related services which may reasonably be expected to 
be performed at any time before the end of the term of such lease 
(determined without regard to renewal options).
    (ii) Allocation of gross receipts from services. In determining 
whether the services related to a sale or lease of export property are 
subsidiary to such sale or lease, the gross receipts to be treated as 
derived from the furnishing of services may not be less than the amount 
of gross receipts reasonably allocated to such services as determined 
under the facts and circumstances of each case without regard to 
whether--
    (a) Such services are furnished under a separate contract or under 
the same contract pursuant to which such sale or lease occurs or
    (b) The cost of such services is specified in the contract of sale 
or lease.
    (iii) Transactions involving more than one item of export property. 
If more than one item of export property is sold or leased in a single 
transaction pursuant to one contract, the total gross receipts from such 
transaction and the total gross receipts from all services related to 
such transaction are each taken into account in determining whether such 
services are subsidiary to such transaction. However, the provisions of 
this subdivision apply only if such items could be included in the same 
product line, as determined under Sec. 1.994-1(c)(7).

[[Page 716]]

    (iv) Renewed service contracts. If under the terms of a contract for 
related services, such contract is renewable within 10 years after a 
sale of export property, or during the term of a lease of export 
property, related services to be performed under the renewed contract 
are subsidiary to such sale or lease if it is reasonably expected at the 
time of such renewal that the gross receipts from all related services 
which have been and which are to be furnished by the DISC (as described 
in subparagraph (2) of this paragraph) will not exceed 50 percent of the 
sum of (a) the gross receipts from such sale or lease and (b) the gross 
receipts from related services furnished by the DISC (as so described). 
Reasonable expectations are determined as provided in subdivision (i) of 
this subparagraph.
    (v) Parts used in services. In a services contract described in 
subparagraph (3) of this paragraph provides for the furnishing of parts 
in connection with the furnishing of related services, gross receipts 
from the furnishing of such parts are not taken into account in 
determining whether under this subparagraph the services are subsidiary. 
See paragraph (b) or (c) of this section to determine whether the gross 
receipts from the furnishing of parts consitute qualified export 
receipts. See Sec. 1.993-3(c)(2)(iv) and (e)(3) for rules regarding the 
treatment of such parts with respect to the manufacture of export 
property and the foreign content of such property, respectively.
    (5) Relation to leases. If the gross receipts for services which are 
related and subsidiary to a lease of property have been prepaid at any 
time for all such services which are to be performed before the end of 
the term of such lease, then as of the time of the prepayment the rules 
in paragraph (c)(2) of this section (relating to prepayment of lease 
receipts) will determine whether prepaid services under this subdivision 
are qualified export receipts. Thus, for example if it is reasonably 
expected that leased property will be export property for the first year 
of the term of the lease but will not be export property for the second 
year of the term, prepaid gross receipts for related and subsidiary 
services to be furnished in the first year may be qualified export 
receipts. However, any prepaid gross receipts for such services to be 
furnished in the second year cannot be qualified export receipts.
    (6) Relation with export property determination. The determination 
as to whether gross receipts from the sale or lease of export property 
constitute qualified export receipts does not depend upon whether 
services connected with such sale or lease are related and subsidiary to 
such sale or lease. Thus, for example, assume that a DISC receives gross 
receipts of $1,000 from the sale of export property and gross, receipts 
of $1,100 from installation and maintenance services which are to be 
furnished by such DISC within 10 years after the sale and which are 
related to such sale. The $1,100 which the DISC receives for such 
services would not be qualified export receipts since the gross receipts 
from the services exceed 50 percent of the sum of the gross receipts 
from the sale and the gross receipts from the related services furnished 
by such DISC. The $1,000 which the DISC receives from the sale of export 
property would, however, be a qualified export receipt if the sale met 
the requirements of paragraph (b) of this section.
    (e) Gains from sales of certain qualified export assets. Qualified 
export receipts of a DISC include gross receipts from the sale by such 
DISC of any assets (wherever located) which, as of the date of such 
sale, are qualified export assets as defined in Sec. 1.993-2 even 
though such assets are not export property (as defined in Sec. 1.993-
3). Gross receipts are derived from the sale of such assets only where 
such sale results in recognized gain (see Sec. 1.993-6(a)). For 
purposes of this paragraph, losses from the sale of such qualified 
export assets shall not be taken into account for purposes of 
determining the DISC's qualified export receipts.
    (f) Dividends. Qualified export receipts of a DISC for a taxable 
year include all dividends includible in the gross income of such DISC 
for such taxable year with respect to the stock of related foreign 
export corporations (as defined in Sec. 1.993-5) and all amounts 
includible in the gross income of such DISC with respect to such 
corporations pursuant to section 951 (relating to

[[Page 717]]

amounts included in the gross income of U.S. shareholders of controlled 
foreign corporations).
    (g) Interest on obligations which are qualified export assets. 
Qualified export receipts of a DISC include interest on any obligation 
which is a qualified export asset of such DISC, including any amount 
includible in gross income as interest (such as, for example, an amount 
treated as original issue discount pursuant to section 1232) or as 
imputed interest under section 483. Gain from the sale of obligations 
described in this paragraph is treated (to the extent such gain is not 
treated as interest on such obligations) as qualified export receipts 
pursuant to paragraph (e) of this section.
    (h) Engineering and architectural services--(1) In general. 
Qualified export receipts of a DISC include gross receipts from 
engineering services (as described in subparagraph (5) of this 
paragraph) or architectural services (as described in subparagraph (5) 
of this paragraph) or architectural services (as described in 
subparagraph (6) of this paragraph) furnished by such DISC (as described 
in subparagraph (7) of this paragraph) for a construction project (as 
defined in subparagraph (8) of this paragraph) located, or proposed for 
location, outside the United States. Such services may be performed 
within or without the United States.
    (2) Services included. Engineering and architectural services 
include feasibility studies for a proposed construction project whether 
or not such project is ultimately initiated.
    (3) Excluded services. Engineering and architectural services do not 
include--
    (i) Services connected with the exploration for minerals or
    (ii) Technical assistance or knowhow.


For purposes of this paragraph, the term ``technical assistance or 
knowhow'' includes activities or programs designed to enable business, 
commerce, industrial establishments, and governmental organizations to 
acquire or use scientific, architectural, or engineering information.
    (4) Other services. Receipts from the performance of construction 
activities other than engineering and architectural services constitute 
qualified export receipts to the extent that such activities are related 
and subsidiary services (within the meaning of paragraph (d) of this 
section) with respect to a sale or lease of export property.
    (5) Engineering services. For purposes of this paragraph, 
engineering services in connection with any construction project (within 
the meaning of subparagraph (8) of this paragraph) include any 
professional services requiring engineering education, training, and 
experience and the application of special knowledge of the mathematical, 
physical, or engineering sciences to such professional services as 
consultation, investigation, evaluation, planning, design, or 
responsible supervision of construction for the purpose of assuring 
compliance with plans, specifications, and design.
    (6) Architectural services. For purposes of this paragraph, 
architectural services include the offering or furnishing of any 
professional services such as consultation, planning, aesthetic, and 
structural design, drawings and specifications, or responsible 
supervision of construction (for the purpose of assuring compliance with 
plans, specifications, and design) or erection, in connection with any 
construction project (within the meaning of subparagraph (8) of this 
paragraph).
    (7) Definition of ``furnished by such DISC''. For purposes of this 
paragraph, architectural and engineering services are considered 
furnished by a DISC if such services are provided--
    (i) By the DISC,
    (ii) By another person (whether or not a United States person) 
pursuant to a contract entered into by such person with the DISC at any 
time prior to the furnishing of such services, provided that the DISC 
acts as principal with respect to the furnishing of such services, or
    (iii) By another person (whether or not a United States person) 
pursuant to a contract for the furnishing of such services entered into 
at any time prior to the furnishing of such services provided that the 
DISC acts as commission agent with respect to such services.
    (8) Definition of ``construction project''. For purposes of this 
paragraph, the term ``construction project'' includes the erection, 
expansion, or repair (but

[[Page 718]]

not including minor remodeling or minor repairs) of new or existing 
buildings or other physical facilities including, for example, roads, 
dams, canals, bridges, tunnels, railroad, tracks, and pipelines. The 
term also includes site grading and improvement and installation of 
equipment necessary for the construction. Gross receipts from the sale 
or lease of construction equipment are not qualified export receipts 
unless such equipment is export property (as defined in Sec. 1.993-3).
    (i) Managerial services--(1) In general. Qualified export receipts 
of a first DISC for its taxable year include gross receipts from the 
furnishing of managerial services provided for another DISC, which is 
not a related person, to aid such unrelated DISC in deriving qualified 
export receipts, provided that at least 50 percent of the gross receipts 
of the first DISC for such year consists of qualified export receipts 
derived from the sale or lease of export property and the furnishing of 
related and subsidiary services, as described in paragraph (b), (c), and 
(d) of this section, respectively.


For purposes of this paragraph, managerial services are considered 
furnished by a DISC if such services are provided--
    (i) By the first DISC,
    (ii) By another person (whether or not a United States person) 
pursuant to a contract entered into by such person with the first DISC 
at any time prior to the furnishing of such services, provided that the 
first DISC acts as principal with respect to the furnishing of such 
services, or
    (iii) By another person (whether or not a United States person) 
pursuant to a contract for the furnishing of such services entered into 
at any time prior to the furnishing of such services provided that the 
DISC acts as commission agent with respect to such services.
    (2) Definition of ``managerial services.'' The term ``managerial 
services'' as used in this paragraph means activities relating to the 
operation of another unrelated DISC which derives qualified export 
receipts from the sale or lease of export property and from the 
furnishing of services related and subsidiary to such sales or leases. 
Such term includes staffing and operational services necessary to 
operate such other DISC, but does not include legal, accounting, 
scientific, or technical services. Examples of managerial services are: 
(i) Export market studies, (ii) making shipping arrangements, and (iii) 
contracting potential foreign purchasers.
    (3) Status of recipient of managerial services--(i) In general. 
Qualified export receipts of a first DISC include receipts from the 
furnishing of managerial services during any taxable year of a recipient 
if such recipient qualifies as a DISC (within the meaning of Sec. 
1.992-1(a) for such taxable year.
    (ii) Recipient deemed to qualify as a DISC. For purposes of 
subdivision (i) of this subparagraph, a recipient is deemed to qualify 
as a DISC for its taxable year if the first DISC obtains from such 
recipient a copy of such recipient's election to be treated as a DISC as 
described in Sec. 1.992-2(a) together with such recipient's sworn 
statement that such election has been filed with the Internal Revenue 
Service Center. The recipient may mark out the names of its shareholders 
on a copy of its election to be treated as a DISC before submitting it 
to the first DISC. The copy of the election and the sworn statement of 
such recipient must be received by the first DISC within 6 months after 
the beginning of the first taxable year of the recipient during which 
such first DISC furnishes managerial services for such recipient. The 
copy of the election and the sworn statement of the recipient need not 
be obtained by the first DISC for subsequent taxable years of the 
recipient.
    (iii) Recipient not treated as a DISC. For purposes of subdivision 
(i) of this subparagraph, a recipient of managerial services is not 
treated as a DISC with respect to such services performed during a 
taxable year for which such recipient does not qualify as a DISC if the 
DISC performing such services does not believe or if a reasonable person 
would not believe (taking into account the furnishing DISC's managerial 
relationship with such recipient DISC) at the beginning of such taxable 
year that the recipient will qualify as a DISC for such taxable year.

[[Page 719]]

    (j) Excluded receipts--(1) In general. Notwithstanding the 
provisions of paragraphs (b) through (i) of this section, qualified 
export receipts of a DISC do not include any of the five amounts 
described in subparagraphs (2) through (6) of this paragraph.
    (2) Sales and leases of property for ultimate use in the United 
States. Property which is sold or leased for ultimate use in the United 
States does not constitute export property. See Sec. 1.993-3(d)(4) 
(relating to determination of where the ultimate use of the property 
occurs). Thus, qualified export receipts of a DISC described in 
paragraph (b) or (c) of this section do not include gross receipts of 
the DISC from the sale or lease of such property.
    (3) Sales of export property accomplished by subsidy. Qualified 
export receipts of a DISC do not include gross receipts described in 
paragraph (b) of this section if the sale of export property (whether or 
not such property consists of agricultural products) is pursuant to any 
of the following:
    (i) The development loan program, or grants under the technical 
cooperation and development grants program of the Agency for 
International Development, or grants under the military assistance 
program administered by the Department of Defense, pursuant to the 
Foreign Assistance Act of 1961, as amended (22 U.S.C. 2151), unless the 
DISC shows to the satisfaction of the district director that, under the 
conditions existing at the time of the sale, the purchaser had a 
reasonable opportunity to purchase, on competitive terms and from a 
seller who was not a U.S. person, goods which were substantially 
identical to such property and which were not manufactured, produced, 
grown, or extracted (as described in Sec. 1.993-3(c)) in the United 
States,
    (ii) The Pub. L. 480 program authorized under title I of the 
Agricultural Trade Development and Assistance Act of 1954, as amended (7 
U.S.C. 1691, 1701-1710),
    (iii) For taxable years ending before January 1, 1974, the Barter 
program of the Commodity Credit Corporation authorized by section 4(h) 
of the Commodity Credit Corporation Charter Act, as amended (15 U.S.C. 
714b(h)), and section 303 of the Agricultural Trade Development and 
Assistance Act of 1954, as amended (7 U.S.C. 1692) but only if the 
taxpayer treats such sales as sales giving rise to excluded receipts,
    (iv) The Export Payment program of the Commodity Credit Corporation 
authorized by sections 5(d) and (f) of the Commodity Credit Corporation 
Charter Act, as amended (15 U.S.C. 714c (d) and (f)),
    (v) The section 32 export payment programs authorized by section 32 
of the Act of August 24, 1935, as amended (7 U.S.C. 612c), and
    (vi) For taxable years beginning after November 3, 1972, the Export 
Sales program of the Commodity Credit Corporation authorized by sections 
5 (d) and (f) of the Commodity Credit Corporation Charter Act, as 
amended (15 U.S.C. 714c (d) and (f)), other than the GSM-4 program 
provided under 7 CFR part 1488, and section 407 of the Agricultural Act 
of 1949, as amended (7 U.S.C. 1427), for the purpose of disposing of 
surplus agricultural commodities and exporting or causing to be exported 
agricultural commodities, except that for taxable years beginning on or 
before November 3, 1972, the taxpayer may treat such sales as sales 
giving rise to excluded receipts.
    (4) Sales or lease of export property and furnishing of engineering 
or architectural services for use by the United States--(i) In general. 
Qualified export receipts of a DISC do not include gross receipts 
described in paragraph (b), (c), or (h) of this section if a sale or 
lease of export property, or the furnishing of engineering or 
architectural services, is for use by the United States or an 
instrumentality thereof in any case in which any law or regulation 
requires in any manner the purchase or lease of property manufactured, 
produced, grown, or extracted in the United States or requires the use 
of engineering or architectural services performed by a U.S. person. For 
example, a sale by a DISC of export property to the Department of 
Defense for use outside the United States would not produce qualified 
export receipts for such DISC if the Department of Defense purchased 
such property from appropriated funds subject to any provisions of the 
Armed Services Procurement Regulations (32

[[Page 720]]

CFR subchapter A, part 6, subpart A) or any appropriations act for the 
Department of Defense for the applicable year which restricts the 
availability of such appropriated funds to the procurement of items 
which are grown, reprocessed, reused, or produced in the United States.
    (ii) Direct or indirect sales or leases. Any sale or lease of export 
property is for use by the United States or an instrumentality thereof 
is such property is sold or leased by a DISC (or by a principal for whom 
such DISC acts as commission agent) to--
    (a) A person who is a related person with respect to such DISC or 
such principal and who sells or leases such property for use by the 
United States or an instrumentality thereof or
    (b) A person who is not a related person with respect to such DISC 
or such principal if, at the time of such sale or lease, there is an 
agreement or understanding that such property will be sold or leased for 
use by the United States or an instrumentality thereof (or if a 
reasonable person would have known at the time of such sale or lease 
that such property would be sold or leased for use by the United States 
or an instrumentality thereof) within 3 years after such sale or lease.
    (iii) Excluded programs. The provisions of subdivisions (i) and (ii) 
of this subparagraph do not apply in the case of a purchase by the 
United States or an instrumentality thereof if such purchase is pursuant 
to--
    (a) The Foreign Military Sales Act, as amended (22 U.S.C. 2751 et 
seq.), or a program under which the U.S. Government purchases property 
for resale, on commercial terms, to a foreign government or agency or 
instrumentality thereof, or
    (b) A program (whether bilateral or multilateral) under which sales 
to the U.S. Government are open to international competitive bidding.
    (5) Services. Qualified export receipts of a DISC do not include 
gross receipts described in paragraph (d) of this section (concerning 
related and subsidiary services) if the services from which such gross 
receipts are derived are related and subsidiary to the sale or lease of 
property which results in excluded receipts pursuant to this paragraph.
    (6) Receipts within controlled group--(i) In general. Gross receipts 
of a corporation do not constitute qualified export receipts for any 
taxable year of such corporation if--
    (a) At the time of the sale, lease, or other transaction resulting 
in such gross receipts, such corporation and the person from whom such 
receipts are directly or indirectly derived (whether or not such 
corporation and such person are the same person) are members of the same 
controlled group (as defined in paragraph (k) of this section) and
    (b) Such corporation and such person each qualifies (or is treated 
under section 992(a)(2)) as a DISC for its taxable year in which its 
receipts arise.


Thus, for example, assume that R, S, X, and Y are members of the same 
controlled group and that X and Y are DISC's. If R sells property to S 
and pays X a commission relating to that sale and if S sells the same 
property to an unrelated foreign party and pays Y a commission relating 
to that sale, the receipts received by X from the sale of such property 
by R to S will be considered to be derived from Y, a DISC which is a 
member of the same controlled group as X, and thus will not result in 
qualified export receipts to X. The receipts received by Y from the sale 
to an unrelated foreign party may, however, result in qualified export 
receipts to Y. For another example, if R and S both assign the 
commissions to X, receipts derived from the sale from R to S will be 
considered to be derived from X acting as commission agent for S and 
will not result in qualified export receipts to X. Receipts derived by X 
from the sale of property by S to an unrelated foreign party, may, 
however, constitute qualified export receipts.
    (ii) Leased property. See Sec. 1.993-3(f)(2) regarding property not 
constituting export property in certain cases where such property is 
leased to any corporation which is a member of the same controlled group 
as the lessor.
    (k) Definition of ``controlled group''. For purposes of sections 991 
through 996 and the regulations thereunder, the term ``controlled 
group'' has the same meaning as is assigned to the term

[[Page 721]]

``controlled group of corporations'' by section 1563(a), except that (1) 
the phrase ``more than 50 percent'' is substituted for the phrase ``at 
least 80 percent'' each place the latter phrase appears in section 
1563(a), and (2) section 1563(b) shall not apply. Thus, for example, a 
foreign corporation subject to tax under section 881 may be a member of 
a controlled group. Furthermore, two or more corporations (including a 
foreign corporation) are members of a controlled group at any time such 
corporations meet the requirements of section 1563(a) (as modified by 
this paragraph).
    (l) DISC's entitlement to income--(1) Application of section 994. A 
corporation which meets the requirements of Sec. 1.992-1(a) to be 
treated as a DISC for a taxable year is entitled to income, and the 
intercompany pricing rules of section 994(a)(1) or (2) apply, in the 
case of any transactions described in Sec. 1.994-1(b) between such DISC 
and its related supplier (as defined in Sec. 1.994-1(a)(3)). For 
purposes of this subparagraph, such DISC need not have employees or 
perform any specific function.
    (2) Other transactions. In the case of a transaction to which the 
provisions of subparagraph (1) of this paragraph do not apply but from 
which a DISC derives gross receipts, the income to which the DISC is 
entitled as a result of the transaction is determined pursuant to the 
terms of the contract for such transaction and, if applicable, section 
482 and the regulations thereunder.
    (3) Examples. The provisions of this paragraph may be illustrated by 
the following examples:

    Example 1. P Corporation forms S Corporation as a wholly-owned 
subsidiary. S qualifies as a DISC for its taxable year. S has no 
employees on its payroll. S is granted a franchise with respect to 
specified exports of P. P will sell such exports to S for resale by S. 
Such exports are of a type which produce qualified export receipts as 
defined in paragraph (b) of this section. P's sales force will solicit 
orders in the name of S using S's order forms. S places orders with P 
only when S itself has received orders. No inventory is maintained by S. 
P makes shipments directly to customers of S. Employees of P will act 
for S and billings and collections will be handled by P in the name of 
S. Under these facts, the income derived by S for such taxable year from 
the purchase and resale of the specified export is treated for Federal 
income tax purposes as the income of S, and the amount of income 
allocable to S will be determined under section 994 of the Code.
    Example 2. P Corporation forms S Corporation as a wholly-owned 
subsidiary. S qualifies as a DISC for its taxable year. S has no 
employees on its payroll. S is granted a sales franchise with respect to 
specified exports of P and will receive commissions with respect to such 
exports. Such exports are of a type which will produce gross receipts 
for S which are qualified export receipts as defined in paragraph (b) of 
this section. P's sales force will solicit orders in the name of P. 
Billings and collections are handled directly by P. Under these facts, 
the commissions paid to S for such taxable year with respect to the 
specified exports shall be treated for Federal income tax purposes as 
the income of S, and the amount of income allocable to S is determined 
under section 994 of the Code.

[T.D. 7514, 42 FR 55454, Oct. 17, 1977; 42 FR 60910, Nov. 30, 1977, as 
amended by T.D. 7854, 47 FR 51739, Nov. 17, 1982]



Sec. 1.993-2  Definition of qualified export assets.

    (a) In general. For a corporation to qualify as a DISC, at the close 
of its taxable year it must have qualified export assets with adjusted 
bases equal to at least 95 percent of the sum of the adjusted bases of 
all its assets. An asset which is a qualified export asset under more 
than one paragraph of this section shall be taken into account only once 
in determining the sum of the adjusted bases of all qualified export 
assets. Under section 993(b), the qualified export assets held by a 
corporation are--
    (1) Export property as defined in Sec. 1.993-3 (see paragraph (b) 
of this section),
    (2) Business assets described in paragraph (c) of this section,
    (3) Trade receivables described in paragraph (d) of this section,
    (4) Temporary investments to the extent described in paragraph (e) 
of this section,
    (5) Producer's loans as defined in Sec. 1.993-4 (see paragraph (f) 
of this section),
    (6) Stock or securities (described in paragraph (g) of this section) 
of related foreign export corporations as defined in Sec. 1.993-5,
    (7) Export-Import Bank and other obligations described in paragraph 
(h) of this section,

[[Page 722]]

    (8) Financing obligations described in paragraph (i) of this 
section, and
    (9) Funds awaiting investment described in paragraph (j) of this 
section.
    (b) Export property. In general, export property is certain property 
held for sale or lease which meets the requirements of Sec. 1.993-3.
    (c) Business assets. For purposes of this section, business assets 
are assets used by a DISC (other than as a lessor) primarily in 
connection with--
    (1) The sale, lease, storage, handling, transportation, packaging, 
assembly, or servicing of export property, or
    (2) The performance of engineering or architectural services 
(described in Sec. 1.993-1(h)) or managerial services (described in 
Sec. 1.993-1(i)) in furtherance of the production of qualified export 
receipts.


Assets used primarily in the manufacture, production, growth, or 
extraction (within the meaning of Sec. 1.993-3(c)) of property are not 
business assets.
    (d) Trade receivables--(1) In general. For purposes of this section, 
trade receivables are accounts receivable and evidences of indebtedness 
which arise by reason of transactions of such corporation or of another 
corporation which is a DISC and which is a member of a controlled group 
which includes such corporation described in subparagraph (A), (B), (C), 
(D), (G), or (H), of section 993(a)(1) and which are due the DISC (or, 
if it acts as an agent, due its principal) and held by the DISC.
    (2) Trade receivables representing commissions. If a DISC acts as 
commission agent for a principal in a transaction described in Sec. 
1.993-1 (b), (c), (d), (e), (h), or (i) which results in qualified 
export receipts for the DISC, and if an account receivable or evidence 
of indebtedness held by the DISC and representing the commission payable 
to the DISC as a result of the transaction arises (and, in the case of 
an evidence of indebtedness, designated on its face as representing such 
commission), such account receivable or evidence of indebtedness shall 
be treated as a trade receiveable. If, however, the principal is a 
related supplier (as defined in Sec. 1.994-1(a)(3)) with respect to the 
DISC, such account receivable or evidence of indebtedness will not be 
treated as a trade receivable unless it is payable and paid in a time 
and manner which satisfy the requirements of Sec. 1.994-1(e)(3) or (5) 
(relating to initial payment of transfer price or commission and 
procedure for adjustments to transfer price or commission, 
respectively), as the case may be. However, see subparagraph (3) of this 
paragraph for rules regarding certain accounts receivable representing 
commissions payable to a DISC by its related supplier.
    (3) Indebtedness arising under Sec. 1.994-1(e). An indebtedness 
arising under Sec. 1.994-1(e)(3)(iii) (relating to initial payment of 
transfer price or commission) in favor of a DISC is not a qualified 
export asset. An indebtedness arising under Sec. 1.994-1(e)(5)(i) 
(relating to procedure for adjustments to transfer price or commission) 
in favor of a DISC is a trade receivable if it is paid in the time and 
manner described in Sec. 1.994-1(e)(5)(i) and (ii) and if it otherwise 
satisfies the requirements of subparagraph (2) of this paragraph. If 
such an indebtedness is not paid in the time and manner described in 
Sec. 1.994-1(e)(5)(i) and (ii), it is not a qualified export asset.
    (e) Temporary investments--(1) In general. For purposes of this 
section, temporary investments are money, bank deposits (not including 
time deposits of more than 1 year), and other similar temporary 
investments to the extent maintained by a DISC as reasonably necessary 
to meet its requirements for working capital. For purposes of this 
paragraph, a temporary investment is an obligation, including an 
evidence of indebtedness as defined in paragraph (d)(1) of this section, 
which is a demand obligation or has a period remaining to maturity of 
not more than 1 year at the date it is acquired by the DISC. A temporary 
investment does not include trade receivables.
    (2) Determination of amount of working capital maintained. For 
purposes of this paragraph--
    (i) The working capital of a DISC is the excess of its current 
assets over current liabilities.
    (ii) Current assets are cash and other assets (other than trade 
receivables) which may reasonably be expected to be converted into cash 
or sold or consumed during the current normal operating cycle of the 
DISC's trade or business.

[[Page 723]]

    (iii) Current liabilities are obligations (or portions of 
obligations) due within the current normal operating cycle of the trade 
or business of the DISC whose satisfaction when due is reasonably 
expected to require the use of current assets.
    (iv) Generally accepted financial accounting treatments will be 
accepted, and
    (v) Current assets (other than temporary investments) are taken into 
account before temporary investments, and trade receivables are never 
taken into account, in determining whether such temporary investments 
are maintained by the DISC as reasonably necessary to meet his current 
liabilities and its requirements for working capital.
    (3) Determination of amount of working capital reasonably required. 
For purposes of this paragraph, a determination of the amount of money, 
bank deposits, and other similar temporary investments reasonably 
necessary to meet the requirements of the DISC for working capital will 
depend upon the nature and volume of the activities of the DISC existing 
at the end of the DISC's taxable year for which such determination is 
made, such as, for example--
    (i) In the case of a DISC which purchases and sells inventory, the 
amount of working capital reasonably required is limited to an amount 
reasonably necessary to meet the ordinary operating expenses during the 
current normal operating cycle of the trade or business of the DISC, an 
amount reasonably needed to meet specific and definite plans for 
expansion and any amounts necessary for reasonably anticipated 
extraordinary business expenses.
    (ii) In the case of a DISC which actively conducts a trade or 
business (including the employment of a sales force) and receives 
commissions in respect of goods to which such DISC does not have title, 
the amount of working capital required will depend upon the nature and 
volume of the activities of the DISC which produce such income as they 
exist on the applicable determination date. In determining the amount of 
working capital which is reasonably required for the production of such 
income, the anticipated future needs of the business will be taken into 
account to the extent that such needs relate to the year of the DISC 
following the applicable determination date. Anticipated future needs 
relating to a later period will not be taken into account unless it is 
clearly established that such needs are reasonably related to the 
production of such income as of the applicable determination date.
    (iii) In the case of a DISC which does not actively conduct a trade 
or business, and which receives commissions solely by reason of section 
994(a)(1), (a)(2), or (b) with respect to goods to which such DISC does 
not have title, no working capital would be required beyond a de minimis 
amount unless it appears from the facts and circumstances that 
additional working capital will be required.
    (iv) In the case of a DISC deriving income from the leasing of 
property, the amount of working capital required will be determined on 
the basis of the facts and circumstances in such case.
    (4) Relationship of working capital to other qualified export 
assets. If a temporary investment is a qualified export asset under any 
provision of this section (other than this paragraph), this paragraph 
shall not affect its status as a qualified export asset. However, any 
such temporary investment is taken into account before other temporary 
investments in determining whether such other temporary investments are 
maintained by a DISC as reasonably necessary to meet its requirements 
for working capital. Current assets (other than temporary investments) 
are taken into account before temporary investments, and trade 
receivables are never taken into account, in determining whether such 
temporary investments are maintained by the DISC as reasonably necessary 
requirements for working capital. An obligation issued or incurred by a 
member of a controlled group (as defined in Sec. 1.993-1(k)) of which 
the DISC is a member is not a qualified export asset under this 
paragraph. For rules regarding working capital as of the end of each 
month of a taxable year for purposes of the 70-percent reasonableness 
standard with respect to certain deficiency distributions, see paragraph 
(j)(3) of this section.

[[Page 724]]

    (f) Producer's loans. For purposes of this section, a producer's 
loan is an evidence of indebtedness arising in connection with 
producer's loans which are made by a DISC and which meet the 
requirements of Sec. 1.993-4. If a producer's loan is a qualified 
export asset, interest accrued with respect to the producer's loan will 
also be treated as a qualified export asset provided that payment is 
made in the form of money, property (valued at its fair market value on 
its date of transfer and including accounts receivable for sales by or 
through a DISC), a written obligation which qualifies as a debt under 
the safe harbor rule of Sec. 1.992-1(d)(2)(ii), or an accounting entry 
offsetting the account receivable against an existing debt owed by the 
person in whose favor the account receivable was established to the 
person with whom it engaged in the transaction and that payment is made 
no later than 60 days following the close of the taxable year of accrual 
of the interest. This paragraph (f) is effective for taxable years 
beginning after January 10, 1985 except that the taxpayer may at its 
option apply the provisions of this paragraph to taxable years ending 
after December 31, 1971.
    (g) Stock or securities of related foreign corporations. For 
purposes of this section, the term ``stock or securities'', with respect 
to a related foreign export corporation (as defined in Sec. 1.993-5), 
has the same meaning as such term has as used in section 351 (relating 
to transfers to controlled corporations), except that the term 
``securities'' does not include obligations which are repaid, in whole 
or in part, at any time during the taxable year of the DISC following 
the taxable year of the DISC during which such obligations were acquired 
by the DISC or were issued, unless the DISC demonstrates to the 
satisfaction of the district director that the repayment was for bona 
fide business purposes and not for the purpose of avoidance of Federal 
income taxes.
    (h) Export-Import Bank obligations. For purposes of this section, 
the term ``Export-Import Bank obligations'' means obligations issued, 
guaranteed, insured, or reinsured (in whole or in part) by the Export-
Import Bank of the United States or by the Foreign Credit Insurance 
Association, but only if such obligations are acquired by the DISC--
    (1) From the Export-Import Bank of the United States,
    (2) From the Foreign Credit Insurance Association, or
    (3) From the person selling or purchasing the goods or services by 
reason of which such obligations arose, or from any corporation which is 
a member of the same controlled group (as defined in Sec. 1.993-1(k)) 
as such person.


For purposes of this paragraph, obligations issued by a person described 
in subparagraphs (1), (2), and (3) of this paragraph are treated as 
acquired from such person by the DISC if acquired from any person not 
more than 90 days after the date of original issue (as defined in Sec. 
1.1232-3(b)(3)). Examples of specific types of Export-Import Bank 
obligations include debentures issued by such bank and certificates of 
loan participation.
    (i) Financing obligations. For purposes of this section, financing 
obligations are obligations (held by a DISC) of a domestic corporation 
organized solely for the purpose of financing sales of export property 
pursuant to an agreement with the Export-Import Bank of the United 
States under which such corporation makes export loans guaranteed by 
such Bank.
    (j) Funds awaiting investment--(1) In general. For purposes of this 
section, subject to the limitation descibed in subparagraph (2) of this 
paragraph, if, at the close of a DISC's taxable year, the sum of the 
DISC's money, bank deposits, and other similar temporary investments is 
determined under paragraph (e) of this section to exceed an amount 
reasonably necessary to meet the DISC's requirements for working 
capital, the amount of the DISC's bank deposits in the United States to 
the extent of the amount of this excess are funds awaiting investment at 
the close of such taxable year.
    (2) Limitation. Bank deposits described in subparagraph (1) of this 
paragraph are funds awaiting investment only if, by the last day of each 
of the sixth, seventh, and eighth months after the close of such taxable 
year, the sum of the adjusted bases of the qualified export assets of 
the DISC (other

[[Page 725]]

than such bank deposits) equals or exceeds 95 percent of the sum of the 
adjusted bases of all assets of the DISC (including such bank deposits) 
it held on the last day of such taxable year. For purposes of this 
subparagraph, the adjusted bases of assets of a DISC are determined as 
of the end of each of the months referred to in this subparagraph. Funds 
awaiting investment as described in this paragraph need not be traceable 
to any of the qualified export assets held by the DISC at the end of any 
of the months referred to in this subparagraph.
    (3) Coordination with certain deficiency distribution provisions. 
Under section 992(c)(3) and Sec. 1.992-3(d) a deficiency distribution 
made on or before the 15th day of the ninth month after the end of a 
corporation's taxable year is deemed to be for reasonable cause if 
certain requirements are met, including the requirement (described in 
section 992(c)(3)(B) and Sec. 1.992-3(d)(2)) that the sum of the 
adjusted bases of the qualified export assets held by the corporation on 
the last day of each month of such year equals or exceeds 70 percent of 
the sum of the adjusted bases of all assets held by the corporation on 
each such last day. If, on any such last day, the sum or a DISC's money, 
bank deposits, and other similar temporary investments is determined 
under paragraph (e) of this section to exceed an amount reasonably 
necessary to meet the DISC's requirements for working capital, the 
amount of the DISC's bank deposits to the extent of the amount of this 
excess are funds awaiting investment on such last day, if either--
    (i) The requirements of subparagraph (2) of this paragraph are 
satisfied with respect to the taxable year of the DISC which includes 
such month or
    (ii) At the close of such taxable year the sum of the DISC's money, 
bank deposits, and other similar temporary investments is determined 
under paragraph (e) of this section not to exceed an amount reasonably 
necessary to meet the DISC's requirements for working capital.

(Secs. 995(e)(7), (8) and (10), 995(g) and 7805 of the Internal Revenue 
Code of 1954 (90 Stat. 1655, 26 U.S.C. 995 (e)(7), (8) and (10); 90 
Stat. 1659, 26 U.S.C. 995(g); and 68A Stat 917, 26 U.S.C. 7805))

[T.D. 7514, 42 FR 55459, Oct. 17, 1977; 42 FR 60910, Nov. 30, 1977, as 
amended by T.D. 7854, 47 FR 51740, Nov. 17, 1982; T.D. 7984, 49 FR 
40018, Oct. 12, 1984]



Sec. 1.993-3  Definition of export property.

    (a) General rule. Under section 993(c), except as otherwise provided 
with respect to excluded property in paragraph (f) of this section and 
with respect to certain short supply property in paragraph (i) of this 
section, export property is property in the hands of any person (whether 
or not a DISC)--
    (1) Manufactured, produced, grown, or extracted in the United States 
by any person or persons other than a DISC (see paragraph (c) of this 
section),
    (2) Held primarily for sale or lease in the ordinary course of a 
trade or business to any person for direct use, consumption, or 
disposition outside the United States (see paragraph (d) of this 
section),
    (3) Not more than 50 percent of the fair market value of which is 
attributable to articles imported into the United States (see paragraph 
(e) of this section), and
    (4) Which is not sold or leased by a DISC, or with a DISC as 
commission agent, to another DISC which is a member of the same 
controlled group (as defined in Sec. 1.993-1(k)) as the DISC.
    (b) Services. For purposes of this section, services (including the 
written communication of services in any form) are not export property. 
Whether an item is property or services shall be determined on the basis 
of the facts and circumstances attending the development and disposition 
of the item. Thus, for example, the preparation of a map of a particular 
construction site would constitute services and not export property, but 
standard maps prepared for sale to customers generally would not 
constitute services and would be export property if the requirements of 
this section were otherwise met.

[[Page 726]]

    (c) Manufacture, production, growth, or extraction of property--(1) 
By a person other than a DISC. Export property may be manufactured, 
produced, grown, or extracted in the United States by any person, 
provided that such person does not qualify (and is not treated) as a 
DISC. Property held by a DISC which was manufactured, produced, grown, 
or extracted by it at a time when it did not qualify (and was not 
treated) as a DISC is not export property of the DISC. Property which 
sustains further manufacture or production outside the United States 
prior to sale or lease by a person but after manufacture or production 
in the United States will not be considered as manufactured, produced, 
grown, or extracted in the United States by such person.
    (2) Manufactured or produced--(i) In general. For purposes of this 
section, property which is sold or leased by a person is considered to 
be manufactured or produced by such person if such property is 
manufactured or produced (within the meaning of either subdivision (ii), 
(iii), or (iv) of this subparagraph) by such person or by another person 
pursuant to a contract with such person. Except as provided in 
subdivision (iv) of this subparagraph, manufacture or production of 
property does not include assembly or packaging operations with respect 
to property.
    (ii) Substantial transformation. Property is manufactured or 
produced by a person if such property is substantially transformed by 
such person. Examples of substantial transformation of property would 
include the conversion of woodpulp to paper, steel rods to screws and 
bolts, and the canning of fish.
    (iii) Operations generally considered to constitute manufacturing. 
Property is manufactured or produced by a person if the operations 
performed by such person in connection with such property are 
substantial in nature and are generally considered to constitute the 
manufacture or production of property.
    (iv) Value added to property. Property is manufactured or produced 
by a person if with respect to such property conversion costs (direct 
labor and factory burden including packaging or assembly) of such person 
account for 20 percent of more of--
    (a) The cost of goods sold or inventory amount of such person for 
such property is such property is sold or held for sale, or
    (b) The adjusted basis of such person for such property, as 
determined in accordance with the provisions of section 1011, if such 
property is held for lease or leased.


The value of parts provided pursuant to a services contract, as 
described in Sec. 1.993-1 (d)(4)(v), is not taken into account in 
applying this subdivision.
    (d) Primary purpose of which property is held--(1) In general--(i) 
General rule. Under paragraph (a)(2) of this section, export property 
(a) must be held primarily for the purpose of sale or lease in the 
ordinary course of trade or business to a DISC, or to any other person, 
and (b) such sale or lease must be for direct use, consumption, or 
disposition outside the United States. Thus, property cannot qualify as 
export property unless it is sold or leased for direct use, consumption 
or disposition outside the United States. Property is sold or leased for 
direct use, consumption, or disposition outside the United States if 
such sale or lease satisfies the destination test described in 
subparagraph (2) of this paragraph, the proof of compliance requirements 
described in subparagraph (3) of this paragraph, and the use outside the 
United States test described in subparagraph (4) of this paragraph.
    (ii) Factors not taken into account. In determining whether property 
which is sold or leased to a DISC is sold or leased for direct use 
consumption, or disposition outside the United States, the fact that the 
acquiring DISC holds the property in inventory or for lease prior to the 
time it sells or leases it for direct use, consumption, or disposition 
outside the United States will not affect the characterization of the 
property as export property. Export property need not be physically 
segregated from other property.
    (2) Destination test. (i) For purposes of subparagraph (1) of this 
paragraph the destination test in this subparagraph is satisfied with 
respect to property sold or leased by a seller or lessor only if it is 
delivered by such seller or lessor (or an agent of such seller or 
lessor) regardless of the F.O.B. point or the

[[Page 727]]

place at which title passes or risk of loss shifts from the seller or 
lessor--
    (a) Within the United States to a carrier or freight forwarder for 
ultimate delivery outside the United States to a purchaser or lessee (or 
to a subsequent purchaser or sublessee),
    (b) Within the United States to a purchaser or lessee, if such 
property is ultimately delivered, directly used, or directly consumed 
outside the United States (including delivery to a carrier or freight 
forwarder for delivery outside the United States) by the purchaser or 
lessee (or a subsequent purchaser or sublessee) within 1 year after such 
sale or lease,
    (c) Within or outside the United States to a purchaser or lessee 
which, at the time of the sale or lease, is a DISC and is not a member 
of the same controlled group (as defined in Sec. 1.993-1(k)) as the 
seller or lessor,
    (d) From the United States to the purchaser or lessee (or a 
subsequent purchaser or sublessee) at a point outside the United States 
by means of a ship, aircraft, or other delivery vehicle, owned, leased, 
or chartered by the seller or lessor,
    (e) Outside the United States to a purchaser or lessee from a 
warehouse, a storage facility, or assembly site located outside the 
United States, if such property was previously shipped by such seller or 
lessor from the United States, or
    (f) Outside the United States to a purchaser or lessee if such 
property was previously shipped by such seller or lessor from the United 
States and if such property is located outside the United States 
pursuant to a prior lease by the seller or lessor, and either (1) such 
prior lease terminated at the expiration of its term (or by the action 
of the prior lessee acting alone), (2) the sale occurred or the term of 
the subsequent lease began after the time at which the term of the prior 
lease would have expired, or (3) the lessee under the subsequent lease 
is not a related person (as defined in Sec. 1.993-1(a)(6)) with respect 
to the lessor and the prior lease was terminated by the action of the 
lessor (acting alone or together with the lessee).
    (ii) For purposes of this subparagraph (other than (c) and (f)(3) of 
subdivision (i) thereof), any relationship between the seller or lessor 
and any purchaser, subsequent purchaser, lessee, or sublessee is 
immaterial.
    (iii) In no event is the destination test of this subparagraph 
satisfied with respect to property which is subject to any use (other 
than a resale or sublease), manufacture, assembly, or other processing 
(other than packaging) by any person between the time of the sale or 
lease by such seller or lessor and the delivery or ultimate delivery 
outside the United States described in this subparagraph.
    (iv) If property is located outside the United States at the time it 
is purchased by a person or leased by a person as lessee, such property 
may be export property in the hands of such purchaser or lessee only if 
it is imported into the United States prior to its further sale or lease 
(including a sublease) outside the United States. Paragraphs (a)(3) and 
(e) of this section (relating to 50 percent foreign content test) are 
applicable in determining whether such property is export property. 
Thus, for example, if such property is not subjected to manufacturing or 
production (as defined in paragraph (c) of this section) within the 
United States after such importation, it does not qualify as export 
property.
    (3) Proof of compliance with destination test--(i) Delivery outside 
the United States. For purposes of subparagraph (2) of this paragraph 
(other than subdivision (i)(c) thereof), a seller or lessor shall 
establish ultimate delivery, use, or consumption of property outside the 
United States by providing--
    (a) A facsimile or carbon copy of the export bill of lading issued 
by the carrier who delivers the property,
    (b) A certificate of an agent or representative of the carrier 
disclosing delivery of the property outside the United States,
    (c) A facsimile or carbon copy of the certificate of lading for the 
property executed by a customs officer of the country to which the 
property is delivered,
    (d) If such country has no customs administration, a written 
statement by the person to whom delivery outside the United States was 
made,

[[Page 728]]

    (e) A facsimile or carbon copy of the shipper's export declaration, 
a monthly shipper's summary declaration filed with the Bureau of 
Customs, or a magnetic tape filed in lieu of the Shipper's Export 
Declaration, covering the property,
    (f) Any other proof (including evidence as to the nature of the 
property or the nature of the transaction) which establishes to the 
satisfaction of the Commissioner that the property was ultimately 
delivered, or directly sold, or directly consumed outside the United 
States within 1 year after the sale or lease.
    (ii) The requirements of subdivision (i) (a), (b), (c), or (e) of 
this subparagraph will be considered satisfied even though the name of 
the ultimate consignee and the price paid for the goods is marked out 
provided that, in the case of a Shipper's Export Declaration or other 
document listed in such subdivision (e) or a document such as an export 
bill of lading such document still indicates the country in which 
delivery to the ultimate consignee is to be made and, in the case of a 
certificate of an agent or representative of the carrier, that such 
document indicates that the property was delivered outside the United 
States.
    (iii) A seller or lessor shall also establish the meeting of the 
requirement of subparagraph (2)(i) of this paragraph (other than 
subdivision (c) thereof), that the property was delivered outside the 
United States without further use, manufacture, assembly, or other 
processing within the United States.
    (iv) Sale or lease to an unrelated DISC. For purposes of 
subparagraph (2)(i)(c) of this paragraph, a purchaser or lessee of 
property is deemed to qualify as a DISC for its taxable year if the 
seller or lessor obtains from such purchaser or lessee a copy of such 
purchaser's or lessee's election to be treated as a DISC as described in 
Sec. 1.992-2(a) together with such purchaser's or lessee's sworn 
statement that such election has been filed with the Internal Revenue 
Service Center. The copy of the election and the sworn statement of such 
purchaser or lessee must be received by the seller or lessor within 6 
months after the sale or lease. A purchaser or lessee is not treated as 
a DISC with respect to a sale or lease during a taxable year for which 
such purchaser or lessee does not qualify as a DISC if the seller or 
lessor does not believe or if a reasonable person would not believe at 
the time such sale or lease is made that the purchaser or lessee will 
qualify as a DISC for such taxable year.
    (v) Failure of proof. If a seller or lessor fails to provide proof 
of compliance with the destination test as required by this 
subparagraph, the property sold or leased is not export property.
    (4) Sales and leases of property for ultimate use in the United 
States--(i) In general. For purposes of subparagraph (1) of this 
paragraph, the use test in this subparagraph is satisfied with respect 
to property which--
    (a) Under subdivisions (ii) through (iv) of this subparagraph is not 
sold for ultimate use in the United States or
    (b) Under subdivision (v) of this subparagraph is leased for 
ultimate use outside the United States.
    (ii) Sales of property for ultimate use in the United States. For 
purposes of subdivision (i) of this subparagraph, a purchaser of 
property (including components, as defined in subdivision (vii) of this 
subparagraph) is deemed to use such property ultimately in the United 
States if any of the following conditions exists:
    (a) Such purchaser is a related person (as defined in Sec. 1.993-
1(a)(6)) with respect to the seller and such purchaser ultimately uses 
such property, or a second product into which such property is 
incorporated as a component, in the United States.
    (b) At the time of the sale, there is an agreement or understanding 
that such property, or a second product into which such property is 
incorporated as a component, will be ultimately used by the purchaser in 
the United States.
    (c) At the time of the sale, a reasonable person would have believed 
that such property or such second product would be ultimately used by 
such purchaser in the United States unless, in the case of a sale of 
components, the fair market value of such components at the time of 
delivery to the purchaser constitutes less than 20 percent of the fair 
market value of the second product into which such components are 
incorporated (determined at the time of

[[Page 729]]

completion of the production, manufacture or assembly of such second 
product).


For purposes of (b) of this subdivision, there is an agreement or 
understanding that property will ultimately be used in the United States 
if, for example, a component is sold abroad under an express agreement 
with the foreign purchaser that the component is to be incorporated into 
a product to be sold back to the United States. As a further example 
there would also be such an agreement or understanding if the foreign 
purchaser indicated at the time of the sale or previously that the 
component is to be incorporated into a product which is designed 
principally for the United States market. However, such an agreement or 
understanding does not result from the mere fact that a second product, 
into which components exported from the United States have been 
incorporated and which is sold on the world market, is sold in 
substantial quantities in the United States.
    (iii) Use in the United States. For purposes of subdivision (ii) of 
this subparagraph, property (including components incorporated into a 
second product) is or would be ultimately used in the United States by 
such purchaser if, at any time within 3 years after the purchase of such 
property or components, either such property or components (or the 
second product into which such components are incorporated) is resold by 
such purchaser for use by a subsequent purchaser within the United 
States or such purchaser or subsequent purchaser fails, for any period 
of 365 consecutive days, to use such property or second product 
predominantly outside the United States as defined in subdivision (vi) 
of this subparagraph).
    (iv) Sales to retailers. For purposes of subdivision (ii)(c) of this 
subparagraph, property sold to any person whose principal business 
consists of selling from inventory to retail customers at retail outlets 
ouside the United States will be considered as property for ultimate use 
outside the United States.
    (v) Leases of property for ultimate use outside the United States. 
For purposes of subdivision (i) of this subparagraph a lessee of 
property is deemed to use such property ultimately outside the United 
States during a taxable year of the lessor if such property is used 
predominantly outside the United States (as defined in subdivision (vi) 
of this subparagraph) by the lessee during the portion of the lessor's 
taxable year which is included within the term of the lease. A 
determination as to whether the ultimate use of leased property 
satisfies the requirements of this subdivision is made for each taxable 
year of the lessor. Thus, leased property may be used predominantly 
outside the United States for a taxable year of the lessor (and thus, 
constitute export property if the remaining requirements of this section 
are met) even if the property is not used predominantly outside the 
United States in earlier taxable years or later taxable years of the 
lessor.
    (vi) Predominant use outside the United States. For purposes of this 
subparagraph, property is used predominantly outside the United States 
for any period if, during such period, such property is located outside 
the United States more than 50 percent of the time. An aircraft, 
railroad rolling stock, vessel, motor vehicle, container, or other 
property used for transportation purposes in deemed to be used 
predominantly outside the United States for any period if, during such 
period, either such property is located outside the United States more 
than 50 percent of the time or more than 50 percent of the miles 
traversed in the use of such property are traversed in outside the 
United States. However, any such property is deemed to be within the 
United States at all times during which it is engaged in transport 
between any two points within the United States, except where such 
transport constitutes uninterrupted international air transportation 
within the meaning of section 4262(c)(3) and the regulations thereunder 
(relating to tax on air transportation of persons). For purposes of 
applying section 4262(c)(3) to this subdivision, the term ``United 
States'' has the same meaning as in Sec. 1.993-7.
    (vii) Component. For purposes of this subparagraph, a component is 
property which is (or is reasonably expected to be) incorporated into a 
second product by the purchaser of such component by

[[Page 730]]

means of production, manufacture, or assembly.
    (e) Foreign content of property--(1) The 50 percent test. Under 
paragraph (a)(3) of this section, no more than 50 percent of the fair 
market value of export property may be attributable to the fair market 
value of articles which were imported into the United States. For 
purposes of this paragraph, articles imported into the United States are 
referred to as ``foreign content''. The fair market value of the foreign 
content of export property is computed in accordance with subparagraph 
(4) of this paragraph. The fair market value of export property which is 
sold to a person who is not a related person with respect to the seller 
is the sale price for such property (not including interest finance or 
carrying charges, or similar charges)
    (2) Application of 50 percent test. The 50 percent test described in 
subparagraph (1) of this paragraph is applied on an item-by-item basis 
If, however, a person sells or leases a substantial volume of 
substantially identical export property in a taxable year and if all of 
such property contains substantially identical foreign content is 
substantially the same proportion, such person may determine the portion 
of foreign content contained in such property on an aggregate basis.
    (3) Parts and services. If, at the time property is sold or leased 
the seller or lessor agrees to furnish parts pursuant to a services 
contract (as provided in Sec. 1.993-1(d)(4)(v)) and the price for the 
parts is not separately stated, the 50 percent test described in 
subparagraph (1) of this paragraph is applied on an aggregate basis to 
the property and parts. If the price for the parts is described in 
subparagraph (1) of this paragraph is applied separately to the property 
and to the parts.
    (4) Computation of foreign content--(i) Valuation. For purposes of 
applying the 50 percent test described in subparagraph (1) of this 
paragraph, it is necessary to determine the fair market value of all 
articles which constitute foreign content of the property being tested 
to determine if it is export property. The fair market value of such 
imported articles is determined as of the time such articles are 
imported into the United States. With respect to articles imported into 
the United States before July 1, 1980, the fair market value of such 
articles is their appraised value as determined under section 402 or 
402a of the Tariff Act of 1930 (19 U.S.C. 1401a or 1402) in connection 
with their importation. With respect to articles imported into the 
United States on or after July 1, 1980, the fair market value of such 
articles is their appraised value as determined under section 402 of the 
Tariff Act of 1930 (19 U.S.C. 1401a) in connection with their 
importation. The appraised value of such articles is the full dutiable 
value of such articles, determined, however, without regard to any 
special provision in the United States tariff laws which would result in 
a lower dutiable value. Thus, an article which is imported into the 
United States is treated as entirely imported even if all or a portion 
of such article was originally manufactured, produced, grown, or 
extracted in the United States.
    (ii) Evidence of fair market value. For purposes of subdivision (i) 
of this subparagraph, the fair market value of imported articles 
constituting foreign content may be evidenced by the customs invoice 
issued on the importation of such articles into the United States. If 
the holder of such articles is not the importer (or a related person 
with respect to the importer), the fair market value of such articles 
may be evidenced by a certificate based upon information contained in 
the customs invoice and furnished to the holder by the person from whom 
such articles (or property incorporating such articles) were purchased. 
If a customs invoice or certificate described in the preceding sentence 
is not available to a person purchasing property, such person shall 
establish that no more than 50 percent of the fair market value of such 
property is attributable to the fair market value of articles which were 
imported into the United States.
    (iii) Interchangeable component articles--(a) Where identical or 
similar component articles can be incorporated interchangeably into 
property and a person acquires some such component articles that are 
imported into the United States and other such component articles that 
are not imported

[[Page 731]]

into the United States, the determination whether imported component 
articles were incorporated in such property as is exported from the 
United States shall be made on a substitution basis as in the case of 
the rules relating to drawback accounts under the customs laws. See 
section 313(b) of the Tariff Act of 1930, as amended (19 U.S.C. 
1313(b)).
    (b) The provisions of (a) of this subdivision may be illustrated by 
the following example:

    Example. Assume that a manufacturer produces a total of 20,000 
electronic devices. The manufacturer exports 5,000 of the devices and 
subsequently sells 11,000 of the devices to a DISC which exports the 
11,000 devices. The major single component article in each device is a 
tube which represents 60 percent of the fair market value of the device 
at the time the device is sold by the manufacturer. The manufacturer 
imports 8,000 of the tubes and produces the remaining 12,000 tubes. For 
purposes of this subdivision, in accordance with the substitution 
principle used in the customs drawback laws, the 5,000 devices exported 
by the manufacturer are each treated as containing an imported tube 
because the devices were exported prior to the sale to the DISC. The 
remaining 3,000 imported tubes are treated as being contained in the 
first 3,000 devices purchased and exported by the DISC. Thus, since the 
50 percent test is not met with respect to the first 3,000 devices 
purchased and exported by the DISC, those devices are not export 
property. The remaining 8,000 devices purchased and exported by the DISC 
are treated as containing tubes produced in United States, and those 
devices are export property (if they otherwise meet the requirements of 
this section).

    (f) Excluded property--(1) In general. Notwithstanding any other 
provision of this section, the following property is not export 
property--
    (i) Property described in subparagraph (2) of this paragraph 
(relating to property leased to a member of a controlled group),
    (ii) Property described in subparagraph (3) of this paragraph 
(relating to certain types of intangible property),
    (iii) Products described in paragraph (g) of this section (relating 
to depletable products), and
    (iv) Products described in paragraph (h) of this section (relating 
to certain export controlled products).
    (2) Property leased to member of controlled group--(i) In general. 
Property leased to a person (whether or not a DISC) which is a member of 
the same controlled group (as defined in Sec. 1.993-1(k)) as the lessor 
constitutes export property for any period of time only if during the 
period--
    (a) Such property is held for sublease, or is subleased, by such 
person to a third person for the ultimate use of such third person;
    (b) Such third person is not a member of the same controlled group; 
and
    (c) Such property is used predominantly outside the United States by 
such third person.
    (ii) Predominant use. The provisions of paragraph (d)(4)(vi) of this 
section apply in determining under subdivision (i)(c) of this 
subparagraph whether such property is used predominently outside the 
United States by such third person.
    (iii) Leasing rule. For purposes of this subparagraph, leased 
property is deemed to be ultimately used by a member of the same 
controlled group as the lessor if such property is leased to a person 
which is not a member of such controlled group but which subleases such 
property to a person which is a member of such controlled group. Thus, 
for example, if X, a DISC for the taxable year, leases a movie film to 
Y, a foreign corporation which is not a member of the same controlled 
group as X, and Y then subleases the film to persons which are members 
of such group for showing to the general public, the film is not export 
property. On the other hand, if X, a DISC for the taxable year, leases a 
movie film to Z, a foreign corporation which is a member of the same 
controlled group as X, and Z then subleases the film to Y, another 
foreign corporation, which is not a member of the same controlled group 
for showing to the general public, the film is not disqualified under 
this subparagraph from being export property.
    (iv) Certain copyrights. With respect to a copyright which is not 
excluded by subparagraph (3) of this paragraph from being export 
property, the ultimate use of such property is the sale or exhibition of 
such property to the general public. Thus, if A, a DISC for the taxable 
year, leases recording tapes to B, a foreign corporation which is a 
member of the same controlled group

[[Page 732]]

as A, and if B makes records from the recording tape and sells the 
records to C, another foreign corporation, which is not a member of the 
same controlled group, for sale by C to the general public, the 
recording tape is not disqualified under this subparagraph from being 
export property, notwithstanding the leasing of the recording tape by A 
to a member of the same controlled group, since the ultimate use of the 
tape is the sale of the records (i.e., property produced from the 
recording tape).
    (3) Intangible property. Export property does not include any 
patent, invention, model, design, formula, or process, whether or not 
patented, or any copyright (other than films, tapes, records, or similar 
reproductions, for commercial or home use), goodwill, trademark, 
tradebrand, franchise, or other like property. Although a copyright such 
as a copyright on a book does not constitute export property, a 
copyrighted article (such as a book) if not accompanied by a right to 
reproduce it is export property if the requirements of this section are 
otherwise satisfied. However, a license of a master recording tape for 
reproduction outside the United States is not disqualified under this 
subparagraph from being export property.
    (g) Depletable products--(1) In general. Under section 993(c)(2)(C), 
a product or commodity which is a depletable product (as defined in 
subparagraph (2) of this paragraph) or contains a depletable product is 
not export property if--
    (i) It is a primary product from oil, gas, coal, or uranium (as 
described in subparagraph (3) of this paragraph), or
    (ii) It does not qualify as a 50-percent manufactured or processed 
product (as described in subparagraph (4) of this paragraph).
    (2) Definition of ``depletable product''. For purposes of this 
paragraph, the term ``depletable product'' means any product or 
commodity of a character with respect to which a deduction for depletion 
is allowable under section 613 or 613A. Thus, the term depletable 
product includes any mineral extracted from a mine, an oil or gas well, 
or any other natural deposit, whether or not the DISC or related 
supplier is allowed a deduction, or is eligible to take a deduction, for 
depletion with respect to the mineral in computing its taxable income. 
Thus, for example, iron ore purchased by a DISC from a broker is a 
depletable product in the hands of the DISC for purposes of this 
paragraph even though the DISC is not eligible to take a deduction for 
depletion under section 613 or 613A.
    (3) Primary product from oil, gas, coal, or uranium. A primary 
product from oil, gas, coal, or uranium is not export property. For 
purposes of this paragraph--
    (i) Primary product from oil. The term ``primary product from oil'' 
means crude oil and all products derived from the destructive 
distillation of crude oil, including--
    (a) Volatile products,
    (b) Light oils such as motor fuel and kerosene,
    (c) Distillates such as naphtha,
    (d) Lubricating oils,
    (e) Greases and waxes, and
    (f) Residues such as fuel oil.


For purposes of this paragraph, a product or commodity derived from 
shale oil which would be a primary product from oil if derived from 
crude oil is considered a primary product from oil.
    (ii) Primary product from gas. The term ``primary product from gas'' 
means all gas and associated hydrocarbon components from gas wells or 
oil wells, whether recovered at the lease or upon further processing, 
including--
    (a) Natural gas,
    (b) Condensates,
    (c) Liquefied petroleum gases such as ethane, propane, and butane, 
and
    (d) Liquid products such as natural gasoline.
    (iii) Primary product from coal. The term ``primary product from 
coal'' means coal and all products recovered from the carbonization of 
coal including--
    (a) Coke,
    (b) Coke-oven gas,
    (c) Gas liquor,
    (d) Crude light oil, and
    (e) Coal tar.
    (iv) Primary product from uranium. The term ``primary product from 
uranium'' means uranium ore and uranium concentrates (known in the 
industry as ``yellow cake''), and nuclear

[[Page 733]]

fuel materials derived from the refining of uranium ore and uranium 
concentrates, or produced in a nuclear reaction, including--
    (a) Uranium hexafluoride,
    (b) Enriched uranium hexafluoride,
    (c) Uranium metal,
    (d) Uranium compounds, such as uranium carbide,
    (e) Uranium dioxide, and
    (f) Plutonium fuels.
    (v) Primary products and changing technology. The primary products 
from oil, gas, coal, or uranium described in subdivisions (i) through 
(iv) of this subparagraph and the processes described in those 
subdivisions are not intended to represent either the only primary 
products from oil, gas, coal, or uranium, or the only processes from 
which primary products may be derived under existing and future 
technologies, such as the gasification and liquefaction of coal.
    (vi) Petrochemicals. For purposes of this paragraph, petrochemicals 
are not considered primary products from oil, gas, or coal.
    (4) 50-percent manufactured or processed product--(i) In general. A 
product or commodity (other than a primary product from oil, gas, coal, 
or uranium) which is or contains a depletable product is not excluded 
from the term ``export property'' by reason of section 993(c)(2)(C) if 
it is a 50-percent manufactured or processed product. Such a product or 
commodity is a ``50-percent manufactured or processed product'' if, 
after the cutoff point of the depletable product, it is manufactured or 
processed (as defined in subdivision (ii) of this subparagraph) and 
either the cost test described in subdivision (iv) of this subparagraph 
or the fair market value test described in subdivision (v) of this 
subparagraph is satisfied. To determine cutoff point, see subdivisions 
(vi) and (vii) of this subparagraph.
    (ii) Manufactured or processed. A product is manufactured or 
processed if it is manufactured or produced within the meaning of 
paragraph (c)(2) of this section, except that for purposes of this 
subdivision the term manufacturing or processing does not include any 
excluded process (as defined in subdivision (iii) of this subparagraph) 
and the term conversion costs (as used in subdivision (iv) of such 
paragraph (c)(2)) does not include any costs attributable to any 
excluded process.
    (iii) Excluded processes. For purposes of this paragraph, excluded 
processes are extracting (i.e., all processes which are applied before 
the cutoff point of the mineral to which such processes are applied), 
and handling, packing, packaging, grading, storing, and transporting.
    (iv) Cost test. A product or commodity will qualify as a 50-percent 
manufactured or processed product if--
    (a) Its manufacturing and processing costs (that is, the portion of 
the cost of goods sold or inventory amount of the product or commodity 
attributable to the aggregate cost of manufacturing or processing each 
mineral contained therein) equal or exceed--
    (b) An amount equal to either of the following:
    (1) 50 percent of its cost of goods sold or inventory amount 
(decreased, at the DISC's option, by the portion of such cost or amount 
the DISC establishes is allocable to the difference between each prior 
owner's selling price for each depletable product contained in such 
product or commodity and such prior owner's cost of goods sold with 
respect thereto).
    (2) The aggregate of the cost at the cutoff point (see subdivisions 
(vi) and (vii) of this subparagraph) properly attributable to each 
mineral contained in such product or commodity. However, if this 
subdivision (2) is applied, then the amount in (a) of this subparagraph 
(iv) shall be decreased and the amount in this subdivision (2) shall be 
increased, by so much of the cost of goods sold or inventory amount of 
the product or commodity as is properly allocable to any process other 
than transportation applied after the cutoff point of such mineral which 
would be a mining process (within the meaning of Sec. 1.613-4) were it 
applied before such point.
    (v) Fair market value test. A product or commodity will qualify as a 
50-percent manufactured or processed product if--
    (a) The excess of its fair market value on the date it is sold, 
exchanged, or otherwise disposed of (or, if not sold, exchanged, or 
otherwise disposed of,

[[Page 734]]

the last day of the DISC's taxable year) over the portion thereof 
properly allocable to excluded processes other than extracting is equal 
to or greater than
    (b) Twice the aggregate of the fair market value at the cutoff point 
for each mineral contained in such product or commodity.


For purposes of this subdivision (v), the fair market value of a product 
or commodity on the date it is sold, exchanged, or otherwise disposed of 
is the price at which it is disposed of, subject to any adjustment that 
may be required under the arm's length standard of section 482 and the 
regulations thereunder. If such product or commodity is not sold, 
exchanged, or otherwise disposed of, then, for purposes of section 
992(a)(1)(B) (relating to the 95-percent test with respect to qualified 
export assets), the fair market value of a product or commodity on the 
last day of the DISC's taxable year is the arm's length price at which 
such product or commodity would have been sold on such date, determined 
by applying the principles of section 482 and the regulations 
thereunder.
    (vi) Cutoff point of a mineral. For purposes of this subparagraph:
    (a) The cutoff point is the point at which gross income from the 
property (within the meaning of section 613(a)) was in fact determined.
    (b) The cost at the cutoff point is deemed to be the amount of the 
gross income from the property of the taxpayer eligible for a depletion 
deduction with respect to the mineral.
    (c) The fair market value at the cutoff point is deemed to be the 
amount of the gross income from the property of the taxpayer eligible 
for a depletion deduction with respect to the mineral, except that, if 
(1) the fair market value of a product or commodity on the date 
specified in subdivision (v)(a) of this subparagraph exceeds the 
aggregate of the fair market value at the cutoff point for each mineral 
contained therein and (2) 10 percent or more of such excess is 
attributable to a net increase in the fair market values of such 
minerals by reason of factors other than manufacturing or processing or 
the application of excluded processes (such as, for example, increases 
in the fair market values of some minerals by reason of inflation or 
speculation exceed decreases in such values of other minerals by reason 
of deflation or speculation), then the aggregate of the fair market 
value at the cutoff point for each such mineral shall be increased to 
reflect the net excess so attributable.
    (d) The provisions of this subdivision (vi) are illustrated by the 
following example.

    Example. An integrated manufacturer, X, on February 1, 1976, had 
gross income from the property (within the meaning of section 613(a)) of 
$50 with respect to a specified volume of a mineral. Thus, the cost at 
the cutoff point of the mineral was $50. X converted the mineral into a 
product which it sold on July 15, 1976, for $75. Of the $25 excess of 
the selling price over the gross income from the property, $23 was 
attributable to manufacturing, processing, and the application or 
excluded processes, and $2 was attributable to an increase in the fair 
market value of the mineral due to inflation between February 1 and July 
15, 1976. Since only 8 percent of such excess ($2/$25) was attributable 
to factors other than manufacturing, processing, and the application of 
excluded processes, the fair market value at the cutoff point of the 
mineral is $50. However, had $3 of the $25 excess, or 12 percent, been 
attributable to an increase in the fair market value of the mineral due 
to inflation, then the fair market value at the cutoff point of the 
mineral would be $53.

    (vii) [Reserved]
    (viii) Special rule for certain used products and scrap products. If 
a product or commodity is a used 50-percent manufactured or processed 
product, or is recovered as scrap from a 50-percent manufactured or 
processed product, such product or commodity will be treated as a 50-
percent manufactured or processed product.
    (ix) Special rule for byproducts and waste products. For purposes of 
applying the cost test or fair market value test of subdivision (iv) or 
(v) of this subparagraph if a depletable product is recovered from a 
manufacturing process as a byproduct or waste product, then the cost and 
fair market value at the cutoff point are each deemed to be the lesser 
of--
    (a) The fair market value of the waste product or byproduct 
containing the depletable product, determined as of the date the 
byproduct or waste product is recovered, or

[[Page 735]]

    (b) The amount the cost at the cut-off point would be for a 
depletable product of like kind and grade which is extracted, determined 
as of the date the byproduct or waste product is recovered.


For purposes of (b) of this subdivision the cutoff point for the 
depletable product of like kind and grade is deemed to be the point at 
which gross income from the property would be determined if such 
depletable product were sold by the taxpayer eligible to take a 
deduction for depletion after the completion of all mining processes 
applied to the depletable product and before the application of any 
nonmining process.
    (x) Proof of satisfaction of 50-percent manufactured or processed 
test. (a) No substantiation is required to establish that either the 
cost test or the fair market value test of subdivisions (iv) or (v) of 
this subparagraph is satisfied or that a product or commodity qualifies 
under (viii) of this subdivision as either a used 50-percent 
manufactured or processed product or as scrap from a 50-percent 
manufactured or processed product as long as it is reasonably obvious, 
on the basis of all relevant facts and circumstances, that either the 
cost test or fair market value test is satisfied, or that the product or 
commodity qualifies as either as used 50-percent manufactured or 
processed product or as scrap from a 50-percent manufactured or 
processed product. Thus, for example, in the case of a DISC exporting a 
high precision lens at least 50 percent of the fair market value of 
which is obviously attributable to grinding, no substantiation of gross 
income from the property properly allocable to the depletable products 
contained in the lens, cost, or fair market values will be required.
    (b) In cases in which satisfaction of either the cost test or the 
fair market value test is not reasonably obvious, a DISC will be 
required to substantiate the gross income from the property properly 
allocable to each depletable product in a product or commodity and 
either all costs or fair market values relied upon the DISC.
    (c) For purposes of substantiating (1) gross income from the 
property properly allocable to a depletable product, (2) costs, and (3) 
fair market values, the DISC and related supplier shall each identify 
items in (or that were in) inventory in the same manner each used to 
identify items in inventory for purposes of computing Federal income 
tax.
    (xi) Application of 50-percent test. The 50-percent test described 
in this subparagraph is applied on an item-by-item basis. If, however, a 
DISC sells a substantial volume of substantially identical products or 
commodities and if all or a group of such products or commodities 
contain substantially identical depletable products in substantially the 
same proportions and have cost or fair market value relationships (as 
the case may be) that are in substantially the same proportions, such 
DISC may apply the 50-percent test on an aggregate basis with respect to 
all such products or commodities, or group, as the case may be.
    (5) Effective dates. Except as provided in subparagraph (6) of this 
paragraph, section 993(c)(2)(C) applies--
    (i) With respect to any product or commodity not owned by a DISC, to 
sales, exchanges, or other dispositions made after March 18, 1975, with 
respect to which the DISC derives gross receipts.
    (ii) With respect to any product or commodity acquired by a DISC 
after March 18, 1975.
    (iii) With respect to any product or commodity owned by a DISC on 
March 18, 1975, to sales, exchanges, or other dispositions made after 
March 18, 1976, and to owning such product or commodity after such date.


For purposes of this paragraph and subparagraph (6) of this paragraph, 
the date of a sale, exchange, or other disposition of a product or 
commodity is the date as of which title to such product or commodity 
passes. The accounting method of a person is not determinative of the 
date of a sale, exchange, or other disposition.
    (6) Fixed contracts. Section 1101(f) of the Tax Reform Act of 1976 
provides an exception to the effective date rules in this paragraph and 
in paragraph (h) of this section. Section 1101(f)(2) of the Act provides 
that section 993(c)(2)(C) and (D) shall not apply to sales, exchanges, 
and other dispositions made

[[Page 736]]

after March 18, 1975, but before March 19, 1980, if they are made 
pursuant to a fixed contract. Section 1101(f)(2) also defines fixed 
contract. Under that definition, if the seller can vary the price of the 
product for unspecified cost increases (which could include tax cost 
increases), or if the quantity of products or commodities to be sold can 
be increased or decreased under the contract by the seller without 
penalty, the contract is not to be considered a fixed contract with 
respect to the amount over which the seller has discretion. For example, 
if a contract calls for a minimum delivery of x amount of a product but 
allows the seller to refuse to deliver goods beyond that minimum amount 
(or allows a renegotiation of the sales price of goods beyond that 
amount), then with respect to the amount above the minimum the contract 
is not a fixed quantity contract.
    (h) Export controlled products--(1) In general. An export controlled 
product is not export property. A product or commodity may be an export 
controlled product at one time but not an export controlled product at 
another time. For purposes of this paragraph, a product or commodity is 
an ``export controlled product'' at a particular time if at that time 
the export of such product or commodity is prohibited or curtailed under 
section 4(b) of the Export Administration Act of 1969 or section 7(a) of 
the Export Administration Act of 1979, to effectuate the policy relating 
to the protection of the domestic economy set forth in such Acts 
(paragraph (2)(A) of section 3 of the Export Administration Act of 1969 
and paragraph (2)(C) of section 3 of the Export Administration Act of 
1979). Such policy is to use export controls to the extent necessary 
``to protect the domestic economy from the excessive drain of scarce 
materials and to reduce the serious inflationary impact of foreign 
demand.''
    (2) Products considered export controlled products--(i) In general. 
For purposes of this paragraph, an export controlled product is a 
product or commodity which is subject to short supply export controls 
under 15 CFR part 377. A product or commodity is considered an export 
controlled product for the duration of each control period which applies 
to such product or commodity. A control period of a product or commodity 
begins on and includes the initial control date (as defined in 
subdivision (ii) of this subparagraph) and ends on and includes the 
final control date (as defined in subdivision (iii) of this 
subparagraph).
    (ii) Initial control date. The initial control date of a product or 
commodity which was subject to short supply export controls on March 19, 
1975, is March 19, 1975. The initial control date of a product or 
commodity which is subject to short supply export controls after March 
19, 1975, is the effective date stated in the regulations to 15 CFR part 
377 which subjects such product or commodity to short supply export 
controls. If there is no effective date stated in such regulations, the 
initial control date of such product or commodity is the date on which 
such regulations are filed for publications in the Federal Register.
    (iii) Final control date. The final control date of a product or 
commodity is the effective date stated in the regulations to 15 CFR part 
377 which removes such product or commodity from short supply export 
controls. If there is no effective date stated in such regulations, the 
final control date of such product or commodity is the date on which 
such regulations are filed for publication in the Federal Register.
    (iv) Expiration of Export Administration Act. An initial control 
date and a final control date cannot occur after the expiration date of 
the Export Administration Act under the authority of which the short 
supply export controls were issued.
    (3) Effective dates--(i) Products controlled on March 19, 1975. 
Except as provided in paragraph (g)(6) of this section, if a product or 
commodity was subject to short supply export controls on March 19, 1975, 
this paragraph applies--
    (a) With respect to any such product or commodity not owned by a 
DISC, to sales, exchanges, other dispositions, or leases made after 
March 18, 1975, with respect to which the DISC derives gross receipts.
    (b) With respect to any such product or commodity acquired by a DISC 
after March 18, 1975, and

[[Page 737]]

    (c) With respect to any such product or commodity owned by a DISC on 
March 18, 1975, to sales, exchanges, other dispositions, and leases made 
after March 18, 1976, and to owning such product or commodity after such 
date.
    (ii) Products first controlled after March 19, 1975. If a product or 
commodity becomes subject to short supply export controls after March 
19, 1975, this paragraph applies to sales, exchanges, other 
dispositions, or leases of such product or commodity made on or after 
the initial control date of such product or commodity, and to owning 
such product or commodity on or after such date.
    (iii) Date of sale, exchange, lease, or other disposition. For 
purposes of this subparagraph, the date of sale, exchange, or other 
disposition of a product or commodity is the date as of which title to 
such product or commodity passes. The date of a lease is the date as of 
which the lessee takes possession of a product or commodity. The 
accounting method of a person is not determinative of the date of sale, 
exchange, other disposition, or lease.
    (iv) Property in short supply. If the President determines that the 
supply of any property which is otherwise export property as defined in 
this section is insufficient to meet the requirements of the domestic 
economy, he may by Executive order designate such property as in short 
supply. Any property so designated will be treated as property which is 
not export property during the period beginning with the date specified 
in such Executive order and ending with the date specified in an 
Executive order setting forth the President's determination that such 
property is no longer in short supply.

[T.D. 7514, 42 FR 55461, Oct. 17, 1977, as amended by T.D. 7513, 42 FR 
57309, Nov. 2, 1977; T.D. 7854, 47 FR 51740, Nov. 17, 1982]



Sec. 1.993-4  Definition of producer's loans.

    (a) General rule--(1) Definition. Under section 993(d), a loan made 
by a DISC to a person, referred to in this section as the ``borrower,'' 
is a producer's loan if--
    (i) The loan is made out of accumulated DISC income within the 
meaning of subparagraph (3) of this paragraph.
    (ii) The loan is evidenced by an obligation described in 
subparagraph (4) of this paragraph.
    (iii) The requirement as to the trade or business of the borrower 
described in subparagraph (5) of this paragraph is satisfied.
    (iv) At the time the loan is made, the obligation referred to in 
subdivision (ii) of this subparagraph bears a legend stating ``This 
Obligation Is Designated A Producer's Loan Within The Meaning of section 
993(d) of the Internal Revenue Code'' or words of substantially the same 
meaning.
    (v) The limitation as to the export-related assets of the borrower 
described in paragraph (b) of this section is satisfied.
    (vi) The requirement as to the increased investment of the borrower 
in export-related assets described in paragraph (c) of this section is 
satisfied, and
    (vii) The requirement of paragraph (d) of this section as to proof 
of compliance with paragraphs (b) and (c) of this section is satisfied.
    (2) Application of this section--(i) In general. A loan which is a 
producer's loan is a qualified export asset of the DISC (see Sec. 
1.993-2(a)(5) and (F)). The interest on a producer's loan is a qualified 
export receipt of the DISC (see Sec. 1.993-1(g)). A producer's loan is 
not a dividend to a borrower which is also a shareholder of the DISC 
making the loan. For rules with respect to deemed distributions by 
reason of the amount of foreign investment attributable to producer's 
loans, see section 995(b)(1)(G) and (d) and the regulations thereunder.
    (ii) No tracing of loan proceeds. For purposes of applying this 
section, in order to qualify as a producer's loan, the proceeds of the 
loan need not be traced to an investment in any specific asset.
    (iii) Unrelated borrower. For purposes of applying this section, it 
is not necessary for a borrower to be a related person with respect to 
the DISC from which it receives a producer's loan, or a member of the 
same controlled group as the DISC.

[[Page 738]]

    (iv) Unpaid balance of producer's loans. For purposes of applying 
this section, the unpaid balance of producer's loans does not include 
the unpaid balance of any producer's loan to the extent the loan has 
been deducted or charged off by the DISC as totally or partially 
worthless under section 165 or 166.
    (v) Refinancing, renewal, and extension. For purposes of applying 
this section, the refinancing, renewal, or extension of a producer's 
loan shall be treated as the making of a new loan which may qualify as a 
producer's loan only if the requirements of subparagraph (1) of this 
paragraph are met.
    (vi) Events subsequent to time loan is made. The determination as to 
whether a loan qualifies as a producer's loan is made on the basis of 
the relevant facts taken into account for purposes of determining 
whether the loan was a producer's loan when made. Thus, for example, if 
the accumulated DISC income of the lender is later reduced below the 
unpaid balance of all producer's loans previously made by the DISC, such 
subsequent decrease in the amount of accumulated DISC income will not 
result in later disqualification of such loan (or part thereof) as a 
producer's loan. Similarly, if a loan (or part of a loan) does not 
qualify as a producer's loan because of an insufficient amount of 
accumulated DISC income at the time the loan is made, a subsequent 
increase in the amount of accumulated DISC income will not result in 
later qualification of such loan (or part thereof) as a producer's loan. 
As a further example, for purposes of applying the borrower's export 
related assets limitation described in paragraph (b) of this section, a 
loan which qualifies as a producer's loan when made will not later be 
disqualified if property, the gross receipts from the sale or lease of 
which were includible in the numerator of the fraction described in 
paragraph (b)(3)(i) of this section at the time of sale or lease by the 
borrower, is later characterized as excluded property (as defined in 
Sec. 1.993-3(f)).
    (vii) Application of tests under paragraphs (b) and (c) on 
controlled group bases. If the borrower is a member of a controlled 
group (as defined in Sec. 1.993-1(k)) at the time a loan is made, all 
amounts that must be determined for purposes of applying the limitation 
and increased investment requirement with respect to the export-related 
assets of the borrower (described in paragraphs (b) and (c), 
respectively, of this section) may be determined at the election of the 
borrower by aggregating such amounts for all members of the controlled 
group, determined for the taxable year of each member of the controlled 
group during which the loan is made, excluding only such members of the 
group as are DISC's or foreign corporations for such year. However, such 
amounts may be included only to the extent that such amounts have not 
already been taken into account in applying the limitation and increased 
investment requirement with respect to any other borrower. Amounts to be 
aggregated for all such members if such election is made include, for 
example, gross receipts (described in paragraphs (b)(3)(i) and (ii) of 
this section) and export-related assets (described in paragraph (b)(2) 
of this section). The borrower may make such election by causing its 
written statement of election to be attached to the lending DISC's 
return under section 6011(e)(2) for the first taxable year of the 
lending DISC within which or with which the borrower's taxable year for 
which the election is to apply ends. An election once made is binding on 
all members of the controlled group which includes the borrower with 
respect to all taxable years of the borrower beginning with its first 
taxable year for which the election is made. A borrower who makes such 
election may revoke it only if it secures the consent of the 
Commissioner to such revocation upon application made through the 
lending DISC.
    (3) Loan out of accumulated DISC income--(i) In general. A loan is a 
producer's loan only to the extent that it is made out of accumulated 
DISC income. A loan is made out of accumulated DISC income only if the 
amount of the loan, when added to the unpaid balance at the time such 
loan is made of all other producer's loans made by a DISC, does not 
exceed the amount of accumulated DISC income of the DISC at the 
beginning of the month in which

[[Page 739]]

the loan is made. The amount of accumulated DISC income at the beginning 
of any month is determined as if the DISC's taxable year closed at the 
end of the immediately preceding month.
    (ii) Presumption. A loan made during a taxable year shall be deemed 
under subdivision (i) of this subparagraph to have been made out of 
accumulated DISC income if the balance of producer's loans at the 
beginning of the year and those made during the year do not exceed 
accumulated DISC income at the end of the year.
    (iii) Deemed distributions. For purposes of this subparagraph, 
accumulated DISC income as of the end of any taxable year (or month) 
shall be determined without regard to deemed distributions under section 
995(b)(1)(G) for the amount of foreign investment attributable to 
producer's loans for such year (or for the taxable year for which such 
month is a part) but actual distributions shall be taken into account.
    (4) Evidence and terms of obligation. A loan is a producer's loan 
only if the loan is evidenced by a note or other evidence of 
indebtedness which is made by the borrower and which has a stated 
maturity date not more than 5 years from the date the loan is made. 
Accordingly, a loan which does not have a stated maturity date or which 
has a stated maturity date more than 5 years from the date such loan is 
made can never meet the 5-year requirement of this subparagraph. Thus, 
for example, even if there is a period of less than 5 years remaining to 
the stated maturity date of a loan, the loan can never be a producer's 
loan if it had a stated maturity date more than 5 years from the date it 
was made. For a further example, if a loan having a period remaining to 
maturity of 2 years is extended for a further period of 3 years (making 
a total of 5 years to maturity from the date of the extension), the 
extension of the loan would under subparagraph (2)(v) of this paragraph 
constitute the making of a new producer's loan and the original 
producer's loan would terminate. If, however, a loan having a period 
remaining to maturity of 2 years is extended for a further period of 4 
years (making a total of 6 years to maturity from the date of the 
extension), the original producer's loan will terminate and the new loan 
will not be a producer's loan. If a producer's loan is not paid in full 
at its maturity date and is not formally refinanced, renewed, or 
extended, such loan shall be deemed to be a new loan which does not have 
a stated maturity date and, thus, will not be a producer's loan. For 
purposes of this subparagraph, an evidence of indebtedness is a written 
instrument of indebtedness. Section 482 and the regulations thereunder 
are applicable to determine, in the case of a loan by the DISC to a 
borrower which is owned or controlled directly or indirectly by the same 
interests as the DISC within the meaning of section 482, whether the 
interest charged on such loan is at an arm's length rate.
    (5) Borrower's trade or business. A loan is a producer's loan only 
if the loan is made to a person engaged in the United States in the 
manufacture, production, growth, or extraction (within the meaning of 
Sec. 1.993-3(c)) of export property determined without regard to Sec. 
1.993-3(f)(1)(iii) and (iv). The borrower may also be engaged in other 
trades or businesses and the loan need not be traceable to specific 
investments in export property.
    (b) Borrower's export related assets limitation--(1) General rule. A 
loan to a borrower is a producer's loan only to the extent that the 
amount of the loan, when added to the unpaid balance of all other 
producer's loans made by all DISC's to the borrower which are 
outstanding at the time the loan is made, does not exceed an amount 
equal to the amount of the borrower's export-related assets (determined 
under subparagraph (2) of this paragraph) multiplied by the fraction set 
forth in subparagraph (3) of this paragraph.
    (2) Amount of export-related assets--(i) In general. For purposes of 
subparagraph (1) of this paragraph, the amount of the borrower's export-
related assets is the sum of the amounts described in subdivisions (ii), 
(iii), and (iv) of this subparagraph.
    (ii) Borrower's plant and equipment. The amount described in this 
subdivision is the sum of the borrower's adjusted bases (determined as 
of the beginning of the borrower's taxable year in which a loan is made 
to it) for plant, machinery, equipment, and supporting

[[Page 740]]

production facilities, which are located in the United States. 
Supporting production facilities are all property used primarily in 
connection with the manufacture, production, growth, or extraction 
(within the meaning of Sec. 1.993-3(c)) or storage, handling, 
transportation, or assembly of property by the borrower.
    (iii) Borrower's property held primarily for sale or lease. The 
amount described in this subdivision is the amount of the borrower's 
property (at the beginning of the taxable year of the borrower in which 
a loan is made to it) held primarily for sale or lease to customers in 
the ordinary course of its trade or business. The amount of such 
property held for sale is determined under the methods of identifying 
and valuing inventory normally used by the borrower. The amount of such 
property held for lease or leased is the borrower's adjusted bases, 
determined under section 1011, for such property.
    (iv) Borrower's research and experimental expenditures. The amount 
described in this subdivision is the aggregate amount, whether or not 
charged to capital account, of research and experimental expenditures 
(within the meaning of section 174) incurred in the United States by the 
borrower during each of its taxable years which begin after December 31, 
1971, and precede the taxable year in which the loan is made to the 
borrower. Such research and experimental expenditures need bear no 
relationship to export property (as defined in Sec. 1.993-3) of the 
borrower. The aggregate amount of all such expenditures for each of such 
preceding taxable years is taken into account for purposes of this 
subparagraph, regardless of whether all or any portion of the aggregate 
amount has been taken into account with respect to producer's loans made 
to the borrower by any DISC in preceding taxable years. The aggregate 
amount of all such expenditures shall include such expenditures of a 
corporation, the assets of which were acquired by the borrower in a 
distribution or a transfer described in section 381(a)(1) or (2) 
(relating to carryovers in certain corporate acquisitions).
    (3) Fraction referred to in subparagraph (1) of this paragraph--(i) 
Numerator of fraction. The numerator of the fraction set forth in this 
subparagraph is the sum of the borrower's gross receipts for each of its 
3 taxable years immediately preceding the taxable year in which the loan 
is made (but not including any taxable year beginning before January 1, 
1972) from the sale or lease of export property (determined without 
regard to Sec. 1.993-3(f)(1)(iii) and (iv)) which is manufactured, 
produced, grown, or extracted (within the meaning of Sec. 1.993-3(c)) 
by the borrower whether or not sold or leased directly or through a 
related domestic person (notwithstanding Sec. 1.993-3(a)(4) and 
(f)(2)). For purposes of the preceding sentence, with respect to a sale 
or lease to a related DISC in which the transfer price is determined 
under section 994(a)(1) or (2), the rules under Sec. 1.994-1(c)(5) 
(relating to incomplete transactions) shall be applied, and with respect 
to all other sales and leases the rules under Sec. 1.994-1(c)(5) other 
than subdivision (i)(d) thereof shall be applied.
    (ii) Denominator of fraction. The denominator of the fraction set 
forth in this subparagraph is the sum of the amount included in the 
numerator and all other gross receipts of the borrower, for each of its 
taxable years for which gross receipts are included in the numerator of 
the fraction, from all sales or leases of all property held by the 
borrower primarily for sale or lease to customers in the ordinary course 
of its trade or business. For purposes of subdivision (i) of this 
subparagraph and this subdivision, if such property is sold or leased to 
a domestic related person which resells or subleases such property, the 
borrower's gross receipts shall be the gross receipts derived by the 
domestic related person from the resale or sublease of the export 
property.
    (iii) Taxable years. If the borrower has not engaged in the sale or 
lease of property (as described in this subparagraph) for the 3 
immediately preceding taxable years, or if 3 taxable years beginning 
after December 31, 1971, have not elapsed, the fraction will be computed 
on the basis of such gross receipts for its taxable years immediately 
preceding the loan and beginning after December 31, 1971, during which 
the borrower has so engaged. No

[[Page 741]]

producer's loans can be made to a borrower until after the end of the 
first taxable year of the borrower beginning after December 31, 1971.
    (c) Requirement for increased investment in export-related assets--
(1) In general. A loan to a borrower is a producer's loan only to the 
extent that the amount of the loan, when added to the unpaid balance of 
all other producer's loans made by all DISC's to the borrower during the 
borrower's taxable year during which such loan is made, does not exceed 
the amount of the borrower's increase for the year in investment in 
export-related assets. Such increase for any taxable year is the sum 
of--
    (i) The increase (if any) in the borrowers adjusted basis of certain 
types of assets as determined under subparagraph (2) of this paragraph 
and
    (ii) The amount (if any) during the year of its research and 
experimental expenditures as determined under paragraph (b)(2)(iv) of 
this section.
    (2) Increase in adjusted basis. The amount under this subparagraph 
is the amount (not less than zero) by which--
    (i) The borrower's adjusted basis (determined as of the end of its 
taxable year in which the producer's loan is made) in all of its 
property which is described in paragraph (b)(2)(ii) (plant and 
equipment), and (iii) (property held primarily for sale or lease) of 
this section, including any such property acquired by it during such 
taxable year, exceeds
    (ii) Its adjusted bases in all such property (determined as of the 
beginning of such year).
    (3) Ordering rule. If during the borrower's taxable year the amount 
of increase in investment in export-related assets determined under this 
subparagraph is exceeded by amounts loaned to the borrower during such 
year that would otherwise qualify as producer's loans, such loans shall 
be applied in the order made against the amount of such increase in 
order to determine which loans qualify as producer's loans.
    (d) Proof of borrower's compliance with paragraphs (b) and (c) of 
this section. For purposes of paragraphs (b) and (c) of this section, a 
DISC shall be prepared to establish initially the compliance of the 
borrower with the requirements of such paragraphs by providing the 
written statement of the borrower, certified by a certified public 
accountant, stating that the borrower has complied with the limitation 
and increased investment requirement in section 993(d)(2) and (3) of the 
Internal Revenue Code of 1954. In lieu of certification by a certified 
public accountant, the DISC may attach to its return a statement signed 
by the borrower under penalties of perjury on a form provided by the 
Internal Revenue Service certifying that the borrower has complied with 
the limitation and increased investment requirement in section 993(d)(2) 
and (3) of the Internal Revenue Code of 1954. For taxable years ending 
after October 17, 1977, the DISC must attach either the certification by 
the certified public accountant or the certification by the borrower to 
its return. Additional full substantiation of the borrower's compliance 
with the requirements of such paragraphs may be required by the district 
director. If full substantiation of such compliance is not provided by 
the DISC (or the borrower) when required, the loan shall be deemed not 
to be a producer's loan.
    (e) Special limitation in the case of domestic film maker--(1) 
General rule. The limitation of paragraph (b) of this section as to the 
export-related assets of the borrower will be considered satisfied if 
the DISC--
    (i) Is engaged in the trade or business of selling or leasing films 
which are export property, or is acting as a commission agent for a 
person who is so engaged,
    (ii) Makes a loan to a borrower which is a domestic film maker (as 
defined in subparagraph (5) of this paragraph) for the purpose of making 
a film, and
    (iii) The amount of such loan, when added to the unpaid balance of 
all other producer's loans made by all DISC's to the borrower which are 
outstanding at the time the loan is made, does not exceed an amount 
determined by multiplying--
    (a) The sum of (1) the amount of the export-related assets of the 
borrower (determined under paragraph (b)(2)(i) of this section as of the 
beginning of the borrower's taxable year in which the loan is made), 
plus (2) the amount of a reasonable estimate of the amount of

[[Page 742]]

such export related assets obtained or to be obtained by the borrower 
during such year and subsequent years with respect to films as to which 
filming begins within such year by
    (b) The percentage which, based on the experience of other film 
makers of similar films for the 5 calendar years preceding the calendar 
year in which the loan is made, the annual gross receipts (as described 
in Sec. 1.993-6(a)(1), whether or not such films constitute property 
described therein) of such other film makers from the sale or lease of 
such films outside the United States is of the annual gross receipts of 
such other film makers from all sales or leases of such films.
    (2) Purpose of loan. A loan by a DISC will be deemed to be for the 
making of a film if there exists a written agreement between the DISC 
and the borrower, executed at or before the time the loan is made, 
stating that the loan is made or to be made to enable the borrower to 
make such film.
    (3) Reasonable estimate of amounts. For purposes of subparagraph 
(1)(iii)(a)(2) of this paragraph, a reasonable estimate shall be based 
on the conditions known by the DISC and borrower to exist at the time a 
loan is made (or which the DISC and borrower have reason to know to 
exist at such time).
    (4) Experience of film makers. For purposes of subparagraph 
(1)(iii)(b) of this paragraph, the experience of other film makers of 
similar films for the 5 calendar years preceding the calendar year in 
which the loan is made shall be derived from such records and statistics 
as are acknowledged in the trade as reasonably reliable.
    (5) Domestic film maker. For purposes of this section, a borrower is 
a domestic film maker with respect to a film if--
    (i) The borrower is a U.S. person within the meaning of section 
7701(a)(30), except that (a) with respect to a partnership all of the 
partners must be U.S. persons and (b) with respect to a corporation all 
of its officers and at least a majority of its directors must be U.S. 
persons,
    (ii) The borrower is engaged in the trade or business of making the 
film with respect to which the loan is made,
    (iii) Each studio, if any, used or to be used for filming or for 
recording sound incorporated into such film is located in the United 
States (as defined in section 7701(a)(9)),
    (iv) At least 80 percent of the aggregate playing time of the film 
is or will be photographed within the United States (as defined in 
section 7701(a)(9)), and
    (v) At least 80 percent of the total amount (not including any 
amount which is contingent upon receipts or profits of such film and 
which is fully taxable by the United States) paid or to be paid for 
services performed in the making of the film is either paid or to be 
paid to persons who are U.S. persons at the time such services are 
performed or consists of amounts which are fully taxable by the United 
States.
    (6) Amounts as fully taxable. For purposes of subparagraph (5)(v) of 
this paragraph, an amount is considered fully taxable by the United 
States if the entire amount is included in gross income under section 61 
or is subject to withholding under any provision of U.S. law or treaty 
to which the U.S. is a party and is not exempt from taxation under any 
provision of such law or treaty. Where a nonresident alien individual is 
engaged for the making of a film or where a foreign corporation is 
engaged to furnish the services of one of its officers or employees for 
the making of a film, the amount paid such individual or corporation 
will be considered as fully taxable by the United States only if it 
meets the test of this subparagraph.

[T.D. 7514, 42 FR 55464, Oct. 17, 1977, as amended by T.D. 7513, 42 FR 
57311, Nov. 2, 1977; T.D. 7514, 42 FR 60910, Nov. 30, 1977; T.D. 7854, 
47 FR 51741, Nov. 17, 1982]



Sec. 1.993-5  Definition of related foreign export corporation.

    (a) General rule--(1) Definition. Under section 993(e), a foreign 
corporation is a related foreign export corporation with respect to a 
DISC if--
    (i) It is a foreign international sales corporation described in 
paragraph (b) of this section,
    (ii) It is a real property holding company described in paragraph 
(c) of this section, or

[[Page 743]]

    (iii) It is an associated foreign corporation described in paragraph 
(d) of this section.
    (2) Application of this section. It is necessary to determine 
whether a foreign corporation is a related foreign export corporation 
with respect to a DISC for the following two purposes:
    (i) Qualified export assets. Under Sec. 1.993-2(g), the stock or 
securities of a related foreign export corporation held by the DISC are 
qualified export assets.
    (ii) Qualified export receipts. Under Sec. 1.993-1 (e), (f), and 
(g), certain receipts of the DISC with respect to stock or securities of 
a related foreign export corporation held by the DISC are qualified 
export receipts.
    (b) Foreign international sales corporation--(1) In general. A 
foreign corporation is a foreign international sales corporation with 
respect to a taxable year of a DISC if--
    (i) On each day during such taxable year of the DISC on which the 
foreign corporation has stock issued and outstanding, the DISC owns 
directly stock of the foreign corporation possessing more than 50 
percent of the total combined voting power of all classes of stock of 
the foreign corporation entitled to vote as determined under the 
principles of Sec. 1.957-1(b) (relating to definition of controlled 
foreign corporation),
    (ii) 95 percent or more of such foreign corporation's gross receipts 
(as defined in Sec. 1.993-6) for its taxable year ending with or within 
such taxable year of the DISC consists of qualified export receipts 
described in Sec. 1.993-1 (b) through (e) or interest described in 
Sec. 1.993-1(g) derived from any obligations described in Sec. 1.993-2 
(d) or (e), and
    (iii) The sum of the adjusted bases of the assets of the foreign 
corporation which are qualified export assets described in Sec. 1.993-2 
(b) through (e) and which are held by the foreign corporation at the 
close of its taxable year which ends with or within such taxable year of 
the DISC equals or exceeds 95 percent of the sum of the adjusted bases 
of all assets held by the foreign corporation at the close of such 
taxable year.
    (2) Certain determinations. The determinations as to whether gross 
receipts are qualified export receipts described in subparagraph (1)(ii) 
of this paragraph and as to whether assets are qualified export assets 
described in subparagraph (1)(iii) of this paragraph are made by 
applying the requirements of Sec. Sec. 1.993-1 and 1.993-2 to the 
foreign corporation as if it were a domestic corporation being tested to 
determine whether it is a DISC. For purposes of making either of such 
determinations, the principles of accounting applicable for purposes of 
computing earnings and profits under Sec. 1.964-1 (relating to a 
controlled foreign corporation's earnings and profits) shall apply.
    (c) Real property holding company--(1) In general. A foreign 
corporation is a real property holding company with respect to a taxable 
year of a DISC if--
    (i) On each day during such taxable year of the DISC on which the 
foreign corporation has stock issued and outstanding, the DISC owns 
directly stock of the foreign corporation possessing more than 50 
percent of the total combined voting power of all classes of stock of 
the foreign corporation entitled to vote as determined under the 
principles of Sec. 1.957-1(b) and
    (ii) The sole function of the foreign corporation is to hold title 
to real property situated outside the United States for the exclusive 
use of the DISC, title to which may not be held by the DISC (and, if the 
DISC subleases such property to a related supplier, as described in 
subparagraph (3) of this paragraph, by such related supplier) under the 
law of the country in which such property is situated.
    (2) Activities of the foreign corporation. For purposes of 
subparagraph (1)(ii) of this paragraph, a foreign corporation which 
holds title to real property situated outside the United States may also 
perform activities with respect to such property (such as management, 
maintenance, and payment of taxes) which are ancillary to its function 
of holding title to such property.
    (3) Exclusive use by the DISC. Real property held by the foreign 
corporation must be used exclusively by the DISC whether under a lease 
or any other arrangement. Real property is not so used by the DISC if 
the DISC subleases such property to any other person. If, however, 
during a taxable year of the DISC--

[[Page 744]]

    (i) 90 percent or more of the qualified export receipts of the DISC 
for such year are derived from transactions with respect to which it is 
a commission agent for a related supplier (as defined in Sec. 1.994-
1(a)(3)(ii)), and
    (ii) The DISC subleases such property to such related supplier


then such property will be considered as used exclusively by the DISC 
during such year if such related supplier does not sublease such 
property.
    (d) Associated foreign corporation--(1) In general. A foreign 
corporation is an associated foreign corporation with respect to a 
taxable year of the DISC if--
    (i) On each day during such taxable year of the DISC on which the 
foreign corporation has stock issued and outstanding, the DISC, or one 
or more members of the same controlled group of corporations (as defined 
in subparagraph (2) of this paragraph) as the DISC, owns (within the 
meaning of section 1563 (d) and (e)) stock of the foreign corporation 
possessing less than 10 percent of the total combined voting power of 
all classes of stock of the foreign corporation entitled to vote, as 
determined under the principles of Sec. 1.957-1(b), or owns no stock of 
such corporation, and
    (ii) The ownership of stock, or of securities (as defined in Sec. 
1.993-2(g)), of the foreign corporation by the DISC or by one or more 
members of such controlled group of corporations reasonably furthers a 
transaction or transactions giving rise to qualified export receipts for 
the DISC.
    (2) Controlled group of corporations. For purposes of this 
paragraph, the term ``controlled group of corporations'' has the same 
meaning assigned to the term in section 1563(a) and not section 
993(a)(3) and Sec. 1.993-1(k). Thus, for purposes of this paragraph, 
the test of control is 80 percent control and, since the rules of 
section 1563(b) apply, only domestic members are considered to be 
members of the controlled group.
    (3) Furtherance of qualified export receipts. Ownership of stock or 
securities of a foreign corporation will be considered as reasonably 
furthering a transaction or transactions giving rise to qualified export 
receipts for a DISC if--
    (i) The ownership is necessary to obtain or maintain the foreign 
corporation as a customer of the DISC or of a related supplier, as 
defined in Sec. 1.994-1(a)(3)(ii) of the DISC or to aid the sales 
distribution system of the DISC or of such related supplier, and
    (ii) The amount of the investment in the foreign corporation bears a 
reasonable relationship to the amount of the DISC's annual net profit 
from transactions in its trade or business which it may reasonably 
expect to derive on account of such ownership.


In determining whether the amount of the investment is reasonable, there 
shall be taken into account any stock or securities of the foreign 
corporation owned by any other foreign corporation which, if it were a 
domestic corporation, would be a member of the same controlled group of 
corporations as the DISC.

[T.D. 7514, 42 FR 55467, Oct. 17, 1977; 42 FR 60910, Nov. 30, 1977]



Sec. 1.993-6  Definition of gross receipts.

    (a) General rule. Under section 993(f), for purposes of sections 991 
through 996, the gross receipts of a person for a taxable year are--
    (1) The total amounts received or accrued by the person from the 
sale or lease of property held primarily for sale or lease in the 
ordinary course of a trade or business, and
    (2) Gross income recognized from all other sources, such as, for 
example, from--
    (i) The furnishing of services (whether or not related to the sale 
or lease of property described in subparagraph (1) of this paragraph),
    (ii) Dividends and interest,
    (iii) The sale at a gain of any property not described in 
subparagraph (1) of this paragraph, and
    (iv) Commission transactions as and to the extent described in 
paragraph (e) of this section.
    (b) Nongross receipts items. For purposes of paragraph (a) of this 
section, gross receipts do not include amounts received or accrued by a 
person from--
    (1) The proceeds of a loan or of the repayment of a loan, or
    (2) A receipt of property in a transaction to which section 118 
(relating to contribution to capital) or 1032 (relating to exchange of 
stock for property) applies.

[[Page 745]]

    (c) Nonreduction of total amounts. For purposes of paragraph (a) of 
this section, the total amounts received or accrued by a person are not 
reduced by returns and allowances, costs of goods sold, expenses, 
losses, a deduction for dividends received under section 243, or any 
other deductible amounts.
    (d) Method of accounting. For purposes of paragraph (a) of this 
section, the total amounts received or accrued by a person shall be 
determined under the method of accounting used in computing its taxable 
income. If, for example, a DISC receives advance or installment payments 
for the sale or lease of property described in paragraph (a)(1) of this 
section, for the furnishing of services, or which represent recognized 
gain from the sale of property not described in paragraph (a)(1) of this 
section, any amount of such advance payments is considered to be gross 
receipts of the DISC for the taxable year for which such amount is 
included in the gross income of the DISC.
    (e) Commission transactions. (1) In the case of transactions which 
give rise to a commission on the sale or lease of property or the 
furnishing of services by a principal, the amount recognized by the 
commission agent as gross income from all such transactions shall be the 
gross receipts derived by the principal from the sale or lease of the 
property, or the gross income derived by the principal from the 
furnishing of services, with respect to which the commissions are 
derived. In the case of a commission agent for a related supplier (as 
defined in Sec. 1.994-1(a)(3)(ii)), the gross receipts or gross income 
of such agent shall be determined as if it used the same method of 
accounting as its related supplier. In the case of a commission agent 
for a principal other than a related supplier, the gross receipts or 
gross income of such principal shall be determined as if such principal 
used the same method of accounting as its agent.
    (2) If the commission arrangement provides that the commission agent 
will receive a commission only with respect to sales or leases of export 
property, or the furnishing of services, which result in qualified 
export receipts, the commission agent will not take into account the 
gross receipts or gross income, as the case may be, derived by the 
principal from any transaction for which the commission agent would not 
be entitled to a commission under the commission arrangement.
    (f) Example. The provisions of this section may be illustrated by 
the following example:

    Example. During 1973, M, a related supplier (as defined in Sec. 
1.994-1(a)(3)(ii)) of N, is engaged in the manufacture of machines in 
the United States. N, a calendar year taxpayer, is engaged in the sale 
and lease of such machines in foreign countries. N furnishes services 
which are related and subsidiary to its sale and lease of such machines. 
N also acts as a commission agent in foreign countries for Z, an 
unrelated supplier, with respect to Z's sale of products. N receives 
dividends on stock owned by it in a related foreign export corporation 
(as defined in Sec. 1.993-5), interest on producer's loans made to M, 
and proceeds from sales of business assets located outside the United 
States resulting in a recognized gains and losses. N's gross receipts 
for 1973 are $3,550, computed on the basis of the additional facts 
assumed in the table below:

(1) N's sales receipts for machines manufactured by M (without    $1,500
 reduction for cost of goods sold and selling expenses)........
(2) N's lease receipts for machines manufactured by M (without       500
 reduction for depreciation and leasing expenses)..............
(3) N's gross income from services for machines manufactured by      400
 M (without reduction for service expenses)....................
(4) Z's sale receipts for products manufactured by Z (without        550
 reduction for Z's cost of goods sold, commissions on sales,
 and commission sales expenses)................................
(5) Dividends received by N....................................      150
(6) Interest received by N on producer's loans.................      200
(7) Proceeds received by N representing recognized gain (but         250
 not losses) from sales of business assets located outside the
 United States.................................................
                                                                --------
(8) N's gross receipts.........................................    3,550
                                                                ========
 


[T.D. 7514, 42 FR 55468, Oct. 17, 1977]



Sec. 1.993-7  Definition of United States.

    Under section 993(g), the term ``United States'' includes the 
States, the District of Columbia, the Commonwealth of Puerto Rico, and 
possessions of the United States. For the requirement that a DISC must 
be incorporated and existing under the laws of a State or the District 
of Columbia, see Sec. 1.992-1(a)(1).

[T.D. 7514, 42 FR 55468, Oct. 17, 1977]

[[Page 746]]



Sec. 1.994-1  Inter-company pricing rules for DISC's.

    (a) In general--(1) Scope. In the case of a transaction described in 
paragraph (b) of this section, section 994 permits a person related to a 
DISC to determine the allowable transfer price charged the DISC (or 
commission paid the DISC) by its choice of three methods described in 
paragraph (c)(2), (3), and (4) of this section: The ``4 percent'' gross 
receipts method, the ``50-50'' combined taxable income method, and the 
section 482 method. Under the first two methods, the DISC is entitled to 
10 percent of its export promotion expenses as additional taxable 
income. When the gross receipts method or combined taxable income method 
is applied to a transaction, the Commissioner may not make 
distributions, apportionments, or allocations as provided by section 482 
and the regulations thereunder. For rules as to certain ``incomplete 
transactions'' and for computing combined taxable income, see paragraph 
(c)(5) and (6) of this section. Grouping of transactions for purposes of 
applying the method chosen is provided by paragraph (c)(7) of this 
section. The rules in paragraph (c) of this section are directly 
applicable only in the case of sales or exchanges of export property to 
a DISC for resale, and are applicable by analogy to leases, commissions, 
and services as provided in paragraph (d) of this section. For rules 
limiting the application of the gross receipts method and combined 
taxable income method so that the supplier related to the DISC will not 
incur a loss on transactions, see paragraph (e)(1) of this section. 
Paragraph (e)(2) of this section provides for the applicability of 
section 482 to resales by the DISC to related persons. Paragraph (e)(3) 
of this section provides for the time by which a reasonable estimate of 
the transfer price (including commissions and other payments) should be 
paid. The subsequent determination and further adjustments to transfer 
prices are set forth in paragraph (e)(4) of this section. Export 
promotion expenses are defined in paragraph (f) of this section. 
Paragraph (g) of this section has several examples illustrating the 
provisions of this section. Section 1.994-2 prescribes the marginal 
costing rules authorized by section 994(b)(2).
    (2) Performance of substantial economic functions. The application 
of section 994(a)(1) or (2) does not depend on the extent to which the 
DISC performs substantial economic functions (except with respect to 
export promotion expenses). See paragraph (l) of Sec. 1.993-1.
    (3) Related party and related supplier. For the purposes of this 
section--
    (i) The term ``related party'' means a person which is owned or 
controlled directly or indirectly by the same interests as the DISC 
within the meaning of section 482 and Sec. 1.482-1(a).
    (ii) The term ``related supplier'' means a related party which 
singly engages in a transaction directly with the DISC which is subject 
to the rules of section 994 and this section. However, a DISC may have 
different related suppliers with respect to different transactions. If, 
for example, X owns all the stock of Y, a corporation, and of Z, a DISC, 
and sells a product to Y which is resold to Z, only Y is the related 
supplier of Z, and, thus, only the resale from Y to Z is subject to 
section 994 and this section. If, however, X sells directly to Z and Y 
also sells directly to Z, then, as to the transactions involving direct 
sales to Z, each of X and Y is a related supplier of Z.
    (b) Transactions to which section 994 applies. Section 994(a)(3) may 
be applied, as described in paragraph (a) of this section, to any 
transaction between a related supplier and a DISC. Section 994(a)(1) or 
(2) may be applied, as described in paragraph (a) of this section, to a 
transaction between a related supplier and a DISC only in the following 
cases:
    (1) Where the related supplier sells export property to the DISC for 
resale or where the DISC is commission agent for the related supplier on 
sales by the related supplier of export property to third parties 
whether or not related parties. For purposes of this section, references 
to sales include exchanges.
    (2) Where the related supplier leases export property to the DISC 
for sublease for a comparable period with comparable terms of payment or 
where the DISC is commission agent for the related supplier on leases by 
the related supplier of export property to

[[Page 747]]

third parties whether or not related parties.
    (3) Where services are furnished by a related supplier which are 
related and subsidiary to any sale or lease by the DISC, acting as 
principal or commission agent, of export property under subparagraph (1) 
or (2) of this paragraph.
    (4) Where engineering or architectural services for construction 
projects located (or proposed for location) outside of the United States 
are furnished by a related supplier where the DISC is acting as 
principal or commission agent with respect to the furnishing of such 
services to a third party whether or not a related party.
    (5) Where the related supplier furnishes managerial services in 
furtherance of the production of qualified export receipts of an 
unrelated DISC where the related DISC is acting as principal or 
commission agent with respect to the furnishing of such services to an 
unrelated DISC.


Transactions are included, for purposes of this paragraph, only if they 
give rise to qualified export receipts (within the meaning of section 
993(a)) in the hands of the related DISC. If a transaction is not 
included in subparagraph (1), (2), (3), (4), or (5) of this paragraph, 
the rules of section 994(a)(1) or (2) do not apply. Thus, for example, 
the rules of section 994(a)(1) or (2) would not apply if a DISC 
purchased export property from its related supplier and leased such 
property to a third party.
    (c) Transfer price for sales of export property--(1) In general. 
Under this paragraph, rules are prescribed for computing the allowable 
price for a transfer from a related supplier to a DISC in the case of a 
sale of export property described in paragraph (b)(1) of this section.
    (2) The ``4-percent'' gross receipts method. Under the gross 
receipts method of pricing, the transfer price for a sale by the related 
supplier to the DISC is the price as a result of which the taxable 
income derived by the DISC from the sale will not exceed the sum of (i) 
4 percent of the qualified export receipts of the DISC derived from the 
sale of the export property (as defined in section 993 (c)) and (ii) 10 
percent of the export promotion expenses (as defined in paragraph (f) of 
this section) of the DISC attributable to such qualified export 
receipts.
    (3) The ``50-50'' combined taxable income method. Under the combined 
taxable income method of pricing, the transfer price for a sale by the 
related supplier to the DISC is the price as a result of which the 
taxable income derived by the DISC from the sale will not exceed the sum 
of (i) 50 percent of the combined taxable income (as defined in 
subparagraph (6) of this paragraph) of the DISC and its related supplier 
attributable to the qualified export receipts from such sale and (ii) 10 
percent of the export promotion expenses (as defined in paragraph (f) of 
this section) of the DISC attributable to such qualified export 
receipts.
    (4) Section 482 method. If the rules of subparagraphs (2) and (3) of 
this paragraph are inapplicable to a sale or a taxpayer does not choose 
to use them, the transfer price for a sale by the related supplier to 
the DISC is to be determined on the basis of the sale price actually 
charged but subject to the rules provided by section 482 and the 
regulations thereunder.
    (5) Incomplete transactions. (i) For purposes of the gross receipts 
and combined taxable income methods, where property (encompassed within 
a transaction or group chosen under subparagraph (7) of this paragraph) 
is transferred by a related supplier to a DISC during a taxable year of 
either the DISC or related supplier, but some or all of such property is 
not sold by the DISC during such year--
    (a) The transfer price of such property sold by the DISC during such 
year shall be computed separately from the transfer price of the 
property not sold by the DISC during such year,
    (b) With respect to such property not sold by the DISC during such 
year, the transfer price paid by the DISC for such year shall be the 
related supplier's cost of goods sold (see subparagraph (6)(ii) of this 
paragraph) with respect to the property, except that, with respect to 
such taxable years ending on or before August 15, 1975, the transfer 
price paid by the DISC shall be at least (but need not exceed) the 
related supplier's cost of goods sold with respect to the property.

[[Page 748]]

    (c) For the subsequent taxable year during which such property is 
resold by the DISC, an additional amount shall be paid by the DISC (to 
be treated as income for such year by the related supplier) equal to the 
excess of the amount which would have been the transfer price under this 
section had the transfer to the DISC by the related supplier and the 
resale by the DISC taken place during the taxable year of the DISC 
during which it resold the property over the amount already paid under 
(b) of this subdivision.
    (d) The time and manner of payment of transfer prices required by 
(b) and (c) of this subdivision shall be determined under paragraphs 
(e)(3), (4), and (5) of this section.
    (ii) For purposes of this paragraph, a DISC may determine the year 
in which it receives property from a related supplier and the year in 
which it sells property in accordance with the method of identifying 
goods in its inventory properly used under section 471 or 472 (relating 
respectively to general rule for inventories and to LIFO inventories). 
Transportation expense of the related supplier in connection with a 
transaction to which this subparagraph applies shall be treated as an 
item of cost of goods sold with respect to the property if the related 
supplier includes the cost of intracompany transportation between its 
branches, divisions, plants, or other units in its cost of goods sold 
(see subparagraph (6)(ii) of this paragraph).
    (6) Combined taxable income. For purposes of this section, the 
combined taxable income of a DISC and its related supplier from a sale 
of export property is the excess of the gross receipts (as defined in 
section 993(f)) of the DISC from such sale over the total costs of the 
DISC and related supplier which relate to such gross receipts. Gross 
receipts from a sale do not include interest with respect to the sale. 
Combined taxable income under this paragraph shall be determined after 
taking into account under paragraph (e)(2) of this section all 
adjustments required by section 482 with respect to transactions to 
which such section is applicable. In determining the gross receipts of 
the DISC and the total costs of the DISC and related supplier which 
relate to such gross receipts, the following rules shall be applied:
    (i) Subject to subdivisions (ii) through (v) of this subparagraph, 
the taxpayer's method of accounting used in computing taxable income 
will be accepted for purposes of determining amounts and the taxable 
year for which items of income and expense (including depreciation) are 
taken into account. See Sec. 1.991-1(b)(2) with respect to the method 
of accounting which may be used by a DISC.
    (ii) Cost of goods sold shall be determined in accordance with the 
provisions of Sec. 1.61-3. See sections 471 and 472 and the regulations 
thereunder with respect to inventories. With respect to property to 
which an election under section 631 applies (relating to cutting of 
timber considered as a sale or exchange), cost of goods sold shall be 
determined by applying Sec. 1.631-1(d)(3) and (e) (relating to fair 
market value as of the beginning of the taxable year of the standing 
timber cut during the year considered as its cost).
    (iii) Costs (other than cost of goods sold) which shall be treated 
as relating to gross receipts from sales of export property are (a) the 
expenses, losses, and other deductions definitely related, and therefore 
allocated and apportioned, thereto, and (b) a ratable part of any other 
expenses, losses, or other deductions which are not definitely related 
to a class of gross income, determined in a manner consistent with the 
rules set forth in Sec. 1.861-8.
    (iv) The taxpayer's choice in accordance with subparagraph (7) of 
this paragraph as to the grouping of transactions shall be controlling, 
and costs deductible in a taxable year shall be allocated and 
apportioned to the items or classes of gross income of such taxable year 
resulting from such grouping.
    (v) If an account receivable arising with respect to a sale of 
export property is transferred by the related supplier to a DISC which 
is a member of the same controlled group within the meaning of Sec. 
1.993-1(k) for an amount reflecting a discount from the selling price 
taken into account in computing (without regard to this subdivision) 
combined taxable income of the DISC

[[Page 749]]

and its related supplier, then the combined taxable income from such 
sale shall be reduced by the amount of the discount.
    (7) Grouping transactions. (i) Generally, the determinations under 
this section are to be made on a transaction-by-transaction basis. 
However, at the annual choice of the taxpayer some or all of these 
determinations may be made on the basis of groups consisting of products 
or product lines.
    (ii) A determination by a taxpayer as to a product or a product line 
will be accepted by a district director if such determination conforms 
to any one of the following standards: (a) A recognized industry or 
trade usage, or (b) the 2-digit major groups (or any inferior 
classifications or combinations thereof, within a major group) of the 
Standard Industrial Classification as prepared by the Statistical Policy 
Division of the Office of Management and Budget, Executive Office of the 
President.
    (iii) A choice by the taxpayer to group transactions for a taxable 
year on a product or product line basis shall apply to all transactions 
with respect to that product or product line consummated during the 
taxable year. However, the choice of a product or product line grouping 
applies only to transactions covered by the grouping and, as to 
transactions not encompassed by the grouping, the determinations are 
made on a transaction-by-transaction basis. For example, the taxpayer 
may choose a product grouping with respect to one product and use the 
transaction-by-transaction method for another product within the same 
taxable year.
    (iv) For rules as to grouping certain related and subsidiary 
services, see paragraph (d)(3)(ii) of this section.
    (d) Rules under section 994(a)(1) and (2) for transactions other 
than sales. The following rules are prescribed for purposes of applying 
the gross receipts method or combined taxable income method to 
transactions other than sales:
    (1) Leases. In the case of a lease of export property by a related 
supplier to a DISC for sublease by the DISC to produce gross receipts, 
for any taxable year the amount of rent the DISC must pay to the related 
supplier shall be determined under the DISC's lease with its related 
supplier but must be computed in a manner consistent with the rules in 
paragraph (c) of this section for computing the transfer price in the 
case of sales and resales of export property under the gross receipts 
method or combined taxable income method. For purposes of applying this 
subparagraph, transactions may not be so grouped on a product or product 
line basis under the rules of paragraph (c)(7) of this section as to 
combine in any one group of transactions both lease transactions and 
sale transactions involving the same product or product line.
    (2) Commissions. If any transaction to which section 994 applies is 
handled on a commission basis for a related supplier by a DISC and such 
commissions give rise to qualified export receipts under section 
993(a)--
    (i) The amount of the income that may be earned by the DISC in any 
year is the amount, computed in a manner consistent with paragraph (c) 
of this section, which the DISC would have been permitted to earn under 
the gross receipts method, the combined taxable income method, or 
section 482 method if the related supplier had sold (or leased) the 
property or service to the DISC and the DISC in turn sold (or subleased) 
to a third party, whether or not a related party, and
    (ii) The maximum commission the DISC may charge the related supplier 
is the sum of the amount of income determined under subdivision (i) of 
this subparagraph plus the DISC's total costs for the transaction as 
determined under paragraph (c)(6) of this section.
    (3) Receipts from services--(i) Related and subsidiary services 
attributable to the year of the export transaction. The gross receipts 
for related and subsidiary services described in paragraph (b)(3) of 
this section shall be treated as part of the receipts from the export 
transaction to which such services are related and subsidiary, but only 
if, under the arrangement between the DISC and its related supplier and 
the accounting method otherwise employed by the DISC, the income from 
such services is includible for the same taxable year as income from 
such export transaction.

[[Page 750]]

    (ii) Other services. In the case of related and subsidiary services 
to which subdivision (i) of this subparagraph does not apply and other 
services described in paragraph (b)(4) or (5) of this section performed 
by a related supplier (relating respectively to engineering and 
architectural services and certain managerial services), the amount of 
taxable income which the DISC may derive for any taxable year shall be 
determined under the arrangement between the DISC and its related 
supplier and shall be computed in a manner consistent with the rules in 
paragraph (c) of this section for computing the transfer price in the 
case of sales for resale of export property under the gross receipts 
method or combined taxable income method. Related and subsidiary 
services to which subdivision (i) of this subparagraph does not apply 
may be grouped, under the rules for grouping of transactions in 
paragraph (c)(7) of this section, with the products or product lines to 
which they are related and subsidiary, so long as the grouping of 
services chosen is consistent with the grouping of products or product 
lines chosen for the taxable year in which either the product or product 
lines were sold or in which payment for such services is received or 
accrued. The rules for grouping of transactions in paragraph (c)(7) of 
this section shall not apply with respect to the determination of 
taxable income which the DISC may derive from other services described 
in paragraph (b)(4) or (5) of this section performed by a related 
supplier or commissions on such services, and such determination shall 
be made only on a transaction-by-transaction basis.
    (e) Methods of applying paragraphs (c) and (d) of this section--(1) 
Limitation on DISC income (``no loss'' rule)--(i) In general. Except as 
otherwise provided in this subparagraph, neither the gross receipts 
method nor the combined taxable income method may be applied to cause in 
any taxable year a loss to the related supplier, but either method may 
be applied to the extent it does not cause a loss. A loss to a related 
supplier would result if the taxable income of the DISC would exceed the 
combined taxable income of the related supplier and the DISC. If, 
however, there is no combined taxable income of the DISC and the related 
supplier (because, for example, a combined loss is incurred), a transfer 
price (or commission) will not be deemed to cause a loss to the related 
supplier if it allows the DISC to recover an amount not in excess of its 
costs (if any).
    (ii) Special rule for applying ``4 percent'' gross receipts method 
to sales. A transfer price or commission, determined under the ``4 
percent'' gross receipts method (determined without regard to 
subdivision (i) of this subparagraph), for a sale of export property 
referred to in paragraph (b)(1) of this section, will not be considered 
to cause a loss for the related supplier if for the DISC's taxable year, 
the ratio that (a) the taxable income of the DISC derived from such sale 
by using such price or commission bears to (b) the DISC's gross receipts 
from such sale is not greater than the ratio that (c) all of the taxable 
income of the related supplier and the DISC from all sales of the same 
product or product line (domestic and foreign) to third parties whether 
or not related parties bears to (d) the total gross receipts of the 
related supplier and the DISC from such sales. For purposes of the 
preceding sentence, sales between the DISC and its related suppliers 
shall not be taken into account under (c) or (d) of this subdivision. 
For example, assume that for a taxable year of a DISC the total costs of 
the related supplier and the DISC with respect to all sales ($150 for 
domestic and $44 for foreign) of a product line are $194 and the total 
gross receipts of the related supplier and the DISC with respect to such 
sales are $200 so that the total taxable income of the related supplier 
and the DISC with respect to such sales is $6. The parties would thus be 
entitled to compute a transfer price determined under the gross receipts 
method on any given sale of product A of such product line by the 
related supplier to the DISC which would allocate to the DISC taxable 
income equal to not more than 3 percent (i.e., $6/$200) of its gross 
receipts derived from its resale of such product. If the DISC were to 
resell an item of product A for $10, the transfer price paid by the DISC 
to the related

[[Page 751]]

supplier determined under the gross receipts method could be as low as 
$9.70.
    (iii) Grouping transactions. For purposes of subdivision (i) of this 
subparagraph, the basis for grouping transactions chosen by the taxpayer 
under paragraph (c)(7) of this section for the taxable year shall be 
applied. For purposes of making the computations of subdivision (ii) (c) 
and (d) of this subparagraph, however, the taxpayer may choose any basis 
for grouping transactions permissible under paragraph (c)(7) of this 
section, even though it may not be the same basis as that already chosen 
under paragraph (c)(7) of this section for computing transfer prices or 
commissions to a DISC. If, for example, the taxpayer has chosen to group 
transactions on a product basis for computing transfer prices or 
commissions to a DISC for a taxable year, the taxpayer may still group 
transactions on a product line basis for purposes of computing taxable 
income and total gross receipts under subdivision (ii) (c) and (d) of 
this subparagraph. For a further example, if the taxpayer computes 
taxable income for one group of transactions under the gross receipts 
method and computes taxable income for a second group of transactions 
under the combined taxable income method, the taxpayer may aggregate 
these transactions for purposes of computing taxable income and total 
gross receipts under subdivision (ii) (c) and (d) of this subparagraph.
    (2) Relationship to section 482. In applying the rules under section 
994, it may be necessary to first take into account the price of a 
transfer (or other transaction) between the DISC (or related supplier) 
and a related party which is subject to the arm's length standard of 
section 482. Thus, for example, where a related supplier sells export 
property to a DISC which the related supplier purchased from related 
parties, the costs taken into account in computing the combined taxable 
income of the DISC and the related supplier are determined after any 
necessary adjustment under section 482 of the price paid by the related 
supplier to the related parties. In applying section 482 to a transfer 
by a DISC, however, the DISC and its related supplier are treated as if 
they were a single entity carrying on all the functions performed by the 
DISC and the related supplier with respect to the transaction and the 
DISC shall be allowed to receive under the section 482 standard the 
amount the related supplier would have received had there been no DISC.
    (3) Initial payment of transfer price or commission. (i) The amount 
of a transfer price (or reasonable estimate thereof) actually charged by 
a related supplier to a DISC, or a sales commission (or reasonable 
estimate thereof) actually charged by a DISC to a related supplier, in a 
transaction to which section 994 applies must be paid no later than 60 
days following the close of the taxable year of the DISC during which 
the transaction occurred.
    (ii) Payment must be in the form of money, property (including 
accounts receivable from sales by or through the DISC), a written 
obligation which qualifies as debt under the safe harbor rule of Sec. 
1.992-1(d)(2)(ii), or an accounting entry offsetting the account 
receivable against an existing debt owed by the person in whose favor 
the account receivable was established to the person with whom it 
engaged in the transaction. The form of the payment to a DISC need not 
be a qualified export asset under Sec. 1.993-2. However, for the 
requirement that the adjusted basis of the qualified export assets of 
the DISC at the close of its taxable year must equal or exceed 95 
percent of the sum of the adjusted bases of all assets of the DISC at 
the close of its taxable year, see section 992(a)(1)(B).
    (iii) If the district director can demonstrate, based upon the data 
available as of the 60th day after the close of such taxable year, that 
the amount actually paid did not represent a reasonable estimate of the 
transfer price or commission (as the case may be) to be determined under 
section 994 and this section, an indebtedness will be deemed to arise, 
from the person required to make the payment in favor of the person to 
whom the payment is required to be made, in an amount equal to the 
difference between the amount of the transfer price or commission 
determined under section 994 and this section and the amount (if any) 
actually paid and received. Such indebtedness will be deemed to arise as 
of the date

[[Page 752]]

the transaction occurred which gave rise to the indebtedness, except 
that, if such transaction occurred in a taxable year of the DISC ending 
on or before August 15, 1975, at the taxpayer's option, the indebtedness 
will be deemed to arise as of the date by which payment was required 
under subdivision (i) of this paragraph (e)(3). Such indebtedness owed 
to a DISC shall be treated as an asset but shall not be treated as a 
trade receivable or other qualified export asset (see Sec. 1.993-
2(d)(3)) as of the end of the taxable year of the DISC in which the 
indebtedness is deemed to arise.
    (iv)(a) Except with respect to incomplete transactions to which 
paragraph (c)(5)(i)(b) of this section applies, if the amount actually 
paid results in the DISC realizing at least 50 percent of the DISC's 
taxable income from the transaction as reported in its tax return for 
the taxable year the transaction is completed, then the amount actually 
paid shall be deemed to be a reasonable estimate of such transfer price 
or commission.
    (b) With respect to incomplete transactions to which paragraph 
(c)(5)(i)(b) of this section applies and which were initiated during a 
taxable year ending after August 15, 1975, the amount actually paid 
shall be deemed to be a reasonable estimate of such transfer price if 
any one of the following three tests is met:
    (1) The amount actually paid by the DISC to the related supplier in 
respect of the property does not exceed the related supplier's cost of 
goods sold (see paragraph (c)(6)(ii) of this section) with respect to 
the property.
    (2) If the transaction is completed by the date on which the DISC's 
return is required to be filed for the year in which the transaction was 
initiated, the amount actually paid by the DISC to the related supplier 
in respect of the property results in the DISC realizing at least 50 
percent of the DISC's taxable income from the transaction when 
completed.
    (3) The percentage that (i) an amount equal to (a) the amount 
actually paid by the DISC to the related supplier in respect of the 
property minus (b) the related supplier's cost of goods sold with 
respect to the property, bears to (ii) the related supplier's cost of 
goods sold in respect of the property, is not greater than 50 percent of 
the percentage that (iii) the combined taxable income for completed 
transactions of the same group as the property during the DISC's taxable 
year in which the incomplete transaction was initiated, bears to (iv) 
the cost of goods sold of the related supplier and DISC with respect to 
such transactions.
    (c) For purposes of this subdivision (iv), whether the transfer 
price or commission actually paid is deemed a reasonable estimate may be 
determined on the basis for grouping transactions chosen by the taxpayer 
under paragraph (c)(5) and (7) of this section.
    (v) An indebtedness arising under subdivision (iii) of this 
subparagraph shall bear interest at an arm's length rate, computed in 
the manner provided by Sec. 1.482-2(a)(2) from the 61st day after the 
close of the DISC's taxable year in which the transaction occurred which 
gave rise to the indebtedness to the date of payment. The interest so 
computed shall be accrued and included in the taxable income of the 
person to whom the indebtedness is owed for each taxable year during 
which the indebtedness is unpaid.
    (4) Subsequent determination of transfer price or commission. The 
DISC and its related supplier would ordinarily determine under section 
994 and this section the transfer price payable by the DISC (or the 
commission payable to the DISC) for a transaction before the DISC files 
its return for the taxable year of the transaction. After the DISC has 
filed its return, a redetermination of the transfer price (or 
commission) may only be made if permitted by the Code and the 
regulations thereunder. Such a redetermination would include a 
redetermination by reason of an adjustment under section 482 and the 
regulations thereunder or section 861 and Sec. 1.861-8 which affects 
the amounts which entered into the determination of the transfer price 
or commission.
    (5) Procedure for adjustments to transfer price or commission--
(i)(a) If the transfer price (or commission) for a transaction 
determined under section 994 is different from the price (or commission) 
actually charged, the person who received too small a transfer price

[[Page 753]]

(or commission) or paid too large a transfer price (or commission) shall 
establish (or be deemed to have established), at the date of the 
determination or redetermination under subparagraph (4) of this 
paragraph of the transfer price (or commission) under section 994, an 
account receivable due the DISC from the person with whom it engaged in 
the transaction equal to the difference in amount between the transfer 
price (or commission) so determined and the transfer price (or 
commission) previously paid and received. If the account receivable is 
paid within 90 days after the date it is established (or deemed 
established), then as of the end of the taxable year of the DISC in 
which the transaction occurred which gave rise to the indebtedness, the 
account receivable shall be treated as an asset and, under Sec. 1.993-
2(d)(3) as a trade receivable, and thus as a qualified export asset.
    (b) If, for example, during 1972, a DISC which uses the calendar 
year as its taxable year sold a product which it purchased that year 
from its related supplier and paid a price of $10,000 which price is a 
reasonable estimate under subparagraph (3)(iii) of this paragraph but is 
later determined under section 994 to be $8,000 immediately before the 
DISC filed its return for 1972, the DISC must be paid $2,000 (i.e., 
$10,000-$8,000) by its related supplier or establish an account 
receivable from its related supplier of $2,000. The account receivable 
may be paid without tax consequences, provided that such account 
receivable is paid within 90 days after the date it is established (or 
deemed established). Such account receivable paid within such 90 days 
will be considered to relate to the taxable year in which the 
transaction occurred which gave rise thereto rather than the taxable 
year during which it is established or paid.
    (ii) Payment must be in a form specified in subparagraph (3) of this 
paragraph.
    (iii) If an account receivable of a DISC described in subdivision 
(i) of this paragraph (e)(5) is not paid within 90 days of the date it 
is established (or deemed established), then, as of the end of the 
taxable year of the DISC in which the transaction occurred which gives 
rise to the indebtedness, the account receivable shall be treated as an 
asset except that, if the account receivable is established (or deemed 
established) in a taxable year of the DISC ending on or before August 
15, 1975, at the taxpayer's option, the account receivable shall be 
treated as an asset as of the end of such taxable year. However, under 
Sec. 1.993-2(d)(3), an account receivable referred to in the preceding 
sentence shall not be treated as a trade receivable or other qualified 
export asset.
    (iv) An account receivable established in accordance with 
subdivision (i) of this subparagraph shall bear interest at an arm's 
length rate, computed in the manner provided by Sec. 1.482-2(a)(2) from 
the day after the date the account receivable is deemed established to 
the date of payment. The interest so computed shall be accrued and 
included in the taxpayer's taxable income for each taxable year during 
which the account receivable is outstanding.
    (v)(a) In lieu of establishing an account receivable in accordance 
with subdivision (i) of this subparagraph for all or part of an amount 
due a related supplier, the related supplier and DISC are permitted to 
treat all or part of any distribution which was made by the DISC out of 
its previously taxed income with respect to the year to which the 
determination or redetermination relates as an additional payment of 
transfer price or repayment of commission (and not as a distribution) 
made as of the date the distribution was made. Any additional amount 
arising on the determination or redetermination due the related supplier 
after this treatment shall be represented by an account receivable 
established under subdivision (i) of this subparagraph. To the extent 
that a distribution is so treated under this subdivision (v), it shall 
cease to qualify as distribution for any Federal income tax purpose, and 
the DISC's account for previously taxed income shall be adjusted 
accordingly. If all or part of any distribution made to a shareholder 
other than the related supplier is recharacterized under this 
subdivision (v), the related supplier shall establish an account 
receivable from that shareholder for the

[[Page 754]]

amount so recharacterized. Such account receivable shall be paid in the 
time and manner set forth in this paragraph (e)(5). In order to obtain 
the relief provided by this subdivision (v), the conditions and 
procedures prescribed by Revenue Procedure 84-3 must be met. The 
provisions of this paragraph (e)(5)(v) shall apply to all open taxable 
years ending after December 31, 1971.
    (b) If, for example, during 1982, a DISC commission from a related 
supplier with respect to a transaction completed in 1980 was 
redetermined to be $1,000 less than the commission actually charged by, 
and paid to, the DISC, the amount of any distribution previously made by 
the DISC from its 1980 previously taxed income to the related supplies 
as a shareholder may, to the extent of $1,000, be treated not as a 
distribution but as a repayment of the commission.
    (vi) The procedure for adjustments to transfer price provided by 
this subparagraph does not apply to incomplete transactions described in 
paragraph (c)(5)(i)(b) of this section. Such procedure will, however, be 
applied to any such transaction with respect to the taxable year in 
which the transaction is completed.
    (6) Examples. The provisions of this paragraph may be illustrated by 
the following examples:

    Example 1. (i) During 1975, a DISC which uses the calendar year as 
its taxable year purchased a product from its related supplier and made 
an initial payment of $8,500. If $8,500 were determined to be the 
transfer price under section 994, the DISC's taxable income from the 
transaction would be $1,000. Immediately before the DISC filed its 
return for 1975, under section 994 it is determined that the transfer 
price is $8,000 and the DISC's taxable income is $1,500. Thus, the 
requirement of a reasonable estimate under subparagraph (3) of this 
paragraph was met because the amount ($8,500) actually paid resulted in 
the DISC realizing taxable income of $1,000 which is not less than 50 
percent of the DISC's taxable income ($1,500) from the transaction as 
determined under section 994.
    (ii) Pursuant to subparagraph (5) of this paragraph, an account 
receivable due the DISC for $500, i.e., $8,500-$8,000, is established on 
September 15, 1976, the date the DISC files its return for 1975, and is 
paid on December 1, 1976. The account receivable for $500 will be 
considered to relate to the taxable year (1975) in which the transaction 
occurred which gave rise thereto and will be a qualified export asset 
under Sec. 1.993-2(d)(3) for the last day of such year.
    Example 2. Assume the same facts as in example 1 except that the 
account receivable for $500 is paid on January 1, 1977. The account 
receivable for $500 will still be considered to relate to the taxable 
year (1975) in which the transaction occurred which gave rise thereto. 
However, such account receivable will be treated as an asset which is 
not a qualified export asset under Sec. 1.993-2(d)(3) for the last day 
of such year.

    (f) Export promotion expenses--(1) Purpose of expense. (i) In order 
for an expense or cost of a type described in subparagraph (2) of this 
paragraph to be an export promotion expense, the expense or cost must be 
incurred or treated as incurred by the DISC (under subparagraph (7) of 
this paragraph) to advance the sale, lease, or other distribution of 
export property for use, consumption, or distribution outside the United 
States. Costs of services in performing installation (but not assembly) 
on the site and for meeting warranty commitments if such services are 
related and subsidiary (within the meaning of Sec. 1.993-1(d)) to any 
qualified sale, lease, or other distribution of export property by the 
DISC (or with respect to which the DISC received a commission) will be 
considered to advance the sale, lease, or other distribution of export 
property. General and administrative expenses attributable to billing 
customers, other clerical functions of the DISC, or generally operating 
the DISC, will also be considered to advance the sale, lease, or other 
distribution of export property.
    (ii) Where an expense or cost incurred or treated as incurred by the 
DISC qualifies only in part as an export promotion expense, such expense 
or cost must be allocated between the qualified portion and such other 
portion on a reasonable basis. See Sec. 1.994-2(b)(2) for the option of 
the related supplier not to claim expenses as export promotion expenses.
    (2) Types of expenses. The only expenses or costs which may be 
export promotion expenses are those expenses or costs meeting the test 
of subparagraph (1) of this paragraph which constitute--
    (i) Ordinary and necessary expenses of the DISC paid or incurred 
during the

[[Page 755]]

DISC's taxable year in carrying on any trade or business, allowable as 
deductions under section 162, such as expenses for market studies, 
advertising, salaries and wages (including contributions or 
compensations deductible under section 404) of sales, clerical, and 
other personnel, rentals on property, sales commissions, warehousing, 
and other selling expenses,
    (ii) A reasonable allowance under section 167 for exhaustion, wear 
and tear, or obsolescence of the property of the DISC,
    (iii) Costs of freight (subject to the limitations of subparagraph 
(4) of this paragraph),
    (iv) Costs of packaging for export (as defined in subparagraph (5) 
of this paragraph), or
    (v) Costs of designing and labeling packages exclusively for export 
markets (under subparagraph (6) of this paragraph).
    (3) Ineligible expenses. Items ineligible to be export promotion 
expenses include, for example, interest expenses, bad debt expenses, 
freight insurance, State and local income and franchise taxes, the cost 
of manufacture or assembly operations, and items of cost of goods sold 
(except as otherwise provided in this paragraph in the case of certain 
freight, packaging, and designing and labeling expenses). Income or 
similar taxes eligible for a foreign tax credit under sections 901 and 
903 are also not eligible to be export promotion expenses.
    (4) Freight expenses--(i) In general. Export promotion expenses 
include one-half of the freight expense (not including insurance) for 
shipping export property aboard a U.S.-flag carrier in those cases where 
law or regulation of the United States or of any State or political 
subdivision thereof or of any agency or instrumentality of any of these 
does not require that the export property be shipped aboard a U.S.-flag 
carrier. For purposes of this paragraph, the term ``freight expense'' 
includes charges paid for c.o.d. service, miscellaneous ground charges, 
such as charges incurred for services normally performed by U.S.-flag 
carriers, charges for services of loading aboard U.S.-flag carriers 
normally performed by such carriers, freight forwarders, or independent 
contractors engaged in loading property, and charges attributable to a 
freight consolidation function normally performed by freight forwarders. 
In order for one-half of freight expenses paid to the owner (or the 
agent of the owner) of a U.S.-flag carrier to be claimed as an export 
promotion expense, the DISC must obtain a written statement (such as, 
for example, a bill of lading) from the owner (or the agent) disclosing 
that the export property was shipped aboard the owner's U.S.-flag 
carrier or another U.S.-flag carrier, and the DISC must have no 
reasonable basis for disbelieving such statement of the owner (or the 
agent). For the requirement of a written statement from a freight 
forwarder, see subdivision (iv) of this subparagraph.
    (ii) U.S.-flag carrier defined. For purposes of this paragraph, the 
term ``U.S.-flag carrier'' is an airplane owned and operated by a U.S. 
person or persons (as defined in section 7701(a)(30)) or a ship 
documented under the laws of the United States. Shipment initiated by 
delivery to the U.S. Postal Service shall be considered shipment aboard 
a U.S.-flag carrier, but not if shipped to a place to which mail 
shipments from the United States are ordinarily accomplished by land 
transportation, such as to Canada or Mexico, unless airmail is 
specified.
    (iii) Shipment pursuant to law or regulation. Shipment pursuant to 
law or regulation includes instances where a U.S.-flag carrier must be 
used in order to obtain permission from the Government to make the 
export. If the law or regulation requires a fixed portion of the export 
property to be shipped aboard a U.S.-flag carrier, the freight expense 
on that portion of such export property that was so shipped in order to 
satisfy such requirement cannot qualify as an export promotion expense.
    (iv) Freight forwarders. A payment to a freight forwarder shall be 
considered freight expense within the meaning of this paragraph to the 
extent the forwarder utilizes a U.S.-flag carrier. For purposes of this 
paragraph, the term ``freight forwarder'' includes air freight 
consolidators and carriers owned and operated by U.S. persons utilizing 
U.S.-

[[Page 756]]

flag carriers such as non-vessel-owning common carriers. In order for 
one-half of freight expenses paid to a freight forwarder to be claimed 
as export promotion expenses, the DISC must obtain a written statement 
(such as, for example, a bill of lading) from the freight forwarder 
disclosing that the export property was shipped aboard a U.S.-flag 
carrier, and the DISC must have no reasonable basis for disbelieving 
such statement of the freight forwarder.
    (v) Freight within the United States. A DISC may not claim as export 
promotion expense any amount that is attributable to carriage of export 
property between points within the United States. If, however, export 
property is carried from the United States to a foreign country on a 
through shipment pursuant to a single bill of lading or similar document 
aboard one or more U.S.-flag carriers, the freight expense of such 
carriage shall not be apportioned between the domestic and foreign 
portions of such carriage, even though a carrier may stop en route 
within the United States or the export property may be shifted from one 
carrier to another, and one-half of such freight expense may be claimed 
as an export promotion expense. Freight expense does not include the 
cost of transporting the export property to the depot of the U.S.-flag 
carrier or freight forwarder for shipment abroad. The expense of 
shipment of export property initiated by delivery to the U.S. Postal 
Service for ultimate delivery outside the United States shall be 
considered as attributable entirely to carriage of such property outside 
the United States.
    (5) Packaging for export. (i) Export promotion expenses include the 
direct and indirect cost of packaging export property (including the 
cost of the package) for export whether or not the packaging is the same 
as domestic packaging. Such packaging costs do not include costs of 
manufacturing (as defined in the regulations under section 993) and 
assembly. Thus, if a DISC buys and packages export property for resale, 
its costs of packaging the export property are export promotion 
expenses. If, however, the process of such packaging by the DISC is 
physically integrated with the process of manufacturing the export 
property by the related supplier, the costs of such packaging are not 
export promotion expenses.
    (ii) The cost of containers leased from a shipping company to which 
the DISC also pays freight for the property packaged is not a cost of 
packaging. However, in such circumstances, one-half of the rental charge 
may be allowable as a freight expense if permitted under subparagraph 
(4) of this paragraph.
    (6) Designing and labeling packages. Export promotion expenses 
include the direct and indirect costs of designing and labeling 
packages, including bottles, cans, jars, boxes, cartons, or containers, 
to the extent incurred for export markets. Thus, for example, to the 
extent incurred for supplying export markets, the cost of designing 
labels in a foreign language and the cost of printing such labels are 
export promotion expenses.
    (7) DISC must incur export promotion expenses--(i) In general. In 
order for an expense to be an export promotion expense it must be 
incurred or treated as incurred under this subparagraph by the DISC. For 
example, an expense is incurred by a DISC if the expense results from 
(a) the DISC incurring an obligation to pay compensation to its 
employees, (b) depreciation of property owned by the DISC and used by 
its employees, (c) the DISC incurring an obligation to pay for office 
supplies used by its employees, (d) the DISC incurring an obligation to 
pay space costs for use by its employees, or (e) the DISC incurring an 
obligation to pay other costs supporting efforts by its employees.
    (ii) Payments to independent contractors. A payment to an 
independent contractor, directly or indirectly, is treated as incurred 
by the DISC if the cost of performing the function performed by the 
independent contractor would be considered an export promotion expense 
described in subparagraphs (1) and (2) of this paragraph if performed by 
the DISC, and if, in a case where the services of the independent 
contractor were engaged by a party related to the DISC, such related 
party and such DISC agreed in writing before the contract was entered 
into that a specified

[[Page 757]]

portion or all of the contract was for the benefit of the DISC and that 
all of the expenses of the contract (eligible to be considered as export 
promotion expenses) with respect to such portion would be borne by the 
DISC.
    (iii) Expenses incurred by related parties. Reimbursements or other 
payments by a DISC to a related party are export promotion expenses only 
if the expenses of the related party for which reimbursement is made are 
for space in a building actually used by employees of the DISC or for 
export property owned by the DISC. Except as otherwise provided in the 
preceding sentence, expenses incurred by a foreign international sales 
corporation (FISC) or a real property holding company (as defined in 
section 993(e)(1) and (2), respectively) shall not be treated as export 
promotion expenses of its DISC.
    (iv) Selling commissions paid by a DISC. A commission paid by a DISC 
to a person other than a related person, with respect to a transaction 
which gives rise to qualified export receipts of the DISC, is an export 
promotion expense of the DISC. A commission paid by a DISC to a related 
person is not an export promotion expense.
    (v) Sales of promotional material. If a DISC sells promotional 
material to a buyer of export property from the DISC at a price which is 
greater than the costs of the DISC for such material, such costs are not 
export promotion expenses. If, however, the DISC sells promotional 
material at a price which is less than its costs for such material, the 
excess of such costs over such price is an export promotion expense. For 
rules relating to the status of promotional material as qualified export 
assets and export property, see Sec. Sec. 1.993-2 and 1.993-3, 
respectively.
    (vi) An expense may be incurred by the DISC under subdivisions (i) 
through (v) of this subparagraph even if the accounting for and payment 
of such expense is handled by a related party and the DISC reimburses 
the related party for such expenses.
    (8) Incomplete transactions. Expenses eligible to be treated as 
export promotion expenses which are attributable to the sale, lease, or 
other distribution of export property and which are incurred prior to 
the taxable year of sale, lease, or other distribution by the DISC are 
not treated as export promotion expenses until the taxable year of sale, 
lease, or other distribution or until the taxable year in which it is 
first determined that no transaction is reasonably expected to result 
from the expense incurred (whether or not a transaction subsequently 
results). Thus, for example, if a DISC incurs a packaging cost which is 
otherwise eligible to be treated as an export promotion expense, the 
DISC may not include such charge as an export promotion expense until 
the year in which the export property with respect to which the 
packaging cost was incurred is actually sold by the DISC. If no 
transaction is reasonably expected to result from the packaging cost, 
such cost should be allocated as an export promotion expense to the 
group of transactions to which such cost is most closely related.
    (g) Examples. The provisions of this section may be illustrated by 
the following examples:

    Example 1. J and K are calendar year taxpayers. J, a domestic 
manufacturing company, owns all the stock of K, a DISC for the taxable 
year. During 1972, J manufactures only 100 units of a product (which is 
eligible to be export property as defined in section 993(c)). J enters 
into a written agreement with K whereby K is granted a sales franchise 
with respect to exporting such property and K will receive commissions 
with respect to such exports equal to the maximum amount permitted to be 
received under the intercompany pricing rules of section 994. 
Thereafter, the 100 units are sold for $1,000. J's cost of goods sold 
attributable to the 100 units is $650. J's direct selling expenses so 
attributable are $100. Although J has other deductible expenses, for 
purposes of this example assume that J has no other deductible expenses. 
K pays $230 to independent contractors which qualify as export promotion 
expenses under paragraph (f)(7)(ii) of this section. K does not perform 
functions substantial enough to entitle it to an allocation of income 
which meets the arm's length standard of section 482. The income which K 
may earn under section 994 under the franchise is $20, computed as 
follows:

(1) Combined taxable income:
  (a) K's sales price.................................  .......   $1,000
  (b) Less deductions:
    J's cost of goods sold............................     $650
    J's direct selling expenses.......................      100
    K's export promotion expenses.....................      230
                                                       ---------
        Total deductions..............................  .......      980
                                                                --------

[[Page 758]]

 
  (c) Combined taxable income.........................  .......       20
                                                                ========
(2) K's profit under combined taxable income method (before
 application of loss limitation):
  (a) 50 percent of combined taxable income....................       10
  (b) Plus: 10 percent of K's export promotion expenses (10% of       23
   $230).......................................................
                                                       ----------
  (c) K's profit...............................................       33
                                                       ==========
(3) K's profit under gross receipts method (before application
 of loss limitation):
  (a) 4 percent of K's sales price (4% of $1,000)..............       40
  (b) Plus: 10 percent of K's export promotion expenses (10% of       23
   $230).......................................................
                                                       ----------
  (c) K's profit...............................................       63
                                                                ========
 

    Since combined taxable income ($20) is lower than both K's profit 
under the combined taxable income method ($33) and under the gross 
receipts method ($63), the maximum income K may earn is $20. 
Accordingly, the commissions K may receive from J are $250, i.e., K's 
expenses ($230) plus K's profit ($20).
    Example 2. M and N are calendar year taxpayers. M, a domestic 
manufacturing company, owns all the stock of N, a DISC for the taxable 
year. During 1972, M produces and sells a particular product line of 
export property to N for $75, a price which can be justified as 
satisfying the standard of arm's length price of section 482. N performs 
substantial functions with respect to the transaction and resells the 
export property for $100. M's cost of goods sold attributable to the 
export property is $60. M's direct selling expenses so attributable 
(relating to advertising of the product line in foreign markets) are 
$12. Although M has other deductible expenses, for purposes of this 
example, assume that M has no other deductible expenses. N's expenses 
attributable to resale of the export property are $22 of which $20 are 
export promotion expenses. The maximum profit which N may earn with 
respect to the product line is $6, computed as follows:

(1) Combined taxable income:
  (a) N's sales price.................................  .......     $100
  (b) Less deductions:
    M's cost of goods sold............................      $60
    M's direct selling expenses.......................       12
    N's expenses......................................       22
                                                                --------
      Total deductions................................  .......       94
                                                                --------
  (c) Combined taxable income.........................  .......        6
                                                                ========
(2) N's profit under combined taxable income method (before
 application of loss limitation):
  (a) 50 percent of combined taxable income....................        3
  (b) Plus: 10 percent of N's export promotion expenses (10% of        2
   $20)........................................................
                                                       ----------
  (c) N's profit...............................................        5
                                                       ==========
(3) N's profit under gross receipts method (before application
 of loss limitation):
  (a) 4 percent of N's sales price (4% of $100)................        4
  (b) Plus: 10 percent of N's export promotion expenses (10% of        2
   $20)........................................................
                                                       ----------
  (c) N's profit...............................................        6
                                                       ==========
(4) N's profit under section 482 method:
  (a) N's sales price..........................................      100
  (b) Less deductions:
    N's cost of goods sold (price paid by N to M).....       75
    N's expenses......................................       22
                                                                --------
      Total deductions................................  .......       97
                                                                --------
  (c) N's profit......................................  .......        3
                                                                ========
 

    Since the gross receipts method results in greater profit to N ($6) 
than does the combined taxable income method ($5) or section 482 method 
($3), and does not exceed combined taxable income ($6), N may earn a 
maximum profit of $6. Accordingly, the transfer price from M to N may be 
readjusted as long as the transfer price is not readjusted below $72, 
computed as follows:

(5) Transfer price from M to N:
  (a) N's sales price...................................  ......    $100
  (b) Less:
    N's expenses........................................     $22
    N's profit..........................................       6
                                                         --------
      Total subtractions................................  ......      28
                                                                 -------
  (c) Transfer price....................................  ......      72
 

    Example 3. Q and R are calendar year taxpayers. Q, a domestic 
manufacturing company, owns all the stock of R, a DISC for the taxable 
year. During 1972, Q produces and sells a product line of export 
property to R for $170, a price which can be justified as satisfying the 
standards of arm's length price of section 482, and R resells the export 
property for $200. Q's cost of goods sold attributable to the export 
property is $115 so that the combined gross income from the sale of the 
export property is $85 (i.e., $200 minus $115). Q's expenses incurred in 
connection with the property sold are $35. Q's deductible overhead and 
other supportive expenses allocable to all gross income are $6. 
Apportionment of these supportive expenses on the basis of gross income 
does not result in a material distortion of income and is a reasonable 
method of apportionment. Q's gross income from sources other than the 
transaction is $170 making total gross income of Q and R (excluding the 
transfer price paid by R) $255 (i.e., $85 plus $170). R's expenses 
attributable to resale of the export property are $20, all of which are 
export promotion expenses. The maximum profit which R may earn with 
respect to the product line is $16, computed as follows:

(1) Combined taxable income:
  (a) R's sales price...................................  ......    $200
  (b) Less deductions:
    (i) Q's cost of goods sold..........................     115
    (ii) Q's expenses incurred in connection with the         35
     property sold......................................

[[Page 759]]

 
    (iii) Apportionment of Q's supportive
     expenses:
      Q's supportive expenses.................        $6
      Combined gross income from sale of              85
       export property........................
      Total gross income of Q and R...........       255
      Apportionment...........................  (6 x 85)/      2
                                                     255
    (iv) R's expenses.........................  ........      20
                                                         --------
      Total deductions........................  ........  ......     172
                                                                 -------
  (c) Combined taxable income...................................      28
                                               ===========
(2) R's profit under combined taxable income method (before
 application of loss limitation):
  (a) 50 percent of combined taxable income.....................      14
  (b) Plus: 10 percent of R's export promotion expenses (10% of        2
   $20).........................................................
                                               -----------
  (c) R's profit................................................      16
                                               ===========
(3) R's profit under gross receipts method (before application
 of loss limitation):
  (a) 4 percent of R's sales price (4% of $200).................       8
  (b) Plus: 10 percent of R's export promotion expenses (10% of        2
   $20).........................................................
                                               -----------
  (c) R's profit................................................      10
                                               ===========
(4) R's profit under section 482 method:
  (a) R's sales price...........................................     200
  (b) Less deductions:
    R's cost of goods sold (price paid by R to Q).......     170
    R's expenses........................................      20
                                               ----------
      Total deductions..................................  ......     190
                                                         ---------
  (c) R's profit........................................  ......      10
                                                                 =======
 

    Since the combined taxable income method results in greater profit 
to R ($16) than does the gross receipts method ($10) or section 482 
method ($10), and does not exceed combined taxable income ($28), R may 
earn a maximum profit of $16. Accordingly, the transfer price from Q to 
R may be readjusted as long as the transfer price is not readjusted 
below $164 computed as follows:

(5) Transfer price from Q to R:
  (a) R's sales price...................................  ......    $200
  (b) Less:
    R's expenses........................................     $20
    R's profit..........................................      16
                                                         --------
      Total.............................................  ......      36
                                                                 -------
  (c) Transfer price....................................  ......     164
                                                                 =======
 

    Example 4. S and T are calendar year taxpayers. S, a domestic 
manufacturing company, owns all the stock of T, a DISC for the taxable 
year. During 1972, S produces and sells 100 units of a particular 
product to T under a written agreement which provides that the transfer 
price between S and T shall be that price which allocates to T the 
maximum permitted to be received under the intercompany pricing rules of 
section 994. Thereafter, the 100 units are sold by T for $950. S's cost 
of goods sold attributable to the 100 units is $650. S's other 
deductible expenses so attributable are $300. Although S has other 
deductible expenses, for purposes of this example, assume that S has no 
deductible expenses not definitely allocable to any item of gross 
income. T's expenses attributable to the resale of the 100 units are 
$50. S chooses not to apply the section 482 method. T may not earn any 
income under the gross receipts or combined taxable income method with 
respect to resale of the 100 units because combined taxable income is a 
negative figure, computed as follows:

(1) Combined taxable income:
  (a) T's sales price...................................  ......    $950
  (b) Less deductions:
    S's cost of goods sold..............................    $650
    S's expenses........................................     300
    T's expenses........................................      50
                                                         --------
      Total deductions..................................  ......   1,000
                                                                 -------
  (c) Combined taxable income (loss)....................  ......   ($50)
                                                                 =======
 

    Under paragraph (e)(1)(i) of this section, T is permitted to recover 
its expenses attributable to the 100 units ($50) even though such 
recovery results in a loss or increased loss to the related supplier. 
Accordingly, the transfer price from S to T may be readjusted as long as 
the transfer price is not readjusted below $900, computed as follows:

(2) Transfer price from S to T:
  (a) T's sales price...........................................    $950
  (b) Less: T's expenses........................................      50
                                                                 -------
  (c) Transfer price............................................     900
                                                                 =======
 

    Example 5. Assume the same facts as in example 4 except that S 
chooses to apply the section 482 method and that under arm's length 
dealings T would have derived $10 of income. Accordingly, the transfer 
price from S to T may be set at an amount not less than $890, computed 
as follows:

(1) Transfer price from S to T:
  (a) T's sales price...................................  ......    $950
  (b) Less:
    T's expenses........................................     $50
    T's profit..........................................      10
                                                         --------
      Total deductions..................................  ......      60
                                                                 -------
  (c) Transfer price....................................  ......     890
                                                                 =======
 

    Example 6. X and Y are calendar year taxpayers. X, a domestic 
manufacturing company, owns all the stock of Y, a DISC for the taxable 
year. During March 1972, X manufactures a particular product of export 
property which it leases on April 1, 1972, to Y for a term of 1 year at 
a monthly rental of $1,000, a rent which satisfies the standard of arm's 
length rental under section 482. Y subleases the product on April 1, 
1972, for a term of 1 year at a monthly rental of $1,200. X's cost

[[Page 760]]

for the product leased is $40,000. X's other deductible expenses 
attributable to the product are $900, all of which are incurred in 1972. 
Although X has other deductible expenses, for purposes of this example, 
assume that X has no other deductible expenses. Y's expenses 
attributable to sublease of the export property are $450, all of which 
are incurred in 1972 and are export promotion expenses. X depreciates 
the property on a straight line basis without the use of an averaging 
convention, assuming a useful life of 8 years and no salvage value. The 
profit which Y may earn with respect to the transaction is $2,895 for 
1972 and $1,175 for 1973, computed as follows:

                          computation for 1972
(1) Combined taxable income:
  (a) Y's sublease rental receipts for year ($1,200   ........   $10,800
   x 9 months)......................................
  (b) Less deductions:
    X's depreciation ($40,000 x 1/8 x 9/12).........    $3,750
    X's other expenses..............................       900
    Y's expenses....................................       450
                                                     ----------
      Total deductions..............................  ........     5,100
                                                               ---------
  (c) Combined taxable income.......................  ........     5,700
                                                               =========
(2) Y's profit under combined taxable income method (before
 application of loss limitation):
  (a) 50 percent of combined taxable income...................     2,850
  (b) Plus: 10 percent of Y's export promotion expenses (10%          45
   of $450)...................................................
                                                     -----------
  (c) Y's profit..............................................     2,895
                                                     ===========
(3) Y's profit under gross receipts method (before application
 of loss limitation):
  (a) 4 percent of Y's sublease rental receipts for year (4%         432
   of $10,800)................................................
  (b) Plus: 10 percent of Y's export promotion expenses (10%          45
   of $450)...................................................
                                                     -----------
  (c) Y's profit..............................................       477
                                                     ===========
(4) Y's profit under section 482 method:
  (a) Y's sublease rental receipts for year...................   $10,800
  (b) Less deductions:
    Y's lease rental payments for year..............    $9,000
    Y's expenses....................................       450
                                                     ----------
  Total deductions..................................  ........     9,450
                                                               ---------
  (c) Y's profit....................................  ........     1,350
 

    Since the combined taxable income method results in greater profit 
to Y ($2,895) than does the gross receipts method ($477) or section 482 
method ($1,350), Y may earn a profit of $2,895 for 1972. Accordingly, 
the monthly rental payable by Y to X for 1972 may be readjusted as long 
as the monthly rental payable is not readjusted below $828.33, computed 
as follows:

(5) Monthly rental payable by Y to X for 1972:
  (a) Y's sublease rental receipts for year.................  $10,800.00
  (b) Less:
    Y's expenses..................................    450.00
    Y's profit....................................  2,895.00
                                                   ----------
      Total.......................................  ........    3,345.00
                                                             -----------
  (c) Rental payable for 1972...............................    7,455.00
                                                   -----------
  (d) Rental payable each month ($7,455 / 9 months).........      828.33
                                                   ===========
                          computation for 1973
 
(1) Combined taxable income:
  (a) Y's sublease rental receipts for year ($1,200 x 3           $3,600
   months)..................................................
  (b) Less: X's depreciation ($40,000 x 1/8 x 3/12).........       1,250
                                                   -----------
  (c) Combined taxable income...............................       2,350
                                                   ===========
(2) Y's profit under combined taxable income method (before
 application of loss limitation):
  (a) 50 percent of combined taxable income.................      $1,175
                                                   -----------
  (b) Y's profit............................................       1,175
                                                   ===========
(3) Y's profit under gross receipts method (before
 application of loss limitation):
  (a) 4 percent of Y's sublease rental receipts for year (4%         144
   of $3,600)...............................................
                                                   ===========
  (b) Y's profit............................................         144
                                                   ===========
(4) Y's profit under section 482 method:
  (a) Y's sublease rental receipts for year.................       3,600
  (b) Less: Y's lease rental payments for year..............       3,000
                                                   -----------
  (c) Y's profit............................................         600
 

    Since the combined taxable income method results in greater profit 
to Y ($1,175) than does the gross receipts method ($144) or section 482 
method ($600), Y may earn a profit of $1,175 for 1973. Accordingly, the 
monthly rental payable by Y to X for 1973 may be readjusted as long as 
the monthly rental payable is not readjusted below $808.33, computed as 
follows:

(5) Monthly rental payable by Y to X for 1973:
  (a) Y's sublease rental receipts for year.................   $3,600.00
  (b) Less: Y's profit......................................    1,175.00
                                                             -----------
  (c) Rental payable for 1973...............................    2,425.00
                                                             ===========
  (d) Rental payable for each month ($2,425 / 3 months).....      808.33
                                                             ===========
 


(Secs. 995(e)(7), (8) and (10), 995(g) and 7805 of the Internal Revenue 
Code of 1954 (90 Stat. 1655, 26 U.S.C. 995 (e)(7), (8) and (10); 90 
Stat. 1659, 26 U.S.C. 995(g); and 68A Stat 917, 26 U.S.C. 7805))

[T.D. 7364, 40 FR 29827, July 16, 1975, as amended by T.D. 7435, 41 FR 
43142, Sept. 30, 1976; T.D. 7854, 47 FR 51741, Nov. 17, 1982; T.D. 7984, 
49 FR 40018, Oct. 12, 1984]



Sec. 1.994-2  Marginal costing rules.

    (a) In general. This section prescribes the marginal costing rules 
authorized by section 994(b)(2). If under paragraph (c)(1) of this 
section a DISC is treated for its taxable year as seeking to establish 
or maintain a foreign market for sales of an item, product, or product 
line of export property (as defined in

[[Page 761]]

Sec. 1.993-3) from which qualified export receipts are derived, the 
marginal costing rules prescribed in paragraph (b) of this section may 
be applied to allocate costs between gross receipts derived from such 
sales and other gross receipts for purposes of computing, under the 
``50-50'' combined taxable income method of Sec. 1.994-1(c)(3), the 
combined taxable income of the DISC and related supplier derived from 
such sales. Such marginal costing rules may be applied whether or not 
the related supplier manufactures, produces, grows, or extracts (within 
the meaning of Sec. 1.993-3(c)) the export property sold. Such marginal 
costing rules do not apply to sales of export property which in the 
hands of a purchaser related under section 954(d)(3) to the seller give 
rise to foreign base company sales income as described in section 954(d) 
unless, for the purchaser's year in which it resells the export 
property, section 954(b)(3)(A) is applicable or such income is under the 
exceptions in section 954(b)(4). Such marginal costing rules do not 
apply to leases of property or the performance of any services whether 
or not related and subsidiary services (as defined in Sec. 1.994-
1(b)(3).
    (b) Marginal costing rules for allocations of costs--(1) In general. 
Marginal costing is a method under which only marginal or variable costs 
of producing and selling a particular item, product, or product line are 
taken into account for purposes of section 994. Where this section is 
applicable, costs attributable to deriving qualified export receipts for 
the DISC's taxable year from sales of an item, product, or product line 
may be determined in any manner the related supplier (as defined in 
Sec. 1.994-1(a)(3)(ii)) chooses, provided that the requirements of both 
subparagraphs (2) and (3) of this paragraph are met.
    (2) Variable costs taken into account. There are taken into account 
in computing the combined taxable income of the DISC and its related 
supplier from sales of an item, product, or product line the following 
costs:
    (i) Direct production costs (as defined in Sec. 1.471-11(b)(2)(i)) 
and
    (ii) Costs which are export promotion expenses, but only if they are 
claimed as export promotion expenses in determining taxable income 
derived by the DISC under the combined taxable income method of Sec. 
1.994-1(c)(3).


At the taxpayer's option, all, a part, or none of the costs which 
qualify as export promotion expenses may be so claimed as export 
promotion expenses.
    (3) Overall profit percentage limitation. As a result of such 
determination of costs attributable to such qualified export receipts 
for the DISC's taxable year, the combined taxable income of the DISC and 
its related supplier from sales of such item, product, or product line 
for the DISC's taxable year does not exceed gross receipts (determined 
under Sec. 1.993-6) of the DISC derived from such sales, multiplied by 
the overall profit percentage (determined under paragraph (c)(2) of this 
section).
    (c) Definitions--(1) Establishing or maintaining a foreign market. A 
DISC shall be treated for its taxable year as seeking to establish or 
maintain a foreign market with respect to sales of an item, product, or 
product line of export property from which qualified export receipts are 
derived if the combined taxable income computed under paragraph (b) of 
this section is greater than the combined taxable income computed under 
Sec. 1.994-1(c)(6).
    (2) Overall profit percentage. (i) For purposes of this section, the 
overall profit percentage for a taxable year of the DISC for a product 
or product line is the percentage which--
    (a) The combined taxable income of the DISC and its related supplier 
plus all other taxable income of its related supplier from all sales 
(domestic and foreign) of such product or product line during the DISC's 
taxable year, computed under the full costing method, is of
    (b) The total gross receipts (determined under Sec. 1.993-6) from 
all such sales.
    (ii) At the annual option of the related supplier, the overall 
profit percentage for the DISC's taxable year for all products and 
product lines may be determined by aggregating the amounts described in 
subdivision (i) (a) and (b) of this subparagraph of the DISC, and all 
domestic members of the controlled group (as defined in Sec. 1.993-
1(k)) of which the DISC is a member,

[[Page 762]]

for the DISC's taxable year and for taxable years of such members ending 
with or within the DISC's taxable year.
    (iii) For purposes of determining the amounts in subdivisions (i) 
(b) and (ii) of this subparagraph, a sale of property between a DISC and 
its related supplier or between domestic members of the controlled group 
shall be taken into account only during the DISC's taxable year (or 
taxable year of the member ending within the DISC's taxable year) during 
which the property is ultimately sold to a person which is neither the 
DISC nor such a domestic member.
    (3) Grouping of transactions. (i) In general, for purposes of this 
section, an item, product, or product line is the item or group 
consisting of the product or product line pursuant to Sec. 1.994-
1(c)(7) used by the taxpayer for purposes of applying the intercompany 
pricing rules of Sec. 1.994-1.
    (ii) However, for purposes of determining the overall profit 
percentage under subparagraph (2) of this paragraph, any product or 
product line grouping permissible under Sec. 1.994-1(c)(7) may be used 
at the annual choice of the taxpayer, even though it may not be the same 
item or grouping referred to in subdivision (i) of this subparagraph, as 
long as the grouping chosen for determining the overall profit 
percentage is at least as broad as the grouping referred to in such 
subdivision (i).
    (4) Full costing method. For purposes of this section, the term 
``full costing method'' is the method for determining combined taxable 
income set forth in Sec. 1.994-1(c)(6).
    (d) Application of limitation on DISC income (``no loss'' rule). If 
the marginal costing rules of this section are applied, the combined 
taxable income method of Sec. 1.994-1(c)(3) may not be applied to cause 
in any taxable year a loss to the related supplier, but such method may 
be applied to the extent it does not cause a loss. For purposes of the 
preceding sentence, a loss to a related supplier would result if the 
taxable income of the DISC would exceed the combined taxable income of 
the related supplier and the DISC determined in accordance with 
paragraph (b) of this section. If, however, there is no combined taxable 
income (so determined), see the last sentence of Sec. 1.994-1(e)(1)(i).
    (e) Examples. The provisions of this section may be illustrated by 
the following examples:

    Example 1. X and Y are calendar year taxpayers. X, a domestic 
manufacturing company, owns all the stock of Y, a DISC for the taxable 
year. During 1973, X manufactures a product line which is eligible to be 
export property (as defined in Sec. 1.993-3). X enters into a written 
agreement with Y whereby Y is granted a sales franchise with respect to 
exporting such product line from which qualified export receipts will be 
derived and Y will receive commissions with respect to such exports 
equal to the maximum amount permitted to be received under the 
intercompany pricing rules of section 994. Commissions are computed 
using the combined taxable income method under Sec. 1.994-1(c)(3). For 
purposes of applying the combined taxable income method, X and Y compute 
their combined taxable income attributable to the product line of export 
property under the marginal costing rules in accordance with the 
additional facts assumed in the table below:

(1) Maximum combined taxable income (determined under
 paragraph (b)(2) of this section):
  (a) Y's gross receipts from export sales....................    $95.00
  (b) Less:
    (i) Direct materials............................     40.00
    (ii) Direct labor...............................     20.00
    (iii) Y's export promotion expenses claimed in        5.00
     determining Y's DISC taxable income............
    (iv) Total deductions...........................     65.00
                                                     ----------
  (c) Maximum combined taxable income.........................     30.00
                                                     ===========
(2) Overall profit percentage limitation (determined under
 paragraph (b)(3) of this section):
  (a) Gross receipts of X and Y from all domestic and foreign     400.00
   sales......................................................
  (b) Less deductions:
    (i) Direct materials............................    160.00
    (ii) Direct labor...............................     80.00
    (iii) Other costs (of which $8 are costs of the      40.00
     DISC including $5 of export promotion expenses
     claimed in determining Y's taxable income).....
                                                     ----------
  (c) Total deductions........................................    280.00
                                                     -----------
  (d) Total taxable income from all sales computed on a full      120.00
   costing method.............................................
                                                     ===========
  (e) Overall profit percentage (line (d) ($120) divided by          30%
   line (a) ($400)) (percent).................................
  (f) Multiply by gross receipts from Y's export sales (line      $95.00
   (1)(a))....................................................
                                                     ===========
  (g) Overall profit percentage limitations...................     28.50
 


Since the overall profit percentage limitation under line (2)(g) 
($28.50) is less than

[[Page 763]]

maximum combined taxable income under line (1)(c) ($30), combined 
taxable income under marginal costing is limited to $28.50. Since under 
the franchise agreement Y is to earn the maximum commission permitted 
under the intercompany pricing rules of section 994, combined taxable 
income on the transactions is $28.50. Accordingly, the costs 
attributable to export sales (other than for direct material, direct 
labor, and export promotion expenses) are $1.50, i.e., line (1)(c) ($30) 
minus line (2)(g) ($28.50). Under the combined taxable income method of 
Sec. 1.994-1 (c)(3), Y will have taxable income attributable to the 
sales of $14.75, i.e., the sum of \1/2\ of combined taxable income (1/2 
of $28.50) and 10 percent of Y's export promotion expenses claimed in 
determining Y's taxable income (10 percent of $5). Accordingly, the 
commissions Y receives from X are $22.75, i.e., Y's costs ($8, see line 
(2)(b)(iii)) plus Y's profit ($14.75).
    Example 2. (1) Assume the same facts as in example 1, except that 
gross receipts from export sales are only $85 and gross receipts from 
all sales remain at $400. For purposes of applying the combined taxable 
income method, X and Y may compute their combined taxable income 
attributable to the product line of export property under the marginal 
costing rules as follows:

(1) Maximum combined taxable income (determined under paragraph
 (b)(2) of this section):
  (a) Y's gross receipts from export sales.....................   $85.00
  (b) Less:
    (i) Direct materials..............................    40.00
    (ii) Direct labor.................................    20.00
    (iii) Y's export promotion expenses claimed in         5.00
     determining Y's taxable income...................
                                                       ---------
    (iv) Total deductions......................................    65.00
                                                       ----------
  (c) Maximum combined taxable income..........................    20.00
                                                       ==========
(2) Overall profit percentage limitation (determined under
 paragraph (b)(3) of this section):
  (a) Gross receipts from Y's export sales (line (1)(a)).......    85.00
  (b) Multiply by overall profit percentage (as determined in        30%
   example 1) (percent)........................................
                                                       ----------
  (c) Overall profit percentage limitation.....................    25.50
                                                                ========
 


Since maximum combined taxable income under line (1)(c) ($20) is less 
than the overall profit percentage limitation under line (2)(c) 
($25.50), combined taxable income under marginal costing is limited to 
$20. Since under the franchise agreement Y is to earn the maximum 
commission permitted under the intercompany pricing rules of section 
994, combined taxable income on the transactions is $20. Accordingly, no 
costs (other than for direct material, direct labor, and export 
promotion expenses) will be attributed to export sales. Under the 
combined taxable income method of Sec. 1.994-1(c)(3), Y will have 
taxable income attributable to the sales of $10.50, i.e., the sum of \1/
2\ of combined taxable income (1/2 of $20) and 10 percent of Y's export 
promotion expenses claimed in determining Y's taxable income (10 percent 
of $5). Accordingly, the Commissions Y receives from X are $18.50, i.e., 
Y's costs ($8, see line (2)(b)(iii) of example 1) plus Y's profit 
($10.50).
    (2) If export promotion expenses are not claimed in determining 
taxable income of Y under the combined taxable income method, the 
taxable income of Y would be increased to $12.50 and commissions payable 
to Y would be increased to $20.50, computed as follows:

(3) Maximum combined taxable income (determined under
 paragraph (b)(2) of this section):
  (a) Y's gross receipts from export sales............   $85.00
  (b) Less:
    (i) Direct materials..............................    40.00
    (ii) Direct labor.................................    20.00
                                                       ---------
    (iii) Total deductions............................  .......    60.00
                                                                --------
  (c) Maximum combined taxable income..........................    25.00
                                                       ==========
(4) Overall profit percentage limitation (line (2)(c)).........    25.50
                                                                ========
 

Since maximum combined taxable income under line (3)(c) ($25) is less 
than the overall profit percentage under line (4) ($25.50), combined 
taxable income under marginal costing is limited to $25. Since under the 
franchise agreement Y is to earn the maximum commission permitted under 
the intercompany pricing rules of section 994, combined taxable income 
on the transactions is $25. Accordingly, no costs (other than for direct 
material and direct labor) will be attributed to export sales. Under the 
combined taxable income method of Sec. 1.994-1(c)(3), Y will have 
taxable income attributable to the sales of $12.50, i.e., \1/2\ of 
combined taxable income (\1/2\ of $25). Accordingly, the commissions Y 
receives from X are $20.50, i.e., Y's costs ($8, see line (2)(b)(iii) of 
example 1) plus Y's profit ($12.50).
    Example 3. (1) Assume the same facts as in example 1, except that 
gross receipts from export sales are only $85, gross receipts from all 
sales remain at $400, and Y has costs of $40 consisting of Y's export 
promotion expenses of $35 and costs of $5 other than for direct 
material, direct labor, or export promotion expenses. For purposes of 
applying the combined taxable income method, X and Y may compute their 
combined taxable income attributable to the product line of export 
property under the marginal costing rules as follows:

(1) Maximum combined taxable income (determined under
 paragraph (b)(2) of this section):
  (a) Y's gross receipts from export sales............   $85.00
  (b) Less:
    (i) Direct materials..............................    40.00

[[Page 764]]

 
    (ii) Direct labor.................................    20.00
    (iii) Y's export promotion expenses claimed in        35.00
     determining Y's taxable income...................
                                                       ---------
    (iv) Total deductions.............................  .......    95.00
                                                                --------
  (c) Maximum combined taxable income (loss)...................  (10.00)
                                                       ==========
(2) Overall profit percentage limitation (as determined in         25.50
 example 2)....................................................
                                                                ========
 


Since maximum combined taxable income under line (1)(c) (which is a loss 
of $10) is less than the overall profit percentage limitation under line 
(2)(c) ($25.50), combined taxable income under marginal costing is a 
loss of $10 and, under the combined taxable income method of Sec. 
1.994-1(c)(3), Y will have no taxable income or loss attributable to the 
sales. Accordingly, the commissions Y receives from X are $40, i.e., Y's 
costs ($40).
    (2) If export promotion expenses are not claimed in determining Y's 
taxable income under the combined taxable income method, the taxable 
income of Y would be increased to $12.50 and commissions payable to Y 
would be increased to $52.50 computed as follows:

(3) Maximum combined taxable income (determined under paragraph   $25.00
 (b)(2) of this section) (line (3)(c) of example 2)............
(4) Overall profit percentage limitation (as determined in         25.50
 example 2)....................................................
 

The results would be the same as in part (2) of example 2, except that 
the commissions Y receives from X are $52.50, i.e., Y's costs ($40) plus 
Y's profit ($12.50).

[T.D. 7364, 40 FR 29836, July 16, 1975; 40 FR 33972, Aug. 13, 1975]



Sec. 1.995-1  Taxation of DISC income to shareholders.

    (a) In general. (1) Under Sec. 1.991-1(a), a corporation which is a 
DISC for a taxable year is not subject to any tax imposed by subtitle A 
of the Code (sections 1 through 1564) for the taxable year, except for 
the tax imposed by chapter 5 thereof (sections 1491 through 1494) on 
certain transfers to avoid tax.
    (2) Under section 995(a), the shareholders of a DISC, or a former 
DISC, are subject to taxation on the earnings and profits of the DISC in 
accordance with the provisions of chapter 1 of the Code generally 
applicable to shareholders, but subject to the modifications provided in 
sections 995, 996, and 997.
    (3) Under Sec. 1.996-3, three divisions of earnings and profits of 
a DISC, or former DISC, are defined: ``accumulated DISC income'', 
``previously taxed income'', and ``other earnings and profits''. Under 
Sec. 1.995-2, certain amounts of the DISC's earnings and profits are 
deemed to be distributed as dividends to shareholders of the DISC at the 
close of the DISC's taxable year in which such earnings were derived. 
Such deemed distributions do not cause a reduction in the DISC's 
earnings and profits, but are taken into account in Sec. 1.996-3(c) as 
an increase in previously taxed income. To the extent the DISC's 
earnings and profits are paid out in a subsequent distribution which is, 
under Sec. 1.996-1, treated as made out of such ``previously taxed 
income,'' they will not be taxable to the shareholders a second time.
    (4) In general, ``accumulated DISC income'' is the earnings and 
profits of the DISC which have not been deemed distributed and which may 
be deferred from taxation so long as they are not actually distributed 
with respect to its stock. However, deferral of taxation on 
``accumulated DISC income'' may be terminated, in whole or in part, in 
the event of: (i) Certain foreign investment attributable to producer's 
loans (see Sec. 1.995-2(a)(5) and Sec. 1.995-5); (ii) revocation of 
the election to be treated as a DISC or other disqualification (see 
Sec. 1.995-3); and (iii) certain dispositions of DISC stock in which 
gain is realized (see Sec. 1.995-4).
    (5) Since a DISC is not taxed on its taxable income, section 246(d) 
and Sec. 1.246-4 provide that the deduction otherwise allowed under 
section 243 shall not be allowed with respect to a dividend from a DISC, 
or former DISC, paid or treated as paid out of accumulated DISC income 
or previously taxed income or with respect to a deemed distribution in a 
qualified year under Sec. 1.995-2(a).
    (b) Amounts and character of amounts includible in shareholder's 
gross income. Each shareholder of a corporation which is a DISC, or 
former DISC, shall include in his gross income--
    (1) Amounts actually distributed to him that are includible in his 
gross income in accordance with paragraph (c) of this section.
    (2) Amounts which, pursuant to Sec. 1.995-2, he is deemed to 
receive as a distribution taxable as a dividend on

[[Page 765]]

the last day of each of the corporation's taxable years for which it 
qualifies as a DISC,
    (3) Amounts which, pursuant to Sec. 1.995-3, he is deemed to 
receive as a distribution taxable as a dividend in the event the 
corporation revokes its election to be treated as a DISC or otherwise is 
disqualified as a DISC, and
    (4) Gain realized on certain dispositions of stock in the 
corporation which, under Sec. 1.995-4, is includible in his gross 
income as a dividend.
    (c) Treatment of actual distributions. (1) Except as provided in 
subparagraph (3) of this paragraph, amounts actually distributed to a 
shareholder of a DISC, or former DISC, with respect to his stock are 
includible in his gross income in accordance with section 301.
    (2) Since a deemed distribution does not reduce the earnings and 
profits of a DISC, it does not affect the determination as to whether a 
subsequent actual distribution is a ``dividend'' under section 316(a). 
Since, however, the amount of a deemed distribution increases 
``previously taxed income'', it does affect the determination as to 
whether a subsequent actual distribution is excluded (as described in 
subparagraph (3) of this paragraph) from gross income.
    (3) Under Sec. 1.996-1(c), the amount of any actual distribution 
(including a deficiency distribution made pursuant to Sec. 1.992-3), 
with respect to stock in a DISC, or former DISC, which is treated under 
Sec. 1.996-1 as made out of previously taxed income, is excluded by the 
distributee from gross income, but only to the extent that such amount 
does not exceed the adjusted basis of the distributee's stock. Under 
Sec. 1.996-5(b), that portion of any actual distribution which is 
treated as made out of previously taxed income shall be applied against 
and reduce the adjusted basis of the stock and, to the extent that it 
exceeds the adjusted basis of the stock, it shall be treated as gain 
from the sale or exchange of property.
    (4) A deficiency distribution pursuant to Sec. 1.992-3 may be made 
after the close of the DISC's taxable year with respect to which it is 
made. The determinations as to whether such deficiency distribution is a 
dividend under section 301 and as to which division of earnings and 
profits is the source thereof depend upon the status of the DISC's 
earnings and profits account and divisions thereof at the time the 
distribution is actually made. See Sec. 1.996-1(d) for the priority of 
such deficiency distribution over other actual distributions made during 
the same taxable year.
    (d) Personal holding company income. (1) Any amount includible in a 
shareholder's gross income as a dividend with respect to the stock of a 
DISC, or former DISC, pursuant to paragraph (b) of this section shall be 
treated as a dividend for all purposes of the Code, except that for 
purposes of determining whether such shareholder is a personal holding 
company within the meaning of section 542 any amount deemed distributed 
for qualified years under Sec. 1.995-2 or upon disqualification under 
Sec. 1.995-3, any amount of gain on certain dispositions of DISC stock 
to which Sec. 1.995-4 applies, and any amount treated under Sec. 
1.996-1 as distributed out of accumulated DISC income or previously 
taxed income shall not be treated as a dividend or any other kind of 
income described in section 543(a).
    (2) Notwithstanding subparagraph (1) of this paragraph, the 
shareholder may treat as an item of income described under section 543 
(for example, rents) any amount to which the exception in such 
subparagraph (1) applies, if it establishes to the satisfaction of the 
district director that such amount is attributable to earnings and 
profits derived from such item of income.

[T.D. 7324, 39 FR 35109, Sept. 30, 1974]



Sec. 1.995-2  Deemed distributions in qualified years.

    (a) General rule. Under section 995 (b)(1), each shareholder of a 
DISC shall be treated as having received a distribution taxable as a 
dividend with respect to his stock on the last day of each taxable year 
of the DISC, in an amount which is equal to his pro rata share of the 
sum (as limited by paragraph (b) of this section), of the following 
seven items:
    (1) An amount equal to the gross interest derived by the DISC during 
such year from producer's loans (as defined in Sec. 1.993-4).
    (2) An amount equal to the lower of--

[[Page 766]]

    (i) Any gain recognized by the DISC during such year on the sale or 
exchange of property (other than property which in the hands of the DISC 
is a qualified export asset) which was previously transferred to it in a 
transaction in which the transferor realized gain which was not 
recognized in whole or in part, or
    (ii) The amount of the transferor's gain which was not recognized on 
the previous transfer of the property to the DISC.


For purposes of this subparagraph, each item of property shall be 
considered separately. See paragraph (d) of this section for special 
rules with respect to certain tax-free acquisitions of property by the 
DISC.
    (3) An amount equal to the lower of--
    (i) Any gain recognized by the DISC during such year on the sale or 
exchange of property which in the hands of the DISC is a qualified 
export asset (other than stock in trade or property described in section 
1221(1)) and which was previously transferred to the DISC in a 
transaction in which the transferor realized gain which was not 
recognized in whole or in part, or
    (ii) The amount of the transferor's gain which was not recognized on 
the previous transfer of the property to the DISC and which would have 
been includible in the transferor's gross income as ordinary income if 
its entire realized gain had been recognized upon the transfer.


For purposes of this subparagraph, each item of property shall be 
considered separately. See paragraph (d) of this section for special 
rules with respect to certain tax-free acquisitions of property by the 
DISC.
    (4) For taxable years beginning after December 31, 1975, an amount 
equal to 50 percent of the taxable income of the DISC for the taxable 
years attributable to military property (as defined in Sec. 1.995-6).
    (5) For taxable years beginning after December 31, 1975, the taxable 
income for the taxable year attributable to base period export gross 
receipts (as defined in Sec. 1.995-7).
    (6) The sum of--
    (i)(A) In the case of a corporate share holder, an amount equal to 
57.5 percent of the excess (if any) (one-half for DISCs' taxable years 
beginning before January 1, 1983) of the taxable income of the DISC for 
such year (computed as provided in Sec. 1.991-1(b)(1)) over the sum of 
the amounts deemed distributed for the taxable year in accordance with 
subparagraphs (1), (2), (3), (4) and (5) of this paragraph, or
    (B) In the case of a non-corporate share holder, an amount equal to 
one-half of the excess (if any) of the taxable income of the DISC for 
such year (computed as provided in Sec. 1.991-1(b)(1)) over the sum of 
the amounts deemed distributed for the taxable year in accordance with 
subparagraphs (1), (2), (3), (4), and (5) of this paragraph.
    (ii)(A) An amount equal to the amount under subdivision (i) of 
paragraph (a)(6) of this section multiplied by the international boycott 
factor as determined under section 999 (c)(1) , or
    (B) In lieu of the amount determined under subdivision (ii)(A) of 
paragraph (a)(6) of this section, the amount described under section 999 
(c)(2) of such international boycott income, and
    (iii) An amount equal to the sum of any illegal bribes, kickbacks, 
or other payments paid by or on behalf of the DISC directly or 
indirectly to an official, employee, or agent in fact of a government. 
An amount is paid by a DISC where it is paid by any officer, director, 
employee, shareholder, or agent of the DISC for the benefit of such 
DISC. For purposes of this section, the principles of section 162 (c) 
and the regulations thereunder shall apply. The fair market value of an 
illegal payment made in the form of property or services shall be 
considered the amount of such illegal payment.
    (7) The amount of foreign investment attributable to producer's 
loans of the DISC, as of the close of the ``group taxable year'' ending 
with such taxable year of the DISC, determined in accordance with Sec. 
1.995-5. The amount of such foreign investment attributable to 
producer's loans so determined for any taxable year of a former DISC 
shall be deemed distributed as a dividend to the shareholders of such 
former DISC on the last day of such taxable year. See Sec. 1.995-3(e) 
for the effect that

[[Page 767]]

such deemed distribution has on scheduled installments of deemed 
distributions of accumulated DISC income under Sec. 1.995-3(a) upon 
disqualification.
    (b) Limitation on amount of deemed distributions under section 
995(b)(1). (1) The sum of the amounts described in paragraph (a)(1) 
through (a)(6) of this section which is deemed distributed pro rata to 
the DISC's shareholders a dividend for any taxable year of the 
corporation shall not exceed the DISC's earnings and profits for such 
year.
    (2) The amount of foreign investment attributable to producer's 
loans of the DISC (as described in paragraph (a)(7) of this section) 
which is deemed to be distributed pro rata to the DISC's shareholders as 
dividends for any taxable year of the corporation shall not exceed the 
lower of the corporation's accumulated DISC income at the beginning of 
such year or the corporation's accumulated earnings and profits at the 
beginning of such year (but not less than zero)--
    (i) Increased by any DISC income of the corporation for such year as 
defined in Sec. 1.996-3(b)(2) (i.e., any excess of the DISC's earnings 
and profits for such year over the sum of the amounts described in 
paragraph (a)(1) through (a)(6) of this section), or
    (ii) Decreased by any deficit in the corporation's earnings and 
profits for such year.


Thus, for example, if a DISC has a deficit in accumulated earnings and 
profits at the beginning of a taxable year of $10,000, current earnings 
and profits of $12,000, no amounts described in paragraphs (a)(1) 
through (a)(6) of this section for the year, and foreign investment 
attributable to producer's loans for the taxable year of $5,000, the 
DISC would have a deemed distribution described in paragraph (a)(7) of 
this section of $5,000 for the taxable year. On the other hand, suppose 
the DISC had accumulated earnings and profits of $13,000 at the 
beginning of the taxable year, accumulated DISC income of $10,000 at the 
beginning of the taxable year, a deficit in earnings and profits for the 
taxable year of $12,000, no amounts described in paragraphs (a)(1) 
through (a)(6) of this section for the taxable year, and foreign 
investment attributable to producer's loans for the taxable year of 
$5,000. Under these facts the DISC would have no deemed distribution 
described in paragraph (a)(7) of this section because the corporation 
had no DISC income for the taxable year and the current year's deficit 
in earnings and profits subtracted from the DISC's accumulated DISC 
income at the beginning of the year produces a negative amount. For 
rules relating to the carryover to a subsequent year of the $5,000 of 
foreign investment attributable to producer's loans, see Sec. 1.995-
5(a)(6).
    (3) If, by reason of the limitation in subparagraph (1) of this 
paragraph, less than the sum of the amounts described in paragraphs 
(a)(1) through (a)(6) of this section is deemed distributed, then the 
portion of such sum which is deemed distributed shall be attributed 
first to the amount described in subparagraph (1) of such paragraph, to 
the extent thereof; second to the amount described in subparagraph (2) 
of such paragraph, to the extent thereof; third to the amount described 
in subparagraph (3) of such paragraph, to the extent thereof; and so 
forth, and finally to the amount described in paragraph (b)(6) of this 
paragraph.
    (c) Examples. Paragraphs (a) and (b) of this section may be 
illustrated by the following examples:

    Example 1. Y is a corporation which uses the calendar year as its 
taxable year and which elects to be treated as a DISC beginning with 
1972. X is its sole shareholder. In 1972, X transfers certain property 
to Y in exchange for Y's stock in a transaction in which X does not 
recognize gain or loss by reason of the application of section 351(a). 
Included in the property transferred to Y is depreciable property 
described in paragraph (a)(3) of this section on which X realizes, but 
does not recognize by reason of the application of section 1245(b)(3), a 
gain of $20,000. If X had sold such property for cash, the $20,000 gain 
would have been recognized as ordinary income under section 1245. Also 
included in the transfer to Y is 100 shares of stock in a third 
corporation (which is not a related foreign export corporation) on which 
X realizes, but does not recognize, a gain of $5,000. In 1973, Y sells 
such property and recognizes a gain of $25,000 on the depreciable 
property and $8,000 on the 100 shares of stock. Y has accumulated 
earnings and profits at the beginning of 1973 of $5,000, earnings and 
profits for 1973 of $72,000, and taxable income for 1973 of $100,000. At 
the beginning of 1973, Y has

[[Page 768]]

$6,000 of accumulated DISC income, no previously taxed income, and a 
deficit of $1,000 of other earnings and profits. Under these facts and 
the additional facts assumed in the table below, X is treated as having 
received a deemed distribution taxable as a dividend of $76,000 on 
December 31, 1973, determined as follows:

(1) Gross interest derived by Y in 1973 from producer's loans..   $7,000
(2) Amount of gain on depreciable property (lower of Y's          20,000
 recognized gain ($25,000) or X's gain not recognized on
 section 1245 property ($20,000))..............................
(3) Amount of gain on stock (lower of X's gain not recognized      5,000
 or Y's recognized gain ($8,000) ($5,000)).....................
(4) One-half excess of taxable income for 1973 over the sum of    34,000
 lines (1), (2), and (3) (1/2 of ($100,000 minus $32,000)).....
                                                                --------
(5) Limitation on lines (1) through (4):
  (a) Sum of lines (1) through (4).............................   66,000
  (b) Earnings and profits for 1973............................   72,000
                                                                --------
  (c) Lower of lines (a) and (b)...............................   66,000
                                                                --------
(6) Amount under paragraph (a)(5) of this section:
    (a) Foreign investment attributable to producer's loans       10,000
     under Sec. 1.995-5......................................
    (b) Sum of the lower of accumulated earnings and profits at   11,000
     beginning of 1973 ($5,000) or accumulated DISC income at
     beginning of 1973 ($6,000) and excess of earnings and
     profits for 1973 over line (5)(c) ($72,000 minus $66,000).
                                                                --------
    (c) Lower of lines (a) and (b).............................   10,000
                                                                --------
(7) Total deemed distribution (sum of lines (5)(c) and (6)(c)).   76,000
                                                                ========
 

    Example 2. Assume the facts are the same as in example 1, except 
that earnings and profits for 1973 amount to only $60,000. Under these 
facts, X is treated as receiving a deemed distribution taxable as a 
dividend of $65,000 on December 31, 1973, determined as follows:

(5) Limitation on lines (1) through (4):
    (a) Line (5)(a) of example 1..............................   $66,000
    (b) Earnings and profits for 1973.........................    60,000
                                                               ---------
    (c) Lower of lines (a) and (b)............................    60,000
                                                               ---------
(6) Amount under paragraph (a)(5) of this section:
    (a) Line (6)(a) of example 1..............................    10,000
    (b) Sum of the lower of accumulated earnings and profits       5,000
     at beginning of 1973 ($5,000) or accumulated DISC income
     at beginning of 1973 ($6,000) plus excess of earnings and
     profits for 1973 over line (5)(c) ($60,000 minus $60,000)
                                                               ---------
    (c) Lower of lines (a) and (b)............................     5,000
                                                               ---------
(7) Total deemed distribution (sum of lines (5)(c) and (6)(c))    65,000
                                                               =========
 

    Example 3. Assume the facts are the same as in example 1, except 
that Y has a deficit in accumulated earnings and profits at the 
beginning of 1973 of $4,000. Such deficit is comprised of accumulated 
DISC income of $1,000, no previously taxed income, and a deficit in 
other earnings and profits of $5,000. Under these facts, X is treated as 
receiving a deemed distribution taxable as a dividend in the amount of 
$72,000 on December 31, 1973, determined as follows:

(5) Limitation on lines (1) through (4):
  (a) Line (5)(a) of example 1................................   $66,000
  (b) Earnings and profits for 1973...........................    72,000
                                                               ---------
  (c) Lower of lines (a) and (b)..............................    66,000
                                                               ---------
(6) Amount under paragraph (a)(5) of this section:
  (a) Line (6)(a) of example 1................................    10,000
  (b) Sum of accumulated earnings and profits at beginning of      6,000
   1973 (not less than $0), and excess of earnings and profits
   for 1973 over amount in line (5)(c) ($72,000 minus $66,000)
                                                               ---------
  (c) Lower of lines (a) and (b)..............................     6,000
                                                               ---------
(7) Total deemed distribution sum of lines (5)(c) and (6)(c)..    72,000
                                                               =========
 

    (d) Special rules for certain tax-free acquisitions of property by 
the DISC. (1) For purposes of paragraph (a)(2)(i) and (3)(i) of this 
section, if--
    (i) A DISC acquires property in a first transaction and in a second 
transaction it disposes of such property in exchange for other property, 
and
    (ii) By reason of the application of section 1031 (relating to like-
kind exchanges) or section 1033 (relating to involuntary conversions), 
the basis in the DISC's hands of the other property acquired in such 
second transaction is determined in whole or in part with reference to 
the basis of the property acquired in the first transaction,


then upon a disposition of such other property in a third transaction by 
the DISC such other property shall be treated as though it had been 
transferred to the DISC in the first transaction. Thus, if the first 
transaction is a purchase of the property for cash, then paragraphs 
(a)(2) and (3) of this section will not apply to a sale by the DISC of 
the other property acquired in the second transaction.
    (2) For purposes of paragraphs (a)(2)(i) and (3)(i) of this section, 
if a DISC acquires property in a first transaction and it transfers such 
property to a transferee DISC in a second transaction in which the 
transferor DISC's gain is not recognized in whole or in part, then such 
property shall be treated as though it had been transferred to

[[Page 769]]

the transferee DISC in the same manner in which it was acquired in the 
first transaction by the transferor DISC. For example, if X and Y both 
qualify as DISC's and X transfers property to Y in a second transaction 
in which gain or loss is not recognized, paragraph (a)(2) or (3) of this 
section does not apply to a sale of such property by Y in a third 
transaction if X had acquired the property in a first transaction by a 
purchase for cash. If, however, X acquired the property from a 
transferor other than a DISC in the first transaction in which the 
transferor's realized gain was not recognized, then paragraph (a)(2) or 
(3) of this section may apply to the sale by Y if the other conditions 
of such paragraph (a)(2) or (3) are met.
    (3) If a DISC acquires property in a second transaction described in 
subparagraph (1) or (2) of this paragraph in which it (or, in the case 
of a second transaction described in subparagraph (2) of this paragraph, 
the transferor DISC) recognizes a portion (but not all) of the realized 
gain, then the amount described in paragraph (a)(2)(ii) or (a)(3)(ii) of 
this section with respect to a disposition by the DISC of such acquired 
property in a third transaction shall not exceed the transferor's gain 
which was not recognized on the first transaction minus the amount of 
gain recognized by the DISC (or transferor DISC) on the second 
transaction.
    (4) The provisions of this paragraph may be illustrated by the 
following examples:

    Example 1. X and Y are corporations each of which qualifies as a 
DISC and uses the calendar year as its taxable year. In 1972, X acquires 
section 1245 property in a first transaction in which the transferor's 
entire realized gain of $17 is not recognized. In 1973, X transfers such 
property to Y in a second transaction in which X realizes a gain of $20 
of which only $4 is recognized. (On December 31, 1973, X's shareholders 
are treated as having received a deemed distribution of a dividend which 
includes such $4 under paragraph (a)(3) of this section, provided the 
limitation in paragraph (b) of this section is met.) In a third 
transaction in 1974, Y sells such property and recognizes a gain of $25. 
With respect to Y's shareholders on December 31, 1974, the amount 
described in paragraph (a)(3)(ii) of this section would be limited to 
$13, which is the amount of the transferor's gain which was not 
recognized on the first transaction ($17) minus the amount of gain 
recognized by X on the second transaction ($4).
    Example 2. Z is a DISC using the calendar year as its taxable year. 
In a first transaction in 1972, in exchange for its stock, Z acquires 
section 1245 property from A, an individual who is its sole shareholder, 
in a transaction in which A's realized gain of $30 is not recognized by 
reason of the application of section 351(a). In a second transaction in 
1973, Z exchanges such property for other property in a like-kind 
exchange to which section 1031(b) applies and recognizes $10 of a 
realized gain of $35. (On December 31, 1973, A is treated as having 
received a deemed distribution of a dividend which includes such $10 
under paragraph (a)(3) of this section, provided the limitation in 
paragraph (b) of this section is met.) In a third transaction in 1974, Z 
sells the property acquired in the like-kind exchange and recognizes a 
gain of $25. With respect to A on December 31, 1974, the amount 
described in paragraph (a)(3)(ii) of this section is limited to $20, 
which is the amount of A's gain which was not recognized on the first 
transaction ($30) minus the amount of gain recognized by Z on the second 
transaction ($10).

    (e) Carry back of net operating loss and capital loss to prior DISC 
taxable year. For purposes of sections 991, 995, and 996, the amount of 
the deduction for the taxable year under section 172 for a net operating 
loss carryback or carryover or under section 1212 for a capital loss 
carryback or carryover shall be determined in the same manner as if the 
DISC were a domestic corporation which had not elected to be treated as 
a DISC. Thus, the amount of the deduction will be the same whether or 
not the corporation was a DISC in the year of the loss or in the year to 
which the loss is carried. For provisions setting forth adjustments to 
the DISC's, or former DISC's, deemed distributions, adjustments to its 
divisions of earnings and profits, and other tax consequences arising 
from such carrybacks, see Sec. 1.996-8.

(Secs. 995(e)(7), (8) and (10), 995(g) and 7805 of the Internal Revenue 
Code of 1954 (90 Stat. 1655, 26 U.S.C. 995 (e)(7), (8) and (10); 90 
Stat. 1659, 26 U.S.C. 995(g); and 68A Stat 917, 26 U.S.C. 7805))

[T.D. 7324, 39 FR 35110, Sept. 30, 1974, as amended by T.D. 7862, 47 FR 
56492, Dec. 17, 1982; T.D. 7984, 49 FR 40018, Oct. 12, 1984]

[[Page 770]]



Sec. 1.995-3  Distributions upon disqualification.

    (a) General rule. Under section 995 (b)(2), a shareholder of a 
corporation which is disqualified from being a DISC, either because 
pursuant to Sec. 1.992-2(e)(2) it revoked its election to be treated as 
a DISC or because it has failed to satisfy the requirements as set forth 
in Sec. 1.992-1 to be a DISC for a taxable year, shall be deemed to 
have received (at the times specified in paragraph (b) of this section) 
distributions taxable as dividends aggregating an amount equal to his 
pro rata share of the accumulated DISC income (as defined in Sec. 
1.996-3(b)) of such corporation which was accumulated during the 
immediately preceding consecutive taxable years for which the 
corporation was a DISC. The pro rata share referred to in the preceding 
sentence shall be determined as of the close of the last of such 
consecutive taxable years for which the corporation was a DISC. See 
Sec. 1.996-7(c) for rules relating to the carryover of, and maintaining 
a separate account for, such accumulated DISC income in certain 
reorganizations.
    (b) Time of receipt of deemed distributions. Distributions described 
in paragraph (a) of this section shall be deemed to be received in equal 
installments on the last day of each of the 10 taxable years of the 
corporation following the year of the disqualification described in 
paragraph (a) of this section, except that in no case may the number of 
equal installments exceed the number of the immediately preceding 
consecutive taxable years for which the corporation was a DISC.
    (c) Transfer of shares. Deemed distributions are includible under 
paragraphs (a) and (b) of this section in a shareholder's gross income 
as a dividend only so long as he continues to hold the shares with 
respect to which the distribution is deemed made. Thus, the transferee 
of such shareholder will include in his gross income under paragraphs 
(a) and (b) of this section the remaining installments of the deemed 
distribution which the transferor would have included in his gross 
income as a dividend had he not transferred the shares. However, if the 
transferee acquires the shares in a transaction in which the 
transferor's gain is treated under Sec. 1.995-4 in whole or in part as 
a dividend, then under Sec. 1.996-4(a) such transferee does not include 
subsequent installments in his gross income to the extent that the 
transferee treats such subsequent installments as made out of previously 
taxed income.
    (d) Effect of requalification. Deemed distributions under paragraphs 
(a) and (b) of this section continue and are includible in gross income 
as dividends by the shareholders whether or not the corporation 
subsequently requalifies and is treated as a DISC.
    (e) Effect of actual distributions and deemed distributions under 
section 995(b)(1)(G). If, during the period a shareholder of a DISC, or 
former DISC, is taking into account deemed distributions under 
paragraphs (a) and (b) of this section, an actual distribution is made 
to him out of accumulated DISC income or a deemed distribution because 
of foreign investment attributable to producer's loans is made under 
Sec. 1.995-2(a)(5) out of accumulated DISC income, such actual or 
deemed distribution shall first reduce the last installment of the 
deemed distributions scheduled to be included in the shareholder's gross 
income as a dividend, and then the preceding scheduled installments in 
reverse order. If deemed distributions are scheduled to be included in 
gross income for two or more disqualifications, an actual distribution 
or a deemed distribution under Sec. 1.995-2 (a)(5) which is treated as 
made out of accumulated DISC income reduces the deemed distributions 
resulting from the earlier disqualification first.
    (f) Examples. This section may be illustrated by the following 
examples:

    Example 1. X Corporation, which uses the calendar year as its 
taxable year, elects to be treated as a DISC beginning with 1972. X 
qualifies as a DISC for taxable years 1972 through 1975, but, pursuant 
to Sec. 1.992-2(e)(2), revokes its election as of January 1, 1976, and 
is disqualified as a DISC. On that date, X has $24,000 of accumulated 
DISC income. X's shareholders will be deemed to receive $6,000 in 
distributions taxable as a dividend on the last day of each of X's four 
succeeding taxable years (1977, 1978, 1979, and 1980).

[[Page 771]]

    Example 2. Assume the same facts as in example 1, except that in 
1978 X makes an actual distribution of $22,000 to its shareholders of 
which $10,000 is treated under Sec. 1.996-1 as made out of accumulated 
DISC income. (The remaining $12,000 of such distribution is treated as 
made out of previously taxed income.) The actual distribution would 
first reduce the $6,000 deemed distribution scheduled for 1980 to zero 
and then reduce the $6,000 deemed distribution scheduled for 1979 to 
$2,000. Thus, X's shareholders include in 1978 $16,000 is gross income 
as dividends ($10,000 of actual distributions and the $6,000 deemed 
distribution scheduled for that year) and $2,000 as a dividend in 1979.
    Example 3. Assume the same facts as in example 2, except that X 
requalifies as a DISC for taxable year 1977 during which it derives 
$7,000 of DISC income (computed after taking into account a deemed 
distribution under Sec. 1.995-2(a)(4) of $7,000), but is again 
disqualified in 1978. In addition X makes an actual distribution in 1977 
equal to the deemed distribution of $7,000. Such actual distribution is 
excluded from gross income under Sec. 1.996-1(c). In 1977. X's 
shareholders include in gross income as dividends the $6,000 deemed 
distribution upon disqualification (in addition to the deemed 
distributions of $7,000 under Sec. 1.995-2 for 1977 when it was treated 
as a DISC). The actual distribution in 1978 still reduces the 
installments resulting from the earlier disqualification. Thus, in 1978, 
X's shareholders include $16,000 in gross income as dividends. In 1979, 
X's shareholders include $9,000 in gross income as dividends (the final 
installment of $2,000 from the earlier disqualification plus the single 
deemed distribution of $7,000 resulting from the later 
disqualification).

[T.D. 7324, 39 FR 35112, Sept. 30, 1974, as amended by T.D. 7854, 47 FR 
51741, Nov. 17, 1982]



Sec. 1.995-4  Gain on disposition of stock in a DISC.

    (a) Disposition in which gain is recognized--(1) In general. If a 
shareholder disposes, or is treated as disposing, of stock in a DISC, or 
former DISC, then any gain recognized on such disposition shall be 
included in the shareholder's gross income as a dividend, 
notwithstanding any other provision of the Code, to the extent of the 
accumulated DISC income amount (described in paragraph (d) of this 
section). To the extent the recognized gain exceeds the accumulated DISC 
income amount, it is taxable as gain from the sale or exchange of the 
stock.
    (2) Nonapplication of subparagraph (1). The provisions of 
subparagraph (1) of this paragraph do not apply (i) to the extent gain 
is not recognized (such as, for example, in the case of a gift or an 
exchange of stock to which section 354 applies) and (ii) to the amount 
of any recognized gain which is taxable as a dividend (such as, for 
example, under section 301 or 356(a)(2)) or as gain from the sale or 
exchange of property which is not a capital asset. The amount taxable as 
a dividend under section 301 or 356(a)(2) is subject to the rules 
provided in Sec. 1.995-1(c) for the treatment of actual distributions 
by a DISC.
    (b) Disposition in which separate corporate existence of DISC is 
terminated--(1) General. If stock in a corporation that is a DISC, or 
former DISC, is disposed of in a transaction in which its separate 
corporate existence as a DISC, or former DISC, is terminated, then, 
notwithstanding any other provision of the Code, an amount of realized 
gain shall be recognized and included in the transferor's gross income 
as a dividend. The realized gain shall be recognized to the extent that 
such gain--
    (i) Would not have been recognized but for the provisions of this 
paragraph, and
    (ii) Does not exceed the accumulated DISC income amount (described 
in paragraph (d) of this section).
    (2) Cessation of separate corporate existence as a DISC, or former 
DISC. For purposes of subparagraph (1) of this paragraph, separate 
corporate existence as a DISC, or former DISC, will be treated as having 
ceased if, as a result of the transaction, there is no separate entity 
which is a DISC and to which is carried over the accumulated DISC income 
and other tax attributes of the DISC, or former DISC, the stock of which 
is disposed of. Thus, for example, if stock in a DISC, or former DISC, 
is exchanged in a transaction described in section 381(a) (relating to 
carryovers in certain corporate acquisitions), the gain realized on the 
transfer of such stock will not be recognized under subparagraph (1) of 
this paragraph if the assets of such DISC, or former DISC, are acquired 
by a corporation which immediately after the acquisition qualifies as a 
DISC. For a further example, if a DISC, or former DISC, is liquidated in 
a transaction to which

[[Page 772]]

section 332 (relating to complete liquidations of subsidiaries) applies, 
the transaction will be subject to subparagraph (1) of this paragraph if 
the basis to the transferee corporation of the assets acquired on the 
liquidation is determined under section 334(b)(2) (as in effect prior to 
amendment by the Tax Equity and Fiscal Responsibility Act of 1982) or if 
immediately after such liquidation the transferee of such assets does 
not qualify as a DISC. However, separate corporate existence as a DISC, 
or former DISC, will not be treated as having ceased in the case of a 
mere change in place of organization, however effected. See Sec. 1.996-
7 for rules for the carryover of the divisions of a DISC's earnings and 
profits to one or more DISC's.
    (c) Disposition to which section 311, 336, or 337 applies--(1) In 
general. If, after December 31, 1976, a shareholder distributes, sells, 
or exchanges stock in a DISC, or former DISC, in a transaction to which 
section 311, 336, or 337 applies, then an amount equal to the excess of 
the fair market value of such stock over its adjusted basis in the hands 
of the shareholder shall, notwithstanding any other provision of the 
Code, be included in gross income of the shareholder as a dividend to 
the extent of the accumulated DISC income amount (described in paragraph 
(d) of this section).
    (2) Nonapplication of subparagraph (1). Subparagraph (1) shall not 
apply if the person receiving the stock in the disposition has a holding 
period for the stock which includes the period for which the stock was 
held by the shareholder disposing of such stock.
    (d) Accumulated DISC income amount--(1) General. For purposes of 
this section, the accumulated DISC income amount is the accumulated DISC 
income of the DISC or former DISC which is attributable to the stock 
disposed of and which was accumulated in taxable years of such DISC or 
former DISC during the period or periods such stock was held by the 
shareholder who disposed of such stock.
    (2) Period during which a shareholder has held stock. For purposes 
of this section, the period during which a shareholder has held stock 
includes the period he is considered to have held it by reason of the 
application of section 1223 and, if his basis is determined in whole or 
in part under the provisions of section 1014(d) (relating to special 
rule for DISC stock acquired from decedent), the holding period of the 
decedent. Such holding period is to exclude the day of acquisition but 
include the day of disposition. Thus, for example, if A purchases stock 
in a DISC on December 31, 1972, and makes a gift of such stock to B on 
June 30, 1973, then on December 31, 1974, B will be treated as having 
held the stock for 2 full years. If the basis of the stock in C's hands 
is determined under section 1014(d) upon a transfer from B's estate on 
December 31, 1976, by reason of B's death on June 30, 1974, then on 
December 31, 1976, C will be treated as having held the stock for 4 full 
years.
    (e) Accumulated DISC income allocable to shareholder under section 
995(c)(2)--(1) In general. Under this paragraph, rules are prescribed 
for purposes of paragraph (d) of this section as to the manner of 
determining, with respect to the stock of a DISC, or former DISC, 
disposed of, the amount of accumulated DISC income which is attributable 
to such stock and which was accumulated in taxable years of the 
corporation during the period or periods the stock disposed of was held 
or treated under paragraph (d)(2) of this section as held by the 
transferor. Subparagraphs (2), (3), and (4) of this paragraph set forth 
a method of computation which may be employed to determine such amount. 
Any other method may be employed so long as the result obtained would be 
the same as the result obtained under such method.
    (2) Step 1. Determine the increase (or decrease) in accumulated DISC 
income for each taxable year of the DISC, or former DISC, by subtracting 
from the amount of accumulated DISC income (as defined in Sec. 1.996-
3(b)) at the close of each taxable year the amount thereof as of the 
close of the immediately preceding taxable year.
    (3) Step 2. (i) Determine for each taxable year of the DISC, or 
former DISC, the increase (or decrease) in accumulated DISC income per 
share by dividing such increase (or decrease) for the

[[Page 773]]

year by the number of shares outstanding or deemed outstanding on each 
day of such year.
    (ii) If the number of shares of stock in the corporation outstanding 
on each day of a taxable year of the DISC, or former DISC, is not 
constant, then the number of such shares deemed outstanding on each day 
of such year shall be the sum of the fractional amounts in respect of 
each share which was outstanding on any day of the taxable year. The 
fractional amount in respect of a share shall be determined by dividing 
the number of days in the taxable year on which such share was 
outstanding (excluding the day the share became outstanding, but 
including the day the share ceased to be outstanding), by the total 
number of days in such taxable year.
    (iii) If for any taxable year of a DISC, or former DISC, the share 
disposed of was not held (or treated under paragraph (d)(2) of this 
section as held) by the disposing shareholder for the entire year, then 
the amount of increase (or decrease) in accumulated DISC income 
attributable to such share for such year is the amount determined as if 
he held the share until the end of such year multiplied by a fraction 
the numerator of which is the number of days in the taxable year on 
which the shareholder held (or under paragraph (d)(2) of this section is 
treated as having held) such share and the denominator of which is the 
total number of days in the taxable year.
    (4) Step 3. Add the amounts computed in step 2 for each taxable year 
of the DISC, or former DISC, in which the shareholder held such share of 
stock.
    (5) Examples. This paragraph may be illustrated by the following 
examples:

    Example 1. X Corporation uses the calendar year as its taxable year 
and elects to be a DISC for the first time for 1973. On January 1, 1973, 
X has 20 shares issued and outstanding. A and B each own 10 shares. On 
July 1, 1976, X issues 10 shares to C. On December 31, 1977, A sells his 
10 shares to D and recognizes a gain of $120. Under these facts and 
other facts assumed in the table below, A includes in his gross income 
for 1977 a dividend under paragraph (b) of this section of $61.30 and 
long-term capital gain of $58.70.

----------------------------------------------------------------------------------------------------------------
                                                                                                   (d)--Increase
                                                          (a)--Year   (b)--Increase                  (decrease)
                                                             end      (decrease) in   (c)--Shares    per share
                         Year                            accumulated   accumulated    outstanding   (column (b)
                                                         DISC income   DISC income                   divided by
                                                                                                    column (c))
----------------------------------------------------------------------------------------------------------------
1973..................................................           $80            $80            20          $4.00
1974..................................................            50           (30)            20         (1.50)
1975..................................................            80             30            20           1.50
1976..................................................           100             20        \1\ 25            .80
1977..................................................           140             40            30           1.33
                                                       ---------------------------------------------------------
(1) Total increase in accumulated DISC income for each  ............  .............  ............           6.13
 share disposed of (sum of amounts in column (d)).....
Multiply by number of shares disposed of..............  ............  .............  ............             10
                                                       ---------------------------------------------------------
(2) Total amount of accumulated DISC income             ............  .............  ............          61.30
 attributable to A's shares disposed of...............
(3) A's gain..........................................  ............  .............  ............         120.00
(4) Portion of A's gain taxable as a dividend (lower    ............  .............  ............          61.30
 of lines (2) and (3))................................
(5) Portion of A's gain taxable as long-term capital    ............  .............  ............          58.70
 gain (line (3) minus line (4)).......................
----------------------------------------------------------------------------------------------------------------
\1\ Under subparagraph (3)(ii) of this paragraph, the aggregate fractional amounts of the 10 shares issued on
  July 1, 1976, is 5 shares, i.e., 10 shares, multiplied by (183 days/366 days). Thus, the number of shares
  deemed outstanding for 1976 is 25 shares, i.e., 20 shares plus 5 shares.

    Example 2. Assume the same facts as in example 1, except that A 
sells his 10 shares to D on July 1, 1977. Under subparagraph (3)(iii) of 
this paragraph, the amount of increase in accumulated DISC income for 
1977 which is attributable to each share disposed of is limited to $.67, 
i.e., $1.33 multiplied by 182 days/365 days. Therefore, the sum of the 
yearly increases (and decreases) in accumulated DISC income for each 
share is reduced by $.66 (i.e., $1.33 minus $.67). The total increase in 
accumulated DISC income for each share disposed of is $5.47 (i.e., $6.13 
minus $.66). Under these facts, A would include in his gross income for 
1977 a dividend of $54.70 and long-

[[Page 774]]

term capital gain of $65.30 determined as follows:

(1) Total increase in accumulated DISC income for each             $5.47
 share disposed of.........................................
Multiplied by number of shares disposed of.................           10
                                                            ------------
(2) Total amount of accumulated DISC income attributable of        54.70
 to all shares disposed of.................................
(3) A's gain...............................................       120.00
(4) Portion of A's gain taxable as a dividend (lower of            54.70
 lines (2) and (3))........................................
(5) Portion of A's gain taxable as long-term capital gain          65.30
 (line (3) minus line (4)).................................
 


[T.D. 7324, 39 FR 35112, Sept. 30, 1974, as amended by T.D. 7854, 47 FR 
51741, Nov. 17, 1982]



Sec. 1.995-5  Foreign investment attributable to producer's loans.

    (a) In general--(1) Limitation. Under section 995(d), the amount as 
of the close of a ``group taxable year'' (as defined in subparagraph (3) 
of this paragraph) of foreign investment attributable to producer's 
loans of a DISC for purposes of section 995(b)(1)(G) shall be the excess 
(as of the close of such year) of--
    (i) The smallest of--
    (a) The amount of the net increase in foreign assets (as defined in 
paragraph (b) of this section) by domestic and foreign members of the 
controlled group which includes the DISC,
    (b) The amount of the actual foreign investment by the domestic 
members of such group (as determined under paragraph (c) of this 
section), or
    (c) The amount of outstanding producer's loans (as determined under 
Sec. 1.993-4) by such DISC to members of such controlled group, over
    (ii) The amount (determined under Sec. 1.995-2 (a)(5) and (b)(2)) 
of foreign investment attributable to producer's loans treated under 
section 995(b)(1)(G) as deemed distributions by the particular DISC 
taxable as dividends for prior taxable years of that particular DISC.


Thus, for example, if the shareholders of a DISC which uses the calendar 
year as its taxable year (and which is a member of a controlled group in 
which all of the members use the calendar year as their taxable year) 
are treated under section 995(b)(1)(G) as receiving foreign investment 
attributable to producer's loans of a DISC of $0 in 1972, $10 in 1973, 
and $30 in 1974, or a total of $40, and if the smallest of the amounts 
described in subdivision (i) of this subparagraph at the end of 1975 is 
$90, then the amount of the foreign investment attributable to 
producer's loans of a DISC at the end of 1975 is $50, i.e., the excess 
(as of the close of 1975) of the smallest of the amounts described in 
subdivision (i) of this subparagraph ($90) over the sum of the amounts 
of foreign investment attributable to producer's loans treated under 
section 995(b)(1)(G) as deemed distributions by the DISC taxable as 
dividends for prior taxable years of the DISC ($40). If the separate 
corporate existence of the DISC as to which the amount described in 
subdivision (ii) of this subparagraph relates ceases to exist within the 
meaning of Sec. 1.995-4(c)(2), then such amount shall no longer be 
taken into account by the group for any purpose. For inclusion of 
amounts because of certain corporate acquisitions, see paragraph (d) of 
this section.
    (2) Controlled group; domestic and foreign member. For purposes of 
this section--
    (i) The term ``controlled group'' has the meaning assigned to such 
term by Sec. 1.993-1(k).
    (ii) The term domestic member means a domestic corporation which is 
a member of a controlled group, and the term foreign member means a 
foreign corporation which is a member of a controlled group.
    (3) Group taxable year. (i) The term group taxable year refers 
collectively to the taxable year of the DISC and to the taxable year of 
each corporation in the controlled group which includes the DISC ending 
with or within the taxable year of the DISC. Thus, for example, if a 
corporation has a subsidiary which uses the calendar year as its taxable 
year and which elects to be treated as a DISC, and if the parent has a 
taxable year ending on October 31, the ``group taxable year'' for 1973 
would refer to calendar year 1973 for the DISC and to the parent's 
taxable year ending October 31, 1973.
    (ii) In cases in which the DISC makes a return for a short taxable 
year, that is, for a taxable year consisting of a period of less than 12 
months, pursuant to section 443 and the regulations thereunder, or Sec. 
1.991-1(b)(3), the following rules shall apply--

[[Page 775]]

    (a) In the case of a change in the annual accounting period of the 
DISC resulting in a short taxable year, the group taxable year refers 
collectively to the short taxable year and to the taxable year of each 
corporation in the controlled group which includes the DISC ending with 
or within the short taxable year.
    (b) In the case of a DISC which is in existence during only part of 
what would otherwise be its taxable year, the group taxable year refers 
collectively to the short period during which the DISC was in existence 
and to the taxable year of each corporation in the controlled group 
which includes the DISC ending with or within the 12-month period ending 
on the last day of the short period.
    (iii) With respect to periods prior to the first taxable year for 
which a member of the group qualified (or is treated) as a DISC, each 
group taxable year shall be determined under subdivision (i) of this 
subparagraph as if such member was in existence, it qualified as a DISC, 
and its taxable year ended on that date corresponding to the date such 
member's first taxable year ended after it qualified (or is treated) as 
a DISC whether or not the corporation which qualifies (or is treated) as 
a DISC used the same taxable year before it so qualified (or is so 
treated). Thus, for example, if a corporation which is organized on 
March 3, 1975, uses the calendar year as its taxable year, and is a 
member of a controlled group which does not include a DISC, first 
qualifies (or is treated) as a DISC for calendar year 1975, then the 
term ``group taxable year'' with respect to years prior to 1975 refers 
collectively to such prior calendar years and to the taxable year of 
each corporation in the group ending with or within such prior calendar 
years.
    (iv) For special rules in the case of a group which includes more 
than one DISC, see paragraph (g) of this section.
    (4) Amounts determined for prior years. Unless the 3-year limitation 
is properly elected under subparagraph (5) of this paragraph, the 
amounts described in paragraphs (b) (relating to net increase in foreign 
assets) and (c) (relating to actual foreign investments by domestic 
members) of this section reflect, as of the close of a group taxable 
year, amounts for all taxable years of members of the group beginning 
after December 31, 1971 (and amounts arising after December 31, 1971, or 
such other date prescribed in paragraph (b)(7) of this section), 
provided that such amounts relate to such group taxable year and 
preceding group taxable years. Thus, for example, if all members of a 
controlled group use the calendar year as the taxable year, and 1980 is 
the first taxable year for which any member of the group qualifies (or 
is treated) as a DISC, then, unless the 3-year limitation is elected 
under subparagraph (5) of this paragraph, the amounts described in 
paragraphs (b) and (c) of this section will be taken into account 
beginning with the dates specified in the preceding sentence. For rules 
as to carryovers on certain corporate acquisitions and reorganizations, 
see paragraph (d) of this section.
    (5) Three-year elective limitation. (i) A DISC may elect to take 
into account only amounts described in paragraphs (b) (relating to net 
increase in foreign assets) and (c) (relating to actual foreign 
investment by domestic members) of this section for the 3 taxable years 
of each member immediately preceding its taxable year included in that 
first group taxable year which includes a member's first taxable year 
during which it qualifies (or is treated) as a DISC. For purposes of the 
preceding sentence, determinations shall be made by reference to the 
taxable year of the issuer or transferor (as the case may be). If an 
election is made under this subdivision, the offset for uncommitted 
transitional funds under paragraph (b)(7) of this section is not 
allowed. If an election is made under this subdivision, the 3-year 
limitation applies to amounts described in paragraphs (b)(4) and (c)(1) 
and (2) of this section.
    (ii) An election under subdivision (i) of this subparagraph shall 
not apply with respect to amounts which must be carried over under 
paragraph (d) of this section in the case of certain corporate 
acquisitions and reorganizations.
    (iii) An election under subdivision (i) of this subparagraph shall 
be made by the DISC attaching to its first return,

[[Page 776]]

filed under section 6011(e)(2), a statement to the effect that the 3-
year limitation is being elected under Sec. 1.995-5(a)(5)(i).
    (6) Cumulative basis. Pursuant to section 995(d)(5), all 
determinations of amounts specified in this section are to be made on a 
cumulative basis from the 1st year (or date) provided for in this 
section. Thus, each such determination shall take into account a net 
increase or a net decrease during the year, as the case may be. However, 
if the 3-year limitation is elected under subparagraph (5) of this 
paragraph, then only amounts with respect to periods specified in such 
subparagraph (5) are amounts taken into account for years before a 
member of the group qualifies (or is treated) as a DISC. The 
computations described in this section may be made in any way chosen by 
the DISC (including a corporation being tested as to whether it 
qualifies as a DISC), provided such method results in the amount 
prescribed by this section.
    (7) Example. The provisions of this paragraph may be illustrated by 
the following example:

    Example. X Corporation, which uses the calendar year as its taxable 
year, is a member of a controlled group (within the meaning of 
subparagraph (2) of this paragraph). X elects to be treated as a DISC 
beginning with 1972. The amount of foreign investment attributable to 
X's producer's loans treated under section 995(b)(1)(G) as a 
distribution taxable as a dividend as of the close of each group taxable 
year with respect to each taxable year of X from 1972 through 1975 are 
set forth in the table below, computed on the basis of the facts assumed 
(the amounts on lines (1), (2), (3), and (5) being running balances):

------------------------------------------------------------------------
         Taxable year of X             1972      1973     1974     1975
------------------------------------------------------------------------
(1) Net increase (or decrease) in       ($30)      $10     $100     $150
 foreign assets since January 1,
 1972, at close of group taxable
 year..............................
(2) Actual foreign investment at           20       60       80      140
 close of group taxable year.......
(3) Outstanding producer's loans of         0       40       90      120
 X (the DISC) as of the close of
 group taxable year................
                                    ====================================
(4) Smallest of lines (1), (2), or          0       10       80      120
 (3) (not less than zero)..........
(5) Less section 995(b)(1)(G)               0        0       10       80
 deemed distributions for prior
 taxable years (sum of lines (5)
 and (6) from prior year)..........
                                    ------------------------------------
(6) Section 995(b)(1)(G) deemed             0       10       70       40
 distribution as of close of
 taxable year......................
------------------------------------------------------------------------

    (b) Net increase in foreign assets--(1) In general. (i) The term net 
increase in foreign assets when used in this section means the excess 
for the controlled group (as of the close of the group taxable year) of 
(a) the investment in foreign assets to be taken into account under 
subparagraph (2) of this paragraph over (b) the aggregate of the five 
offsets allowed by subparagraphs (3) through (7) of this paragraph.
    (ii) No amount described in this paragraph (other than amounts 
described in subparagraphs (4) and (7) of this paragraph) with respect 
to a member of the group (or foreign branch of a member) shall be taken 
into account unless it is attributable to a taxable year of such member 
beginning after December 31, 1971. For a 3-year elective limitation with 
respect to the first taxable year for which a member qualifies (or is 
treated) as a DISC, see paragraph (a)(5) of this section. For manner of 
determining amounts on a cumulative basis, see paragraph (a)(6) of this 
section.
    (2) Investments made in foreign assets. (i) For purposes of 
subparagraph (1) of this paragraph, there shall be taken into account as 
investment in foreign assets the aggregate of the amounts expended 
(within the meaning of subdivision (ii) of this subparagraph) during the 
period described in subparagraph (1)(ii) of this paragraph by all 
members of the controlled group which includes the DISC to acquire 
assets described in section 1231(b) (determined without regard to any 
holding period therein provided) which are located outside the United 
States (as defined in Sec. 1.993-7) reduced by the aggregate of the 
amounts received by all such members of the controlled group from the 
sale,

[[Page 777]]

exchange, or involuntary conversion of such assets described in section 
1231(b) which are located outside the United States. For purposes of 
this section, amounts expended for assets which are qualified export 
assets (as defined in Sec. 1.993-2) of a DISC (or which would be 
qualified export assets if owned by a DISC) shall not be taken into 
account. Thus, for example, if a DISC acquires a qualified export asset 
located outside the United States, the asset is not to be taken into 
account for purposes of determining the net increase in foreign assets.
    (ii) As used in subdivision (i) of this subparagraph, the term 
amounts expended (or amounts received) means the amount of any money or 
the fair market value (on the date of acquisition, sale, exchange, or 
involuntary conversion) of any property (other than money) used to 
acquire (or received for) the assets described in such subdivision (i).
    (iii) For purposes of this subparagraph, an asset (other than an 
aircraft or vessel) is considered as located outside the United States 
if it was used predominantly outside the United States during the group 
taxable year. The determination as to whether such an asset is used 
predominantly outside the United States during the group taxable year in 
which it was acquired or sold, exchanged, or involuntarily converted 
shall be made by applying the rules of Sec. 1.993-3(d) except that an 
aircraft described in section 48(a)(2)(B)(i) or a vessel described in 
section 48(a)(2)(B)(iii) shall be considered located in the United 
States and all other aircraft or vessels shall be considered located 
outside the United States. Thus, for example, if a member of a 
controlled group which includes a DISC acquires a vessel which is 
documented under the laws of a foreign country, the amount expended to 
acquire that vessel is an amount described in subdivision (i) of this 
subparagraph.
    (iv) Examples. The provisions of this subparagraph may be 
illustrated by the following examples:

    Example 1. X Corporation, which uses the calendar year as its 
taxable year, is a domestic member of a controlled group (within the 
meaning of paragraph (a)(2) of this section). During 1972, in a 
transaction to which section 1031 applies, X acquires a warehouse 
located outside the United States and having a fair market value of 
$100. As consideration, X transfers $20 in cash and a warehouse located 
within the United States and having a fair market value of $80. Under 
these facts, $100 will be taken into account as investment in foreign 
assets.
    Example 2. The facts are the same as in example 1, except that the 
warehouse transferred by X as consideration is located outside the 
United States. Under these facts, only $20 will be taken into account as 
investment in foreign assets because the amount expended for such assets 
(i.e., $100) is reduced by the fair market value of any property located 
outside the United States received in exchange for such assets (i.e., 
$80).

    (3) Depreciation with respect to all foreign assets of a controlled 
group. (i) An offset allowed by this subparagraph is the depreciation 
(determined under subdivision (ii) of this subparagraph) or depletion 
(determined under subdivision (iii) of this subparagraph) attributable 
to taxable years of the member beginning after December 31, 1971, with 
respect to all of the group's foreign assets described in subparagraph 
(2) of this paragraph including such assets acquired prior to the date 
provided in such subparagraph (2), and without regard to whether the 3-
year election in paragraph (a)(5) of this section is made. Thus, for 
example, depreciation for a taxable year of a member beginning after 
December 31, 1971, with respect to an asset described in section 1231(b) 
which is located outside of the United States and which was acquired 
during a taxable year of the member beginning before January 1, 1972, is 
an offset allowed by this subparagraph. For a further example, 
depreciation with respect to a qualified export asset is not such an 
offset.
    (ii) The depreciation taken into account under subdivision (i) of 
this subparagraph shall be--
    (a) In the case of an asset owned by a domestic member, only the 
amount allowed under section 167(b)(1) (relating to the allowance of the 
straight-line method of depreciation) and Sec. 1.162-11 (b) (relating 
to amortization in lieu of depreciation), but not the amount allowed 
under section 179 (relating to the additional first-year depreciation 
allowance).

[[Page 778]]

    (b) In the case of an asset owned by a foreign member, the 
depreciation and amortization (referred to in (a) of this subdivision) 
allowable for purposes of computing earnings and profits under 
subparagraph (5)(i) of this paragraph.
    (iii) The depletion taken into account under subdivision (i) of this 
subparagraph shall be limited to cost depletion computed under sections 
611 and 612 and the regulations thereunder. Thus, percentage depletion 
is not to be taken into account in computing the offset under this 
subparagraph.
    (4) Amount of outstanding stock or debt. (i) An offset allowed by 
this subparagraph is the outstanding amount of stock (including treasury 
stock) or debt obligations of any member of the group issued, sold, or 
exchanged after December 31, 1971, by any member (whether or not the 
same member) to persons who (on the date of such issuance, sale, or 
exchange) were neither United States persons (within the meaning of 
section 7701(a)(30)) nor members of the group: Provided, That, in the 
case of a debt obligation, such obligation is not repaid within 12 
months after such issuance, sale, or exchange. Thus, for example, if 
stock is issued to a member of the group before January 1, 1972, and 
after December 31, 1971, it is sold to a person who is neither a United 
States person nor a member of the group, an offset allowed by this 
subparagraph includes the outstanding amount of such stock. For purposes 
of this subparagraph, foreign branches of United States banks are not 
considered to be United States persons.
    (ii) The outstanding amount of stock or debt obligations shall be 
determined in accordance with the following provisions:
    (a) The outstanding amount of stock or debt obligations described in 
subdivision (i) of this subparagraph is equal to the net amount 
described in (b) of this subdivision reduced (but not below zero) by the 
amount described in (c) of this subdivision.
    (b) The net amount described in this subdivision (b) is the excess 
of (1) the aggregate of the amount of money and the fair market value of 
property (other than money) transferred by persons who are not members 
of the group and who are not U.S. persons as consideration for such 
stock and debt obligations over (2) fees and commission expenses borne 
by the issuer or transferror with respect to their issuance, sale, or 
exchange.
    (c) The amount described in this subdivision (c) is the aggregate 
amount of money and fair market value of property (other than money) 
distributed to such persons on distributions in respect of such stock 
from other than earnings and profits or on distributions in redemption 
of such stock and the amount of principal paid pursuant to such debt 
obligations.
    (d) For purposes of this subdivision (ii), in the case of a 
redemption, the stock or debt redeemed shall be charged against the 
earliest of such stock or debt issued, sold, or exchanged in order to 
determine the amount by which the balance of outstanding stock or debt 
is to be reduced. For purposes of this subparagraph, the fair market 
value of property received as consideration shall be determined as of 
the date the transaction occurs, and a contribution to capital within 
the meaning of section 118 shall be treated as the issuance of stock.
    (iii) The provisions of subdivision (i) of this subparagraph apply 
regardless of the treatment under the Code of the transaction in which 
the stock or debt was issued, sold, or exchanged. Thus, for example, if 
X Corporation, a member of a controlled group which includes a DISC, 
acquires from a nonresident alien individual in exchange solely for X's 
voting stock all of the stock of Y Corporation pursuant to a 
reorganization as defined in section 368(a)(1)(B), the fair market value 
of the Y stock on the date of the exchange would be an offset allowed by 
this subparagraph.
    (iv) The provisions of this subparagraph may be illustrated by the 
following example:

    Example. X Corporation is a member of a controlled group (within a 
meaning of paragraph (a)(2) of this section) every member of which uses 
the calendar year as its taxable year. On January 1, 1972, X issues in a 
public offering its stock to persons described in subdivision (i) of 
this subparagraph who, in the aggregate, pay $1,000 as consideration. X 
pays $100 in underwriting fees. On the same date, X receives $425 upon 
issuing a $500 debt

[[Page 779]]

obligation to such persons at a discount of $75 and pays $25 in 
underwriting fees. On December 31, 1972, the offset allowed under this 
subparagraph is $1,300, i.e., ($1,000 minus $100) plus ($425 minus $25). 
If, during 1973, X makes a distribution of $150 (not in redemption) from 
other than earnings and profits with respect to such stock, then the 
offset is reduced to $1,150.

    (5) Earnings and profits. (i) An offset allowed by this subparagraph 
is one-half the aggregate of the earnings and profits accumulated for 
all taxable years beginning after December 31, 1971, computed (without 
regard to any distributions from earnings and profits by a foreign 
corporation to a domestic corporation in accordance with Sec. 1.964-1 
(relating to a controlled foreign corporation's earnings and profits), 
of each foreign member of the group which is controlled directly or 
indirectly (as determined under the principles of section 958 and the 
regulations thereunder) by a domestic member of the group and each 
foreign branch of a domestic member of the group (computed as if the 
branch were a foreign corporation). The DISC is bound by any action on 
behalf of a foreign member that was taken pursuant to Sec. 1.964-
1(c)(3) or by any failure to take action by or on behalf of a foreign 
member within the time specified in Sec. 1.964-1(c)(6). With respect to 
a foreign member for which action was not previously required under 
Sec. 1.964-1(c)(6) to be taken, the DISC may take action on behalf of 
such member by attaching a statement to that effect to the return of the 
DISC under section 6011(e)(2) for the first taxable year during which it 
qualifies (or is treated) as a DISC and there is outstanding a 
producer's loan made by such DISC to a member of the controlled group 
which includes the DISC.
    (ii) If the aggregate of the accumulated earnings and profits 
described in subdivision (i) of this subparagraph is a deficit, the 
amount allowable as an offset under this subparagraph is zero.
    (6) Royalties and fees. An offset allowed by this subparagraph is 
one-half the royalties and fees paid by foreign members of the group to 
domestic members of the group and by foreign branches of domestic 
members of the group to domestic members of the group during the taxable 
years of such members beginning after December 31, 1971.
    (7) Uncommitted transitional funds. (i) An offset allowed by this 
subparagraph for the uncommitted transitional funds of the group is the 
sum described in subdivision (ii) of this subparagraph of the amount of 
certain capital raised under the foreign direct investment program and 
the amounts described in subdivision (iv) of this subparagraph of 
certain foreign excess working capital held on October 31, 1971.
    (ii) The amount described in this subdivision of certain capital 
raised under the foreign direct investment program is the excess (if 
any) of--
    (a) The amount of the offset allowed by subparagraph (4) of this 
paragraph, determined, however, with respect to the stock and debt 
obligations of domestic members of the group outstanding on December 31, 
1971 (including amounts treated as stock outstanding by reason of a 
contribution to capital), whether or not outstanding after such date, 
which were issued, sold, or exchanged on or after January 1, 1968, by 
any member (whether or not the same member) to persons who (on the date 
of such issuance, sale, or exchange) were neither United States persons 
(within the meaning of section 7701(a)(30)) nor members of the group, 
but only to the extent the taxpayer establishes that such amount 
constitutes a long-term borrowing (see 15 CFR 1000.324 \1\) for purposes 
of the foreign direct investment program (see 15 CFR part 1000 \1\), 
over
---------------------------------------------------------------------------

    \1\ Editorial Note: 15 CFR part 1000 was removed at 39 FR 30481, 
Aug. 23, 1974.
---------------------------------------------------------------------------

    (b) The amount (determined under paragraph (c) of this section) of 
actual foreign investment by the domestic members of the group during 
the portion of the period such stock or debt obligations have been 
outstanding prior to January 1, 1972, such determination to be made by 
substituting January 1, 1968, for the December 31, 1971, date specified 
in such paragraph (c) and by not taking into account the earnings and 
profits described in paragraph (c)(3) of this section.


For purposes of this subparagraph, foreign branches of United States 
banks

[[Page 780]]

are not considered to be United States persons.
    (iii)(a) A taxpayer may establish that an amount under subdivision 
(ii) (a) of this subparagraph constitutes a long-term borrowing for 
purposes of the foreign direct investment program by keeping records 
sufficient to demonstrate that appropriate reports were filed with the 
Office of Foreign Direct Investment of the Department of Commerce with 
respect to the foreign borrowing or by any other method satisfactory to 
the district director.
    (b) The amounts described in subdivision (ii) (a) of this 
subparagraph include amounts with respect to which an election under 
section 4912(c), to subject certain obligations of a United States 
person to the interest equalization tax, has been made: Provided, That 
the obligations to which such amounts relate were issued by an 
``overseas financing subsidiary'' described in 15 CFR part 1000 \1\ and 
were assumed by a United States person from such overseas financing 
subsidiary. Thus, for example, if an overseas financing subsidiary 
issues its notes to a foreign person in 1968, and such notes are assumed 
by its United States parent in 1973, which parent elects under section 
4912(c) to have the notes subject to the interest equalization tax, then 
the amount of money received by the subsidiary is an amount described in 
subdivision (ii)(a) of this subparagraph.
    (iv) The amount described in this subdivision of foreign excess 
working capital is the amount of liquid assets held by the foreign 
members of such group and foreign branches of domestic members of such 
group on October 31, 1971 (whether or not so held after such date) in 
excess of their reasonable working capital needs (as defined in Sec. 
1.993-2 (e)) on that date, but only to the extent not included in 
subdivision (ii) of this subparagraph. For purposes of this subdivision, 
the term liquid assets means money, bank deposits (not including time 
deposits), and indebtedness of any kind (including time deposits) which 
on the day acquired had a maturity of 2 years or less.
    (8) Example. The provisions of this paragraph may be illustrated by 
the following example:

    Example. X Corporation, which uses the calendar year as its taxable 
year is a member of a controlled group (within the meaning of paragraph 
(a)(2) of this section). X elects to be treated as a DISC beginning with 
1972. The amount of net increase in foreign assets of the group at the 
close of each group taxable year with respect to each taxable year of X 
from 1972 through 1975 are set forth in the table below, computed on the 
basis of the facts assumed (the amounts on each line being running 
balances):

------------------------------------------------------------------------
          Taxable year of X             1972     1973     1974     1975
------------------------------------------------------------------------
(1) Investment in foreign assets....     $150     $165     $260     $300
                                     ===================================
(2) Depreciation with respect to           20       40       60       80
 foreign assets of group............
(3) Amount of stock or debt                30       30       30       30
 outstanding issued after December
 31, 1971...........................
(4) One-half earnings and profits of       40       70      100      130
 foreign members....................
(5) Royalties and fees paid by             10       15       20       20
 foreign members to domestic members
(6) Uncommitted transitional funds..       10       10       10       10
                                     -----------------------------------
(7) Sum of lines (2) through (6)....      110      165      220      270
                                     -----------------------------------
(8) Net increase in foreign assets         40        0       40       30
 (line (1) minus line (6))..........
------------------------------------------------------------------------

    (c) Actual foreign investment by domestic members. For purposes of 
determining the limitation in paragraph (a) of this section, the amount 
of the actual foreign investment by domestic members of a controlled 
group is the sum (as of the close of the group taxable year) determined 
on a cumulative basis (see paragraph (a)(6) of this section) of--
    (1) Outstanding stock or debt (including contributions to capital). 
The outstanding amount (determined in accordance with the principles of 
paragraph (b)(4)(ii) of this section, applied with respect to stock or 
debt obligations described in this subparagraph) of stock (including 
treasury stock) or debt obligations (other than normal trade 
indebtedness) of foreign members of the group issued, sold, or exchanged 
after December 31, 1971, by any person (whether or not a member) which 
is not a domestic member to domestic members of the group: Provided, 
That the

[[Page 781]]

outstanding amount of debt obligations of any foreign member shall be 
the greater of such amount outstanding at the close of the taxable year 
of such member or the highest such amount outstanding at any time during 
the immediately preceding 90 days,
    (2) Transfers to foreign branches. The amount of money or the fair 
market value of property (other than money) transferred by domestic 
members of the group after December 31, 1971, to foreign branches of 
such members in transactions which would, if the branch were a 
corporation, be in consideration for the sale of stock or debt 
obligations of (or a contribution of capital to) such foreign branches 
(as determined under subparagraph (1) of this paragraph), and
    (3) Earnings and profits of foreign members. One-half of the 
earnings and profits (computed in accordance with paragraph (b)(5) of 
this section for purposes of computing net increase in foreign assets) 
of foreign members of the group which are controlled directly or 
indirectly (as determined under the principles of section 958 and the 
regulations thereunder) by a domestic member of the group and foreign 
branches (treated for this purpose as a corporation) of domestic members 
of the group accumulated during the taxable years of such foreign 
members (or branches) beginning after December 31, 1971, or, if later, 
the taxable year referred to in paragraph (a)(5)(i) of this section if 
the 3-year election provided for in such paragraph (a)(5)(i) is made.
    (d) Carryovers on certain corporate acquisitions and 
reorganizations--(1) Certain corporate acquisitions. (i) If--
    (a) A member of a controlled group (``first controlled group'') 
acquires in a transaction to which section 381 applies the assets of a 
corporation which is a member of a second controlled group or acquires 
stock in such a corporation pursuant to a reorganization as defined in 
section 368(a)(1)(B) to which section 361 applies, or
    (b) A member or combination of members of the first controlled group 
acquire in a transaction not described in (a) of this subdivision a 
majority interest (as defined in paragraph (e)(2) of this section) in 
the stock of a corporation which is a member of a second controlled 
group which includes a DISC so that such DISC after the acquisition is a 
member of the new controlled group,


then, for purposes of computing foreign investment attributable to 
producer's loans with respect to the new controlled group as constituted 
after such acquisition, all amounts described in paragraphs (a) through 
(c) of this section, including the amount specified in paragraph 
(a)(1)(ii) of this section (relating to amounts treated under section 
995(b)(1)(G) as deemed distributions by the DISC taxable as dividends 
for prior taxable years of the DISC), with respect to members of the 
second controlled group which become members of the new controlled group 
shall carry over to such new controlled group. For purposes of this 
subdivision (i), a controlled group may consist of only one member. With 
respect to certain transactions involving foreign corporations, see 
section 367.
    (ii) If a member or combination of members of a controlled group, 
immediately after an acquisition of stock to which subdivision (i) of 
this subparagraph applies, do not control the total combined voting 
power (determined under Sec. 1.957-1(b)) of the corporation whose stock 
was acquired, proper apportionment consistent with the principles of 
paragraph (e)(5) of this section shall be made with respect to amounts 
to which paragraphs (a) through (c) of this section apply.
    (iii)(a) If subdivision (i) of this subparagraph applies, then for 
purposes of determining the application of the 3-year elective 
limitation provided for in paragraph (a)(5) of this section, the rules 
in (b), (c), and (d) of this subdivision (iii) apply.
    (b) If both the ``first controlled group'' and the ``second 
controlled group'' (as those terms are defined in subdivision (i) of 
this subparagraph) include a DISC, and a DISC in either group has 
elected the 3-year limitation provided in paragraph (a)(5) of this 
section, then only those amounts taken into account under such paragraph 
(a)(5) by the electing DISC or DISC's shall be taken into account.
    (c) If one of the groups includes a DISC and the other does not, and 
if the DISC has elected the 3-year limitation

[[Page 782]]

provided in paragraph (a)(5) of this section, then, for purposes of 
computing foreign investment attributable to producer's loans with 
respect to the new controlled group as constituted after the 
acquisition, all amounts described in paragraphs (a) through (c) of this 
section with respect to members of the controlled group which did not 
include the DISC shall carry over to such new controlled group, but only 
to the extent provided in such paragraph (a)(5), computed as if the 
group taxable year in which the acquisition occurred was the first group 
taxable year which includes a member's first taxable year during which 
it qualifies (or is treated) as a DISC.
    (d) If (c) of this subdivision (iii) applies, except that the DISC 
has not elected the 3-year limitation provided in paragraph (a)(5) of 
this section, then the DISC in the new controlled group as constituted 
after the acquisition may, with respect to members of the controlled 
group which did not include the DISC, make the election provided in such 
paragraph (a)(5), and treat the year in which the acquisition occurred 
as if it were the first group taxable year which includes a member's 
first taxable year during which it qualifies (or is treated) as a DISC.
    (iv) If a majority interest, or an interest in addition to a 
majority interest, is acquired in a transaction other than a transaction 
described in subdivision (i) of this subparagraph, then the rules in 
paragraph (e) of this section (relating to the acquisition of the 
foreign assets of a corporation) apply.
    (2) Corporation ceasing to be a member. As of the date a corporation 
which is a member of a controlled group ceases to be a member of such 
group, the amounts of such group described in paragraphs (a) through (c) 
of this section will be reduced by such amounts which are attributable 
to the corporation which is no longer a member of the group.
    (e) Acquisition of a majority interest in a corporation--(1) In 
general. If paragraph (d)(1)(i) of this section (relating to certain 
corporate acquisitions in which all amounts described in paragraphs (a) 
through (c) of this section carry over) does not apply, then, for 
purposes of determining under paragraph (b)(2) of this section the 
investments made in foreign assets by a controlled group, the 
acquisition of a majority interest (as defined in subparagraph (2) of 
this paragraph) or an interest in addition to a majority interest in a 
corporation by any member or combination of members of the controlled 
group is considered an acquisition of the assets (to the extent provided 
in subparagraph (5) of this paragraph) of the acquired corporation by 
the group, including the assets of any foreign corporation in which the 
acquired corporation owns a majority interest (to the extent provided in 
subparagraph (5) of this paragraph). For the rules concerning the date 
upon which an acquisition of a majority interest is considered to have 
occurred, see subparagraph (3) of this paragraph.
    (2) Majority interest. For purposes of this section, a majority 
interest is more than 50 percent of the total combined voting power of 
all classes of a corporation's stock entitled to vote, as determined 
under Sec. 1.957-1(b).
    (3) Acquisition date. For purposes of this paragraph, an acquisition 
of a majority interest shall be considered to have occurred on the day 
on which the combined voting power of the group first reached the 
percentage required in subparagraph (2) of this paragraph.
    (4) Valuation of assets. For purposes of this section, the amount of 
a corporation's assets deemed acquired is the fair market value of the 
assets on the date a majority interest, or an interest in addition to a 
previously held majority interest, is acquired.
    (5) Apportionment in the case of the acquisition of less than all of 
the voting stock. (i) If the acquisition described in subparagraph (1) 
of this paragraph of a majority interest is of less than 100 percent of 
the total combined voting power of all classes of stock of the acquired 
corporation entitled to vote, then for purposes of subparagraph (1) of 
this paragraph the amount of the foreign assets of the corporation 
deemed acquired as of the day the majority interest is considered 
acquired shall be an amount equal to the fair market value of all of the 
corporation's foreign assets described in paragraph (b)(2) of this 
section as of such day multiplied

[[Page 783]]

by the percentage of the total combined voting power (determined under 
Sec. 1.957-1(b)) held by members of the group on the day the majority 
interest is considered acquired.
    (ii) If any member or combination of members of the controlled group 
hold a majority interest in a corporation, then for purposes of 
subparagraph (1) of this paragraph the acquisition of additional 
combined voting power by members of the controlled group shall be 
considered an acquisition of its foreign assets described in paragraph 
(b)(2) of this section in an amount equal to the fair market value of 
all such assets held by the foreign corporation on the date of the 
acquisition, multiplied by the increase (expressed in percentage points) 
in total combined voting power (as determined under Sec. 1.957-1(b)) 
which occurred.
    (6) Examples. The application of this paragraph may be illustrated 
by the following examples:

    Example 1. M Corporation uses the calendar year as its taxable year. 
On November 18, 1973, M acquires from A, an individual United States 
person, for $1 million cash all 10,000 shares of the voting stock of N, 
a foreign corporation. N's only asset is a warehouse located in France 
with a fair market value on the date of acquisition of $1 million. Under 
subparagraph (1) of this paragraph, the controlled group of which M is a 
member is considered to have expended $1 million for the acquisition of 
foreign assets described in paragraph (b)(2) of this section.
    Example 2. The facts are the same as in example 1, except that on 
November 18, 1973, M acquires only 80 percent of N's voting stock. M is 
considered to have expended $800,000 for the acquisition of assets 
described in paragraph (b)(2) of this section, computed as follows:

(1) Fair market value of N's foreign assets described in      $1,000,000
 paragraph (b)(2) of this section..........................
(2) Multiply by percentage of total combined voting power             .8
 of all classes of N stock entitled to vote acquired by M..
                                                            ------------
(3) Amount considered expended.............................     $800,000
                                                            ============
 

    Example 3. The facts are the same as in example 2, except that 
individual A is not a United States person, and M acquires the 80 
percent of N voting stock in exchange for cash of $100,000 and M stock 
having a fair market value on the date of the acquisition of $700,000. M 
is considered to have acquired assets described in paragraph (b)(2) of 
this section in the amount of $800,000 (see computations in example 2) 
and to have an offset under paragraph (b)(4) of this section (relating 
to outstanding stock or debt) of $700,000 (the fair market value of the 
M stock transferred to A who is not a United States person). However, 
the controlled group of which M is a member is not considered to have 
acquired any other amounts described in paragraphs (a) through (c) of 
this section with respect to N for taxable years prior to the taxable 
year of N during which the acquisition occurred.
    Example 4. P Corporation, which uses the calendar year as its 
taxable year, is a member of a controlled group which includes a DISC. 
During 1973, P acquires from B, an individual United States person, for 
cash, 30 percent of the total combined voting power of all classes of 
stock entitled to vote of Q, a foreign corporation. All of Q's assets 
are assets described in paragraph (b)(2) of this section. No additional 
interest in Q is acquired by members of the group during 1973. The 
controlled group of which Q is a member is not considered to have made 
any investments in foreign assets described in such paragraph (b)(2) as 
of the close of 1973.
    Example 5. Assume the same facts as in example 4. Assume further 
that during 1974, R Corporation, a member of the controlled group which 
includes P, acquires for cash 40 percent of the total combined voting 
power of all classes of stock of Q entitled to vote as follows: 20 
percent on July 31, and 20 percent on December 31. Thus, on December 31, 
1974, members of the controlled group own 70 percent of Q's voting power 
(30 + 20 + 20) and on that date are considered to have acquired a 
majority interest in Q. The fair market value of Q's assets on December 
31, 1974, is $5 million. The group is considered to have expended 
$3,500,000 for the acquisition of assets described in paragraph (b)(2) 
of this section computed as follows:

(1) Fair market value of Q's foreign assets described in      $5,000,000
 paragraph (b)(2) of this section as of the date the
 acquisition is deemed to have occurred under subparagraph
 (3) of this paragraph (December 31, 1974).................
(2) Multiply by percentage of total combined voting power             .7
 of all classes of Q stock entitled to vote held by members
 of the group on such date.................................
                                                            ------------
                                                              $3,500,000
                                                            ============
 

    Example 6. The facts are the same as in example 5. Assume further 
that on July 15, 1975, P acquires the remaining 30 percent of the total 
combined voting power of all classes of Q stock entitled to vote, and on 
such date the fair market value of Q's assets is $5,500,000. The group 
is considered to have expended $5,150,000 for the acquisition of assets 
described in paragraph (b)(2) of this section as of the close of 1975, 
computed as follows:

(1) Amount of prior years' investment......................   $3,500,000
                                                            ============

[[Page 784]]

 
(2) Investment during 1975:
  (a) Fair market value of Q's foreign assets described in    $5,500,000
   paragraph (b)(2) of this section on July 15, 1975.......
  (b) Multiply by additional percentage acquired of total             .3
   combined voting power of all classes of Q stock entitled
   to vote.................................................
                                                            ------------
  (c) Investment during 1975...............................   $1,650,000
                                                            ============
(3) Amount considered expended for foreign assets described   $5,150,000
 in paragraph (b)(2) of this section by reason of the
 acquisition of Q stock....................................
 

    (f) Records. A DISC shall keep or be readily able to produce such 
permanent books of account or records as are sufficient to establish the 
transactions and amounts described in this section. Where applicable, 
such books of account or records shall be cumulative and shall show 
transactions and amounts of the members of the controlled group which 
includes the DISC which occurred prior to the date the DISC qualified 
(or is treated) as a DISC.
    (g) Multiple DISC's--(1) Allocation among DISC's. In the case of a 
controlled group which includes more than one DISC, the amounts 
described in paragraphs (b) and (c) of this section shall be allocated 
among the DISC's in order to determine the limitation in paragraph (a) 
of this section. Each DISC's allocable portion of these amounts shall be 
equal to the total of such amounts multiplied by a fraction the 
numerator of which is the individual DISC's outstanding producer's loans 
to members of the group, and the denominator of which is the aggregate 
amounts of outstanding producer's loans to members of the group by all 
DISC's which are members of the group.
    (2) Different taxable years. If all of the DISC's which are members 
of the controlled group do not have the same taxable year, then one such 
DISC shall on behalf of all such DISC's elect to make all computations 
under section 995(d) as if all DISC's that are members of the group use 
the same taxable year as the actual taxable year of any one of the 
DISC's. The election as to which DISC's taxable year is to be used shall 
be made by the electing DISC attaching to its first return, filed under 
section 6011(e)(2), a statement indicating which such taxable year will 
be used. Once such an election is made it may not be revoked until such 
time as all of the DISC's which are members of the group use the same 
taxable year. If this subparagraph applies, books and records must be 
kept by the group which are adequate to show the necessary computations 
under section 995(d).
    (3) This paragraph may be illustrated by the following example:

    Example. Corporation X and corporation Y are members of the same 
controlled group and each has elected to be treated as a DISC. X uses a 
taxable year ending March 31, and Y uses a taxable year ending November 
30. Notwithstanding the fact that all other members of the group use the 
calendar year as their taxable year, all computations for purposes of 
determining the amount of foreign investment attributable to producer's 
loans under section 995(d) must be made as if both DISC's use a taxable 
year ending either March 31 (X's taxable year) or November 30 (Y's 
taxable year).

[T.D. 7324, 39 FR 35114, Sept. 30, 1974, as amended by T.D. 7420, 41 FR 
20655, May 20, 1976; T.D. 7854, 47 FR 51742, Nov. 17, 1982]



Sec. 1.995-6  Taxable income attributable to military property.

    (a) Gross income attributable to military property. For purposes of 
section 995(b)(3)(A)(i), the term ``gross income which is attributable 
to military property'' includes income from the sale, exchange, lease, 
or rental of military property (as described in paragraph (c) of this 
section). The term also includes gross income from the performance of 
services which are related and subsidiary (as defined in Sec. 1.993-
1(d)) to any qualified sale, exchange, lease, or rental of military 
property. Where gross income cannot be determined on an item by item 
basis, the gross income with respect to those items not so determinable 
shall be apportioned. Such apportionment shall be accomplished using 
appropriate facts and circumstances, so that the gross income 
apportioned to sale of military property bears a reasonably close 
factual relationship to the actual gross income earned on such sales. 
The apportionment shall be based on methods which include the fair 
market value of property sold or exchanged, the fair rental value of any 
leaseholds granted, the

[[Page 785]]

fair market value of any related or subsidiary services performed in 
connection with such sale or leases or methods based on gross receipts 
or costs of goods sold, where appropriate.
    (b) Deductions. For purposes of section 995(b)(3)(A)(ii), deductions 
shall be properly allocated and apportioned to gross income, described 
in paragraph (a) of this section, in accordance with the rules of Sec. 
1.861-8. These deductions include all applicable deductions from gross 
income provided under part VI of subchapter B of chapter 1 of the Code.
    (c) Military property. For purposes of this section, the term 
military property means any property which is an arm, ammunition, or 
implement of war designated in the munitions list published pursuant to 
section 38 of the International Security Assistance and Arms Export 
Control Act of 1976 (22 U.S.C. 2778 which superseded 22 U.S.C. 1934) and 
the regulations thereunder (22 CFR 121.01).
    (d) Illustration. The principles of this section may be illustrated 
by the following example:
    Example. X Corporation elects to be a DISC for the first time in 
1976. X has taxable income of $50,000, of which $30,000 is attributable 
to military property and $10,000 to interest on producer's loans. The 
total deemed distributions with respect to X are as follows:

(1) Gross interest from Producer's loans in 1976.............    $10,000
(2) 50 percent of the taxable income of the DISC attributable     15,000
 to military property in 1976................................
(3) One-half of the excess of taxable income for 1976 over        12,500
 the sum of lines (1) and (2) (\1/2\ of ($50,000 minus
 $25,000))...................................................
(4) Total deemed distributions (sum of total lines (1), (2),      37,500
 and (3))....................................................
 


(Secs. 995(e)(7), (8) and (10), 995(g) and 7805 of the Internal Revenue 
Code of 1954 (90 Stat. 1655, 26 U.S.C. 995 (e)(7), (8) and (10); 90 
Stat. 1659, 26 U.S.C. 995(g); and 68A Stat 917, 26 U.S.C. 7805))

[T.D. 7984, 49 FR 40019, Oct. 12, 1984]



Sec. 1.996-1  Rules for actual distributions and certain deemed
distributions.

    (a) General rule. Under section 996(a)(1), any actual distribution 
(other than a distribution described in paragraph (b) of this section or 
to which Sec. 1.995-4 applies) to a shareholder by a DISC, or former 
DISC, which is made out of earnings and profits shall be treated as 
made--
    (1) First, out of ``previously taxed income'' (as defined in Sec. 
1.996-3(c)) to the extent thereof,
    (2) Second, out of ``accumulated DISC income'' (as defined in Sec. 
1.996-3(b)) to the extent thereof, and
    (3) Third, out of ``other earnings and profits'' (as defined in 
Sec. 1.996-3(d)) to the extent thereof.
    (b) Rules for qualifying distributions and deemed distributions 
under section 995(b)(1)(G)--(1) In general. Except as provided in 
subparagraph (2), any actual distribution to meet qualification 
requirements made pursuant to Sec. 1.992-3 and any deemed distribution 
pursuant to Sec. 1.995-2(a)(5) (relating to foreign investment 
attributable to producer's loans) which is made out of earnings and 
profits shall be treated as made--
    (i) First, out of ``accumulated DISC income'' (as defined in Sec. 
1.996-3(b)) to the extent thereof.
    (ii) Second, out of ``other earnings and profits'' (as defined in 
Sec. 1.996-3(d)) to the extent thereof, and
    (iii) Third, out of ``previously taxed income'' (as defined in Sec. 
1.996-3(c)) to the extent thereof.
    (2) Special rule. For taxable years beginning after December 31, 
1975, paragraph (b)(1) of this section shall apply to one-half of the 
amount of an actual distribution made pursuant to Sec. 1.992-3 to 
satisfy the condition of Sec. 1.992-1(b) (the gross receipts test) and 
paragraph (a) of this section shall apply to the remaining one-half of 
such amount.
    (c) Exclusion from gross income. Under section 996(a)(3), amounts 
distributed out of previously taxed income shall be excluded by the 
distributee from gross income. However, see Sec. 1.996-5(b) for 
treatment as gain from the sale or exchange of property of the portion 
of an actual distribution out of previously taxed income to the extent 
it exceeds the adjusted basis of the stock with respect to which the 
distribution is made.
    (d) Priority of distributions. Under section 996(c), for purposes of 
determining their treatment under paragraphs (a), (b), and (c) of this 
section, distributions made during a taxable year shall be treated as 
being made in the following order--
    (1) Deemed distributions under Sec. Sec. 1.995-2 and 1.995-3.

[[Page 786]]

    (2) Actual distributions to meet qualification requirements made 
pursuant to Sec. 1.992-3 in the order in which they are made, and
    (3) Other actual distributions in the order in which they are made.


Thus, the treatment of any distribution shall be determined after the 
divisions of earnings and profits have been properly adjusted by taking 
into account distributions of higher priority which are made or deemed 
made during the same taxable year.
    (e) Examples. The provisions of this section may be illustrated by 
the following examples:

    Example 1. Y Corporation, which uses the calendar year as its 
taxable year elects to be treated as a DISC beginning with 1972. During 
1973, Y makes a cash distribution of $100 to X Corporation, Y's sole 
shareholder. For 1973, Y has no earnings and profits. As of the 
beginning of 1973, Y has $300 of accumulated earnings and profits, which 
consist of $70 of accumulated DISC income, $40 of previously taxed 
income, and $190 of other earnings and profits. The entire $100 
distribution is a dividend under section 316. However, $40 thereof is 
treated as made out of previously taxed income and is thus excluded from 
gross income. Accordingly, only $60 is treated as distributed out of 
accumulated DISC income and includible in gross income. See Sec. 1.246-
4 for the inapplicability of the dividend received deduction with 
respect to the entire distribution of $100.
    Example 2. Assume the same facts as in example 1, except that the 
cash distribution is designated as a distribution to meet qualification 
requirements made pursuant to Sec. 1.992-3. Under these facts, X 
includes the entire distribution in its gross income as a dividend. Of 
the $100 distributed, $70 is treated as made out of accumulated DISC 
income and the remaining $30 is treated as made out of other earnings 
and profits. The dividend received deduction under section 243 is 
available only with respect to such $30.
    Example 3. Y Corporation, which uses the calendar year as its 
taxable year, elects to be treated as a DISC beginning with 1972. As of 
the end of 1975, Y had failed to meet the gross receipts test for that 
year. In 1975 Y had $100 of taxable income, $80 of which was 
attributable to qualified export receipts and $20 of which was 
attributable to receipts that did not qualify as qualified export 
receipts. As of the beginning of 1976, Y had $300 of accumulated 
earnings and profits, which consisted of $70 of accumulated DISC income, 
$40 of previously taxed income, and $190 of other earnings and profits. 
In 1976 Y makes a cash distribution of $20 pursuant to Sec. 1.992-3 in 
order to satisfy the gross receipts test for 1975. For 1976 Y has no 
earnings and profits and no deemed distributions. The entire $20 
distribution is a dividend under section 316. Under Sec. 1.996-1(b)(2), 
half of the $20 cash distribution is treated pursuant to Sec. 1.996-
1(b)(1) and half is treated pursuant to Sec. 1.996-1(a). Thus, $10 is 
treated as distributed out of accumulated DISC income and is includible 
in gross income. The other $10 is treated as made out of previously 
taxed income and is thus excluded from gross income. As of the beginning 
of 1977, Y has $280 of accumulated earnings and profits, which consists 
of $60 of accumulated DISC income, $30 of previously taxed income, and 
$190 of other earnings and profits.

[T.D. 7324, 39 FR 35120, Sept. 30, 1974, as amended by T.D. 7854, 47 FR 
51742, Nov. 17, 1982]



Sec. 1.996-2  Ordering rules for losses.

    (a) In general. Under section 996(b), if for any taxable year a 
DISC, or a former DISC, incurs a deficit in earnings and profits, such 
deficit shall be charged--
    (1) First, to other earnings and profits (as defined in Sec. 1.996-
3(d)) to the extent thereof,
    (2) Second, to accumulated DISC income (as defined in Sec. 1.996-
3(b)) to the extent thereof, subject to the special rule in paragraph 
(b) of this section,
    (3) Third, to previously taxed income (as defined in Sec. 1.996-
3(c)) to the extent thereof, and
    (4) To the extent that the amount of such deficit exceeds the sum of 
the amounts charged in accordance with subparagraphs (1), (2), and (3) 
of this paragraph, to other earnings and profits (as defined in Sec. 
1.996-3(d)).


Thus, the excess deficit charged to other earnings and profits under 
subparagraph (4) of this paragraph will create a deficit therein in the 
amount of such excess. To determine the amount of any division of 
earnings and profits for the purpose of determining under Sec. 1.996-1 
the treatment of any actual and certain deemed distributions, the 
portion of a deficit in earnings and profits chargeable under this 
paragraph to such division prior to such distribution shall be 
determined in a manner consistent with the rules in Sec. 1.316-2(b) for 
determining the amount of earnings and profits available on the date of 
any distribution.

[[Page 787]]

    (b) Deficits subsequent to a disqualification. A deficit in earnings 
and profits of a DISC, or former DISC, shall not be charged to 
accumulated DISC income which has been determined is to be deemed 
distributed to the shareholders pursuant to Sec. 1.995-3 as a result of 
a revocation of election or other disqualification. Thus, in accordance 
with paragraph (a) of this section as modified by this paragraph, a 
deficit incurred by a former DISC following such a revocation or 
disqualification shall be charged first to other earnings and profits 
and then to previously taxed income with any balance being charged to 
other earnings and profits and creating a deficit therein. The preceding 
sentence shall also apply in the case of a deficit incurred by a DISC 
which has no accumulated DISC income accumulated during its current 
taxable year and all immediately preceding consecutive taxable years for 
which it was a DISC. If as a result of the application of this paragraph 
the amount of a deficit in other earnings and profits exceeds the amount 
of a deficit in accumulated earnings and profits, then upon any 
subsequent actual distribution the deficit in other earnings and profits 
shall be reduced by the lower of (1) the amount of such actual 
distribution chargeable to accumulated DISC income or previously taxed 
income or (2) the amount of such excess.
    (c) Examples. The provisions of this section may be illustrated by 
the following examples:

    Example 1. X Corporation, which uses the calendar year as its 
taxable year, becomes a DISC beginning with 1976. In addition to other 
facts assumed in the table below, X incurs a deficit in earnings and 
profits for 1979 of $70. Such deficit is charged to the divisions of X's 
earnings and profits pursuant to paragraph (a) of this section in the 
manner set forth in such table.

------------------------------------------------------------------------
                                                                  Other
                                       Accumulated  Previously  earnings
                                       DISC income     taxed       and
                                                      income     profits
------------------------------------------------------------------------
Balance January 1, 1976..............  ...........  ..........      $50
Increase for 1976....................        $10          $8
Increase for 1977....................         10           8
Increase for 1978....................         10           8
                                      ----------------------------------
  Balance January 1, 1979............         30          24         50
Deficit for 1979 of $70:
  Charge No. 1.......................  ...........  ..........     (50)
  Charge No. 2.......................       (20)
                                      ----------------------------------
    Balance January 1, 1980..........         10    ..........        0
------------------------------------------------------------------------

    Example 2. Assume the same facts as in example 1, except that 
effective for taxable years beginning with 1979, X revokes its election 
to be treated as a DISC. Under Sec. 1.995-3, X has $30 of accumulated 
DISC income which is to be deemed distributed $10 per year in 1980, 
1981, and 1982. The deficit in earnings and profits for 1979 is charged 
to the divisions of X's earnings and profits pursuant to paragraph (b) 
of this section in the manner set forth in the table below:

------------------------------------------------------------------------
                                                                  Other
                                       Accumulated  Previously  earnings
                                       DISC income     taxed       and
                                                      income     profits
------------------------------------------------------------------------
Balance January 1, 1979..............        $30         $24        $50
Deficit for 1979 of $70:.............
  Charge No. 1.......................  ...........  ..........     (50)
  Charge No. 2.......................  ...........      (20)
                                      ----------------------------------
    Balance January 1, 1980..........         30           4          0
------------------------------------------------------------------------

    Example 3. Assume the same facts as in example 2, except that the 
deficit in earnings and profits for 1979 is $120. Assume further that 
for 1980, 1981, and 1982, during which years X's shareholders are 
receiving scheduled installments of the deemed distributions of 
accumulated DISC income under Sec. 1.995-3, X, a former DISC, has 
neither earnings and profits nor a deficit in earnings and profits. The 
$120 deficit for 1979 is charged to the divisions of X's earnings and 
profits pursuant to paragraph (b) of this section in the manner set 
forth in the table below:

----------------------------------------------------------------------------------------------------------------
                                                                                             Other
                                                                  Accumulated  Previously  earnings  Accumulated
                                                                  DISC income     taxed       and      earnings
                                                                                 income     profits  and profits
----------------------------------------------------------------------------------------------------------------
Balance January 1, 1979.........................................        $30         $24        $50        $104
Deficit for 1979 of $120........................................  ...........  ..........  ........      (120)
  Charge No. 1..................................................  ...........  ..........     (50)
  Charge No. 2..................................................  ...........      (24)
  Charge No. 3..................................................  ...........  ..........     (46)
                                                                 -----------------------------------------------
    Balance January 1, 1980.....................................         30           0       (46)        (16)
Deemed distributions in 1980 under Sec. 1.995-3...............       (10)          10
                                                                 -----------------------------------------------
    Balance January 1, 1981.....................................         20          10       (46)        (16)
----------------------------------------------------------------------------------------------------------------


[[Page 788]]

    Example 4. Assume the same facts as in example 3, except that on 
December 31, 1980, X makes an actual distribution of $10 out of 
previously taxed income. On January 1, 1981, X has $20 of accumulated 
DISC income, no previously taxed income, and a deficit of $36 in other 
earnings and profits. The deficit of $16 in accumulated earnings and 
profits remains the same.

[T.D. 7324, 39 FR 35120, Sept. 30, 1974]



Sec. 1.996-3  Divisions of earnings and profits.

    (a) In general. For purposes of sections 991 through 997, the 
earnings and profits of a DISC, or former DISC, shall be treated as 
composed of the following three divisions:
    (1) Accumulated DISC income (as defined in paragraph (b) of this 
section),
    (2) Previously taxed income (as defined in paragraph (c) of this 
section), and
    (3) Other earnings and profits (as defined in paragraph (d) of this 
section),
    (b) Accumulated DISC income defined. (1) Accumulated DISC income is 
that portion of a corporation's earnings and profits which were derived 
during taxable years for which it qualified as a DISC and which were 
deferred from taxation. Accumulated DISC income as of the close of each 
taxable year of the corporation is--
    (i) The amount of accumulated DISC income as of the close of the 
immediately preceding taxable year increased by,
    (ii) The amount of DISC income for the year (as determined in 
subparagraph (2) of this paragraph) and reduced (but not below zero) by,
    (iii) The items enumerated in subparagraph (3) of this paragraph.
    (2) Under section 996(f)(1), DISC income is (i) the earnings and 
profits derived by the corporation during a taxable year for which such 
corporation is a DISC minus (ii) amounts deemed distributed under Sec. 
1.995-2 other than the amount of foreign investment attributable to 
producer's loans described in Sec. 1.995-2(a)(5). For example, the 
earnings and profits of a DISC for a taxable year include any amounts 
includible in such DISC's gross income pursuant to section 951(a) 
(relating to controlled foreign corporations). Deemed distributions 
under Sec. 1.995-2(a)(5) are taken into account under subparagraph (3) 
of this paragraph as a reduction in computing accumulated DISC income.
    (3) The accumulated DISC income (as increased by DISC income for the 
year determined under subparagraph (2) of this paragraph) is reduced by 
each of the following items in the following order:
    (i) Any amount deemed distributed for such year under Sec. 1.995-3 
(relating to deemed distributions upon disqualification),
    (ii) Any amount of foreign investment attributable to producer's 
loans deemed distributed for such year under Sec. 1.995-2(a)(5) to the 
extent it is charged to accumulated DISC income under Sec. 1.996-
1(b)(1)(i),
    (iii) The amount of any adjustment to accumulated DISC income for 
such year under Sec. 1.966-4(b)(1), and
    (iv) To the extent they are treated, under Sec. 1.996-1 (a) or (b) 
(relating to ordering rules for distributions), as made out of 
accumulated DISC income, the amounts of any actual qualifying 
distributions pursuant to Sec. 1.992-3 in the order in which they are 
made, and thereafter by the amounts of any other actual distributions in 
the order in which they are made, except that, prior to each actual 
distribution, accumulated DISC income shall be reduced by the portion of 
any deficit in earnings and profits for the taxable year chargeable at 
that time under Sec. 1.996-2(a)(2) to accumulated DISC income.
    (4) Every distribution or other reduction in accumulated DISC income 
pursuant to subparagraph (3) of this paragraph shall be charged to the 
most recently accumulated DISC income.
    (c) Previously taxed income. Under section 996(f)(2), previously 
taxed income as of the close of each taxable year of the corporation is 
an amount equal to--
    (1) The sum of--
    (i) The amount of previously taxed income as of the close of the 
immediately preceding taxable year,
    (ii) Amounts deemed distributed for the current year under Sec. 
1.995-2 (relating to deemed distributions in qualified years),
    (iii) Amounts deemed distributed for the current year under Sec. 
1.995-3 (relating to deemed distributions upon disqualification),

[[Page 789]]

    (iv) With respect to a distribution in redemption to which Sec. 
1.996-4(b)(1) applies, an amount equal to the excess (if any) of (a) the 
amount of the reduction under Sec. 1.996-4(b)(1) in accumulated DISC 
income over (b) the reduction in the corporation's earnings and profits 
(see section 312(e)), and
    (v) Any amount by which accumulated DISC income is reduced under 
paragraph (b)(3)(ii) of this section by reason of a deemed distribution 
as a dividend, under Sec. 1.995-2(a)(5), of an amount of foreign 
investment attributable to producer's loans,
    (2) Decreased (but not below zero), to the extent they are treated, 
under Sec. 1.996-1 (a) or (b) (relating to ordering rules for 
distributions), as made out of previously taxed income, by the amounts 
of any actual qualifying distributions pursuant to Sec. 1.992-3 in the 
order in which they are made, and thereafter by the amounts of any other 
actual distributions in the order in which they are made, except that, 
prior to any actual distribution, previously taxed income shall be 
reduced by the portion of any deficit in earnings and profits for the 
taxable year chargeable at that time under Sec. 1.996-2(a)(3) to 
previously taxed income.
    (d) Other earnings and profits. Under section 996(f)(3), other 
earnings and profits consist of earnings and profits other than 
accumulated DISC income and previously taxed income described 
respectively in paragraphs (b) and (c) of this section. Other earnings 
and profits as of the close of each taxable year of the corporation is 
(subject to paragraph (e) of this section) an amount equal to the amount 
of other earnings and profits as of the close of the immediately 
preceding taxable year decreased (if necessary, below zero) in the 
following order by--
    (1) To the extent they are treated, under Sec. 1.996-1 (a) or (b) 
(relating to ordering rules for distributions), as made out of other 
earnings and profits, the amounts of any actual qualifying distributions 
pursuant to Sec. 1.992-3 in the order in which they are made, and 
thereafter the amounts of any other actual distributions in the order in 
which they are made, except that, prior to any actual distribution, 
other earnings and profits shall be reduced by the portion of any 
deficit in earnings and profits for the taxable year chargeable at that 
time under Sec. 1.996-2(a)(1) to other earnings and profits, and
    (2) With respect to a distribution in redemption to which Sec. 
1.996-4(b)(1) applies, an amount equal to the excess (if any) of (a) the 
reduction in the corporation's earnings and profits (see section 312(e)) 
over (b) the amount of the reduction under Sec. 1.996-4(b)(1) in 
accumulated DISC income.
    (e) Distributions in kind. (1) For purposes of determining, under 
paragraphs (b), (c), and (d) of this section, the amount by which any 
division of earnings and profits is reduced by reason of a distribution 
of property (other than money or the DISC's, or former DISC's, own 
obligations), the amount of such distribution is the fair market value 
of such property at the time of the distribution.
    (2) For any taxable year in which the DISC makes a distribution of 
such property, the amount of other earnings and profits determined under 
paragraph (d) of this section (without regard to this subparagraph) 
shall be--
    (i) Increased by the excess (if any) of the amount of such 
distribution treated as a dividend under section 316(a) over the 
adjusted basis of such property, and
    (ii) Decreased by the excess (if any) of the adjusted basis of such 
property over the amount of such distribution treated as a dividend 
under section 316 (a).


Each item of property shall be considered separately for purposes of 
making the adjustment under this subparagraph.
    (f) Examples. The provisions of Sec. Sec. 1.996-1, 1.996-2, and 
this section may be illustrated by the following examples:

    Example 1. M Corporation, which uses the calendar year as its 
taxable year, elects to be treated as a DISC beginning with 1974. During 
1975, M derives no earnings and profits and makes no deemed or actual 
distributions, except that on December 31, 1975, M's shareholders are 
treated as having received a dividend distribution of $100 under Sec. 
1.995-2 (a)(5) (relating to foreign investment attributable to 
producer's loans). M's earnings and profits are adjusted as shown on 
line (2) of the table below on the basis of facts assumed therein.

[[Page 790]]



----------------------------------------------------------------------------------------------------------------
                                                                                                         Other
                                                                Accumulated  Accumulated  Previously   earnings
                                                                  earnings   DISC income     taxed        and
                                                                and profits                 income      profits
----------------------------------------------------------------------------------------------------------------
(1) Balance January 1, 1975...................................         $450         $100        $250        $100
(2) Adjustments (see paragraphs (b)(3)(ii) and (c)(1)(v) of               0        (100)         100           0
 this section)................................................
                                                               -------------------------------------------------
(3) Balance January 1, 1976...................................          450            0         350         100
----------------------------------------------------------------------------------------------------------------

    Example 2. N Corporation, which uses the calendar year as its 
taxable year, elects to be treated as a DISC beginning with 1972. During 
1973, N derives no earnings and profits for the year and makes no deemed 
or actual distributions, except that A, a shareholder, realized $200 of 
gain upon receiving an actual cash distribution of $300 in redemption of 
N stock having an adjusted basis of $100 in his hands. The redemption is 
treated as an exchange under section 302(a) but, under section 995(c), A 
includes the $200 of gain in his gross income as a dividend. Assuming 
that, under section 312(e), $240 is properly chargeable to capital 
account of N and that, under Sec. 1.996-4(b), accumulated DISC income 
is reduced by $200, N's accounts are adjusted on line (2) of the table 
below on the basis of facts assumed therein.

----------------------------------------------------------------------------------------------------------------
                                                                                                         Other
                                                                Accumulated  Accumulated  Previously   earnings
                                                       Capital    earnings   DISC income     taxed        and
                                                                and profits                 income      profits
----------------------------------------------------------------------------------------------------------------
(1) Balance January 1, 1973.........................    $2,000         $400         $300        $100           0
(2) Adjustments (see Sec. 1.996-4(b) and paragraph     (240)         (60)        (200)         140           0
 (c)(1)(iv) of this section)........................
                                                     -----------------------------------------------------------
(3) Balance January 1, 1974.........................     1,760          340          100         240           0
----------------------------------------------------------------------------------------------------------------

    Example 3. P Corporation, which uses the calendar year as its 
taxable year, elects to be treated as a DISC beginning with 1973. During 
1974, P derives no earnings and profits for the year and makes no deemed 
or actual distributions, except for a distribution to B, its sole 
shareholder, of property with a fair market value of $100 and an 
adjusted basis in P's hands of $40. Under Sec. 1.996-1(a)(1), B treats 
the entire amount of the distribution as being made out of previously 
taxed income and, under Sec. 1.996-1(c), excludes it from his gross 
income. P's earnings and profits, divisions are adjusted on lines (2) 
and (3) of the table below on the basis of facts assumed therein.

----------------------------------------------------------------------------------------------------------------
                                                                                                         Other
                                                                Accumulated  Accumulated  Previously   earnings
                                                                  earnings   DISC income     taxed        and
                                                                and profits                 income      profits
----------------------------------------------------------------------------------------------------------------
(1) Balance January 1, 1974...................................         $200          $80        $120           0
(2) Adjustment under paragraphs (c)(2) and (e)(1) this section         (40)            0       (100)           0
(3) Adjustment under paragraph (e)(2)(i) of this section......            0            0           0         $60
                                                               -------------------------------------------------
(4) Balance January 1, 1975...................................          160           80          20          60
----------------------------------------------------------------------------------------------------------------

    Example 4. Q Corporation, which uses the calendar year as its 
taxable year, elects to be treated as a DISC beginning with 1974. On 
January 1, 1975, Q has accumulated earnings and profits of $1,200 and, 
during 1975, Q incurs a deficit in earnings and profits of $365. The 
amount of such deficit incurred as of any date before the close of 1975 
cannot be shown. On July 1, 1975, Q makes a cash distribution of $650, 
with respect to its stock to C, Q's sole shareholder. C subsequently 
transfers by gift all of his Q stock to D. On December 31, 1975, Q makes 
a cash distribution of $650, with respect to its stock, to D. Under 
these facts and additional facts assumed in the table below, C is 
treated as having received a dividend of $650 of which $320 is treated 
as distributed out of previously taxed income and excluded from gross 
income. D is treated as receiving a dividend of $186. Adjustments to Q's 
earnings and profits accounts are illustrated in the table below:

[[Page 791]]



----------------------------------------------------------------------------------------------------------------
                                                                                                         Other
                                                                Accumulated  Accumulated  Previously   earnings
                                                                  earnings   DISC income     taxed        and
                                                                and profits                 income      profits
----------------------------------------------------------------------------------------------------------------
(1) Balance January 1, 1975...................................       $1,200         $800        $320         $80
(2) Portion of 1975 deficit of $365 chargeable as of June 30,         (181)        (101)           0        (80)
 1975, pursuant to Sec. 1.996-2(a)..........................
                                                               -------------------------------------------------
(3) Balance July 1, 1975......................................        1,019          699         320           0
(4) $650 distributed to C on July 1, 1975.....................        (650)        (330)       (320)           0
(5) Portion of 1975 deficit of $365 chargeable as of December         (183)        (183)           0           0
 30, 1975, pursuant to Sec. 1.996-2(a)......................
                                                               -------------------------------------------------
(6) Balance December 31, 1975.................................         $186         $186           0           0
(7) $650 distributed to D on December 31, 1975 \1\............        (186)        (186)           0           0
                                                               -------------------------------------------------
(8) Balance January 1, 1976...................................            0            0           0           0
----------------------------------------------------------------------------------------------------------------
\1\ $60 treated as return of capital pursuant to section 301(c)(2).

    Example 5. (1) Facts. R Corporation, which uses the calendar year as 
its taxable year elects to be treated as a DISC beginning with 1972. X 
Corporation is its sole shareholder. At the beginning of 1974, R has a 
deficit in earnings and profits of $60 all of which is composed of 
``other earnings and profits''. For 1974, R has earnings and profits of 
$80 before reduction for any distributions and taxable income of $70. On 
June 15, 1974, R makes a cash distribution to X of $60, with respect to 
its stock, to which section 301 applies. On August 15, 1974, R makes a 
cash distribution to X of $30 designated as a distribution to meet 
qualification requirements pursuant to Sec. 1.992-3. Under Sec. 1.995-
2(a), X is deemed to receive, on December 31, 1974, a distribution of a 
dividend of $35, i.e., one-half of R's taxable income of $70. The tax 
consequences of these facts to X and their effect on R's earnings and 
profits are set forth in the subsequent subparagraphs of this example.
    (2) Dividend treatment of actual distributions. Since R had $80 of 
earnings and profits for 1974 and a deficit in accumulated earnings and 
profits at the beginning of 1974, only $80 of the actual distributions 
($90) are treated as dividends under sections 301(c)(1) and 316(a)(2). 
($10 of the actual distribution, which is not treated as a dividend is 
treated in the manner specified in section 301(c) (2) and (3).) Thus, 
under Sec. 1.316-2(b), $26.67 of the actual qualifying distribution 
made on August 15, 1974 ($30 x $80/$90), and $53.33 of the actual 
distribution made on June 15, 1974 ($60 x $80/$90), are considered made 
out of earnings and profits.
    (3) Priority of distributions. Under Sec. 1.996-1(d), for purposes 
of adjusting the divisions of R's earnings and profits and determining 
the treatment of subsequent distributions, the sequence in which each 
distribution is treated as having been made is--
    (i) First, the deemed distribution of $35,
    (ii) Second, the actual qualifying distribution of $30 made on 
August 15, 1974, pursuant to Sec. 1.992-3, and
    (iii) Finally, the actual distribution of $60 made on June 15, 1974.
    (4) Treatment and effect of deemed distribution. Under Sec. 1.995-
2(a), on December 31, 1974, X includes the deemed distribution of $35 in 
its gross income as a dividend. Under paragraph (c)(1)(ii) of this 
section, R's previously taxed income is increased by $35 as shown on 
line (3) of the table in subparagraph (7) of this example. Under 
paragraph (b)(1)(ii) and (2) of this section, accumulated DISC income is 
increased by $45 of DISC income, i.e., R's earnings and profits for 
1974, $80, minus the deemed distribution of $35, as shown on line (4) of 
the table.
    (5) Treatment and effect of actual qualifying distribution of $30. 
As indicated in subparagraph (2) of this example, $26.67 of the $30 
qualifying distribution on August 15, 1974, is treated as made out of 
earnings and profits for 1974. Under Sec. 1.996-1(b)(1)(i), the entire 
$26.67 is treated as distributed out of accumulated DISC income. Thus, 
on August 15, 1974, X includes $26.67 in its gross income as a dividend. 
No deduction is allowable under section 243. Under paragraph (b)(3)(iv) 
of this section, R's accumulated DISC income is reduced by $26.67 as 
shown on line (6) of the table in subparagraph (7) of this example.
    (6) Treatment and effect of actual distribution of $60. As indicated 
in subparagraph (2) of this example, $53.33 of the $60 distribution on 
June 15, 1974, is treated as made out of earnings and profits for 1974. 
Under Sec. 1.996-1(a), the $53.33 is treated as distributed out of 
previously taxed income to the extent thereof, $35, and then out of 
accumulated DISC income, $18.33. Thus, on June 15, 1974, X includes 
$18.33 in its gross income as a dividend. Under Sec. 1.996-1(c), the 
distribution of $35 out of previously taxed income is excluded from 
gross income. No deduction is allowable under section 243 with respect 
to the actual distribution of $53.33. Under paragraph (b)(3)(iv) of this 
section, accumulated DISC income is reduced by $18.33 and, under 
paragraph (c)(2) of this section, previously taxed income is reduced by 
$35, as shown on

[[Page 792]]

line (7) of the table in subparagraph (7) of this example.
    (7) Summary. The effects on earnings and profits and the divisions 
of earnings and profits are summarized in the following table:

----------------------------------------------------------------------------------------------------------------
                                                   Earnings   Accumulated                Previously     Other
                                                 and profits    earnings   Accumulated     taxed       earnings
                                                   for year   and profits  DISC income     income    and profits
----------------------------------------------------------------------------------------------------------------
(1) Balance January 1, 1974....................  ...........     ($60.00)  ...........  ...........     ($60.00)
(2) Earnings and profits for year before              $80.00
 reduction for distributions...................
(3) Deemed distribution of $35 to X on December  ...........  ...........  ...........       $35.00
 31, 1974, under Sec. 1.995-2(a).............
(4) DISC income for 1974 of $45 as defined in    ...........  ...........       $45.00
 paragraph (b)(2) of this section (line 2 ($80)
 minus line 3 ($35))...........................
                                                ----------------------------------------------------------------
(5) Balance before actual distributions........        80.00      (60.00)        45.00        35.00      (60.00)
(6) Qualifying distribution of $30 to X on           (26.67)  ...........      (26.67)
 August 15, 1974, pursuant to Sec. 1.992-3...
(7) Actual distribution to P of $60 on June 15,      (53.33)  ...........      (18.33)      (35.00)
 1974..........................................
                                                ----------------------------------------------------------------
(8) Balance January 1, 1975....................            0      (60.00)            0  ...........      (60.00)
----------------------------------------------------------------------------------------------------------------

    Example 6. Assume the facts are the same as in example 5, except 
that at the beginning of 1974 R's accumulated earnings and profits 
amount to $60 consisting of accumulated DISC income of $20, previously 
taxed income of $10, and other earnings and profits of $30. In addition, 
on August 1, 1974, X transfers all R's stock to Y Corporation in a 
reorganization described in section 368(a)(1)(B) in which under section 
354 X recognizes no gain or loss. Under these facts, X includes in its 
gross income for 1974 a dividend of $15 which is attributable to the 
actual distribution of $60 paid out of earnings and profits on June 15, 
1974. X excludes from gross income the balance of the $60 distribution 
($45) paid out of earnings and profits because, under Sec. 1.996-1(a), 
it is treated as paid out of previously taxed income. Y includes in its 
gross income for 1974 a dividend of $65 of which $35 is attributable to 
the deemed distribution of a dividend to Y on December 31, 1974, under 
Sec. 1.995-2(a) and $30 is attributable to the qualifying distribution 
paid out of earnings and profits to Y on August 15, 1974. The 
adjustments to R's earnings and profits are summarized in the following 
table:

----------------------------------------------------------------------------------------------------------------
                                                   Earnings   Accumulated                Previously     Other
                                                 and profits    earnings   Accumulated     taxed       earnings
                                                   for year   and profits  DISC income     income    and profits
----------------------------------------------------------------------------------------------------------------
(1) Balance January 1, 1974....................  ...........          $60          $20          $10          $30
(2) Earnings and profits for year before                 $80
 reduction for distributions...................
(3) Deemed distribution of $35 to Y on December  ...........  ...........  ...........           35
 31, 1974, under Sec. 1.995-2(a).............
(4) DISC income for 1974 of $45 as defined in    ...........  ...........           45
 paragraph (b)(2) of this section (line 2 ($80)
 minus line 3 ($35))...........................
                                                ----------------------------------------------------------------
(5) Balance before actual distributions........           80           60           65           45           30
(6) Qualifying distribution of $30 to Y on           (26.67)       (3.33)         (30)
 August 15, 1974, pursuant to Sec. 1.992-3...
(7) Actual distribution to X of $60 on June 15,      (53.33)       (6.67)         (15)         (45)
 1974..........................................
                                                ----------------------------------------------------------------
(8) Balance January 1, 1975....................  ...........           50           20            0           30
----------------------------------------------------------------------------------------------------------------

    (g) DISCs having corporate and noncorporate shareholders. In the 
case of a DISC having one or more corporate shareholders but less than 
all of its shareholders subject to the special rules of section 
291(a)(4), relating to certain deferred DISC income as a corporate 
preference item, accumulated DISC income and previously taxed income of 
the DISC are divided between the corporate shareholders, as a class, and 
the other shareholders, as a class,

[[Page 793]]

in proportion to amounts of DISC income not deemed distributed and 
amounts deemed distributed to each class. Subsequent taxation of actual 
and qualifying distributions shall be based upon this division. Thus, if 
a DISC is owned 50 percent by corporate shareholders and 50 percent by 
individual shareholders and has undistributed taxable income of $2,000 
for its year, the division is made as follows:

Corporate shareholders:
    Previously taxed income (57.5% of $2,000 / 2)..........         $575
    Accumulated DISC income (42.5% of $2,000 / 2)..........          425
Individual shareholders:
    Previously taxed income (50% of $2,000 / 2)............          500
    Accumulated DISC income (50% of $2,000 / 2)............          500
 


(Secs. 995(e)(7), (8) and (10), 995(g) and 7805 of the Internal Revenue 
Code of 1954 (90 Stat. 1655, 26 U.S.C. 995 (e)(7), (8) and (10); 90 
Stat. 1659, 26 U.S.C. 995(g); and 68A Stat. 917, 26 U.S.C. 7805))

[T.D. 7324, 39 FR 35121, Sept. 30, 1974, as amended by T.D. 7854, 47 FR 
51742, Nov. 17, 1982; T.D. 7984, 49 FR 40024, Oct. 12, 1984]



Sec. 1.996-4  Subsequent effect of previous disposition of DISC stock.

    (a) Shareholder adjustment for previously taxed income. (1) Under 
section 996(d)(1), except as provided in subparagraph (2) of this 
paragraph, if--
    (i) Gain with respect to a share of stock of a DISC, or former DISC, 
is treated under Sec. 1.995-4 as a dividend, and
    (ii) With respect to such share, any person subsequently receives an 
actual distribution made out of accumulated DISC income, or a deemed 
distribution made, pursuant to Sec. 1.995-3, by reason of 
disqualification, out of accumulated DISC income,


then such person shall treat such distribution in the same manner as a 
distribution from previously taxed income (and thus excludable from 
gross income under Sec. 1.996-1(c)) to the extent that the gain 
referred to in subdivision (i) of this subparagraph exceeds the 
aggregate amount of any other distributions with respect to such share 
which were treated under this subparagraph as made from previously taxed 
income.
    (2) In applying subparagraph (1) of this paragraph with respect to a 
share of stock in a DISC, or former DISC, the gain referred to in 
subparagraph (1)(i) of this paragraph does not include any gain to a 
shareholder on a redemption of such share which qualifies as an exchange 
under section 302(a) or any gain on a disposition of such share prior to 
such redemption. Distributions described in subparagraph (1)(ii) of this 
paragraph do not include a distribution in a redemption which qualifies 
as an exchange under section 302(a). For adjustments to accumulated DISC 
income by reason of dividend treatment under Sec. 1.995-4 with respect 
to gain upon a redemption of DISC stock to which section 302(a) applies 
and upon a prior disposition of such stock, see paragraph (b) of this 
section.
    (3) Example. The provisions of this paragraph may be illustrated by 
the following example:

    Example. In 1974, under Sec. 1.995-4, A, a shareholder of a DISC, 
on the sale of his DISC stock to B, is required to treat $20 of his gain 
as a dividend. The DISC has no previously taxed income and $40 of 
accumulated DISC income. Subsequently in the same year, B, the purchaser 
of the stock, receives an actual dividend distribution of $15 with 
respect to such stock which, under Sec. 1.996-1(a), is treated as made 
out of accumulated DISC income. The amounts of the DISC's previously 
taxed income and accumulated DISC income were not adjusted by reason of 
the $20 treated as a dividend on the prior sale. However, even though 
the DISC had no previously taxed income, the purchaser would treat the 
$15 as though it had been paid out of previously taxed income and, 
therefore would not include the $15 in gross income. If in 1975, B 
receives another actual distribution of $9 with respect to such stock, 
$5 (i.e., $20 dividend on A's sale less the $15 distribution to B in 
1974 which was treated under subparagraph (1) of this paragraph as made 
from previously taxed income) is treated as made from previously taxed 
income and excluded from gross income. The result would be the same if, 
on January 1, 1975, B had transferred such stock to C by gift and the $9 
distribution had been made to C.

    (b) Corporate adjustment upon redemption. (1) Under section 
996(d)(2), if by reason of Sec. 1.995-4 gain on a redemption of stock 
in a DISC, or former DISC, is included in the shareholder's gross income 
as a dividend, then the accumulated DISC income shall be reduced by an 
amount equal to the sum of--

[[Page 794]]

    (i) The amount of gain on such redemption which, under Sec. 1.995-
4, is treated as a dividend, and
    (ii) The amount of any gain with respect to such redeemed stock 
which, under Sec. 1.995-4, was treated as a dividend on a disposition 
prior to such redemption minus the amount of distributions with respect 
to such stock which have been treated as made out of previously taxed 
income by reason of the application of paragraph (a)(1) of this section.
    (2) The provisions of this paragraph may be illustrated by the 
following examples:

    Example 1. The entire stock of a DISC, which uses the calendar year 
as its taxable year, has been owned equally by A, B, C, and D since it 
was organized. At the close of 1976, when the DISC has $100 of 
accumulated DISC income, it redeems all of A's shares in a transaction 
qualifying as an exchange under section 302(a) and A, under Sec. 1.995-
4, includes $25 in his gross income as a dividend. The redemption has 
the effect of reducing accumulated DISC income by $25 to $75.
    Example 2. Assume the same facts as in example 1 except that the 
stock of the DISC has not been held equally by A, B, C, and D since its 
organization. A purchased his shares from X in 1974 in a transaction in 
which X, under Sec. 1.995-4, included in his gross income $30 as a 
dividend. In 1975, A receives a distribution of $10 out of accumulated 
DISC income which, under paragraph (a)(1) of this section, is treated as 
made out of previously taxed income. Under these facts, the redemption 
of A's stock in 1976 has the effect of reducing accumulated DISC income 
by $45 to $55 determined as follows:

(a) Accumulated DISC income.......................  .........       $100
(b) Minus sum of:
  (1) Dividend on redemption of A's stock.........        $25
  (2) Excess of dividend on X's sale ($30) over           $20
   distribution to A treated as made out of
   previously taxed income ($10)..................
    Total.........................................  .........         45
                                                              ----------
(c) Accumulated DISC income on 12/31/76......................         55
 


[T.D. 7324, 39 FR 35121, Sept. 30, 1974]



Sec. 1.996-5  Adjustment to basis.

    (a) Addition to basis. Under section 996(e)(1) amounts representing 
deemed distributions as provided in section 995(b) shall increase the 
basis of the stock with respect to which the distribution is made.
    (b) Reductions of basis. Under section 996(e)(2), the portion of an 
actual distribution treated as made out of previously taxed income shall 
reduce the basis of the stock with respect to which it is made and, to 
the extent that it exceeds the adjusted basis of such stock, shall be 
treated as gain from the sale or exchange of property. In the case of 
stock includible in the gross estate of a decedent for which an election 
is made under section 2032 (relating to alternate valuation), this 
paragraph shall not apply to any distribution made after the date of the 
decendent's death and before the alternate valuation date provided by 
section 2032. See section 1014(d) for a special rule for determining the 
basis of stock in a DISC, or former DISC, acquired from a decedent.

[T.D. 7324, 39 FR 35124, Sept. 30, 1974]



Sec. 1.996-6  Effectively connected income.

    In the case of a shareholder who is a nonresident alien individual 
or a foreign corporation, trust, or estate, amounts taxable as dividends 
by reason of the application of Sec. 1.995-4 (relating to gain on 
disposition of stock in a DISC), amounts treated under Sec. 1.996-1 as 
distributed out of accumulated DISC income, and amounts deemed 
distributed under Sec. 1.995-2(a) (1) through (4) shall be treated as 
gains and distributions which are effectively connected with the conduct 
of a trade or business conducted through a permanent establishment of 
such shareholder within the United States, and shall be subject to tax 
in accordance with the provisions of section 871(b) and the regulations 
thereunder in the case of nonresident alien individuals, trusts, or 
estates, or section 882 and the regulations thereunder in the case of 
foreign corporations. In no case, however shall other income of such 
shareholder be taxable as effectively connected with the conduct of a 
trade or business through a permanent establishment in the United States 
solely because of the application of this section.

[T.D. 7324, 39 FR 35124, Sept. 30, 1974]



Sec. 1.996-7  Carryover of DISC tax attributes.

    (a) In general. Carryover of a DISC's divisions of earnings and 
profits to acquiring corporations in nontaxable

[[Page 795]]

transactions shall be subject to rules generally applicable to other 
corporate tax attributes. For example, a DISC which acquires the assets 
of another DISC in a transaction to which section 381(a) applies shall 
succeed to, and take into account, the divisions of the earnings and 
profits of the transferor DISC in accordance with section 381(c)(2).
    (b) Allocation of divisions of earnings and profits in corporate 
separations. (1) If one DISC transfers part of its assets to a 
controlled DISC in a transaction to which section 368(a)(1)(D) applies 
and immediately thereafter the stock of the controlled DISC is 
distributed in a distribution or exchange to which section 355 (or so 
much of section 356 as relates to section 355) applies, then--
    (i) The earnings and profits of the distributing DISC immediately 
before the transaction shall be allocated between the distributing DISC 
and the controlled DISC in accordance with the provisions of Sec. 
1.312-10.
    (ii) Each of the divisions of such earnings and profits, namely 
previously taxed income, accumulated DISC income, and other earnings and 
profits, shall be allocated between the distributing DISC and the 
controlled DISC on the same basis as the earnings and profits are 
allocated.
    (iii) Any assets of the distributing DISC whose status as qualified 
export assets is limited by its accumulated DISC income (e.g., 
producer's loans described in Sec. 1.993-4, Export-Import Bank and 
other obligations described in Sec. 1.993-2(h), and financing 
obligations described in Sec. 1.993-2(i)) shall be treated as having 
been allocated, for the purpose of determining the classification of 
such assets in the hands of the distributing DISC or the controlled 
DISC, on the same basis as the earnings and profits are allocated 
regardless of how such assets are actually allocated.
    (2) Example. The provisions of this paragraph may be illustrated by 
the following example:

    Example. On January 1, 1974, P Corporation transfers part of its 
assets to S Corporation, a newly organized subsidiary of P, in a 
transaction described in section 368(a)(1)(D) and distributes all the S 
stock in a transaction which qualifies under section 355. Immediately 
before such transfer, P had earnings and profits of $120,000 of which 
$100,000 constitutes accumulated DISC income. The unpaid balance of P's 
producer's loans is $80,000 all of which is retained by P. Pursuant to 
Sec. 1.312-10, 25 percent of P's accumulated DISC income is allocated 
to S (i.e., $25,000). P's producer's loans will be treated as allocated 
to S in the same proportion. Accordingly, for purposes of determining, 
under Sec. 1.993-4(a)(3), the amount of producer's loans which S is 
entitled to make, S is treated as having an unpaid balance of producer's 
loans of $20,000 (i.e., 25% x $80,000) and P is treated as having an 
unpaid balance of $60,000 (i.e., 75% x $80,000).

    (c) Accumulated DISC income accounts of separate DISC's maintained 
after corporate combination. If two or more DISC's combine to form a new 
DISC, or if the assets of one DISC are acquired by another DISC, in a 
transaction described in section 381(a), accumulated DISC income of the 
acquired DISC or DISC's shall carry over and be taken into account by 
the acquiring or new DISC, except that a separate account shall be 
maintained for the accumulated DISC income of any DISC scheduled to be 
received as a deemed distribution by its shareholders under Sec. 1.995-
3 (relating to deemed distributions upon disqualification). If, as a 
part of such transaction, the stock of the DISC which has accumulated 
DISC income scheduled to be deemed distributed is exchanged for stock of 
the acquiring or new DISC to which such accumulated DISC income is 
carried over and which maintains a separate account, then such 
accumulated DISC income shall be deemed distributed pro rata to 
shareholders of the acquiring or new DISC on the basis of stock 
ownership immediately after the exchange.

[T.D. 7324, 39 FR 35125, Sept. 30, 1974]



Sec. 1.996-8  Effect of carryback of capital loss or net operating
loss to prior DISC taxable year.

    (a) Under Sec. 1.995-2(e), the deduction under section 172 for a 
net operating loss carryback or under section 1212 for a capital loss 
carryback is determined as if the DISC were a domestic corporation which 
had not elected to be treated as a DISC. A carryback of a net operating 
loss or of a capital loss of any corporation which reduces its taxable 
income for a preceding taxable year for which it qualified as a DISC 
will have the consequences enumerated in paragraphs (b) through (e) of 
this section.

[[Page 796]]

    (b) For such preceding taxable year, the amount of a deemed 
distribution of one-half of certain taxable income described in Sec. 
1.995-2(a)(4) will ordinarily be reduced in effect (but not below zero) 
by one-half of the sum of the amount of the deduction under section 172 
for such year for net operating loss carrybacks and the amount of the 
deduction under section 1212 for such year for capital loss carrybacks.
    (c) The amount of reduction in the deemed distribution under 
paragraph (b) of this section will have the effect of increasing the 
limitation, provided in Sec. 1.995-2(b)(2), on the amount of foreign 
investment attributable to producer's loans which is deemed distributed 
under Sec. 1.995-2(a)(5).
    (d) If the amount of a deemed distribution for a preceding taxable 
year is reduced as described in paragraph (b) of this section, then for 
such preceding taxable year the previously taxed income (as defined in 
Sec. 1.996-3(c)) shall be decreased by the amount of such reduction and 
the accumulated DISC income (as defined in Sec. 1.996-3(b)) shall be 
increased by the amount of such reduction. Such adjustments shall be 
made as of the time the deemed distribution for such preceding taxable 
year is treated as having occurred. See Sec. 1.996-1(d) for the 
priority of such deemed distribution in relation to other distributions 
made in that preceding taxable year.
    (e) The amount and treatment of any actual distribution made in such 
preceding taxable year or a year subsequent to such preceding year, and 
the treatment of gain on a disposition (in any such year) of the DISC's 
stock to which Sec. 1.995-4 applies, shall be properly adjusted to 
reflect the adjustments to previously taxed income and accumulated DISC 
income described in paragraph (d) of this section.

[T.D. 7324, 39 FR 35125, Sept. 30, 1974]



Sec. 1.997-1  Special rules for subchapter C of the Code.

    (a) For purposes of applying the provisions of sections 301 through 
395 of the Code, any distribution in property to a corporation by a 
DISC, or former DISC, which is made out of previously taxed income or 
accumulated DISC income shall be treated as a distribution in the same 
amount as if such distribution of property were made to an individual, 
and have a basis, in the hands of the recipient corporation, equal to 
such amount treated as having been distributed.
    (b) This section may be illustrated by the following example:

    Example. X Corporation is the sole shareholder of Y Corporation 
which is a DISC. Y makes an actual distribution of property to X with 
respect to X's stock in Y. The property has a basis of $50 and a fair 
market value of $100. The distribution is treated as made out of 
accumulated DISC income under section 996(a) and is taxable as a 
dividend under section 301(c)(1). Even though X is a corporation, the 
amount of the distribution is $100 notwithstanding the provisions of 
section 301(b)(1)(B) and the basis the property in X's hands is $100 
notwithstanding the provisions of section 301(d)(2).

[T.D. 7324, 39 FR 35125, Sept. 30 1974]



Sec. Sec. 1.998-1.1000  [Reserved]

[[Page 797]]



                              FINDING AIDS




  --------------------------------------------------------------------

  A list of CFR titles, subtitles, chapters, subchapters and parts and 
an alphabetical list of agencies publishing in the CFR are included in 
the CFR Index and Finding Aids volume to the Code of Federal Regulations 
which is published separately and revised annually.

  Table of CFR Titles and Chapters
  Alphabetical List of Agencies Appearing in the CFR
  Table of OMB Control Numbers
  List of CFR Sections Affected

[[Page 799]]



                    Table of CFR Titles and Chapters




                      (Revised as of April 1, 2016)

                      Title 1--General Provisions

         I  Administrative Committee of the Federal Register 
                (Parts 1--49)
        II  Office of the Federal Register (Parts 50--299)
       III  Administrative Conference of the United States (Parts 
                300--399)
        IV  Miscellaneous Agencies (Parts 400--500)

                    Title 2--Grants and Agreements

            Subtitle A--Office of Management and Budget Guidance 
                for Grants and Agreements
         I  Office of Management and Budget Governmentwide 
                Guidance for Grants and Agreements (Parts 2--199)
        II  Office of Management and Budget Guidance (Parts 200--
                299)
            Subtitle B--Federal Agency Regulations for Grants and 
                Agreements
       III  Department of Health and Human Services (Parts 300--
                399)
        IV  Department of Agriculture (Parts 400--499)
        VI  Department of State (Parts 600--699)
       VII  Agency for International Development (Parts 700--799)
      VIII  Department of Veterans Affairs (Parts 800--899)
        IX  Department of Energy (Parts 900--999)
         X  Department of the Treasury (Parts 1000--1099)
        XI  Department of Defense (Parts 1100--1199)
       XII  Department of Transportation (Parts 1200--1299)
      XIII  Department of Commerce (Parts 1300--1399)
       XIV  Department of the Interior (Parts 1400--1499)
        XV  Environmental Protection Agency (Parts 1500--1599)
     XVIII  National Aeronautics and Space Administration (Parts 
                1800--1899)
        XX  United States Nuclear Regulatory Commission (Parts 
                2000--2099)
      XXII  Corporation for National and Community Service (Parts 
                2200--2299)
     XXIII  Social Security Administration (Parts 2300--2399)
      XXIV  Housing and Urban Development (Parts 2400--2499)
       XXV  National Science Foundation (Parts 2500--2599)
      XXVI  National Archives and Records Administration (Parts 
                2600--2699)
     XXVII  Small Business Administration (Parts 2700--2799)

[[Page 800]]

    XXVIII  Department of Justice (Parts 2800--2899)
      XXIX  Department of Labor (Parts 2900--2999)
       XXX  Department of Homeland Security (Parts 3000--3099)
      XXXI  Institute of Museum and Library Services (Parts 3100--
                3199)
     XXXII  National Endowment for the Arts (Parts 3200--3299)
    XXXIII  National Endowment for the Humanities (Parts 3300--
                3399)
     XXXIV  Department of Education (Parts 3400--3499)
      XXXV  Export-Import Bank of the United States (Parts 3500--
                3599)
     XXXVI  Office of National Drug Control Policy, Executive 
                Office of the President (Parts 3600--3699)
    XXXVII  Peace Corps (Parts 3700--3799)
     LVIII  Election Assistance Commission (Parts 5800--5899)
       LIX  Gulf Coast Ecosystem Restoration Council (Parts 5900--
                5999)

                        Title 3--The President

         I  Executive Office of the President (Parts 100--199)

                           Title 4--Accounts

         I  Government Accountability Office (Parts 1--199)

                   Title 5--Administrative Personnel

         I  Office of Personnel Management (Parts 1--1199)
        II  Merit Systems Protection Board (Parts 1200--1299)
       III  Office of Management and Budget (Parts 1300--1399)
        IV  Office of Personnel Management and Office of the 
                Director of National Intelligence (Parts 1400--
                1499)
         V  The International Organizations Employees Loyalty 
                Board (Parts 1500--1599)
        VI  Federal Retirement Thrift Investment Board (Parts 
                1600--1699)
      VIII  Office of Special Counsel (Parts 1800--1899)
        IX  Appalachian Regional Commission (Parts 1900--1999)
        XI  Armed Forces Retirement Home (Parts 2100--2199)
       XIV  Federal Labor Relations Authority, General Counsel of 
                the Federal Labor Relations Authority and Federal 
                Service Impasses Panel (Parts 2400--2499)
       XVI  Office of Government Ethics (Parts 2600--2699)
       XXI  Department of the Treasury (Parts 3100--3199)
      XXII  Federal Deposit Insurance Corporation (Parts 3200--
                3299)
     XXIII  Department of Energy (Parts 3300--3399)
      XXIV  Federal Energy Regulatory Commission (Parts 3400--
                3499)
       XXV  Department of the Interior (Parts 3500--3599)
      XXVI  Department of Defense (Parts 3600--3699)
    XXVIII  Department of Justice (Parts 3800--3899)

[[Page 801]]

      XXIX  Federal Communications Commission (Parts 3900--3999)
       XXX  Farm Credit System Insurance Corporation (Parts 4000--
                4099)
      XXXI  Farm Credit Administration (Parts 4100--4199)
    XXXIII  Overseas Private Investment Corporation (Parts 4300--
                4399)
     XXXIV  Securities and Exchange Commission (Parts 4400--4499)
      XXXV  Office of Personnel Management (Parts 4500--4599)
     XXXVI  Department of Homeland Security (Parts 4600--4699)
    XXXVII  Federal Election Commission (Parts 4700--4799)
        XL  Interstate Commerce Commission (Parts 5000--5099)
       XLI  Commodity Futures Trading Commission (Parts 5100--
                5199)
      XLII  Department of Labor (Parts 5200--5299)
     XLIII  National Science Foundation (Parts 5300--5399)
       XLV  Department of Health and Human Services (Parts 5500--
                5599)
      XLVI  Postal Rate Commission (Parts 5600--5699)
     XLVII  Federal Trade Commission (Parts 5700--5799)
    XLVIII  Nuclear Regulatory Commission (Parts 5800--5899)
      XLIX  Federal Labor Relations Authority (Parts 5900--5999)
         L  Department of Transportation (Parts 6000--6099)
       LII  Export-Import Bank of the United States (Parts 6200--
                6299)
      LIII  Department of Education (Parts 6300--6399)
       LIV  Environmental Protection Agency (Parts 6400--6499)
        LV  National Endowment for the Arts (Parts 6500--6599)
       LVI  National Endowment for the Humanities (Parts 6600--
                6699)
      LVII  General Services Administration (Parts 6700--6799)
     LVIII  Board of Governors of the Federal Reserve System 
                (Parts 6800--6899)
       LIX  National Aeronautics and Space Administration (Parts 
                6900--6999)
        LX  United States Postal Service (Parts 7000--7099)
       LXI  National Labor Relations Board (Parts 7100--7199)
      LXII  Equal Employment Opportunity Commission (Parts 7200--
                7299)
     LXIII  Inter-American Foundation (Parts 7300--7399)
      LXIV  Merit Systems Protection Board (Parts 7400--7499)
       LXV  Department of Housing and Urban Development (Parts 
                7500--7599)
      LXVI  National Archives and Records Administration (Parts 
                7600--7699)
     LXVII  Institute of Museum and Library Services (Parts 7700--
                7799)
    LXVIII  Commission on Civil Rights (Parts 7800--7899)
      LXIX  Tennessee Valley Authority (Parts 7900--7999)
       LXX  Court Services and Offender Supervision Agency for the 
                District of Columbia (Parts 8000--8099)
      LXXI  Consumer Product Safety Commission (Parts 8100--8199)
    LXXIII  Department of Agriculture (Parts 8300--8399)
     LXXIV  Federal Mine Safety and Health Review Commission 
                (Parts 8400--8499)

[[Page 802]]

     LXXVI  Federal Retirement Thrift Investment Board (Parts 
                8600--8699)
    LXXVII  Office of Management and Budget (Parts 8700--8799)
      LXXX  Federal Housing Finance Agency (Parts 9000--9099)
   LXXXIII  Special Inspector General for Afghanistan 
                Reconstruction (Parts 9300--9399)
    LXXXIV  Bureau of Consumer Financial Protection (Parts 9400--
                9499)
    LXXXVI  National Credit Union Administration (Parts 9600--
                9699)
     XCVII  Department of Homeland Security Human Resources 
                Management System (Department of Homeland 
                Security--Office of Personnel Management) (Parts 
                9700--9799)
     XCVII  Council of the Inspectors General on Integrity and 
                Efficiency (Parts 9800--9899)
      XCIX  Military Compensation and Retirement Modernization 
                Commission (Parts 9900--9999)
         C  National Council on Disability (Partys 10000--10049)

                      Title 6--Domestic Security

         I  Department of Homeland Security, Office of the 
                Secretary (Parts 1--199)
         X  Privacy and Civil Liberties Oversight Board (Parts 
                1000--1099)

                         Title 7--Agriculture

            Subtitle A--Office of the Secretary of Agriculture 
                (Parts 0--26)
            Subtitle B--Regulations of the Department of 
                Agriculture
         I  Agricultural Marketing Service (Standards, 
                Inspections, Marketing Practices), Department of 
                Agriculture (Parts 27--209)
        II  Food and Nutrition Service, Department of Agriculture 
                (Parts 210--299)
       III  Animal and Plant Health Inspection Service, Department 
                of Agriculture (Parts 300--399)
        IV  Federal Crop Insurance Corporation, Department of 
                Agriculture (Parts 400--499)
         V  Agricultural Research Service, Department of 
                Agriculture (Parts 500--599)
        VI  Natural Resources Conservation Service, Department of 
                Agriculture (Parts 600--699)
       VII  Farm Service Agency, Department of Agriculture (Parts 
                700--799)
      VIII  Grain Inspection, Packers and Stockyards 
                Administration (Federal Grain Inspection Service), 
                Department of Agriculture (Parts 800--899)
        IX  Agricultural Marketing Service (Marketing Agreements 
                and Orders; Fruits, Vegetables, Nuts), Department 
                of Agriculture (Parts 900--999)
         X  Agricultural Marketing Service (Marketing Agreements 
                and Orders; Milk), Department of Agriculture 
                (Parts 1000--1199)

[[Page 803]]

        XI  Agricultural Marketing Service (Marketing Agreements 
                and Orders; Miscellaneous Commodities), Department 
                of Agriculture (Parts 1200--1299)
       XIV  Commodity Credit Corporation, Department of 
                Agriculture (Parts 1400--1499)
        XV  Foreign Agricultural Service, Department of 
                Agriculture (Parts 1500--1599)
       XVI  Rural Telephone Bank, Department of Agriculture (Parts 
                1600--1699)
      XVII  Rural Utilities Service, Department of Agriculture 
                (Parts 1700--1799)
     XVIII  Rural Housing Service, Rural Business-Cooperative 
                Service, Rural Utilities Service, and Farm Service 
                Agency, Department of Agriculture (Parts 1800--
                2099)
        XX  Local Television Loan Guarantee Board (Parts 2200--
                2299)
       XXV  Office of Advocacy and Outreach, Department of 
                Agriculture (Parts 2500--2599)
      XXVI  Office of Inspector General, Department of Agriculture 
                (Parts 2600--2699)
     XXVII  Office of Information Resources Management, Department 
                of Agriculture (Parts 2700--2799)
    XXVIII  Office of Operations, Department of Agriculture (Parts 
                2800--2899)
      XXIX  Office of Energy Policy and New Uses, Department of 
                Agriculture (Parts 2900--2999)
       XXX  Office of the Chief Financial Officer, Department of 
                Agriculture (Parts 3000--3099)
      XXXI  Office of Environmental Quality, Department of 
                Agriculture (Parts 3100--3199)
     XXXII  Office of Procurement and Property Management, 
                Department of Agriculture (Parts 3200--3299)
    XXXIII  Office of Transportation, Department of Agriculture 
                (Parts 3300--3399)
     XXXIV  National Institute of Food and Agriculture (Parts 
                3400--3499)
      XXXV  Rural Housing Service, Department of Agriculture 
                (Parts 3500--3599)
     XXXVI  National Agricultural Statistics Service, Department 
                of Agriculture (Parts 3600--3699)
    XXXVII  Economic Research Service, Department of Agriculture 
                (Parts 3700--3799)
   XXXVIII  World Agricultural Outlook Board, Department of 
                Agriculture (Parts 3800--3899)
       XLI  [Reserved]
      XLII  Rural Business-Cooperative Service and Rural Utilities 
                Service, Department of Agriculture (Parts 4200--
                4299)

                    Title 8--Aliens and Nationality

         I  Department of Homeland Security (Immigration and 
                Naturalization) (Parts 1--499)

[[Page 804]]

         V  Executive Office for Immigration Review, Department of 
                Justice (Parts 1000--1399)

                 Title 9--Animals and Animal Products

         I  Animal and Plant Health Inspection Service, Department 
                of Agriculture (Parts 1--199)
        II  Grain Inspection, Packers and Stockyards 
                Administration (Packers and Stockyards Programs), 
                Department of Agriculture (Parts 200--299)
       III  Food Safety and Inspection Service, Department of 
                Agriculture (Parts 300--599)

                           Title 10--Energy

         I  Nuclear Regulatory Commission (Parts 0--199)
        II  Department of Energy (Parts 200--699)
       III  Department of Energy (Parts 700--999)
         X  Department of Energy (General Provisions) (Parts 
                1000--1099)
      XIII  Nuclear Waste Technical Review Board (Parts 1300--
                1399)
      XVII  Defense Nuclear Facilities Safety Board (Parts 1700--
                1799)
     XVIII  Northeast Interstate Low-Level Radioactive Waste 
                Commission (Parts 1800--1899)

                      Title 11--Federal Elections

         I  Federal Election Commission (Parts 1--9099)
        II  Election Assistance Commission (Parts 9400--9499)

                      Title 12--Banks and Banking

         I  Comptroller of the Currency, Department of the 
                Treasury (Parts 1--199)
        II  Federal Reserve System (Parts 200--299)
       III  Federal Deposit Insurance Corporation (Parts 300--399)
        IV  Export-Import Bank of the United States (Parts 400--
                499)
         V  Office of Thrift Supervision, Department of the 
                Treasury (Parts 500--599)
        VI  Farm Credit Administration (Parts 600--699)
       VII  National Credit Union Administration (Parts 700--799)
      VIII  Federal Financing Bank (Parts 800--899)
        IX  Federal Housing Finance Board (Parts 900--999)
         X  Bureau of Consumer Financial Protection (Parts 1000--
                1099)
        XI  Federal Financial Institutions Examination Council 
                (Parts 1100--1199)
       XII  Federal Housing Finance Agency (Parts 1200--1299)
      XIII  Financial Stability Oversight Council (Parts 1300--
                1399)
       XIV  Farm Credit System Insurance Corporation (Parts 1400--
                1499)

[[Page 805]]

        XV  Department of the Treasury (Parts 1500--1599)
       XVI  Office of Financial Research (Parts 1600--1699)
      XVII  Office of Federal Housing Enterprise Oversight, 
                Department of Housing and Urban Development (Parts 
                1700--1799)
     XVIII  Community Development Financial Institutions Fund, 
                Department of the Treasury (Parts 1800--1899)

               Title 13--Business Credit and Assistance

         I  Small Business Administration (Parts 1--199)
       III  Economic Development Administration, Department of 
                Commerce (Parts 300--399)
        IV  Emergency Steel Guarantee Loan Board (Parts 400--499)
         V  Emergency Oil and Gas Guaranteed Loan Board (Parts 
                500--599)

                    Title 14--Aeronautics and Space

         I  Federal Aviation Administration, Department of 
                Transportation (Parts 1--199)
        II  Office of the Secretary, Department of Transportation 
                (Aviation Proceedings) (Parts 200--399)
       III  Commercial Space Transportation, Federal Aviation 
                Administration, Department of Transportation 
                (Parts 400--1199)
         V  National Aeronautics and Space Administration (Parts 
                1200--1299)
        VI  Air Transportation System Stabilization (Parts 1300--
                1399)

                 Title 15--Commerce and Foreign Trade

            Subtitle A--Office of the Secretary of Commerce (Parts 
                0--29)
            Subtitle B--Regulations Relating to Commerce and 
                Foreign Trade
         I  Bureau of the Census, Department of Commerce (Parts 
                30--199)
        II  National Institute of Standards and Technology, 
                Department of Commerce (Parts 200--299)
       III  International Trade Administration, Department of 
                Commerce (Parts 300--399)
        IV  Foreign-Trade Zones Board, Department of Commerce 
                (Parts 400--499)
       VII  Bureau of Industry and Security, Department of 
                Commerce (Parts 700--799)
      VIII  Bureau of Economic Analysis, Department of Commerce 
                (Parts 800--899)
        IX  National Oceanic and Atmospheric Administration, 
                Department of Commerce (Parts 900--999)
        XI  Technology Administration, Department of Commerce 
                (Parts 1100--1199)
      XIII  East-West Foreign Trade Board (Parts 1300--1399)

[[Page 806]]

       XIV  Minority Business Development Agency (Parts 1400--
                1499)
            Subtitle C--Regulations Relating to Foreign Trade 
                Agreements
        XX  Office of the United States Trade Representative 
                (Parts 2000--2099)
            Subtitle D--Regulations Relating to Telecommunications 
                and Information
     XXIII  National Telecommunications and Information 
                Administration, Department of Commerce (Parts 
                2300--2399)

                    Title 16--Commercial Practices

         I  Federal Trade Commission (Parts 0--999)
        II  Consumer Product Safety Commission (Parts 1000--1799)

             Title 17--Commodity and Securities Exchanges

         I  Commodity Futures Trading Commission (Parts 1--199)
        II  Securities and Exchange Commission (Parts 200--399)
        IV  Department of the Treasury (Parts 400--499)

          Title 18--Conservation of Power and Water Resources

         I  Federal Energy Regulatory Commission, Department of 
                Energy (Parts 1--399)
       III  Delaware River Basin Commission (Parts 400--499)
        VI  Water Resources Council (Parts 700--799)
      VIII  Susquehanna River Basin Commission (Parts 800--899)
      XIII  Tennessee Valley Authority (Parts 1300--1399)

                       Title 19--Customs Duties

         I  U.S. Customs and Border Protection, Department of 
                Homeland Security; Department of the Treasury 
                (Parts 0--199)
        II  United States International Trade Commission (Parts 
                200--299)
       III  International Trade Administration, Department of 
                Commerce (Parts 300--399)
        IV  U.S. Immigration and Customs Enforcement, Department 
                of Homeland Security (Parts 400--599)

                     Title 20--Employees' Benefits

         I  Office of Workers' Compensation Programs, Department 
                of Labor (Parts 1--199)
        II  Railroad Retirement Board (Parts 200--399)
       III  Social Security Administration (Parts 400--499)
        IV  Employees' Compensation Appeals Board, Department of 
                Labor (Parts 500--599)

[[Page 807]]

         V  Employment and Training Administration, Department of 
                Labor (Parts 600--699)
        VI  Office of Workers' Compensation Programs, Department 
                of Labor (Parts 700--799)
       VII  Benefits Review Board, Department of Labor (Parts 
                800--899)
      VIII  Joint Board for the Enrollment of Actuaries (Parts 
                900--999)
        IX  Office of the Assistant Secretary for Veterans' 
                Employment and Training Service, Department of 
                Labor (Parts 1000--1099)

                       Title 21--Food and Drugs

         I  Food and Drug Administration, Department of Health and 
                Human Services (Parts 1--1299)
        II  Drug Enforcement Administration, Department of Justice 
                (Parts 1300--1399)
       III  Office of National Drug Control Policy (Parts 1400--
                1499)

                      Title 22--Foreign Relations

         I  Department of State (Parts 1--199)
        II  Agency for International Development (Parts 200--299)
       III  Peace Corps (Parts 300--399)
        IV  International Joint Commission, United States and 
                Canada (Parts 400--499)
         V  Broadcasting Board of Governors (Parts 500--599)
       VII  Overseas Private Investment Corporation (Parts 700--
                799)
        IX  Foreign Service Grievance Board (Parts 900--999)
         X  Inter-American Foundation (Parts 1000--1099)
        XI  International Boundary and Water Commission, United 
                States and Mexico, United States Section (Parts 
                1100--1199)
       XII  United States International Development Cooperation 
                Agency (Parts 1200--1299)
      XIII  Millennium Challenge Corporation (Parts 1300--1399)
       XIV  Foreign Service Labor Relations Board; Federal Labor 
                Relations Authority; General Counsel of the 
                Federal Labor Relations Authority; and the Foreign 
                Service Impasse Disputes Panel (Parts 1400--1499)
        XV  African Development Foundation (Parts 1500--1599)
       XVI  Japan-United States Friendship Commission (Parts 
                1600--1699)
      XVII  United States Institute of Peace (Parts 1700--1799)

                          Title 23--Highways

         I  Federal Highway Administration, Department of 
                Transportation (Parts 1--999)
        II  National Highway Traffic Safety Administration and 
                Federal Highway Administration, Department of 
                Transportation (Parts 1200--1299)

[[Page 808]]

       III  National Highway Traffic Safety Administration, 
                Department of Transportation (Parts 1300--1399)

                Title 24--Housing and Urban Development

            Subtitle A--Office of the Secretary, Department of 
                Housing and Urban Development (Parts 0--99)
            Subtitle B--Regulations Relating to Housing and Urban 
                Development
         I  Office of Assistant Secretary for Equal Opportunity, 
                Department of Housing and Urban Development (Parts 
                100--199)
        II  Office of Assistant Secretary for Housing-Federal 
                Housing Commissioner, Department of Housing and 
                Urban Development (Parts 200--299)
       III  Government National Mortgage Association, Department 
                of Housing and Urban Development (Parts 300--399)
        IV  Office of Housing and Office of Multifamily Housing 
                Assistance Restructuring, Department of Housing 
                and Urban Development (Parts 400--499)
         V  Office of Assistant Secretary for Community Planning 
                and Development, Department of Housing and Urban 
                Development (Parts 500--599)
        VI  Office of Assistant Secretary for Community Planning 
                and Development, Department of Housing and Urban 
                Development (Parts 600--699) [Reserved]
       VII  Office of the Secretary, Department of Housing and 
                Urban Development (Housing Assistance Programs and 
                Public and Indian Housing Programs) (Parts 700--
                799)
      VIII  Office of the Assistant Secretary for Housing--Federal 
                Housing Commissioner, Department of Housing and 
                Urban Development (Section 8 Housing Assistance 
                Programs, Section 202 Direct Loan Program, Section 
                202 Supportive Housing for the Elderly Program and 
                Section 811 Supportive Housing for Persons With 
                Disabilities Program) (Parts 800--899)
        IX  Office of Assistant Secretary for Public and Indian 
                Housing, Department of Housing and Urban 
                Development (Parts 900--1699)
         X  Office of Assistant Secretary for Housing--Federal 
                Housing Commissioner, Department of Housing and 
                Urban Development (Interstate Land Sales 
                Registration Program) (Parts 1700--1799)
       XII  Office of Inspector General, Department of Housing and 
                Urban Development (Parts 2000--2099)
        XV  Emergency Mortgage Insurance and Loan Programs, 
                Department of Housing and Urban Development (Parts 
                2700--2799) [Reserved]
        XX  Office of Assistant Secretary for Housing--Federal 
                Housing Commissioner, Department of Housing and 
                Urban Development (Parts 3200--3899)
      XXIV  Board of Directors of the HOPE for Homeowners Program 
                (Parts 4000--4099) [Reserved]
       XXV  Neighborhood Reinvestment Corporation (Parts 4100--
                4199)

[[Page 809]]

                           Title 25--Indians

         I  Bureau of Indian Affairs, Department of the Interior 
                (Parts 1--299)
        II  Indian Arts and Crafts Board, Department of the 
                Interior (Parts 300--399)
       III  National Indian Gaming Commission, Department of the 
                Interior (Parts 500--599)
        IV  Office of Navajo and Hopi Indian Relocation (Parts 
                700--799)
         V  Bureau of Indian Affairs, Department of the Interior, 
                and Indian Health Service, Department of Health 
                and Human Services (Part 900)
        VI  Office of the Assistant Secretary-Indian Affairs, 
                Department of the Interior (Parts 1000--1199)
       VII  Office of the Special Trustee for American Indians, 
                Department of the Interior (Parts 1200--1299)

                      Title 26--Internal Revenue

         I  Internal Revenue Service, Department of the Treasury 
                (Parts 1--End)

           Title 27--Alcohol, Tobacco Products and Firearms

         I  Alcohol and Tobacco Tax and Trade Bureau, Department 
                of the Treasury (Parts 1--399)
        II  Bureau of Alcohol, Tobacco, Firearms, and Explosives, 
                Department of Justice (Parts 400--699)

                   Title 28--Judicial Administration

         I  Department of Justice (Parts 0--299)
       III  Federal Prison Industries, Inc., Department of Justice 
                (Parts 300--399)
         V  Bureau of Prisons, Department of Justice (Parts 500--
                599)
        VI  Offices of Independent Counsel, Department of Justice 
                (Parts 600--699)
       VII  Office of Independent Counsel (Parts 700--799)
      VIII  Court Services and Offender Supervision Agency for the 
                District of Columbia (Parts 800--899)
        IX  National Crime Prevention and Privacy Compact Council 
                (Parts 900--999)
        XI  Department of Justice and Department of State (Parts 
                1100--1199)

                            Title 29--Labor

            Subtitle A--Office of the Secretary of Labor (Parts 
                0--99)
            Subtitle B--Regulations Relating to Labor
         I  National Labor Relations Board (Parts 100--199)

[[Page 810]]

        II  Office of Labor-Management Standards, Department of 
                Labor (Parts 200--299)
       III  National Railroad Adjustment Board (Parts 300--399)
        IV  Office of Labor-Management Standards, Department of 
                Labor (Parts 400--499)
         V  Wage and Hour Division, Department of Labor (Parts 
                500--899)
        IX  Construction Industry Collective Bargaining Commission 
                (Parts 900--999)
         X  National Mediation Board (Parts 1200--1299)
       XII  Federal Mediation and Conciliation Service (Parts 
                1400--1499)
       XIV  Equal Employment Opportunity Commission (Parts 1600--
                1699)
      XVII  Occupational Safety and Health Administration, 
                Department of Labor (Parts 1900--1999)
        XX  Occupational Safety and Health Review Commission 
                (Parts 2200--2499)
       XXV  Employee Benefits Security Administration, Department 
                of Labor (Parts 2500--2599)
     XXVII  Federal Mine Safety and Health Review Commission 
                (Parts 2700--2799)
        XL  Pension Benefit Guaranty Corporation (Parts 4000--
                4999)

                      Title 30--Mineral Resources

         I  Mine Safety and Health Administration, Department of 
                Labor (Parts 1--199)
        II  Bureau of Safety and Environmental Enforcement, 
                Department of the Interior (Parts 200--299)
        IV  Geological Survey, Department of the Interior (Parts 
                400--499)
         V  Bureau of Ocean Energy Management, Department of the 
                Interior (Parts 500--599)
       VII  Office of Surface Mining Reclamation and Enforcement, 
                Department of the Interior (Parts 700--999)
       XII  Office of Natural Resources Revenue, Department of the 
                Interior (Parts 1200--1299)

                 Title 31--Money and Finance: Treasury

            Subtitle A--Office of the Secretary of the Treasury 
                (Parts 0--50)
            Subtitle B--Regulations Relating to Money and Finance
         I  Monetary Offices, Department of the Treasury (Parts 
                51--199)
        II  Fiscal Service, Department of the Treasury (Parts 
                200--399)
        IV  Secret Service, Department of the Treasury (Parts 
                400--499)
         V  Office of Foreign Assets Control, Department of the 
                Treasury (Parts 500--599)
        VI  Bureau of Engraving and Printing, Department of the 
                Treasury (Parts 600--699)
       VII  Federal Law Enforcement Training Center, Department of 
                the Treasury (Parts 700--799)

[[Page 811]]

      VIII  Office of International Investment, Department of the 
                Treasury (Parts 800--899)
        IX  Federal Claims Collection Standards (Department of the 
                Treasury--Department of Justice) (Parts 900--999)
         X  Financial Crimes Enforcement Network, Department of 
                the Treasury (Parts 1000--1099)

                      Title 32--National Defense

            Subtitle A--Department of Defense
         I  Office of the Secretary of Defense (Parts 1--399)
         V  Department of the Army (Parts 400--699)
        VI  Department of the Navy (Parts 700--799)
       VII  Department of the Air Force (Parts 800--1099)
            Subtitle B--Other Regulations Relating to National 
                Defense
       XII  Defense Logistics Agency (Parts 1200--1299)
       XVI  Selective Service System (Parts 1600--1699)
      XVII  Office of the Director of National Intelligence (Parts 
                1700--1799)
     XVIII  National Counterintelligence Center (Parts 1800--1899)
       XIX  Central Intelligence Agency (Parts 1900--1999)
        XX  Information Security Oversight Office, National 
                Archives and Records Administration (Parts 2000--
                2099)
       XXI  National Security Council (Parts 2100--2199)
      XXIV  Office of Science and Technology Policy (Parts 2400--
                2499)
     XXVII  Office for Micronesian Status Negotiations (Parts 
                2700--2799)
    XXVIII  Office of the Vice President of the United States 
                (Parts 2800--2899)

               Title 33--Navigation and Navigable Waters

         I  Coast Guard, Department of Homeland Security (Parts 
                1--199)
        II  Corps of Engineers, Department of the Army (Parts 
                200--399)
        IV  Saint Lawrence Seaway Development Corporation, 
                Department of Transportation (Parts 400--499)

                          Title 34--Education

            Subtitle A--Office of the Secretary, Department of 
                Education (Parts 1--99)
            Subtitle B--Regulations of the Offices of the 
                Department of Education
         I  Office for Civil Rights, Department of Education 
                (Parts 100--199)
        II  Office of Elementary and Secondary Education, 
                Department of Education (Parts 200--299)
       III  Office of Special Education and Rehabilitative 
                Services, Department of Education (Parts 300--399)

[[Page 812]]

        IV  Office of Career, Technical and Adult Education, 
                Department of Education (Parts 400--499)
         V  Office of Bilingual Education and Minority Languages 
                Affairs, Department of Education (Parts 500--
                599)[Reserved]
        VI  Office of Postsecondary Education, Department of 
                Education (Parts 600--699)
       VII  Office of Educational Research and Improvement, 
                Department of Education (Parts 700--799)[Reserved]
            Subtitle C--Regulations Relating to Education
        XI  [Reserved]
       XII  National Council on Disability (Parts 1200--1299)

                          Title 35 [Reserved]

             Title 36--Parks, Forests, and Public Property

         I  National Park Service, Department of the Interior 
                (Parts 1--199)
        II  Forest Service, Department of Agriculture (Parts 200--
                299)
       III  Corps of Engineers, Department of the Army (Parts 
                300--399)
        IV  American Battle Monuments Commission (Parts 400--499)
         V  Smithsonian Institution (Parts 500--599)
        VI  [Reserved]
       VII  Library of Congress (Parts 700--799)
      VIII  Advisory Council on Historic Preservation (Parts 800--
                899)
        IX  Pennsylvania Avenue Development Corporation (Parts 
                900--999)
         X  Presidio Trust (Parts 1000--1099)
        XI  Architectural and Transportation Barriers Compliance 
                Board (Parts 1100--1199)
       XII  National Archives and Records Administration (Parts 
                1200--1299)
        XV  Oklahoma City National Memorial Trust (Parts 1500--
                1599)
       XVI  Morris K. Udall Scholarship and Excellence in National 
                Environmental Policy Foundation (Parts 1600--1699)

             Title 37--Patents, Trademarks, and Copyrights

         I  United States Patent and Trademark Office, Department 
                of Commerce (Parts 1--199)
        II  U.S. Copyright Office, Library of Congress (Parts 
                200--299)
       III  Copyright Royalty Board, Library of Congress (Parts 
                300--399)
        IV  Assistant Secretary for Technology Policy, Department 
                of Commerce (Parts 400--599)

           Title 38--Pensions, Bonuses, and Veterans' Relief

         I  Department of Veterans Affairs (Parts 0--199)
        II  Armed Forces Retirement Home (Parts 200--299)

[[Page 813]]

                       Title 39--Postal Service

         I  United States Postal Service (Parts 1--999)
       III  Postal Regulatory Commission (Parts 3000--3099)

                  Title 40--Protection of Environment

         I  Environmental Protection Agency (Parts 1--1099)
        IV  Environmental Protection Agency and Department of 
                Justice (Parts 1400--1499)
         V  Council on Environmental Quality (Parts 1500--1599)
        VI  Chemical Safety and Hazard Investigation Board (Parts 
                1600--1699)
       VII  Environmental Protection Agency and Department of 
                Defense; Uniform National Discharge Standards for 
                Vessels of the Armed Forces (Parts 1700--1799)
      VIII  Gulf Coast Ecosystem Restoration Council (Parts 1800--
                1899)

          Title 41--Public Contracts and Property Management

            Subtitle A--Federal Procurement Regulations System 
                [Note]
            Subtitle B--Other Provisions Relating to Public 
                Contracts
        50  Public Contracts, Department of Labor (Parts 50-1--50-
                999)
        51  Committee for Purchase From People Who Are Blind or 
                Severely Disabled (Parts 51-1--51-99)
        60  Office of Federal Contract Compliance Programs, Equal 
                Employment Opportunity, Department of Labor (Parts 
                60-1--60-999)
        61  Office of the Assistant Secretary for Veterans' 
                Employment and Training Service, Department of 
                Labor (Parts 61-1--61-999)
   62--100  [Reserved]
            Subtitle C--Federal Property Management Regulations 
                System
       101  Federal Property Management Regulations (Parts 101-1--
                101-99)
       102  Federal Management Regulation (Parts 102-1--102-299)
  103--104  [Reserved]
       105  General Services Administration (Parts 105-1--105-999)
       109  Department of Energy Property Management Regulations 
                (Parts 109-1--109-99)
       114  Department of the Interior (Parts 114-1--114-99)
       115  Environmental Protection Agency (Parts 115-1--115-99)
       128  Department of Justice (Parts 128-1--128-99)
  129--200  [Reserved]
            Subtitle D--Other Provisions Relating to Property 
                Management [Reserved]
            Subtitle E--Federal Information Resources Management 
                Regulations System [Reserved]
            Subtitle F--Federal Travel Regulation System
       300  General (Parts 300-1--300-99)
       301  Temporary Duty (TDY) Travel Allowances (Parts 301-1--
                301-99)

[[Page 814]]

       302  Relocation Allowances (Parts 302-1--302-99)
       303  Payment of Expenses Connected with the Death of 
                Certain Employees (Part 303-1--303-99)
       304  Payment of Travel Expenses from a Non-Federal Source 
                (Parts 304-1--304-99)

                        Title 42--Public Health

         I  Public Health Service, Department of Health and Human 
                Services (Parts 1--199)
        IV  Centers for Medicare & Medicaid Services, Department 
                of Health and Human Services (Parts 400--599)
         V  Office of Inspector General-Health Care, Department of 
                Health and Human Services (Parts 1000--1999)

                   Title 43--Public Lands: Interior

            Subtitle A--Office of the Secretary of the Interior 
                (Parts 1--199)
            Subtitle B--Regulations Relating to Public Lands
         I  Bureau of Reclamation, Department of the Interior 
                (Parts 400--999)
        II  Bureau of Land Management, Department of the Interior 
                (Parts 1000--9999)
       III  Utah Reclamation Mitigation and Conservation 
                Commission (Parts 10000--10099)

             Title 44--Emergency Management and Assistance

         I  Federal Emergency Management Agency, Department of 
                Homeland Security (Parts 0--399)
        IV  Department of Commerce and Department of 
                Transportation (Parts 400--499)

                       Title 45--Public Welfare

            Subtitle A--Department of Health and Human Services 
                (Parts 1--199)
            Subtitle B--Regulations Relating to Public Welfare
        II  Office of Family Assistance (Assistance Programs), 
                Administration for Children and Families, 
                Department of Health and Human Services (Parts 
                200--299)
       III  Office of Child Support Enforcement (Child Support 
                Enforcement Program), Administration for Children 
                and Families, Department of Health and Human 
                Services (Parts 300--399)
        IV  Office of Refugee Resettlement, Administration for 
                Children and Families, Department of Health and 
                Human Services (Parts 400--499)
         V  Foreign Claims Settlement Commission of the United 
                States, Department of Justice (Parts 500--599)

[[Page 815]]

        VI  National Science Foundation (Parts 600--699)
       VII  Commission on Civil Rights (Parts 700--799)
      VIII  Office of Personnel Management (Parts 800--899)
         X  Office of Community Services, Administration for 
                Children and Families, Department of Health and 
                Human Services (Parts 1000--1099)
        XI  National Foundation on the Arts and the Humanities 
                (Parts 1100--1199)
       XII  Corporation for National and Community Service (Parts 
                1200--1299)
      XIII  Office of Human Development Services, Department of 
                Health and Human Services (Parts 1300--1399)
       XVI  Legal Services Corporation (Parts 1600--1699)
      XVII  National Commission on Libraries and Information 
                Science (Parts 1700--1799)
     XVIII  Harry S. Truman Scholarship Foundation (Parts 1800--
                1899)
       XXI  Commission on Fine Arts (Parts 2100--2199)
     XXIII  Arctic Research Commission (Part 2301)
      XXIV  James Madison Memorial Fellowship Foundation (Parts 
                2400--2499)
       XXV  Corporation for National and Community Service (Parts 
                2500--2599)

                          Title 46--Shipping

         I  Coast Guard, Department of Homeland Security (Parts 
                1--199)
        II  Maritime Administration, Department of Transportation 
                (Parts 200--399)
       III  Coast Guard (Great Lakes Pilotage), Department of 
                Homeland Security (Parts 400--499)
        IV  Federal Maritime Commission (Parts 500--599)

                      Title 47--Telecommunication

         I  Federal Communications Commission (Parts 0--199)
        II  Office of Science and Technology Policy and National 
                Security Council (Parts 200--299)
       III  National Telecommunications and Information 
                Administration, Department of Commerce (Parts 
                300--399)
        IV  National Telecommunications and Information 
                Administration, Department of Commerce, and 
                National Highway Traffic Safety Administration, 
                Department of Transportation (Parts 400--499)

           Title 48--Federal Acquisition Regulations System

         1  Federal Acquisition Regulation (Parts 1--99)
         2  Defense Acquisition Regulations System, Department of 
                Defense (Parts 200--299)

[[Page 816]]

         3  Health and Human Services (Parts 300--399)
         4  Department of Agriculture (Parts 400--499)
         5  General Services Administration (Parts 500--599)
         6  Department of State (Parts 600--699)
         7  Agency for International Development (Parts 700--799)
         8  Department of Veterans Affairs (Parts 800--899)
         9  Department of Energy (Parts 900--999)
        10  Department of the Treasury (Parts 1000--1099)
        12  Department of Transportation (Parts 1200--1299)
        13  Department of Commerce (Parts 1300--1399)
        14  Department of the Interior (Parts 1400--1499)
        15  Environmental Protection Agency (Parts 1500--1599)
        16  Office of Personnel Management, Federal Employees 
                Health Benefits Acquisition Regulation (Parts 
                1600--1699)
        17  Office of Personnel Management (Parts 1700--1799)
        18  National Aeronautics and Space Administration (Parts 
                1800--1899)
        19  Broadcasting Board of Governors (Parts 1900--1999)
        20  Nuclear Regulatory Commission (Parts 2000--2099)
        21  Office of Personnel Management, Federal Employees 
                Group Life Insurance Federal Acquisition 
                Regulation (Parts 2100--2199)
        23  Social Security Administration (Parts 2300--2399)
        24  Department of Housing and Urban Development (Parts 
                2400--2499)
        25  National Science Foundation (Parts 2500--2599)
        28  Department of Justice (Parts 2800--2899)
        29  Department of Labor (Parts 2900--2999)
        30  Department of Homeland Security, Homeland Security 
                Acquisition Regulation (HSAR) (Parts 3000--3099)
        34  Department of Education Acquisition Regulation (Parts 
                3400--3499)
        51  Department of the Army Acquisition Regulations (Parts 
                5100--5199)
        52  Department of the Navy Acquisition Regulations (Parts 
                5200--5299)
        53  Department of the Air Force Federal Acquisition 
                Regulation Supplement (Parts 5300--5399) 
                [Reserved]
        54  Defense Logistics Agency, Department of Defense (Parts 
                5400--5499)
        57  African Development Foundation (Parts 5700--5799)
        61  Civilian Board of Contract Appeals, General Services 
                Administration (Parts 6100--6199)
        63  Department of Transportation Board of Contract Appeals 
                (Parts 6300--6399)
        99  Cost Accounting Standards Board, Office of Federal 
                Procurement Policy, Office of Management and 
                Budget (Parts 9900--9999)

[[Page 817]]

                       Title 49--Transportation

            Subtitle A--Office of the Secretary of Transportation 
                (Parts 1--99)
            Subtitle B--Other Regulations Relating to 
                Transportation
         I  Pipeline and Hazardous Materials Safety 
                Administration, Department of Transportation 
                (Parts 100--199)
        II  Federal Railroad Administration, Department of 
                Transportation (Parts 200--299)
       III  Federal Motor Carrier Safety Administration, 
                Department of Transportation (Parts 300--399)
        IV  Coast Guard, Department of Homeland Security (Parts 
                400--499)
         V  National Highway Traffic Safety Administration, 
                Department of Transportation (Parts 500--599)
        VI  Federal Transit Administration, Department of 
                Transportation (Parts 600--699)
       VII  National Railroad Passenger Corporation (AMTRAK) 
                (Parts 700--799)
      VIII  National Transportation Safety Board (Parts 800--999)
         X  Surface Transportation Board, Department of 
                Transportation (Parts 1000--1399)
        XI  Research and Innovative Technology Administration, 
                Department of Transportation (Parts 1400--1499) 
                [Reserved]
       XII  Transportation Security Administration, Department of 
                Homeland Security (Parts 1500--1699)

                   Title 50--Wildlife and Fisheries

         I  United States Fish and Wildlife Service, Department of 
                the Interior (Parts 1--199)
        II  National Marine Fisheries Service, National Oceanic 
                and Atmospheric Administration, Department of 
                Commerce (Parts 200--299)
       III  International Fishing and Related Activities (Parts 
                300--399)
        IV  Joint Regulations (United States Fish and Wildlife 
                Service, Department of the Interior and National 
                Marine Fisheries Service, National Oceanic and 
                Atmospheric Administration, Department of 
                Commerce); Endangered Species Committee 
                Regulations (Parts 400--499)
         V  Marine Mammal Commission (Parts 500--599)
        VI  Fishery Conservation and Management, National Oceanic 
                and Atmospheric Administration, Department of 
                Commerce (Parts 600--699)

[[Page 819]]





           Alphabetical List of Agencies Appearing in the CFR




                      (Revised as of April 1, 2016)

                                                  CFR Title, Subtitle or 
                     Agency                               Chapter

Administrative Committee of the Federal Register  1, I
Administrative Conference of the United States    1, III
Advisory Council on Historic Preservation         36, VIII
Advocacy and Outreach, Office of                  7, XXV
Afghanistan Reconstruction, Special Inspector     5, LXXXIII
     General for
African Development Foundation                    22, XV
  Federal Acquisition Regulation                  48, 57
Agency for International Development              2, VII; 22, II
  Federal Acquisition Regulation                  48, 7
Agricultural Marketing Service                    7, I, IX, X, XI
Agricultural Research Service                     7, V
Agriculture Department                            2, IV; 5, LXXIII
  Advocacy and Outreach, Office of                7, XXV
  Agricultural Marketing Service                  7, I, IX, X, XI
  Agricultural Research Service                   7, V
  Animal and Plant Health Inspection Service      7, III; 9, I
  Chief Financial Officer, Office of              7, XXX
  Commodity Credit Corporation                    7, XIV
  Economic Research Service                       7, XXXVII
  Energy Policy and New Uses, Office of           2, IX; 7, XXIX
  Environmental Quality, Office of                7, XXXI
  Farm Service Agency                             7, VII, XVIII
  Federal Acquisition Regulation                  48, 4
  Federal Crop Insurance Corporation              7, IV
  Food and Nutrition Service                      7, II
  Food Safety and Inspection Service              9, III
  Foreign Agricultural Service                    7, XV
  Forest Service                                  36, II
  Grain Inspection, Packers and Stockyards        7, VIII; 9, II
       Administration
  Information Resources Management, Office of     7, XXVII
  Inspector General, Office of                    7, XXVI
  National Agricultural Library                   7, XLI
  National Agricultural Statistics Service        7, XXXVI
  National Institute of Food and Agriculture      7, XXXIV
  Natural Resources Conservation Service          7, VI
  Operations, Office of                           7, XXVIII
  Procurement and Property Management, Office of  7, XXXII
  Rural Business-Cooperative Service              7, XVIII, XLII
  Rural Development Administration                7, XLII
  Rural Housing Service                           7, XVIII, XXXV
  Rural Telephone Bank                            7, XVI
  Rural Utilities Service                         7, XVII, XVIII, XLII
  Secretary of Agriculture, Office of             7, Subtitle A
  Transportation, Office of                       7, XXXIII
  World Agricultural Outlook Board                7, XXXVIII
Air Force Department                              32, VII
  Federal Acquisition Regulation Supplement       48, 53
Air Transportation Stabilization Board            14, VI
Alcohol and Tobacco Tax and Trade Bureau          27, I
Alcohol, Tobacco, Firearms, and Explosives,       27, II
     Bureau of
AMTRAK                                            49, VII
American Battle Monuments Commission              36, IV
American Indians, Office of the Special Trustee   25, VII

[[Page 820]]

Animal and Plant Health Inspection Service        7, III; 9, I
Appalachian Regional Commission                   5, IX
Architectural and Transportation Barriers         36, XI
     Compliance Board
Arctic Research Commission                        45, XXIII
Armed Forces Retirement Home                      5, XI
Army Department                                   32, V
  Engineers, Corps of                             33, II; 36, III
  Federal Acquisition Regulation                  48, 51
Bilingual Education and Minority Languages        34, V
     Affairs, Office of
Blind or Severely Disabled, Committee for         41, 51
     Purchase from People Who Are
Broadcasting Board of Governors                   22, V
  Federal Acquisition Regulation                  48, 19
Career, Technical and Adult Education, Office of  34, IV
Census Bureau                                     15, I
Centers for Medicare & Medicaid Services          42, IV
Central Intelligence Agency                       32, XIX
Chemical Safety and Hazardous Investigation       40, VI
     Board
Chief Financial Officer, Office of                7, XXX
Child Support Enforcement, Office of              45, III
Children and Families, Administration for         45, II, III, IV, X
Civil Rights, Commission on                       5, LXVIII; 45, VII
Civil Rights, Office for                          34, I
Council of the Inspectors General on Integrity    5, XCVIII
     and Efficiency
Court Services and Offender Supervision Agency    5, LXX
     for the District of Columbia
Coast Guard                                       33, I; 46, I; 49, IV
Coast Guard (Great Lakes Pilotage)                46, III
Commerce Department                               2, XIII; 44, IV; 50, VI
  Census Bureau                                   15, I
  Economic Analysis, Bureau of                    15, VIII
  Economic Development Administration             13, III
  Emergency Management and Assistance             44, IV
  Federal Acquisition Regulation                  48, 13
  Foreign-Trade Zones Board                       15, IV
  Industry and Security, Bureau of                15, VII
  International Trade Administration              15, III; 19, III
  National Institute of Standards and Technology  15, II
  National Marine Fisheries Service               50, II, IV
  National Oceanic and Atmospheric                15, IX; 50, II, III, IV, 
       Administration                             VI
  National Telecommunications and Information     15, XXIII; 47, III, IV
       Administration
  National Weather Service                        15, IX
  Patent and Trademark Office, United States      37, I
  Productivity, Technology and Innovation,        37, IV
       Assistant Secretary for
  Secretary of Commerce, Office of                15, Subtitle A
  Technology Administration                       15, XI
  Technology Policy, Assistant Secretary for      37, IV
Commercial Space Transportation                   14, III
Commodity Credit Corporation                      7, XIV
Commodity Futures Trading Commission              5, XLI; 17, I
Community Planning and Development, Office of     24, V, VI
     Assistant Secretary for
Community Services, Office of                     45, X
Comptroller of the Currency                       12, I
Construction Industry Collective Bargaining       29, IX
     Commission
Consumer Financial Protection Bureau              5, LXXXIV; 12, X
Consumer Product Safety Commission                5, LXXI; 16, II
Copyright Royalty Board                           37, III
Corporation for National and Community Service    2, XXII; 45, XII, XXV
Cost Accounting Standards Board                   48, 99
Council on Environmental Quality                  40, V
Court Services and Offender Supervision Agency    5, LXX; 28, VIII
     for the District of Columbia
Customs and Border Protection                     19, I
Defense Contract Audit Agency                     32, I

[[Page 821]]

Defense Department                                2, XI; 5, XXVI; 32, 
                                                  Subtitle A; 40, VII
  Advanced Research Projects Agency               32, I
  Air Force Department                            32, VII
  Army Department                                 32, V; 33, II; 36, III; 
                                                  48, 51
  Defense Acquisition Regulations System          48, 2
  Defense Intelligence Agency                     32, I
  Defense Logistics Agency                        32, I, XII; 48, 54
  Engineers, Corps of                             33, II; 36, III
  National Imagery and Mapping Agency             32, I
  Navy Department                                 32, VI; 48, 52
  Secretary of Defense, Office of                 2, XI; 32, I
Defense Contract Audit Agency                     32, I
Defense Intelligence Agency                       32, I
Defense Logistics Agency                          32, XII; 48, 54
Defense Nuclear Facilities Safety Board           10, XVII
Delaware River Basin Commission                   18, III
District of Columbia, Court Services and          5, LXX; 28, VIII
     Offender Supervision Agency for the
Drug Enforcement Administration                   21, II
East-West Foreign Trade Board                     15, XIII
Economic Analysis, Bureau of                      15, VIII
Economic Development Administration               13, III
Economic Research Service                         7, XXXVII
Education, Department of                          2, XXXIV; 5, LIII
  Bilingual Education and Minority Languages      34, V
       Affairs, Office of
  Career, Technical and Adult Education, Office   34, IV
       of
  Civil Rights, Office for                        34, I
  Educational Research and Improvement, Office    34, VII
       of
  Elementary and Secondary Education, Office of   34, II
  Federal Acquisition Regulation                  48, 34
  Postsecondary Education, Office of              34, VI
  Secretary of Education, Office of               34, Subtitle A
  Special Education and Rehabilitative Services,  34, III
       Office of
  Career, Technical, and Adult Education, Office  34, IV
       of
Educational Research and Improvement, Office of   34, VII
Election Assistance Commission                    2, LVIII; 11, II
Elementary and Secondary Education, Office of     34, II
Emergency Oil and Gas Guaranteed Loan Board       13, V
Emergency Steel Guarantee Loan Board              13, IV
Employee Benefits Security Administration         29, XXV
Employees' Compensation Appeals Board             20, IV
Employees Loyalty Board                           5, V
Employment and Training Administration            20, V
Employment Standards Administration               20, VI
Endangered Species Committee                      50, IV
Energy, Department of                             2, IX; 5, XXIII; 10, II, 
                                                  III, X
  Federal Acquisition Regulation                  48, 9
  Federal Energy Regulatory Commission            5, XXIV; 18, I
  Property Management Regulations                 41, 109
Energy, Office of                                 7, XXIX
Engineers, Corps of                               33, II; 36, III
Engraving and Printing, Bureau of                 31, VI
Environmental Protection Agency                   2, XV; 5, LIV; 40, I, IV, 
                                                  VII
  Federal Acquisition Regulation                  48, 15
  Property Management Regulations                 41, 115
Environmental Quality, Office of                  7, XXXI
Equal Employment Opportunity Commission           5, LXII; 29, XIV
Equal Opportunity, Office of Assistant Secretary  24, I
     for
Executive Office of the President                 3, I
  Environmental Quality, Council on               40, V
  Management and Budget, Office of                2, Subtitle A; 5, III, 
                                                  LXXVII; 14, VI; 48, 99

[[Page 822]]

  National Drug Control Policy, Office of         2, XXXVI; 21, III
  National Security Council                       32, XXI; 47, 2
  Presidential Documents                          3
  Science and Technology Policy, Office of        32, XXIV; 47, II
  Trade Representative, Office of the United      15, XX
       States
Export-Import Bank of the United States           2, XXXV; 5, LII; 12, IV
Family Assistance, Office of                      45, II
Farm Credit Administration                        5, XXXI; 12, VI
Farm Credit System Insurance Corporation          5, XXX; 12, XIV
Farm Service Agency                               7, VII, XVIII
Federal Acquisition Regulation                    48, 1
Federal Aviation Administration                   14, I
  Commercial Space Transportation                 14, III
Federal Claims Collection Standards               31, IX
Federal Communications Commission                 5, XXIX; 47, I
Federal Contract Compliance Programs, Office of   41, 60
Federal Crop Insurance Corporation                7, IV
Federal Deposit Insurance Corporation             5, XXII; 12, III
Federal Election Commission                       5, XXXVII; 11, I
Federal Emergency Management Agency               44, I
Federal Employees Group Life Insurance Federal    48, 21
     Acquisition Regulation
Federal Employees Health Benefits Acquisition     48, 16
     Regulation
Federal Energy Regulatory Commission              5, XXIV; 18, I
Federal Financial Institutions Examination        12, XI
     Council
Federal Financing Bank                            12, VIII
Federal Highway Administration                    23, I, II
Federal Home Loan Mortgage Corporation            1, IV
Federal Housing Enterprise Oversight Office       12, XVII
Federal Housing Finance Agency                    5, LXXX; 12, XII
Federal Housing Finance Board                     12, IX
Federal Labor Relations Authority                 5, XIV, XLIX; 22, XIV
Federal Law Enforcement Training Center           31, VII
Federal Management Regulation                     41, 102
Federal Maritime Commission                       46, IV
Federal Mediation and Conciliation Service        29, XII
Federal Mine Safety and Health Review Commission  5, LXXIV; 29, XXVII
Federal Motor Carrier Safety Administration       49, III
Federal Prison Industries, Inc.                   28, III
Federal Procurement Policy Office                 48, 99
Federal Property Management Regulations           41, 101
Federal Railroad Administration                   49, II
Federal Register, Administrative Committee of     1, I
Federal Register, Office of                       1, II
Federal Reserve System                            12, II
  Board of Governors                              5, LVIII
Federal Retirement Thrift Investment Board        5, VI, LXXVI
Federal Service Impasses Panel                    5, XIV
Federal Trade Commission                          5, XLVII; 16, I
Federal Transit Administration                    49, VI
Federal Travel Regulation System                  41, Subtitle F
Financial Crimes Enforcement Network              31, X
Financial Research Office                         12, XVI
Financial Stability Oversight Council             12, XIII
Fine Arts, Commission on                          45, XXI
Fiscal Service                                    31, II
Fish and Wildlife Service, United States          50, I, IV
Food and Drug Administration                      21, I
Food and Nutrition Service                        7, II
Food Safety and Inspection Service                9, III
Foreign Agricultural Service                      7, XV
Foreign Assets Control, Office of                 31, V
Foreign Claims Settlement Commission of the       45, V
     United States
Foreign Service Grievance Board                   22, IX
Foreign Service Impasse Disputes Panel            22, XIV
Foreign Service Labor Relations Board             22, XIV
Foreign-Trade Zones Board                         15, IV

[[Page 823]]

Forest Service                                    36, II
General Services Administration                   5, LVII; 41, 105
  Contract Appeals, Board of                      48, 61
  Federal Acquisition Regulation                  48, 5
  Federal Management Regulation                   41, 102
  Federal Property Management Regulations         41, 101
  Federal Travel Regulation System                41, Subtitle F
  General                                         41, 300
  Payment From a Non-Federal Source for Travel    41, 304
       Expenses
  Payment of Expenses Connected With the Death    41, 303
       of Certain Employees
  Relocation Allowances                           41, 302
  Temporary Duty (TDY) Travel Allowances          41, 301
Geological Survey                                 30, IV
Government Accountability Office                  4, I
Government Ethics, Office of                      5, XVI
Government National Mortgage Association          24, III
Grain Inspection, Packers and Stockyards          7, VIII; 9, II
     Administration
Gulf Coast Ecosystem Restoration Council          2, LIX; 40, VIII
Harry S. Truman Scholarship Foundation            45, XVIII
Health and Human Services, Department of          2, III; 5, XLV; 45, 
                                                  Subtitle A,
  Centers for Medicare & Medicaid Services        42, IV
  Child Support Enforcement, Office of            45, III
  Children and Families, Administration for       45, II, III, IV, X
  Community Services, Office of                   45, X
  Family Assistance, Office of                    45, II
  Federal Acquisition Regulation                  48, 3
  Food and Drug Administration                    21, I
  Human Development Services, Office of           45, XIII
  Indian Health Service                           25, V
  Inspector General (Health Care), Office of      42, V
  Public Health Service                           42, I
  Refugee Resettlement, Office of                 45, IV
Homeland Security, Department of                  2, XXX; 5, XXXVI; 6, I; 8, 
                                                  I
  Coast Guard                                     33, I; 46, I; 49, IV
  Coast Guard (Great Lakes Pilotage)              46, III
  Customs and Border Protection                   19, I
  Federal Emergency Management Agency             44, I
  Human Resources Management and Labor Relations  5, XCVII
       Systems
  Immigration and Customs Enforcement Bureau      19, IV
  Transportation Security Administration          49, XII
HOPE for Homeowners Program, Board of Directors   24, XXIV
     of
Housing and Urban Development, Department of      2, XXIV; 5, LXV; 24, 
                                                  Subtitle B
  Community Planning and Development, Office of   24, V, VI
       Assistant Secretary for
  Equal Opportunity, Office of Assistant          24, I
       Secretary for
  Federal Acquisition Regulation                  48, 24
  Federal Housing Enterprise Oversight, Office    12, XVII
       of
  Government National Mortgage Association        24, III
  Housing--Federal Housing Commissioner, Office   24, II, VIII, X, XX
       of Assistant Secretary for
  Housing, Office of, and Multifamily Housing     24, IV
       Assistance Restructuring, Office of
  Inspector General, Office of                    24, XII
  Public and Indian Housing, Office of Assistant  24, IX
       Secretary for
  Secretary, Office of                            24, Subtitle A, VII
Housing--Federal Housing Commissioner, Office of  24, II, VIII, X, XX
     Assistant Secretary for
Housing, Office of, and Multifamily Housing       24, IV
     Assistance Restructuring, Office of
Human Development Services, Office of             45, XIII
Immigration and Customs Enforcement Bureau        19, IV
Immigration Review, Executive Office for          8, V

[[Page 824]]

Independent Counsel, Office of                    28, VII
Independent Counsel, Offices of                   28, VI
Indian Affairs, Bureau of                         25, I, V
Indian Affairs, Office of the Assistant           25, VI
     Secretary
Indian Arts and Crafts Board                      25, II
Indian Health Service                             25, V
Industry and Security, Bureau of                  15, VII
Information Resources Management, Office of       7, XXVII
Information Security Oversight Office, National   32, XX
     Archives and Records Administration
Inspector General
  Agriculture Department                          7, XXVI
  Health and Human Services Department            42, V
  Housing and Urban Development Department        24, XII, XV
Institute of Peace, United States                 22, XVII
Inter-American Foundation                         5, LXIII; 22, X
Interior Department                               2, XIV
  American Indians, Office of the Special         25, VII
       Trustee
  Endangered Species Committee                    50, IV
  Federal Acquisition Regulation                  48, 14
  Federal Property Management Regulations System  41, 114
  Fish and Wildlife Service, United States        50, I, IV
  Geological Survey                               30, IV
  Indian Affairs, Bureau of                       25, I, V
  Indian Affairs, Office of the Assistant         25, VI
       Secretary
  Indian Arts and Crafts Board                    25, II
  Land Management, Bureau of                      43, II
  National Indian Gaming Commission               25, III
  National Park Service                           36, I
  Natural Resource Revenue, Office of             30, XII
  Ocean Energy Management, Bureau of              30, V
  Reclamation, Bureau of                          43, I
  Safety and Enforcement Bureau, Bureau of        30, II
  Secretary of the Interior, Office of            2, XIV; 43, Subtitle A
  Surface Mining Reclamation and Enforcement,     30, VII
       Office of
Internal Revenue Service                          26, I
International Boundary and Water Commission,      22, XI
     United States and Mexico, United States 
     Section
International Development, United States Agency   22, II
     for
  Federal Acquisition Regulation                  48, 7
International Development Cooperation Agency,     22, XII
     United States
International Joint Commission, United States     22, IV
     and Canada
International Organizations Employees Loyalty     5, V
     Board
International Trade Administration                15, III; 19, III
International Trade Commission, United States     19, II
Interstate Commerce Commission                    5, XL
Investment Security, Office of                    31, VIII
James Madison Memorial Fellowship Foundation      45, XXIV
Japan-United States Friendship Commission         22, XVI
Joint Board for the Enrollment of Actuaries       20, VIII
Justice Department                                2, XXVIII; 5, XXVIII; 28, 
                                                  I, XI; 40, IV
  Alcohol, Tobacco, Firearms, and Explosives,     27, II
       Bureau of
  Drug Enforcement Administration                 21, II
  Federal Acquisition Regulation                  48, 28
  Federal Claims Collection Standards             31, IX
  Federal Prison Industries, Inc.                 28, III
  Foreign Claims Settlement Commission of the     45, V
       United States
  Immigration Review, Executive Office for        8, V
  Independent Counsel, Offices of                 28, VI
  Prisons, Bureau of                              28, V
  Property Management Regulations                 41, 128
Labor Department                                  2, XXIX; 5, XLII
  Employee Benefits Security Administration       29, XXV
  Employees' Compensation Appeals Board           20, IV

[[Page 825]]

  Employment and Training Administration          20, V
  Employment Standards Administration             20, VI
  Federal Acquisition Regulation                  48, 29
  Federal Contract Compliance Programs, Office    41, 60
       of
  Federal Procurement Regulations System          41, 50
  Labor-Management Standards, Office of           29, II, IV
  Mine Safety and Health Administration           30, I
  Occupational Safety and Health Administration   29, XVII
  Public Contracts                                41, 50
  Secretary of Labor, Office of                   29, Subtitle A
  Veterans' Employment and Training Service,      41, 61; 20, IX
       Office of the Assistant Secretary for
  Wage and Hour Division                          29, V
  Workers' Compensation Programs, Office of       20, I, VII
Labor-Management Standards, Office of             29, II, IV
Land Management, Bureau of                        43, II
Legal Services Corporation                        45, XVI
Library of Congress                               36, VII
  Copyright Royalty Board                         37, III
  U.S. Copyright Office                           37, II
Local Television Loan Guarantee Board             7, XX
Management and Budget, Office of                  5, III, LXXVII; 14, VI; 
                                                  48, 99
Marine Mammal Commission                          50, V
Maritime Administration                           46, II
Merit Systems Protection Board                    5, II, LXIV
Micronesian Status Negotiations, Office for       32, XXVII
Military Compensation and Retirement              5, XCIX
     Modernization Commission
Millennium Challenge Corporation                  22, XIII
Mine Safety and Health Administration             30, I
Minority Business Development Agency              15, XIV
Miscellaneous Agencies                            1, IV
Monetary Offices                                  31, I
Morris K. Udall Scholarship and Excellence in     36, XVI
     National Environmental Policy Foundation
Museum and Library Services, Institute of         2, XXXI
National Aeronautics and Space Administration     2, XVIII; 5, LIX; 14, V
  Federal Acquisition Regulation                  48, 18
National Agricultural Library                     7, XLI
National Agricultural Statistics Service          7, XXXVI
National and Community Service, Corporation for   2, XXII; 45, XII, XXV
National Archives and Records Administration      2, XXVI; 5, LXVI; 36, XII
  Information Security Oversight Office           32, XX
National Capital Planning Commission              1, IV
National Commission for Employment Policy         1, IV
National Commission on Libraries and Information  45, XVII
     Science
National Council on Disability                    5, C; 34, XII
National Counterintelligence Center               32, XVIII
National Credit Union Administration              5, LXXXVI; 12, VII
National Crime Prevention and Privacy Compact     28, IX
     Council
National Drug Control Policy, Office of           2, XXXVI; 21, III
National Endowment for the Arts                   2, XXXII
National Endowment for the Humanities             2, XXXIII
National Foundation on the Arts and the           45, XI
     Humanities
National Geospatial-Intelligence Agency           32, I
National Highway Traffic Safety Administration    23, II, III; 47, VI; 49, V
National Imagery and Mapping Agency               32, I
National Indian Gaming Commission                 25, III
National Institute of Food and Agriculture        7, XXXIV
National Institute of Standards and Technology    15, II
National Intelligence, Office of Director of      5, IV; 32, XVII
National Labor Relations Board                    5, LXI; 29, I
National Marine Fisheries Service                 50, II, IV
National Mediation Board                          29, X
National Oceanic and Atmospheric Administration   15, IX; 50, II, III, IV, 
                                                  VI

[[Page 826]]

National Park Service                             36, I
National Railroad Adjustment Board                29, III
National Railroad Passenger Corporation (AMTRAK)  49, VII
National Science Foundation                       2, XXV; 5, XLIII; 45, VI
  Federal Acquisition Regulation                  48, 25
National Security Council                         32, XXI
National Security Council and Office of Science   47, II
     and Technology Policy
National Telecommunications and Information       15, XXIII; 47, III, IV
     Administration
National Transportation Safety Board              49, VIII
Natural Resources Conservation Service            7, VI
Natural Resource Revenue, Office of               30, XII
Navajo and Hopi Indian Relocation, Office of      25, IV
Navy Department                                   32, VI
  Federal Acquisition Regulation                  48, 52
Neighborhood Reinvestment Corporation             24, XXV
Northeast Interstate Low-Level Radioactive Waste  10, XVIII
     Commission
Nuclear Regulatory Commission                     2, XX; 5, XLVIII; 10, I
  Federal Acquisition Regulation                  48, 20
Occupational Safety and Health Administration     29, XVII
Occupational Safety and Health Review Commission  29, XX
Ocean Energy Management, Bureau of                30, V
Oklahoma City National Memorial Trust             36, XV
Operations Office                                 7, XXVIII
Overseas Private Investment Corporation           5, XXXIII; 22, VII
Patent and Trademark Office, United States        37, I
Payment From a Non-Federal Source for Travel      41, 304
     Expenses
Payment of Expenses Connected With the Death of   41, 303
     Certain Employees
Peace Corps                                       2, XXXVII; 22, III
Pennsylvania Avenue Development Corporation       36, IX
Pension Benefit Guaranty Corporation              29, XL
Personnel Management, Office of                   5, I, XXXV; 5, IV; 45, 
                                                  VIII
  Human Resources Management and Labor Relations  5, XCVII
       Systems, Department of Homeland Security
  Federal Acquisition Regulation                  48, 17
  Federal Employees Group Life Insurance Federal  48, 21
       Acquisition Regulation
  Federal Employees Health Benefits Acquisition   48, 16
       Regulation
Pipeline and Hazardous Materials Safety           49, I
     Administration
Postal Regulatory Commission                      5, XLVI; 39, III
Postal Service, United States                     5, LX; 39, I
Postsecondary Education, Office of                34, VI
President's Commission on White House             1, IV
     Fellowships
Presidential Documents                            3
Presidio Trust                                    36, X
Prisons, Bureau of                                28, V
Privacy and Civil Liberties Oversight Board       6, X
Procurement and Property Management, Office of    7, XXXII
Productivity, Technology and Innovation,          37, IV
     Assistant Secretary
Public Contracts, Department of Labor             41, 50
Public and Indian Housing, Office of Assistant    24, IX
     Secretary for
Public Health Service                             42, I
Railroad Retirement Board                         20, II
Reclamation, Bureau of                            43, I
Refugee Resettlement, Office of                   45, IV
Relocation Allowances                             41, 302
Research and Innovative Technology                49, XI
     Administration
Rural Business-Cooperative Service                7, XVIII, XLII
Rural Development Administration                  7, XLII
Rural Housing Service                             7, XVIII, XXXV
Rural Telephone Bank                              7, XVI
Rural Utilities Service                           7, XVII, XVIII, XLII

[[Page 827]]

Safety and Environmental Enforcement, Bureau of   30, II
Saint Lawrence Seaway Development Corporation     33, IV
Science and Technology Policy, Office of          32, XXIV
Science and Technology Policy, Office of, and     47, II
     National Security Council
Secret Service                                    31, IV
Securities and Exchange Commission                5, XXXIV; 17, II
Selective Service System                          32, XVI
Small Business Administration                     2, XXVII; 13, I
Smithsonian Institution                           36, V
Social Security Administration                    2, XXIII; 20, III; 48, 23
Soldiers' and Airmen's Home, United States        5, XI
Special Counsel, Office of                        5, VIII
Special Education and Rehabilitative Services,    34, III
     Office of
State Department                                  2, VI; 22, I; 28, XI
  Federal Acquisition Regulation                  48, 6
Surface Mining Reclamation and Enforcement,       30, VII
     Office of
Surface Transportation Board                      49, X
Susquehanna River Basin Commission                18, VIII
Technology Administration                         15, XI
Technology Policy, Assistant Secretary for        37, IV
Tennessee Valley Authority                        5, LXIX; 18, XIII
Thrift Supervision Office, Department of the      12, V
     Treasury
Trade Representative, United States, Office of    15, XX
Transportation, Department of                     2, XII; 5, L
  Commercial Space Transportation                 14, III
  Contract Appeals, Board of                      48, 63
  Emergency Management and Assistance             44, IV
  Federal Acquisition Regulation                  48, 12
  Federal Aviation Administration                 14, I
  Federal Highway Administration                  23, I, II
  Federal Motor Carrier Safety Administration     49, III
  Federal Railroad Administration                 49, II
  Federal Transit Administration                  49, VI
  Maritime Administration                         46, II
  National Highway Traffic Safety Administration  23, II, III; 47, IV; 49, V
  Pipeline and Hazardous Materials Safety         49, I
       Administration
  Saint Lawrence Seaway Development Corporation   33, IV
  Secretary of Transportation, Office of          14, II; 49, Subtitle A
  Surface Transportation Board                    49, X
  Transportation Statistics Bureau                49, XI
Transportation, Office of                         7, XXXIII
Transportation Security Administration            49, XII
Transportation Statistics Bureau                  49, XI
Travel Allowances, Temporary Duty (TDY)           41, 301
Treasury Department                               2, X;5, XXI; 12, XV; 17, 
                                                  IV; 31, IX
  Alcohol and Tobacco Tax and Trade Bureau        27, I
  Community Development Financial Institutions    12, XVIII
       Fund
  Comptroller of the Currency                     12, I
  Customs and Border Protection                   19, I
  Engraving and Printing, Bureau of               31, VI
  Federal Acquisition Regulation                  48, 10
  Federal Claims Collection Standards             31, IX
  Federal Law Enforcement Training Center         31, VII
  Financial Crimes Enforcement Network            31, X
  Fiscal Service                                  31, II
  Foreign Assets Control, Office of               31, V
  Internal Revenue Service                        26, I
  Investment Security, Office of                  31, VIII
  Monetary Offices                                31, I
  Secret Service                                  31, IV
  Secretary of the Treasury, Office of            31, Subtitle A
  Thrift Supervision, Office of                   12, V
Truman, Harry S. Scholarship Foundation           45, XVIII
United States and Canada, International Joint     22, IV
     Commission
United States and Mexico, International Boundary  22, XI
   and Water Commission, United States Section
[[Page 828]]

U.S. Copyright Office                             37, II
Utah Reclamation Mitigation and Conservation      43, III
     Commission
Veterans Affairs Department                       2, VIII; 38, I
  Federal Acquisition Regulation                  48, 8
Veterans' Employment and Training Service,        41, 61; 20, IX
     Office of the Assistant Secretary for
Vice President of the United States, Office of    32, XXVIII
Wage and Hour Division                            29, V
Water Resources Council                           18, VI
Workers' Compensation Programs, Office of         20, I, VII
World Agricultural Outlook Board                  7, XXXVIII

[[Page 829]]







                      Table of OMB Control Numbers



The OMB control numbers for chapter I of title 26 were consolidated into 
Sec. Sec.  601.9000 and 602.101 at 50 FR 10221, Mar. 14, 1985. At 61 FR 
58008, Nov. 12, 1996, Sec.  601.9000 was removed. Section 602.101 is 
reprinted below for the convenience of the user.



PART 602_OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT--Table of Contents





Sec.  602.101  OMB Control numbers.

    (a) Purpose. This part collects and displays the control numbers 
assigned to collections of information in Internal Revenue Service 
regulations by the Office of Management and Budget (OMB) under the 
Paperwork Reduction Act of 1980. The Internal Revenue Service intends 
that this part comply with the requirements of Sec. Sec.  1320.7(f), 
1320.12, 1320.13, and 1320.14 of 5 CFR part 1320 (OMB regulations 
implementing the Paperwork Reduction Act), for the display of control 
numbers assigned by OMB to collections of information in Internal 
Revenue Service regulations. This part does not display control numbers 
assigned by the Office of Management and Budget to collections of 
information of the Bureau of Alcohol, Tobacco, and Firearms.
    (b) Display.

------------------------------------------------------------------------
                                                             Current OMB
     CFR part or section where identified and described      control No.
------------------------------------------------------------------------
1.1(h)-1(e)................................................    1545-1654
1.23-5.....................................................    1545-0074
1.25-1T....................................................    1545-0922
                                                               1545-0930
1.25-2T....................................................    1545-0922
                                                               1545-0930
1.25-3T....................................................    1545-0922
                                                               1545-0930
1.25-4T....................................................    1545-0922
1.25-5T....................................................    1545-0922
1.25-6T....................................................    1545-0922
1.25-7T....................................................    1545-0922
1.25-8T....................................................    1545-0922
1.25A-1....................................................    1545-1630
1.28-1.....................................................    1545-0619
1.31-2.....................................................    1545-0074
1.32-2.....................................................    1545-0074
1.32-3.....................................................    1545-1575
1.36B-5....................................................    1545-2232
1.37-1.....................................................    1545-0074
1.37-3.....................................................    1545-0074
1.41-2.....................................................    1545-0619
1.41-3.....................................................    1545-0619
1.41-4A....................................................    1545-0074
1.41-4 (b) and (c).........................................    1545-0074
1.41-8(b)..................................................    1545-1625
1.41-8(d)..................................................    1545-0732
1.41-9.....................................................    1545-0619
1.42-1T....................................................    1545-0984
                                                               1545-0988
1.42-2.....................................................    1545-1005
1.42-5.....................................................    1545-1357
1.42-6.....................................................    1545-1102
1.42-8.....................................................    1545-1102
1.42-10....................................................    1545-1102
1.42-13....................................................    1545-1357
1.42-14....................................................    1545-1423
1.42-17....................................................    1545-1357
1.42-18....................................................    1545-2088
1.43-3(a)(3)...............................................    1545-1292
1.43-3(b)(3)...............................................    1545-1292
1.44B-1....................................................    1545-0219
1.45D-1....................................................    1545-1765
1.45G-1....................................................    1545-2031
1.46-1.....................................................    1545-0123
                                                               1545-0155
1.46-3.....................................................    1545-0155
1.46-4.....................................................    1545-0155
1.46-5.....................................................    1545-0155
1.46-6.....................................................    1545-0155
1.46-8.....................................................    1545-0155
1.46-9.....................................................    1545-0155
1.46-10....................................................    1545-0118
1.46-11....................................................    1545-0155
1.47-1.....................................................    1545-0155
                                                               1545-0166
1.47-3.....................................................    1545-0155
                                                               1545-0166
1.47-4.....................................................    1545-0123
1.47-5.....................................................    1545-0092
1.47-6.....................................................    1545-0099
1.48-3.....................................................    1545-0155
1.48-4.....................................................    1545-0155
                                                               1545-0808
1.48-5.....................................................    1545-0155
1.48-6.....................................................    1545-0155
1.48-12....................................................    1545-0155
                                                               1545-1783
1.50A-1....................................................    1545-0895
1.50A-2....................................................    1545-0895
1.50A-3....................................................    1545-0895
1.50A-4....................................................    1545-0895
1.50A-5....................................................    1545-0895
1.50A-6....................................................    1545-0895
1.50A-7....................................................    1545-0895
1.50B-1....................................................    1545-0895
1.50B-2....................................................    1545-0895
1.50B-3....................................................    1545-0895

[[Page 830]]

 
1.50B-4....................................................    1545-0895
1.50B-5....................................................    1545-0895
1.51-1.....................................................    1545-0219
                                                               1545-0241
                                                               1545-0244
                                                               1545-0797
1.52-2.....................................................    1545-0219
1.52-3.....................................................    1545-0219
1.56-1.....................................................    1545-0123
1.56(g)-1..................................................    1545-1233
1.56A-1....................................................    1545-0227
1.56A-2....................................................    1545-0227
1.56A-3....................................................    1545-0227
1.56A-4....................................................    1545-0227
1.56A-5....................................................    1545-0227
1.57-5.....................................................    1545-0227
1.58-1.....................................................    1545-0175
1.58-9(c)(5)(iii)(B).......................................    1545-1093
1.58-9(e)(3)...............................................    1545-1093
1.59-1.....................................................    1545-1903
1.61-2.....................................................    1545-0771
1.61-2T....................................................    1545-0771
1.61-4.....................................................    1545-0187
1.61-15....................................................    1545-0074
1.62-2.....................................................    1545-1148
1.63-1.....................................................    1545-0074
1.66-4.....................................................    1545-1770
1.67-2T....................................................    1545-0110
1.67-3.....................................................    1545-1018
1.67-3T....................................................    1545-0118
1.71-1T....................................................    1545-0074
1.72-4.....................................................    1545-0074
1.72-6.....................................................    1545-0074
1.72-9.....................................................    1545-0074
1.72-17....................................................    1545-0074
1.72-17A...................................................    1545-0074
1.72-18....................................................    1545-0074
1.74-1.....................................................    1545-1100
1.79-2.....................................................    1545-0074
1.79-3.....................................................    1545-0074
1.83-2.....................................................    1545-0074
1.83-5.....................................................    1545-0074
1.83-6.....................................................    1545-1448
1.103-10...................................................    1545-0123
                                                               1545-0940
1.103-15AT.................................................    1545-0720
1.103-18...................................................    1545-1226
1.103(n)-2T................................................    1545-0874
1.103(n)-4T................................................    1545-0874
1.103A-2...................................................    1545-0720
1.105-4....................................................    1545-0074
1.105-5....................................................    1545-0074
1.105-6....................................................    1545-0074
1.108-4....................................................    1545-1539
1.108-5....................................................    1545-1421
1.108-7....................................................    1545-2155
1.108(i)-1.................................................    1545-2147
1.108(i)-2.................................................    1545-2147
1.110-1....................................................    1545-1661
1.117-5....................................................    1545-0869
1.118-2....................................................    1545-1639
1.119-1....................................................    1545-0067
1.120-3....................................................    1545-0057
1.121-1....................................................    1545-0072
1.121-2....................................................    1545-0072
1.121-3....................................................    1545-0072
1.121-4....................................................    1545-0072
                                                               1545-0091
1.121-5....................................................    1545-0072
1.127-2....................................................    1545-0768
1.132-1T...................................................    1545-0771
1.132-2....................................................    1545-0771
1.132-2T...................................................    1545-0771
1.132-5....................................................    1545-0771
1.132-5T...................................................    1545-0771
                                                               1545-1098
1.132-9(b).................................................    1545-1676
1.141-1....................................................    1545-1451
1.141-12...................................................    1545-1451
1.142-2....................................................    1545-1451
1.142(f)(4)-1..............................................    1545-1730
1.148-0....................................................    1545-1098
1.148-1....................................................    1545-1098
1.148-2....................................................    1545-1098
                                                               1545-1347
1.148-3....................................................    1545-1098
                                                               1545-1347
1.148-4....................................................    1545-1098
                                                               1545-1347
1.148-5....................................................    1545-1098
                                                               1545-1490
1.148-6....................................................    1545-1098
                                                               1545-1451
1.148-7....................................................    1545-1098
                                                               1545-1347
1.148-8....................................................    1545-1098
1.148-11...................................................    1545-1098
                                                               1545-1347
1.149(e)-1.................................................    1545-0720
1.150-1....................................................    1545-1347
1.151-1....................................................    1545-0074
1.152-3....................................................    1545-0071
                                                               1545-1783
1.152-4....................................................    1545-0074
1.152-4T...................................................    1545-0074
1.162-1....................................................    1545-0139
1.162-2....................................................    1545-0139
1.162-3....................................................    1545-0139
1.162-4....................................................    1545-0139
1.162-5....................................................    1545-0139
1.162-6....................................................    1545-0139
1.162-7....................................................    1545-0139
1.162-8....................................................    1545-0139
1.162-9....................................................    1545-0139
1.162-10...................................................    1545-0139
1.162-11...................................................    1545-0139
1.162-12...................................................    1545-0139
1.162-13...................................................    1545-0139
1.162-14...................................................    1545-0139
1.162-15...................................................    1545-0139
1.162-16...................................................    1545-0139
1.162-17...................................................    1545-0139
1.162-18...................................................    1545-0139
1.162-19...................................................    1545-0139
1.162-20...................................................    1545-0139
1.162-24...................................................    1545-2115
1.162-27...................................................    1545-1466
1.163-5....................................................    1545-0786
                                                               1545-1132
1.163-8T...................................................    1545-0995
1.163-10T..................................................    1545-0074
1.163-13...................................................    1545-1491
1.163(d)-1.................................................    1545-1421
1.165-1....................................................    1545-0177
1.165-2....................................................    1545-0177
1.165-3....................................................    1545-0177
1.165-4....................................................    1545-0177
1.165-5....................................................    1545-0177
1.165-6....................................................    1545-0177
1.165-7....................................................    1545-0177
1.165-8....................................................    1545-0177
1.165-9....................................................    1545-0177
1.165-10...................................................    1545-0177
1.165-11...................................................    1545-0074

[[Page 831]]

 
                                                               1545-0177
                                                               1545-0786
1.165-12...................................................    1545-0786
1.166-1....................................................    1545-0123
1.166-2....................................................    1545-1254
1.166-4....................................................    1545-0123
1.166-10...................................................    1545-0123
1.167(a)-5T................................................    1545-1021
1.167(a)-7.................................................    1545-0172
1.167(a)-11................................................    1545-0152
                                                               1545-0172
1.167(a)-12................................................    1545-0172
1.167(d)-1.................................................    1545-0172
1.167(e)-1.................................................    1545-0172
1.167(f)-11................................................    1545-0172
1.167(l)-1.................................................    1545-0172
1.168(d)-1.................................................    1545-1146
1.168(f)(8)-1T.............................................    1545-0923
1.168(i)-1.................................................    1545-1331
1.168-5....................................................    1545-0172
1.169-4....................................................    1545-0172
1.170-1....................................................    1545-0074
1.170-2....................................................    1545-0074
1.170-3....................................................    1545-0123
1.170A-1...................................................    1545-0074
1.170A-2...................................................    1545-0074
1.170A-4(A)(b).............................................    1545-0123
1.170A-8...................................................    1545-0074
1.170A-9...................................................    1545-0052
                                                               1545-0074
1.170A-11..................................................    1545-0074
                                                               1545-0123
                                                               1545-1868
1.170A-12..................................................    1545-0020
                                                               1545-0074
1.170A-13..................................................    1545-0074
                                                               1545-0754
                                                               1545-0908
                                                               1545-1431
1.170A-13(f)...............................................    1545-1464
1.170A-14..................................................    1545-0763
1.171-4....................................................    1545-1491
1.171-5....................................................    1545-1491
1.172-1....................................................    1545-0172
1.172-13...................................................    1545-0863
1.173-1....................................................    1545-0172
1.174-3....................................................    1545-0152
1.174-4....................................................    1545-0152
1.175-3....................................................    1545-0187
1.175-6....................................................    1545-0152
1.177-1....................................................    1545-0172
1.179-2....................................................    1545-1201
1.179-3....................................................    1545-1201
1.179-5....................................................    1545-0172
                                                               1545-1201
1.179B-1T..................................................    1545-2076
1.179C-1...................................................    1545-2103
1.179C-1T..................................................    1545-2103
1.180-2....................................................    1545-0074
1.181-1....................................................    1545-2059
1.181-2....................................................    1545-2059
1.181-3....................................................    1545-2059
1.182-6....................................................    1545-0074
1.183-1....................................................    1545-0195
1.183-2....................................................    1545-0195
1.183-3....................................................    1545-0195
1.183-4....................................................    1545-0195
1.190-3....................................................    1545-0074
1.194-2....................................................    1545-0735
1.194-4....................................................    1545-0735
1.195-1....................................................    1545-1582
1.197-1T...................................................    1545-1425
1.197-2....................................................    1545-1671
1.199-6....................................................    1545-1966
1.213-1....................................................    1545-0074
1.215-1T...................................................    1545-0074
1.217-2....................................................    1545-0182
1.243-3....................................................    1545-0123
1.243-4....................................................    1545-0123
1.243-5....................................................    1545-0123
1.248-1....................................................    1545-0172
1.261-1....................................................    1545-1041
1.263(a)-1.................................................    1545-2248
1.263(a)-3.................................................    1545-2248
1.263(a)-5.................................................    1545-1870
1.263(e)-1.................................................    1545-0123
1.263A-1...................................................    1545-0987
1.263A-1T..................................................    1545-0187
1.263A-2...................................................    1545-0987
1.263A-3...................................................    1545-0987
1.263A-8(b)(2)(iii)........................................    1545-1265
1.263A-9(d)(1).............................................    1545-1265
1.263A-9(f)(1)(ii).........................................    1545-1265
1.263A-9(f)(2)(iv).........................................    1545-1265
1.263A-9(g)(2)(iv)(C)......................................    1545-1265
1.263A-9(g)(3)(iv).........................................    1545-1265
1.265-1....................................................    1545-0074
1.265-2....................................................    1545-0123
1.266-1....................................................    1545-0123
1.267(f)-1.................................................    1545-0885
1.268-1....................................................    1545-0184
1.274-1....................................................    1545-0139
1.274-2....................................................    1545-0139
1.274-3....................................................    1545-0139
1.274-4....................................................    1545-0139
1.274-5....................................................    1545-0771
1.274-5A...................................................    1545-0139
                                                               1545-0771
1.274-5T...................................................    1545-0074
                                                               1545-0172
                                                               1545-0771
1.274-6....................................................    1545-0139
                                                               1545-0771
1.274-6T...................................................    1545-0074
                                                               1545-0771
1.274-7....................................................    1545-0139
1.274-8....................................................    1545-0139
1.279-6....................................................    1545-0123
1.280C-4...................................................    1545-1155
1.280F-3T..................................................    1545-0074
1.280G-1...................................................    1545-1851
1.281-4....................................................    1545-0123
1.302-4....................................................    1545-0074
1.305-3....................................................    1545-0123
1.305-5....................................................    1545-1438
1.307-2....................................................    1545-0074
1.312-15...................................................    1545-0172
1.316-1....................................................    1545-0123
1.331-1....................................................    1545-0074
1.332-4....................................................    1545-0123
1.332-6....................................................    1545-2019
1.336-2....................................................    1545-2125
1.336-4....................................................    1545-2125
1.337(d)-1.................................................    1545-1160
1.337(d)-2.................................................    1545-1160
                                                               1545-1774
1.337(d)-4.................................................    1545-1633
1.337(d)-5.................................................    1545-1672
1.337(d)-6.................................................    1545-1672
1.337(d)-7.................................................    1545-1672
1.338-2....................................................    1545-1658
1.338-5....................................................    1545-1658
1.338-10...................................................    1545-1658
1.338-11...................................................    1545-1990

[[Page 832]]

 
1.338(h)(10)-1.............................................    1545-1658
1.338(i)-1.................................................    1545-1990
1.341-7....................................................    1545-0123
1.351-3....................................................    1545-2019
1.355-5....................................................    1545-2019
1.362-2....................................................    1545-0123
1.362-4....................................................    1545-2247
1.367(a)-1T................................................    1545-0026
1.367(a)-2T................................................    1545-0026
1.367(a)-3.................................................    1545-0026
                                                               1545-1478
1.367(a)-3T................................................    1545-2183
1.367(a)-6T................................................    1545-0026
1.367(a)-7.................................................    1545-2183
1.367(a)-7T................................................    1545-2183
1.367(a)-8.................................................    1545-1271
                                                               1545-2056
                                                               1545-2183
1.367(b)-1.................................................    1545-1271
1.367(b)-3T................................................    1545-1666
1.367(d)-1T................................................    1545-0026
1.367(e)-1.................................................    1545-1487
1.367(e)-2.................................................    1545-1487
1.368-1....................................................    1545-1691
1.368-3....................................................    1545-2019
1.371-1....................................................    1545-0123
1.371-2....................................................    1545-0123
1.374-3....................................................    1545-0123
1.381(b)-1.................................................    1545-0123
1.381(c)(4)-1..............................................    1545-0123
                                                               1545-0152
                                                               1545-0879
1.381(c)(5)-1..............................................    1545-0123
                                                               1545-0152
1.381(c)(6)-1..............................................    1545-0123
                                                               1545-0152
1.381(c)(8)-1..............................................    1545-0123
1.381(c)(10)-1.............................................    1545-0123
1.381(c)(11)-1(k)..........................................    1545-0123
1.381(c)(13)-1.............................................    1545-0123
1.381(c)(17)-1.............................................    1545-0045
1.381(c)(22)-1.............................................    1545-1990
1.381(c)(25)-1.............................................    1545-0045
1.382-1T...................................................    1545-0123
1.382-2....................................................    1545-0123
1.382-2T...................................................    1545-0123
1.382-3....................................................    1545-1281
                                                               1545-1345
1.382-4....................................................    1545-1120
1.382-6....................................................    1545-1381
1.382-8....................................................    1545-1434
1.382-9....................................................    1545-1120
                                                               1545-1260
                                                               1545-1275
                                                               1545-1324
1.382-11...................................................    1545-2019
1.382-91...................................................    1545-1260
                                                               1545-1324
1.383-1....................................................    1545-0074
                                                               1545-1120
1.401-1....................................................    1545-0020
                                                               1545-0197
                                                               1545-0200
                                                               1545-0534
                                                               1545-0710
1.401(a)-11................................................    1545-0710
1.401(a)-20................................................    1545-0928
1.401(a)-31................................................    1545-1341
1.401(a)-50................................................    1545-0710
1.401(a)(9)-1..............................................    1545-1573
1.401(a)(9)-3..............................................    1545-1466
1.401(a)(9)-4..............................................    1545-1573
1.401(a)(9)-6..............................................    1545-2234
1.401(a)(31)-1.............................................    1545-1341
1.401(b)-1.................................................    1545-0197
1.401(f)-1.................................................    1545-0710
1.401(k)-1.................................................    1545-1039
                                                               1545-1069
                                                               1545-1669
                                                               1545-1930
1.401(k)-2.................................................    1545-1669
1.401(k)-3.................................................    1545-1669
1.401(k)-4.................................................    1545-1669
1.401(m)-3.................................................    1545-1699
1.401-12(n)................................................    1545-0806
1.401-14...................................................    1545-0710
1.402(c)-2.................................................    1545-1341
1.402(f)-1.................................................    1545-1341
                                                               1545-1632
1.402A-1...................................................    1545-1992
1.403(b)-1.................................................    1545-0710
1.403(b)-3.................................................    1545-0996
1.403(b)-7.................................................    1545-1341
1.403(b)-10................................................    1545-2068
1.404(a)-4.................................................    1545-0710
1.404(a)-12................................................    1545-0710
1.404A-2...................................................    1545-0123
1.404A-6...................................................    1545-0123
1.408-2....................................................    1545-0390
1.408-5....................................................    1545-0747
1.408-6....................................................    1545-0203
                                                               1545-0390
1.408-7....................................................    1545-0119
1.408(q)-1.................................................    1545-1841
1.408A-2...................................................    1545-1616
1.408A-4...................................................    1545-1616
1.408A-5...................................................    1545-1616
1.408A-7...................................................    1545-1616
1.410(a)-2.................................................    1545-0710
1.410(d)-1.................................................    1545-0710
1.411(a)-11................................................    1545-1471
                                                               1545-1632
1.411(d)-4.................................................    1545-1545
1.411(d)-6.................................................    1545-1477
1.412(b)-5.................................................    1545-0710
1.412(c)(1)-2..............................................    1545-0710
1.412(c)(2)-1..............................................    1545-0710
1.412(c)(3)-2..............................................    1545-0710
1.414(c)-5.................................................    1545-0797
1.414(r)-1.................................................    1545-1221
1.415-2....................................................    1545-0710
1.415-6....................................................    1545-0710
1.417(a)(3)-1..............................................    1545-0928
1.417(e)-1.................................................    1545-1471
                                                               1545-1724
1.417(e)-1T................................................    1545-1471
1.419A(f)(6)-1.............................................    1545-1795
1.422-1....................................................    1545-0820
1.430(f)-1.................................................    1545-2095
1.430(g)-1.................................................    1545-2095
1.430(h)(2)-1..............................................    1545-2095
1.432(e)(9)-1T.............................................    1545-2260
1.436-1....................................................    1545-2095
1.441-2....................................................    1545-1748
1.442-1....................................................    1545-0074
                                                               1545-0123
                                                               1545-0134
                                                               1545-0152
                                                               1545-0820
                                                               1545-1748
1.443-1....................................................    1545-0123
1.444-3T...................................................    1545-1036
1.444-4....................................................    1545-1591
1.446-1....................................................    1545-0074

[[Page 833]]

 
                                                               1545-0152
1.446-4(d).................................................    1545-1412
1.448-1(g).................................................    1545-0152
1.448-1(h).................................................    1545-0152
1.448-1(i).................................................    1545-0152
1.448-2....................................................    1545-1855
1.448-2T...................................................    1545-0152
                                                               1545-1855
1.451-1....................................................    1545-0091
1.451-4....................................................    1545-0123
1.451-5....................................................    1545-0074
1.451-6....................................................    1545-0074
1.451-7....................................................    1545-0074
1.453-1....................................................    1545-0152
1.453-2....................................................    1545-0152
1.453-8....................................................    1545-0152
                                                               1545-0228
1.453-10...................................................    1545-0152
1.453A-1...................................................    1545-0152
                                                               1545-1134
1.453A-2...................................................    1545-0152
                                                               1545-1134
1.453A-3...................................................    1545-0963
1.454-1....................................................    1545-0074
1.455-2....................................................    1545-0152
1.455-6....................................................    1545-0123
1.456-2....................................................    1545-0123
1.456-6....................................................    1545-0123
1.456-7....................................................    1545-0123
1.457-8....................................................    1545-1580
1.458-1....................................................    1545-0879
1.458-2....................................................    1545-0152
1.460-1....................................................    1545-1650
1.460-6....................................................    1545-1031
                                                               1545-1572
                                                               1545-1732
1.461-1....................................................    1545-0074
1.461-2....................................................    1545-0096
1.461-4....................................................    1545-0917
1.461-5....................................................    1545-0917
1.463-1T...................................................    1545-0916
1.465-1T...................................................    1545-0712
1.466-1T...................................................    1545-0152
1.466-4....................................................    1545-0152
1.468A-3...................................................    1545-1269
                                                               1545-1378
                                                               1545-1511
1.468A-3(h), 1.468A-7, and 1.468A-8(d).....................    1545-2091
1.468A-4...................................................    1545-0954
1.468A-7...................................................    1545-0954
                                                               1545-1511
1.468A-8...................................................    1545-1269
1.468B-1...................................................    1545-1631
1.468B-1(j)................................................    1545-1299
1.468B-2(k)................................................    1545-1299
1.468B-2(l)................................................    1545-1299
1.468B-3(b)................................................    1545-1299
1.468B-3(e)................................................    1545-1299
1.468B-5(b)................................................    1545-1299
1.468B-9...................................................    1545-1631
1.469-1....................................................    1545-1008
1.469-2T...................................................    1545-0712
                                                               1545-1091
1.469-4T...................................................    1545-0985
                                                               1545-1037
1.469-7....................................................    1545-1244
1.471-2....................................................    1545-0123
1.471-5....................................................    1545-0123
1.471-6....................................................    1545-0123
1.471-8....................................................    1545-0123
1.471-11...................................................    1545-0123
                                                               1545-0152
1.472-1....................................................    1545-0042
                                                               1545-0152
1.472-2....................................................    1545-0152
1.472-3....................................................    1545-0042
1.472-5....................................................    1545-0152
1.472-8....................................................    1545-0028
                                                               1545-0042
                                                               1545-1767
1.475(a)-4.................................................    1545-1945
1.475(b)-4.................................................    1545-1496
1.481-4....................................................    1545-0152
1.481-5....................................................    1545-0152
1.482-1....................................................    1545-1364
1.482-4....................................................    1545-1364
1.482-7....................................................    1545-1364
                                                               1545-1794
1.482-9(b).................................................    1545-2149
1.501(a)-1.................................................    1545-0056
                                                               1545-0057
1.501(c)(3)-1..............................................    1545-0056
1.501(c)(9)-5..............................................    1545-0047
1.501(c)(17)-3.............................................    1545-0047
1.501(e)-1.................................................    1545-0814
1.501(r)-3.................................................    1545-0047
1.501(r)-4.................................................    1545-0047
1.501(r)-6.................................................    1545-0047
1.503(c)-1.................................................    1545-0047
                                                               1545-0052
1.505(c)-1T................................................    1545-0916
1.507-1....................................................    1545-0052
1.507-2....................................................    1545-0052
1.508-1....................................................    1545-0052
                                                               1545-0056
1.509(a)-3.................................................    1545-0047
1.509(a)-4.................................................    1545-2157
1.509(a)-5.................................................    1545-0047
1.509(c)-1.................................................    1545-0052
1.512(a)-1.................................................    1545-0687
1.512(a)-4.................................................    1545-0047
                                                               1545-0687
1.521-1....................................................    1545-0051
                                                               1545-0058
1.527-2....................................................    1545-0129
1.527-5....................................................    1545-0129
1.527-6....................................................    1545-0129
1.527-9....................................................    1545-0129
1.528-8....................................................    1545-0127
1.533-2....................................................    1545-0123
1.534-2....................................................    1545-0123
1.542-3....................................................    1545-0123
1.545-2....................................................    1545-0123
1.545-3....................................................    1545-0123
1.547-2....................................................    1545-0045
                                                               1545-0123
1.547-3....................................................    1545-0123
1.551-4....................................................    1545-0074
1.552-3....................................................    1545-0099
1.552-4....................................................    1545-0099
1.552-5....................................................    1545-0099
1.556-2....................................................    1545-0704
1.561-1....................................................    1545-0044
1.561-2....................................................    1545-0123
1.562-3....................................................    1545-0123
1.563-2....................................................    1545-0123
1.564-1....................................................    1545-0123
1.565-1....................................................    1545-0043
                                                               1545-0123
1.565-2....................................................    1545-0043
1.565-3....................................................    1545-0043
1.565-5....................................................    1545-0043
1.565-6....................................................    1545-0043
1.585-1....................................................    1545-0123

[[Page 834]]

 
1.585-3....................................................    1545-0123
1.585-8....................................................    1545-1290
1.586-2....................................................    1545-0123
1.593-1....................................................    1545-0123
1.593-6....................................................    1545-0123
1.593-6A...................................................    1545-0123
1.593-7....................................................    1545-0123
1.595-1....................................................    1545-0123
1.597-2....................................................    1545-1300
1.597-4....................................................    1545-1300
1.597-6....................................................    1545-1300
1.597-7....................................................    1545-1300
1.611-2....................................................    1545-0099
1.611-3....................................................    1545-0007
                                                               1545-0099
                                                               1545-1784
1.612-4....................................................    1545-0074
1.612-5....................................................    1545-0099
1.613-3....................................................    1545-0099
1.613-4....................................................    1545-0099
1.613-6....................................................    1545-0099
1.613-7....................................................    1545-0099
1.613A-3...................................................    1545-0919
1.613A-3(e)................................................    1545-1251
1.613A-3(l)................................................    1545-0919
1.613A-5...................................................    1545-0099
1.613A-6...................................................    1545-0099
1.614-2....................................................    1545-0099
1.614-3....................................................    1545-0099
1.614-5....................................................    1545-0099
1.614-6....................................................    1545-0099
1.614-8....................................................    1545-0099
1.617-1....................................................    1545-0099
1.617-3....................................................    1545-0099
1.617-4....................................................    1545-0099
1.631-1....................................................    1545-0007
1.631-2....................................................    1545-0007
1.641(b)-2.................................................    1545-0092
1.642(c)-1.................................................    1545-0092
1.642(c)-2.................................................    1545-0092
1.642(c)-5.................................................    1545-0074
1.642(c)-6.................................................    1545-0020
                                                               1545-0074
                                                               1545-0092
1.642(g)-1.................................................    1545-0092
1.642(i)-1.................................................    1545-0092
1.645-1....................................................    1545-1578
1.663(b)-2.................................................    1545-0092
1.664-1....................................................    1545-0196
1.664-1(a)(7)..............................................    1545-1536
1.664-1(c).................................................    1545-2101
1.664-2....................................................    1545-0196
1.664-3....................................................    1545-0196
1.664-4....................................................    1545-0020
                                                               1545-0196
1.665(a)-0A through
1.665(g)-2A................................................    1545-0192
1.666(d)-1A................................................    1545-0092
1.671-4....................................................    1545-1442
1.671-5....................................................    1545-1540
1.701-1....................................................    1545-0099
1.702-1....................................................    1545-0074
1.703-1....................................................    1545-0099
1.704-2....................................................    1545-1090
1.706-1....................................................    1545-0074
                                                               1545-0099
                                                               1545-0134
1.706-1T...................................................    1545-0099
1.706-4(f).................................................    1545-0123
1.707-3(c)(2)..............................................    1545-1243
1.707-5(a)(7)(ii)..........................................    1545-1243
1.707-6(c).................................................    1545-1243
1.707-8....................................................    1545-1243
1.708-1....................................................    1545-0099
1.732-1....................................................    1545-0099
                                                               1545-1588
1.736-1....................................................    1545-0074
1.743-1....................................................    1545-0074
                                                               1545-1588
1.751-1....................................................    1545-0074
                                                               1545-0099
                                                               1545-0941
1.752-2....................................................    1545-1905
1.752-5....................................................    1545-1090
1.752-7....................................................    1545-1843
1.754-1....................................................    1545-0099
1.755-1....................................................    1545-0099
1.761-2....................................................    1545-1338
1.801-1....................................................    1545-0123
                                                               1545-0128
1.801-3....................................................    1545-0123
1.801-5....................................................    1545-0128
1.801-8....................................................    1545-0128
1.804-4....................................................    1545-0128
1.811-2....................................................    1545-0128
1.812-2....................................................    1545-0128
1.815-6....................................................    1545-0128
1.818-4....................................................    1545-0128
1.818-5....................................................    1545-0128
1.818-8....................................................    1545-0128
1.819-2....................................................    1545-0128
1.821-1....................................................    1545-1027
1.821-3....................................................    1545-1027
1.821-4....................................................    1545-1027
1.822-5....................................................    1545-1027
1.822-6....................................................    1545-1027
1.822-8....................................................    1545-1027
1.822-9....................................................    1545-1027
1.823-2....................................................    1545-1027
1.823-5....................................................    1545-1027
1.823-6....................................................    1545-1027
1.825-1....................................................    1545-1027
1.826-1....................................................    1545-1027
1.826-2....................................................    1545-1027
1.826-3....................................................    1545-1027
1.826-4....................................................    1545-1027
1.826-6....................................................    1545-1027
1.831-3....................................................    1545-0123
1.831-4....................................................    1545-0123
1.832-4....................................................    1545-1227
1.832-5....................................................    1545-0123
1.848-2(g)(8)..............................................    1545-1287
1.848-2(h)(3)..............................................    1545-1287
1.848-2(i)(4)..............................................    1545-1287
1.851-2....................................................    1545-1010
1.851-4....................................................    1545-0123
1.852-1....................................................    1545-0123
1.852-4....................................................    1545-0123
                                                               1545-0145
1.852-6....................................................    1545-0123
                                                               1545-0144
1.852-7....................................................    1545-0074
1.852-9....................................................    1545-0074
                                                               1545-0123
                                                               1545-0144
                                                               1545-0145
                                                               1545-1783
1.852-11...................................................    1545-1094
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1.860E-2(a)(5).............................................    1545-1276
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1.860E-2(b)(2).............................................    1545-1276
1.860G-2...................................................    1545-2110
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1.861-4....................................................    1545-1900
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1.861-8(e)(6) and (g)......................................    1545-1224
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1.863-3A...................................................    1545-0126
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1.884-0....................................................    1545-1070
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1.884-2....................................................    1545-1070
1.884-2T...................................................    1545-0126
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1.884-5....................................................    1545-1070
1.892-1T...................................................    1545-1053
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1.892-7T...................................................    1545-1053
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1.897-3....................................................    1545-0123
1.897-5T...................................................    1545-0902
1.897-6T...................................................    1545-0902
1.901-2....................................................    1545-0746
1.901-2A...................................................    1545-0746
1.901-3....................................................    1545-0122
1.902-1....................................................    1545-0122
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1.904-1....................................................    1545-0121
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1.904-5....................................................    1545-0121
1.904-7....................................................    1545-2104
1.904-7T...................................................    1545-2104
1.904(f)-1.................................................    1545-0121
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1.904(f)-2.................................................    1545-0121
1.904(f)-3.................................................    1545-0121
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1.904(f)-6.................................................    1545-0121
1.904(f)-7.................................................    1545-1127
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1.924(a)-1T................................................    1545-0935
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1.927(b)-1T................................................    1545-0935
1.927(d)-1.................................................    1545-0884
1.927(d)-2T................................................    1545-0935
1.927(e)-1T................................................    1545-0935
1.927(e)-2T................................................    1545-0935
1.927(f)-1.................................................    1545-0884
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1.936-10(c)................................................    1545-1138
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1.1033(a)-2................................................    1545-0184
1.1033(g)-1................................................    1545-0184
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1.1039-1...................................................    1545-0184
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1.1042-1T..................................................    1545-0916
1.1044(a)-1................................................    1545-1421
1.1045-1...................................................    1545-1893
1.1060-1...................................................    1545-1658
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1.1092(b)-1T...............................................    1545-0644
1.1092(b)-2T...............................................    1545-0644
1.1092(b)-3T...............................................    1545-0644
1.1092(b)-4T...............................................    1545-0644
1.1092(b)-5T...............................................    1545-0644
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1.1244(e)-1................................................    1545-0123
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1.1248-7...................................................    1545-0074
1.1248(f)-2................................................    1545-2183
1.1248(f)-3T...............................................    1545-2183
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1.1254-1(c)(3).............................................    1545-1352
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1.1254-5(d)(2).............................................    1545-1352
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1.1272-3...................................................    1545-1353
1.1273-2(f)(9).............................................    1545-1353
1.1273-2(h)(2).............................................    1545-1353
1.1274-3(d)................................................    1545-1353
1.1274-5(b)................................................    1545-1353
1.1274A-1(c)...............................................    1545-1353
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1.1367-1(f)................................................    1545-1139
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1.1368-1(f)(4).............................................    1545-1139
1.1368-1(g)(2).............................................    1545-1139
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1.1402(b)-1................................................    1545-0171
1.1402(c)-2................................................    1545-0074
1.1402(e)(1)-1.............................................    1545-0074
1.1402(e)(2)-1.............................................    1545-0074
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1.1402(e)-2A...............................................    1545-0168
1.1402(e)-3A...............................................    1545-0168
1.1402(e)-4A...............................................    1545-0168
1.1402(e)-5A...............................................    1545-0168
1.1402(f)-1................................................    1545-0074
1.1402(h)-1................................................    1545-0064
1.1411-10(g)...............................................    1545-2227
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1.1445-7...................................................    1545-0902
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1.1445-9T..................................................    1545-0902
1.1445-10T.................................................    1545-0902
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1.1446-3...................................................    1545-1934
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1.1502-5...................................................    1545-0257
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1.1502-9A..................................................    1545-0121
1.1502-13..................................................    1545-0123
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1.1502-21T.................................................    1545-2171
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1.1502-76T.................................................    1545-2019
1.1502-77..................................................    1545-1699
1.1502-77A.................................................    1545-0123
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1.1502-77B.................................................    1545-1699
1.1502-78..................................................    1545-0582
1.1502-95..................................................    1545-1218
1.1502-95A.................................................    1545-1218
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1.1503-2A..................................................    1545-1083
1.1503(d)-1................................................    1545-1946
1.1503(d)-3................................................    1545-1946
1.1503(d)-4................................................    1545-1946
1.1503(d)-5................................................    1545-1946
1.1503(d)-6................................................    1545-1946
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1.1561-3...................................................    1545-0123
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1.6015(a)-1................................................    1545-0087
1.6015(b)-1................................................    1545-0087
1.6015(d)-1................................................    1545-0087
1.6015(e)-1................................................    1545-0087
1.6015(f)-1................................................    1545-0087
1.6015(g)-1................................................    1545-0087
1.6015(h)-1................................................    1545-0087
1.6015(i)-1................................................    1545-0087
1.6017-1...................................................    1545-0074
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1.6031(a)-1................................................    1545-1583
1.6031(b)-1T...............................................    1545-0099
1.6031(c)-1T...............................................    1545-0099
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1.6035-1...................................................    1545-0704
1.6035-2...................................................    1545-0704
1.6035-3...................................................    1545-0704
1.6037-1...................................................    1545-0130
                                                               1545-1023
1.6038-2...................................................    1545-1617
                                                               1545-2020
1.6038-3...................................................    1545-1617
1.6038A-2..................................................    1545-1191
1.6038A-3..................................................    1545-1191
                                                               1545-1440
1.6038B-1..................................................    1545-1617
                                                               1545-2183
1.6038B-1T.................................................    1545-0026
                                                               1545-2183
1.6038B-2..................................................    1545-1617
1.6039-2...................................................    1545-0820
1.6041-1...................................................    1545-0008
                                                               1545-0108
                                                               1545-0112
                                                               1545-0115
                                                               1545-0120
                                                               1545-0295
                                                               1545-0350
                                                               1545-0367
                                                               1545-0387
                                                               1545-0441
                                                               1545-0957
                                                               1545-1705
1.6041-2...................................................    1545-0008
                                                               1545-0119
                                                               1545-0350
                                                               1545-0441
                                                               1545-1729
1.6041-3...................................................    1545-1148
1.6041-4...................................................    1545-0115
                                                               1545-0295
                                                               1545-0367
                                                               1545-0387
                                                               1545-0957
1.6041-5...................................................    1545-0295
                                                               1545-0367
                                                               1545-0387
                                                               1545-0957
1.6041-6...................................................    1545-0008
                                                               1545-0115
1.6041-7...................................................    1545-0112
                                                               1545-0295
                                                               1545-0350
                                                               1545-0367
                                                               1545-0387
                                                               1545-0441
                                                               1545-0957
1.6042-1...................................................    1545-0110
1.6042-2...................................................    1545-0110
                                                               1545-0295

[[Page 839]]

 
                                                               1545-0367
                                                               1545-0387
                                                               1545-0957
1.6042-3...................................................    1545-0295
                                                               1545-0367
                                                               1545-0387
                                                               1545-0957
1.6042-4...................................................    1545-0110
1.6043-1...................................................    1545-0041
1.6043-2...................................................    1545-0041
                                                               1545-0110
                                                               1545-0295
                                                               1545-0387
1.6043-3...................................................    1545-0047
1.6044-1...................................................    1545-0118
1.6044-2...................................................    1545-0118
1.6044-3...................................................    1545-0118
1.6044-4...................................................    1545-0118
1.6044-5...................................................    1545-0118
1.6045-1...................................................    1545-0715
                                                               1545-1705
1.6045-1(c)(3)(xi)(C)......................................    1545-2186
1.6045-1(n)(5).............................................    1545-2186
1.6045A-1..................................................    1545-2186
1.6045-2...................................................    1545-0115
1.6045-4...................................................    1545-1085
1.6046-1...................................................    1545-0704
                                                               1545-0794
                                                               1545-1317
1.6046-2...................................................    1545-0704
1.6046-3...................................................    1545-0704
1.6046A....................................................    1545-1646
1.6047-1...................................................    1545-0119
                                                               1545-0295
                                                               1545-0387
1.6047-2...................................................    1545-2234
1.6049-1...................................................    1545-0112
                                                               1545-0117
                                                               1545-0295
                                                               1545-0367
                                                               1545-0387
                                                               1545-0597
                                                               1545-0957
1.6049-2...................................................    1545-0117
1.6049-3...................................................    1545-0117
1.6049-4...................................................    1545-0096
                                                               1545-0112
                                                               1545-0117
                                                               1545-1018
                                                               1545-1050
1.6049-5...................................................    1545-0096
                                                               1545-0112
                                                               1545-0117
1.6049-6...................................................    1545-0096
1.6049-7...................................................    1545-1018
1.6049-7T..................................................    1545-0112
                                                               1545-0117
                                                               1545-0118
1.6050A-1..................................................    1545-0115
1.6050B-1..................................................    1545-0120
1.6050D-1..................................................    1545-0120
                                                               1545-0232
1.6050E-1..................................................    1545-0120
1.6050H-1..................................................    1545-0901
                                                               1545-1380
1.6050H-1T.................................................    1545-0901
1.6050H-2..................................................    1545-0901
                                                               1545-1339
                                                               1545-1380
1.6050I-2..................................................    1545-1449
1.6050J-1T.................................................    1545-0877
1.6050K-1..................................................    1545-0941
1.6050S-1..................................................    1545-1678
1.6050S-2..................................................    1545-1729
1.6050S-3..................................................    1545-1678
1.6050S-4..................................................    1545-1729
1.6052-1...................................................    1545-0008
1.6052-2...................................................    1545-0008
1.6055-1...................................................    1545-2252
1.6055-2...................................................    1545-2252
1.6060-1...................................................    1545-0074
1.6060-1(a)(1).............................................    1545-1231
1.6061-1...................................................    1545-0123
1.6062-1...................................................    1545-0123
1.6063-1...................................................    1545-0123
1.6065-1...................................................    1545-0123
1.6071-1...................................................    1545-0123
                                                               1545-0810
1.6072-1...................................................    1545-0074
1.6072-2...................................................    1545-0123
                                                               1545-0807
1.6073-1...................................................    1545-0087
1.6073-2...................................................    1545-0087
1.6073-3...................................................    1545-0087
1.6073-4...................................................    1545-0087
1.6074-1...................................................    1545-0123
1.6074-2...................................................    1545-0123
1.6081-1...................................................    1545-0066
                                                               1545-0148
                                                               1545-0233
                                                               1545-1057
                                                               1545-1081
1.6081-2...................................................    1545-0148
                                                               1545-1036
                                                               1545-1054
1.6081-3...................................................    1545-0233
1.6081-4...................................................    1545-0188
                                                               1545-1479
1.6081-6...................................................    1545-0148
                                                               1545-1054
1.6081-7...................................................    1545-0148
                                                               1545-1054
1.6091-3...................................................    1545-0089
1.6107-1...................................................    1545-0074
                                                               1545-1231
1.6109-1...................................................    1545-0074
1.6109-2...................................................    1545-2176
1.6115-1...................................................    1545-1464
1.6151-1...................................................    1545-0074
1.6153-1...................................................    1545-0087
1.6153-4...................................................    1545-0087
1.6161-1...................................................    1545-0087
1.6162-1...................................................    1545-0087
1.6164-1...................................................    1545-0135
1.6164-2...................................................    1545-0135
1.6164-3...................................................    1545-0135
1.6164-5...................................................    1545-0135
1.6164-6...................................................    1545-0135
1.6164-7...................................................    1545-0135
1.6164-8...................................................    1545-0135
1.6164-9...................................................    1545-0135
1.6302-1...................................................    1545-0257
1.6302-2...................................................    1545-0098
                                                               1545-0257
1.6411-1...................................................    1545-0098
                                                               1545-0135
                                                               1545-0582
1.6411-2...................................................    1545-0098
                                                               1545-0582
1.6411-3...................................................    1545-0098
                                                               1545-0582
1.6411-4...................................................    1545-0582
1.6414-1...................................................    1545-0096
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[[Page 840]]

 
1.6425-2...................................................    1545-0170
1.6425-3...................................................    1545-0170
1.6654-1...................................................    1545-0087
                                                               1545-0140
1.6654-2...................................................    1545-0087
1.6654-3...................................................    1545-0087
1.6654-4...................................................    1545-0087
1.6655(e)-1................................................    1545-1421
1.6662-3(c)................................................    1545-0889
1.6662-4(e) and (f)........................................    1545-0889
1.6662-6...................................................    1545-1426
1.6694-1...................................................    1545-0074
1.6694-2...................................................    1545-0074
1.6694-2(c)................................................    1545-1231
1.6694-2(c)(3).............................................    1545-1231
1.6694-3(e)................................................    1545-1231
1.6695-1...................................................    1545-0074
                                                               1545-1385
1.6695-2...................................................    1545-1570
1.6696-1...................................................    1545-0074
                                                               1545-0240
1.6851-1...................................................    1545-0086
                                                               1545-0138
1.6851-2...................................................    1545-0086
                                                               1545-0138
1.7476-1...................................................    1545-0197
1.7476-2...................................................    1545-0197
1.7519-2T..................................................    1545-1036
1.7520-1...................................................    1545-1343
1.7520-2...................................................    1545-1343
1.7520-3...................................................    1545-1343
1.7520-4...................................................    1545-1343
1.7701(l)-3................................................    1545-1642
1.7872-15..................................................    1545-1792
1.9100-1...................................................    1545-0074
1.9101-1...................................................    1545-0008
2.1-4......................................................    1545-0123
2.1-5......................................................    1545-0123
2.1-6......................................................    1545-0123
2.1-10.....................................................    1545-0123
2.1-11.....................................................    1545-0123
2.1-12.....................................................    1545-0123
2.1-13.....................................................    1545-0123
2.1-20.....................................................    1545-0123
2.1-22.....................................................    1545-0123
2.1-26.....................................................    1545-0123
3.2........................................................    1545-0123
4.954-1....................................................    1545-1068
4.954-2....................................................    1545-1068
5.6411-1...................................................    1545-0042
                                                               1545-0074
                                                               1545-0098
                                                               1545-0129
                                                               1545-0172
                                                               1545-0582
                                                               1545-0619
5c.44F-1...................................................    1545-0619
5c.128-1...................................................    1545-0123
5c.168(f)(8)-1.............................................    1545-0123
5c.168(f)(8)-2.............................................    1545-0123
5c.168(f)(8)-6.............................................    1545-0123
5c.168(f)(8)-8.............................................    1545-0123
5c.305-1...................................................    1545-0110
5c.442-1...................................................    1545-0152
5f.103-1...................................................    1545-0720
5f.103-3...................................................    1545-0720
5f.6045-1..................................................    1545-0715
6a.103A-2..................................................    1545-0123
                                                               1545-0720
6a.103A-3..................................................    1545-0720
7.465-1....................................................    1545-0712
7.465-2....................................................    1545-0712
7.465-3....................................................    1545-0712
7.465-4....................................................    1545-0712
7.465-5....................................................    1545-0712
7.936-1....................................................    1545-0217
7.999-1....................................................    1545-0216
7.6039A-1..................................................    1545-0015
7.6041-1...................................................    1545-0115
11.410-1...................................................    1545-0710
11.412(c)-7................................................    1545-0710
11.412(c)-11...............................................    1545-0710
12.7.......................................................    1545-0190
12.8.......................................................    1545-0191
12.9.......................................................    1545-0195
14a.422A-1.................................................    1545-0123
15A.453-1..................................................    1545-0228
16.3-1.....................................................    1545-0159
16A.126-2..................................................    1545-0074
16A.1255-1.................................................    1545-0184
16A.1255-2.................................................    1545-0184
18.1371-1..................................................    1545-0130
18.1378-1..................................................    1545-0130
18.1379-1..................................................    1545-0130
18.1379-2..................................................    1545-0130
20.2010-2..................................................    1545-0015
20.2011-1..................................................    1545-0015
20.2014-5..................................................    1545-0015
                                                               1545-0260
20.2014-6..................................................    1545-0015
20.2016-1..................................................    1545-0015
20.2031-2..................................................    1545-0015
20.2031-3..................................................    1545-0015
20.2031-4..................................................    1545-0015
20.2031-6..................................................    1545-0015
20.2031-7..................................................    1545-0020
20.2031-10.................................................    1545-0015
20.2032-1..................................................    1545-0015
20.2032A-3.................................................    1545-0015
20.2032A-4.................................................    1545-0015
20.2032A-8.................................................    1545-0015
20.2039-4..................................................    1545-0015
20.2051-1..................................................    1545-0015
20.2053-3..................................................    1545-0015
20.2053-9..................................................    1545-0015
20.2053-10.................................................    1545-0015
20.2055-1..................................................    1545-0015
20.2055-2..................................................    1545-0015
                                                               1545-0092
20.2055-3..................................................    1545-0015
20.2056(b)-4...............................................    1545-0015
20.2056(b)-7...............................................    1545-0015
                                                               1545-1612
20.2056A-2.................................................    1545-1443
20.2056A-3.................................................    1545-1360
20.2056A-4.................................................    1545-1360
20.2056A-10................................................    1545-1360
20.2106-1..................................................    1545-0015
20.2106-2..................................................    1545-0015
20.2204-1..................................................    1545-0015
20.2204-2..................................................    1545-0015
20.6001-1..................................................    1545-0015
20.6011-1..................................................    1545-0015
20.6018-1..................................................    1545-0015
                                                               1545-0531
20.6018-2..................................................    1545-0015
20.6018-3..................................................    1545-0015
20.6018-4..................................................    1545-0015
                                                               1545-0022
20.6036-2..................................................    1545-0015
20.6060-1(a)(1)............................................    1545-1231
20.6061-1..................................................    1545-0015
20.6065-1..................................................    1545-0015
20.6075-1..................................................    1545-0015

[[Page 841]]

 
20.6081-1..................................................    1545-0015
                                                               1545-0181
                                                               1545-1707
20.6091-1..................................................    1545-0015
20.6107-1..................................................    1545-1231
20.6161-1..................................................    1545-0015
                                                               1545-0181
20.6161-2..................................................    1545-0015
                                                               1545-0181
20.6163-1..................................................    1545-0015
20.6166-1..................................................    1545-0181
20.6166A-1.................................................    1545-0015
20.6166A-3.................................................    1545-0015
20.6324A-1.................................................    1545-0754
20.7520-1..................................................    1545-1343
20.7520-2..................................................    1545-1343
20.7520-3..................................................    1545-1343
20.7520-4..................................................    1545-1343
22.0.......................................................    1545-0015
25.2511-2..................................................    1545-0020
25.2512-2..................................................    1545-0020
25.2512-3..................................................    1545-0020
25.2512-5..................................................    1545-0020
25.2512-9..................................................    1545-0020
25.2513-1..................................................    1545-0020
25.2513-2..................................................    1545-0020
                                                               1545-0021
25.2513-3..................................................    1545-0020
25.2518-2..................................................    1545-0959
25.2522(a)-1...............................................    1545-0196
25.2522(c)-3...............................................    1545-0020
                                                               1545-0196
25.2523(a)-1...............................................    1545-0020
                                                               1545-0196
25.2523(f)-1...............................................    1545-0015
25.2701-2..................................................    1545-1241
25.2701-4..................................................    1545-1241
25.2701-5..................................................    1545-1273
25.2702-5..................................................    1545-1485
25.2702-6..................................................    1545-1273
25.6001-1..................................................    1545-0020
                                                               1545-0022
25.6011-1..................................................    1545-0020
25.6019-1..................................................    1545-0020
25.6019-2..................................................    1545-0020
25.6019-3..................................................    1545-0020
25.6019-4..................................................    1545-0020
25.6060-1(a)(1)............................................    1545-1231
25.6061-1..................................................    1545-0020
25.6065-1..................................................    1545-0020
25.6075-1..................................................    1545-0020
25.6081-1..................................................    1545-0020
25.6091-1..................................................    1545-0020
25.6091-2..................................................    1545-0020
25.6107-1..................................................    1545-1231
25.6151-1..................................................    1545-0020
25.6161-1..................................................    1545-0020
25.7520-1..................................................    1545-1343
25.7520-2..................................................    1545-1343
25.7520-3..................................................    1545-1343
25.7520-4..................................................    1545-1343
26.2601-1..................................................    1545-0985
26.2632-1..................................................    1545-0985
                                                               1545-1892
26.2642-1..................................................    1545-0985
26.2642-2..................................................    1545-0985
26.2642-3..................................................    1545-0985
26.2642-4..................................................    1545-0985
26.2642-6..................................................    1545-1902
26.2652-2..................................................    1545-0985
26.2654-1..................................................    1545-1902
26.2662-1..................................................    1545-0015
                                                               1545-0985
26.2662-2..................................................    1545-0985
26.6060-1(a)(1)............................................    1545-1231
26.6107-1..................................................    1545-1231
31.3102-3..................................................    1545-0029
                                                               1545-0059
                                                               1545-0065
31.3121(b)(19)-1...........................................    1545-0029
31.3121(d)-1...............................................    1545-0004
31.3121(i)-1...............................................    1545-0034
31.3121(k)-4...............................................    1545-0137
31.3121(r)-1...............................................    1545-0029
31.3121(s)-1...............................................    1545-0029
31.3121(v)(2)-1............................................    1545-1643
31.3302(a)-2...............................................    1545-0028
31.3302(a)-3...............................................    1545-0028
31.3302(b)-2...............................................    1545-0028
31.3302(e)-1...............................................    1545-0028
31.3306(c)(18)-1...........................................    1545-0029
31.3401(a)-1...............................................    1545-0029
31.3401(a)(6)..............................................    1545-1484
31.3401(a)(6)-1............................................    1545-0029
                                                               1545-0096
                                                               1545-0795
31.3401(a)(7)-1............................................    1545-0029
31.3401(a)(8)(A)-1 ........................................    1545-0029
                                                               1545-0666
31.3401(a)(8)(C)-1 ........................................    1545-0029
31.3401(a)(15)-1...........................................    1545-0182
31.3401(c)-1...............................................    1545-0004
31.3402(b)-1...............................................    1545-0010
31.3402(c)-1...............................................    1545-0010
31.3402(f)(1)-1............................................    1545-0010
31.3402(f)(2)-1............................................    1545-0010
                                                               1545-0410
31.3402(f)(3)-1............................................    1545-0010
31.3402(f)(4)-1............................................    1545-0010
31.3402(f)(4)-2............................................    1545-0010
31.3402(f)(5)-1............................................    1545-0010
                                                               1545-1435
31.3402(h)(1)-1............................................    1545-0029
31.3402(h)(3)-1............................................    1545-0010
                                                               1545-0029
31.3402(h)(4)-1............................................    1545-0010
31.3402(i)-(1).............................................    1545-0010
31.3402(i)-(2).............................................    1545-0010
31.3402(k)-1...............................................    1545-0065
31.3402(l)-(1).............................................    1545-0010
31.3402(m)-(1).............................................    1545-0010
31.3402(n)-(1).............................................    1545-0010
31.3402(o)-2...............................................    1545-0415
31.3402(o)-3...............................................    1545-0008
                                                               1545-0010
                                                               1545-0415
                                                               1545-0717
31.3402(p)-1...............................................    1545-0415
                                                               1545-0717
31.3402(q)-1...............................................    1545-0238
                                                               1545-0239
31.3404-1..................................................    1545-0029
31.3405(c)-1...............................................    1545-1341
31.3406(a)-1...............................................    1545-0112
31.3406(a)-2...............................................    1545-0112
31.3406(a)-3...............................................    1545-0112
31.3406(a)-4...............................................    1545-0112
31.3406(b)(2)-1............................................    1545-0112
31.3406(b)(2)-2............................................    1545-0112
31.3406(b)(2)-3............................................    1545-0112
31.3406(b)(2)-4............................................    1545-0112
31.3406(b)(2)-5............................................    1545-0112
31.3406(b)(3)-1............................................    1545-0112
31.3406(b)(3)-2............................................    1545-0112

[[Page 842]]

 
31.3406(b)(3)-3............................................    1545-0112
31.3406(b)(3)-4............................................    1545-0112
31.3406(b)(4)-1............................................    1545-0112
31.3406(c)-1...............................................    1545-0112
31.3406(d)-1...............................................    1545-0112
31.3406(d)-2...............................................    1545-0112
31.3406(d)-3...............................................    1545-0112
31.3406(d)-4...............................................    1545-0112
31.3406(d)-5...............................................    1545-0112
31.3406(e)-1...............................................    1545-0112
31.3406(f)-1...............................................    1545-0112
31.3406(g)-1...............................................    1545-0096
                                                               1545-0112
                                                               1545-1819
31.3406(g)-2...............................................    1545-0112
31.3406(g)-3...............................................    1545-0112
31.3406(h)-1...............................................    1545-0112
31.3406(h)-2...............................................    1545-0112
31.3406(h)-3...............................................    1545-0112
31.3406(i)-1...............................................    1545-0112
31.3501(a)-1T..............................................    1545-0771
31.3503-1..................................................    1545-0024
31.3504-1..................................................    1545-0029
31.6001-1..................................................    1545-0798
31.6001-2..................................................    1545-0034
                                                               1545-0798
31.6001-3..................................................    1545-0798
31.6001-4..................................................    1545-0028
31.6001-5..................................................    1545-0798
31.6001-6..................................................    1545-0029
                                                               1459-0798
31.6011(a)-1...............................................    1545-0029
                                                               1545-0034
                                                               1545-0035
                                                               1545-0059
                                                               1545-0074
                                                               1545-0256
                                                               1545-0718
                                                               1545-2097
31.6011(a)-2...............................................    1545-0001
                                                               1545-0002
31.6011(a)-3...............................................    1545-0028
31.6011(a)-3A..............................................    1545-0955
31.6011(a)-4...............................................    1545-0034
                                                               1545-0035
                                                               1545-0718
                                                               1545-1413
                                                               1545-2097
31.6011(a)-5...............................................    1545-0028
                                                               1545-0718
                                                               1545-2097
31.6011(a)-6...............................................    1545-0028
31.6011(a)-7...............................................    1545-0074
31.6011(a)-8...............................................    1545-0028
31.6011(a)-9...............................................    1545-0028
31.6011(a)-10..............................................    1545-0112
31.6011(b)-1...............................................    1545-0003
31.6011(b)-2...............................................    1545-0029
31.6051-1..................................................    1545-0008
                                                               1545-0182
                                                               1545-0458
                                                               1545-1729
31.6051-2..................................................    1545-0008
31.6051-3..................................................    1545-0008
31.6053-1..................................................    1545-0029
                                                               1545-0062
                                                               1545-0064
                                                               1545-0065
                                                               1545-1603
31.6053-2..................................................    1545-0008
31.6053-3..................................................    1545-0065
                                                               1545-0714
31.6053-4..................................................    1545-0065
                                                               1545-1603
31.6060-1(a)(1)............................................    1545-1231
31.6065(a)-1...............................................    1545-0029
31.6071(a)-1...............................................    1545-0001
                                                               1545-0028
                                                               1545-0029
31.6071(a)-1A..............................................    1545-0955
31.6081(a)-1...............................................    1545-0008
                                                               1545-0028
31.6091-1..................................................    1545-0028
                                                               1545-0029
31.6107-1..................................................    1545-1231
31.6157-1..................................................    1545-0955
31.6205-1..................................................    1545-0029
                                                               1545-2097
31.6301(c)-1AT.............................................    1545-0035
                                                               1545-0112
                                                               1545-0257
31.6302-1..................................................    1545-1413
31.6302-2..................................................    1545-1413
31.6302-3..................................................    1545-1413
31.6302-4..................................................    1545-1413
31.6302(c)-2...............................................    1545-0001
                                                               1545-0257
31.6302(c)-2A..............................................    1545-0955
31.6302(c)-3...............................................    1545-0257
31.6402(a)-2...............................................    1545-0256
                                                               1545-2097
31.6413(a)-1...............................................    1545-0029
                                                               1545-2097
31.6413(a)-2...............................................    1545-0029
                                                               1545-0256
                                                               1545-2097
31.6413(c)-1...............................................    1545-0029
                                                               1545-0171
31.6414-1..................................................    1545-0029
                                                               1545-2097
32.1.......................................................    1545-0029
                                                               1545-0415
32.2.......................................................    1545-0029
35a.3406-2.................................................    1545-0112
35a.9999-5.................................................    1545-0029
36.3121(l)(1)-1............................................    1545-0137
36.3121(l)(1)-2............................................    1545-0137
36.3121(l)(3)-1............................................    1545-0123
36.3121(1)(7)-1............................................    1545-0123
36.3121(1)(10)-1...........................................    1545-0029
36.3121(1)(10)-3...........................................    1545-0029
36.3121(1)(10)-4...........................................    1545-0257
40.6060-1(a)(1)............................................    1545-1231
40.6107-1..................................................    1545-1231
40.6302(c)-3(b)(2)(ii).....................................    1545-1296
40.6302(c)-3(b)(2)(iii)....................................    1545-1296
40.6302(c)-3(e)............................................    1545-1296
40.6302(c)-3(f)(2)(ii).....................................    1545-1296
41.4481-1..................................................    1545-0143
41.4481-2..................................................    1545-0143
41.4483-3..................................................    1545-0143
41.6001-1..................................................    1545-0143
41.6001-2..................................................    1545-0143
41.6001-3..................................................    1545-0143
41.6060-1(a)(1)............................................    1545-1231
41.6071(a)-1...............................................    1545-0143
41.6081(a)-1...............................................    1545-0143
41.6091-1..................................................    1545-0143
41.6107-1..................................................    1545-1231
41.6109-1..................................................    1545-0143
41.6151(a)-1...............................................    1545-0143
41.6156-1..................................................    1545-0143
41.6161(a)(1)-1............................................    1545-0143
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44.4403-1..................................................    1545-0235
44.4412-1..................................................    1545-0236
44.4901-1..................................................    1545-0236
44.4905-1..................................................    1545-0236
44.4905-2..................................................    1545-0236
44.6001-1..................................................    1545-0235
44.6011(a)-1...............................................    1545-0235
                                                               1545-0236
44.6060-1(a)(1)............................................    1545-1231
44.6071-1..................................................    1545-0235
44.6091-1..................................................    1545-0235
44.6107-1..................................................    1545-1231
44.6151-1..................................................    1545-0235
44.6419-1..................................................    1545-0235
44.6419-2..................................................    1545-0235
46.4371-4..................................................    1545-0023
46.4374-1..................................................    1545-0023
46.4375-1..................................................    1545-2238
46.4376-1..................................................    1545-2238
46.4701-1..................................................    1545-0023
                                                               1545-0257
48.4041-4..................................................    1545-0023
48.4041-5..................................................    1545-0023
48.4041-6..................................................    1545-0023
48.4041-7..................................................    1545-0023
48.4041-9..................................................    1545-0023
48.4041-10.................................................    1545-0023
48.4041-11.................................................    1545-0023
48.4041-12.................................................    1545-0023
48.4041-13.................................................    1545-0023
48.4041-18.................................................    1545-0023
48.4041-19.................................................    1545-0023
48.4041-20.................................................    1545-0023
48.4041-21.................................................    1545-1270
48.4042-2..................................................    1545-0023
48.4052-1..................................................    1545-1418
48.4061(a)-1...............................................    1545-0023
48.4061(a)-2...............................................    1545-0023
48.4061(b)-3...............................................    1545-0023
48.4064-1..................................................    1545-0014
                                                               1545-0242
48.4071-1..................................................    1545-0023
48.4073-1..................................................    1545-0023
48.4073-3..................................................    1545-0023
                                                               1545-1074
                                                               1545-1087
48.4081-2..................................................    1545-1270
                                                               1545-1418
48.4081-3..................................................    1545-1270
                                                               1545-1418
                                                               1545-1897
48.4081-4(b)(2)(ii)........................................    1545-1270
48.4081-4(b)(3)(i).........................................    1545-1270
48.4081-4(c)...............................................    1545-1270
48.4081-6(c)(1)(ii)........................................    1545-1270
48.4081-7..................................................    1545-1270
                                                               1545-1418
48.4082-1T.................................................    1545-1418
48.4082-2..................................................    1545-1418
48.4082-6..................................................    1545-1418
48.4082-7..................................................    1545-1418
48.4091-3..................................................    1545-1418
48.4101-1..................................................    1545-1418
48.4101-1T.................................................    1545-1418
48.4101-2..................................................    1545-1418
48.4161(a)-1...............................................    1545-0723
48.4161(a)-2...............................................    1545-0723
48.4161(a)-3...............................................    1545-0723
48.4161(b)-1...............................................    1545-0723
48.4216(a)-2...............................................    1545-0023
48.4216(a)-3...............................................    1545-0023
48.4216(c)-1...............................................    1545-0023
48.4221-1..................................................    1545-0023
48.4221-2..................................................    1545-0023
48.4221-3..................................................    1545-0023
48.4221-4..................................................    1545-0023
48.4221-5..................................................    1545-0023
48.4221-6..................................................    1545-0023
48.4221-7..................................................    1545-0023
48.4222(a)-1...............................................    1545-0014
                                                               1545-0023
48.4223-1..................................................    1545-0023
                                                               1545-0257
                                                               1545-0723
48.6302(c)-1...............................................    1545-0023
                                                               1545-0257
48.6412-1..................................................    1545-0723
48.6416(a)-1...............................................    1545-0023
                                                               1545-0723
48.6416(a)-2...............................................    1545-0723
48.6416(a)-3...............................................    1545-0723
48.6416(b)(1)-1............................................    1545-0723
48.6416(b)(1)-2............................................    1545-0723
48.6416(b)(1)-3............................................    1545-0723
48.6416(b)(1)-4............................................    1545-0723
48.6416(b)(2)-1............................................    1545-0723
48.6416(b)(2)-2............................................    1545-0723
48.6416(b)(2)-3............................................    1545-0723
                                                               1545-1087
48.6416(b)(2)-4............................................    1545-0723
48.6416(b)(3)-1............................................    1545-0723
48.6416(b)(3)-2............................................    1545-0723
48.6416(b)(3)-3............................................    1545-0723
48.6416(b)(4)-1............................................    1545-0723
48.6416(b)(5)-1............................................    1545-0723
48.6416(c)-1...............................................    1545-0723
48.6416(e)-1...............................................    1545-0023
                                                               1545-0723
48.6416(f)-1...............................................    1545-0023
                                                               1545-0723
48.6416(g)-1...............................................    1545-0723
48.6416(h)-1...............................................    1545-0723
48.6420(c)-2...............................................    1545-0023
48.6420(f)-1...............................................    1545-0023
48.6420-1..................................................    1545-0162
                                                               1545-0723
48.6420-2..................................................    1545-0162
                                                               1545-0723
48.6420-3..................................................    1545-0162
                                                               1545-0723
48.6420-4..................................................    1545-0162
                                                               1545-0723
48.6420-5..................................................    1545-0162
                                                               1545-0723
48.6420-6..................................................    1545-0162
                                                               1545-0723
48.6421-0..................................................    1545-0162
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48.6421-1..................................................    1545-0162
                                                               1545-0723
48.6421-2..................................................    1545-0162
                                                               1545-0723
48.6421-3..................................................    1545-0162
                                                               1545-0723
48.6421-4..................................................    1545-0162
                                                               1545-0723
48.6421-5..................................................    1545-0162
                                                               1545-0723
48.6421-6..................................................    1545-0162
                                                               1545-0723
48.6421-7..................................................    1545-0162
                                                               1545-0723
48.6424-0..................................................    1545-0723
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48.6424-2..................................................    1545-0723
48.6424-3..................................................    1545-0723
48.6424-4..................................................    1545-0723
48.6424-5..................................................    1545-0723
48.6424-6..................................................    1545-0723
48.6427-0..................................................    1545-0723
48.6427-1..................................................    1545-0023
                                                               1545-0162
                                                               1545-0723
48.6427-2..................................................    1545-0162
                                                               1545-0723
48.6427-3..................................................    1545-0723
48.6427-4..................................................    1545-0723
48.6427-5..................................................    1545-0723
48.6427-8..................................................    1545-1418
48.6427-9..................................................    1545-1418
48.6427-10.................................................    1545-1418
48.6427-11.................................................    1545-1418
49.4251-1..................................................    1545-1075
49.4251-2..................................................    1545-1075
49.4251-4(d)(2)............................................    1545-1628
49.4253-3..................................................    1545-0023
49.4253-4..................................................    1545-0023
49.4264(b)-1...............................................    1545-0023
                                                               1545-0224
                                                               1545-0225
                                                               1545-0226
                                                               1545-0230
                                                               1545-0257
                                                               1545-0912
49.4271-1(d)...............................................    1545-0685
49.5000B-1.................................................    1545-2177
51.2(f)(2)(ii).............................................    1545-2209
51.7.......................................................    1545-2209
52.4682-1(b)(2)(iii).......................................    1545-1153
52.4682-2(b)...............................................    1545-1153
                                                               1545-1361
52.4682-2(d)...............................................    1545-1153
                                                               1545-1361
52.4682-3(c)(2)............................................    1545-1153
52.4682-3(g)...............................................    1545-1153
52.4682-4(f)...............................................    1545-0257
                                                               1545-1153
52.4682-5(d)...............................................    1545-1361
52.4682-5(f)...............................................    1545-1361
53.4940-1..................................................    1545-0052
                                                               1545-0196
53.4942(a)-1...............................................    1545-0052
53.4942(a)-2...............................................    1545-0052
53.4942(a)-3...............................................    1545-0052
53.4942(b)-3...............................................    1545-0052
53.4945-1..................................................    1545-0052
53.4945-4..................................................    1545-0052
53.4945-5..................................................    1545-0052
53.4945-6..................................................    1545-0052
53.4947-1..................................................    1545-0196
53.4947-2..................................................    1545-0196
53.4948-1..................................................    1545-0052
53.4958-6..................................................    1545-1623
53.4961-2..................................................    1545-0024
53.4963-1..................................................    1545-0024
53.6001-1..................................................    1545-0052
53.6011-1..................................................    1545-0049
                                                               1545-0052
                                                               1545-0092
                                                               1545-0196
53.6060-1(a)(1)............................................    1545-1231
53.6065-1..................................................    1545-0052
53.6071-1..................................................    1545-0049
53.6081-1..................................................    1545-0066
                                                               1545-0148
53.6107-1..................................................    1545-1231
53.6161-1..................................................    1545-0575
54.4972-1..................................................    1545-0197
54.4975-7..................................................    1545-0575
54.4977-1T.................................................    1545-0771
54.4980B-6.................................................    1545-1581
54.4980B-7.................................................    1545-1581
54.4980B-8.................................................    1545-1581
54.4980F-1.................................................    1545-1780
54.4981A-1T................................................    1545-0203
54.6011-1..................................................    1545-0575
54.6011-1T.................................................    1545-0575
54.6060-1(a)(1)............................................    1545-1231
54.6107-1..................................................    1545-1231
54.9801-3..................................................    1545-1537
54.9801-4..................................................    1545-1537
54.9801-5..................................................    1545-1537
54.9801-6..................................................    1545-1537
54.9812-1T.................................................    1545-2165
54.9815-1251T..............................................    1545-2178
54.9815-2711T..............................................    1545-2179
54.9815-2712T..............................................    1545-2180
54.9815-2714T..............................................    1545-2172
54.9815-2715...............................................    1545-2229
54.9815-2719AT.............................................    1545-2181
54.9815-2719T..............................................    1545-2182
55.6001-1..................................................    1545-0123
55.6011-1..................................................    1545-0123
                                                               1545-0999
                                                               1545-1016
55.6060-1(a)(1)............................................    1545-1231
55.6061-1..................................................    1545-0999
55.6071-1..................................................    1545-0999
55.6107-1..................................................    1545-1231
56.4911-6..................................................    1545-0052
56.4911-7..................................................    1545-0052
56.4911-9..................................................    1545-0052
56.4911-10.................................................    1545-0052
56.6001-1..................................................    1545-1049
56.6011-1..................................................    1545-1049
56.6060-1(a)(1)............................................    1545-1231
56.6081-1..................................................    1545-1049
56.6107-1..................................................    1545-1231
56.6161-1..................................................    1545-0257
                                                               1545-1049
57.2(e)(2)(i)..............................................    1545-2249
145.4051-1.................................................    1545-0745
145.4052-1.................................................    1545-0120
                                                               1545-0745
                                                               1545-1076
145.4061-1.................................................    1545-0224
                                                               1545-0230
                                                               1545-0257
                                                               1545-0745
156.6001-1.................................................    1545-1049
156.6011-1.................................................    1545-1049
156.6060-1(a)(1)...........................................    1545-1231
156.6081-1.................................................    1545-1049
156.6107-1.................................................    1545-1231
156.6161-1.................................................    1545-1049
157.6001-1.................................................    1545-1824
157.6011-1.................................................    1545-1824
157.6060-1(a)(1)...........................................    1545-1231
157.6081-1.................................................    1545-1824
157.6107-1.................................................    1545-1231
157.6161-1.................................................    1545-1824
301.6011-2.................................................    1545-0225
                                                               1545-0350
                                                               1545-0387
                                                               1545-0441
                                                               1545-0957
301.6011(g)-1..............................................    1545-2079
301.6017-1.................................................    1545-0090

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301.6034-1.................................................    1545-0092
301.6035-1.................................................    1545-0123
301.6036-1.................................................    1545-0013
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301.6047-1.................................................    1545-0367
                                                               1545-0957
301.6056-1.................................................    1545-2251
301.6056-2.................................................    1545-2251
301.6057-1.................................................    1545-0710
301.6057-2.................................................    1545-0710
301.6058-1.................................................    1545-0710
301.6059-1.................................................    1545-0710
301.6103(c)-1..............................................    1545-1816
301.6103(n)-1..............................................    1545-1841
301.6103(p)(2)(B)-1........................................    1545-1757
301.6104(a)-1..............................................    1545-0495
301.6104(a)-5..............................................    1545-0056
301.6104(a)-6..............................................    1545-0056
301.6104(b)-1..............................................    1545-0094
                                                               1545-0742
301.6104(d)-1..............................................    1545-1655
301.6104(d)-2..............................................    1545-1655
301.6104(d)-3..............................................    1545-1655
301.6109-1.................................................    1545-0003
                                                               1545-0295
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                                                               1545-0387
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301.6109-3.................................................    1545-1564
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301.6110-5.................................................    1545-0074
301.6111-1T................................................    1545-0865
                                                               1545-0881
301.6111-2.................................................    1545-0865
                                                               1545-1687
301.6112-1.................................................    1545-0865
                                                               1545-1686
301.6112-1T................................................    1545-0865
                                                               1545-1686
301.6114-1.................................................    1545-1126
                                                               1545-1484
301.6222(a)-2..............................................    1545-0790
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301.6223(c)-1..............................................    1545-0790
301.6223(e)-2..............................................    1545-0790
301.6223(g)-1..............................................    1545-0790
301.6223(h)-1..............................................    1545-0790
301.6224(b)-1..............................................    1545-0790
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301.6224(c)-3..............................................    1545-0790
301.6227(c)-1..............................................    1545-0790
301.6227(d)-1..............................................    1545-0790
301.6229(b)-2..............................................    1545-0790
301.6230(b)-1..............................................    1545-0790
301.6230(e)-1..............................................    1545-0790
301.6231(a)(1)-1...........................................    1545-0790
301.6231(a)(7)-1...........................................    1545-0790
301.6231(c)-1..............................................    1545-0790
301.6231(c)-2..............................................    1545-0790
301.6241-1T................................................    1545-0130
301.6316-4.................................................    1545-0074
301.6316-5.................................................    1545-0074
301.6316-6.................................................    1545-0074
301.6316-7.................................................    1545-0029
301.6324A-1................................................    1545-0015
301.6361-1.................................................    1545-0024
                                                               1545-0074
301.6361-2.................................................    1545-0024
301.6361-3.................................................    1545-0074
301.6402-2.................................................    1545-0024
                                                               1545-0073
                                                               1545-0091
301.6402-3.................................................    1545-0055
                                                               1545-0073
                                                               1545-0091
                                                               1545-0132
                                                               1545-1484
301.6402-5.................................................    1545-0928
301.6404-1.................................................    1545-0024
301.6404-2T................................................    1545-0024
301.6404-3.................................................    1545-0024
301.6405-1.................................................    1545-0024
301.6501(c)-1..............................................    1545-1241
                                                               1545-1637
301.6501(d)-1..............................................    1545-0074
                                                               1545-0430
301.6501(o)-2..............................................    1545-0728
301.6511(d)-1..............................................    1545-0024
                                                               1545-0582
301.6511(d)-2..............................................    1545-0024
                                                               1545-0582
301.6511(d)-3..............................................    1545-0024
                                                               1545-0582
301.6652-2.................................................    1545-0092
301.6685-1.................................................    1545-0092
301.6689-1T................................................    1545-1056
301.6707-1T................................................    1545-0865
                                                               1545-0881
301.6708-1T................................................    1545-0865
301.6712-1.................................................    1545-1126
301.6723-1A(d).............................................    1545-0909
301.6903-1.................................................    1545-0013
                                                               1545-1783
301.6905-1.................................................    1545-0074
301.7001-1.................................................    1545-0123
301.7101-1.................................................    1545-1029
301.7207-1.................................................    1545-0092
301.7216-2.................................................    1545-0074
301.7216-2(o)..............................................    1545-1209
301.7425-3.................................................    1545-0854
301.7430-2(c)..............................................    1545-1356
301.7502-1.................................................    1545-1899
301.7507-8.................................................    1545-0123
301.7507-9.................................................    1545-0123
301.7513-1.................................................    1545-0429
301.7517-1.................................................    1545-0015
301.7605-1.................................................    1545-0795
301.7623-1.................................................    1545-0409
                                                               1545-1534
301.7654-1.................................................    1545-0803
301.7701-3.................................................    1545-1486
301.7701-4.................................................    1545-1465
301.7701-7.................................................    1545-1600
301.7701-16................................................    1545-0795
301.7701(b)-1..............................................    1545-0089
301.7701(b)-2..............................................    1545-0089
301.7701(b)-3..............................................    1545-0089
301.7701(b)-4..............................................    1545-0089
301.7701(b)-5..............................................    1545-0089
301.7701(b)-6..............................................    1545-0089
301.7701(b)-7..............................................    1545-0089
                                                               1545-1126
301.7701(b)-9..............................................    1545-0089
301.7805-1.................................................    1545-0805
301.9000-5.................................................    1545-1850
301.9001-1.................................................    1545-0220
301.9100-2.................................................    1545-1488
301.9100-3.................................................    1545-1488
301.9100-4T................................................    1545-0016

[[Page 846]]

 
                                                               1545-0042
                                                               1545-0074
                                                               1545-0129
                                                               1545-0172
                                                               1545-0619
301.9100-6T................................................    1545-0872
301.9100-7T................................................    1545-0982
301.9100-8.................................................    1545-1112
301.9100-11T...............................................    1545-0123
301.9100-12T...............................................    1545-0026
                                                               1545-0074
                                                               1545-0172
                                                               1545-1027
301.9100-14T...............................................    1545-0046
301.9100-15T...............................................    1545-0046
301.9100-16T...............................................    1545-0152
302.1-7....................................................    1545-0024
305.7701-1.................................................    1545-0823
305.7871-1.................................................    1545-0823
404.6048-1.................................................    1545-0160
420.0-1....................................................    1545-0710
Part 509...................................................    1545-0846
Part 513...................................................    1545-0834
Part 514...................................................    1545-0845
Part 521...................................................    1545-0848
601.104....................................................    1545-0233
601.105....................................................    1545-0091
601.201....................................................    1545-0019
                                                               1545-0819
601.204....................................................    1545-0152
601.401....................................................    1545-0257
601.504....................................................    1545-0150
601.601....................................................    1545-0800
601.602....................................................    1545-0295
                                                               1545-0387
                                                               1545-0957
601.702....................................................    1545-0429
------------------------------------------------------------------------


(26 U.S.C. 7805)

[T.D. 8011, 50 FR 10222, Mar. 14, 1985]

    Editorial Note: For Federal Register citations affecting Sec.  
602.101, see the List of CFR Sections Affected, which appears in the 
Finding Aids section of the printed volume and at www.fdsys.gov.

[[Page 847]]



List of CFR Sections Affected



All changes in this volume of the Code of Federal Regulations (CFR) that 
were made by documents published in the Federal Register since January 
1, 2011 are enumerated in the following list. Entries indicate the 
nature of the changes effected. Page numbers refer to Federal Register 
pages. The user should consult the entries for chapters, parts and 
subparts as well as sections for revisions.
For changes to this volume of the CFR prior to this listing, consult the 
annual edition of the monthly List of CFR Sections Affected (LSA). The 
LSA is available at www.fdsys.gov. For changes to this volume of the CFR 
prior to 2001, see the ``List of CFR Sections Affected, 1949-1963, 1964-
1972, 1973-1985, and 1986-2000'' published in 11 separate volumes. The 
``List of CFR Sections Affected 1986-2000'' is available at 
www.fdsys.gov.

                                  2011

26 CFR
                                                                   76 FR
                                                                    Page
Chapter I
1.932-1 (e)(1) correctly revised....................................4244
1.954-2 (c)(2)(ii), (v), (vi), (vii), (3) Example 6 and (i) 
        revised....................................................26180
1.954-2T Removed...................................................26181
1.954-3 (b)(1)(i)(c), (ii)(a), (c), (2)(i)(c), (ii)(a), (b), (e), 
        (4) introductory text, Example 3, (c) and (d) revised; 
        (b)(2)(ii)(d) removed; (b)(4) Examples 8 and 9 added.......78546
1.954-3T Removed...................................................78553
1.956-1 (e)(1) amended; (e)(5) and (6) revised; (f) removed........36994
1.956-1T (e)(6) removed; (f) revised...............................36995
1.956-2 (b)(1)(vi) and (e) revised.................................26181
1.956-2T (b)(1)(vi) and (e) removed................................26181

                                  2012

26 CFR
                                                                   77 FR
                                                                    Page
Chapter I
1.909-0T Added......................................................8135
1.909-1T Added......................................................8136
1.909-2T Added......................................................8136
1.909-3T Added......................................................8136
1.909-4T Added......................................................8136
1.909-5T Added......................................................8136
1.909-6T Added......................................................8136
1.956-2 (b)(1)(xi) added...........................................27614
1.956-2T (a) through (d)(1) revised; (f) and (g) added.............27614
1.988-5 (a)(6)(ii) revised; (a)(9)(iv) Example 11 added............54809
1.988-5T Added.....................................................54810
    (i) corrected..................................................57013

                                2013	2014

                       (No regulations published)

                                  2015

26 CFR
                                                                   80 FR
                                                                    Page
Chapter I
1.909-0 Added.......................................................7327
1.909-0T Removed....................................................7328
1.909-1 Added.......................................................7328
1.909-1T Removed....................................................7328
1.909-2 Added.......................................................7328
1.909-2T Removed....................................................7332
1.909-3 Added.......................................................7332
1.909-3T Removed....................................................7332
1.909-4 Added.......................................................7332
1.909-4T Removed....................................................7332
1.909-5 Added.......................................................7332
1.909-5T Removed....................................................7332
1.909-6 Added.......................................................7332
1.909-6T Removed....................................................7336

[[Page 848]]

1.954-2 (c)(1)(i), (iv), (2)(ii), (d)(1)(i), (ii) and (2)(ii) 
        revised; (c)(2)(iii)(E), (viii), (d)(2)(iii)(E), (v) and 
        (j) added..................................................52979
1.954-2T Added.....................................................52980
    (a)(1) through (c)(1) introductory text, (c)(2)(iii) 
introductory text through (D), (3), (d)(1) introductory text and 
(2)(iii) introductory text through (D) correctly revised; (j) 
correctly amended..................................................66416
1.956-1 (b)(4), (5), (f), (g)(1), (2) and (3) added; (e)(6)(vii) 
        redesignated as (g)(4) and revised.........................52981
    (g) introductory text through (3) correctly revised............66416
1.956-1T (b)(4) revised; (b)(5), (e)(6), (g) and (h) added.........52981
    (b)(4)(ii) and (g)(1) correctly revised; (b)(4)(iv) Example 1 
and Example 3 correctly amended....................................66416
1.956-2T (b)(1)(xi), (f) and (g) revised...........................26442
1.988-5 (a)(6)(ii) and (9)(iv) Example 11 added; (a)(10)(iv) 
        revised....................................................53733
    (a)(9)(iv) Examples 4 and 5 amended............................53735
1.988-5T Removed...................................................53735

                                  2016

   (Regulations published from January 1, 2016, through April 1, 2016)

26 CFR
                                                                   81 FR
                                                                    Page
Chapter I
1.955A-3 (e) heading revised; CFR correction.......................18749


                                  [all]